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Summary Making asset allocation decisions using a backward looking framework based on the global financial portfolio ensures mental rigor. Investors asset allocation decisions should take into account current conditions. Investors will need to adjust expectations and allocations as equity and bond returns will likely be lower than in the past. We’ve written a several articles in the past about what investments and assets classes shouldn’t be in your portfolio such as commodities , currency funds , and bank loan funds . We also wrote a few articles about asset classes that should be in your portfolio such as international bonds . But, we’ve never discussed how to assemble a comprehensive, well diversified portfolio. It’s important to note we are talking about an investment portfolio so we will not be considering cash which would be part of someone’s savings portfolio. In this ongoing series of articles we’ll be discussing each of the asset classes we use to assemble client portfolios. Over the next few weeks we’ll be discussing each asset class in depth and talking about what risk and reward attributes they bring to a portfolio. For this series of articles we’ve divided the asset classes into three conceptual categories: low risk, medium risk, and high risk. The links to previous articles are below. Low Risk Medium Risk High Risk How to Assemble a Comprehensive Investment Portfolio Every Investor’s Starting Point When assembling your portfolio from all the worthwhile asset classes it’s important to keep your starting point in mind. Many investors probably utilize a forward looking mental framework. They think well, I have $100,000 to invest so I’ll allocate $x to asset class A, $y to asset class B, etc. I think a better way to look at things is to take a backward looking point of view. Start with what a portfolio of all global investable financial assets would look like. From the paper in the previous link, which was published in 2011, we can see the breakdown of all financial assets in the world is as follows. We removed some assets like hedgefunds which mostly just hold duplicative positions in equities and bonds which are already included in the global portfolio. We also removed private equity funds because they are not generally available to most investors. It’s also arguable whether or not they would constitute a distinct asset class. After all, they are just funds made up of equity investments. However since those equity investments are not publicly tradable it’s likely that private equity should be considered a separate, albeit expensive to invest in, asset class. In any case, investors should use the adjusted global financial asset portfolio as a starting point and then make changes based on their preferences and goals. For example, the global portfolio is a very bond heavy. An investor with a higher risk tolerance and a desire for higher growth would likely find it much better to overweight equities and underweight government bonds as compared to the global portfolio. Investors who’ve read our articles on commodities and high yield bonds and know that neither asset provides a compelling risk versus reward ratio would know to skip allocations to those assets. An investor with extensive private real estate holdings may elect to skip or reduce their real estate exposure. Don’t Ignore Current Conditions It’s also important to not ignore current conditions when making asset allocation decisions. For example, with short term US interest rates at zero it is highly unlikely that interest rates along the entire curve will fall very far (if at all) thus US bond returns are likely to be muted during the next few years as the Fed slowly begins to raise rates. On the other hand many foreign central banks are still keeping interest rates low or negative. Thus, investors desiring both the safety of government bonds and higher returns may find overweighting currency hedged foreign bonds a good idea. Likewise, a conservative investor planning for retirement who previously may have liked a 50/50 balanced stock and bond portfolio might find that no longer adequate to meet their return goals. As we said bond returns are likely to be below historical averages and with the US stock market either fairly or perhaps slightly overvalued equity returns are likely to be average at best going forward. Therefore, our conservative investor may need to adjust his portfolio, however uncomfortable that may be, to be more aggressive in order to meet his retirement goals. The point of all of this is that deviating from the global financial portfolio is fine. In fact, I’m not sure there would be many investors for whom the global financial portfolio would be appropriate for anyway. What investors need to do, however, is make sure that there are logical reasons for choosing the asset weightings in their portfolio. Summary In summary, an investor should start with the global financial portfolio and then in a logical manner work backward in adjusting the asset allocation of the portfolio to meet their investment goals. I believe this method is most helpful as it forces investors to put more thought into why they are making the asset allocation decisions they are.