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Useful Portfolio building blocks for these times

A major challenge for investors in these very risky times, is that in periods like the Global Financial Crisis, traditional portfolio diversification failed becaus most shares and property all crashed together.

To build more robust portfolios, we place a lot on emphasis in timing BUT we also seek to build portfolios of components that are far less correlated than in traditional portfolios. The thinking behind this borrows heavily from the Permanent Portfolio Concept - an approach that is intended to do well in virtually all market conditions.

Investments that go up when shares go down.

December 28, 2016

Remember the Global Financial Crisis. Shares crashed. Listed and direct property crashed. Many of the traditional approachs to Portfolio Construction failed - and as a result, many investors lost a lot of sleep - because their overall portfolio had fallen a long way.

To make your portfolio more resilient - so you can sleep more securely, we need to include good investments that are not  correlated to shares and property. That is what we seek to do in multiple way. We seek to include in the portfolio many highly-uncorrelated good investments. (Note: In times like the Global Financial Crisis, shares and property are highly correlated in terms of performance.)

A few key points:

  • Don't diversify for the sake of it.

  • Diversify between investments that each have a good chance of of positive return.

  • A key element investment selection should be valuation.

  • Ideally if shares or property, the sector you are in should in a secular bull market... if not, at least a cyclical bull market.

In other words, you should employ "intelligent" diversification. Some references:

The key reason to try to diversify intelligently, is that the more highly correlated your portfolio is, the more likely that you will find times when most of the key elements of your portfolio are down (as many investors found during the Global Financial Crisis). When investors face major losses across their entire portfolio, that is when "investors cut their losses because they cannot bear having such losses any longer."  This one of the key reasons why many investors make the major mistake of buying high and selling low.

As background, the investment theory behind diversification was defined by Professor Harry Markowitz:

Cash and term deposits - portfolio stabilisers.

December 05, 2016

Boring maybe but comparatively safe. If you want your overall portfolio to be less volatile, you need to have more cash. The objective with cash is to keep overall portfolio volatility down to an acceptable level while you seek to get a higher return with the other part of the portfolio where you accept the risk of capital loss. Cash (and term deposits) therefore do have an important role to play.

The most useful theoretical framework for the use of cash in a portfolio, is James Tobin's Separation Theorem.

Value shares tend to out-perform over the longer-term

December 05, 2016

Value shares tend to out-perform growth stocks over the medium-to-long run. Research by Kenneth French and Eugene Fama around 1990.

Low Beta shares tend to out-perform over the longer-term

December 05, 2016

Academic research over the last 10 years, shows that that there is a low beta effect, separate and independent of the Fama & French value effect.

  • “One study of US stocks between 1968-2008 showed that stocks in the bottom 20% based on past volatility outperformed those in the top 20% by a compounded return of around 11.2% per year. (Baker, Bradley and Wurgler: Benchmarks as Limits to Arbitrage, Understanding the Low Volatility Anomaly 2010).”

International shares - useful portfolio building block

January 22, 2017

Usually, international shares are a very useful part of the portfolio. And I think they are particularly important right now because:

  • I think that somewhere over the next 5 years, the A$ will fall substantially (making for useful currency gains) AND

  • Over the next 10-20 years, Asian and the emerging world more broadly have better return prospects on broad average than Australian shares AND

  • International shares enable you to get a much more diverse share portfolio including in particular, much better exposure to the drivers of the current technological revolution - and the 3billion-strong emerging middle class.

Emerging markets should also have a role

February 13, 2017


  • the majority of global growth coming from the developing world over the last 15 years ( and likely to continue for the next 40 years) and

  • where the emerging world is rapidly becoming more than half global GDP (at least on a Purchasing Power Parity (PPP) basis,

I think that there is an overwhelming case that the developing world is well represented in your investment portfolio - particularly given that shares in the developing world are on broad average at this time, cheaper (on a cyclically adjusted P/E basis) than much of the developed world. eg at this time, emerging world stocks on broad averages are less than half as expensive as US stocks - and hence very likely to do much better than US stocks in real terms over the next 20 years.

Contrarian Investing - buying good investments when out of favour

December 05, 2016

As a general simplistic rule, the share market sector which is most out of favour, tends to be the cheapest sector - and hence has potential for higher returns.

Buying stocks which are cheap?

December 05, 2016

As a simplistic guide, if you buy an asset that is expensive (on a valuation basis), then you are far more likely to get a low or negative return. The most reliable guide to whether a share market index is expensive for example, is by using the cyclically adjusted price/earnings ratio - a concept first explored by famous value investors, Ben Graham and David Dodd, in the 1930s.

Trend-following hedge funds

December 05, 2016

Trend-following hedge funds go long when an asset sector is trending up, and go short when an asset sector is falling. Therefore trend following hedge funds can make positive returns in both rising and falling markets. Winton is a good example - very strong steady returns since 1997, making very good returns during the global financial crisis.

Long-short market neutral funds

December 05, 2016

Long short market neutral funds can make positive returns during rising and falling markets. A good example is teh Ellerston long-short market neutral fund.

Does gold have a role?

December 05, 2016

Gold has historically made positive returns when US has negative real US cash rates, particularly if US shares are trending down. Investors tend to buy gold when confidence in central banks and the banking system more generally is low. Gold made good returns in A$ during the global financial crisis.


That said, the wealthy have used gold as a traditional store of family wealth for thousands of years.

Further, if we look at the Global Financial Crisis, we saw that Gold in Australian dollars rose in value while shares and property fell in value. Therefore, gold can have a great value in helping make the overall portfolio more robust and secure through a wide range of market conditions - which is why gold is included in the "Permanent Portfolio" concept.  (  )

Timing is extremely important.

December 05, 2016

If you ignore market timing, there are times during which you make very large losses.  Over the long-term, the historical evidence does not support a buy-and-hold strategy - except during a secular bull market for shares like 1982-2007 for Australian shares.

And if you ignore secular bear markets (which on average last about 15 years, you make make large losses over a long period. [Long-term investment historical simply does not provide support to the long-term buy and hold philosophy for share-investing.]

We seek to invest in secular bull markets

December 05, 2016

Share markets travel in long cycles. If we use the last 200 years of US share market history as a guide, we can see that share markets tend to experience a secular bull market of about 20 years followed by a secular bear market of about 15 years.

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