There Is More To Portfolio Allocation Than Meets The Eye

by: Jeff Blokker

A recent article praising the virtues of the Permanent Portfolio grabbed my interest. The Permanent Portfolio is a portfolio with equal allocation of S&P 500, bonds, gold, and cash. But why use this allocation? What is the optimum allocation? How does a fixed allocation strategy affect portfolio performance?

To explore these questions I used the Robert Shiller's Irrational Exuberance data and MATLAB to plot the performance of the Permanent Portfolio against the S&P 500 and the S&P 500 Total Return.

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The S&P 500 Total Return Portfolio is created by reinvesting the dividends earned back into the S&P 500. The Permanent Portfolio is rebalanced monthly and reinvests its S&P 500 dividend equally in each asset class. Taxation and commissions are ignored. Comparing the Permanent Portfolio to the S&P 500 price graph demonstrates the Permanent Portfolio's advantages of having a low volatility with almost the same return. However, in my opinion, the S&P 500 price is not the best benchmark for performance comparison. I believe the S&P Total Return Portfolio is a more realistic benchmark for comparison and clearly has greater return than the Permanent Portfolio.

Next, to satisfy my curiosity of what balance of assets had the highest return, I optimized the portfolio to find the best fixed asset allocation ratios. The result was that the highest return was achieved when the portfolio maximized its margin to buy 200% S&P 500 while borrowing 100% from bonds. The average annual return of each portfolio is summarized in the table below.

Since it is difficult for most investors to hold on to their positions during the rollercoaster ride of the S&P 500 when they are fully margined, I decided to optimize asset allocation to maximize the Sharp Ratio. The best Sharp Ratio is achieved with 20% S&P 500 and 80% Bonds. Notice that gold and cash do not play a role in any of the optimized portfolios.

S&P 500

Bonds

Gold

Cash

Avg. Annual Return

S&P 500 Total Return

100%

0%

0%

0%

8.85%

Permanent Portfolio

25%

25%

25%

25%

4.34%

Optimum Return

200%

-100%

0%

0%

10.92%

Optimum Sharp Ratio

19.86%

80.14%

0%

0%

5.60%

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But there is more to the story. It is possible to hold the value of S&P 500 above 200% when the market drops until you get a forced margin call. With a 30% maintenance margin this occurs when the value of your holdings in the S&P 500 exceeds 333% of the total portfolio value.

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The chart above shows the difference between two portfolios. The Active Rebalancing Portfolio forces a fixed 200% allocation of S&P 500 shares each month as the market rises and falls. This means that when the market falls the portfolio sells the S&P 500. But when the market rises again it buys those shares back. The Margin Call Portfolio demonstrates the effects of margin call on portfolio value. This portfolio buys 200% of the S&P 500 whenever the allocation falls below 200% and sells shares when a margin call is forced. The Margin Call Portfolio suffers because it is forced to sell at the bottom of the market but cannot buy any shares back until the value of the portfolio rises significantly. Therefore, this portfolio has poor performance because it cannot fully participate in each rally off the bottom of the market.

It is clear that the Actively Rebalanced Portfolio is superior the Margin Call Portfolio. Yet, active monthly rebalancing is not the rebalancing of the average asset manager. My asset managers prescribe holding 70%-80% stocks allocation. Although this seems like they are actively rebalancing my portfolio, the leeway they give themselves in the asset allocation defeat much of the purpose of rebalancing which is to sell stocks high and to buy stocks low. It also takes less work for them to set up an asset allocation program that has range of allocation because it reduces the amount of rebalancing necessary. Unfortunately this has serious drawbacks.

The chart below shows the effect of setting an asset rebalancing range of 70% to 80%. When the asset allocation falls out of this range at the beginning of any month it is brought back to 75%. In contrast, the Active Rebalancing Portfolio always sets the asset allocation to 75% at the beginning of each month.

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From this study it is clear that rebalancing every month out-performs having an asset allocation range with the same risk profile. Now all I have to do is get my asset managers to read this article, get off their butts, and rebalance my portfolio each month to a fixed asset allocation percent.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.