Simple Pound

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After I talked about the principle of asset allocation the other day, I also promised to share what I think will work best for me in the future. This model portfolio was proposed by Richard Ferri, author of the book “All About Asset Allocation”. It is one of the two models he outlined for young investors and I am told that his book contains further examples for people in mid-life, early retirement and late retirement.

The “Early Saver” is based on a 70 : 30 distribution between stocks and bonds, which seems rather conservative for young people at first, but bonds in themselves aren’t necessarily only dull and boring.

Since the book is ultimately targeted at a US-American audience, the original classification reads “Total US Stock Market” instead of what I simply called “Domestic Stocks“, i.e. equities from companies within your country of residence - so in my case UK companies. This accounts for around 40% of the portfolio.

A further 20% is dedicated to “International Stocks“, which covers anything from China or India to the US or Australia, but also European equities (which don’t seem quite so international to me). And the final 10 percent of the stocks section is taken up by REITs, which are an American investment security that somehow replicate the property market. Since I am not aware of anything similar in the UK, and with the current state of the property market in which I don’t really want to get my fingers burnt, I will probably extend my international stocks section to 30%.

The remaining 30% of the model portfolio are taken up by intermediate term bonds, i.e. debt securities with a maturity of less than 10 years (but at least 1). This part of the portfolio will guarantee a regular income stream which - if re-invested - can build up significantly over time.

Up to here, there’s no real rocket science in the portfolio, but Ferri breaks it down further, and there lies the real reason of why I like this particular portfolio: diversity!

The breakdown of the stocks section is as follows (percentages are in terms of the whole portfolio - i.e. 25% means a quarter of all money invested as opposed to 25% of all money in stocks; notice how the following numbers add up to 70%, not 100%).

• Domestic mid- to large-cap stocks (25%): these are the “blue chips”, the established companies that don’t give you massive growth, but stability and regular dividends
• Domestic small-cap (10%): smaller companies with a market capitalisation of less than, say, 300 million; these companies - if well researched (!) - provide capital gains through a steady growth that mature stocks can’t provide
• Domestic micro-cap (5%): penny stocks - shares bought literally for a few pennies that can give you phenomenal growth, but are also rather risky
• Property (10%): as explained earlier, I will probably put these 10% towards European stocks or any specialist sector that might be under-represented in the portfolio
• Pacific stocks (5%): corporations that have their country of origin in the Asia-Pacific regions, e.g. Japan, Taiwan or Korea
• European stocks (5%): since I feel I know a fair amount about European (especially German) companies I will probably end up investing more than 5% in European equity
• International small-cap (5%): companies with a low market capitalisation outside the UK
• Emerging Markets (5%): this is a particular exiting market sector, covering economies that are just at the brink of becoming (fully) industrialised and whose companies therefore show excellent growth potential (remember the Indian stock index!?!)

And finally, a more precise break-down of the bonds section of the portfolio that shows that bonds don’t necessarily have to be all old-school and boring, but can bear some pretty substantial risk and thus returns

10% of the portfolio is tied up in high yield bonds, which are also called junk bonds because the companies generally have a low(er) credit rating and thus have to pay higher premiums in order to get loans. A further 10% (or a third of the bonds section) is categorised as intermediate term bonds, which is a fairly general classification as this section only needs to fulfill the maturity requirements (i.e. more than a year but less than 10 years maturity). These will generally pay a lower coupon rate than the junk bonds, but also have a lower risk of defaulting and are thus part of the “safe haven” of the portfolio.

The final 10% in the model portfolio is broken down into 5% for emerging market bonds and 5% into inflation-linked bonds. Here we essentially have two extremes in that the emerging market bonds are clearly the most risky of debt securities to rely on (and thus yield the highest returns) while inflation-linked bonds pay a premium that is only marginally higher than the current rate of inflation. Here the goal is clearly capital preservation.

So this is how the overall portfolio would look:

If you can’t get enough of asset allocation and model portfolios I suggest you start reading here and move on to here.

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