2 Portfolio Allocations For Conservative Investors

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Includes: DBC, GLD, IWM, SHY, SPY, TLT
by: Michael Harris

Summary

Historical back-tests of portfolios reveal just one possible path.

Additional work is required to compare different allocation schemes.

Smooth past returns do not guarantee similar behavior in the future.

In this article we compare the performances of Golden Butterfly and Price Action Lab Diversified Portfolio strategic allocations. Despite any apparent differences, the performances of the portfolios are statistically indistinguishable.

On all charts in this article, Portfolio 1 is the Golden Butterfly portfolio and Portfolio 2 is the Price Action Lab Diversified Portfolio. The allocation mix is shown below.

Allocations for Golden Butterfly and Price Action Lab Diversified portfolios

Portfolio 1 equally weighs large caps blend, small cap value, long-term Treasuries, Short-term Treasuries and gold.

Portfolio 2 invests half of equity in large cap value, 30% in long-term Treasuries, 10% in gold and 10% in commodities.

Both portfolios are rebalanced annually. Backtests do not include commissions.

Performance comparison

The performances of the two portfolios and of S&P500 total return since 1987 are shown in the chart below.

Historical performance of the Golden Butterfly and Price Action Lab Diversified portfolios

The Golden Butterfly portfolio (1) trades-off return for lower drawdown. Specifically, Portfolio 1 has much less drawdown than Portfolio 2, but this comes with nearly 100 basis points of reduction in annualized return.

Both portfolios underperform the S&P 500 total return (yellow line) by a significant margin but at much lower drawdown and as a result their performance is superior on a risk-adjusted basis.

It is important to notice that the correlation of both portfolios to US Market is comparable: 0.75 for Portfolio 1 and 0.79 for Portfolio 2. I will not go into the mathematical details, but it can be shown that the statistical null hypothesis that the Sharpe ratios of the two portfolios are equal cannot be rejected. Therefore, the performance of the two portfolios is statistically indistinguishable.

The key point to realize is that charts and backtests reveal a single possible path in the time domain. Sharpe ratios are about the state-space domain. This fancy terminology basically means that, in the future, the paths may have different characteristics, and Portfolio 1 may have higher return and drawdown as compared to Portfolio 2. Unfortunately, most professional advisers, book authors, and financial bloggers do not consider these details.

Below is the performance of the two portfolios using ETFs. First the allocation is shown below.

Allocation of ETF portfolios

Both portfolios use SPY as the main ETF for the stock market and TLT for the bond market. Below is the portfolio performance:

ETF portfolio performance

Portfolio 1 has lower return (CAGR) but at lower maximum drawdown. Sharpe ratios are close and the correlation to US market does not differ significantly. Although Portfolio 1 appears to have the smooth returns conservative strategic investors prefer, this is only one possible path manifested by particular market conditions. In reality, the performances of the two portfolios are statistically indistinguishable and future performance cannot be inferred from the past.

Both portfolios have outperformed buy-and-hold since 2007. In case there is another correction in stocks, it is highly probable that both portfolios will offer some degree of protection against a large drawdown. However, nothing is certain, and advisers and investors should be prepared for conditions where everything fails. How to deal with that possibility may be the subject of another article, but I will only mention that situations where everything fails are considered unique opportunities for certain aggressive investors with proper background and psychology.

Original article

Backtesting and analysis was performed with Portfolio Visualizer

Disclosure: I/we 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.