David Peartree, The Daily Record Newswire
How to allocate investment dollars is one of the most basic decisions confronting any investor. The “market portfolio” is a useful reference point for building an investment allocation.
The market portfolio refers to a hypothetical portfolio representing the basic asset classes, and their sub-categories, in which one can readily invest. The basic asset classes include stocks, bonds, real estate and commodities from around the world. This discussion will focus on stocks and bonds, the two predominate asset classes in the markets readily accessible to investors.
The purpose of spreading investment dollars across the capital markets is two-fold. First, we invest in order to make money by sharing in the benefits of economic growth. Stocks and bonds are simply proxies that reflect economic activity and offer a way for investors to share in what is hopefully positive economic growth.
Second, to diversify or hedge their bets, investors spread investments across various asset classes. Rather than taking a concentrated position in one company or investment idea, investors spread investments across various asset classes to increase the odds of success and decrease the odds of failure.
In theory, then, the market portfolio would be the default portfolio for any investor looking to make money by sharing in the returns from economic growth. Whether it is the optimal portfolio for any given investor is another matter. It is, however, a starting point from which investors can add or subtract and thereby aim for the optimal allocation for their own objectives and risk profile.
What does the investable market portfolio look like? If you could allocate your investment dollars to match the publicly traded capital markets across the globe, what would your portfolio look like?
Three points stand out: 1) it would be primarily global, not U.S. focused; 2) it would hold more bonds than stocks; and 3) bond holdings in the U.S. would be dominated by government debt.
Global capital markets dwarf the U.S. markets. As of 2011, global capital markets held $212 trillion of stocks and bonds. As a single country, the U.S. may be the largest and most dominant market, but its share of the global capital markets is smaller than many realize.
Investors invariably think of stocks when they think of “the market,” but as a capital asset bonds rule. As much as 75 percent of the global capital markets consists of bonds and other debt.
The same approximate relationship between stocks and bonds is true in the U.S. where bonds represent about 65 percent of a total capital market of $55 trillion.
In a global bond market of $158 trillion as of 2011, government debt represented $41 trillion or about 25 percent. In the U.S., federal government and agency debt alone accounted for about 35 percent of the $36 trillion U.S. bond market. If municipal debt and government backed mortgage debt are included, the total public debt in the U.S. approaches 70 percent.
U.S. stocks represent a significant but declining share of the global stock market capitalization. The more rapidly growing emerging markets, at around $9 trillion to $10 trillion, already represent about 16 percent of the global stock market.
McKinsey’s figures are not the last word on the allocation of global capital. Other sources report that the stock/bond split in the global markets is closer to 40/60 and that the U.S. vs. non-U.S. stock split is closer to 45/55. It’s hard to find tight agreement on the data because it is derived from multiple sources and, sometimes, proprietary databases.
Even so, the core observations remain true: The capital markets are more global than U.S. based, more bonds than stocks and, particularly in the U.S., more government debt than non-government debt.
The task for investors is to decide which parts of the market to under emphasize, over emphasize, or perhaps avoid altogether. Every decision to deviate from the market portfolio should be based on a well-founded expectation of improving one’s risk-adjusted returns. Otherwise, investors are simply making bets with their asset allocation.
If nothing else, understanding the basic composition of the global capital markets allows investors to think for themselves. Should investors really shun — as some have suggested — an entire asset class, bonds, which represents between 65 percent and 75 percent of the global capital markets? Can bonds, a $36 trillion U.S. asset class, really rotate into stocks, a $19 trillion U.S. asset class,
as suggested by the “Great Rotation” theory currently in vogue?
A little information fortifies common sense.
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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.
