Nearly all portfolios are dominated by stock risk. For example, in a 60/40 stock/bond portfolio, stocks typically account for well over 90% of the risk. Therefore, in seeking to reduce overall portfolio risk, it is much more important to diversify stock risk than bond risk. Bonds currently have a low correlation with stocks, and so do a good job of diversifying stocks, but bonds also currently have low expected return.
The presence of many individual country ETFs (exchange-traded funds) and CEFs (closed-end funds) makes country-targeted investing easy. It can also be profitable. This article will highlight several characteristics that have provided consistent risk-adjusted excess return, including value-, quality-, and sentiment-related factors.
Vanguard’s target date funds include a meaningful allocation to international bonds despite their ridiculously low (or in many cases negative!) yields. Their rationale is based on the premise that global capital markets are efficient and asset prices provide a fair return that reflects their risks. This assumption is so firmly embedded in the Vanguard DNA that they are apparently unable to adjust to the compelling evidence that many international bonds are artificially overpriced and should be avoided.
The presence of many sector and industry ETFs makes industry-targeted investing convenient and inexpensive. It can also be profitable. This article will highlight several characteristics that have provided consistent risk-adjusted excess return, including value-, momentum-, quality-, and sentiment-related factors.
Most of the return from a diversified portfolio is derived from stock market exposure. If an investor can increase or decrease exposure to the stock market at the right time, he or she can avoid much downside loss and gain much upside return. There is more reason to believe that asset classes are inefficiently priced relative to each other than that individual assets are mispriced within asset classes. If that is true, then tactical asset allocation, if done well, can be extremely beneficial.
Measuring risk is the first step in controlling risk. In a diversified portfolio, most risk is systematic risk, since a lot of the non-systematic risk is diversified away. Systematic risk is explained by one or more risk factors such as stock market risk or interest rate risk. My research suggests that four risk factors will capture most of the risk in most portfolios.
Real estate is a huge part of the global capital market, but most portfolios have little exposure. Many investors have an undiversified investment in residential real estate by owning a home, but REITs provide a convenient way of gaining broad exposure to many types of commercial real estate. They also help diversify a portfolio’s stock market risk.
Next to the stocks vs bonds allocation, the U.S. vs international stocks decision is the most important for most portfolios. Unlike the 60/40 traditional stocks/bonds mix, there is no well-recognized default position for this choice. I recommend a middle path between two extreme views, with significant flexibility in tactically implementing around the long-term strategic allocation target.
Although they are often excellent diversifiers of equity market risks, government bonds are not likely to be good investments going forward. Their yields are low (or in some cases, negative!). The marginal buyers for government bonds are often motivated by considerations other than risk and return. This keeps their prices structurally above the levels that would make them attractive to most investors.
Most people intuitively understand the appeal of diversification—spreading your risks around so that if something goes wrong in one investment hopefully some others will be doing well. It has to do with the old saying, “don’t put all your eggs in one basket.” But how do you measure diversification? And how much difference does it make in portfolio returns and ending wealth?