For the longest time, the industry pushed fixed asset allocation solutions to retail investors. These are your 60% stocks/40% bonds portfolio, or more commonly referred to as the 60/40. And depending on the investor's risk preference, they can play around with the allocations. A young and aggressive investor might opt for 80/20 while someone older and more conservative may settle for 20/80. It is a simple solution that is easy to understand, implement and sell. But it is actually not an ideal way to allocate.
There are better ways to allocate capital across your assets. And one of these is known as the All-Weather asset allocation. This is the term layman are familiar with. Within the industry, we call it Risk Parity asset allocation. Its roots went as far back as the 1950s when Harry Markowitz came up with the Modern Portfolio Theory. But Ray Dalio, founder of the largest hedge fund in the world Bridgewater Associates, is the one that commercialized it by pioneering an All-Weather fund in 1996 based on the concept. The fund grew rapidly and manages more than $60 billion as of May 2021 [source: www.BarclaysHedge.com].
So how is an All-Weather allocation different from fixed allocation solutions?
The Concept of Balance
All-Weather allocation premises on a simple concept - Balance. But it is not the balance most retail investors have in mind. Let's use a simple case where you have a portfolio comprising stocks and bonds. If you think balance means a 50/50 capital allocation between the two, then you are on the wrong track. What All-Weather allocation need is a balance in the risk and not in the capital. The risk of a dollar in stocks is much higher than that in a dollar of bonds. So a 50/50 capital allocation across stocks and bonds is in fact far from balanced.
The Shortcomings of Traditional Fixed Asset Allocation
As much as 80% or 90% of the risks in a 50/50 or 60/40 portfolio are concentrated in stocks. This makes them still pretty vulnerable to shocks from the stock market. In addition, these portfolios do not adapt to changing market regimes. Because they maintain the same allocations whether we are in a bull or bear cycle. Finally, from an efficiency point of view, they are also not generating enough returns for the amount of risk they are taking.
The Beauty of All-Weather Asset Allocation
All-Weather allocation addresses these gaps by balancing out the risks of the assets in the portfolio. So in the case of a stocks/bonds portfolio, we will size them such that stocks and bonds both hold an equal amount of risk. And what do we get out of this?
A balanced portfolio in terms of risk. No one can consistently and reliably predict the markets. Thus taking such an approach gives you the best chance to weather through different regimes. The reasoning is elegant and simple.
A dynamic portfolio that adapts to market conditions. Risks are dynamic parameters derived from the markets so they are a reflection of what is happening. As an example, in a bear market, risks from stocks will be much higher relative to bonds than during a bull market. When such a regime happens, we size down stocks and size up bonds which is something desirable.
An efficient portfolio that gives a higher return for each unit of risk taken. In theory, you can mix and match all possible allocations between stocks and bonds. At any given time, the one that gives the best return per unit risk taken is the most optimal portfolio. But this optimal portfolio is not implementable as it is only known in hindsight. An All-Weather allocation can, however, produce a portfolio that is very close to this optimal portfolio in practice [Source: Wikipedia].
A Multi-Asset All-Weather Portfolio
While I have been only using stocks and bonds to illustrate my points, an all-weather portfolio need not be constrained to just these 2 assets. We can extend it to asset classes such as Commodities, REITs, and others for a more well-rounded performance. Below is the model performance of a multi-asset All-Weather portfolio we run.
It delivers a higher return than S&P 500 while still maintaining a lower risk. In terms of efficiency, it is definitely better. And at its worst point in history, it loses only 13% as compared with more than 50% for S&P 500. What is also worth mentioning is how the portfolio weathers extreme stress during the 2008-2009 Great Financial Crisis and the 2020 Covid-19 Pandemic. As you can see from the chart, in both episodes, it not only survived but profited as well.
This is just one way to invest without losing your sleep and compromising on the returns. And you can do so without predicting what the markets are going to do next. There are other strategies out there. So think carefully about how you want to build your long-term wealth.