Many investors spend a lot of time thinking about which assets to add to their portfolios and then spend very little time thinking about how much capital they should allocate to each position. It is a big mistake, and it can lead us to make unbalanced and unnecessarily risky portfolios. But by following these two simple steps, we can avoid that mistake and build a more solid and secure portfolio…
What are the two steps?
1. Distribute our assets based on their level of volatility.
Let's assume that we have a greater preference for two types of investments. On the one hand we have an investment in cryptocurrencies such as bitcoin (BTC) and on the other an investment in stocks such as Coca-Cola (NYSE:KO). We seek to ensure that our portfolio has a total balance. The simplest option would be to split the portfolio 50/XNUMX. The problem is that they are two very different asset classes, and that will not give us the combination we are looking for.
On the one hand, the price of bitcoin has more volatility than that of Coca-Cola shares, which have less volatility. Bitcoin's annualized volatility is 61%, about four times more than the 16% of Coca-Cola shares. So, if we make an investment in Coca Cola stock and an investment in bitcoin and allocate $100 to each of them, we can expect our bitcoin investment to move (up or down) by $61 this year, and investment in Coca-Cola shares only at 16 dollars.
We see how the combination between an investment in stocks and cryptocurrencies would be the most balanced for our portfolios. Source: Portfolio Visualizer.
Having a 50/50 allocation means that we have more conviction about bitcoin, because the benefits it can generate are greater compared to those that investing in Coca Cola shares can generate. In other words, our portfolio will be dominated by bitcoin, despite having initially been allocated the same proportion in both assets. To eliminate this bias, and make the contribution of each of your investments more aligned, you need to allocate less to those “high octane” assets and more to “low octane” ones. In our example, it means investing about four times more money in Coca-Cola than in bitcoin. That is, 17% in bitcoin and 83% in Coca-Cola.
2. Allocate our assets based on their diversification advantages.
Suppose we have an investment in shares, specifically 9 shares. We're also thinking about adding gold to the mix. Assuming your volatilities are similar, it might be tempting to weight the portfolio equally, allocating 10% of the portfolio to each. But this would not be the most optimal, given that gold will provide many more diversification benefits to our current portfolio than another stock. After all, our portfolio is already made up entirely of an investment in stocks, and these tend to move in a similar way.
Comparison between equal diversification and a 50/50 distribution.
Gold, on the other hand, is moved by different factors. It benefits when economic growth is weak and inflation is high, while stock investing benefits when those conditions are reversed. Therefore, we will dedicate more of our portfolio to gold and less to investing in stocks. This way, we add diversification benefits to this mix, and it will likely have a good return when our stock investment runs into trouble.
Comparison of movements between the SPY and gold this year. Source: Portfolio Visualizer.
A useful way to measure the diversification benefits of an asset is to look at its correlation with other assets. Assets that move perfectly in tandem have a correlation of 1, while assets that diversify perfectly with each other have a correlation of -1. The lower the correlation of an asset with the rest of the portfolio, the more useful it is as a diversification tool and the more weight you should give it.
So how do we put this into practice in our portfolios?
To start, let's assume that we know that we want to have an investment in stocks, some gold, and some bitcoin in our portfolio. We can determine our portfolio allocations based on the volatility and diversification advantages of each asset class, using a method called “risk parity«. In this way we use the risk-reward ratio that each asset can contribute to our portfolio. As we have shown you on other occasions, the Portfolio Visualizer page has many useful tools like this. All you have to do is select the assets you want to add to your portfolio, select “risk parity” as the optimization objective, and then we compare “allocation to inverse volatility weighted.” Finally we press the optimization button and... We already have the assignment based on the two steps that we just explained.
Example of a portfolio with its levels of volatility, correlation and weight of each asset. Source: Portfolio Visualizer
As you can see, gold has received a much greater weight than other assets. This is not only because it is the asset with the lowest volatility (14%), but also because it is the most suitable for diversification, with a correlation of zero with other assets. By having a greater weight in it, our portfolio is stronger. That's also why investing in defensive sector stocks like Walmart and Colgate-Palmolive have received a higher weighting than high-volatility ones like Tesla or investing in cyclical stocks like General Motors. As for Bitcoin, the main reason why only 3% should be assigned to it is because it has a volatility four times higher than the average investment in stocks. Therefore, it is not necessary to have that much to have a considerable impact on our portfolio.
Is there any risk in applying these steps?
These weights offer us a recommendation, like a suggestion of how much to allocate to each of our positions, assuming that we do not have a strong conviction in one asset over the others. If this were the case, it would be best to allocate a little more, but without deviating too much from the original allocation, as this can unbalance our portfolio. So, if you trust bitcoin, for example, it is best not to dedicate more than 6% to it, or double the suggested allocation. Conviction is important but it is more useful in determining what we add to our portfolio than in determining allocation amounts.