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The whisky and water approach to investment

The Barnaby Cecil approach to investing is to construct our client portfolios based on extensive academic evidence of what drives returns in the capital markets.

We don’t follow the flavour of the month or react to the day-to-day movement of stock prices. Instead, we rely on robust empirical evidence about how best to capture long-term returns.

Diversification across multiple asset classes (such as bonds, equities) and across countries is a key investment philosophy for us, and is one of the few timeless investment strategies. Indeed the saying “don’t put all your eggs in one basket” first originated via the Spanish novel Don Quixote in 1605!

But the origins of diversification within the context of investing lie in the work of Nobel Prize winning economist Harry Markowitz.

There is, however, another Nobel laureate, James Tobin, whose research underpins one of the central principles of what is now called ‘evidence-based’ investing.


A pioneer in portfolio construction

In a paper [1] published in 1958, Tobin asked the question: What does an efficiently diversified portfolio actually look like?

The most efficient portfolio available, Tobin argued, is the ‘market portfolio’ – that is, all the equities and all the bonds in the world, weighted by market capitalisation.

By that he effectively meant a giant index fund, although the concept had not yet been invented.

Ideally, Tobin argued, investors should own this market portfolio, but then add risk-free assets to reduce their overall risk exposure. Of course, no asset is entirely free of risk, but cash, for example, or, better still, high-quality, short-duration government bonds are sensible substitutes.

This idea of dividing the portfolio between risky and risk-free assets – or, if you prefer, a growth element and a defensive element – came to be known as Tobin’s Separation Theorem.


Whisky and water

In his book Smarter Investing, Tim Hale uses an excellent analogy to explain Separation Theorem – the ‘whisky and water’ approach to portfolio construction.

“Considerable care is taken in the creation of a blended malt whisky,” Tim writes, “to create a distinctive flavour from a number of single malts that is robust and will remain consistent over time.”

That’s a good way of looking at the growth component of an evidence-based portfolio. This growth element is, if you like, the portfolio’s engine – it drives returns. It should either consist of globally diversified, cap-weighted index funds or funds designed to capture specific risk premiums, such as size and value, or - best of all - a combination of the two.

While some will drink their Scotch neat,” Tim goes on, “others, depending on their palate and their desire to avoid ill effects, will dilute it with water to a flavour and strength that is right for them.

Again, this is a brilliant way of explaining the defensive part of a portfolio. For this element, most evidence-based advisers use short-term government bonds.


Tobin’s relevance for today’s investors

For investors today, as in Tobin’s day, the logical approach is to keep it simple.

First, decide how much risk you need to take, can afford to take, and feel comfortable taking. Then, allocate an appropriate proportion of your portfolio to equities.

With the rest, don’t try to be clever. Simply invest in a passively managed and globally diversified government bond fund or funds, not in active management, which could put your capital at risk.

Don’t expect your bonds to deliver an impressive return. That’s not what they’re for. See them instead as simply watering down the risk you’re taking.

Remember, markets can be very scary. Just think back to March last year – the steepest bear market in living memory. Since then, owning stocks has felt pleasantly intoxicating, as global markets defied expectations and rose to new heights.

But things can change again very quickly. There may come a time, perhaps sooner than you think, when you wish you’d mixed a little more water with your whisky.

This is what we do for clients at Barnaby Cecil. Contact us if you’d like to know more.


This article was published with kind permission from our investment partner Betafolio and was originally written by Robin Powell, editor of The Evidence-Based Investor.

1 Tobin, J. (1958) Liquidity preference as behaviour towards risk, The Review of Economic Studies, 67

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