Asset Allocation 3: Allocate with a vengeance

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.

Mr Z

7 thoughts on “Asset Allocation 3: Allocate with a vengeance

  1. ermine

    > He paints a good picture of an individual investor competing against the army of academics and finance professionals with access to more information

    I haven't read the good fellow, in all fairness, because he bores me shitless. However, the issue with markets, IMHO, is not about efficient frontiers. It's about cojones. I've had not enough and too much, at different stages. And I do take the point that investing over a 3 decade time frame is tough, I had the privilege of not having to do that.

    But you can get an edge over fellow investors. It's not PC , and it's easy to say and hard to do.

    Reply
  2. Mr Zombie

    Morning,

    "because he bores me shitless" – haha. I found it easy reading, if not the most interesting.

    Having the cojones to hold during tough times and even go more in?

    My worry is that it would become very time consuming to maintain any edge (although no doubt interesting at times) and the time spent on this could be better spent elsewhere. And it also takes cojones to go for your 'edge' and trust in it.

    Something more automated for me, for now. (In all honesty I do sometimes wonder if I am just looking for the easy way, but that's for another time).

    Thanks,

    Mr Z

    Reply
  3. nibbler

    Interesting to read about your approach, last year I was tackling the same question about my pots. I'm 10 years ahead of you and as a consequence realized my Pot 2 (an ISA) would never get big enough by 55 so decided to really go for it with Pot 3.

    So I massively upped my saving through salary sacrifice to max out the tax, employer contributions and NI boost available. Hopefully this, plus my SIPP, will hit the FI target for me around 57.

    Time will tell if this is the right strategy for me!

    Reply
  4. ambertreeleaves

    Good to read this. I am happy to see that others also take this approach. I have something similar going on.

    Emergency in cash, pot 3 is the company pension. Sadly, in Belgium it is boring as hell: an insurance product with a guaranteed interest rate. No fun with picking assets ourselfs. This is probably a good thing for 90 pct of the people.
    Then pot 2: Interesting to see that you go for such a simple allocation. What instrument do you take to track the world?
    My world tracking is actually 3 trackers: one developped markets, one EU small cap and one EM. Reason: tax in belgium pushes me to accumulating trackers, and I have not yet found a good one that covers the whole world.

    My big difference is that I try to get an edge and do not buy bonds. I will buy when the interest rates are higher in the EU.I can do this as I have a stash of cash from the past locked away in insurance products same as my company pension. I can not access it, it is capital guaranteed, and thus a great volatity damper. They become freely accessible in 5-7 years. Plenty of time to wait.

    Reply
  5. Mr Zombie

    Makes sense, the tax/eers/NI boost is massive. Sometimes the task seems gargantuan and impossible before normal retirement age and sometimes just as if a simple change in perspective is all that's needed!

    Thanks,

    Mr Z

    Reply
  6. Mr Zombie

    I went for the Vanguard FTSE All-World in the end, as it also has some emerging market exposure. I may add small cap (as that is not covered) at some point. And maybe a commercial property one as well.

    Bonds still play on my mind a bit, but I'm sticking with it 🙂

    Mr Z

    Reply
  7. ambertreeleaves

    Commercial property… good call…should be in my portfolio as well but I like to keep it simple. I now have 3 ETFs, bonds will be the 4th, and commercial the 5th… sounds complex too me already 😉
    Anyway, I am half way through the inetlligent asset allocator, and keeping simple means that you will have some more tracking error compared to the bench mark. I don't have a banch mark… so, I should be fine.

    Reply

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