Portfolio Allocation Hypotheticals

Portfolio Allocation Hypotheticals

When on the topic of investing, you will inevitably run into various ideals on portfolio construction. Some of the common adages even have memorable taglines, such as the traditional “60/40”. Despite potential appearances, allocating an investment portfolio amongst core asset classes is not an exact science. This is mostly, but not entirely, because investors hold unique risk tolerances, capacities, and time horizons.

  • A risk tolerance is the subjective risk/reward level an investor is willing to accept (often varying with age, income, and financial goals).1 As a non-financial example let me point out that some people find skiing and snowboarding to be an acceptable risk for the benefits, while others find those sports far too dangerous to partake in.
  • A risk capacity is the objective ability of an investor to take a certain level of risk given the amount of capital they have on hand for the financial goal(s) in question.1
  • A time horizon is the amount of time an investor expects to hold an investment before needing to convert the investment back into money. The shorter the time horizon, the more conservative a prudent investor should be with their portfolio allocation choices. The longer the time horizon, the more aggressive an investor can be. This is because more time allows for a long-term view, and consequently allows for the acceptance of higher volatility in exchange for the potential of higher growth. Furthermore, a longer time horizon enables investors to take advantage of more compound interest and gives the investor more opportunities to add capital to the investment portfolio over time.2

I believe these three portfolio construction considerations (risk tolerances, capacities, and time horizons) should all go hand in hand when constructing a portfolio. However, for this analysis I will be focusing on the objective considerations of portfolio construction. Using historical pricing data, I will showcase a way of looking at risk and reward, and then layout a general portfolio allocation outline for three hypothetical investor scenarios.

The core asset classes that I will utilize in constructing these hypothetical portfolios are: Equities, Fixed Income and Alternatives. To read an overview of these core asset classes, explore the Education tab of AlmondConfirmed.com, https://almondconfirmed.com/education/

To give a broader picture of risk and reward, I split the equity asset class in four by geographic exposure, Domestic Equities, Total International Equities, Developed Market Equities and Emerging Market Equities. With a similar intention, I split the fixed income asset class in two by perceived risk level, Total U.S. Bond Market (higher risk) and Short-Term U.S. Treasuries (lower risk). It is important to note that for fixed income, the split I selected is quite simplistic and does not incorporate international fixed income, this is due to the shorter price history of ETFs focusing on those securities. Lastly, while only a small piece of the alternative asset world, I added two precious metal funds to this analysis to showcase the unique risk, return and diversification characteristics that the alternative asset class can offer.

As substitutes for these asset classes I have used representative ETFs or Index Funds, all of which are structured to track various benchmarks. Representative accounts were selected with assurance that they invest in the asset class they represent, have substantial AUM compared to investable peers, are relatively low in expense fees, and were incepted at least a decade ago. In order to keep the data comparable amongst the representative accounts, I used 120 months (10 years) of trailing monthly returns as of 6/30/2020 and used the management fee rates of these funds to net down the returns (taking fees out of the performance to give a clearer picture of true investment returns). While not nearly as long a look back period as I would like, I believe that this analysis period should provide insight to aid with portfolio construction, based on historical risk and return.

The representative accounts used, largely funded and comparatively low-priced ETFs and index funds, are a great way to get exposure to core investment markets. However, they do come with some negatives, as all investments do. ETFs and index funds can diversify into hundreds or even thousands of underlying securities, and this gives exposure to both good and bad firms. For instance, some publicly traded firms do not consistently generate positive net income. That negative characteristic has historically been an acceptable risk to gain both beta exposure (market tracking exposure) and unsystematic diversification (diversification of security level risk); additional more concentrated investments can be made to supplement the beta exposure if an investor is seeking alpha.

*The graphic above was created in Microsoft Excel with Yahoo Finance historical monthly data for the representative accounts VTI, VGTSX, VEA, VWO, VBTLX, SHY, GLD and SLV.

*Annualized Returns calculated using monthly adjusted closing prices by Yahoo Finance (Total return gross of fees).

**Annualized Hypothetical Net Returns were calculated by subtracting each monthly return by the applicable monthly fee rate for each specific fund’s expense ratio.

Looking at the summary data, the representative ETF for the U.S. stock market had the highest annualized return for the period studied by a large amount. This period of exceptional market performance benefited from many factors. One core factor for the 13.5% annualized net returns was the economic recovery that took place in the aftermath of the Financial Crisis; this recovery was partially fueled by unprecedented dovish monetary and fiscal stimulus measures. Over the analysis period, the U.S. market experienced a sizable amount of price volatility (risk), with an 11.1% annualized downside standard deviation. Taken together, the two measures can be looked at as a ratio of return to risk (Annualized Hypothetical Net Returns/Annualized Downside Standard Deviation), which comes to 1.2. This implies, for each unit of downside risk, investors were rewarded with 1.2 units of return during the observation period.

The three international equity ETFs (Total, Developed and Emerging Markets) performed similarly to one another over the analysis period. During the past decade, these funds had annualized net returns of 2% to 5% and showed downside standard deviations of 11.3% to 12.8%. The risk return ratios of these funds varied between 0.2 to 0.4. These international results over the period of analysis were not good, Europe especially has seen exceptionally low growth and has struggled with economic progress post the Financial Crisis. For example, on January 31st, 2020 Eurostat reported the euro area’s preliminary flash estimate for GDP growth and reported +0.1% for the fourth quarter of 2019, putting the 2019 GDP growth rate to 1.2%3

Both the U.S. fixed income and the U.S. short-term treasury funds had incredibly positive risk/return ratios of 1.9 and 2.7, respectively over the analysis period. The U.S. fixed income fund had annualized net returns of 3.6% and showed an annualized downside standard deviation of 1.9%. Whereas the short-term treasury fund had annualized net returns of 1% and an annualized downside standard deviation of 0.4%. Keep in mind, while the risk return ratios are comparatively high for these two funds, their absolute returns are still lower than most of the equity funds highlighted. It is important to note, this period of analysis was particularly low in risk for U.S. fixed income funds because of the economic recovery taking place in the U.S. (and to a lesser extent around the world) which in turn limited the volume of debt defaults.

Gold had annualized net returns of 3.4% for the period of analysis and showed a 9.8% annualized downside standard deviation. Silver did much worse, returning -0.8% annualized net returns with a significant 17.8% annualized downside standard deviation. While their returns are not anything to admire over the period, the true benefit to alternative investments is their low correlation with traditional asset classes.

The histograms and data tables in the slides below showcase more details around the historical monthly returns of the representative accounts in the analysis.


*The graphics above were created in Microsoft Excel with Yahoo Finance historical monthly data for the representative accounts: VTI, VGTSX, VEA, VWO, VBTLX, SHY, GLD and SLV.

To summarize, the highest annualized net returns over the analysis period came from the U.S. equity market, followed by the developed international and total international equity markets. On the risk side, short-term treasuries had the lowest downside annualized standard deviation level, followed by U.S. fixed income and Gold.

*The graphic above was created in Microsoft Excel with Yahoo Finance historical monthly data for the representative accounts VTI, VGTSX, VEA, VWO, VBTLX, SHY, GLD and SLV.

The chart above showcases the correlation of monthly returns between the representative accounts. Recall correlation is the foundation of diversification, which can be used as a tool for reducing portfolio risk; for additional insight on correlation please visit https://almondconfirmed.com/education/. In the chart, the darkened red cells show each representative account is 100% correlated with itself (this should not be a surprise). The less correlated the two accounts, the more yellow or green the cell appears. The main takeaways are as followed:

  • Equity funds were highly correlated with one another, ranging between 77% to 99% correlation.
  • The two fixed income funds were either very lowly correlated with the equity funds, or negatively correlated with the equity funds. This helps showcase the benefit of diversifying between equities and fixed income. These correlation levels (between fixed income funds and equity funds) ranged from -29% to 7%.
  • Gold and silver, the alternative asset class representative accounts, showcased 9% to 45% correlation with the equity and fixed income funds. These correlation levels showcase the diversification benefit to adding alternative assets to an investment portfolio of equity and fixed income funds.

With various asset class returns, risks and correlations in mind, investors can begin to construct a portfolio with an ideal composition for their unique situation. Below are three hypothetical investor scenarios and suggested portfolio allocations for their simplified but unique circumstances.

Graphic created by: https://garrettsdesigns.com/

Scenario 1: A young investor starts to plan for retirement and has many years in front of them to continue to save and invest for the long haul. Time Horizon: 40+ years

This new investor would want to allocate their portfolio into assets that offer the highest potential return. The long term returns of equities have historically trumped those of fixed income, however, as we have seen, equities come at the cost of increased price volatility. Nevertheless, with a long-term investment horizon, this investor can hold through the downside risk of equities for many years and so should likely allocate their portfolio between domestic and international funds. Although U.S. equity markets did best in the analysis period, it is important to stay diversified globally as past investment returns do not necessarily predict future returns. Later in this investor’s life they will also want to diversify their portfolio into fixed income and alternative assets. Below are a few potential allocation alternatives to get this hypothetical investor started.

Graphic created by: https://garrettsdesigns.com/

Scenario 2: A middle aged investor just had their first child and wants to begin saving for their child’s higher education expenses. (Time Horizon: 18-22 years)

With about 18 years to go before a drawdown of capital is needed for educational expenses, this investor can initially be more aggressive with the portfolio allocation. For the first 8 years or so, this investor can be heavily weighted in equity funds. As the years progress towards the child’s college start date, the investor should trim the equity allocation and increase the fixed income allocation. Below is an example of that reallocation throughout the investment time horizon.

Graphic created by: https://garrettsdesigns.com/

Scenario 3: A retired investor wants to make sure they are not taking too much risk in the markets given their income needs and shorter time horizon (Time Horizon: 10-20+yrs)

Already being in retirement, this investor should be thinking about their cashflow needs each year and planning for those outflows. Life is unpredictable, towards the short end or long end, and so it is important to have both non-volatile investments (to liquidate when needed for life expenses) and continued capital growth for the potential years ahead. Below is an example of slowly decreasing equity exposure and increasing fixed income exposure, while keeping a small allocation in the alternative investments to further diversify.

Please keep in mind these are simple hypothetical examples to showcase the idea behind portfolio construction based on historical return and risk. This write-up should not be interpreted as a recommendation or offer of a sale of the financial products mentioned. If you are interested in the data or calculations cited throughout this writeup, please message me and I would be happy to send you a copy of my Microsoft Excel workbook.


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