For the people that have followed the Jeff bogle style index investing strategy, they have already figured out that passive investing beats active investing the majority of time. Investing in index funds has proved to give the average investor better returns than mutual funds and at a lower cost as well.
But whilst investing in index funds as strategy is all well and good, how should you determine what weights to place on different asset classes that compromise your portfolio and going one step further, the different indexes you can invest in? By this I mean how do you know how much to invest in each region? One way of doing this is by looking at historical returns to see which regions have given the highest returns on average.
When planning out your investment portfolio, asset allocation is key. The task of getting the ‘perfect’ ratio of different asset classes within your portfolio can be a difficult one (see the Bridgewater All wether portfolio). Of course, there is no ‘perfect’ ratio as it all depends on your risk tolerance. If you are risk averse your portfolio will lean more towards investing in bonds and real estate. If you have the stomach to take on more risk, you will have more equities in your portfolio.
Many people have now started using a formula to see how much of their investments should be in equites. The rule of thumb is that you should subtract your age by 120 to see what proportion of your investment portfolio you should have in equities.
Percentage of your portfolio in Equities = 120 – Your age.
Once you decided on an appropriate percentage for equities in your portfolio, your next decision is to decided which stock market to invest in. This could prove even more tricky than the initial asset allocation decision. As equities will potentially bring the highest returns to your portfolio, it is imperative that you invest in the right market. You need to know which regions have historically produced the highest returns.
To help you in deciding which stock market to invest in, the table below shows how some of the biggest markets have performed in the past 10 years.
|North America||UK||Europe||Asia Pacific||Japan||Emerging Market||Corporate Bond|
As you can see the from the above, Emerging Markets and the Asia Pacific region have provided the highest returns over the past 10 years but the volatility associated with these markets are also higher due to their wild swings from one year to the next. As you can see from the above table, you generally need to take more risk to get a higher return (but this is not always the case).
Another interesting note to point out is that Japan and Europe have done poorly as seen by the table. Both these markets have had higher historical returns than we have seen here. This means that Japan and Europe have a lot of ‘catching up’ to do and thus I think in the next few years Japan and Europe will provide some very healthy returns.
The Next 10 Years
Research Affiliates, the research firm led by “smart beta” pioneer Rob Arnott, recently created a great research tool that enables you to choose any eight world markets and compare their valuations. Research Affiliates then takes it a step further by forecasting the expected return over the next 10 years based on those valuations.
You can find this great research tool at http://www.researchaffiliates.com/AssetAllocation/Pages/Equities.aspx
When using the research tool, always remember that Estimates are exactly that: estimates. Real-world results will almost certainly look a lot different than these estimates suggest, but this gives us a nice “quick and dirty” way to gauge how attractively priced a given country is.
Getting Exposure to above listed stock markets,
If you want to get exposure to any of the markets listed above, below are some good index funds that you can choose from. Alternatively, you can go to etfdb.com to find the cheapest ETFs for every investment objective.
- Fidelity Index US. OCF 0.1%
- Vanguard FTSE UK All Share Index Trust (VVFUSI) OCF 0.08%, initial fee 0.4%
- Fidelity Index UK Fund W (GB00BLT1YM08) OCF 0.09%
- Legal and General European Index (Class C). OCF: 0.12.
- Vanguard FTSE Developed Europe ex UK Equity Index OCF: 0.12
- Fidelity Index Japan OCF: 0.12
- Blackrock Japan Equity Tracker OCF 0.17%
- Fidelity Index Pacific Ex Japan OCF 0.15%
- Blackrock Pacific Ex Japan Equity Tracker OCF 0.18%
- Amundi MSCI Emerging Markets ETF (AUEM) OCF 0.20%
- Vanguard FTSE Emerging Markets ETF (VFEM) OCF 0.25%
- Vanguard UK Investment Grade Bond Index (IE00B1S74Q32) OCF 0.15%, initial fee 0.5%
- Vanguard U.K. Short-Term Investment Grade Bond Index (IE00B9M1BB17) OCF 0.15%, initial fee 0.3%
*OCF = Ongoing Charge
Portfolio allocation is hard work but it could be very rewarding. If you do not have the time or the interest in investment management, why not sign up to a robo advisor like Nutmeg. Nutmeg will create a portfolio for you based on your risk preference and will look after that portfolio for a low fee of 1%.