Why would an investor not merely adopt the portfolio that best satisfies their risk appetite, such as a 10% volatility target? First, this approach implies an investor is able to identify their risk appetite, not easy even for sophisticated investors, let alone novices. So, for our discussion here, we’ll do what many investors do when presented with a similar range of choices, we’ll select a portfolio in the middle of the efficient frontier. On this scatter plot that is either the 8% or 10% volatility portfolio. We’ll choose 10%! We do not mean to be flippant in our choice of risk, but only to highlight that asking an investor to provide a well-reasoned response to their risk tolerance presents real challenges.
The majority—or over 66%—of the portfolio consists of asset classes outside of developed-market equities and bonds. A deeper dive shows these asset classes to be allocated 15% in credit, 13% in real estate, 7.5% in foreign and local cash, 7.2% in private equity, 5% in commodities, and 1.6% in inflation-linked assets, also known as linkers.
The Asset Allocation Interactive tool allows us to reallocate away from any asset class, and in an ideal world, diversification calls for putting capital to work in some fairly exotic asset classes, some that may not be accessible to all investors, such as private equity, and some that may be beyond an acceptable comfort zone for certain investors, such as commodities which have declined over 13%, net of inflation, over the past three years.6
Let’s take yet a deeper dive into the composition of 10%-volatility efficient portfolio, which at first glance may appear relatively benign to most investors. In particular, let’s look at the equity allocation. Start by asking whether 27% in equities seems too little, too much, or just right. We would not be surprised by the response “too little,” because many investors and advisors think of the stock market as the main place to allocate investment dollars for the long run. Now take a look at the following breakdown. Approximately 67% of the equity allocation is in emerging markets and 33% in Europe, Australasia, and the Far East (EAFE), with a 0% allocation to US equities. This is not a typo: today’s diversified portfolio does not invest in US equities at all.