An Alternative Guide to Asset Allocation

Sometimes a picture is worth a thousand words.

I haven’t put numbers to this because it’s better to be roughly right than precisely wrong. And it’s just a meme, people. But it does give a sense of priorities as you progress on your investing journey.

You start at the bottom and then work up (I’m talking about the picture here but you could also read that as a metaphor for life).

First things first. It’s important to build on a solid foundation. Your career is the table on which the wedding cake sits. It provides cashflow for living expenses and hopefully a surplus to invest. The more stable the foundation, the higher you can stack the cake.

As soon as you have a job, you build an emergency fund and avoid / get the hell out of any expensive consumer debt ASAP. Then you work “up the stack” as you progress in life and in your career.

When I first sent this out by email last week, people asked whether it was deliberate that I put crypto at the top?

Yes! Crypto is at the top i) because it’s the smallest part of the cake and ii) it’s the thing you add last…or at least when you’ve de-risked your personal finances. And no, I’m not wedded to crypto (pun intended)…you could replace crypto with collectibles: art, stamps, wine or classic cars or whatever floats your boat. These are not really my thing but my point is that there is no One True Path.

As the world changes, we must choose how to respond. Equities and property have traditionally been the asset classes that provided the “engine” of a portfolio: they delivered the highest returns for long term investors that could ride the volatility and bear risk. Bonds and cash traditionally acted as shock-absorbers for those that wanted a smoother ride.

Equities and property still work but now we have more choices for our “engine”. Today we also have venture capital (earlier stage equity without a quoted price) and crypto (early stage venture capital with real time pricing).

What’s happening right now is the convergence of different classes of risk asset:

  • equities
  • venture capital
  • crypto
  • collectibles
  • property

To illustrate: you can own a stake in tech businesses via a tracker fund. You can own a stake in tech businesses via single shares (publicly traded stocks). You can own a stake in tech businesses via venture capital (unquoted equity). And now with crypto, you can own a stake in tech businesses via a token.

Or consider the ownership of property. You can own property direct (eg your house). Or you can own stock in a publicly traded Real Estate Investment Trust (REIT). Or via property crowd-funding sites. It seems inevitable that property will get “tokenized” allowing you to buy an ownership share in it via crypto.

Residential property in the UK has been roughly equivalent to stockmarket investing (equities) from a long term returns perspective. On the downside, property comes with much more hassle and concentration risk. I prefer equities for these reasons. On the upside, you can leverage the hell out of residential property (and you’ll probably get away with it).

Direct commercial property development / investment is more like angel investing in venture capital. It’s only really suitable for pros.

But, with all these investments, there are funds you can buy to gain exposure to the asset class whilst delegating the investment selection, management and custody to a professional manager. There are real estate investment trusts, venture capital funds and crypto funds. Yes, I’m talking about actively managed funds people!

As I may have mentioned before, equity index funds are an excellent choice but I have always invested my own portfolio with a strong active tilt. You could say that I’m not an index fundamentalist (geddit?). Index funds are a useful tool….nothing more, nothing less.

Another good question I got was: why are bonds not shown?

I’m all for having an emergency fund / shock absorber element to the portfolio. You never want to be a forced seller of risk assets in a crash. You avoid this by i) not panicking ii) having income iii) avoiding leverage iv) avoiding lifestyle inflation and v) always having some cash on hand.

Your shock absorber could be cash, government bonds (e.g. UK gilts), NS&I or premium bonds etc. In a world of zero interest rates and yield compression where money printer go BRRRR., bonds don’t really add much in terms of risk-adjusted returns versus cash.

That is why the traditional risk-curve (see below) no longer really makes sense in the way it used to.

A different set of rules apply in a world of zero interest rates and QE infinity. Risk changes as the environment changes. And as the world changes, so does my investment strategy.

Unfortunately, our ability to assess risk in the modern world is shockingly bad. Most people are terrified of price volatility. But volatility is not risk. Volatility is the cost of entry to the best games in town…the games where the odds are tilted in your favour.

The other thing that people are scared off is things that they don’t understand. Equities, venture capital and crypto are all scary for people that haven’t done the work to understand what’s going on under the hood. Learning about these is an investment in yourself. Greater understanding reduces risk and helps you sleep better at night.

Risk comes in many forms. Focus on real world risk, not just financial risk. We persistently overestimate highly visual risks that stick in the mind (my wife is terrified of shark attacks).

If we were guided by statistics, we would worry more about 1) driving 2) taking a shower and 3) sugar which are WAY more dangerous than people realise. We persistently under-estimate the risk of sedentary lifestyles and processed foods.

The older I get, the more I realise that most people probably need to take more (intelligent) risk not less. This applies to your career (especially to your career) as well as to your investing.

There is no such thing as 100% safety, there are only trade-offs. This blog is not for your granny, widows or orphans. You are not going to get to financial independence with just a few more pennies in the savings jar.

Be brave and STAY DANGEROUS!

Asset allocation is contextual: it depends on the individual and their circumstances. What’s right for me, may not be right for you. Everyone should decide their own target asset allocation.

I include model portfolios, example funds and quantified numerical examples of asset allocations for different personality types on The Escape Manual (explained here).

None of this is regulated financial advice!

One comment

  1. As someone who has a high tolerance of risk, to the point of being suicidal with some investments, I agree with the article.
    The flip side of risk is the near certain loss that comes from investing safely in cash or premium bonds or even paying off your mortgage early.
    One thing that really gets me is the mental load that comes with money and the perceived risks – like a friend who has has just bought a £30k car is suddenly worried about their gas/electricity supplier increasing their tariff by 35% – put in perspective it’s nothing but focus on it and you’ll have sleepless nights (in a cold house)

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