Modern Asset Allocation: Riskier Than You Think

by: Todd Wood

How one defines "conservative" is an important question. Conservative investing has different meanings to different constituencies, and perhaps has even been over simplified due to the pigeon-holing effect of investor risk categories.

For many investors, being conservative means they can't afford to take risks that would potentially reduce or eat into principal; however, standard asset allocation models are static and typically heavily weight bonds for conservative investors. While this methodology has worked well in low inflationary markets, risk of a decade of bull markets in bonds means caution should be the primary message to investors. The future may be different from the recent past, and static allocations of heavily weighted portfolios in fixed income creates a poor risk reward scenario.

Standard Conservative Investing

Conservative investors, and by default large bond holders, tend to hold on to their bond investments for long periods. Just a few years ago it would have been difficult for many fixed-income holders, including pension funds and individuals, to consider they would be facing the sovereign debt issues across Europe.

It seems to be an investment norm that conservative investors should hold between 50%-80% bonds of varying maturities, issuers and quality, depending upon the client's income needs and risk tolerance. But this does not mean bonds are without risk for investors who have purchased bonds over the past few years at, or above, par. Rising interest rates causes bond prices to fall.

The bond market crash of 1979-1980 had bond investors on their heels when then-Federal Reserve Chairman Paul Volcker announced he was going to raise the discount rate by two full percentage points. "By some estimates, investors have losses totaling 25% of the market value of their bond holdings, or more the $400 billion."

Conservative investing is relative to the individual. Prevalent static-allocation models with a lack of active risk management, coupled with the attitude that markets will come back, could do a disservice to investors. Retiring baby boomers are at an increased risk of facing losses to the fixed-income portion of their portfolios, which may comprise more than 50% of investable assets based on current conventional wisdom.

Modern Portfolio Theory and Risk

The creation of modern portfolio theory (MPT) and subsequent methods of allocating one's portfolio into various asset and sub-asset classes has turned into an analytical function of form over substance. The most powerful tenant of MPT is finding and allocating a portfolio based on the correlation of the various investment options one has. What many professional advisors have failed to realize is that correlations are not static. As an example when equity markets fall sharply, correlations of various equity classes rise. The fairly static division of asset classes and sub-asset classes into portfolios of aggressive, growth, moderate or conservative risk profiles, considered the hallmark of the professional advisor using MPT as a crutch, has put investors at more directional market risk.

Table 1.0 is a correlation heat map of the most common equity allocations, but also includes real estate as represented by the NAREIT Index. As one can see, these are highly correlated and offer very little diversification.

Table 1.0

From a directional risk perspective, an investor may as well just pick one of these sub-asset classes instead of allocating a portion of their 40% equities across seven different equity investments and leave a remainder of 60% in bonds.

What the Numbers Really Say

Perhaps a more detailed example will help illustrate the effects of a converging correlation among various asset and sub-asset classes. Let's look at a hypothetical allocation for a conservative investor with 60% of the assets spread between bonds, 35% in equities and 5% in real assets consisting of real estate and commodities. Overall this looks to be a very diversified and conservative portfolio; however, if one digs a little deeper to examine the correlation of the components and the R-squared values of the asset class to the overall portfolio, an interesting picture develops beyond the correlation of various equity alternatives and brings to light the directional risk of the overall portfolio.

Graph 1.1 represents the allocation in % terms of the individual asset classes and sub-asset classes recommend by the mainstream financial community.

Graph 1.1 Conservative Portfolio Allocation in Terms of Percent of One's Portfolio

We took the returns of each sub-asset class from January 1995 to December 2010 in a hypothetical conservative portfolio, calculated the relationship of performance of each piece of the portfolio and how closely it moves with the overall portfolio (R-squared), and took the sum of the allocation percent times the R-squared times the standard deviation to give us an idea of the directional portfolio risk.

Graph 1.2 Directional Risk Exposure of Conservative Portfolio Consisting of an Allocation 60% Bonds, 35% Equities, 5% Real Assets

Graph 1.2 indicates the directional risk exposure, based on the pieces that comprise the "Conservative" portfolio and how they move in relationship to equities, bonds or real assets. What this research and analysis demonstrates is investors have much more directional risk than what is alluded to or explained by mainstream investment methodology, and what is considered a conservative portfolio by most professionals actually has nearly two times the directional risk exposure in equities. When equities are going higher, this doesn't present a problem to our conservative investor. However, when stocks are not doing well and going down, sometimes significantly as in 2000 and 2008 with over 50% losses to stocks each time, the conservative investor finds themselves with losses greater than ever expected.

Differentiation for Better Results

At Provident Capital Management, this analysis started what was to be a paradigm shift in portfolio risk analysis and how we determine the appropriateness of a particular investment approach for our clients. The findings have enlightened us about how we look at risk and have helped redirect our research and client portfolio allocation away from standardized asset allocation theme of stocks, bonds and alternatives. Our focus is more on the correlation effects, how the sub-components move in relation to each other and the overall portfolio in up and down market conditions. Developing portfolios containing truly non-correlated pieces helps to reduce the volatility and drawdown.

In summary, traditional wall street analysis produces what appears at first glance to be a well-diversified portfolio, but is in fact fraught with the risk of substantial loss. Mainstream allocation models may lead investors to a false sense of security. In my view, a low volatility, low drawdown approach which may, over short periods of time move sideways, is much more acceptable then taking the roller-coaster ride of conventional benchmark strategies.

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. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: There are no guaranties the past correlations will remain consistent. Risk analysis requires more than reviewing drawdown and volatility. The past may not be indicative of the future.