How to design a bulletproof investment portfolio

If there is one thing that will have the biggest impact on returns in the coming years, it is asset allocation. Many of the trends that have favored investing in stocks (stable growth, constant inflation, falling interest rates) are at risk of reversing. Only a truly balanced portfolio will help us cope with whatever the next few years throw at us. We are going to teach you how to build yours. 

Step 1: Choose an asset for each scenario️​

A truly balanced portfolio doesn't care if economic growth and inflation go up or down. Must be able to perform in any environment. That means finding investments that can generate long-term returns, but are exposed to the economy in different ways. In this way, we will always have on hand an asset that is maintained in any economic scenario...

If growth is strong and inflation is low…​

In this case, the investment in stocks should generate a decent return. But we may want to opt for investing in global stocks rather than US ones as they are trading at a discount, less exposed to US risk and diversified across more sectors. We can invest in them through the Vanguard Total World Stock ETF (VT), which is a cheap, very liquid and well diversified option. Of course, you can always invest in individual stocks or favorite sectors instead of the ETF, or a combination of the three.

If growth is strong but inflation remains high…⛽​

In this scenario, it is most likely that interest rates will remain at much higher levels than those we have experienced in the last two decades. That would likely put pressure on equity investing, while benefiting assets like commodities, which hold their value in real terms. abrdn Bloomberg All Commodity Strategy K-1 Free ETF (BCI) is a cheap, diversified and efficient way to benefit from a potential return on real assets.

If growth is weak and inflation remains high…​

Here investments in stocks, bonds and commodities are likely to suffer. It's also a totally plausible scenario. Structural pressures such as deglobalization, decarbonization, and increasing fiscal stimulus could keep inflation stubbornly high even as growth slows. Fortunately, gold should do well in this "stagflation" scenario, as it would benefit from the falling interest rates, risk aversion and high inflation. It is also likely that the physical be a good hedge against the unforeseen consequences of increasingly experimental monetary and fiscal policies, which could lead to currency devaluation. A cheap and easy way to gain exposure to gold is through the ETF abrdn Physical Gold Shares (SGOL).

If the economy enters a deep and prolonged recession…​

It's scary just thinking about it... Inflation is likely to fall and the Fed will cut interest rates again. This would be a bad environment for investing in stocks and commodities, but great for investors. Treasury bond in the US in the long term, which would benefit from falling rates, low inflation and the rush to buy safe-haven assets. To get the most out of our capital, we could buy the iShares 20+ Year Treasury Bond ETF (TLT), which generally invests in bonds with a maturity of more than a decade.

We can summarize all the previous scenarios as follows:

Step 2: Set assignments ✍️​

Now that we have an asset for each macroeconomic environment, let's make sure that our portfolio does not have a strong bias towards one scenario or another. After all, each of these assets has different volatilities, which means that assigning the same weight of capital (25% each) will not necessarily give us a balanced exposure. Let's imagine that a bond normally moves $1 compared to $3 for a stock. If we have a portfolio made up of 50% investment in bonds and 50% investment in stocks, the latter (which move three times more than bonds) will have an excessive influence on the profitability of our portfolio. Therefore, to balance the portfolio, we must have three times as many bonds as stocks. This is better known as "risk-based" position sizing, and is the key to building a truly balanced portfolio. Of course, it's never as simple as saying "stocks go up $3 for every $1 in bonds." Fortunately, we can use the tool Portfoliovisualizer to calculate how much capital we should allocate to each asset. In our example, it tells us that we should assign a "risk-based weight" of 25% to stocks, 21% to commodities, 24% to gold, and 30% to Treasuries. This portfolio is “macro-neutral”.

Step 3: Tilt our portfolio based on our short-term view ​

If you feel confident in yourself, you can start to "tilt" your macro-neutral portfolio. In other words, we might adjust allocations when we believe a market's price has become disconnected from the reality of the situation. Let's assume that we believe the economy will slow down more than investors have priced in the market. We could expect this slowdown to lower inflation, but not as much as the market expects. To reflect this view, we could reduce our investment allocation to stocks and commodities, and increase our allocation to long-term Treasuries and gold, as follows:

	ticker	GROWTH	INFLATION	PORTFOLIO DISTRIBUTION	FORECAST	PORTFOLIO REDISTRIBUTION
GLOBAL ACTIONS	VT	+	-	25%	-4%	21%
RAW MATERIALS	DBC	+	+	21%	-5%	16%
GOLD	SGL	-	+	+ 2 %	26%
TREASURY BOND	T.L.T.	-	-	30%	+ 7 %	37%

Remember that the more it deviates, the more we will depend on the success of a personal forecast. And as we said at the beginning, this portfolio tries to avoid forecasts as much as possible.

Step 4: Rebalance the portfolio ​⚖️​

We should rebalance our portfolio periodically (e.g. every quarter) or whenever an asset class experiences a big move. This is because your actual allocation will likely have deviated significantly from your target. When we say rebalance we mean buying more of an asset when its price has fallen, and less when it is rising. We should also rebalance our portfolio when our macroeconomic view changes substantially. For example, if the value of our investment in stocks plummets and the Federal Reserve begins to relax its interest rate policy, we may consider increasing our allocation to them. But we must ensure that we do not stray too far from this initial assignment. Basically because we are interested in maintaining the right balance in such an uncertain environment, especially since any of the other scenarios mentioned above could be just around the corner.

Step 5: Maintain realistic expectations ​

We have to keep in mind that our defensive portfolio has the objective of maximizing the probability of making money when we do not know what direction the economy will take. That means this portfolio is much less likely to suffer losses as large or long-lasting as a concentrated portfolio. But it is also likely to underperform a portfolio focused on the asset class that performs best in the coming years. In other words, a balanced portfolio means that we will accept good but not exceptional returns in exchange for better sleep. And in these times of uncertainty, it doesn't seem like a bad compromise...