How To Build The Dream Portfolio For Every Nightmare Scenario

How To Build The Dream Portfolio For Every Nightmare Scenario
Stéphane Renevier, CFA

over 1 year ago6 mins

  • With a balanced portfolio, you’re less likely to suffer sharp losses and more likely to generate positive returns over the next five years, no matter where growth and inflation go next.

  • Start by spreading out your risk equally between stocks, bonds, gold, and commodities. Right now, that means having about 25% in stocks, 21% in commodities, 24% in gold, and 30% in bonds.

  • Feel free to tilt this allocation to reflect your shorter-term macro views: you could, for example, slightly move your exposure away from stocks and commodities and into Treasuries and gold.

With a balanced portfolio, you’re less likely to suffer sharp losses and more likely to generate positive returns over the next five years, no matter where growth and inflation go next.

Start by spreading out your risk equally between stocks, bonds, gold, and commodities. Right now, that means having about 25% in stocks, 21% in commodities, 24% in gold, and 30% in bonds.

Feel free to tilt this allocation to reflect your shorter-term macro views: you could, for example, slightly move your exposure away from stocks and commodities and into Treasuries and gold.

If there’s one thing that will have the single biggest impact on your performance in the next few years, it’s asset allocation. Because with so many of the trends that have favored stocks – stable growth, steady inflation, falling interest rates – at risk of reversal, only a truly balanced portfolio will help you deal with whatever the next few years might throw at you. Here’s how to build your own.

Step 1: Choose an asset for every scenario

A truly balanced portfolio doesn’t care whether economic growth and inflation are rising or falling: it should be able to perform in every environment.

That means finding investments that stand to generate returns over the long term, but that are exposed to the economy in different ways. This way, you’ll always have an asset in hand that holds up – and potentially even profits – in any economic scenario…

If growth is strong and inflation falls…

… stocks should generate decent returns. But you might want to opt for global stocks over US stocks, since they’re trading at a discount, less exposed to US-specific risk, and diversified across more sectors.

You can invest in them via the Vanguard Total World Stock ETF (ticker: VT, expense ratio: 0.07%), which is a cheap, highly liquid, and well-diversified option. Of course, you could always invest in favorite individual stocks or sectors instead of the ETF – or a combination of all three.

If growth is strong but inflation stays high…

… interest rates are likely to stay at much higher levels than we’ve experienced over the past two decades. That would probably put pressure on financial assets, while benefiting real assets (like commodities) that preserve their value in real terms.

The abrdn Bloomberg All Commodity Strategy K-1 Free ETF (ticker: BCI, expense ratio: 0.25%) is a cheap, diversified, and efficient way to profit from a potential comeback of real assets.

If growth is weak and inflation stays high…

… bonds, stocks, and commodities are all likely to struggle. It’s an entirely plausible scenario too: structural pressures like deglobalization, decarbonization, and ever-larger fiscal stimuluses could keep inflation stubbornly high even if growth slows down.

Thankfully, gold should do well in this “stagflationary” scenario, as it would benefit from falling interest rates, risk aversion, and high inflation. Gold’s also likely to be a good hedge against the unintended consequences of ever more experimental monetary and fiscal policies, which could lead to a devaluation of fiat currencies.

A cheap and simple way of owning gold is through the abrdn Physical Gold Shares ETF (ticker: SGOL, expense ratio: 0.17%).

If the economy enters a deep and prolonged recession…

… inflation is likely to fall and the Fed is likely to go back to cutting interest rates. That would be a bad environment for risky assets like stocks and commodities, but great for long-term US Treasury bonds, which would benefit from falling rates, lower inflation, and the rush to buy safe-haven assets.

To get the most bang for your buck, you could buy the iShares 20+ Year Treasury Bond ETF (ticker: TLT, expense ratio: 0.15%), which generally invests in bonds that have a maturity of more than a decade.

All of the above scenarios can be summed up in one handy chart:

We've got an asset performing well in every environment. Source: Finimize
We've got an asset performing well in every environment. Source: Finimize

Step 2: Set your allocations

Now that you have an asset for every macro environment, you’ll want to make sure your portfolio doesn’t have a strong bias towards one scenario or another.

After all, each of these assets has different volatilities, which means allocating the same capital weight – say 25% to each – won’t necessarily give you a balanced exposure. Imagine a bond typically moved $1 to a stock’s $3: if you held a portfolio made up of 50% bonds and 50% stocks, the latter – which move three times as much as bonds – will have an oversized influence on your portfolio’s performance. So to balance the portfolio, you’d need to own three times as many bonds as stocks. This is known as “risk-based” position-sizing, and it’s key to building a truly balanced portfolio.

Of course, it’s never as simple as to say “stocks rise $3 for every bond’s $1”. Fortunately, you can use Portfoliovisualizer’s tool to calculate how much capital you should allocate to each asset. In our example, it’s telling me I should allocate a “risk-based weight” of 25% to stocks, 21% to commodities, 24% to gold, and 30% to Treasury bonds. This is what I call a “macro-neutral” portfolio.

The "macro-neutral" portfolio. Source: Finimize
The "macro-neutral" portfolio. Source: Finimize

Step 3: Tilt your portfolio based on your shorter-term views

If you’re feeling confident, you might decide to start “tilting” your macro-neutral portfolio. In other words, you might adjust your allocations when you think the price of a market has become disconnected from the reality of the situation.

So let’s say you think the economy will slow down more than investors have currently priced into the market. You might expect this slowdown to push inflation lower, but not as low as the market expects. To reflect that view, you could reduce your allocation to stocks and commodities, and increase your allocation to long-term Treasury bonds and gold, like so:

Final portfolio weights after tilting based on your shorter-term views. Source: Finimize
Final portfolio weights after tilting based on your shorter-term views. Source: Finimize

Just remember that the more you deviate, the more you’ll rely on the success of a personal forecast. And as we said at the beginning, this portfolio is about avoiding forecasts as much as possible.

Step 4: Rebalance your portfolio

You should rebalance your portfolio periodically – say every quarter – or whenever an asset class experiences a large move. That’s because your actual allocation will probably have deviated significantly from your target one. Rebalancing means you’ll buy more of an asset when its price has dropped, and less when it’s on the rise.

You should also rebalance when your macro view materially changes. If, for instance, stocks crash and the Fed starts easing again, you may want to consider boosting your allocation to them. But make sure not to deviate too much from this starting allocation: you’ll want to maintain the right balance in an environment so uncertain – not least because any one of the other scenarios mentioned above could be right around the corner.

Step 5: Keep your expectations realistic

Bear in mind that this is a defensive portfolio that aims to maximize the likelihood you’ll make money when you have no idea where the economy will go next. That means this portfolio is much less likely to suffer losses as substantial or as long-lasting as a concentrated portfolio.

But it’s also likely to underperform a portfolio focused on whichever asset class performs best over the next few years. Put differently, a balanced portfolio means you’re accepting good but unexceptional returns in exchange for a better night’s sleep. And in these uncertain times, that doesn’t seem like such a bad trade-off.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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