If you’re interested in asset allocation strategies Meb Faber’s book Global Asset Allocation is worth a read. Generally speaking it’s short and easy to understand. The first few chapters deal with the basics of investment planning (inflation, historic rates of return of bonds, bills and stocks, etc.). Nothing new, but it lays the foundation for the content that proceeds. Whenever I read Faber’s work he always provides a few illuminating morsels of information that seem so simple you wonder why they haven’t been discussed more broadly. Here’s a few interesting points:
- There are only two states that any given portfolio or asset can be at: all time highs or drawdowns
- The traditional 60/40 stock/bond allocation has spent only 22% of it’s time at all time highs and the remaining 78% in a period of drawdown
- The largest financial asset class in the world is foreign ex-US bonds
- US stocks represent about half of all global equities
One of the big values of this book was the historic performance review of various asset allocation strategies as recommended by various investment thought leaders. Faber summarized 17 different strategies and compared metrics such as nominal return, real return, volatility, drawdown, and Sharpe ratio. The analysis spans 40 years from 1973 to 2013. He makes the argument that focusing only on US stocks and bonds was (and is) a mistake, and the data appears to back up his position. For instance, the portfolio recommended by Warren Buffett in his 2013 shareholder letter (90% S&P 500 index and the remaining 10% in Treasury Bills) provided a reasonable real rate of return at 5.35%. However, it was also the most volatile and had the largest drawdown among the strategies compared. Simply allocating to international stocks and bonds improved returns while reducing volatility and drawdowns. Notice the Global 60/40 was better in every way compared to the US 60/40.
|Buffett Asset Allocation||5.35%||14.19%||-49.78%|
|Global Market Portfolio||5.42%||8.76%||-34.10%|
The conclusion is rather straightforward and one that is key to every asset allocation strategy. Diversifying among a greater pool of assets improves the chances of finding assets that are temporarily under-performing and undervalued–valuations matter.
Achieving a real rate of return above 6% was elusive in every strategy, although a few came pretty close. The top two performers after inflation were the El-Erian Portfolio at 5.96% and the William Bernstein Portfolio at 5.84%. The David Swensen Portfolio was a close third at 5.67%. More interesting was the fact that Bernstein’s portfolio performed so well despite having no allocation to real assets. The El-Erian and Swensen portfolios were modeled after endowment strategies and featured allocations to real estate, TIPS and commodities.
The two outliers were the Buffett portfolio mentioned before and the Permanent Portfolio, which featured the lowest return at an annualized real rate of 4.12%. Furthermore, a trend existed among all the portfolios analyzed: higher returns came at the cost of higher volatility. Keep in mind that during this period of time (1973-2013) bonds were largely in a bull market. Therefore, these historic returns are most likely higher than they are likely to be going forward.
Faber also recognized that after eliminating the Permanent Portfolio the remaining strategies produced returns within approximately 1% of each other (more accurately 1.20%). That’s pretty narrow considering the different allocations. Let’s not forget the impact that 1% can have on terminal wealth over a 30 year period of time. The problem is, you don’t know which strategy is likely to perform best in the future. Past performance is no guarantee of future results.
1. Faber, Meb. Global Asset Allocation. 2015.
What I’m Reading
MetLife Does the Ol’ Bait and Switch with its Annuities (Tony Isola)
Professor Fama Explains How Markets Really Work (Bloomberg)
Rebecca Goldstein and Why We Need to Matter (Farnam Street)