In our conversations so far you’ve stressed the importance of a balanced portfolio in which risk and return are in line with your requirements to maximize the return by 2025 when you’re planning to buy a second home in Italy. Based on the portfolio analyses we’d like to make the following recommendations to maximize the return on your investment whilst minimizing risk. Adding an additional security class with a lower beta and redefining the weight of the existing securities as will reduce the volatility of your portfolio and will reduce it’s exposure to systemic risk.
Systemic risk in your portfolio
When looking at volatility we distinguish diversifiable risk (ie. firm-specific or idiosyncratic) and non-diversifiable risk (ie. systemic or economy-wide). Your current portfolio is well diversified in regards to different security classes (45% stock, 35% real estate and 20% bonds) and regions (40% China, 35% UK, 20% Europe and approx 5% Global). As stock securities trade at an average Beta of 1.17 and real estate at 0.94 your portfolio is exposed to systemic risk with a factor of approx 1 which means that the portfolio co-varies with the overall market return. Whereby stock securities vary more than proportionally with the market return at an x 1.17 multiplier. Again, the Beta is calculated on the historical sensitivity of the stock against the market benchmark used in the analyses of the individual securities.
Additional asset class
Since you stressed the requirement not to have individual stocks in your portfolio, otherwise we would have added Virtue (Beta of -0.87) or FlowTraders (Beta of -1.26), we propose adding iShares Gold Trust to your portfolio given its low exposure to systemic risk and good results with other investors with similar short to mid-term portfolio return requirements.
Maximum return portfolio
Given the three states of the world, we’ve calculated what the maximum return on your portfolio would look like by changing the portfolio weight of the assets favorably to the return they deliver, whilst still diversifying with a minimum of 5% and not going short. Even though the outcome of 2.4% return at 4.8% volatility might look interesting on a first glimpse, we don’t think it’s wise to allocate 80% of your portfolio to one asset class as this will leave you overly exposed to the performance of IUKP.MI in this case. Given the political climate in the UK and the looming Brexit end October 2019 we strongly recommend not to exceed the current allocation of 35% in your portfolio.
We recommend the following split across the securities in your portfolio whereby MCHI is brought back to 20% and IAU is introduced to the portfolio at 20% weight. This portfolio mix brings volatility down from 3.7% to 2.8% and the return up from -2.11% to 0.29%. Furthermore the Sharpe ratio of the portfolio will rise to -0.52.
Final words on the recommendation
With ongoing concerns that the economy will fall off a cliff any time soon, and to be fair this is being said for years now, we do see the political climate changing and we are concerned. Growth is slowing down, inflation is record low, interest rates remain low, and a bubble seems to be in the making. For China (40% of the portfolio) for example we see that the economy grew by 6% in the third quarter, the slowest annual rate in 30 years as the trade war is taking its toll. Therefore we’re looking to derisk the portfolio with negative beta securities and a further focus on low-risk securities whilst sacrificing some return in comparison to the last 5 years we’ve managed your portfolio. With 5 years to go until your financial objectives, we feel it’s the right time to derisk the portfolio.