It’s 5 years into the one of the biggest stock market bull runs of all time, and all looks fine for the aging bull even after this brief downturn in October. For many, this has been a great run and they’ve been doing quite well during it. For many others, it’s been rather annoying, as their “smart” choice of diversification has under performed recently.
But here’s the deal – it’s not about beating the S&P 500. You’re on the quest to find a portfolio that best matches your needs before retirement. For some, that’s so far in the future, you’re not worrying about volatility. For some, it’s within reach, and you want to protect what you have before something bad happens. For some, you’re looking for something in between the two. So what’s your “Perfect Portfolio?” It’s not an easy question to answer, and many pros have tried (check out Meb Faber’s impressive list of asset allocation strategies and stats here). The basic portfolios to consider in our mind are the following:
- I Love US Stocks For those choosing the “Robo-Advisors,” or the “ETF’s for any investor” this might mean you’re in multiple stock index ETFs like ( 33% $SPY, 33% $DIA, and 33% $QQQ), hoping to capitalize off of the bull run as long as possible, and after +30% returns last year, why can’t there be a repeat?
- Traditional 60/40. For others not willing to risk no diversification, you might abiding by the 60/40 concept (60% stocks / 40% bonds ($AGG).
- Foreign Diversification. As we previously pointed out, many (including Reformed Broker) write about a 30% allocation to foreign stocks as a diversification from the stock market. (30% S&P 500, 30% Foreign Stocks ($EEM), 40% Bonds).
- Gold will Protect Me. Instead of looking overseas for diversification, some believe that Precious Metals like Gold and Silver are a well thought out diversification strategy. It’s supposedly non correlated with the market, Gold is supposedly its own asset class, and many use gold as an inflation hedge to replace the US Dollar. (33% Stocks, 33% Bonds, 33% Long Only Gold ETF ($GLD).
- Heavy in Alternatives. Finally, Alternative Investments, which give investors the opportunity across dozens of markets whether they’re moving up and down. For percentage allocation, we’ll use our most recent updated Efficient Frontier (36% Stocks, 24% Bonds, 40% Managed Futures). For the purpose of this quest, we’ll use the Attain Trend Following Fund for Managed Futures.
It’s long been argued that that the point of “True Diversification” is to offer the lowest volatility providing the most returns. But what if exposing yourself to the lowest amount of Volatility is actually not the right choice? What if “Low Volatility is not so Smart?” We decided to take on the quest of the perfect portfolio, running the data on the 5 portfolio’s listed above over the past 10 years, to see which portfolio offered the best approach.
First, we’ll start with Volatility compared to Compound Rate of Return.
Most of you know that the combination of these numbers (Compound Rate of Return / Annualized Volatility) is the Sharpe Ratio, but we thought this visual look of the two, side by side, gives a better representation than a ratio. Our takeaways:
- The Traditional 60/40 Portfolio sure looks broken from this chart.
- It shouldn’t be surprising that that long only US stock portfolio is the most volatile portfolio.
- International Stocks are highly correlated with US Stocks, and offer worse returns with only slightly less volatility.
- The Alternatives Portfolio comes right in the middle as far as volatility rankings, while offering the highest Compound ROR in the midst of its own generational drawdown.
- It’s interesting to see long only stocks not outperform all other options out there considering it’s in one of the best bull market runs in decades (I guess losing -50% or so in 2008 really dragged down performance).
- While Gold has struggled recently – it did go up significantly over the past 10 years, greatly aiding its total return numbers. Even with its ups and downs – this diversification has offered the lowest volatility, and returns that are well above what the what Warren Buffet thinks the average investor should see each year, 6%.
Here are the stats in table format:
So who’s the winner? No one. That’s because each portfolio needs to be unique to serve the investors needs. If someone is just starting their retirement plan, maybe low (or no) fees long stock ETF are the right choice, as long as they know they could encounter another -49% drawdown at some point. If the idea of basically no diversification by investing in only US stock indices gives you a heart attack, maybe you want to diversify into Gold and its lower volatility over the past 10 years (not something we would recommend).
But what if you don’t want either extreme? The important thing to remember is that as you decrease your exposure to volatility, you also decrease you opportunity for profits. Finding the balance between the two is the ideal strategy, in our opinion. Which portfolio would you choose? It’s important to remember that past performance is not necessarily indicative of future results. So the question we should be asking is what portfolio would you choose for the next 10 years? The next 20? The next 50 years? Will the bull market come to an end soon? Will Gold go back to all time highs? Will Alternatives do even better without the poor 5 year period they’ve just lived through?
It’s only your life savings on the line…. Choose wisely.