Investors often hear it’s important to choose an appropriate asset allocation. This advice is usually accompanied by specifics, such as, “You should be 60 percent in stocks, 30 percent in bonds, 10 percent in cash.” Is this sound advice? If so, why?
To find out, we examined how different portfolios have behaved in market downturns over the past three decades. But first, let’s look at the concept behind this common investment advice.
The fundamentals of asset allocation are part of Modern Portfolio Theory (MPT). To understand MPT in lay terms, assume we invest in two assets having differing return and risk characteristics. A portfolio made up of those two assets will have its own, different, return and risk characteristics.
In general, the return of the mixed portfolio will be the average of the returns of the two component assets. But the portfolio’s risk will usually be less than the average of each individual assets’ risk. How much less depends on how correlated the two assets’ price behaviors are. The less correlated, the lower the portfolio risk will be.
Think of a portfolio that holds two stocks, A and B. Stock A is expected to produce returns averaging 10 percent annually over the long term, while Stock B has an expected return of 5 percent. For both stocks, the actual return will vary widely in any given year. But, on average, the return will fall within a range that’s within plus or minus 20 percent of each stock’s long-term average. Thus, stock A has an expected return of 10 percent and an “expected variability” of returns of 20 percent, while Stock B has a lower expected return of 5 percent but the same expected variability of returns of plus or minus 20 percent.
Now suppose every time Stock A is up 1 percent, Stock B falls 1 percent. A statistician would tell you that returns for these two stocks are perfectly inversely correlated. If you held these two stocks in your portfolio in equal portions, the portfolio would have an expected return of 7.5 percent, which is the average of two the stocks’ expected returns. However, the expected variability of returns would be zero, meaning risk has been completely eliminated. Of course, it’s unlikely you could find two stocks whose returns are always perfectly inversely correlated, but this helps illustrate the point that the less correlated the returns are, the lower the portfolio risk.
At the bottom line, asset allocation, when properly done, reduces portfolio risk more than it compromises returns. Let’s look at some real world data.
Rather than two stocks, let’s consider two asset classes, stocks and bonds. To represent stock market behavior, we’ll use the Vanguard 500 Index Fund, which tracks the Standard & Poor’s 500 Index as its benchmark. For bonds, we’ll use the Vanguard Long Term Investment Grade Bond Fund. We looked at data for both funds going back to 1976, when the Vanguard 500 Fund was first offered to the public.
Next, we identified six periods when the stock market suffered significant declines. These declines, which lasted for as few as two months to as long as 25 months, caused the value of holdings in the Vanguard 500 Fund to decline anywhere from 12.4 percent to 44.8 percent.
For each period of stock market decline, the chart below shows the results for four portfolios that mix stocks and bonds, along with a portfolio consisting only of stocks. For convenience, the mixes are called “Income” (75 percent bonds, 25 percent stocks), “Conservative” (60 percent bonds, 40 percent stocks), “Balanced” (55 percent stocks, 45 percent bonds) and “Growth” (70 percent stocks, 30 percent bonds).
Over the past 32 years, the most defensive portfolio, Income, had average annual returns of +9.5 percent. At the other end of the spectrum, the average annual return for the all-stock portfolio was +11.5 percent. Returns for the other portfolio mixes, expectedly, fell in between: +9.9 percent for Conservative, +10.3 percent for Balanced, and +10.7 percent for Growth.
As you can see on the chart, the average return for the six preceding periods of stock market declines for the Income portfolio was actually positive (+2.5 percent). The worst return for the Income portfolio in any of these periods was -5.5 percent.
The Conservative portfolio suffered an average decline of 2.2 percent, while the average decline of the all-stock portfolio was 20.8 percent. While returns for those who held the Conservative mix averaged 9.9 percent compared to 11.5 percent for the all-stock fund, the average decline in the Conservative portfolio was only about one-tenth of the all-stock decline during these six troubled market periods. (Data for the current period of decline, whose duration is unknown as I write this column, aren’t included in the averages.)
In short, those who constructed their investment portfolios with appropriate asset allocation techniques, in fact, shed significant amounts of risk in exchange for small differences in overall returns. I’ll talk about how to choose an appropriate allocation in a future column.
