I rehashed a lot in Part III, so I won’t provide an extensive summary here, but briefly: Part I had to do with building a portfolio to meet minimum returns expectations. Part II was about the expected returns versus risks of various asset classes and leveraging them to return the same, what the resultant risk amounted to, and how to combine these by weighting them in such a way to reduce risk relative to a more traditional portfolio. Part III discussed a second approach that involves using the concepts discussed in parts I and II to design a portfolio that takes a “market neutral” stance. But this done by picking individual securities or other traders portfolios that you like rather than simply indexing. Part IV will talk about a third approach. Different Approaches to Asset Allocation So we have three basic approaches: 1. Market-neutral “beta” portfolio: where you pick your allocations to each asset class – e.g., equities, bonds, etc. – and fulfill those through ETFs/indexing. An example would be a 40% stocks, 50% bonds, 10% gold portfolio fulfilled via: 40% $SPY 50% $LQD 10% $IAU 2. Market-neutral “alpha overlay”: where you invest in what you like, but still within the bounds of the balanced allocation in the first approach. So if you like tech and utilities, high-yield and medium-duration US Treasuries, it would look something like this, following the above: 15% $VGT 25% $VPU15% $HYG35% $IEF (preferably buy the bonds outright because these give you a bad deal)10% $IAU 3. Alpha only: where the third is a portfolio purely made up of diversified alpha streams, with no attention paid to the asset class that it’s derived from. Note that the third approach doesn’t necessarily mean investing everything in stocks, as is the conventional approach to asset management. Excess concentration in any asset class is rarely (almost never) the best approach from a risk/reward perspective – unless you have a bona fide competitive advantage by working exclusively within that asset class. The US equity market is one of the toughest to generate alpha in. Rather, it means investing in the best sources of alpha among all asset classes available to you – fixed income, equities, currencies, rates, commodities, alternatives/hard assets, and associated sub-markets – but without necessarily abiding by a targeted allocation to each one. Naturally, most portfolios on WhoTrades Live take this approach by investing in what they like and are often concentrated by theme: Tech (Source: WhoTrades Live Profile Page) Consumer (Source: WhoTrades Live Profile Page) Finance (Source: WhoTrades Live Profile Page) Energy (Source: WhoTrades Live Profile Page) Warren Buffett Portfolio (Source: WhoTrades Live Profile Page) How The Three Approaches Might Appear Graphically The first two images appeared in Part III as example portfolios. Market-Neutral Beta Market-Neutral Alpha Overlay (Allocation by asset class is the same as above, but split up into things the trader likes.) Alpha Only (Same assets as above, but the structure of the portfolio is open and flexible.) What Approach Should You Adopt? Those who invest simply to compound their savings are probably best suited to investing in the first approach (market-neutral beta portfolio). Those who believe they can add value to their portfolios through their own research will probably be best suited to moving closer to the second approach (market-neutral alpha overlay) or even third approach (alpha). My opinion is most individuals should lean more toward the first approach, though many, inevitably, will prefer the third approach and try to make tactical bets. However, when making tactical bets in the markets, most are going to lose, not just smaller investors but institutional investors as well. Whenever you make a trade, there’s somebody on the other side of it and there’s a reason why they’re making it. It’s tough to add value in the markets. For instance, there’s the example of the Peter Lynch Fidelity Magellan Fund, which was the most successful mutual fund of all time, earning 29.2% annualized returns from 1977 to 1990. Yet the average person who invested in it actually lost money. Why? Because when things were good and the results were great, people got excited about it and bought it. Yet when it had the inevitable spells where it did poorly people got spooked and sold out of it. When things do well, people look at the past and assume it’ll continue to do well. And when things go poorly, people assume that it’s a bad asset or a bad strategy. And maybe this is true, but generally when markets go down it shouldn’t be thought of in terms of “this is a bad market” but rather that it’s a cheaper market. Everybody can be a genius in strong bull markets, but over time balance and diversification becomes more important, especially as you protect what you’ve built as you get later into your career. How to Play The Game if You Do Play The Cycle Buying If you do choose to make tactical bets in the market, a simple general outline can be found below. This has to do with stocks, which is the favorite asset class of most individuals. 1. The time to buy is when you see the following: (i) The Federal Reserve (and other G-3/G-7 central banks) has greatly eased monetary policy (ii) Unemployment is high / there’s a lot of slack in the labor market (iii) Bearish sentiment is running at or near all-time highs How do you find out what sentiment is? 1. Look at speculative positioning in various markets. Even free websites like investing.com provide CFTC and other data to see net long/short exposure in various markets. 2. There are also various surveys published to gauge this. BofA Merrill Lynch provides the most comprehensive set with respect to its clients – e.g., FICC flows as a % of AUM, % equity allocation, % cash allocation, the beta of clients’ top 10 stocks (higher beta = more bullish, and vice versa). Goldman Sachs also provides a popular bull/bear market risk indicator. Note that these should be treated as contrarian indicators. If folks are highly invested in stocks – and have low amounts of money dedicated to cash – that means they have “less ammo” to invest in them further. Classically, markets top when there are no additional buyers at the margin. (iv) Credit spreads have blown way out of proportion; see 2008 for a massive buying opportunity, with mild buying opportunities in 2011 (US recession fears) and 2016 (oil plunge) (v) The earnings yield priced into stocks starts getting to a level that doesn’t make the yield worth the risk Using the reciprocal of the forward P/E ratio and converting that to a percentage is a common easy way to find this. For example, for the forward one-year P/E of 17x –> 1/17 –> 5.9% earnings yield. Selling 2. The time to sell, not necessarily all at once but gradually, is when you see the following: (i) The Federal Reserve (and other G-3/G-7 central banks) is tightening monetary policy (ii) Unemployment is low / little spare economic capacity (iii) Bullish sentiment is running at all-time highs (iv) Credit spreads are very tight (v) The earnings yield priced into stocks starts becoming less attractive ____ Conclusion This post primarily covered the third (and, in essence, final) approach in this series of how to think about asset allocation from this perspective. These approaches are designed to solve two of the biggest problems concerning how to design a portfolio: 1) excessive concentration in equities, which leads to lumpy returns and large drawdowns, and 2) inadequate expected returns (US stocks over the long-run will return about 6%-7% annualized) The first and second approaches discuss how to achieve specific risk and return targets by allocating assets and judiciously applying leverage in such a way to engineer these outcomes. While those with cash accounts and strict leverage restrictions (or simply because the cost of financing is too high to make it worth it) may not be able to necessarily achieve specific return targets, they can still benefit from these approaches through specific risk targeting. In Part V, we will look at specific portfolios of different asset combinations to show why the first and second approaches lead to superior long-term reward-to-risk outcomes. Thus far this series has been mostly qualitative, so we will dig into it more quantitatively. If you are looking for additional ideas, WhoTrades Live offers a vast array of portfolios and strategies in how to manage your wealth. Each profile shows full transparency over virtually everything you need to know to make a decision as to whether it fits your personal money management needs and expectations. This includes returns, drawdowns, performance trends, holdings and percentage allocations, a computer- and/or user-generated synopsis of the trading style, popularity based on follower count, and any relevant trading activity.