My battle with sorting out my asset allocation is still in full swing. Part 1 saw me getting over involved with the theory with little thought for practical implications. Part 2, after some very helpful comments, witnessed an excellent flanking manoeuvre from myself in the form of a simplification of my approach.
The various pots
What I was inadvertently struggling with at the beginning was the different pots of money.
For me there are three fairly distinct ones;
Pot 1 – the pot of stability – “Emergency Cash” Fund
Pot 2 – the freedom pot – The freedom fund
Pot 3 – the long term pot – Company pension scheme
Each of these have different uses and timeframes, and so should have different risk considerations.
Pot 1 basically just needs to be liquid, any return on this is a bonus. It will come into it’s forte in times of stress, for example work figuring out that I have plans for Financial Independence and helping me out the door or when we get round to getting someone to fix our leaky roof. Hence it is sitting in cash.
Pot 2 should be the seamless bridge from the corporate lifestyle into that of the Financially Independent. Like the scene from Indiana Jones and the Raiders of the Lost Ark with the invisible bridge, it’s possible for all of us to use it, but not many will. I settled on a 70% equity and 30% bond split. By splitting this into a separate pot it avoids feeling like I have far too much money in cash, which would be the case if I were look at my portolio as a single unit.
Pot 3 will bubble and toil away in the background until what ever regulations are in place at the time let me get access to my pension penalty free. I’m 33 now and current rules would allow access at 57. That’s 24 years for this to steam away for, to give me a nice tender financial stew. This sits 100% in the globally diversified fund that is available through the pension scheme. Nice.
|Mr Z on the road, again|
So I just need to carry on saving into Pot 2 as I skip down the yellow brick road towards financial independence carrying my emergency fund with me as I go to help with emergencies (new walking boots maybe or some patches for my armour of frugality). I can bask in the glory of my Freedom Fund while waiting for the Fire of Regulation to burn down so I can get access to my pension.
But where does that leave me in terms of Asset Allocation?
Keeping Pot 2 simple
Over the last week I read Investing Demystified by Lars Kroijer. He makes the case for an even simpler strategy than the excellent Tim Hale does. He argues that not many of us have an edge in the markets and so to deviate from the market would be folly (as it would suggest that we have an edge). He paints a good picture of an individual investor competing against the army of academics and finance professionals with access to more information, working for a fund manager, do we really think our P/E ratios provide more insight than they have?
Therefore we are better off investing in as broad an equity tracker as possible and some risk free assets (government bonds in our home country if they are rated appropriately). A rational portfolio.
Our world equity tracker will automatically take into account the flows of capital around the world, allowing us to capture the world return, while the split between equities and the risk free asset takes into account our tolerance for risk and expected return.
Pretty simple, right?
Also, if we are feeling a little crazy, he allows us to invest in other government bonds, corporate bonds and property.
Talking of having an edge, it’s not that it is impossible to have an edge, just that the majority of us private investors don’t have a chance against the financial institution power houses. I think that many people massively under estimate the risk they are taking on by investing in 20-30 individual stocks, confuse good performance of their chosen stocks as judgement rather than luck (or just general market movements) and conveniently forget about the dogs that they chose (human nature I guess).
Lars makes the point that if you set up a rational portfolio and continue to invest in this (reviewing you equity/bond split periodically to rebalance and adjust as circumstances change) then you will do better than the majority of active investors in the long run. You won’t be turning heads on the investing catwalk but you’ll be capturing the market returns.
Seems simple and it’s what I will aim for in Pot 2.
The Three Pots
Pot 1 – 100% cash. Will remain pretty stable in size.
Pot 2 – 70% World Tracker, 30% UK Gov’t Bonds
Pot 3 – 100% Equities – World Fund and Emerging Market Fund that is available through scheme
And that’s it for now. As it grows I will inevitably tinker with Pot 2 and probably add some commercial property exposure, if nothing else.
But isn’t Mr Bond fir to burst?
It certainly seems that way if you read around and I have been sitting on the fence for a little while now, waiting for Mr Bond to pop. A couple of recent articles on bonds from RIT and Monevator, combined with Investing Demystified by Lars Kroijer, got me thinking.
What I am doing is suspiciously like trying to time the market to buy bonds when they are cheap, from a base position of no bonds.
It’s all well and good waiting for the Mr Bond to collapse, but in the mean time what happens if equity crashes and money starts to pile into bonds? I wold be crying over equity losses and the bonds I was waiting on crashing could actually be up.
The point of bonds in my allocation isn’t to provide a boost to return by picking up cheap bonds at BondLand. Rather it is there to provide diversification, to reduce the volatility of my investments, to smooth out the potential crashes that equity can see, to allow rebalancing into cheap equity and perhaps to provide liquidity.
Time to stop dragging my hooves and buy into the 70% equity / 30% bond split that I think suits me.