“The virtues of a simple portfolio policy have been emphasized – the purchase of high grade bonds plus a diversified list of leading common stocks – which any investor can carry out with a little expert assistance.”- The Intelligent Investor
A lot of individual investors are so interested in getting answers to questions like which stocks to buy, at what price and when to sell – that they do not realize that these are the least important questions to get answered when it comes to building long term wealth.
Perhaps the single most important decision that influences long term returns has got to do with allocation ratio of asset types. That is – how much of my income after expenses – i.e. savings – do I put in various types of assets across stocks, fixed income, real estate, gold and cash? This is broadly referred to as portfolio asset allocation in financial parlance – and is the single most decision that impacts long term returns.
So why does one need to invest in so many assets? Well the reason is simple – to get different rates of return at different points of time – so that, as a whole, you get a decent rate of return consistently.
How is that achieved – one may ask? Well, that has a simple logic due to the nature of the assets. Fixed income (or fixed deposits as most people know them) is essentially loans to someone – a bank, a company or anyone else – with a guarantee to return it with some interest. So it is more or less assured return with little return. Simply because of the logic that whoever is taking a loan from you has probably found some avenue to invest it somewhere to get a better return – else why would he take a loan?
That brings us to the second category of assets. Equity or share in a company – which is essentially giving capital to someone who has the enterprise to give you returns. Obviously there is possibility of capital loss, so the expectation of return is higher – else why would someone invest capital in a risky proposition?
In between these two categories is real estate. This is sort of an appreciating asset that also gives some return in the form of rent for usage. With lesser risk than equity but with higher return than fixed deposits – primarily because the cost of constructing a new one increases with inflation. Not an exact guarantee – but.
And then finally, there is gold, which is sort of a dead asset which neither guarantees any appreciation, nor provides any return, but acts as a currency due to its short supply. Due to historical reasons, it is a store of value – not necessarily a great one to beat inflation – but an asset nevertheless.
So those are the four primary categories of assets which – as a whole – promise appreciation in their value over time. Everything else reduces in value and is either a clear-cut expense or an expense in the guise of an asset – it will not appreciate. That includes cars, jewellery, art, electronics, clothes, food and everything else.
Hence, for an investor to achieve the compounding required for financial independence, it is essential to build a portfolio of these four core assets – fixed income, equity, real estate and gold – and find a way of beating inflation together.
“We are thus led to put forward for most of our readers what may appear to be an oversimplified 50-50 formula. Under this plan, the guiding rule is to maintain as nearly as practicable an equal division between bond and stock holdings.”- The Intelligent Investor
For simplifying portfolio strategy, all the opinions and advice can be essentially reduced to a set of few simple steps:
- Decide your asset allocation based on your life circumstances: The exact asset allocation does not matter if it is carefully thought out and something that can be adhered to. Graham in his famous book ‘The Intelligent Investor’ proposes a simplistic 50:50 allocation between stocks and bonds. For an individual who does not intend to do investments full time (i.e. has a job or business for his regular income) and has an ability to leave his investments untouched for 10 or more years, an allocation of up to 60% in equity, 10% in gold and the remaining 30% in fixed income might make sense. The exact answer is best decided by the investor himself based on circumstances. It may not give best returns but should be something that is practically followed over the long term.
- Select your core and peripheral assets within the allocation: For most individual investors, index funds or select actively managed mutual funds are the best vehicles for equity participation.
- Review once a year, and Rebalance when allocation ratios go out of whack: i.e. if equities have grown and now account for 70% of assets and your allocation was supposed to be 60% to equities, then shift 10% into others by selling; similarly if cash/fixed income or gold value has increased, shift proportionately into equity or vice versa.
- Set up a system for this: Both contributions and rebalancing should be as per a system that is fixed, so that you do not have to take decisions frequently. It could be contributions by auto-debit and rebalancing on every birthday as an example. Having some system is better than no system, so that decisions need not be taken often.
- Keep increasing absolute amounts or relative asset allocation, as your income levels increase or decrease, life circumstances change or ability to take risk alters.
This can be a framework for deducing a simple investment portfolio strategy for most individual investors. Once this is set up, the investor is likely to realize how unimportant the question of which stock to buy and when to sell really is.