How to do asset allocation in 5 minutes

Asset allocation is incredibly important. Fans of the Efficient Market Hypothesis and Modern Portfolio Theory think that it’s responsible for most of the risks and rewards of your portfolio, and I’m inclined to agree.

But just because it’s important doesn’t mean it’s going to take ages to do or require a rocket scientist to help out.

You might think that five minutes to make your asset allocation decisions is not enough, but I’m going to cheat and give you five different ways to set your asset allocation in just one minute each.

Your first minute – Check out Nutmeg

If you don’t like picking stocks and you don’t like to think about asset allocation at all (shame on you!), then you could do worse than head over to Nutmeg and see what they have to offer. (okay, so it might take fractionally over a minute).

Nutmeg does exactly what I was after a decade ago, which is to use the Efficient Market Hypothesis and Modern Portfolio Theory (which basically means they use a passive indexing approach) as well as questions about your risk aversion and goals to do your asset allocation for you.

I think there’s going to be a mini-revolution for passive investors in the next few years, and it is very overdue. Expect your bank to be offering this sort of stuff in a few short years.

Your second minute – Check out InvestorBee

If you’re a little more hands-on and you actually want to pick funds yourself that will give you the right sort of asset allocation for your circumstances, then check out InvestorBee.

This isn’t a money manager like Nutmeg. Instead, they build up a profile of what the ‘average’ investor is invested in and what returns they actually get. This ‘average’ is then broken down into various risk categories, like low, low-medium, medium risk etc.

InvestorBee then gives you a report on what the ‘average’ investor with your risk profile is invested in. So it might be something like 20% global equities, 40% UK equities, 30% bonds and 10% cash. It then gives you a range of investment funds to pick from that match that asset allocation.

So InvestorBee is more active than Nutmeg but still pretty passive.

Your third minute – Do it yourself with the glide path

So much for letting someone else make the decisions or doing what the ‘average’ investor does; let’s try the manual approach.

First, we’ll just stick to stocks and bonds because I don’t want to complicate it with considerations of cash, gold, other commodities, foreign stocks, property and who knows what else. Stocks and bonds are simple, and I like simple.

In this case, the most important consideration for equity investors is timescale; how long are you expecting to be invested in equities? Is it for the rest of your days, or are you investing for a child’s education or perhaps an annuity?

This is important because equities are risky in that the value tomorrow or next year is uncertain, so if you’re investing in order to turn that investment back into a cash lump sum at some point, then you probably want to know how much that investment is going to be worth, and the closer you get to the cash-in date the more certainty you’ll probably want to have.

The glide path is an elegantly named strategy for getting out of equities and into less-risky and non-risky assets as you approach the cash-in date. Do a Google search, and you’ll find lots of info on glide path strategies, like having 100 minus your age in equities.

That 100 minus your age strategy has the cash-in date set to be your 100th birthday, so it seems to be most appropriate as a way to reduce uncertainty in the money your relatives will inherit upon your death. This is fine, but other investors may want to get out of equities long before that.

Here’s one way to do it which is quite simple, because simple systems are more likely to be followed and used and what good is a system if you don’t use it?

First of all, work out the cash-in date. If there isn’t one and the investments are for income, then other factors are important instead, like stability of income rather than a stable capital value. But if you do have a cash-in date, then here’s a simple way to reduce risk as you close in on that date.

Just work your way backwards from the cash-in date, and for every year you go back, allow a 10% allocation to equities. So, for example, if your cash-in date was 2020, then today, you’d have a maximum allocation to equities of 80%. Next year when you rebalance between stocks and bonds, you’d re-set to 70% stocks at most. So by the time you get within the last few years before cashing in, you’ll only have 20-30% in equities, which is unlikely to have any significant impact on the portfolio. If the remaining 80% or so of the portfolio is in a high-yield, non-volatile investment like cash or bonds held to maturity, then the income should more or less negate any chance of a loss in those last few years.

That way, it’s much easier to know how much you’re going to get on the cash-in date than if you’d have been, say, 60% in equities in 1999, only to see your equity portion fall by 50% by 2003. If you were retiring in 2003, you’d be down anything up to 30% from where you thought you were going to be, which is not good.

Your fourth minute – Do it yourself by understanding your risk profile

Both Nutmeg and InvestorBee provide some simple and sophisticated tools for measuring your risk profile. This is important because if your investments fall so much that you’re scared into selling at the bottom, the net result is that you’re quite likely to miss your investment goals. Selling at the bottom is about the worst thing an investor can do.

You can try Nutmeg and InvestorBee and see how your risk profile turns out, but the problem with that is that you’re measuring your risk tolerance at a single point in time, and although your actual risk tolerance may be quite stable, your perception of it changes radically under different circumstances.

In other words, sitting comfortably at your desk on a sunny day, you might think that you can ride out a 30% decline in your portfolio, but when the media are screaming every day that Lemans/Northern Rock/Greece or the whole world is about to end, and at the same time the market is down 30% and looks like it’s going to keep moving down to zero – only then do you find out that in reality you’ll panic and sell into cash in a terrified sweat and miss the market’s 50% rebound over the next two years.

So during this minute, you need to do some play-acting. My starting assumption is that the market can go down 50% in the short term, say a year or three. Sometimes it can go down a lot more, but 50% is a typical big bear move and an easy-to-work-with figure.

Now you have to imagine that it’s 2008 all over again. At what point are you tempted to blow your investment plans and jump into the ‘safety’ of cash? Is it when you’re down 20%? Or 40%? Or are you utterly certain that you could ride out 50% declines and more, even when your other half is begging you to sell?  It’s no good just going through the motions; you have to do the method actor bit and try to feel the fear that most of us felt in 2008 (and which many investors still feel today).

Okay, so now you have a number. Now it’s a simple case of reducing your maximum equity allocation by replacing it with bonds (or something else that’s un-correlated) until your expected bear market loss is less than your ‘throw in the towel’ limit. So if you can only take a 30% loss, then you shouldn’t have more than 60% in equities at any time (a 50% fall in a 60% holding is a 30% decline in the whole portfolio).

The fifth and final minute – Do it yourself by understanding the market cycle

This final minute is for those who like to play the market timing game. Market timers typically want to get into whatever looks like the best ‘value’ at any given time, so they move from stocks to bonds to property or wherever they see value. It’s a very sensible approach but is also very difficult and requires quite a wide and deep knowledge base.

Sticking to a nice simple strategy once again, here’s an approach to market timing which just moves between stocks and bonds and is more of an active asset allocation system.

I’ve written about this market timing system several times before, so I’ll be brief. Basically, it is possible to say something about future returns from the stock market other than just quoting long-run average returns as academics tend to.

In the efficient market approach, future returns are unknowable, other than to assume that they’ll be the same as the historic average in the long term. This is a good starting point, but by ‘long-term’, they mean over 50 to 100 years. In time periods that are closer to the average investor timeframe of 30 years, the market’s level has a huge impact on future returns.

Put very simply, it was possible to see that the early 1980s was a great time to buy equities and that 1999 was a terrible time. It was also possible to see that 2003 was better than 1999 and that 2009 was better still.

By simply taking the ratio between the current market level and its 10-year average real earnings and comparing that to the long-term average of that ratio, you can see when the market has high-risk and low-return prospects or low-risk and high-return prospects.

A hint is that the long-term average of that ratio is probably somewhere between 12.5 and 15, depending on who you ask, and that currently, the ratio is 11.4 (with the FTSE 100 at 5,300).

Given that the ratio is below average, this implies that downside risks may be less than usual over the next few years, while the potential for gains in the next bull market is higher than usual. Plus, a higher dividend yield is a handy wind at the back.

The last step is to take that knowledge and turn it into a system which increases equity allocation as the market gets cheaper and vice versa.

Unfortunately, creating such a system does take quite a bit of work to put together, but once all the data is in place, it only takes a minute to calculate the asset allocations.  A more casual approach is just to note that the ratio is above or below its average and then to be more or less bullish, depending on where it is.

So there you go; five minutes and five ways to work out your asset allocation for the year, for everyone from passive indexers to seasoned stock pickers.