Does It Belong in My Portfolio?

In today’s world, investors have access to a seemingly limitless number of new investment opportunities due to financial innovation. However, despite new innovation, the method for assessing these investments stays the same. When adding a new element to one’s asset allocation, one must carefully weigh the anticipated benefits against the inclusion costs. The framework that follows outlines possible advantages and disadvantages for investors, serving as a general check list for all investment opportunities.

What’s the Role This Investment Plays?

Determining the expected role of anything is the first step towards properly assessing whether or not it should be included in your portfolio. Ultimately, any investment should either a) raise your expected return or b) assist in risk management.

In the event that raising expected returns is the goal, how well does the questioned asset do that? Since stock ownership offers you a claim on future cash flows from corporations, it is simple to link positive expected return with stocks. In a similar vein, bondholders anticipate receiving principal repayment and monthly interest payments as outlined in the bond’s covenant. Regardless of its historical performance, however, investors should be wary of an asset that has a solid basis for generating a positive expected return.

Additionally, investors should exercise caution when estimating returns for asset classes for which there is limited historical data. Newer products with shorter track records give investors less information about what to expect in an asset class and the absence of reliable market-based performance data may present extra challenges for investments that are not publicly traded. Finally, more volatile asset classes exacerbate the age-old problem of separating talent from luck.

When investing in an asset that mitigates risk, expected return might not be the primary consideration. Risk, according to Professor Ken French, is the uncertainty around lifetime consumption. There are numerous causes of this uncertainty, such as shifts in interest rates, inflation, and market downturns, to mention a few. Risk-management assets should offer a robust way to mitigate the contributions from one or more of these contributors to uncertainty.

When hedging risk, investors should try not to “miss the forest for the trees.” An asset class, for instance, whose returns are linked to inflation but are far more erratic than shifts in the Consumer Price Index, could not be a useful instrument for risk management. Even though you could be protecting against unanticipated inflation, the volatility of the market nevertheless makes future consumption more unclear.

If investments improve portfolio diversification, they may also lower portfolio risk. However, how should investors evaluate the advantages of diversification? Despite the fact that noisy correlation estimates are frequently examined, investors should consider whether the investment broadens their pool of potential opportunities. If all of your investments are in US stocks, diversifying your portfolio internationally enhances it. The value of the world stock market is approximately $80 trillion(1). The value of global bond markets rises by $125 trillion (2). This provides crucial context for the amount of prospective increases to your asset allocation and could be a useful place to start when figuring out how much money to put into the asset.

Considering Investment Costs

The benefit of adding something to your portfolio must outweigh the drawbacks.

One clear drawback is cost. Investors can usually see fees and expenses clearly, but it’s crucial to understand how different charge structures work. ETFs and traditional mutual funds for equities and fixed income typically charge a fixed percentage fee determined by the total amount of assets under management. Performance fees might be included in other asset classes. These cost structures could encourage investment managers to act in ways that are against your investment goals and objectives so it is important to be informed about these.

Adverse selection could also be a less obvious cost (at least in terms of expectations). There will be a queue out the door for the most sought-after allocations, whether we’re talking about the most recent private equity placement or initial public offering (IPO). Those who don’t have access to the best investments will be forced to make less-than-ideal choices. If there are significant minimum investment requirements, it can be more difficult to have diverse exposure across different types of investments.

The potential of an investment is more likely to be advantageous if you can see it through to the end. This is where complexity becomes a drawback. Every investment has times when its performance is subpar. Investors’ ability to persevere through difficult times and adhere to the investment strategy may be determined by how effectively they understand what drove performance. Trust and transparency are frequently closely related. If everything else is equal, investors who have less experience with operating strategies or those that are opaque may be less likely to stick with them during uncertain times.

Finally, there’s the cost of wondering about the road not traveled. Adding a new investment means giving up some of what you already have. If the item you’re giving up has a strong performance run after the transition, that could lead to regret. For instance, value stocks’ ten-year underperformance against growth prior to 2021 prompted many investors to discard value stocks. Investors may regret this for years to come if they replaced value just before its record run in 2021 and the first half of 2022.

Real-Life Illustrations

We can apply this framework to some noteworthy alternative asset classes.

Bitcoin

Due to the media hype surrounding bitcoin, many investors are unsure about whether or not to take a closer look at cryptocurrencies. A few elements of our approach for evaluation are immediately applicable.

To begin, let us consider the expected-return condition. If Bitcoin hadn’t experienced such a sharp increase in value in recent years, it would not have received much attention(3). However, it’s not evident why owning bitcoin should result in a profit. Bitcoin does not provide the guaranteed interest payments that come with bonds or the claim on future cash flows that come with stocks. Future profits from merely retaining bitcoin rely on its value increasing in contrast to another asset- the meaning of a speculative investment.

It is hard to accept an asset that has repeatedly seen double-digit percentage value drops in a single day reducing uncertainty over lifetime use.

Furthermore, it’s unclear if bitcoin or other cryptocurrencies can assist investors in risk management. According to Professor French’s concept of risk, it is hard to see how an asset that has seen numerous days of double-digit percentage declines in value might lessen uncertainty about lifetime consumption.

Asking The Right Questions

When changing asset allocation, errors are costly. In the event that a bright new product proves to be a bust, replacing an investment you once believed in could be counterproductive to reaching your financial objectives. An evaluation process that is consistent helps investors reduce the likelihood of experiencing regret. It is also possible to modify these rating factors to suit personal tastes. After all, an investor’s lifetime needs for liquidity and risk tolerance can change.

At the end of the day, this framework is about asking the right questions, which, as researchers will tell you, is just as important as the answer itself.

 

1. Based on MSCI All Country World IMI Index as of December 31, 2021.

2. Based on statistics from the Bank for International Settlements (BIS) as of September 2021.

3. Cryptocurrency performance in 2022 has me wondering about the shelf life of this article.

   Source: Dimensional