Using Asset Allocation For Investment Success

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Includes: AGG, SPY
by: The Investment Strategist
Summary

Studies show that portfolio returns are 90% driven by asset allocation - but what does that mean to us as investors?

Historical analysis sheds light on the expected returns and risk of portfolios with certain asset allocations.

Investors should use asset allocation as a tool to best position their portfolio based on return objectives and risk tolerance.

There are a number of studies that conclude that the most important part of portfolio returns is asset allocation - not security selection.

(If you're a superstar stock-picker, this doesn't apply to you)

The numbers vary and the explanations provided on how asset allocation affects returns can be misleading and confusing. Some studies say that around 90% of returns are attributable to asset allocation. Unfortunately, the number and explanation for that 90% varies depending on who you ask and whether it has to do with the level of portfolio returns or the volatility of those returns.

I suppose getting the folks conducting these studies in a room to discuss their theory would be interesting - interesting enough to put most of us to sleep - when all we really want to know is how we should be positioning our portfolio to achieve our financial goals.

While the usual disclaimer that historical returns are not indicative of future returns, we can usually look at historical data and evaluate, to some degree, how a particular asset allocation will perform over long periods of time - and - even provide an estimate of how good or how bad returns can be in any given year.

To give our readers an idea of how certain portfolio allocations should perform, we gathered return data from 1980 to 2017 for the S&P 500 Index and the Barclays Global Aggregate Bond Index as proxies for equities and fixed income, respectively. While these indexes are investable directly, investors can use the SPDR S&P 500 Trust ETF (SPY) and the iShares Core Total US Bond Market ETF (AGG) as a way to get exposure to either. We then calculated annual returns of portfolios with different allocations to equities and fixed income, ranging from 100% equities to 100% fixed income, changing the allocation by 10% to create 11 different portfolios. (We could have used the MSCI All-Country World Index as a proxy for global equities but the data for the MSCI ACWI did not go back as far as the S&P 500. Therefore, the following results will be slightly different if calculated with the MSCI ACWI Index instead of the S&P 500, but the concepts and relative performance by asset allocation should be directionally similar.)

The results are both surprising and enlightening and should give readers an idea of how they should be positioned for the targeted returns they seek and the amount of risk they are willing to tolerate.

Not surprisingly, the portfolio with 100% allocated to equities provided the highest annualized return over the period but also had the highest level of volatility - as measured by standard deviation. What might be surprising to readers is that the highest level of returns per measure of risk was a portfolio consisting of 20% equities and 80% fixed income.

Overall Returns

The chart below shows the average return and standard deviation for each of the 11 portfolios ranging from 100% Equities to 100% fixed income in 10% increments. (See table at the bottom for all data) This chart should look familiar to many readers and is the epitome of the concept that higher returns come only by taking on higher risk. By itself, however, it could give an otherwise conservative investor an incentive to take on more risk for the higher return. After all, this graph indicates that portfolios that generate higher returns have higher volatility but it doesn't give the reader any idea of the range or extremes of those returns.

Source: Prepared by author

The chart below shows the range of all annual returns from 1980-2017. The 100% equity portfolio had an average annual return of 13.1%, which resulted in an annualized return of 11.8%. But the range of outcomes is very wide compared to that of a 100% fixed income portfolio - and the potential loss in any given year was much higher. For example, the best year for the 100% equity portfolio was 37.6% while the worst year was -37% - a swing of almost 75%

For the 100% fixed income portfolio, the best return was 32.7% while the worst was just -2.9% - a 35.6% range.

Investors looking to maximize returns, therefore, might want to invest in portfolios with higher allocations to equity but if and only if they are comfortable with large declines in any given year.

Source: Prepared by author

Positive versus Negative Years

Investors that are more risk averse may be interested in knowing which asset allocation is most likely to result in a positive return and in the event of a potential negative return, how many of those years must they endure.

The chart below shows that a 100% equity portfolio had a positive return in 84% of years from 1980 to 2017 - which means six of those years resulted in negative years. When we combine the insight from the previous chart, we can conclude that despite just 6 periods of negative returns, the negative returns in those years can be substantial. In fact, the average decline in years when an all equity portfolio was negative was 15.8%!

Because of the high volatility and high potential loss in any given year, investors with a higher aversion to risk should be looking to allocate at least 60% of their portfolio to fixed income, where historically, the portfolio has had a positive return in 92% of calendar years in our data set - resulting in 3 negative years out of the 32 measured.

Source: Prepared by author

Return/Risk

Not all investors look at either potential returns or risk in isolation. In other words, some of our readers may be risk neutral - which in investment management means you're an investor willing to take on more risk if it will result in a higher return - but at some point, the additional risk may not be worth the additional return.

To calculate that ratio, we used a simple return/risk ratio for the 11 portfolios in our asset allocation analysis. While the 100% equity portfolio provided the highest return, it had the lowest amount of return for the risk inherent in the portfolio with a return/risk of 0.72. Meanwhile, the 100% fixed income portfolio had the lowest annualized return of 7.7% and a higher return/risk of 1.12.

But it didn't provide the most return for the risk taken. The portfolio with 20% allocated to equities and 80% allocated to fixed income produced a return of 8.7% with a standard deviation of 6.9% - for a return/risk factor of 1.26.

Investors looking to get the most bang for their buck may consider looking at the potential returns for the level of risk taken within each asset allocation to determine the best option for their desired combination of target returns, risks, and bank for your buck.

Source: Prepared by author

Expected Return Ranges

Looking at annual returns and standard deviation for a historical data series can give you an idea of the range of returns for each asset allocation. Without the benefit of a crystal ball - or one that works well - we can only estimate the range of possible returns for each of our asset allocation portfolios to determine if we feel comfortable with the range and probability of returns for our chosen allocation.

The chart below uses the historical average and standard deviation for each of the asset allocation portfolios to indicate the range of possible returns and their probabilities. For simplicity, we used a normal distribution. The area highlighted in tan indicates the range of returns within one standard deviation of the average. A normal distribution indicates that each portfolio's return will fall within this range 67% of the time.

The area in blue indicates the range of potential returns within 2 standard deviations of the average, and the probability of the return in any given year should fall within this range 95% of the time.

Lastly, the red area indicates the range of potential returns within 3 standard deviations of the average, and the probability of the return in any given year should fall within this range 99% of the time.

With this information in hand, readers can now make an informed decision on how best to allocate their portfolio to equities and fixed income.

We can further elaborate our asset allocation options to choices within equities and fixed income, such as US Large Caps, Small Caps, Financials, within equities, or High Yield and Emerging Market Debt for fixed income. That, however, is an analysis for another day.

Sequence of Returns

A discussion of expected returns and risk wouldn't be complete without a discussion about how average returns and stated volatility could turn an otherwise well-thought out retirement plan on its head. This is especially true if the performance of the portfolio in the first few years after distributions begin results in losses. The combination of declining values and distributions could cause a portfolio to decline in value enough to never be able to recover.

This risk is called sequence of returns risk and is the reality that over the last 37 years, a 100% equity portfolio didn't have an 11.8% return each year - it ranged from 37.6% to a loss of 37% - and the timing and sequence of those returns is important for retirees dependent on their portfolio for income. Stay tuned for another article on that.

Conclusion

Even though we are all looking for great ideas to invest in, having an overall asset allocation strategy is critical to the success of any investment strategy - except of course for the superstar stock pickers. I always urge readers to start with an overall asset allocation strategy first, then add individual ideas to each bucket accordingly.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances.
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