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Wednesday, May 7, 2014

Putting Riskier Assets Into Your Portfolio Stabilizes It?

Alright, that was a much longer hiatus than I would care to ever repeat and I decided to get back into the swing of things here by writing about one of my favorite little facts in portfolio theory. That is the peculiar fact that adding stocks to an all-bond portfolio actually stabilizes your returns and you get a higher return for less risk.

You know how economists always say there's no free lunch? Well, there's an exception to that rule and it comes from what is referred to as the "efficient frontier," which amounts to a rule about assessing the true relationship between risk and reward. Long story short, there isn't a straight linear relationship. There's a weird bend in the curve that makes a 27% stock portfolio as safe as a 0% stock, 100% bond portfolio and makes a 15% stock portfolio the least risky of all. For all of the charts below, I used data on total returns for stocks and 10-year U.S. from 1928 to 2013.

But wait, there's more! Because of the fact that adding stocks to a portfolio increases your long-term annual returns, this actually means that you can reduce your volatility and increase your returns in that backward-bending portion of the volatility curve. 

The idea that risk and reward are strictly linearly related has been a longstanding fallacy that most people buy into, but there are even every day exceptions to that. For example, you can walk into a street with cars going 25 mph and the odds are that they will stop and not run you over, even though they'll be incredibly angry with you for making them hit the brakes. However, they might not hit the brakes and then you'll be run over. The risk there is pretty high and the reward is saving a few seconds on your commute. 

The reason that it's not linear in the case of investments has to do with the fact that the factors which move stocks and bonds are different. Bonds typically do well in environments where investors are risk-averse and the outlook for inflation is declining, often because growth is declining. Stocks generally (surprise!) do well when growth prospects are strong. There are years where their interests coincide, very notably 1995 and 1982, because falling interest rates are good for bonds and stocks, all else being held constant. The consequence is a distribution of returns that looks something like this.

There's a smattering of about 8 years where they both do very well and you can see that in the upper-right corner, but otherwise there's a decently strong inverse relationship between the two.

So, the conclusion here is that by introducing a riskier asset class, in this case stocks, into a portfolio that starts as 100% bonds, you actually reduce your long-term volatility and increase your returns at the same time.

Now, a related question is what allocation avoids the worst performance historically. The answer isn't quite the same, but it's close. 

It works out that an 11% asset allocation to stocks has had the smallest 1-year decline of any asset allocation at just over a 7% drop. This of course prompted the question of what is the best year each asset allocation has seen. There's no question that 100% stocks will see the best year, but the rest of the curve is kind of interesting.

I know it's a little spooky, almost like Quantum Entanglement, but facts are facts and it's important to know what asset allocations are truly best for reducing volatility if that's your preference.

In case you're curious about the history of this idea, Harry Markowitz, one of the all-time greats in financial economics, was the one who really popularized it. 

With that, it's good to be back and I hope to be posting more in the future.

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