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A winning portfolio in 10 moves

Dominic Picarda outlines a simple strategy to build a well-diversified portfolio that's proven to effortlessly deliver market-beating returns
A winning portfolio in 10 moves

Owning a good spread of different assets is the key to healthy returns over time. But, while we're all aware of the need to diversify, many of us go about it the wrong way. Too many private investors' portfolios resemble Steptoe's yard - a rag-and-bone man's sprawling pile of odds and ends thrown together over the years. Such a higgledy-piggledy approach often leads to lower returns and needlessly high risk.

It doesn't need to be this way, though. We can easily build a broadly spread portfolio of different assets from around the world with just a handful of individual securities. In Seven Steps to a Winning Portfolio: http://bit.ly/1dNKmiF, I showed how six exchange traded funds and some cash could produce superior returns than a bog-standard mix of stocks and bonds, but with much less risk.

The good news is that we can do even better than this, though. By adding a bit of straightforward risk management and a few more assets, we may be able to get fatter returns while slimming down our risks.

Above-average returns

The make-up of our original UK seven-asset asset portfolio is shown in the accompanying pie chart. This collection of investments was inspired by the work of US financial academic Craig Israelsen. Since 1979, my UK version of Dr Israelsen's portfolio made a total return of 11.3 per cent, compared to a 10.9 per cent return for a classic 60/40 mix of UK large-cap stocks and British government bonds.

The original seven

Source: Craig Israelsen & Investors Chronicle

Running this portfolio is simple. At the end of each year, you simply buy and sell as needed for an equal seven-way split. However, with a bit more effort, you could have got a slightly better return with a lot less risk. The key to this is side-stepping really big losses. An objective, proven way to do this is by getting out of an asset every time it ends a month below its 10-month simple moving average, and only buying back in once it posts a monthly close above it.

UK equities: the 10-month rule

Source: Thomson Datastream

Since 1980, combining the seven-asset portfolio and this 10-month average rule would have resulted in an annualised total return of 11.4 per cent a year, compared to 11.1 per cent for the straight-forward version. The really impressive bit was the riskiness, though. Annual volatility dropped from 9.7 per cent to 7.3 per cent. The biggest peak-to-trough drop in the portfolio's value declined from almost 28 to 16.6 per cent.

The portfolios compared

(%)7-asset, with 10-month rule 7-asset
Annual return11.411.1
Volatility7.39.7
Biggest drawdown-16.7-27.8

Source: Thomson Datastream

Of course, the additional trading involved would have run up more costs. Rather than just a simple once-yearly rebalance, there were some 245 extra trades over the 33-year period. That may sound like a lot, although it's actually fewer than eight deals a year. In a world of low-cost dealing and exchange traded funds, it may well be worth doing.

Add depth to your breadth

Having developed the original seven-asset portfolio for the US, Dr Israelsen sought to achieve even better results. As he sets out in his book '7Twelve: A Diversified Investment Portfolio with a Plan', you can add portfolio depth to breadth by adding sub-categories within each asset class. While he went for 12 such groupings, I've tried to simplify further by using just 10. And here they are.

Asset class sub-categories

Weighting Possible TrackerTickers
UK large cap10%FTSE 100 ETFVarious
UK mid cap10%FTSE 250 ETFVarious
Developed equity 10%SG Global QI (SGQL) SGQL
Emerging equity10%MSCI Emerging Markets ETFVarious
Real estate10%HSBC FTSE EPRA/NAREIT Developed UCITS ETFHPRO
Commodities10%iPath S&P GSCI Index Total Return ETNSPGS
Gold10%Gold ETFVarious
UK gilts10%FTSE Actuaries Government/iBoxx £ GiltsVarious
UK index-linked gilts10%iBoxx UK Gilt Inflation-LinkedGILI
Cash10%High return account; instant-access not needed

UK equity

As in the original seven-asset portfolio, my 10-asset portfolio gives an equal weighting to large- and smaller-cap stocks. This runs against what many investors do, which is to give large- and smaller-cap stocks the same weighting as they have in the overall market. That approach leads to a bigger holding of large-cap stocks and lower returns over time. Specifically, my way involves holding one-tenth of the portfolio in the FTSE 100 and FTSE 250, respectively.

Global quality income

In the original seven-asset portfolio, international equities were represented by the easily tradeable MSCI World index, which covers big shares from more than 20 top stock markets in developed countries. However, as Dr Israelsen pointed out, we can boost returns by skewing our holdings towards equity styles that have consistently done better over time.

For this reason, I have decided to use SG's Global Quality Income index in order to make up my international equity exposure. This index - which you can read more on in my piece here: http://bit.ly/1bLct1B - focuses on financially-robust businesses with above-average dividend yields. Its returns have soundly beaten those of the MSCI World index since 1989.

MSCI Emerging Markets

Emerging markets are no longer the great spreaders of risk that they once were. Globalised investment trends mean that stock markets in emerging countries move more closely than ever before with developed markets. However, there's still a good case for investing in these markets, as the first decade of the 2000s showed. And while the MSCI Emerging Markets has lagged behind the MSCI World index since 2011, its longer-term prospects are likely very bright.

Real estate

As in the seven-asset selection, I've gone for broad developed real-estate investment trust exposure to play the part of property in the expanded portfolio. The UK is too narrow a real-estate market for my liking. The corresponding ETF to buy in this instance would be one linked to the FTSE EPRA/NAREIT Developed Index.

Commodities

The S&P Goldman Sachs Commodity (GSCI) index is one of the best recognised and longest running commodity indices around. Although it contains industrial metals, agricultural products, livestock and precious metals, energy is the dominant force, making up more than two-thirds of its value.

Gold

I've decided to give gold a place of its own in my own 10-asset portfolio, alongside commodities. Gold is a great diversifier, helping to lay off stock market risks in particular. It's also a proven hedge against inflationary shocks. As a rule of thumb, it's often said that investors should hold 10 per cent of their wealth in the yellow metal. And that's exactly what we're doing here, therefore.

UK bonds and linkers

A balanced portfolio should always contain some fixed income assets, even if you fear the outlook for bonds is poor, as I do. A diversified collection of bonds of different maturities - such as a tracker covering the FTSE UK All Stock Gilt index or the iBoxx Gilts index - involves less inflation risk than holding a single long maturity bond, such as a 10-year gilt.

To add some inflation protection, I've followed Dr Israelsen's lead by including exposure to inflation-linked government bonds. The FTSE British Government Index-Linked All Stocks index covers inflation-protected securities of various maturities.

Cash

A 10 per cent holding in cash is something that I'm frankly not delighted about. In the current world of ultra-low interest rates, cash on deposit has been a disastrous investment in recent years. Still, in a long-term portfolio-context, there's still a case for having a stable, interest-earning buffer.

The results

Because some of the assets in the portfolio have a short history, I have only been able to calculate the returns of the UK 10-asset portfolio since 1999. However, the results are more than worthwhile. Since that time, the annualised total return has been 9 per cent a year, which is more than respectable in its own right, especially considering the turbulence in financial markets since the turn of the millennium.

How 10 assets beat the rest

(%)Ten-asset UKOriginal 760/40
Total return97.45.4
Standard deviation8.49.38.9
Biggest drawdown-19-28-26

Just as importantly, the UK 10-asset portfolio has soundly beaten a UK 'bog-standard' holding of 60 per cent stocks and 40 per cent bonds, which made just 5.3 per cent. It also beat the original seven-asset allocation, which made just 7.4 per cent. Best of all, it managed this with much lower risk - and just one set of rebalancing trades each year.

Not only will we be tracking this portfolio going forward, but will also be looking at ways to refine its make-up and results yet further.

UK asset portfolio results