Financial advice often sounds logical and is widely adopted by most financial advisors. One of the most common pieces of advice is to diversify your capital across different asset classes according to risk appetite and your age. A popular portfolio asset allocation method is the 60/40 portfolio (60% allocation to stocks and 40% allocation to bonds).
How this fixed allocation came about is unclear. Perhaps it started from a pure 100% allocation to stocks. But the problem with this allocation is that it is too volatile, especially during bear markets. A safer asset is then thrown into the mix to reduce portfolio volatility. This is where bonds come in. However, safer assets also mean lower returns. Hence, there is a price to pay for lower portfolio volatility in the form of a lower return. If we just simply go for an equal split between stocks and bonds, the resultant portfolio return is unattractive. Financial advisors would not have clients and nobody is happy. Skew the allocation more to stocks and voila, the 60/40 portfolio is born.
A variant of the 60/40 portfolio is the life-cycle portfolio. This portfolio would skew even more to stocks if you are young and gradually lessen up as you age. A common rule of thumb is to subtract your age from 110 and allocate that number to stocks. So a 30-year-old should allocate 80% to stocks and 20% to bonds whereas a 60-year-old should allocate 50% to stocks and 50% to bonds.
The 60/40 portfolio has its advantages. It is easy to explain to clients. It is readily understood by clients. Hence, it is more readily adopted. Some diversification is better than none!
A Mathematician's Financial Advice
However, is such a fixed asset allocation approach truly the most efficient way of constructing a portfolio? To answer this question, we turn to Harry Markowitz’s Modern Portfolio Theory (MPT).
Let’s assume that we would like to include two ETFs in our portfolio. The first is SPY which represents stocks and the second is IEF which represents bonds. It turns out that we can obtain the respective portfolio annualized return and annualized volatility for different allocations to the two ETFs. However, we require the historical return series for both ETFs to calculate portfolio annualized return and volatility. The window we choose for the historical return series has an impact on the numbers.
Below is the plot of portfolio annualized return vs annualized volatility for various portfolio allocations using daily historical return for a ten-year period from 2005 to 2014.
This plot is known as the efficient frontier because for any given portfolio volatility, the highest return can only be achieved by the specific portfolio allocation that falls on the blue line. There are a few observations we can make from this chart.
The Minimum Variance Portfolio contains 19% SPY and 81% IEF.
The 60/40 Portfolio is an arbitrary point on the efficient frontier.
If we draw a straight line (red line above) starting from the origin of the plot until it just touches the efficient frontier, we get a portfolio that gives the highest possible annualized return per unit annualized volatility.
This portfolio is known as the tangent portfolio and it gives the highest Sharpe ratio among all possible portfolio allocations.
Moving Beyond Asset Allocation
The reason why combining different asset classes in a portfolio can give you a better risk-return profile is because the asset classes are non-correlated with one another. When one asset class is down, the other might be up and vice versa. This is what diversification is about and what gives rise to the so-called “free lunch” in investing.
However, there are not many asset classes that are non-correlated and there is a tendency for asset classes to correlate to one in a liquidity crisis. Are we then able to create our own asset classes that are non-correlated even during a crisis?
Enter The Multi-Strategy Approach
If we treat an investment strategy as an asset class, we can effectively create our own asset classes without restricting ourselves to the traditional asset classes like stocks and bonds. Hence, there is a better chance that we can put together strategies that have better diversification benefits than simple asset allocation. Such a portfolio can remain diversified even during crisis periods. A multi-strategy portfolio effectively moves the entire efficient frontier upwards as shown below.
You can see that the multi-strategy portfolio gives a higher Sharpe ratio than what a multi-asset portfolio can give. In simple terms, the multi-strategy approach gives a higher return for every unit risk taken.
This is why the multi-strategy approach is the ultimate “free lunch” in investing.