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How to construct a portfolio using simplified modern portfolio theory. Travis Morien Compass Financial Planners Pty Ltd [email protected] http://www.travismorien.com. Before viewing this presentation:. - PowerPoint PPT Presentation
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How to construct a portfolio using simplified modern portfolio theory
Travis MorienCompass Financial Planners Pty Ltd
[email protected]://www.travismorien.com
Before viewing this presentation:
The presentation you are about to view on building portfolios is the “sequel” to a slideshow on selecting
managed funds. Some concepts are carried forward from that presentation and are assumed knowledge.
If you haven’t already done so, download the original presentation from
http://www.travismorien.com/investment.ppt
Part One
The asset classes
Basic principles• There are many asset classes out there and many
of them are useful to investors.
• Some asset classes are noted for their long term stability (low risk), others for their high returns.
• Generally speaking, the higher the reward you are after, the more risk you’ll need to take.
• Portfolios can be constructed out of multiple asset classes that exhibit superior risk and return relationships to any single asset, because diversification can significantly reduce risk.
Why risk and return are linked..
B
AA
B
Investment A is the obvious choice… … but add
risk, is the choice still obvious?
B would die out through lack of takers!
When two investments appear to offer identical risk, investors will prefer to buy the higher returning one. If the market is peopled by reasonably well informed investors, there simply won’t be any high returning low risk investments left and nobody will buy high risk assets with a low expected return.
Risk and return continued• In a portfolio construction context “risk” is usually
measured with some sort of measure of price volatility.• There are other risks of course that need to be taken into
account.• Inflation risk is a major problem with the more
“conservative” asset classes such as fixed interest and cash. Many pensioners find to their horror that they can no longer live off their savings, despite the conservatism of their strategy, simply because their returns weren’t high enough to maintain the portfolio’s real value after inflation, costs and withdrawals.
• It is necessary for all but the most short term oriented investors to consider at least some exposure to growth assets like shares and property, just to fight inflation.
Major asset classes: shares• Shares are part interests in businesses. How good a return you get
on your share depends to a large extent on the fundamental business developments of the company itself and on the price you paid for the share.
• Averaged out over many companies, shares as an asset class tend to respond to interest rates and the economy.
• Although in the last few years many markets have fallen substantially, shares are still the highest performing asset class over the long term and by far the most tax efficient.
• Shares generally go up in price over the long term because businesses don’t pay out 100% of their profits as dividends, they keep some to grow the value of the business itself.
• Over the long term, shares have beaten inflation by about 6%pa.
Major asset classes: property• There are many types of property to invest in, each are
different.• The highest income yield comes generally from commercial
and industrial property, which often pay the owner as much as 10%pa in rent alone.
• Residential property is an asset class that has really been booming over the last few years, but rental yields are now alarmingly bad by historical standards meaning that investors are highly reliant on capital growth.
• Over the longer term you can expect property to grow in capital value at about the same rate as inflation (because the salaries with which we have to pay the mortgages only grow with inflation – there eventually comes a limit when growth above inflation just can’t be sustained), though local supply and demand issues mean actual returns could be higher or lower over a particular period of time.
Major asset classes: fixed interest• A “fixed interest” investment is a debt that can be bought and
sold.• The borrowers are usually governments and companies. A typical
fixed interest investment pays a regular “coupon” (interest payment) and will repay the principle on maturity.
• Some fixed interest securities have a maturity of several decades, others are shorter term.
• The actual price of a fixed interest investment will fluctuate in response to many things, most particularly interest rates. If general interest rates fall, the price of a long term fixed interest security will usually rise such that the “yield to maturity” is similar to those of other investments with a similar risk. On the other hand, if interest rates rise, fixed interest investments fall.
• A typical fixed interest portfolio is yielding less than 5% right now, though falling interest rates over the last decade have helped bonds to deliver very strong performance which included a growth component.
Major asset classes: cash• “Cash” may mean currency, but in an investment context
cash is just a really short term highly liquid fixed interest investment.
• Longer term fixed interest investments are usually called “bonds”, shorter term fixed interest investments may be called “notes” and really short term ones are often called “bills”.
• Cash management trusts usually invest in a portfolio of high quality short term fixed interest investments. Because of the short maturity, these fixed interest investments aren’t as sensitive to interest rate changes and thus don’t have a great deal of capital volatility.
• Many cash investments are returning about 4% at the moment.
Other asset classes• Shares, property, bonds and cash are the major asset
classes, but there are many others to choose from.• Hedge funds are sometimes called a distinct asset class as
they pursue unconventional strategies that give them performance very different to the asset classes that they invest in.
• “Private equity” is basically a shares investment, but in companies not listed on a stock exchange.
• Agribusinesses are agricultural investments in things like tree farms and vineyards.
• Some people also consider commodities like gold to be an asset class of its own, and many people consider collectibles, race horses and fine wines to be useful alternative investment asset classes.
The point of portfolio construction• A portfolio is often more than the sum of its parts.
Because not all asset classes perform the same way over the short term, a portfolio of many asset classes usually offers a superior overall relationship between risk and return to any single asset.
• A portfolio consisting only of shares would have done badly in the last few years since the US market crashed, but property and bonds have performed very well. This is quite typical, more “defensive” asset classes often do well when equities are falling.
• A diversified portfolio has a reasonable long term growth rate because over time all asset classes offer a positive return, but being invested across different asset classes smooths out returns and offers a more predictable growth rate.
The last twenty years have seen very good returns for all major asset classes, well in excess of inflation,
but the risk and return are highly variable.
GROWTH - CUMULATIVE RETURNS
S&P/ASX500 Index A$
MSCI World Index A$
ASX 300 Prop Index A$
UBS Comp Bond A$
UBS 90 Day Bank Bill A$
Aust CPI Index A$
Per
cent
Ret
urn
Time Periods: 1/85 to 3/04
0
500
1000
1500
12/84 5/87 10/89 3/92 8/94 1/97 6/99 11/01 4/04
Part Two
Creating diversified portfolios
How diversification reduces riskThere are two mechanisms by which diversification reduces risk: dilution and interference.
• Dilution is easy enough to understand, if you swap half your shares for cash then you lose half your equity exposure and therefore half your equity risk. If the market crashed tomorrow you’d only lose half as much.
• “Interference” (a term I pinched from physics where it is used to describe the way waves interact), is where negative movements in some assets are partly cancelled by positive ones in other assets. A good example is with property vs. shares, in the recent bear market in shares property did very well while shares tanked, the opposite may be true in the next few years.
Interference and correlation“Correlation” is the word given to the extent to which assets move together, this is measured with statistical formulae. Correlations can range from -1 (perfectly negatively correlated) through to +1 (perfectly positively correlated).
If asset B tends to move in the opposite direction to asset A then these two assets are said to have “negative correlation”, and they can be highly effective at cancelling out each other’s volatility. If the assets both trend upwards over the longer term a combination of them will have a return equal to the average of the two assets’ returns but with substantially reduced volatility.
Negatively correlated assets cancel the greatest amount of each other’s volatility.
Negative correlation isn’t essential• Assets don’t need to be negatively correlated to have some
volatility smoothing.• As long as the correlation is less than +1 the assets will be at
least a little bit different and at least some volatility will be cancelled.
• Most real world assets are positively correlated because most prices are related somehow to important “macro” factors like global economic growth, interest rates, oil prices etc.
• Even if negative correlations are rare, substantial volatility reduction is possible by using assets with a low positive correlation.
• For example, the annual correlation of Australian listed property with Australian shares from 1982 to 2003 has been about 0.68, but the correlation of property with international shares was about 0.30, the correlation of Australian shares with international shares was about 0.64, so a mixed portfolio would be quite effectively diversified.
The “efficient frontier” is the name given to the line that joins all portfolios that have achieved a maximum return for a given level of risk (portfolios that are “efficient”). If you programmed a computer to chart every possible portfolio that could be constructed out of a group of assets and plotted a point on a risk vs. return chart, the resulting plot usually looks much like the chart below. The top of the curve is the efficient frontier, anything below that curve is an “inefficient” portfolio, anything actually on the curve, or close to it, is an “efficient” portfolio.
Risk
Inefficient portfolios below efficient frontier
Efficient portfolios on or near the efficient frontierReturn
Efficient vs. inefficient portfolios
• It is impossible to predict in advance which portfolios will be the most efficient as this would require knowing in advance asset class performance and correlations.
• A portfolio that has been diversified into a variety of asset classes should be close to efficient over the longer term, provided it is rebalanced regularly.
Rebalancing• Rebalancing a portfolio is the process of adjusting a
portfolio to bring it back to its original asset allocation.
• Since assets perform differently at different times, the portfolio is likely to drift from your desired asset allocation.
• Failure to rebalance means that a portfolio can change risk profile over time and may no longer be appropriate.
A simple rule of portfolio construction• If you have two assets with roughly equal
expected returns, putting 50% into each is a way to hedge one’s bets (and spread the risk) without compromising expected return. The lower the correlation of those assets, the more the risk will be reduced while not reducing expected returns at all.
• Actually, this holds true with a greater number of investments as well. For example, if you have five equally attractive assets you could invest one fifth in each.
Since 1982 Australian shares (ASX500 index), international shares (MSCI world index) and property securities (ASX300
listed property index) have had roughly the same return…GROWTH OF DOLLAR
S&P/ASX500 Index A$
MSCI World Index A$
ASX 300 Prop Index A$
Valu
e o
f D
olla
r
Time Periods: 1/82 to 12/03
0
5
10
15
20
25
30
12/81 9/84 6/87 3/90 12/92 9/95 6/98 3/01 12/03
So using our simple rule of thumb that if the three assets have similar returns we’ll use a third in each, we get the following portfolio which
has outperformed all three with much less volatility! (Rebalanced monthly)
GROWTH OF DOLLAR
S&P/ASX500 Index A$
MSCI World Index A$
ASX 300 Prop Index A$
One third in each
Val
ue o
f D
olla
r
Time Periods: 1/82 to 12/03
0
5
10
15
20
25
30
12/81 9/84 6/87 3/90 12/92 9/95 6/98 3/01 12/03
Diversifiable vs. undiversifiable risk• There is such a thing as “diversifiable” risk, as you add
extra assets to the portfolio the volatility tends to decrease – but only up to a point. When a portfolio reaches a certain level of diversification the only way to reduce risk is to add lower risk assets which will reduce volatility by dilution, this usually reduces the return.
• Risk which cannot be diversified away is “undiversifiable” or “systemic” risk. Holding every stock in the market (i.e. with an index fund) smooths out the maximum amount of diversifiable risk for shares, but you are still left with the risk of the market itself, that risk cannot be reduced unless you spread your portfolio across more asset classes.
• According to financial theory, investors only get rewarded for taking on systemic risk. Having an under-diversified portfolio results in greater risk but no extra expected return. This is one definition of “speculation”. (There are others.)
Diversification can also increase returnsA higher return may often be obtained from rebalancing the portfolio as a result of “reversion to the mean”.
If you believe that at some point in the future two assets will give the same cumulative return then it would make sense to invest in the asset class with the worst recent performance and sell the one with the best performance!
Rebalancing does precisely this, although it is normally seen only as a risk management technique.
This is why the diversified portfolio did a little better than all three component asset classes. A small “rebalancing premium” is quite common because last year’s worst performing asset class often outperforms last year’s best performing asset class this year.
Improving the efficient frontier
• Investors desire higher returns with lower risk. There is however a limit to what can be achieved with a particular set of assets, that limit is drawn on charts as the efficient frontier.
• By adding more assets we can change the shape of the efficient frontier. Assets carry two items of interest to us, their returns and their correlation with the rest of the portfolio.
Refining our asset allocation• There is wide acceptance that so-called “value”
stocks outperform “growth” stocks, and “small companies” tend to outperform “large companies”, at least over the longer term.
• Their higher long term performance is very interesting, but so too is the fact that they often have a low correlation to large growth companies, the dominant stocks in the market.
• They provide what asset allocation buffs call an “independent source of risk and return.” This may enable us to improve the efficient frontier.
Fama and French’s “Three factor” model
Your returns mostly come down to asset allocation:
• The mix of stocks vs. bonds
• The average company size
• The value characteristics of the stocks - how “cheap” stocks are compared to book value.
Picture credit: Dimensional Fund Advisors
Over the long term value stocks and small companies have outperformed large companies. These are the returns of global value, large company and small company indexes calculated by
Dimensional Fund Advisors from January 1975 – December 2003:GROWTH OF DOLLAR (LOG PLOT)
Global Value Gross A$
Global Lge Gross A$
Global Small Gross A$
Valu
e o
f D
olla
r
Time Periods: 1/75 to 12/03
1
10
100
1000
12/74 7/78 2/82 9/85 4/89 11/92 6/96 1/00 8/03 3/07
Global small caps 20.29%paGlobal value 19.70%pa
Global large companies 14.98%pa
GROWTH OF DOLLAR (LOG PLOT)
Large Portfolio
Tilted Portfolio
Value
of D
ollar
Time Periods: 1/80 to 8/04
1
10
100
12/79 1/83 2/86 3/89 4/92 5/95 6/98 7/01 8/04
Adding value and small caps to a large cap growth equity portfolio gives a better return than a large cap only portfolio, but the volatility is actually lower, not higher. A mixed portfolio is more “efficient”.
Large cap
Large + value + small
Annualised Return %pa 14.00% 16.33%
Total Cumulative Return 2433% 4072%
Monthly Standard Deviation 4.19% 3.93%
Monthly Average Return 1.19% 1.35%
Annualised Standard Deviation*
14.53% 13.62%
20% Australian large
20% Australian value
10% Australian small
20% global large
20% global value
10% global small
50% Australian large
50% global large
Data from Dimensional Fund Advisors DFA Returnw program, gross return of indexes tracked by DFA equity trusts. See http://www.dimensional.com.au
*Annualised standard deviation is presented as an approximation by multiplying the monthly or quarterly standard deviation by the square root of the number of periods in a year. Please note that the standard deviation computed from annual data may differ materially from this estimate.
Total stock market vs. “slice and dice”• The stock market is dominated by what would be
classified as “large growth companies”, also known as “blue chips”. As a portion of market capitalisation, the very largest companies dominate the market and so an exposure in market weightings tends to have a very small amount of small company and value exposure.
• Many asset allocators believe a portfolio should have more small company and value exposure than the market gives. Although small companies might only make up 5% of the market by capitalisation, they make up the vast majority of listed companies by number. Despite the tiny market weighting, asset allocators often allocate a larger amount of 10 to 20% to small caps and similarly overweight value companies.
Computer backtest optimisation• A common tool used is called a “mean-variance
optimiser” or MVO, a computer program that backtests portfolios to find the ones that lie on the efficient frontier. It looks at historical correlations, mean returns and volatility.
• The idea isn’t as good in practice as it sounds in theory because past performance is no guarantee of future results. The program usually only does what inept investors have always done – chase past performance, wags have dubbed MVO’s “error maximisers”.
• A non-technical approach goes back to the basics – try to build your portfolio from many “independent sources of risk and return”. This simply means you should diversify into many different asset classes.
So how do you go about constructing a portfolio?
• The usefulness of historical correlations and returns is usually overstated, but can form a crude guide as long as we don’t take them too seriously.
• Don’t get too hung up on quantitative data, but try to find assets that are very different (e.g. property vs. shares.)
• Our first example of a diversified portfolio had a one third allocation to Australian shares, one third to international shares and one third to property. Since over the longer term these asset classes deliver approximately the same returns but operate on somewhat different cycles, that isn’t a bad allocation to start with for a high growth portfolio.
Decisions, decisions…• Active funds or passive/index funds?• How much to growth assets, how much to income
assets?• Balance of value stocks to growth stocks?• How much large cap shares, how much small caps?• How much money to put in developed markets vs.
emerging markets?• Currency hedged or unhedged international shares?• Listed or unlisted property?• Short or long maturity fixed interest?
• Within the one third allocated to Australian shares in our simple starting portfolio, we can allocate money between large cap growth, small cap growth, large cap value and small cap value. We can also allocate along the lines of industrials vs. resource stocks.
• Within the one third allocated to international shares we have the same asset classes above, but we can also allocate to developed markets or emerging markets.
• One might even consider allocating some of the shares investments to private equity (unlisted shares), which may often provide a very high return yet at substantial risk. A small allocation to a risky asset with low correlation to other asset classes can actually reduce the volatility of the overall portfolio.
• Long/short managed funds can also be useful as they usually have a very low correlation with the indexes.
Risky assets vs. risky portfolios.
• It is important to think about risk in a portfolio context, not an asset context. Portfolio building should be seen more like cooking – we are more concerned with the final product than the taste of each ingredient. Pepper tastes great on a steak, but makes a lousy meal by itself.
• Small percentage allocations to riskier assets like emerging markets, private equity, commodities, hedge funds and agribusiness can actually reduce the risk of the overall portfolio because they don’t operate on the same cycles as major asset classes. Small allocations to such assets can have a great impact on the efficient frontier.
Are risky assets like emerging markets too risky for conservative portfolios?• Emerging markets are by
themselves a very risky asset class, their monthly volatility is about 50% higher than global large companies (DFA indexes). On the other hand, their correlation with the global large caps indexes is quite low.
• Despite the high volatility of emerging markets, their low correlation with global large cap equities means a small percentage allocation of emerging markets to a global portfolio can actually reduce the volatility of a portfolio while potentially increasing returns.
January 1988 to January 2004, DFA Emerging Markets index plus Global Large Company index.
Addition of emerging markets to a global large cap portfolio
0.0%5.0%
10.0%15.0%
20.0%25.0%
7.5%2.5%
5
6
7
8
9
10
11
12
4.24 4.26 4.28 4.3 4.32 4.34
Monthly std deviation
An
nu
alis
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etu
rn
A little volatility can go a long way
• In a sense, the high volatility of the riskier asset classes is one of their most valuable attributes for a portfolio.
• The high volatility of asset classes like emerging markets and commodities means they punch well above their weight in contributing risk and return to the portfolio.
• A 5% allocation to a risky asset class with low correlation to “mainstream” asset classes might contribute as much diversification as a 20% allocation to a less volatile asset class, so only a small amount needs to be invested to improve portfolio diversification.
Review of the return vs. volatility of major asset classes from January 1988 to January 2004.
Aus value
Aus largeGlobal Value
Global Lge
Global Small
Listed property
CashAus small
Emerg Mkts
Aus bonds
Unlisted property trusts
Global bonds
0
2
4
6
8
10
12
14
16
18
20
0 1 2 3 4 5 6 7
Monthly std deviation %
Anu
alis
ed r
etur
n %
• Obviously some asset classes have been more efficient than others over this time frame, but which asset classes will be best over the next 10 years is another matter entirely.
• Australian value stocks for example continued to provide strong gains over the last few years as the rest of the stock market, especially international stocks, did poorly. In 2003, Australian small caps rose 40% (nearly twice what large companies returned) despite underperforming over the previous decade.
• There really is no way to forecast which assets are going to outperform, although that doesn’t stop people from trying!
Adding conservative assets• So far we’ve only shown what happens when growth
assets of the various flavours of shares and property are added together.
• Although we can substantially improve on large cap growth share portfolios in terms of risk and return there are limits to how conservative a portfolio of growth assets can be, to push the efficient frontier more toward lower risks the income asset classes (bonds, cash, mortgages) will need to be added.
• We have to accept that over the longer term this will probably cost the investor money due to a lower expected return, but the risk reduction potential is tremendous and this may be more suitable for conservative investors.
Half the risk doesn’t mean half the return!• Risk to reward ratios get more favourable for
conservative portfolios. • Putting half a share portfolio into cash will basically
halve the risk, but since cash doesn’t return 0% you won’t halve the return.
• If you gear a portfolio though you do double your risk (if you use 50% leverage), but because you have to pay interest on the loan you won’t double your return.
• Conservative portfolios therefore can greatly reduce risk without necessarily having the same amount of reduction in the return. This can be seen on the efficient frontier, which is usually curved instead of straight.
A property of efficient frontiers is that the left side of the chart is usually a lot steeper than the right side. Addition of even a small
amount of cash to a share portfolio (here we have used the ASX500 All Ordinaries share index from January 1980 to January 2004) can significantly reduce volatility with very little impact on returns and
the addition of a small amount of shares to a cash portfolio can significantly increase returns without increasing volatility much.
Percentage cash in an Australian shares portfolio
0%10%20%30%40%50%60%
70%80%
90%100%
9
10
11
12
13
0 1 2 3 4 5 6
Monthly std deviation %
An
nu
alis
ed
re
turn
%
All cash All shares
Part Three
Risk profiling and portfolio design
So why not always use a medium risk portfolio?• If diversification makes it relatively easy to substantially
reduce risk for only a small cost in return, why not do it all the time?
• The answer lies in compounding interest. Over a long period a small increase in returns makes a big difference to the final portfolio value.
• The difference between a portfolio that returns 8% over 20 years and a portfolio that returns 10% over 20 years is very substantial. Ten thousand dollars invested at 8% for 20 years will grow to $46,610, one thousand invested at 10% for 20 years will grow to $67,275 - a very significant difference! If you are young then your time frame on retirement assets is likely to be 30 years or more.
• Growth assets are also generally more tax efficient and therefore the gap between aggressive and conservative portfolios widens after tax.
Over a short period of time there is very little difference so it may not be worth taking a risk, but if you do have a long term horizon then serious
thought should be put into ways to get an extra percentage point or two out of the portfolio. An extra point of risk is often hard to notice without a
computer, but an extra point of return makes a very big difference in the long term! Risk is important but being overly conservative can be a costly
mistake over the long term.
$0$20,000$40,000$60,000$80,000
$100,000$120,000$140,000$160,000$180,000$200,000
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
8% 10%
Choosing a level of risk vs. return• “Risk profiling” is a tricky business that
depends on the time horizon, risk tolerance and return requirements of an investor.
• As a financial planner I spend a lot of time working on this with clients, but it is a complex area and it is outside the scope of this presentation.
• Some model portfolios with different levels of risk and their risk/return profiles are shown on the next few slides.
Three dimensional approach to risk profiling
Most advisors discuss risk tolerance in terms of potential volatility only, often using short multi-choice questionnaires. In my opinion, this is inadequate and doesn’t really address the client’s needs. I think there are actually three dimensions to risk profiling:
1. Time frame – when is the money required?2. Volatility tolerance – how much volatility?3. Conventionality – given the different cycles of
value and small cap shares and that they may underperform large growth companies for extended periods of time, how much of a value and small cap tilt is acceptable?
Example model portfolios
High growth Growth Balanced Low growth Conservative
Growth assets 100.00% 85.00% 70.00% 55.00% 30.00%
Income assets 0.00% 15.00% 30.00% 45.00% 70.00%
Australian “Value” Equities 15.00% 13.00% 10.00% 8.00% 4.50%
Australian “Large” Equities 15.00% 13.00% 10.00% 11.00% 6.00%
Australian “Small” Equities 5.00% 4.00% 3.00% 0.00% 0.00%
Global “Value” Equities 15.00% 13.00% 10.00% 8.00% 4.50%
Global “Large” Equities 15.00% 13.00% 10.00% 11.00% 6.00%
Global “Small” Equities 5.00% 4.00% 3.00% 0.00% 0.00%
Listed Property 30.00% 25.00% 24.00% 17.00% 9.00%
Australian Bonds 0.00% 5.00% 10.00% 15.00% 20.00%
International Bonds 0.00% 5.00% 10.00% 15.00% 20.00%
Bank Bills (cash) 0.00% 5.00% 10.00% 15.00% 30.00%
Annualised Return 14.12% 13.76% 13.25% 12.84% 11.86%
Monthly Standard Deviation
3.39% 2.93% 2.41% 2.01% 1.25%
Historical risk and return for model portfolios, February 1985 - December 2003
High growth Growth
Balanced
Low growth
Conservative 11.50%
12.00%
12.50%
13.00%
13.50%
14.00%
14.50%
0.00% 1.00% 2.00% 3.00% 4.00%
Monthly standard deviation
Ann
ualis
ed re
turn
February 1985 to December 2003, monthly distribution of returns:Note the higher peak and narrow spread of the conservative portfolio compared to the higher risk portfolios, but note also that the riskier portfolios peak further to the right
showing that on average they have had better returns.
0
10
20
30
40
50
60
70
80
Nu
mb
er
of
oc
cu
ren
ce
s
High Growth Growth Balanced Low growth Conservative
Maximum drawdown is another way to look at risk which is more meaningful to most people. Drawdown is calculated as the loss from the highest previous high. The losses each portfolio experienced in
past bear markets can be clearly seen and compared.
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
Jan-8
5
Jan-8
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Jan-8
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Ma
xim
um
dra
wd
ow
n
High Growth Growth Balanced
Low growth Conservative
Compared to the individual asset classes, the historical drawdown of the diversified “High Growth” portfolio was much less. Individual growth
assets have tended to have up to twice the downside risk.
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
Jan-
82
Jan-
83
Jan-
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Jan-
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00
Jan-
01
Jan-
02
Jan-
03
Australian shares Global shares Property securities High Growth
Typical downside risk as measured by maximum drawdown
• A “High Growth” model portfolio would have lost about 25% in the crash of October 1987 and by the bottom of the next largest three subsequent bear markets (September 90, January 95, February 03), losses were about 12%.
• Every 15% of allocation to income assets reduced the average magnitude of the drawdown at the bottom of each significant bear market by an average of about 15% (not surprisingly!) at a cost of about 0.5%pa in annualised returns.
• It is also worth noting that the drawdown periods tended to last slightly longer in the aggressive portfolios as it took more time to make up the greater losses.
• Bear in mind the inferior tax efficiency of the conservative portfolios, so for taxable investors the gap between each portfolio would be slightly greater.
Designing a portfolio – risk tolerance• First, determine the time frame of the investment. • Examining data from model portfolios and adding on a
margin of safety, decide how much downside risk over that time frame that you can accept.
• Remember, the consequence of risk is more important than the probability of risk. Risk should be assessed in terms of how much damage it would do to your ability to pay for something you need at some time in the future. Don’t get too obsessed about daily, weekly, monthly or even annual volatility if your investment horizon is 20 or 30 years!
• Of course if your investment horizon is quite short term, you probably should be obsessed about short term volatility!
Designing a portfolio – value vs. growth• Value stocks and small companies tend to outperform
large cap growth companies over the longer term but they do have risks of their own.
• Value stocks outperformed by a huge margin during the “bear market” of the last few years, in fact Australian value stocks even outperformed property trusts during a time which is generally remembered as a property boom.
• The trouble though is that during the “tech boom” of the late 1990s, value stocks lagged by a large margin. We know with hindsight this was a bubble, and most of those gains were lost, but this wasn’t that easy to spot at the time. The newspapers were all touting the “new economy”, and value investors seemed like they were obsolete. As a dimension to risk profiling, this one is about how willing you are to ignore underperformance and the prognostications of pundits.
Designing a portfolio – value vs. growth• Personally I am happy to have a very strong tilt toward
value stocks, but not everyone feels that way.• The numbers for value vs. growth strongly favour value for
more than half a century in the US and many foreign markets where data is available, the track record of value is impressive.
• But how many years will you persist with value investing if it underperforms the general market? One year? Five years? Ten years? How do you know there isn’t really a “new paradigm” and markets haven’t really changed?
• Most people prefer to hedge their bets, allocating some but not all of their portfolio to value stocks, buying growth stocks and having a “balanced” exposure. This may not be the highest returning strategy for the very long term, but it seems more conservative for most people.
Is value more risky than growth?• Many academics argue that the outperformance of value stocks vs.
growth stocks is a “risk premium”, i.e. that investors are merely being rewarded for taking on more risk.
• Others who don’t believe in the “efficient market hypothesis” think that the outperformance of value is caused be systematic errors made by analysts who overestimate the future profits of “growth stocks” and underestimate the future profits of “value stocks”, this would be an “inefficiency”, an opportunity to earn a higher return without higher risk.
• Various people have put forward various theories about the extra risk of value, but one of the most obvious troubles with the value = risky theory is that value based portfolios tend to be less volatile, not more, in fact “growth” portfolios, which have lower returns, can be much more volatile.
• This debate has gone on for years and will continue to go on for years more, to some people the idea of a “free lunch” in value stocks is theoretically impossible, so they hypothesise new forms of risk.
Citigroup BMI value and growth indexes, July 1989 to Jan 2004 (Australian shares)
Although the value index in this example outperformed the growth index by more than 3%pa, if there is much extra risk in value stocks then it
doesn’t show in the volatility or drawdown figures.
Longer term in the US: Fama and French large value vs. large growth indexes January 1926 to December 2003. Again, if there is extra risk it isn’t obvious in
the drawdown figures. Value outperformed growth by more than 2%pa over the entire period but this didn’t translate into meaningfully greater downside
risk. Value was marginally more volatile though, 7.45% per month vs. 5.48%.
Risk of value stocks• The main reason why many academics say value stocks
are more risky is because in theory they would have to be more risky for the efficient markets hypothesis to remain valid. Many explanations are given, but some tend to be almost metaphysical, claiming that the risk can’t be measured but is there somehow and somewhere.
• Interestingly, prior to academics discovering the “value premium”, nobody claimed value stocks were more risky, this claim was made by efficient market supporters only after the higher returns were proven.
• It is an interesting issue, but from a personal investor’s point of view it is a question of whether the value premium is likely to persist for ever and whether they are willing to tolerate periods of underperformance where growth does better than value.
Value vs. growthIn the late 1990s, growth stocks outperformed value stocks. If you had switched out of value and into growth following that period of outperformance you would have been hurt badly by the bear market that followed, where value stocks outperformed growth by a big margin. Growth stocks often outperform in rising markets, especially in the latest stages of bull markets when most people invest the most money. Typically, value stocks offer more consistent performance.If you can’t tolerate underperforming the market or don’t want to bet on a value premium continuing, stick with normal large cap “blue chip” shares. Strongly tilted value and small cap portfolios aren’t suitable for everyone.
Conclusions• Asset allocation is an overlooked and underrated
field of investment, but studies show it is more influential on the behaviour of a portfolio than stock selection or market timing, more importantly you can exercise more control over asset allocation whereas the others are often a matter of luck.
• Used properly, asset allocation is the major risk management tool in an investor’s arsenal, but it can also be a source of higher returns.
• Asset allocation can be a complex area with many fine points that are often overlooked and is particularly important for pension portfolios.
Recommended reading•Common Sense on Mutual Funds by John Bogle
•The Intelligent Asset Allocator by William Bernstein
•The Four Pillars of Investing by William Bernstein
•A Random Walk Down Wall Street by Burton G. Malkiel
•The Intelligent Investor by Benjamin Graham
•Contrarian Investment Strategies: The Next Generation by David Dreman
•Against the Gods: The Remarkable Story of Risk by Peter Bernstein
•John Neff on Investing by John Neff
Web sites of interesthttp://www.stanford.edu/~wfsharpe/art/active/active.htm
http://www.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm
http://marriottschool.byu.edu/emp/srt/passive.html
http://www.diehards.org/
http://www.investorsolutions.com/ArticleShow.cfm?Link=art_It_Dont_Get_Much_Worse_Than_This.cfm
http://www.investorhome.com/cherry.htm
http://library.dfaus.com/faqs/
http://library.dfaus.com/articles/dimensions_stock_returns_2002/
http://www.indexfunds.com/
http://faculty.haas.berkeley.edu/odean/
http://www.efficientfrontier.com/
http://www.tweedy.com/library_docs/papers.html
http://www.travismorien.com
Disclaimer:Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. Investors should seek the advice of their own qualified advisor before investing in any securities.
Please note that returns quoted in this article are based on historical performance of indexes, not actual products. Real world products (index funds) are available to track the majority of indexes quoted in this presentation, but returns will be affected by fees and taxes. Past returns are not a reliable indicator of future returns.
