Join our community of smart investors

Simplicity works

Simple portfolios would have protected investors during this crisis
Simplicity works

Back in January I wrote a piece entitled 'how not to lose money', wherein I showed that a simple balanced portfolio achieved reasonable returns with relatively little risk. Subsequent events have at least given us a test of my hypothesis. So how has it held up?

Not too badly. As I write (on 26 March), that portfolio has lost only 3.3 per cent so far this year. That compares with a fall in the All-Share index of 26.1 per cent.

Granted, this doesn’t quite live up to the hubristic title of that piece – although the portfolio is up by 4.6 per cent on a year ago, and a slightly lower equity weighting would have prevented any loss. Nevertheless, such a loss is not abnormal. Based on the portfolio’s performance since 1990, it’s the sort of fall we’d expect to see in one three-month period out of every 13. And, indeed, there have been many times in the past when the portfolio did worse than this. Looking at our portfolio alone, you would never guess that the past few weeks have been some of the most traumatic in recent history. 

The fall in the All-Share index, by contrast, has been truly remarkable. Only the 1987 crash, the 1974 crisis and the bursting of the South Sea bubble in 1720 saw bigger three-month losses.

Simple diversification, therefore, works. One reason for this is that one-fifth of our portfolio is in gilts, which have enjoyed a 6 per cent gain so far this year.

The bigger reason, though, is that the US dollar has risen against sterling, by over 11 per cent. This gave us good returns not only on the 10 per cent of the portfolio held in dollar cash, but also on the 10 per cent held in gold. It also greatly mitigated the losses on the half of the portfolio held in equities. MSCI’s world index in sterling terms has fallen by only 14.4 per cent so far this year as I write.

The US dollar’s rise in not dumb luck. For years, sterling has been a risky asset, which falls when investors lose their appetite for risk: it plummeted in the 2008 crisis too. Foreign currency was a nice form of insurance for UK investors before this crisis, and it has been so during it.

Now, I don’t say all this to show off how clever I am. In fact, the opposite is the case. The notable thing about this portfolio is how simple it is. It involves no trading at all except for monthly rebalancing to maintain its 50-20-10-10-10 weightings – a process that lost us money in March as it increased equity exposure.

It also makes no attempt to pick stocks or to predict the future. There is zero thinking about macroeconomic conditions or market valuations here.

Nor is there even great diversification. I've confined myself to just five assets, ignoring therefore whole asset classes such as index-linked gilts, foreign or corporate bonds and property. And nor is there any optimisation. The portfolio's weights were chosen only as reasonable round numbers.

Despite all this, however, this portfolio performed better than most fund managers. Only five out of the 169 unit trusts in Trustnet’s category of mixed investment funds with 20-60 per cent in equities did better than it.

Which corroborates an important general point made in a classic paper in 1979 by the psychologist Robyn Dawes. He showed that rough-and-ready statistical models have a “robust beauty” and can do better than professional judgement.

Simplicity can sometimes outperform sophistication. And not just in extreme times such as these, but in normal ones too: as I showed in my original article, this portfolio also outperformed many funds in more stable times. Which raises the question: what, then, is the point of fund managers?

Actually, they have at least two purposes. For one thing, they give investors somebody to blame. If we lose money investing for ourselves we suffer not just a financial loss but a blow to our ego too. Delegating our investments to fund managers protects us from this psychological damage. It’s a way of separating financial losses from losses of self-image.

But there’s more. Reducing risk is not just about statistics. It’s about feelings. We need investments we feel comfortable with. Mere numbers about correlations, drawdowns and standard deviations are not sufficient here. Instead, it is financial advisers and fund managers who offer comfort that dry statistics cannot. Serious men in expensive suits in smart offices talking jargon are part of a performance intended to give us reassurance. They are more like priests than scientists. And in uncertain times, many people need priests.