Investment advisers and portfolio managers often divide portfolios into different investment categories. The logic behind this is quite simple. In theory, different assets have different risk-adjusted returns.
Therefore, mixing low risk assets with high risk assets can reduce portfolio volatility and improve returns on a risk-adjusted basis.
The world’s largest hedge fund, Bridgewater, has used this approach with great success for many decades. The Company’s Pure Alpha and All-Weather strategies use a combination of leverage, bonds, commodities, stocks and other assets to produce positive nominal returns in all low volatility markets.
This approach can work if you have a lot of flexibility.
For example, Bridgewater has been successful in its strategy because it has strong relationships with Wall Street, very talented managers, and access to the best ideas. However, many copycat funds have struggled because they don’t have these benefits.
One of the problems is having weights that the investor must achieve, regardless of the market environment. This is where individual investors have a certain advantage over regulated and restricted funds.
Individual investors and unrestricted funds can invest wherever they want. As such, there is no need to focus on a specific area of the market or on a set of assets. If a fund can only invest in stocks and needs to be 100% invested at all times, it will make mistakes because it may have buying ideas even if they are not the best.
An investor will encounter the same problem if they are targeting allocations or other categories of investment.
For example, an investor who today wants a 20% allocation to bonds will have a hard time finding attractive assets. This can lead them to buy poor quality assets.
This is why Warren Buffett (Trades, Portfolio) has always avoided targeted portfolio allocations.
Avoid portfolio targeting
The Oracle of Omaha explained this point at Berkshire Hathaway 2004 (BRK.A, Financial) (BRK.B, Financial) annual meeting:
“We have a number of things that we feel competent to make judgments about, and we have a number of things that we are not competent to make judgments about.
So we’re narrowing down – we’re hoping to narrow it down to investments that we think we can understand. And there are a reasonable number of them, although there are many that we cannot understand. Everything I would say today, you know, can change tomorrow. We don’t think of categories by themselves.
Today, in a time like summer until mid-fall 2002, when junk bonds became very attractive, we bought a lot of them. But we didn’t make the right decision to buy junk bonds; we just started seeing things, individual items, that started yelling at us, you know, “buy, buy, buy”.
And then it ended. And so we don’t go to the office in the morning thinking about which category – how do we prioritize our categories. You know we have an open mind and everything we see that day getting over, or crossing the threshold where we take money short term money and move into it.
This quote perfectly sums up Buffett’s point of view on the subject. Investors should buy what they know, whether it is stocks, bonds, real estate, or whatever. Buying assets that you understand at an attractive price is always a good strategy.
Conversely, buying an asset simply because it fits a pattern or a compartment without really understanding the asset, or thinking that it offers value, is never a good strategy.
What works best
There will never be a single strategy for all investors. The process of buying assets according to a defined pattern or because they belong to specific categories may work for some investors.
Still, it’s worth considering that the best investors of all time have always held onto the assets and asset classes they know and understand.
Following the same strategy may not guarantee returns, but it could help tip the odds of success in its favor.