Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies
Kindle Highlights
Are there other asset classes?
TIPS are U.S. Treasury inflation protected bonds.
what is called the only free lunch in investing – diversification.
if you are going to allocate to a buy and hold portfolio you want to be paying as little as possible in total fees and costs.
Risk parity is a term that focuses on building a portfolio based on allocating weights based on “risk” rather than dollar weights in the portfolio.
“Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep by him in reserve.” — Talmud
In this book, we are going to examine 13 assets and their returns since 1973. They are found in Figure 20 below with a column denoting what broad category of assets they fall under.
“I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting there and trying to dream it up all yourself. Nobody’s that smart.”
Going global in this illustration doesn’t change the end result too much, though it does increase returns, reduce volatility, and improve the Sharpe ratio (all good things). The global portfolio also did better during the inflationary 1973-1981 period,
and you will find several links at the end of this chapter. Three primer papers to read are “The All Weather Story,” “The Biggest Mistake in Investing,” and “Engineering Targeted Returns and Risks”— all of which can be found on the Bridgewater website.
Why try to divine the actual risk parity allocation when we can just go straight to the source and let Mr. Dalio construct it for us? The second allocation is the “All Seasons” portfolio Dalio himself suggested in the recent Tony Robbins book Master the Money Game
All Weather can be sketched out on a napkin. It is as simple as holding four different portfolios each with the same risk, each of which does well in a particular environment: when (1) inflation rises, (2) inflation falls, (3) growth rises, and (4) growth falls relative to expectations.”
Ray Dalio’s Bridgewater, one of the largest hedge funds in the world based on assets under management, was likely the first to launch a true risk parity portfolio in 1996 called All Weather. Many firms have since launched risk parity products. While the underlying construction methods are different, the broad theory is generally the same.
Cliff Asness, co-founder of AQR Capital Management, has a fun piece out on his blog titled “Efficient Frontier “Theory” for the Long Run”, where he talks about five-year periods in stocks, bonds, and commodities and basically how anything can happen over short periods of time. (Although for many investors, five years can feel like a lifetime.)
We consider volatility to be measured by the standard deviation of monthly returns. The Sharpe ratio is a measure of risk adjusted returns, and is calculated as: (returns – risk free rate)/volatility. The risk-free rate is simply the return of Treasury bills. A higher Sharpe ratio is better, and a good rule of thumb is that risky asset classes have Sharpe ratios that cluster around the 0.20 to 0.30 range.
Gold had the highest real returns of any asset class in the inflationary 1970s but also the worst performance from 1982 – 2013. However, adding gold (and to a lesser extent other real assets like commodities and TIPS) could have helped protect the portfolio during a rising inflation environment. Gold also performs well in an environment of negative real interest rates – that is when inflation is higher than current bond yields.
And in Figure 7a, the same chart is presented with a non-log y-axis. We do this to demonstrate to readers the importance of viewing charts that have percentage changes over long time frames with a log axis. Otherwise the chart is almost unreadable and definitely not useful. Perhaps importantly, you can now distinguish between unscrupulous money managers advertising their services with the below style of chart which can be misleading, as the gains look much more dramatic.
U.S. investors usually put around 70% of their stock allocation at home here in the U.S. This is called the “home country bias”, and it occurs everywhere. Most investors around the world invest most of their assets in their own markets. Figure 16 is a chart from Vanguard that details the “home country bias” effect in the U.S., the U.K., Australia, and Canada. The blue bars are how much investors should own of each country according to global weightings, and the red bars are how much they actually own of their own country – way too much!
Risk parity has its roots in the modern portfolio theory of Harry Markowitz. While introduced in the 1950s, it eventually earned him a Nobel Prize. The basic theory suggested the concept of an efficient frontier – the allocation that offers the highest return for any given level of risk, and vice versa. When combined with the work of Tobin, Treynor, Sharpe, and others the theory demonstrates that a portfolio could be leveraged or deleveraged to target desired risk and return parameters. Many commodity trading advisors (CTAs) have also been using risk- or volatility-level position-sizing methods since at least the 1980s.
Any asset by itself can experience catastrophic losses. Diversifying your portfolio by including uncorrelated assets is truly the only free lunch. 60/40 has been a decent benchmark, but due to current valuations, it is unlikely to deliver strong returns going forward. At a minimum, an investor should consider moving to a global 60/40 portfolio to reflect the global market capitalization, especially right now due to lower valuations in foreign markets. Consider including real assets such as commodities, real estate, and TIPS in your portfolio. While covered more extensively in our other three books and white papers, consider tilting the equity exposure to factors such as value and momentum. Trendfollowing approaches work great too. Once you have determined your asset allocation mix, or policy portfolio, stick with it. The exact percentage allocations don’t matter than much.