Over the last few days, I’ve been looking at ideas about portfolio construction and the obvious risks of investing in stock markets. Today I want to finish off by drawing on the research I’ve cited, plus the work of academics at the London Business School. My aim? To draw up some practical suggestions for robust portfolio construction.
Here are my seven ideas, many of which are blindingly obvious but worth restating for the umpteenth time.
- Diversify between bonds and equities.
- Within bonds diversify between those that will protect you in an inflationary environment (inflation-linked bonds) and their more conventional siblings. Crucially also diversify your durations (invest in short and long-dated) and credit risk (low-risk governments and higher risk corporate)
- Within equities, those investors willing to stick with equities over the long term should consider investing in certain riskier types of shares – small caps – as well as value stocks and momentum based strategies
- Gold is a useful diversifier and a sensible way of ensuring against sudden increases in volatility but over the very long term, it hasn’t been a great investment – both bonds and equities have easily outpaced returns from gold over the last hundred years, although gold has had a very impressive last decade.
- Investors worried about a sudden increase in inflation should probably weight their portfolios towards gold, inflation-linked bonds, and equities. Those investors worried by deflation are probably best off in government bonds.
- Currency is a risk for investors over the short to medium term but markets usually correct over the long term. Higher inflation rates (produced by faster GDP growth) usually results in a weaker exchange rate, so investors ‘real’ exposure should balance out i.e what they gain on inflation, they lose via currency depreciation. Hedging your equity exposure does make some sense over the short to medium term but is difficult to achieve cost-effectively over the longer term and of dubious benefit. This implies that international diversification is still useful and that investors shouldn’t overly worry about currency risk.
- All of these investing truths are hugely impacted by your time horizon and can vary between decades – for instance, the last decade has been awful for equities but very positive for bonds and gold. That may change in the next decade but over the very long term, if you are willing to sit tight for 20 to 40 years, taking greater risk through equities could well make sense. Investors with a shorter term time horizon might be less suited to equities and should carefully consider their exposure to interest rates, capital losses, and inflation.