The Portfolio Reset: Episode 3

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News. We already seen the peak of US exceptionalism.

This for me is where Europe and particularly the UK start to get more interesting.

This is a different environment that's going to require higher rates for longer.

Geopolitical fragmentation is one driver of that.

John, so there is one thing that you can take from all that and it is this. It is that the next 10 years may look very, very different from the last 10. But the question then is different how? And where does that leave you as an investor?

Well, yeah, that's the point. Because for two episodes now, we've been telling you that investing has changed. So the market is more concentrated.

A lot of the.

Fastest growing companies have stayed private for longer. And putting your money into a passive fund, just because it's called a passive fund, that doesn't get rid of all the decisions you have to make.

So this time we want to turn that around. We don't want to spend another episode telling you what's changed. This time we want to talk about what you actually do about it. We want to talk about how we should invest for the next 10 years rather than the last 10. Welcome back to Portfolio Reset, our special Merrin Talks Money series on how to get your money to do more. I'm Merrin Somset-Webb, editor-at-large for Bloomberg UK Money and author of the weekly Merrin Talks Money newsletter.

And I'm John Stepak, senior reporter at Bloomberg and author of the daily Money Distilled newsletter.

This is episode three. Now, in episode one, we looked at how passive investing became the new investment wisdom and why that was exactly the right thing at the time.

Then in episode two, we looked at what's changed around it. Concentration, valuations, index flows, the dominance of the US and the fact that more growth is now taking place outside public markets.

And we end it with a slightly uncomfortable conclusion. You can invest passively, but you can't really be a passive decision maker. So today we're going to try to answer the questions that follow from that. If those decisions belong to you, what are they exactly? And how should you go about making them?

Investment funds are a means of transport. but they don't set the destination.

That's Paul Kearney from ARC Investors, a familiar voice in this series by now, I think. And he set this up nicely with the questions that you have to ask and the decisions that you then have to make when you are resetting your portfolio.

What, as an investor, you need to decide is what destination do you want to go to? And by that, I mean, what are your return objectives and what risk are you comfortable taking on the way through?

You have to decide what you're investing for, how much risk you're prepared to take, assets you want to own, and then crucially, how you want to put them together.

So let's just start with what are you investing for?

If you are younger, you have age ahead of you. Time is the greatest gift. You have that horizon.

That's Jumanis Al-Hin of Vanguard. She stresses the time horizon of your investment journey is important to understand. In other words, how long you've got. Saving for a house in five years is obviously completely different from saving for a retirement that's 40 years away, for example.

When you're young, a huge part of your wealth, in fact, most of your wealth is in the form of future earnings.

That's Bloomberg columnist and author Alison Schrager.

That means you're more placed to take risks. As opposed to when you're retired, most of your past earnings are behind you. So most of your wealth is whatever's in your account.

Now, if you've got decades of earnings ahead of you, you've got much more time to recover from markets falling. If you're actually about to need to start spending the money, you totally don't. And that's why asking how much risk can I take isn't just a question about how brave you feel. It's about when you need the money, whatever assets and income you have, and what happens if markets fall at exactly the wrong moment for you.

What is a successful retirement look like? And for most people, that is replacing a large share of their income that they had while working so they don't have to worry about financial stress, but you need a foundation of stable income to feel good about that.

This is a useful way to bring this down from the theoretical. The point isn't to produce the cleverest portfolio. The point is to fund your life.

Once you know what the money's for, then you can ask what each investment is there to actually do.

The two main asset classes are clearly equities and fixed income. But within that, you've then got either geographic spread of equities and the same sort of applies to fixed income, which are bonds.

ARC's Paul Kearney makes an important point. We're not trying to identify the one asset that will win. You're trying to combine things that respond differently to whatever comes next. And to do that properly, you have to understand the different asset classes. So let's start with equities or shares or stocks. They all mean the same thing. At its simplest, equity just means ownership. You own a stake in a productive business. If that business grows and becomes more profitable, you participate in that growth. But you are also heavily exposed to the risk too.

Bonds, also known as fixed income, as Paul was saying, are different. They are loans. Usually you're giving money to a government or a company in return for an agreed stream of payments. And assuming everything goes to plan, which it doesn't always, you're capital back at the end. So you don't have the same upside as an equity owner, but you're usually taking rather less risk.

But Barry Ritholtz, CIO of Ritholtz Wealth Management and host of Bloomberg's Masters in Business podcast, argues that if you're very young and have decades ahead of you, you may not need much in the way of bonds at all.

I don't think you need bonds till you're in your 60s or 50s or have a very specific set.

Of income needs.

Why do I need something that's going to generate 1% or 2% after inflation when I could have an asset class that's going to generate 7% or 8% after inflation.

But if you're closer to needing the money or you simply don't want to take equity-level risk, bonds can play a very useful role.

Then there is cash. Not exciting, but wonderfully liquid, wonderfully stable, and it gives you optionality. So with cash, you have the ability to take advantage of opportunities when everybody else is panicking about things they already own falling in value. And of course, gold.

Gold doesn't produce profits or pay interest, but that doesn't mean it has no purpose. It behaves differently to all the other assets that we've mentioned, and it's very good as a diversifier or a store of value. It particularly comes into its own when investors get worried about the stability of the financial system, which happens surprisingly regularly. So that gives us four very different building blocks, or I like to think of them as the kind of primary colours of asset allocation. Equities, bonds, cash and gold.

And the important thing here isn't necessarily which one wins. The important thing is that they don't all behave in the same way at the same time. So put them together and you can protect yourself. One of the oldest and simplest examples of how you can put all these building blocks together is Harry Brown's permanent portfolio. This is simple stuff. Four equal chunks. 25% equities, 25% long government bonds, 25% cash, 25% gold.

Easy.

Yeah, so the.

Whole point of this one is that you don't even pretend to know which economic environment is coming next. So if you get strong economic growth, your equities should do well then. If there's recession or deflation, bonds might help with that. If you get inflation or monetary panic, that's where gold comes in. And cash, meanwhile, gives you the stability and the optionality. And also it tends to keep up with base interest rates.

So the individual assets here aren't the strategy in themselves. It's their different behavior that is the strategy. You are not taking a bet on which asset will do best. That's very hard. And you're not trying to predict what's happening next in the economy. All you are doing is ensuring that your portfolio can survive regardless of what is going on around it.

And obviously, there are other ways to do this. You don't have to use those exact percentages either.

Yeah. So Charlie Morris, founder of independent investment advisory ByteTree, has a much more adventurous example, risky example, depending on how you look at it. He combines only two assets, Bitcoin and gold, in his bold ETF. There was magic between the assets because you put these two assets together and you rebalance them and you allocate them according to their risk and special things happen. what special things you might be wondering. So Charlie is proposing replacing the gold portion of your portfolio with a combination of Bitcoin and gold.

He's absolutely not saying that your entire portfolio should be gold and Bitcoin. That would not be a well-diversified portfolio. But his argument is that if you hold gold and Bitcoin in the right proportions, then you have better odds of avoiding collapses in either of them while maintaining a good amount of the upside you'd get if you held just one of them alone. Yes.

So the idea is that when gold isn't quite working out, Bitcoin is going stratospheric or whatever it does on a regular basis and the other way around. And it's not necessarily easy to DIY this one because Charlie rebalances this regularly based on the volatility of the two assets. But the rough mix is something like 80% gold and 20% Bitcoin.

Okay, so one very old asset in which we have a lot of confidence, one very new, one relative defensive, one spectacularly volatile. But once again, the point is that if you mix them up, in a sensible way, you take less risk, but you should also make reasonable returns.

And then there's another technique I think lots of listeners will enjoy even more.

The cowboy account.

The entire purpose of the cowboy account is a behavioral hack to distract you. The idea is leave your real money alone and let it compound over time. Humans have a bias towards action. We hate the idea of just sitting there. We feel like we have to do something.

So having an account with just a little bit of your investment allowance feeds that need to do something. So you don't feel compelled to do something actually quite risky or possibly even stupid with your money that actually matters.

And so taking 5% of your liquid net wealth and playing around with it, I don't care what you do in it. You could buy stocks, futures, options. You could market time. You could stock pick. You can sector rotate. Whatever you want to do in that portfolio, who cares? It's a small percentage.

I love this idea. I do it myself, actually. Your sensible portfolio sits over there. And then on the other side, you have a small amount of money, which you let yourself, give yourself permission to do something potentially ridiculous and high risk. So individual shares, individual small caps, companies that don't make any money, Bitcoin, the brilliant investment idea someone told you about over dinner. That happens to me a lot, by the way. You can scratch the itch without actually risking your retirement fund.

Yeah, I think the genius of this is that it recognises that investing is partly, in fact, even majoritively a behavioural problem. Like most people just find it really hard to sit and do nothing. So rather than pretending that you're never going to speculate or you're going to be sensible, just ring fence it. Have a gambling account, basically.

Now we come to something that really connects this episode to the last one. And it is this. You can have a wonderfully diversified looking portfolio, but when you look at it more deeply, you find it actually horribly concentrated. Yeah, exactly.

Because diversification doesn't stop at saying, oh, own some equities, some bonds and some gold. Let's say you decided that 60% of your portfolio should be in equities, or even 80%. You then have another decision, obviously, which equities?

And you can answer that by buying a global tracker, which makes a decision for you according to market capitalization. We talked about this. It looks perfectly sensible, but it is still a decision. And if you make that decision right now, what you end up with is very, very hefty exposure to America and within America to America's biggest companies.

So you have to ask yourself, do you deliberately want as much exposure to America as the index currently gives you? Do you really want, you know, X percent of your portfolio to be in Nvidia, for example? And this is where the old idea of home bias becomes interesting. Now, home bias is something that people talk about where you basically have too much exposure to your own market. And British investors in particular used to be told that owning too much Britain wasn't properly diversified. So we went global, started sticking all our money in the S & P tracker funds. The problem is, A British investor who buys a market cap weighted global tracker today may have simply swapped their British home bias for an American bias instead.

OK, so now we've got somebody else's home bias. So the key here is that, yeah, sure, you've got to diversify between asset classes. Of course you do. But you've also got to diversify within them. Equities isn't just equities. Within equities, you've got to look at the geography, you've got to look at company size, you've got to look at sect, you've got to look at style. And within bonds, which governments, which companies, which maturities, which countries. The idea then is not to find a single place that will outperform.

That is too hard. It is to reduce your dependence on any single prediction being right.

Yeah, and you absolutely don't have to throw away passive investing. This is not anything against passive investing. Barry Ritzholz has quite a festive way of explaining it.

Think about a Christmas tree.

That's your core passive index, your core tracker stock. And that's what you build the portfolio around. The ornaments, the garland, the lights. Maybe it's South Korea. Maybe it's Japan. Maybe it's emerging markets. momentum stocks, value stocks, micro cap, India.

So a cheap, sturdy core, and then around it, deliberate choices that give you exposure to other geographies, other styles, other opportunities.

And once you've built that portfolio, there's another active decision you have to make. What happens when it stops looking like the portfolio you built in the first place? We mentioned this earlier, rebalancing.

Oh, rebalancing. So let's say that you started with 60% equities. That was your positive choice, what you wanted, to have 60% of your portfolio in equities. But then the stock market has a great run, happens all the time. Suddenly, equities are 75% of your portfolio, and that portfolio is not the one you wanted. It's a riskier portfolio than the one you originally decided was appropriate for you.

You were comfortable with the risk. encapsulated by 60-40. But you roll forward five years, 10 years, 15 years, and all of a sudden, your equity allocation isn't 60%. Because over that period, bonds haven't probably done particularly well. Equities have done spectacularly well. So maybe you're now at an 80-20 portfolio. So quietly or stealthily, the market has chosen the risk appetite for you.

That's Paul Kearney there making the point, you have to think about rebalancing And all that means is that every so often you bring your portfolio back towards the allocation you first chose.

And that's tough because you're selling winners to buy something that hasn't performed as well. So you're dialing down your most successful asset class. But if you want to keep the risk even, bounded by the one you're comfortable taking, that's what you have to do.

And that forces you to do just a little of what investors always say they actually want to do. It gets you to buy relatively low and to sell relatively high.

And that is a nod to another important point. In an ideal world, you want to buy assets when they are cheap in historic terms and largely be selling them when they're expensive in historic terms. And the way the market cap weighted passive investing works just now, you're actually doing the opposite.

John, if valuation matters again and concentration is creating these distortions all over the place, then there is one more possible conclusion. Maybe, just maybe, this is the sort of environment in which a good active manager suddenly becomes useful again.

I mean, that is an interesting idea, this idea that possibly we've come full circle here. Because when you think, we know what a genuinely active fund manager is supposed to do. They're meant to look at the company, they're meant to look at the balance sheet, look at the management, actually sit down and work out what the business may be worth and then compare it to the price and refuse to buy it if the price is ridiculous compared to their valuation of the stock.

You find a good active manager and they are still doing the old school thing of checking the quality and the valuation of the companies that they're buying.

That's Simon Evan Cook again, fund manager at Downing Fund Managers. So Simon's argument here is that the concentration that we've been talking about may be creating opportunities away from the biggest companies. So people who've been invested in, say, the smaller and the mid-cap businesses have spent years watching large companies go up while theirs do not. But those small and mid-cap businesses are now significantly cheaper than the big ones.

Yeah, this is the problem for active managers. They are exposed to career risk. So if you keep on performing the benchmark, you eventually get fired. But the ones who manage to survive through this particular period and have managed to avoid buying the same enormous companies as everybody else and have managed to avoid benchmark hugging and still are in their jobs are They may actually be the good active managers.

The really, really good ones, the ones who are brave enough to stick to their guns and invest in the companies they like. They are moving towards these smaller and mid-cap areas where you've got amazing companies at cheap valuations.

Now, there is an enormous catch in all this. It sounds good, right? But in order to reap the rewards of active management, you need to pick the good manager. And the difficulty of doing that was one of the things that drove investors towards passive funds in the first place.

So what should you look for?

Well, first you want to check, are they genuinely active? If you're paying active fees for a portfolio that looks exactly like the index, you might as well buy the index. So have a look, check the portfolio. Is it really differentiated from the index?

So no closet trackers.

Second thing, can you understand what they do? What are they looking for? What makes them buy? What makes them sell? What would make their strategy underperform? Because if you hire an active manager, what you're doing here is you are hiring them to disagree with the market occasionally. And that means that they are inevitably going to look wrong sometimes, possibly.

quite a lot of the time, which has been the difficulty for active managers over the last 20 years. So you need to know whether the investment process is still working, even when the performance isn't. What are they doing? Are they sticking to the guns? Do they have a strategy that can work long term?

And of course, we mustn't forget price matters too.

Absolutely. And this again is one of the reasons why passive really kicked off. Fees are certain, outperformance isn't. When you buy a fund, the only thing you know for sure is how much it costs. You don't know anything else. Also, of course, the more you pay, the greater the hurdle the manager has to clear to outperform because what you pay comes off first, right? And it should probably go without saying, don't pick somebody just because they were top of the performance tables last year. Got to try harder than that. If you buy last year's top performer, you might just be buying whatever investment style has just had a good run rather than one that is going to have a good run.

Yeah, and that brings us to the final problem. So let's see, I've got this wonderfully diversified portfolio, and then I look, and the S & P 500 has gone up 25% in the last year, and my portfolio has only gone up 12%. Am I an abject failure?

No, no. I mean, not necessarily, anyway. This is really important, actually, because the wrong benchmark can destroy a perfectly sensible investment strategy. If you deliberately built a portfolio with less risk in it than the S & P 500, i.e. you've got bonds, you've got gold, you've got some commodity exposure, whatever it is, comparing yourself with the S & P 500 every six months or indeed ever makes absolutely no sense at all.

So Paul Kearney is just thinking about this in three ways.

We look at the returns that the strategic asset allocation with gifts? What proportion of equities? What proportion of bonds? What proportion of other assets? What could you have just got with the risk you were comfortable with? The second is, how have you performed against preserving your wealth?

So three comparisons. One, Did you get roughly what someone taking your level of risk should have got? Two, did you preserve and grow your purchasing power after inflation? That's actually the most important thing there is, by the way. And three, could somebody else reasonably have done better for you at the same level of risk?

Okay, so that is much, much healthier than looking at the hottest asset in the world and wondering why you didn't put your entire pension into it. Much better for your ego.

Humans are very bad at making risk-reward decisions in the capital market. And in fact, the more decisions we make, the more chances we give ourselves for mistakes. So a very surprising way to make fewer mistakes is is make fewer decisions.

This might all sound like a slightly odd conclusion to a series in which we spent three episodes arguing that investors need to make more active decisions.

Yeah, but I think the distinction is pretty simple. You need to make the important decisions.

Exactly. What are you investing for? How much risk can you actually take? What do you own? What do you want to own? Are you genuinely diversified? When should you rebalance? Now, those are the decisions that matter. And what Barry is saying quite rightly here is that once you've made those decisions, don't spend every day making a hundred more.

Exactly. Don't confuse being an active investor with constantly doing something.

It's a life lesson, not just an investing lesson, isn't it, John?

Exactly.

Anyway, that brings us back to where we started this series. So passive investing gave ordinary investors something enormously valuable and something we are very keen on, by the way. Cheaper access to markets, diversification, lower fees, and freedom from constantly having to pick individual winners. None of that has disappeared.

It's still great.

Yeah, but the mistake might have been confusing what is a very good tool with an entire investment philosophy. So a tracker allows you to buy something cheaply, but it doesn't tell you what to own, doesn't tell you how much risk to take. It certainly doesn't tell you whether today's price is sensible. It doesn't tell you whether you're genuinely diversified in the way that they're currently structured. You're probably not. And it certainly doesn't know what you're saving for.

Those decisions still belong to you. And perhaps that's the answer to how we invest for the next 10 years. Not by pretending we know exactly what those 10 years will look like, but by going back to all the old-fashioned questions. What do I own? Why do I own it? What am I paying? What risk am I taking? What happens if I'm wrong? And then build deliberately in case you are wrong. Yep.

Diversify, rebalance, keep your costs under control. Use active management where you think there's a compelling reason to pay for it. And then, what's hardest of all, sit on your hands and give the portfolio time to work.

Don't build a portfolio for the future you expect. Build one that can survive a future that might surprise you. Thanks for listening to the final episode in our three-part investment series. And a reminder, next week we are answering your questions. Send them to merrimoney at bloomberg.net. You can email us or send a voice note and we may even play your question on the show. And as always, if you like the podcast, share it with a few friends and leave us a review wherever you listen. This episode was produced by Sam Asadi, Moses Andam and Jennifer Seeley.

Amy Keaton is executive producer for Talk Podcast and Shara Brumley is our head of podcasts.

Thank you.

The Portfolio Reset: Episode 3

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