Welcome to Finance and Fury. Sorry for the sporadic episodes – flat out with EOFY – In this episode we look at different asset allocations and how they have performed over time in relation to their returns as well as their risk – with a final focus on their risk weighted returns to see what has the most consistent performance au– the aim of this is to explore what portfolios have stood the test of time through the ups and downs of a market cycle

When it comes to returns – I hope everyone knows what this is – it is what income plus growth and asset provides

  1. Each asset classes performs differently in their return profile – cash should get an income in the form of an interest payment but has no capital growth – property and shares can get an income through rent or dividends – plus capital growth as the price of the assets increase
    1. The total return that you receive is the income plus the growth – therefore, if the asset class is only getting an income return, or growth return, your total returns can be reduced compared to an asset class that receives both types of returns – such as property and shares – but due to these asset classes having a growth component – this can introduce risk, as if something can go up in value, it can also go down in value
  2. When it comes to risks of investments – there are two types – absolute or speculative (in the form of volatility)
    1. Absolute is investing all of your money in a small mining company that doesn’t have any mines in operation – then this goes bankrupt and you lose your invested capital – speculative risk is investing in the ASX300 or S&P500 – a large index where your absolute losses are mitigated but you can and will still experience volatility – historically up to a 40% drawdown within a 12-month timeframe
  3. But when risk weighted – what type of allocation works best? In other words – when the level of volatility is taken into account, what performs the best once the returns are adjusted based around the volatility –
    1. To reduce the total volatility of a portfolio – Diversifying across different asset classes is one option to achieve this – holding different allocations between cash, shares, property, gold, etc –
    2. Why does allocation matter – different economic conditions means different asset classes perform differently – So before delving into some example portfolios – its important to look at the four different economic ‘seasons’

The economic seasons could be described as environments with spring, summer, autumn and winter – where different assets perform differently

  1. Spring – higher than expected inflation (rising prices) – In times of rising inflation (since money is losing its purchasing power), investors tend to look towards assets that are more immune to devaluation, such as gold, commodities and real estate. When inflation rises, the prices of real estate (and associated rents) tend to go up, hedging against inflation. But note, since most properties are purchased with loans, the movement of interest rates can also affect demand for property – as we are seeing now
  2. Summer – lower than expected inflation (or deflation) – In times of falling inflation, or deflation, with increased purchasing power, investors consider holding shares and long-term bonds since interest rates are likely to decline and the valuation for these assets will increase
  3. Autumn – higher than expected economic growth – In times of rising growth rates, investments in shares, corporate bonds and commodities, including gold, tend to best match that environment due to the bullish nature of the economy
  4. Winter – lower than expected economic growth – In times of falling growth rates, treasury bonds and inflation-linked bonds tend to best match that environment –
  5. But these conditions are generalisations – as you can have combinations of both as we are seeing now – we are in a period of winter and spring – with low growth, higher inflation and rising interest rates
    1. For a risk weighted return – the ideal scenario for investors is to have a diversified portfolio that aims to consistently earn money for the fund while keeping the fund financially stable during the bear markets and times of market turbulence.
    2. It is important to understand that no asset class performs well in all four economic seasons
  6. This is where the total return of a portfolio can be reduced through over diversification – For a true diversified portfolio, it would be prudent to consider investing in a diversified mix of asset classes that could do well in each economic season, not just a few of them. Put another way, the amount of risk in a portfolio depends on the degree of correlation between assets and asset classes
    1. Asset correlation is a measure of how investments move in relation to each other.
    2. When assets move in the same direction at the same time, they are said to be positively correlated. When one asset moves up and the other goes down, those assets are said to be negatively correlated.
    3. The less assets are correlated, the greater the ability to reduce risk through diversification.
    4. As an example – if you take two assets and they are perfectly negatively correlated – where one increases by $1 the other decreases by $1 – and you invest 50/50 – your returns would be $0 – your volatility would also be 0 when measured as a standard deviation – but that is not a good result
    5. You could invest 50% in shares and 50% in gold – but as these asset classes can be negatively correlated, it could reduce your overall returns – as shares tend to increase by more over the long term than gold

 

Looking at some examples –

  1. Jack Bogle’s Classic 60/40 – The Classic 60/40 portfolio is the benchmark for a lot of portfolio theory and discussions. Popularised by Jack Bogle, who pioneered index investing and founded Vanguard, the Classic 60/40 portfolio is a go-to strategy for many passive investors.
    1. The Classic 60/40 portfolio consists of: 60% total stockmarket (e.g. S&P 500 index fund) and 40% medium-term bonds – The Total Stock Market portfolio is representative of the stockmarket as a whole, much like an ‘index’ fund or an exchange-traded fund (ETF) that tracks the stockmarket
  2. Ray Dalio’s Original All Weather Portfolio – The so-called All Weather Portfolio is a diversified asset mix first introduced by hedge fund legend Ray Dalio and was made popular in Tony Robbins’s book Money: Master the game. The All Weather Portfolio is hailed as being able to handle any economic storm, whether a bull or bear market, and claims to protect investors from bad financial times.
    1. 30% shares
    2. 7.5% commodities and 7.5% gold (15% to Alt) – this has been updated to include 2% BTC, reducing the allocation to gold and commodities by 1% a piece
  • 15% medium-term bonds.
  1. 40% long-term bonds
  1. This portfolio is one based on the four different ‘seasons’ theory, noting again that most asset classes tend to perform well in one or two economic seasons, but not all of them. The result is a diversified portfolio that aims to consistently earn money for you while keeping you financially stable during bear markets.
  1. Golden Butterfly – the portfolio is constructed around the key principle of capital preservation and steady year-on-year returns, also recognising there are four economic seasons, which means certain asset classes tend to do better than others in each season.
    1. The Golden Butterfly consists of: 20% small-cap value stocks, 20% large-cap stocks, 20% long-term Treasury bonds, 20% gold, 20% cash
    2. Shares for prosperity, cash for recession, gold commodities and real estate for inflation and long term bonds for deflation
  2. Harry Browne’s Permanent Portfolio – Contrast the ‘Golden Butterfly’ with the ‘Permanent Portfolio’ originally proposed by Harry Browne in his book ‘Fail-safe investing’. This is another variation on the theme around constructing a portfolio with capital preservation top of mind. The Permanent Portfolio has the following allocation:
    1. 25% total stocks, 25% long-term bonds, 25% gold, 25% cash
    2. This portfolio is similar to the ‘Golden Butterfly’, having a larger proportion of shares since prosperity has historically been the most common economic condition. The Permanent Portfolio has the higher proportion of gold and cash and has the lowest volatility
  3. Warren Buffett’s Estate Plan – What kind of portfolio does Warren Buffett recommend for his family once he is gone to protect and grow their investments?
    1. 90% of his money into a low-cost S&P 500 index fund
    2. 10% in short-term government bonds.
    3. Index funds are a form of passive investing. They hold every stock in an index such as the S&P 500, which includes the big-name companies such as Apple, Microsoft, Facebook (now Meta) and Google. They offer low turnover rates, so the fees tend to be low.
  4. We will go through the returns for these shortly – but the risk is measured by what is called the standard deviation – as this is a way of measuring the volatility or risk within the portfolio
    1. I won’t go into the maths here – but a low standard deviation basically means that most of the numbers are close to the average – whereas a high standard deviation means that the numbers are more spread out on the high and low side, and hence there is a wider range of good and bad financial outcomes that can occur – so a rule of thumb is a low SD is low volatility – something with a SD of 6 would be low – shares can be 12 to 25 – depending on the volatility

Back-testing the risk/return of the classic portfolios

  1. It’s interesting to compare the historical performance of some of these classic portfolios since 1970. Also included is this comparison is JL Collins’ Total Stock Market Portfolio, which on average provided the best average return over the long term, but with the highest risk.
  2. Here is how each of the portfolios fared between 1970 and 2022 (a period which included at least six major ‘crashes’)
    1. Total Stock Market – annualised return of 8.4% – SD of 16.90%
    2. Buffett’s Estate Plan – annualised return of 7.7% – SD of 15.3%
    3. Classic 60/40 – annualised return of 6.1% – SD of 11%
    4. Golden Butterfly – annualised return of 6.1% – SD of 7.4%
    5. All Weather – annualised return of 5.6% – SD of 8.1%
    6. Permanent – annualised return of 4.9% – SD of 7%
  3. the clear winner is the Total Stock Market portfolio at 8.4% but this has also experienced the greatest the greatest volatility (or risk) over the very long term – at close to 17%
    1. However – the Golden Butterfly has arguably delivered the best risk-weighted returns and fewer loss-making years than the other allocations – 20% small-cap value stocks, 20% large-cap stocks, 20% long-term Treasury bonds, 20% gold, 20% cash – 6.1% return vs 7.4% SD
    2. the Permanent Portfolio has delivered the lowest volatility of returns – 25% total stocks, 25% long-term bonds, 25% gold, 25% cash
    3. These results generally support the general rule of thumb when it comes to investing: the higher the risk, the higher expected return – the allocations with higher allocations to shares and volatile assets tend to have higher long term returns – but also higher volatility
    4. In the short term – this is why higher levels of diversification in low correlated assets helps to reduce your chances of loss – however – it can hurt long term returns
      1. Compare total stock market vs the permanent allocation – the difference since 1970 on the returns from $10k invested is $663k vs $120k

Summary – there is no one right allocation for everyone – it does depend on what you need out of your investments

  1. as your wealth grows you can afford to increase allocations to additional asset classes to reduce your volatility risks – this also works well as your wealth will increase over time
    1. And over time you will be closer to retirement where your return needs from a portfolio will change
    2. Through an investment lifecycle – initially people want to accumulate additional wealth – but as your approach retirement, capital preservation can become a bigger concern – therefore holding more cash or alternatives may be appropriate – as they can provide additional protection in downturns
    3. This is because their different performance characteristics and low correlations to traditional asset classes often make alternatives a useful addition to investment portfolios as a way to improve overall risk-adjusted returns

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