What is the main objective of building a portfolio? The goal is to try to make money in the markets. More specifically, you want to achieve a good rate of return with as little risk of loss as possible. Everyone knows that the markets go up and down; you just don't want to take a big hit. There are essentially only two ways to make money in the markets. You can trade investments (repeatedly trying to buy low and sell high) or you can simply hold investments (buying and holding for the long run). The first approach is risky because you might guess wrong and buy too high or sell too low. The second also has downside because you may choose to invest in the wrong markets at the wrong time. Trading securities is a zero sum game because for every winner there has to be a loser, since the market as a whole is made up of all the buyers and sellers. Moreover, with trading, time is not on your side. You can trade for a long period of time and earn nothing (or less than nothing after fees, taxes, and headaches). Holding markets, on the other hand, is not a zero sum game and time is your friend. You have a high likelihood of success if you wait long enough, particularly if you are invested in a well-balanced portfolio. Most importantly, holding markets is far easier to do and anyone can be successful doing it. For this reason, the focus of this book is efficient asset allocation.
What makes picking the correct allocation an onerous task is the fact that guessing what will happen next in the market is inherently difficult, if not impossible. This is particularly true when you consider that even if you think you know for a fact what the future economic environment holds (which you never do, regardless of what you may think), it does not necessarily mean that you will profit from this prescience. Markets are discounting machines. Current prices reflect expectations of the future. Thus, you must not only accurately guess what the future holds, but your guess must be different from the majority view (which set the price in the first place). In other words, be very careful about being too confident about your ability to consistently pick tops and bottoms in markets. Very few market participants have demonstrated success doing so, and even those who have cannot easily prove that their success is due more to skill than luck.
One of the key messages in this book is the notion that you should have greater confidence in the benefits of diversification than in your investment convictions. Even if you strongly believe that you know what the future holds, you should always trust that a well-diversified portfolio will provide greater benefits over time. In fact, the most dangerous scenario is when you are highly confident of future events that never transpire. The greatest losses generally occur not only when they are least expected, but when investors are most confident that the catastrophic loss is a nearly impossible outcome. For it is during these periods that investors are most apt to maximize their bets.
The answer, then, is to develop a truly balanced portfolio. A balanced asset allocation can help you profit during various economic environments and is not dependent on successful forecasting of future conditions. As you read this book, my hope is that you will better appreciate the appropriate context in which to analyze portfolios. You will gain a viewpoint that will make it obvious that the approach taken by most (likely including you) completely misses the mark and exposes portfolios to major, unanticipated risks. You will learn how to effectively construct a well-balanced portfolio that is less vulnerable to economic shocks. And best of all, the concepts that I will share are extremely simple, intuitive, and easy to implement. Although the logical sequence may make sense to you, the makeup of the truly balanced portfolio will undoubtedly surprise you. The simplicity of the thought process and the asset allocation outcome is the most compelling feature. As is often the case, simple is more sophisticated.
This book is divided into the following sections:
• Chapter 1 will establish the foundation for understanding how the economic machine functions. Viewing today's unique climate within this context will explain why maintaining a well-balanced portfolio is even more important than usual.
• Chapter 2 will demonstrate just how rare it is to find true balance in portfolios despite the great need. Many think their portfolios are well balanced and will be surprised to discover the reality of significant imbalance in the conventional asset allocation.
• In Chapter 3 I will explain what fundamentally drives asset class returns. The insights shared in this chapter will set the stage for how you should think about asset classes and balanced portfolio construction.
• Chapters 4–8 will analyze the major asset classes through the newly introduced balanced portfolio lens. By viewing stocks, bonds, commodities, and other market segments through this new perspective, you will likely reach a different, unconventional conclusion about the role of each asset class within the context of a truly balanced portfolio.
• Chapters 9 and 10 will help you apply the lessons in practice. Specific steps to build a balanced portfolio will be described. The rationale for a sample balanced portfolio, as listed below, will be provided.
The Balanced Portfolio
20 % Equities
20 % Commodities
30 % Long-Term Treasuries
30 % Long-Term TIPS
• Chapter 11 will demonstrate the benefits of a truly balanced portfolio by providing long-term historical returns to support the core concepts.
• To round out the discussion, Chapter 12 will provide implementation strategies to help you put into practice the concepts you learn in this book.
Chapter 1
The Economic Machine
Bridgewater Associates, the largest and most successful hedge fund manager in the world, pioneered most of the concepts that I will present in this book more than 20 years ago. Bridgewater is at the forefront of economic and investment research and has been refining and testing its concepts over the past two decades. The company has a great understanding of what drives economic shifts and how those shifts affect asset class returns. The first chapter is effectively my summary of its unique template for understanding how the economic machine functions. Bridgewater has released a short animated video that explains their template and related research at www.economicprinciples.org, and I encourage you to visit the site. The core principles presented throughout the rest of the book were also developed by this remarkable organization over the past couple of decades. I know of no one in the industry that has a better command of this subject.
In order to fully recognize today's unique economic climate, you first need to better comprehend how the economic machine generally functions. The goal of this first chapter is to arm you with a command of the basic inner workings of this machine to enable a deeper appreciation of why this topic of building a balanced portfolio is so timely. Insight into the economic machine will also lay the required foundation for an improved understanding of the key drivers of asset class returns. I will refer back to this opening chapter throughout the book because it introduces core, fundamental concepts that impact markets, and therefore portfolio returns.
How the Economy Functions
Constructing the appropriate asset allocation is always a challenge, but it is particularly difficult in the current economic environment. The reason is simple: The United States and many other developed world economies are fighting through a deleveraging process that is likely to last for a decade or longer. Deleveraging is a fancy term for debt reduction or lowering leverage. When the amount of debt in any economy gets too high relative to the ability to pay it back, then the debt burden must be reduced. But what does this really mean and why is it so important? To effectively answer this central question, I will start at the most basic level.
The economy