In Part 1 I showed that as investment time increased there was, at least historically, a smaller probability of realizing a rebalancing bonus in 60/40 stock/bond portfolios. There was a lot that I left unaddressed at the time and I felt a need to develop a better understanding of the mechanics of the rebalancing bonus. Why does it work in some instances, but not in others? In other words, more was needed to demonstrate what actually drives the rebalancing bonus. A good place to start is with the work of Harry Markowitz, which showed that portfolio performance–both return and volatility–was mathematically related to three characteristics of the constituent assets
- Correlation with other assets
- Rate of return
Go to part 2
The rebalancing exercise that I performed with Shannon’s Demon implied that a premium may be obtained by rebalancing a portfolio of uncorrelated assets. These assets featured highly hypothetical performance with expected rates of return and volatility both well out-of-bounds of anything that’s likely to be seen in real world capital markets. The extreme nature of these make-believe stocks was used to illustrate what is possible.
Back to reality.
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
Harry Markowitz is often referred to as the father of Modern Portfolio Theory–a collection of mathematical models that quantify the behavior of assets and portfolios of assets. Harry’s work specifically addresses the latter and examines how assets may be combined to reduce volatility and (potentially) increase returns. I briefly alluded to Harry’s work in an earlier article on portfolio construction, but wanted to cover the major points in greater detail.
In the mid-nineteenth century the allure of finding gold out west and striking it rich appealed to a certain adventurous type. Thousands of optimists ended up making the exodus to California. A few got lucky, but most were sorely disappointed. The allure continues to this day, although we don’t necessarily have to travel across the country and work the mines as our forefathers did. With the click of a button we can easily purchase the stock of companies involved in the exploration, mining and processing of precious metals like gold and silver. They’re the modern day equivalent of hitching a covered wagon out west, and their 2016 first quarter performance surely didn’t disappoint. A collection of these companies, as measured by the return of the Market Vectors Gold Miners ETF (GDX), was up an incredible 45.6%.
What is risk?
The search for an answer to this question has puzzled philosophers, mathematicians and thinkers for centuries. The question seems so simple but attempting to answer it proves to be quite challenging. The various definitions of risk floating around are fairly broad–so broad that Peter Bernstein wrote an entire book on the subject.
Asset allocation tends to be a rather staid option among investing strategies. Determine an allocation plan, contribute and rebalance regularly, and the job is pretty much finished. Achieving wealth slowly isn’t exactly sexy or exciting. The more intrepid allocators out there may venture into factor tilting or life cycle considerations.