Investors cannot control market returns – they will be what they will be. What they can control is when, in which asset class, and how they invest. This is what we call portfolio construction, and it is arguably the most important decision an investor can make. Get it right, and you are on track to achieve your financial goals. Get it wrong, and it could cost you a lot of money!
A portfolio that makes money in all markets
The idea behind spreading your money across multiple asset classes is simple: some assets will perform well in the short term, others will underperform. By putting your eggs in different baskets, the aim is to smooth out overall portfolio returns.
But do you really need to smooth your returns? If your goal is funding retirement in 20–30 years, short-term swings arguably don’t matter much, as long as your portfolio hits the average returns you need by retirement. Whilst that is true, smoothing returns has two key advantages.
First, life is unpredictable. Over the next few decades, your goals, markets, tax laws, and your financial situation could all change. A smoother return profile makes it easier to adapt when these unexpected changes happen.
Second, there’s a behavioural angle. If you invest all your money in one asset class and it underperforms for a long stretch, you might panic and sell – even if the investment is fundamentally sound. Smoother returns reduce this risk and help investors stick to their plan.
The table below shows asset class returns for the past 32 calendar years, colour-coded and sorted from high to low. Notice any trends? You won’t. Short-term returns are inherently unpredictable. That’s why, if you want to smooth your portfolio’s performance, diversification across multiple asset classes is essential.
Bonds are typically negatively correlated with shares, but…
The most effective way to smooth portfolio returns is by investing in negatively correlated assets. That is, assets that tend to move in opposite directions. When one rises, the other falls. The most common example is shares and bonds. When fear takes over and share markets fall, investors often flock to safer assets like bonds. This is why conventional wisdom says holding both shares and bonds reduces portfolio risk, and smooths returns.
However, there are two important observations.
First, bonds have historically underperformed shares over the long term. Since 1990, the Bloomberg Global Aggregate Bond Index has returned around 3.1–3.3% p.a., while the global share index has returned roughly 10% p.a. Shares have always outperformed bonds over the long run, even if bonds occasionally outperform in a single year.
Second, negative correlation is not guaranteed. In 2022 and 2023, bonds failed to protect portfolios as expected, largely because central banks shocked markets with unexpected aggressive interest rate hikes. While such events are rare, they highlight that investment performance and correlations are never guaranteed.
If your goal is to maximise medium to long-term returns, which is likely the case for most investors, there’s a strong argument that bonds may not belong in your portfolio.
All-weather share portfolio
Therefore, if we are going to focus on investing in shares and property (more on property later), how do we build a portfolio that can thrive in most environments?
The first step is recognising that different rules-based investment strategies perform differently at different times, and each can be used to manage specific risks or capture opportunities. Last week, I wrote about momentum investing and discussed various factor-based approaches.
We should start by assessing the risks and opportunities in each geographical share market. Are there concentration risks, like in the US market? Is value or growth cheap, or is the whole market undervalued? Are you concerned about a potential economic slowdown?
Once we understand these risks and opportunities, we can design a share portfolio to best accommodate them. For example:
- Traditional market-cap indexing: Tends to act like a quasi-growth index, since allocations are linked to share prices. It works well when the broader market is cheap, but the reverse is also true.
- Value factor investing: Useful when value stocks are cheap (as they currently are) or when we want some protection against volatility because the theory is that when the market crashes, undervalued stocks will fall less than overvalued ones.
- Quality factor investing: This could help manage concentration risk. If your portfolio is heavily weighted in a few stocks or sectors (such as tech), quality ensures that concentration is held in fundamentally strong businesses. It can also provide some protection during economic slowdowns.
- High-yield index funds: Generating a higher income does reduce reliance on capital growth to reach your target returns. A note of caution: the tax implications mean this won’t suit every investor.
- Geographical market index funds: Allow you to tilt your portfolio toward the most attractive geographical markets.
- Listed property and infrastructure: Listed property and infrastructure: We might use listed property (REITs) and/or infrastructure to introduce some defensive exposure into a portfolio. These asset classes have both defensive and growth attributes – sort of between bonds and shares.
The goal is to build a well-rounded, evidence-based portfolio that addresses known risks and opportunities without taking aggressive bets i.e., without skewing heavily away from the broad market index or excluding markets entirely. Because that would move into active investing territory, where the overwhelming evidence shows most investors underperform.
Starting valuations always matter
Expected returns depend heavily on starting valuations. Buying cheap (quality) assets generally outperforms buying expensive, popular ones over the medium to long term. There’s a substantial body of academic research showing that investors should be “valuation-aware”. That is, systematically tilting toward markets or styles that are currently undervalued.
Investors can shy away from a value approach because it often involves buying unloved or unpopular assets. It can feel safer to chase what’s popular, like growth/tech stocks right now. As I discussed in last week’s blog on momentum investing, popular assets often outperform in the short term. The problem is the risk: you must time your exit perfectly.
My objective is to maximise medium to long-term returns, irrespective of short-term outcomes. That means focusing on fundamentally sound assets that are historically cheap.
And a key point: this doesn’t mean taking big, aggressive bets. How much you tilt your portfolio toward the most attractive sectors should be guided by your risk profile and time horizon.
Volatility is part of investing
Over the past 100 years, the stock market has experienced crashes of more than 30% roughly every 7 to 10 years. Since 1950, the average intra-year drawdown in the US market has been 14%. Volatility is a normal part of investing and should be expected.
The asset allocation approach outlined above won’t necessarily reduce volatility – it’s something every investor needs to come to terms with. In fact, it can be helpful to reframe volatility not as a threat, but as a wonderful opportunity to invest more capital.
Be careful with illiquid (unlisted) investments
Unlisted investments, like property syndicates, private equity, and private credit funds, have all had their moment in the sun. Their appeal is they give investors access to opportunities usually reserved for a limited few (see my blog on wholesale investments). Because these investments are not publicly traded, they carry higher risk, and the idea is that investors are compensated with higher returns, often referred to as the illiquidity premium – the extra return for holding assets that are hard to sell quickly.
However, research by Cliff Asness and Antti Ilmanen suggests this illiquidity premium may be overstated. Investors might not be rewarded as generously as they expect.
The upside of illiquid investments is that you cannot sell during downturns, which forces you to ride out volatility. The downside, of course, is the loss of control when markets turn sour.
Over the past decade, I have personally invested in unlisted assets and so have some clients. Reflecting on recent years, I have reservations about whether investors are adequately compensated for the additional risk. I place a high value on liquidity, and I would urge any investor to think carefully before committing to unlisted investments.
Residential property is not positively correlated with shares
An interesting study by ScienceDirect found that property is generally negatively correlated with share markets, although the relationship depends on the time period analysed.
From my experience, there tends to be a mild negative correlation. When share markets underperform, investors often shift focus to property, increasing demand and pushing property prices higher. I’m not suggesting that lower share market returns cause higher property returns – it’s more likely a correlation than causation.
In short, the data is somewhat noisy, but it’s reasonable to say there’s little to negative correlation between property and shares – almost certainly no positive correlation. That means investing in direct residential property can help smooth portfolio returns. Property investors in Sydney and Melbourne over the past three years, for example, would have benefited from diversification if they also held share market investments.
My thoughts on other asset classes
Studies on asset allocation often recommend holding a range of asset classes beyond shares, though these additional assets are generally suggested to make up less than 20% of a portfolio. Here are some thoughts on the commonly cited options:
- Inflation protection: Commodities and inflation-linked bonds are often suggested to protect against high inflation. In our view, Australian investors already have significant exposure to commodities, directly or indirectly via the Australian share market, which has around 40–50% exposure. Therefore, I do not recommend investing in commodities as that would result in too much exposure. As for inflation-linked bonds, as discussed above, investing in bonds is unlikely to help maximise long-term returns.
- Cash and short-term fixed interest: Many of our clients hold direct property and accumulate cash in offset accounts linked to their home or investment mortgages. This effectively serves the same defensive role as cash or short-term fixed interest securities.
- Duration and credit: Duration involves investing in long-dated bonds, hoping to be compensated for locking in money far into the future. Credit refers to investment-grade corporate bonds that are lower quality, where the hope is to earn a higher return. While these can sometimes add value, generally current conditions are less appealing: credit spreads are not compelling, and there is not enough reward for taking on duration and interest rate risk. For those reasons, we are not currently attracted to this part of the market.
For now, we generally focus on listed shares and direct property, though other asset classes may become relevant in the future.
Overall asset allocation
We believe most investors benefit from holding both property and shares. When providing advice, we take an asset-class agnostic approach, focusing on what works best for clients’ goals rather than favouring any particular asset class.
For share market investing, as discussed above, portfolio construction is key to managing risk and maximising medium to long-term returns. This can be achieved through using several rules-based, evidence-driven indexing strategies.
For property, following the “four golden rules” that I have previously discussed provides a rules-based framework to help investors maximise returns.
Typically, we aim to first build our property exposure to capture the benefits of compounding capital growth, and then gradually introduce more share market investments, as discussed earlier in this blog.
Typically, we start by establishing property investment exposure to maximise the benefits of compounding capital growth, and then gradually introduce more share market investments, as discussed in this blog.
