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generate a image, in drawing/sketch mode, of some who just wasted 10 years of his/her life.

Welcome back, Fluenteers! 👋🏻

No one subscribes to content on asset allocation, and I know that since I can see which emails are opened, forwarded, or screenshots and shared on X.

It’s the ones with a company name in the subject line that attract people, for example, the Nordic industrial company no one has tried to model, or the European compounder trading at 14x earnings and at the same time quietly gaining market share from a competitor who is still issuing press releases about synergies.

The part I find enjoyable is writing about such companies. That’s exactly why I began and is the reason why I don’t intend to stop.

However, after having carried out this activity for years, I have come across a situation which I continually try to reason myself out of, but without ever managing to do so.

Looking back on the things that actually had the greatest effect on my results, I found that the particular choices were less important than I had hoped.

I had hoped they would be very important, but mostly it was the amount of money that was initially invested and whether I had the self-control to keep it there while the world carried on each year that made the difference.

That’s the key point.

To be honest, that’s the main thing that this article is about, and you could leave it there and still understand the point.

You begin by purchasing the bank, since you have an account with them and frequently see their branch, it seems genuine. Next, you choose the telecommunication company whose logo appears on your monthly phone bill. Later on, you buy a company that keeps showing up in financial news, because it makes sense: if it’s being talked about a lot, there must be some good news happening.

The European style was the one I chose for my first portfolio rather than an American one; at the time that seemed sophisticated, but in fact it was merely the same error presented in a different way.

To be honest, the only thing I really owned was a number of companies that I knew well. That was my sole criterion. I carried out just enough work with spreadsheets to persuade myself that it was research, but now I believe that’s in fact worse than doing nothing at all. You end up with a figure to quote when someone asks you why you own something, even though it has very little significance. Yet it still seems as though you’ve achieved something.

It is known as home bias, and all investors possess some form of it. For example, Dutch investors buy Dutch banks, Australians tend to buy miners, and Americans go for the companies that were featured on CNBC that week. As a result, you end up with only a small part of the world’s investment opportunities, concentrating on a few items which all move for the same reasons and without really considering how they fit together as a portfolio rather than simply as a list.

It wasn’t until after many years, indeed years, that I really came to understand the fact that press coverage is an outcome, not a basic element. Allow me to make it clear: a company can end up in the news because there’s something about to happen that will not benefit you as a shareholder. For example, there could be a takeover rumor, which would reduce your potential gains, or a regulator might be looking into the matter, or someone may have issued a brief report, and as a result everyone is now discussing it. The news coverage comes about as a result of the event; it doesn’t indicate any quality, merely that something has taken place. This kind of situation may seem the same when you’re young and full of enthusiasm, but it doesn’t.

The newspaper has no screening function; I regarded it as one for nearly a year, perhaps even longer if I am honest.

I won’t look down on beginner portfolios since actually getting started is truly the hardest thing, and most people never manage to move beyond just considering it, they read about investing for years without ever carrying out any of it. If wanting to buy your own bank is the way of getting started, then by all means do so, and I’ll be honest in congratulating you.

Only ensure that you are posing the correct question; it should be “what do I really want to own, given what I am aiming to achieve?” not “what should I buy?” Very few people ask that second question, and I didn’t ask it either for years.

I’ve been watching this argument for years and don’t believe it has generated a single useful idea for anyone who isn’t selling something.

It can’t really be called a war when you look at it properly; it’s just a series of events that took place in turn. The first step was to pool funds, a process that was both costly and difficult to enter and which was mainly accessible to people who already had money, just as is the case with most financial initiatives. Then access was extended. After that, passive investing appeared and carried out precisely what it had promised, offering market returns for almost nothing and earning every single euro that was invested, and I need to be absolutely clear about that.

People then began to ask the obvious next question, namely that if you really want to outperform the index you have to know something about what’s in it; you need an opinion on sectors, on different geographical areas, and on where the dispersion is located and why it is located there. That is a real job involving real work. As to whether it’s worth paying someone to carry out this task depends completely on who that person is and on what the market is doing at the time, which is a dull answer but also the right one.

The two statements are true at the same time: the passive approach is the cheapest method of owning a market, while the active one is the way of expressing an opinion about it. As for the people who are viewing this in a religious manner, I should bet that they are mainly defending a product rather than constructing a portfolio.

In my view, I’m going to sound a bit simple here, but please carry on with me; think of it as a house. The passive part is the slab: cheap, dull, nobody pays any attention to it, and it supports all the other parts. The active part is the kitchen that you actually chose. Combining both of them also reduces your total cost, a point which at first looks like a minor detail but ends up being a significant amount after twenty years. I wouldn’t bother working out the figures here because it all depends so much on the assumptions about your fee that it would be rather meaningless, so just accept the general trend.

There is also a debate about regimes involved in all this. In the decade following the financial crisis, there was easy access to money, virtually no volatility and almost no difference in outcomes between winners and losers, so all the things went up together in a sort of hand-in-hand fashion, and passive investing took full advantage of the situation. And it should have, since that was the appropriate environment for it.

Look around you now. Volatility is back, the headlines are more serious, and I don’t see any central bank willing to go back to zero. That means dispersion is making a comeback, and it is in this kind of environment that selection finally begins to pay off, or at least is able to do so. The market continues to rise over time, which is down to your slab working quietly in the background. The road is just in a much worse condition now, and that’s precisely why I’m here.

I can tell that your eyes have already grown, and frankly I would have reacted the same way three years ago, so I’m not going to judge.

I specialize in compounding. To me, fixed income has always seemed like a tax on ambition, something that people enter into only after they’ve already succeeded and are primarily just trying to avoid losing what they’ve got. However, when I actually sat down and considered how large the market is, I felt a bit foolish, since the global bond market is somewhere about $145 trillion, or so, as against global equities, which are roughly $125 trillion. And a typical broad global equity index includes about two thousand companies. The bond market holds individual securities by orders of magnitude more than that; I’ve heard a number of different figures mentioned, so I won’t claim any precision that I don’t actually have, but the main point stands: the asset class that we all overlook without giving it a thought is the larger of the two.

We’re leaving it alone since nothing exciting ever takes place over there, and your potential gain is limited by both spread compression and by the coupon you’re receiving; in fact, for most of the previous decade that coupon was a rather disrespectful amount.

That has changed, though, and I believe that not enough people have actually kept up with it, which is one of the reasons why I’m writing this section. Yields have returned to a level at which fixed income performs three separate functions. It provides you with income regardless of whether or not the market cooperates that year, a feature which is more valuable psychologically than it appears on a spreadsheet. It makes an appropriate contribution to total return, with capital gains being available in addition if yields from here on in end up falling. And it acts differently from your equities at the precise moment when things go wrong, which, if we are being honest with one another, is the only moment at which that third attribute has ever really been important to anyone.

When a person is twenty-four and tells me that he is going to have a hundred per cent equities since he has forty years ahead of him, I don’t try to persuade him to be more conservative. I would have said the same thing when I was twenty-four, with much greater confidence and a lot less evidence. All I do is ask whether an allocation of eighty per cent to equities with five per cent held back might cope a bit better with a reality check. And yes, I am aware that the stock-bond correlation has been put to a pretty severe test in recent years, since people mention it all the time. Over a proper holding period, the two should still offset each other sufficiently to reduce some of the impact of what’s coming next.

The one thing I’ve learned in the unpleasant way, that is, by going through it myself, is that a portfolio with a focus on growth is one that has higher volatility, and a portfolio with higher volatility requires you to keep it for a longer period of time than the length of time you originally decided on in your own mind. Diversification and time are the only two factors that reduce volatility, which is essentially all they achieve, and neither of these helps if you keep disrupting them. This is roughly what everyone does, including myself, on a fairly regular basis.

Just a brief detour here since this point is somewhat overlooked and I don’t have enough to say to fill an entire article on it.

The property, the REITs, and the infrastructure projects are all ones that nearly all of the self-directed investors that I know leave out. Although they do provide income, which is the typical argument made, the more valuable aspect that they offer is that they have different underlying drivers. The factors that determine a rent roll are not the same as those that determine a software gross margin, so even in the cases where they overlap with your equities, they won’t move in sync with each other, and including them tends to lower the overall correlation of the portfolio.

They are kept in much the same drawer. They produce income directly from your equity position and work most effectively when volatility is high and option premiums are large, which is why they complement bond income rather than replacing it. In fact, it is one of perhaps only three tools in all this business that improves as conditions deteriorate, and that fact alone means it’s worth understanding even if you never actually use it.

If you get rid of the consultant jargon, there are two terms that matter: strategic and tactical.

Strategic asset allocation refers to the method of combining different assets in order to achieve a particular goal over a long time horizon, and institutions generally base it on a time frame of about ten to fifteen years. You set out your objective in the form of a figure. You then input the long-term assumptions regarding return, volatility, and correlation. The resulting mixture is obtained at the other end of the process. That is roughly the way it works, although there is obviously a great deal of discussion within it.

Nothing in all this is unusual, a point which I would like to emphasize. Each year the biggest firms produce their long-term capital market assumptions, extending them across hundreds of asset classes and dozens of currencies, the figures having been developed by large teams over thousands of hours. Pension funds take these figures, feed them into their own models, and then use them to work out how they will be paying people in 2050. It is probably the dullest document produced in the finance industry every year, and at the same time one of the most quietly useful, and the document is available free of charge, even though no one appears to find this suspicious.

The fact that the strategic layer ends up having such a big influence on your results is simply due to the time frame: ten to fifteen years is a period long enough for compounding to have a noticeable effect, and it causes you to think in structural terms rather than just reacting to what has happened this week. Moreover, it gets rid of a whole category of mistakes since you can’t attempt to time a market that you weren’t originally trying to time.

Tactical is built on that system and operates on a much shorter time limit; that’s the arrangement that I use the majority of the week, and I’m going to be clear about it being the smaller lever. I’ll deal with that later.

The objection is clear, and I have put it forward myself, out loud, perhaps even directly to some of you: how can it possibly be more important to fill buckets than to find five tenbaggers?

There were two answers; the second one bit a little when I worked it out.

The only reason is the difficulty involved. There are indeed some people who actually do catch every multi-bagger that appears on their screen, and I have come across one or two of them, and they are real. Most people don’t, and this group of most people consists of full-time professionals who have research teams and terminals and have absolutely nothing else to do throughout the day. Wealth is built up through the combined effect of a series of reasonable decisions made over a very long period of time, and this is a much lower standard than requiring genius yet a considerably more difficult one than it may appear, since the difficult aspect lies in the repetition rather than in the decisions themselves.

The reason is that the majority of the gain in my returns has been due to simply not making mistakes, rather than because I’ve been particularly clever. And my mistakes have always been emotional in character; they always occur at the very moment when the market is making the loudest noises, which is of course also the moment when my decisions count the most, and that seems a terribly unfair arrangement to think about. It turns out that a stable allocation acts as a kind of built-in safeguard against my own most detrimental instincts; none of the other things I’ve tried have worked with anything like the same reliability, and I have in fact tried a number of them, such as keeping a journal, setting rules, and introducing cooling-off periods, among other things.

By the way, that doesn’t mean you should not be tactical. You should keep making small adjustments all the time. Such tweaks may help you, or they may harm you; it’s just not the factor that determines how things turn out.

If you want to take just one practical point from all of this, then take these three.

The first thing to do is to state your objective in numerical terms, whether it’s growth, income, or a combination of the two, since all the subsequent decisions depend on that answer and you can’t work backward from a general feeling. Saying “as much as possible” expresses a desire rather than setting out an objective, and it won’t survive its first poor quarter.

Second, what really is available to you? Are you limited to listed markets and funds, or is it possible to go beyond that? The options presented in your menu determine what you can achieve. If you set a goal that lies outside the scope of what your opportunity set can finance, you’ll gradually and boringly end up disappointing yourself over a ten-year period.

Third, and this is the real issue, how much drawdown can you tolerate without taking any action? Ten percent? Thirty? This is the area where people most confidently deceive themselves, and I must certainly include myself in that group. Since you can’t expect high growth and at the same time refuse to see your portfolio decline, these two things are in fact just two ways of looking at the same thing, and the key part of the job really consists in working out where you truly stand on that spectrum.

The asset classes will then take care of themselves. If you’re after growth, go for something such as high-yield credit, since it involves equity-like volatility but also gives you a bit of diversification away from the risks of pure equities. If you need stability, core government bonds are once again paying a real coupon and will provide capital gains should yields fall, though it won’t do much to boost returns, instead, it will give you a floor, and floors are overlooked. Although no one has ever been pleased to have a floor, everyone has been thankful when they’ve had one.

Two things I’ve noticed after observing people, myself being one of them. All of them think that they have a high risk tolerance until the first Monday that the market drops three per cent, and then they check the market at eleven o’clock at night. And almost everybody greatly overestimates the level of liquidity that they need, since in reality you’ll almost never have to sell off your entire portfolio, the only scenario in which you would do so being if something really terrible occurred in your life. Instead, plan for the actual liquidity you need rather than for the ones that are merely imagined.

As for originality, there’s no credit given in the allocation process at all. The large institutional model portfolios make their weights public knowledge. So, select one to use as a starting point and then gain the right to differ from it later on.

I was genuinely surprised by this one when I came across it.

During a recent period in which equities and almost everything else became considerably more expensive, the long-run expected return on a simple 60/40 portfolio did not deteriorate. Isn’t that odd? When you pay more for something, you usually get less back in return. That’s about as solid a rule as this field has, and yet it didn’t apply in this case.

Two factors cancel it out, as far as I can judge. With regard to equity, expectations of long-run fair value have improved together with earning potential, due to structural positive trends in fiscal spending and in the adoption of technology. As for bonds, since inflation has remained sticky, policy rates won’t be returning to zero for some time to come, and among the people who actually ran quantitative easing, only a very small number still support it, so you end up with more normalized rates, better coupons, and also some optionality should yields eventually drop.

The conclusion I draw from that is not as broad as it may appear. Expensive markets do reduce your margin for error, and that is genuine and something that should be respected, and I’m not ignoring it. They simply don’t, all by themselves, make the next ten years a bad time to own things.

A lot of people do it, and it’s a good approach, so I’d like to make that point clear before I begin to examine it. You should have two or three inexpensive global index funds as your main holdings, paying into them each month on a dollar-cost average basis, and then add in a number of individual stocks that you actually care about and that you follow properly.

The first thing to check would be whether your fund covers both equities and fixed income, or whether it’s just three equity funds using diversification as a front. If all the funds in it follow a stock index, then yes, you do have genuine geographic diversification, something that’s worthwhile and which most people don’t have. You also have one type of exposure appearing three times, and in a poor month you’ll feel every basis point of it, leading to confusion since it will seem as though your diversification has failed even though it wasn’t there all along.

The result of having a fuller core is that it provides a second layer beneath the first. It involves bonds which react differently when breaks occur, genuine assets that reduce your overall correlation, income components that pay you when there is volatility rather than merely charging you for it, and you are able to hedge the risks that you already know about as well as having to diversify against all the rest, since there is a great deal of all the rest currently available.

Then go ahead and run the satellite on that, that’s the area where the Nordic industrials are based. That’s the part that attracts my interest and likely also yours, and that’s all right since it’s the enjoyable aspect. Simply pour the slab first.

I have reached the age of twenty-eight, and, after years of doing this, I still spend the vast majority of my week on the aspect that is of least importance.

I realize the way that might sound, and I don’t think I’d alter my position because it’s the research that I enjoy, and it’s precisely because I enjoy it that I’ve been able to stay in this situation long enough for anything to build up in the first place; that situation in itself constitutes an argument in favour of carrying out the enjoyable part even if it’s not the most efficient. It could be motivated reasoning; it’s probably a mixture of both.

I have just stopped mixing up the part that I enjoy with the part that actually works.

Therefore, work out what you would like and what you are able to endure, construct the allocation that brings those two together, and then go out and look for good businesses, aware that there is a solid foundation beneath you throughout the process. It would be nice if all your positions doubled within a year. That isn’t the thing to do. The thing to do is to be patient with something that you have deliberately chosen and to let time take care of the aspects which you never intended to look after yourself.

You only own what you already knew.
The bank that you use, the telecommunication company listed on your phone bill, and the name that continually appears in the news- solution: select a published portfolio of an institutional model, begin with the proportions set out in that portfolio, and then have the right to make deviations later on.
You’re using the newspaper as a screen.
Coverage is an outcome since it indicates that something has taken place, something which could be a takeover rumor limiting your potential gains or a regulator carrying out an inspection. The solution is to alter the question: instead of asking what you should buy, ask yourself what you actually want to own in view of your true objectives.
The core that you have described as diversified consists of three equity funds.
There is a genuine geographic diversification, yet there’s also the case of one exposure appearing three times, something you’ll notice in every basis point during a poor month. The solution is to verify that nothing in your core portfolio is of an equity type; if nothing is, then that is your gap.
You have written off fixed income.
This is the larger asset class, and yet almost no one here gives it any attention. The solution is that yields now carry out three functions again: they provide income regardless of whether the market cooperates, they make a real contribution to total return, and they exhibit different behavior at the very moment when things go wrong. Even a five per cent holdback makes a bad quarter feel different.
The thing you are aiming for remains a feeling.
“As much as possible” is merely a wish and will fail in its first quarter. The solution is to note down the number and state whether you want growth, income, or a combination of the two.
You have never genuinely considered how much of a drawdown you can tolerate.
Most people find this out at eleven o’clock on a Monday night, ten percent or thirty percent. The solution is to choose the number yourself before the market does so, and to realize that wanting high growth and refusing to take any losses is the same question being asked twice.
You devote the entire week to the satellite.
It’s guilty, obviously; that’s basically what I do. The solution is to pour the slab first, then go looking for Nordic industrials with a solid foundation underneath you.

What part of this article spoke the most to you, or what are you taking away from this? Let me know in the comments.

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