Of portfolio balance

There are many different portfolio balance theories out there in the world of personal finance. Some are based on risk management, some based on diversification, and some have a logic so complex that it takes a while to even figure it out. Whichever portfolio strategy you use, one idea is constantly emphasised – you must diversify between different asset classes and markets.

Why diversify across asset classes?

The somewhat classical theories focus on three main asset classes – stocks, real estate and loans. Other options include metals, entrepreneurship etc. The idea behind diversifying asset classes is that they behave differently in different market situations. While stocks can be quick to drop, they can also generate incredible short term returns and are considered relatively stable long term.

With real estate the main value is the idea that you own a physical asset – while a company may go bankrupt then you still own an apartment or a house and while it may drop in value, it won’t completely drop to zero. Real estate and loans also help generate cash flow in a way that stocks generally don’t.

This means that to reduce risk levels you should have different asset classes in your portfolio because in case one asset loses value the others may keep theirs for longer. In the case of a big economic crisis of course all parts of the market drop, but different asset classes recover at different speeds and being able to generate cash flow while you wait for capital growth recovery is valuable.

Why diversify across markets/geographically?

In the case of social lending diversifying across hundreds of loans helps you manage risks by betting on the fact that not all regions of the country lose jobs at the same rate. In case of a crisis it’s clear that the less wealthy regions of Estonia will be hit harder while the bigger cities are likely to have more job opportunities therefore people will be more likely to pay back their loans.

For stock markets geographical diversification in its broadest sense means picking different markets. I invest both into the Baltic market and into the US market. Maybe soon I’ll add in general European markets as well. The benefit of this is easy to see – if you take side by side the growth charts of Europe and USA, then you can clearly see that they don’t always move in a similar direction, which means more stability for your portfolio.

Why diversify across different risk classes?

Everyone who invests wants high returns. It is however important to keep in mind that higher returns are linked to higher risks as well. This means that while you may enjoy higher returns when the market is climbing upwards then higher risk investments also mean a much bigger hit when the market takes a steep downwards turn.

Generally stock indexes are considered much safer than individual stocks due to the lowered risk provided by higher diversification rates. Social lending is inherently riskier than real estate backed loans where you have less of a chance of walking away empty handed.  The same way smaller apartments close to city centres are generally considered lower risk since they’re likely to maintain renters’ interest even in the case of an economic downfall.

How to assess your portfolio?

The easiest way to look at whether your portfolio is balanced is to either write it down in numbers or have a visual outline of your portfolio. Taavi I. wrote a nice piece of code that allows you to visualise your portfolio and I must say I quite like the visual aspect of it.

portfell1704

For example the image above is the balance of my current portfolio. It lists all social lending, stocks, indexes and crowdfunding. As you can see, my portfolio is very heavily influenced by whether or not Bondora does well (Bondora used to be 75% of my portfolio) so I’ve been working hard to push it down to 50% overall portfolio value.

Ideally your portfolio should be close the 1/3 in each asset class. In my case what is arguably missing is real estate (since Crowdestate is not pure real estate), which is why I set the goal of getting into rental real estate this year. Overall though, you can see that my portfolio is getting better in terms of overall balance. While my portfolio isn’t all that big yet, then getting into the habit of it being balanced will help a lot in the long run.

 

4 thoughts on “Of portfolio balance

  1. Few comments:

    You said the different areas of Estonia reacts differently to exogenous shocks.
    Do you have any research papers backing this? I am sure this is something that might be actually a topic for Bachelor’s/Master’s thesis. :) Intuitively, this needs more reasoning in my opinion. I mean, is it really so clear cut?

    The other point you are making here saying “ideally 1/3 to each asset class”. I would disagree respectively. :)
    Some people who have perhaps lower income and thus saving is harder might feel more pain if the stock markets crashes big time (like 60-70 %) and 1/3 of her/his savings are tied into stocks. On the other hand, if you are a rich girl/guy you might be also pretty risk averse since you may not want to lose your money so I would say 1/3 is not ideal for everybody. :) It depends on observator’s willingness to carry losses. How much are you able to lose money.

    Otherwise, nice blog post, thank you!

    1. Yeah, I myself am not sold on the 1/3 of each asset class either since it’s a bit too oversimplified, but ideally they should at least be represented.

      In terms of social lending, there is data about different counties of Estonia and how they do in terms of paying back loans – Võrumaa & Valgamaa for example have the biggest difficulties paying back loans since their salaries are low(est) to start with. Ida-Virumaa is currently highest on unemployment by a large margin. During the last crisis the countryside generally was hit harder since in the bigger cities keeping up demand for services is easier.
      (I couldn’t find a single article that’s in English though, but the topic of how big the differences are in debt in different regions of Estonia has gotten quite a bit of attention in Estonian media.)

  2. I’m my opinion it’s all a matter of taste and personal circumstances how the assets should be balanced. For what it’s worth I have 90% stocks, 10% cash and 0% Real Estate. Might be a bit heavy on the stocks and nothing I can recommend everyone but I like to collect stocks almost as much as I like to drink latte. ‘To each his own’

    1. True, there is no absolutely right formula. As long as you’ve thought it through, then it’s great. The problem is that a lot of people who invest just invest without thinking too hard about what their strategy or asset allocation should be.

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