Even in a pandemic, the foundation for building and managing investment portfolios persevere. That’s easy to overlook amid a firehose of new investment products, roller coaster swings in markets and a global health crisis. Although there’s (still) no silver bullet for success, at least there’s an obvious, productive starting point: the “market” portfolio.

In theory, the market portfolio is everything – all investable assets weighted by market value sans rebalancing. In practice, that’s pie-in-the-sky stuff, although an investable proxy can be estimated with publicly traded funds. (You can find examples here, here, and here, for example.)

For implementation, take your pick: actively managed products or index funds. For a number of reasons, the latter is preferable. Tracking beta, after all, works best with funds that are designed to do exactly that with minimal expense. But that’s a discussion for another day.

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For most investors (institutional and individual), the basic investment choices boil down to five main asset categories: stocks, bonds, real estate, commodities and cash (and their equivalents). We can play with these buckets and do all sorts of financial engineering tricks or get more granular on definitions, but at the end of the day most of what passes for investment strategies in the wider world uses some form of these basic risk-factor building blocks.

Accordingly, the first question for every investor (whether they recognize it or not): Should I hold all of these risk factors? Casual observation suggests that the standard asset allocation decision amounts to dropping commodities and cash. That leaves stocks, bonds and real estate (typically in securitized form) as the main mix for most investors. We can have a long discussion about the wisdom (or the lack thereof) of the decision, but the larger point is that if you own a stock/bond/real estate portfolio you’re making a rather substantial asset allocation decision, namely: second-guessing Mr. Market’s best guess on the “market” portfolio.

There’s nothing wrong with that preference. Some of my best friends are loathe to take Mr. Market’s advice on a global, multi-asset-class scale. What you shouldn’t do is ignore, dismiss or minimize this mother of all strategic investing decisions. Why? That’s a long digression, but let’s simply note that for all Mr. Market’s faults in money management (and there are many), over long stretches of time his portfolio is competitive if not particularly impressive. But I digress.

For a number of reasons, discussions about favoring stocks/bonds/real estate and excluding commodities and cash receive minimal if not zero attention. That’s partly because many (most?) investors don’t recognize that holding, say, a 60/40 stock/bond portfolio (perhaps tweaked a bit with real estate) is a major asset allocation choice. But whether you recognize it or not, it’s a critical decision — and one with far-reaching implications for expected return and risk, for good and ill.

Excluding commodities and cash (or dramatically reducing their influence in a portfolio) can be beneficial or detrimental, depending on a variety of factors (time period, investment horizon, risk tolerance, return expectations). Regardless of how you proceed (and there are good reasons for either path), it’s important to recognize the decision and not ignore it as if it’s the fourth request from your brother-in-law who wants to borrow money because he has an amazing idea for a new restaurant.

And while we’re talking about commodities, don’t be lulled into the trap of rationalizing that since you own a bit of gold that you’re exposed to the commodity space. Yes, the 79th element on the periodic table is a bona fide commodity. But assuming that this precious metal is representative of the commodities footprint writ large is akin to arguing that an ear exemplifies the human body.

Don’t misunderstand: I’m not recommending or dissing commodities, at least not here. Everyone can make their own decision on whether to include or sidestep the asset class. (For the moment we’ll leave aside the debate about whether commodities overall are an asset class.) The point is that avoiding commodities (and/or cash) is a significant asset allocation decision, and one with potentially major consequences for expected return and risk. Accordingly, spending a non-zero amount of time thinking about the choice is a no-brainer.

In upcoming editions of this series I’ll dive into relevant issues on the next, basic steps in the portfolio design and management journey. But the first step is the most important because it lays the groundwork for what’s possible — and what’s not. Defining the opportunity set is second to none as a portfolio design factor. That’s another way of saying that asset allocation is arguably the single-most critical choice for every investment strategy. No wonder, then, that starting the thousand-mile journey with eyes wide open (and all the choices fully vetted) is the first step for tipping the odds in your favor in the money game.

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