the know-nothing investor

It was on the first days of 2013 when I started to think what kind of assets should be in the portfolio and in what percentage. Because I wanted to delay paying profit taxes for how much I could, I knew that what I decided it would be for all the investment period. I tried to be cautious.

If I gathered 100 years of market data and I assume only mean reversion, probably I would not end up with all type of asset classes. But no one know what the future will bring, so for the long run I thought it would be extremely important to cover all asset classes.

I like to divide asset classes in two major groups:

• Non-equities shares
• Equities shares

Those two groups have different correlations and therefore a well structured portfolio must have both. Because of negative correlation between groups, normally when stock markets are going up the other group tend to go in opposite direction and vice-versa. Of course this doesn’t work all the time and there are always exceptions that we must be aware, for instance because 2008 markets crash was due to the sub-prime, real estate was also severed hit.

First group can be subdivide as described below.

Non-equities shares

Bonds

In first group we have government and corporate bonds and normally they represent a fixed income to our portfolio.  Their yield depends on the investment period and the risk of getting payed. So government bond pay less than corporate, because countries are less likely to go bankrupt. Between countries there are also differences, countries with economic and political stability will pay less because they represent minor risk to your money (although at this moment Spain and Italy are paying less than US, which is odd). Long-term maturities bonds (15 to 30 years) pay more than intermediate (3 to 10 years) and short-term ones (less than 3 years).

There is also another type of government bond that is an inflation-protected security aka TIPs. This security is very interesting because your fixed income will be inflation free and we should be aware of what inflation could do to our rate of return.

Bonds also represent a negative correlation with shares. If shares are in a turmoil investors will look for safety instead of returns and that means going for bonds. In uncertain times you need to have bonds from countries which are reliable and dictate external police (this means being the world’s biggest military superpower) and that is USA…USA…USA.

Bonds are a must have in any portfolio. They are ice when things start to heat.

Gold

My precious…the shining metal has intrinsic value since ever and will have in future, because it’s rare, is used in the industry and some say that countries can go back again to gold standard (China and Russia are among those, be careful USA). Pundits also say owning it is good way to have protection against inflation, especially in these times of central bank planning, where burning currency is the main agenda. Nevertheless, Barry Ritholtz point out that “In real, inflation-adjusted terms, gold is unchanged since the early 1980s — the last peak in gold.”  and it doesn’t give any kind of dividend, which might discourage some investor of having it.

But in uncertain times is where investors also put their money as it seen after 2008 markets collapse. Adding to this all the speculation around reintroducing gold standard by some of the world strongest economies, makes gold a must have in any future proof portfolio.

Commodities

In this category it fits a world of raw materials and essential commodities for everyday life, such as crude, oil, gas, gold, copper, zinc, wheat, corn, timber to name a few. When inflation is high, commodities are a good hedge to protect your money, because commodities prices also tend to rise and there are few assets that can handle high inflation. But we haven’t seen inflation in recent year and as Cullen Roche affirms commodities are not an investment, it’s basically short-term speculation, in fact he arguments that commodities at real prices are in bear market for at least 130 years and it is probably best to own commodities equities producers (CEP) instead. So why should I include commodities? Simply because I real can predict the future and as LTCM (portuguese multi-asset expert nickname not the fund) said to me once “Isn’t because you have commodities that your portfolio will underperform”. And why not to choose a CEP ETF instead? Because as we will see later I will be exposed to that equities in shares assets.

In my humble opinion commodities must be in multi-asset portfolio, with time I will have enough data to understand if commodities are being my weakest link but for now it makes sense to have it. No one know really how commodities will perform in the future, where earth’s population is still growing and the need for food and raw materials will for sure increase.

REIT

Real Estate Investment Trust (REIT) is an asset that trades like a stock in the exchanges and invest in real estate. Who has never dream of owning an hotel or a condominium, through reit you can and revenues will come from renting or interests of lending money for mortgages to real estate owners.

In Portugal investing in real estate is everyone dream, but dealing with tenants must be a nightmare. I would rather put 150k in a REIT, but probably no bank would give me a loan for that.

If this is no-brainer investment for sure that it has its place in multi-assets portfolio. At least in mine has.

Although these assets are different from stocks, most of them are extreme volatile and shouldn’t be purchase if money will be needed in short time. These type of assets should be considered for an intermediate to long-term investment period.

Negative correlation with stocks is quite different of low volatility and therefore is important to understand that depending of the assets you choose you can still have real big drawdowns. The difference lies in the fact if you had only stocks it would be a massacre.

At this time I knew that an important part of my portfolio’s allocation would go to bonds, gold, commodities and REIT.

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