What Is a Balanced Portfolio?

What Is a Balanced Portfolio?

Everybody is a genius.  But, if you judge a fish by its ability to climb a tree, it will spend its whole life believing that it is stupid.

~Albert Einstein

Balance Fulcrum

Update: This article was included in the Canadian Personal Finance & Investing Carnival #9 at Investing Thesis. Thanks!

Last week I wrote about what it would take to get me to invest in the markets again. My friend Jim Yih challenged me with a really great question in the comments section and I promised to answer it in full this week. I’ve heard the same question on occasion from others as well, so I’ll do my best to address it today.

I’m not currently invested in any stocks or bonds except for a small position in an inverse ETF. I won’t go over my rationale again, as I’ve covered it pretty well already. The question is basically the following: How can a Balance Junkie have an all cash portfolio? You have to have a mix of stocks, bonds, and cash in order to have a balanced portfolio, right? I hate to answer a question with more questions but . . .  ;)

Are Diversified and Balanced the Same Thing?

How diversified does your portfolio have to be in order to be considered balanced? I suppose that mathematically, a truly balanced portfolio would include 33% stocks, 33% bonds, and 33% cash. Does that mean that’s the only right asset allocation if you want to be able to tell anyone that you have a balanced portfolio? Is everybody else wrong?

A retired person might very well have a portfolio that is 50% bonds and 50% cash. Another retired person might have 40% stocks, 40% bonds, and 20% cash. A 30-something mom might have 75% stocks, 15% bonds and 10% cash. Another 30-something mom might have 75% bonds, 15% stocks and 10% cash. Are these portfolios balanced? Who says so?

What’s Wrong with Being a Cashetarian?

Many people hold to their religious beliefs very firmly, excluding the philosophies of the other major religions from their lives. Are Christians unbalanced because they don’t embrace Buddhism, Judaism, or all the other great “isms”? Are atheists ammoral or unspiritual because they checked the “none of the above box” in the religion section? Is my portfolio unbalanced because I checked the “none of the above” box on stocks and bonds? Who says so?

I eat almost no meat. I’m mostly a vegetarian. Does that mean I can’t be a Balance Junkie? I think I can still have a balanced diet without meat. It works for me and I’m happy and (touch wood) healthy.

I mostly invest in cash right now. I guess you could say I’m a cashetarian. Does that mean I don’t have a balanced portfolio? My savings are growing and I can sleep at night. The market could fall 50% or more over the next 6 months and it wouldn’t hurt my retirement savings. I think I can have a balanced portfolio without stocks or bonds. How?

It’s All about the Fulcrum

Let’s briefly look at a simple balancing mechanism similar to a teeter totter. You basically have a plank balanced on some kind of pointy thing. There are two main ways to make that plank balance:

  1. You can add or remove weight on the left side.
  2. You can add or remove weight on the right side.

But there’s a third way. Many people assume the pointy thing, which is called the fulcrum, is fixed. Who says so? That’s the third way: You can move the fulcrum in order to make the plank balance.

What does any of this have to do with asset allocation, portfolio balance, or life balance? Whether you’re talking about the financial, physical, spiritual or psychological quadrant of your life balance sheet, it’s all about the fulcrum. Your centre point may not be the same as mine in any or all of these areas. We’re all different.

That’s what makes the world work so beautifully. Without that diversity, our society would be unbalanced. If you step back and take a bigger view of the world, my 100% cash allocation balances out my friend’s 100% stock allocation. In fact, I could make a pretty decent argument for the idea that too much money moving toward the same asset allocation has caused our financial system to become unbalanced as everyone shifts to one side of the boat or the other all at once.

Balance Is the New Old Black

Balance is the most basic principle in science, economics and life. It’s the default setting. It’s the original black. For every buyer, there’s a seller. For every gifted mathematician, there’s a brilliant musician. You get the picture. There’s more than one way to achieve balance in any area. In fact, there are probably thousands of ways.

In many ways, we’ve strayed from allowing nature to take its course. We’ve upset the balance in nature by polluting the environment. We’ve upset the balance in the economy by tinkering with it to the point that it no longer works the way it’s supposed to. Herding behaviour has increased so remarkably in global markets that diversification is nearly useless. Innovation is a good thing, as long as it doesn’t upset the balance.

Some of our actions have done just that, and some of us are gradually awakening to the idea that not all changes lead to real progress. As we come to realize that some of these innovations have not advanced society, many of us will return to the principles that worked in the past. Dare to be different. Who knows? Maybe balance will become the new black – again.

What Does It Take to Be a Balance Junkie?

Some financial blogs spend a lot of time telling people what the right way to invest is. The more mainstream sites will tell you to hold a balanced portfolio of stocks and bonds, ride out the ups and downs, and retire wealthy after about 40 years of investing. Some of them scoff at any other way of doing it, but I would venture a guess that none of them would guarantee any level of returns to you.

At Balance Junkie, there’s room for all approaches. Any idea that has any basis in fact and causes no harm to anyone else is welcome here. I keep simple kindergarten classroom rules, although I’ve never had to enforce them. Somehow this blog has attracted some of the most insightful, classy contributors out there. Thanks to all of you. I hope you’ll keep asking the tough questions. Maybe if we put our heads together we can answer some of them and learn something new while we’re at it. ;)

I started out answering a question on asset allocation and ended up writing a manifesto for Balance Junkie. What do you think?

Written by Kim Petch

34 Responses to What Is a Balanced Portfolio?

  1. The term Balanced has been interchangeably (incorrectly) used with diversified. Diversified has been (incorrectly) become a synonym with a mix of stocks and bonds. This confusion originates from the days that stocks and bonds (the two main asset classes available to the “people”) were negatively correlated.
    What an oxymoron today to consider a diversified portfolio one that has two assets classes that are positively correlated. Only hoping that there be a structural change that will alter this relationship? Layman investors betting through their portfolios that we will return to bonds dropping (rates going up) and stocks going down?
    What a scam! Any financial “advisor” that keeps providing clients those forms about risk and asset allocation should be ridiculed. Tear up those forms. rethink the basics and stop talking about Balance, diversification and a mix of asset classes that offer no reduction of risk!

    • 2 Cents says:

      “What an oxymoron today to consider a diversified portfolio one that has two assets classes that are positively correlated.”

      Thank you for summing up my “No Respite in Diversification” thesis in one sentence! Stocks and bonds have been moving in the same direction for so long now that it makes no sense for advisors to treat them as non-correlated asset classes. It’s their job to know about this stuff and help their clients invest accordingly.

      Thanks for your insightful commentary!

  2. Kim:
    GICs and high-interest accounts are fine for those in their 20s and 30s if they are still saving for short-term needs (car, down payments on a house, etc.) and establishing an emergency fund. Persons in their 70s to 90s don’t have a long-term horizon for stocks.

    As for retirement savings, GICs etc. can be fine too! They can create a nest egg just as large as investing in stocks assuming a higher savings rate is used. For risk-averse persons, the additional sacrifice in present consumption is a trade-off they are willing to accept for a more certain route to reaching retirement funding goals. The risk-tolerant persons are willing to try and get there with a lower savings rate on the assumption the historically superior (but variable) returns of stocks will make up for their preference for a higher level of current consumption while in the accumulation stage.

    • 2 Cents says:

      Exactly. Risk averse investors who avoid the markets may need to save more in order to achieve their retirement goals, especially in today’s low interest rate environment. Investors who do venture into the markets are buying the possibility of higher returns. There’s no guarantee they’ll get them, and the possibility of losing money is just as real.

      As I mentioned in the article, both approaches are fine, depending on your unique situation. I do, however, take issue with the conventional wisdom that a mix of stocks and bonds offers diversification and is always the best way to save for retirement.

      Thanks for sharing your thoughts Larry!

  3. At Balance Junkie, there’s room for all approaches. Any idea that has any basis in fact and causes no harm to anyone else is welcome here.

    This article is one of the best and smartest and most compassionate and most insightful that I have ever read in the field of investing. The insight being evidenced here is up at the level that has been evidenced in the past by people like Bogle and Buffett and Shiller. I am not a vain flatterer (ask anyone who knows me) but I AM given to enthusiasm when my eyes see something worthy of my enthusiasm.

    I agree with you about the 100 percent cash portfolio balancing out the 100 percent stock portfolio in the grand scheme of things. There are reasons why one smart and good person elects to go 100 percent cash and why another smart and good person elects to go 100 percent stocks and both viewpoints must be respected if our economy is to reach its potential (or, in the sort of extreme situation we are in today, for it even to survive much longer).

    I will add one element to the picture. It’s not just portfolios that need to be balanced. DISCUSSIONS of how to invest need to be balanced. I am banned at the following places: (1) Motley Fool; (2) Morningstar.com; (3) Bogleheads.org; (4) IndexUniverse.com; and numerous other investing boards and blogs. I have never once put forward a post that could be said to be abusive in any way, shape, or form. So why am I banned? I pointed out the dangers of Buy-and-Hold and that hurt the feelings of a good number of Buy-and-Holders (although there were many community members at all those places who raved about my stuff). Morningstar told me that it was :”inflammatory” for me to point out the dangers of Buy-and-Hold at a time when millions of middle-class investors are following this “strategy.”

    That’s not balanced. It’s not even a close call. There are millions of people who sincerely believe today that Buy-and-Hold is a good strategy. Not because they have thought the matter through carefully. Because they have never even heard the other side of the story! Human knowledge advances when new ideas catch on. By definition, a new idea starts out as a minority viewpoint. Those who have doubts about the conventional wisdom of a given time have not only a right to express their honest views but a responsibility to do so. They let down the entire community when they hold back from saying what they truly believe.

    This article is encouraging. I hope (and believe) that it will help change some minds and thereby take us all (Buy-and-Holders and non-Buy-and-Holders alike) to a better place.

    Rob

    • 2 Cents says:

      Sheesh, Rob. You made me blush! I know you don’t dole out compliments like Halloween candy, so your kind thoughts mean a lot. Thank you.

      I appreciate you lumping me in with all of those great voices, but I’m afraid they represent the wisdom of elders whereas I merely express the wisdom of idiots. I look at the financial world as an outsider, so that gives me a different perspective.

      As for the sites you mentioned, they are not communities. They’re cliques. The same goes for a few of the PF and investing blogs as well. They offer round-ups from the same 10 buddies every week, all of them saying essentially the same thing. I guess that’s OK if you’re so sure you’re right that you don’t need to learn anything new. I hold no such illusions.

      Again, thanks very much.

  4. Well said Kim like the poet you are. Or maybe like the philosopher you are. Or maybe you should have been a lawyer!

    Anyhow, I think you did a great job defining what balance means and how it differs from diversification. I must admit I was really curious how you were going to tackle the question.

    One more question you can write about . . . Where did you dig up the word Fulcrum – that was perfect!
    Jim

    • 2 Cents says:

      Poet? Philosopher? Lawyer? Hmmmm …

      Shockingly, I choose “none of the above.”

      On the “fulcrum” thing: OK. That was not part of my vocabulary until I wrote this article. I was looking for an interactive graphic that represented a balance mechanism with a movable centre point. In the process, I discovered an educational software that actually lets you do that, but it’s not free. I also accidentally discovered that the balance component that I so brilliantly labeled the “pointy thing” was actually called a fulcrum. ;)

      Keep those questions coming Jim. And thanks so much for inspiring this article!

  5. This is a really good, even “balanced” article. There are merits to different approaches, and I can certainly appreciate the perspective of going all cash. While I’m not at that place, Im less excited about equities than I have been in the past based on valuations and macroeconomic conditions.

    I especially like the term “casheterian”. Good stuff!

    • 2 Cents says:

      Thanks. I’m glad you noticed that I’m not promoting cashetarianism any more than I promote vegetarianism. Those happen to be my personal preferences, but I wouldn’t want everyone to choose the same.

  6. Where do you get the idea that stocks and bonds are correlated? Check out the various asset class returns for 2008.

    I don’t think there is anything wrong with having a portfolio of one asset class or even one investment. However, I wouldn’t call it balanced.

    In my mind, balanced implies that you have at least two asset classes and have attained some sort of balance between them.

    Great article, Mike

    • 2 Cents says:

      Look at a 20 or 30 year chart of stocks along side a chart of Treasury prices. Both have mostly been rising for that period of time. You’re correct that bonds outperformed stocks by quite a margin in 2008 due to the market crash, but the recent recovery of stock prices has reinstated the larger trend.

      I maintain that diversified and balanced are not the same. My portfolio is most definitely not diversified, but it’s balanced for me. I get your point, though, and for most people, balanced does imply more than one asset class. I guess you could say that our second asset class is us: the ability that we have to earn income and set some of it aside in a disciplined way.

      Thanks for stopping by Mike. :)

  7. Ray says:

    hahah, I was looking for a reason to finally remove this blog from my RSS reader. 100% cash, haha, good luck with that. Bye!

  8. What’s balanced for one person may not be balanced for another. In the end, everyone’s preferences are subjective, and their perceived risk/loss assessments will naturally also be subjectively perceived.

    When looked from that fashion, there is really no objective right or wrong. Historical returns, while an indicator of history, are not enough to conclusively say that returns will be the same going forward. They are only enough to say that us equity investors are BETTING that they will.

    The fulcrum is indeed at a different point for different folks! Hence, why I still buy PMs, you buy cash, and others go all-in stocks. Each of us is making a rational decision, even if we might disagree with each other.

    • 2 Cents says:

      Well said Kevin. I’d love to leave an insightful reply, but I can’t say it any better than you just did. Thank you. :)

  9. While I wouldn’t necessarily consider an all cash portfolio balanced per se, it certainly works for you. I also believe you are waiting to capitalize on another greatly depressed market. Many contrarians aren’t celebrated when they are making their next mark, but that doesn’t mean that they are wrong or that there even is a wrong. Who would have thought that investing philosophy would be so interesting? :)

    • 2 Cents says:

      I’m not so much waiting for a cathartic collapse as a sign that the market is functioning based on fundamentals rather than central bank manipulation. I’ll be reviewing Grantham’s latest quarterly update on Friday, so I’ll have more on that topic.

      We definitely live in interesting times. Thanks for stopping by Shawn! :)

  10. Why does risk averse always equal no stocks… I am certainly risk averse in many ways when it comes to investing. I hate to lose money. However, there are steps that can be taken to minimize risk and maximize returns. I prefer to think of integration over balance (although I know in this comment I poke at the very name of your blog). Integer (or whole) from which we get integration captures the kind of life (and investment portfolio) I seek to maintain. It’s less about balance and equilibrium… it’s more about living a whole life! But now I’ve somehow begun to “philosophize” :)

    • 2 Cents says:

      Like it or not, stocks are riskier than cash. You’re many times less likely to lose any money in cash whereas you can lose up to 100% in stocks. Risk averse doesn’t have to means no stocks, but it probably means less stocks.

      I think your idea of integration and my idea of balance are the same thing. I seek a holistic approach to life too. For now, I feel better being out of the market. You’ve got a good system for trading the markets that would likely minimize your losses. Both approaches seem fine to me.

      You choose to trade stocks and I choose cash. We’re both investing, just differently. While you enjoy an all-beef patty at dinner, I might have a veggie burger instead. Why does one have to be right or wrong? ;)

  11. Robert says:

    “I mostly invest in cash right now. … The market could fall 50% or more over the next 6 months and it wouldn’t hurt my retirement savings.”

    You were right the second time, cash is a form of savings, not investment. Bonds, stocks and real estate are (usually) a form of investment. Gold and other commodities are usually a form of speculation. This is a small quibble on an intriguing post.

    Although I invest in stocks and real estate, but no bonds or cash (since I have mortgage and business debt), I don’t think everyone needs to own stock. I’m not sure I would call my approach (or yours) “balanced”, but my approach is “appropriate” for my personality, skills and situation. And your approach is appropriate for you. The only thing I worry about is when people try to predict the future. Maybe the central banks ARE manipulating the economy, but that doesn’t mean markets can’t grow.

    • 2 Cents says:

      Yeah. I guess the word “balanced” is a big hang-up for a lot of people. No matter what you call it, I think your approach is just as acceptable as mine. I still see my cash in GICs as investments, as they do pay some interest, as low as it is. Incidentally, they would be a much better option without the Fed’s “help.”

      I don’t necessarily think Fed manipulation means markets will fall, at least not in the short term. I just don’t think they can do what they’re doing and still call it a free market. In fact, I wrote an article a while ago that said that the end of free markets meant it was a good time to buy stocks.

      I didn’t buy stocks myself, however, because I’m not interested in playing a game that’s fixed. That’s not to say agile traders can’t or won’t profit from the game, but I worry about the Mom and Pop investors who aren’t aware of the new rules of engagement and are listening to advisors who are telling them markets always rise.

      More on QE2 in tomorrow’s post! Thanks for your thoughts Robert! :)

  12. Wow – quite the post and comments!

    Kim, I give you HUGE props for believing and being committed to your approach. To hold your line when others scoff; you’ve got some integrity and I respect that.

    My only criticism, as have a few others have already noted, “balance” implies an appropriateness, an equilibrium or harmony amongst elements. Being all cash, you’re not really balanced. That said, you feel balanced because your approach keeps you confident, keeps you secure and assured. It provides balance in your life. Isn’t that what all of us working towards our respective financial journeys are looking for? (I am :)

    Cheers!
    FC

    • 2 Cents says:

      Thanks for mentioning the comments. I wasn’t kidding when I said that I’m constantly amazed by the calibre of people who contribute here. Thanks to the 99% of you who found a way to tactfully disagree with my characterization of balance. I guess a couple of you just aren’t buying the vegetarian-cashetarian metaphor, including you FC.

      That’s OK. As you said, I still feel balanced. I always had a feeling my fulcrum was a little off-kilter from everyone else’s! ;)

      Thanks for stopping by and adding to the excellent string of comments here.

  13. Excellent post 2 cents, while we have opposite views when it comes to investing, it is really this difference that attracts me to read your articles. Long live diversity :)

    • 2 Cents says:

      Thanks Mich. I read your articles for the same reason. Even if I don’t invest in the same things as you right now, I might some day, and I’ll be that much more informed.

      Thanks for reading! :)

  14. A key to investing is your risk tolerance. But, the only real risk we worry about is the risk that the portfolio value will drop. Even cash though can lose value due to inflation (although there’s not much inflation now). If you aren’t comfortable with the volatility of the stock & bond markets, no one should tell you to dive in. Investing is a very personal endeavor!

    • 2 Cents says:

      Thanks Barb. Good point. Just as I wouldn’t want anyone telling me I must invest in stocks, I wouldn’t tell anyone not to be involved in the markets – as long as they understand the risks involved.

      Thanks for stopping by!:)

  15. Janet Hutchins says:

    “I suppose that mathematically, a truly balanced portfolio would include 33% stocks, 33% bonds, and 33% cash.” And 33% real estate. And 33% angel investing. And 33% antiques. And 33% bank accounts. Etc.

    So, yes, I agree that there is no set definition for “balanced”.

    • 2 Cents says:

      You know, I actually had the same thought on adding a bunch of “alternative” asset classes like the ones you mentioned to the mix. I elected to stick to the basics, but you make an excellent point. Asset allocation can include a lot more than stocks, bonds, and cash.

      Thanks!

  16. Jessica07 says:

    I agree with your premises, and I have to say that is probably one of the best posts I have ever read about investing. Thanks for sharing your thoughts. :)

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