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Asset Allocation for different economic environments

Asset Allocation for different economic environments

Recently I came across a chart on twitter that made me rethink my approach to asset allocation. The chart shows which asset classes are expected to generate strong returns in different economic environments and is a powerful tool for helping you develop your asset allocation. While I don’t recommend making substantial changes to your asset allocation, small changes can be beneficial depending on your economic outlook.

 

Asset Allocation chart

Source: ReSolve Asset Management

For each of the four quadrants, the red inner ring reflects the low volatility asset class expected to perform well while the outer ring reflects the high volatility asset classes that is expected to perform well. For example, if you expect an inflationary boom, Emerging Equities is the highest volatility asset class option, and inflation protected bonds is the lowest volatility asset class option, with other asset classes in between offering varying levels of expected risk and return.

The asset classes in this chart can be grouped into a few buckets: Bonds, Stocks, Real Estate, Cash, and Commodities. Commodities is the only one of these asset classes I have not written about previously. Before we dive into different asset allocation strategies using the above chart, let’s briefly talk about Commodities. Personally, I’m not a big advocate of investing in commodities as an asset class but let’s discuss the pros and cons so you can make up your own mind.

Commodities

Commodities offer some attractive attributes such as returns that have historically being uncorrelated with stocks and bonds. Additionally, commodities have usually provided a hedge against rising inflation by increasing in value. For example, Gold provided strong returns during the era of high inflation in the 1970’s. Gold has also seen its price increase recently driven by fears of higher inflation due to high levels of federal government spending and Federal Reserve stimulus to help offset the economic damage caused by COVID-19.

Gold Prices from 1972-2020
Gold price over time.jpeg
Source: http://www.lazyportfolioetf.com/allocation/gold/

The biggest weakness for commodities, is that they don’t generate any income for their investors, unlike the other asset classes listed above: bonds (principal and interest), stocks (dividends), and real estate (rental income). Not only do commodities not generate positive income for investors, but they generate negative cash flows due to storage costs. As a result, your return on a commodity investment is entirely based on selling that asset for a higher price in the future, aka speculation. Because commodities don’t generate cash flows for investors, there is no way to determine the fair value of commodities, so there is no way to know if they are undervalued or overvalued. I also include fine art and other collectibles with commodities.

Because you are so reliant on the price return for commodities, you can experience long periods with very weak returns. As shown in the chart above, gold didn’t surpass its 1980 peak until 2006! How many investors would have the patience to hold on to an investment after losing money on it for more than 25 years?

As always, there’s a Warren Buffett quote to summarize my thoughts on Gold: “You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what it's worth at current gold prices, you could buy -- not some -- all of the farmland in the United States. Plus, you could buy 10 ExxonMobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"

Putting theory into practice

To help put this idea into practice here are a few investment strategies built around the idea of creating a portfolio for different economic environments. I should also point out that the three below strategies all include Gold in their asset allocation, so clearly some investors see value in investing in commodities.

All-Weather portfolio

Arguably the most famous strategy built around the idea of different asset classes for different economic environments, is the All-Weather Portfolio created by Ray Dalio, CEO of the largest hedge fund in the world, Bridgewater Associates. The All-Weather asset allocation is: 55% U.S. bonds, 30% U.S. stocks, and 15% hard assets (gold and commodities), and can be easily recreated using low cost ETF’s. For example, this strategy can be created with the following ETF’s: 40% TLT (Long-Term U.S. Bonds), 30% SPY (S&P 500), 15% IEI (Intermediate Term U.S. Bonds), 7.5% GLD (Gold), and 7.5% DBC (Commodities Index).

These asset classes are chosen as each will perform well in various economic environments with bonds performing well in deflationary environments, stocks performing well in a growth environment and commodities expected to generate strong returns in an inflationary environment. Additionally, the weightings of each asset class were chosen to reflect the idea that economic environments happen at different regularities.

This strategy has worked well historically, generating positive real returns each of the past five decades with much less volatility than a 60/40 portfolio or the S&P 500, and lower drawdowns. Since 2006, the worst drawdown for the All-Weather strategy was 12.2% during the Great Financial Crisis compared to a 51% drawdown for the U.S. stock market during that time period.

allweather return by decade

Source: https://ofdollarsanddata.com/ray-dalio-all-weather-portfolio/

However, while the All-Weather strategy has shown less volatility over time, returns have not been as strong given the low equity allocation. The All-Weather Portfolio generated an annual real return of 5.4% compared to 6.4% per year for the S&P 500 from 1973-2020. While that doesn’t sound like a large difference, you can see that the S&P 500 generated 50% higher returns ($18 compared to $12), over that time frame. Additionally, the 55% allocation to fixed income will likely limit performance going forward given how low interest rates are today.

allweather compared to SP 500

 Source: https://ofdollarsanddata.com/ray-dalio-all-weather-portfolio/

The Permanent Portfolio

Harry Browne’s Permanent Portfolio is a similar strategy to the All-Weather Portfolio and is comprised of 25% U.S. Stocks, 25% long Treasuries, 25% cash, and 25% gold. Harry Browne created this portfolio in 1982 with the goal of the portfolio performing well in any economic environment. When this portfolio was created the yield on the 10Yr. Treasury was in the 12-14% range, and you could earn 9-11% in short-term CD’s! As a result, the large allocation to cash and Treasuries made sense given those market conditions.

While the Permanent Portfolio returned 6.62% compounded annually over the past 10 years, the total stock market index returned 13.48% compounded annually. As a result, you would have generated an 89% return over that time frame in the Permanent Portfolio but a 254% return investing in the Vanguard Total Stock Market. ETF, or any other broad-based stock market ETF.

Permanent portfolio

Source: http://www.lazyportfolioetf.com/allocation/harry-browne-permanent/

On the positive side, the Permanent Portfolio has experienced much lower drawdowns during recessions than an all equity portfolio. The largest drawdown for the Permanent Portfolio was only 12.6% during the Great Financial Crisis compared to a 51% drawdown for the U.S. stock market during that time frame. Going forward you should experience lower drawdowns during recessions compared to a mostly equity portfolio and much lower volatility over time. However, long-term investors shouldn’t be worried so much about volatility given their long-time horizon. The 50% allocation to cash and long-Treasuries will act as a drag on performance for this portfolio and will likely lead to much lower performance going forward.

The Weird Portfolio

Finally, I found an interesting asset allocation approach online called The Weird Portfolio. This asset allocation is more aggressive than the prior two strategies and includes: 20% Real Estate, 40 Equities (20% Small Cap Value, 20% International Small Cap), 20% Gold, and 20% Long-Term Treasuries.

Similarly, you can create this portfolio using low-cost ETF’s. Here is one possible approach to building this portfolio:

Weird Portfolio Asset Allocation

Per the author, this portfolio generated an average 7.7% return from 1970-2019 compared to an 8% return for the Total Stock Market Index. Despite similar return profiles, the Weird Portfolio exhibited much less volatility due to its allocation of Long-Term Treasuries and Gold. For example, the worst drawdown for the Weird Portfolio was only 19%, compared to a 49% drawdown for U.S. equities.

The Weird Portfolio takes advantage of the anomaly that small cap stocks have historically performed better than large cap stocks over time, and small cap stocks make up 40% of this portfolio. Additionally, REIT’s which make up 20% of this portfolio, have also generated higher returns that other equity sectors on a historical basis. I don’t have a strong opinion about whether small cap stocks or REIT’s will continue to outperform other equity asset classes, but many of these historical anomalies do get arbitraged away over time.

Conclusion and further reading

For now, I’m not making any changes to our asset allocation, I’m comfortable with a roughly 95% Equity, 5% Cash allocation. As I noted in a recent blog post, we allocate a substantial portion of free cash flow each month to paying down debt given the guaranteed rate of return on paying down debt, and the unattractive investment options for the time being. However, as interest rates and market conditions change, we will always reevaluate.

If you are interested in learning more about different approaches to asset allocation there are many good resources online including Resolve Asset Management who created the first chart in this post, as well as several free downloadable books on asset allocation by investor Meb Faber. Additionally, the blog Breaking The Market details a more tactical approach to the Permanent Portfolio. For historical back testing of various strategies check out this free portfolio analyzer and http://www.lazyportfolioetf.com/.

As a disclaimer, I don’t advocate for any of these specific strategies or asset management firms. Do your own research before investing, and it may be helpful to speak with a licensed financial professional regarding these decisions.

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