Claim that 50/50 portfolio is not balanced?

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Bustoff
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Claim that 50/50 portfolio is not balanced?

Post by Bustoff » Mon Sep 23, 2013 5:13 pm

Today I heard some hedge fund guy make the claim that if you have a 50/50 stock/bond portfolio you have about 80% of your risk in stocks and about 20% of your risk in bonds and so you don't have diversification?
He claims that to be truly diversified a portfolio needs comparable amounts of risk.
Does anyone know if those risk percentages are accurate?
Is there any validity to the claim that a portfolio should be constructed so that the "risk" is perfectly balanced ?

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Re: Claim that 50/50 portfolio is not balanced?

Post by The Wizard » Mon Sep 23, 2013 5:16 pm

Boolsheet.
Step 1 is to smile and ignore that hedge fund guy...
Attempted new signature...

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FNK
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Re: Claim that 50/50 portfolio is not balanced?

Post by FNK » Mon Sep 23, 2013 5:23 pm

In other words, he'd recommend 20/80? That's... conservative. His next argument is probably "but I can beat that"?

The argument vaguely reminds me of the efficient frontier. Indeed, in some periods, the 20/80 mix offered minimum volatility (even less than pure bonds).

What we usually do here is assume that stocks have both higher risk and higher expected return and dial the mix to ability, need and willingness of the investor.

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telemark
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Re: Claim that 50/50 portfolio is not balanced?

Post by telemark » Mon Sep 23, 2013 5:32 pm

He's wrong! A truly balanced fund would only contain funds whose tickers are palindromes...

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Re: Claim that 50/50 portfolio is not balanced?

Post by dratkinson » Mon Sep 23, 2013 5:39 pm

Bonds are supposed to less risky. That's why we buy them, to reduce our portfolio risk to the point where we can sleep at night.

I can only conclude he is proposing increasing the risk of our bond holding by adding more risky bonds. Maybe he has a lot of old GM bonds he is trying to unload.

Hedge fund manager holding and wanting to unload old GM bonds? Stranger things have happened.
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Re: Claim that 50/50 portfolio is not balanced?

Post by Clearly_Irrational » Mon Sep 23, 2013 6:07 pm

He's talking about risk parity. http://en.wikipedia.org/wiki/Risk_parity

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Re: Claim that 50/50 portfolio is not balanced?

Post by nisiprius » Mon Sep 23, 2013 6:31 pm

Why would one want to have equal amounts of risk in stocks and bonds? I want my bonds to have less risk than my stocks, that's why I have them.
I can only conclude he is proposing increasing the risk of our bond holding by adding more risky bonds. Maybe he has a lot of old GM bonds he is trying to unload.
It's worse. He's proposing to increase the risk by adding leverage.

These guys are all pushing risk, and this is a perfect example. As long as any part of your portfolio is low risk, they aren't happy. If anything in it doesn't have risk, lever it up.

Risk parity is a recent fad, but I think it is already on the way out:
Fashionable 'Risk Parity' Funds Hit Hard
Strategy, Using Leverage to Boost Returns, Hurt by Market Tumult
Investors who piled into "risk parity" funds, which follow a popular strategy that promises to make money in most environments, are being hit hard by the current market turmoil.

The losses are touching a broad swath of investors, ranging from hedge-fund firms Bridgewater Associates LP and AQR Capital Management LLC, to mutual funds and local pension funds....
Risk Parity: What Happened?
n the first of a two-part feature, Bridgewater, Invesco, AQR, Lombard Odier, and Northwater Capital explain why their products’ returns recently fell, and why investors shouldn’t be concerned....
Last edited by nisiprius on Mon Sep 23, 2013 7:04 pm, edited 1 time in total.
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Bustoff
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Re: Claim that 50/50 portfolio is not balanced?

Post by Bustoff » Mon Sep 23, 2013 6:59 pm

Clearly_Irrational wrote:He's talking about risk parity. http://en.wikipedia.org/wiki/Risk_parity
Thanks for the wiki article. The theory sounds similar to the Permanent Portfolio.

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Re: Claim that 50/50 portfolio is not balanced?

Post by umfundi » Mon Sep 23, 2013 7:00 pm

In the first of a two-part feature, Bridgewater, Invesco, AQR, Lombard Odier, and Northwater Capital explain why their products’ returns recently fell, and why investors shouldn’t be concerned.
http://dilbert.com/strips/comic/1996-12-20/

I am sure they all got paid. Of course, their customers should not be concerned.

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Re: Claim that 50/50 portfolio is not balanced?

Post by nisiprius » Mon Sep 23, 2013 7:08 pm

Bustoff wrote:
Clearly_Irrational wrote:He's talking about risk parity. http://en.wikipedia.org/wiki/Risk_parity
Thanks for the wiki article. The theory sounds similar to the Permanent Portfolio.
No, not at all.

1) The Permanent Portfolio doesn't use leverage.

2) The Permanent Portfolio does not resemble risk parity. 25% of it is in Treasury bills, which have very little if any risk. They in fact are the usual real-world realization of the "riskless asset." 25% of it is stocks, which have a lot.
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Re: Claim that 50/50 portfolio is not balanced?

Post by bayview » Mon Sep 23, 2013 7:23 pm

telemark wrote:He's wrong! A truly balanced fund would only contain funds whose tickers are palindromes...
Excellent post. :sharebeer

Question: how do these people make a living writing this drivel? Doesn't anyone vet their articles, or is it just throw it all up there and see what sticks?
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Bustoff
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Re: Claim that 50/50 portfolio is not balanced?

Post by Bustoff » Mon Sep 23, 2013 7:25 pm

umfundi wrote:
In the first of a two-part feature, Bridgewater, Invesco, AQR, Lombard Odier, and Northwater Capital explain why their products’ returns recently fell, and why investors shouldn’t be concerned.
http://dilbert.com/strips/comic/1996-12-20/

I am sure they all got paid. Of course, their customers should not be concerned.

Keith
Reminds me of the book titled,Where are the Customers Yachts.

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Bustoff
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Re: Claim that 50/50 portfolio is not balanced?

Post by Bustoff » Mon Sep 23, 2013 7:33 pm

nisiprius wrote:
Bustoff wrote:
Clearly_Irrational wrote:He's talking about risk parity. http://en.wikipedia.org/wiki/Risk_parity
Thanks for the wiki article. The theory sounds similar to the Permanent Portfolio.
No, not at all.

1) The Permanent Portfolio doesn't use leverage.

2) The Permanent Portfolio does not resemble risk parity. 25% of it is in Treasury bills, which have very little if any risk. They in fact are the usual real-world realization of the "riskless asset." 25% of it is stocks, which have a lot.
Thanks nisi. The similarity I was referring to was not the use of leverage but rather how each allocation is equally weighted as in the PP.

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Re: Claim that 50/50 portfolio is not balanced?

Post by nedsaid » Mon Sep 23, 2013 10:04 pm

The traditional 60% stocks/40% bonds or even a 50/50 porfolio is a balanced portfolio. Pairing a risky and volatile and higher returning asset class with a less risky and less volatile and lower returning asset class is a time honored way of capturing most of the return of a 100% stock portfolio with a lot less volatliity.

The hedge fund manager would be correct in saying that in the future that bonds will offer less of a cushion to falling stock prices because of lower yields. He would also be correct in saying that investors ought to consider refining their risk control strategies beyond a plain vanilla 60/40 portfolio. We know that non-correlating and volatile asset classes when added to the mix can actually reduce volatility and perhaps increase returns.

From my reading about risk parity, many of these models go beyond adding volatile non-correlating asset class to the mix and also use leverage. But I sure would not add leverage to the mix. Markets are risky enough on their own.

What he left out is that all of this is an inexact science. Returns, risk, and correlations of asset classes all change over time. Asset classes (even the "non-correlating" asset classes) tend to correlate at the precise moment you don't want them to, that is on the way down. So even the best conceived asset allocation plans can fail temporarily. Sometimes, we just have to wait for the markets to return to sanity.

The problem with all of this is human behavior, which can be unpredictable. In market panics, the mathematical models don't work. The baby, the bathwater, and yes even the bath tub can get thrown out the window in a panic. Leverage would only magnify the drops of value in a portfolio during a panic.

We know that it is prudent to diversify among asset classes; the most basic are stocks, bonds and cash. We know how these asset classes have performed in the past and that gives us a pretty good idea of how they will fare in the future. But when we build portfolios, we have to allow a margin of error. We have to allow enough time in case our best investment strategies fail temporarily. We have to realize that at best this is all well educated guesswork.

Building levered asset allocation strategies upon a foundation of precise mathematical relationships when in fact no such precision exists in the real investment world is like the man in the parable who built his house upon the sand. When the storms come and the winds blow, these will fall with a great crash. We have seen it again and again.
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Re: Claim that 50/50 portfolio is not balanced?

Post by Bustoff » Tue Sep 24, 2013 6:01 am

nedsaid wrote: From my reading about risk parity, many of these models go beyond adding volatile non-correlating asset class to the mix and also use leverage. But I sure would not add leverage to the mix. Markets are risky enough on their own.
Ned - Totally agree that introducing leverage into a portfolio is really bad.
(Harry Browne's Permanent Portfolio is probably the most well-known risk-parity-like strategy and it does not involve leverage. It simply attempts to balance one's risk exposures across all four economic configurations.)

What's intriguing is the pure proposition that the typical 50% stock/50% bond portfolio's volatility is 80% determined by equities, which are reliant on declining inflation and economic growth.
I need to research the validity of that proposition since my strategy is to focus first, and primarily, on avoiding major losses and only then on generating gains.

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Re: Claim that 50/50 portfolio is not balanced?

Post by nisiprius » Tue Sep 24, 2013 6:54 am

Focus on understanding the risk and return of a simple portfolio and making sure they match your needs and wishes. The big lever for reducing drawdown risk is to reduce stock allocation. It reduces return, of course, but it's simple and it works. Fiddling around with portfolio construction in hopes that you can hang onto stock returns while making some really big reduction in risk is a fool's errand. You'll fiddle and tweak and tune and get something that declines 45% instead of 48% in 2008-2009.
Bustoff wrote:What's intriguing is the pure proposition that the typical 50% stock/50% bond portfolio's volatility is 80% determined by equities...
Of course. This is why I don't think there's any point in overthinking bonds; the bond part of the portfolio almost doesn't matter as long as you have any meaningful stock allocation to speak of.
which are reliant on declining inflation and economic growth.
I don't understand this.
I need to research the validity of that proposition since my strategy is to focus first, and primarily, on avoiding major losses and only then on generating gains.
When comparing strategies or portfolios, it is important to compare only strategies or portfolios that have been adjusted to have the same risk as each other. What people love to do is make some tweak that increases both risk and return and point to the improved return. For example, if you start with 60% stocks, 40% bonds, and you decide to add international stocks or small value stocks to the portfolio, you have increased the portfolio risk and therefore to make a valid comparison you should decrease the overall stock allocation to compensate. People publishing illustrations almost never do this and I have to wonder why.

I would like to riff on John C. Bogle's statement:
There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund. Ignore interim fluctuations in their net asset values. Hold your positions for as long as you live, subject only to infrequent and marginal adjustments as your circumstances change. When there are multiple solutions to a problem, choose the simplest one.
I would prefer to state it like this: There are a large number of strategies that have about the same risk as a simple portfolio of two or three index funds. If risk is equalized, what you find is that
  • they all have about the same return;
  • the differences in return are so small that they go either way depending on what endpoints you measure between;
  • if you go for a touted strategy, you may do better or you may do worse than with the simple portfolio, but you are never going to live long enough to know whether the difference was real or luck;
  • If you do worse, the people that touted it are not going to do a darn thing for you, not even send you a nice apology. They will just quietly move on to some new thing and imply that they never really supported the old thing.
Here is a useful exercise. Find some older fad strategy that is now forgotten or discredited, such as 130/30 funds. Find some articles written about them before the risk showed up. Read the articles. Don't they sound convincing? Can you see anything obviously wrong?

For example,The Track Record of 130/30 Funds. Snippets:
The underlying rationale behind 130/30 funds is to allow managers to place additional bets on securities they like (by extending their long positions) and on securities they dislike (by employing short positions). The use of short positions is critical, because long-only portfolios are constrained in their ability to underweight stocks. Johnson looked at the Russell 1000 (large cap) and MSCI EAFE indices and, in both cases, only about 80 stocks have more than .25% exposure in the index, and only 35 stocks have more than .50% exposure. If a manager dislikes a stock, there is a rigid limit on the amount it can be underweighted. Allowing short positions removes this limit.
That sounds perfectly sensible, right?
We asked Johnson whether the 130/30 structure represents the optimal use of leverage in a portfolio. After all, if the introduction of leverage enhances portfolio returns by allowing managers more freedom, why not go to a fully levered 200/100 structure? Johnson explained that there is no definitive answer to whether 130/30 is optimal, but studies[2] have shown that the 130/30 structure captures about 90% of the benefit of leverage.
That sounds good, too, doesn't it? A moderate use of leverage captures almost all of the benefit, and there's an academic research study which he cites, that bears that out.
The domestic 130/30 strategy outperformed the long-only by about 1.5 times... researchers have shown analytically that superior returns hold up even when ... costs are considered.
Wow! 50% more! Surely it's worthwhile trying something new, just a skosh outside your comfort zone, in order to get 50% more?
This narrowed down the universe to nine pairs of 130/30 and long-only strategies, with performance histories of 21 to 36 months. In all nine cases, the 130/30 portfolio outperformed the long-only portfolio, in many cases by very substantial margins.... Johnson’s extensive empirical back-testing, and his demonstration that 130/30 portfolios can provide superior risk-adjusted performance, as compared to their benchmarks and to the corresponding long-only strategy.
At any given point in time one can of course always find both advocates and naysayers, and plenty of people were asking questions about 130/30, but really, if you go back and look, 130/30 had wide support. I mean they were starting to show up as choices in 401(k) plans. Another article says
The strongest advocates of 130/30 funds say this investing technique is much more than a passing trend. "If the world were a perfectly rational place, then by all rights this should put long-only funds out of business," says Kevin Means, manager of Ridgeworth Real Estate 130/30.
Why am I going on and on about 130/30 funds when you are asking about risk parity funds? To make an important point. There are always these strategies coming along, and they always look genuinely good at the time.
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Re: Claim that 50/50 portfolio is not balanced?

Post by Bustoff » Tue Sep 24, 2013 7:55 am

nisiprius wrote:Focus on understanding the risk and return of a simple portfolio and making sure they match your needs and wishes.
My primary desire is to avoid major losses. Generating gains is secondary.
nisiprius wrote:Fiddling around with portfolio construction in hopes that you can hang onto stock returns while making some really big reduction in risk is a fool's errand.
You are correct sir.
Bustoff wrote:What's intriguing is the pure proposition that the typical 50% stock/50% bond portfolio's volatility is 80% determined by equities...
nisi, Im not proposing that it works or that I have any interest in executing such a strategy. I simply want to know if the above figures are accurate.
nisiprius wrote:When comparing strategies or portfolios, it is important to compare only strategies or portfolios that have been adjusted to have the same risk as each other. What people love to do is make some tweak that increases both risk and return and point to the improved return. For example, if you start with 60% stocks, 40% bonds, and you decide to add international stocks or small value stocks to the portfolio, you have increased the portfolio risk and therefore to make a valid comparison you should decrease the overall stock allocation to compensate. People publishing illustrations almost never do this and I have to wonder why.
Me too. So what is the best way to lower downside risk if your happy to accept lower returns ?

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Re: Claim that 50/50 portfolio is not balanced?

Post by telemark » Tue Sep 24, 2013 8:10 am

It depends on what you mean by risk (also balanced, and diversified, but let's stick with risk). We say that stocks are riskier than bonds because they have more volatility, but bonds have their own risks which are different in nature from stock risks (when we describe Treasuries as the canonical riskless asset, that refers only to default risk). One of the better reasons to own both stocks and bonds is that you don't want to have all of your wealth subject to one kind of risk -- this is an idea as old as the Talmud. Cash and commodities have their own kinds of risks and the Permanent Portfolio includes those too. What I don't buy is the idea that you can usefully fine tune this kind of approach, or that comparing the volatility of different kinds of investments will lead to meaningful results.

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Re: Claim that 50/50 portfolio is not balanced?

Post by Bustoff » Tue Sep 24, 2013 8:52 am

Perhaps we could simply ask the question as follows.
How do we adjust a simple three fund stock/bond portfolio for less portfolio risk?

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Re: Claim that 50/50 portfolio is not balanced?

Post by staythecourse » Tue Sep 24, 2013 9:31 am

I dont' support the hedge fund guy's view, but he is 100% correct in his statement. Now the retort of "Boy I don't want my bonds to have the same level of risk as it is supposed to give my a cushion to my equity %" is very reasonable as well.

The point is what one is trying to accomplish. Doesn't mean one is wrong for the other to be right.

Good luck.
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Re: Claim that 50/50 portfolio is not balanced?

Post by Phineas J. Whoopee » Tue Sep 24, 2013 2:02 pm

Bustoff wrote:Perhaps we could simply ask the question as follows.
How do we adjust a simple three fund stock/bond portfolio for less portfolio risk?
Hold less of the stock funds and more of the bond fund for a long period of time.

It isn't the 3-fund portfolio that defines your risk, but your chosen asset allocation. The 3-fund portfolio is just an extremely cost-effective way of implementing your AA, as long as you're satisfied with market weights rather than tilting.

If we take 60/40 as sort of a default asset allocation, you can focus more on preservation and less on growth by going to, say, 40/60. Too risky? 30/70.

Despite all the long threads on the topic, adjusting the domestic/international stock ratio has far less impact than adjusting the stock/bond ratio.

PJW

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Re: Claim that 50/50 portfolio is not balanced?

Post by technovelist » Tue Sep 24, 2013 2:21 pm

Bustoff wrote:
nisiprius wrote:Focus on understanding the risk and return of a simple portfolio and making sure they match your needs and wishes.
My primary desire is to avoid major losses. Generating gains is secondary.
nisiprius wrote:Fiddling around with portfolio construction in hopes that you can hang onto stock returns while making some really big reduction in risk is a fool's errand.
You are correct sir.
Bustoff wrote:What's intriguing is the pure proposition that the typical 50% stock/50% bond portfolio's volatility is 80% determined by equities...
nisi, Im not proposing that it works or that I have any interest in executing such a strategy. I simply want to know if the above figures are accurate.
nisiprius wrote:When comparing strategies or portfolios, it is important to compare only strategies or portfolios that have been adjusted to have the same risk as each other. What people love to do is make some tweak that increases both risk and return and point to the improved return. For example, if you start with 60% stocks, 40% bonds, and you decide to add international stocks or small value stocks to the portfolio, you have increased the portfolio risk and therefore to make a valid comparison you should decrease the overall stock allocation to compensate. People publishing illustrations almost never do this and I have to wonder why.
Me too. So what is the best way to lower downside risk if your happy to accept lower returns ?
Add some gold.
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Re: Claim that 50/50 portfolio is not balanced?

Post by nisiprius » Tue Sep 24, 2013 2:22 pm

Bustoff wrote:Perhaps we could simply ask the question as follows.
How do we adjust a simple three fund stock/bond portfolio for less portfolio risk?
Reduce stock allocation and increase bond allocation. Simple as that.

In a larger view, we should also include single-premium immediate annuities (SPIAs) as something that can be very useful in a retirement portfolio, although it is not a mutual fund and not an investment. Subject to a list of tradeoffs and considerations, in a broad way a very effective tool for lowering risk is to use some of the retirement portfolio to buy an SPIA.
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Re: Claim that 50/50 portfolio is not balanced?

Post by Valuethinker » Tue Sep 24, 2013 5:54 pm

Bustoff wrote:Today I heard some hedge fund guy make the claim that if you have a 50/50 stock/bond portfolio you have about 80% of your risk in stocks and about 20% of your risk in bonds and so you don't have diversification?
He claims that to be truly diversified a portfolio needs comparable amounts of risk.
Does anyone know if those risk percentages are accurate?
Is there any validity to the claim that a portfolio should be constructed so that the "risk" is perfectly balanced ?
This is called 'risk budgeting' and it is all the rage CFA publications, institutional investors and consultants etc.

he is right in a strict sense.

However as an individual investor you have so many moving parts which are uncertain:

- inflation
- when you retire (might not be your choice)
- equity performance
- bond performance
- what your financial needs upon retirement *are*

Long experience has tended to show that 50/50 bond equity gives a good balance of risk and return for most investors, the process of rebalancing forcing them to buy stocks when they are low, and sell stocks when they are high. 60-40 equity/ bonds is probably better for young investors, but 50-50 for those over 50.

The only significant issues then are whether to hold TIPS and whether to hold international stocks. And in addition whether to devote any money to the Small Cap Value effect (if you have access to DFA funds, then international SCV is diversifying-- most other ways of pursuing that factor are not 'valuey' enough).

TIPS (and ibonds) offer the one advantage that in a repeat of the 70s, they would likely outperform stocks and conventional bonds. (ie period of high inflation and economic volatility).

Indeed Franco Modigliani, of Modigliani and Miller fame (they invented a lot of modern corporate finance theory and won a Nobel Prize for it), when asked, said that he kept half his money in stocks and half in bonds (probably what he was doing was 50% in the TIAA stock fund, 50% in the TIAA Traditional Annuity, which is what was available to professors in those days-- the only investment options).

So if Franco Modigliani followed such a practice (albeit 40 years ago) then we have some strong steers that this is the way to go.

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Re: Claim that 50/50 portfolio is not balanced?

Post by Lee Saage » Tue Sep 24, 2013 6:00 pm

Rick Ferri has written:
My investment motto is: there is risk, there is return, and there are costs, all else is marketing.
Truth, that.
Most of my money went to fast cars, fast living and good wine. The rest I just wasted.

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Re: Claim that 50/50 portfolio is not balanced?

Post by larryswedroe » Tue Sep 24, 2013 6:25 pm

sorry don't have time to read all thread but actually he is correct in terms of where the risks are
I 50/50 portfolio is balanced in terms of asset allocation but not even close in terms of risks. A 50% bond portfolio in good year might go up say 10-15%, but stock in bad year can go down 50%. So it clearly is not balanced in terms of risk though it is in terms of asset classes.

Larry

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Re: Claim that 50/50 portfolio is not balanced?

Post by Rodc » Tue Sep 24, 2013 6:41 pm

Bustoff wrote:
Bustoff wrote:What's intriguing is the pure proposition that the typical 50% stock/50% bond portfolio's volatility is 80% determined by equities...
nisi, Im not proposing that it works or that I have any interest in executing such a strategy. I simply want to know if the above figures are accurate.
It depends somewhat on the time period and the bonds and stocks used.

But consider this. A portfolio of cash in a mattress and stocks. Make it 99% cash and 1% stocks. Then 100% of the portfolio's volatility is determined by the stocks.

Why? Because cash in the mattress has zero volatility. The stocks drive the volatility even though the overall volatility is very near zero (99% zero and 1% whatever the stocks did).

So sure, if you use bonds, especially high quality bonds of modest duration, the overall volatility is driven almost entirely by stocks. True for 30% stocks or 70% stocks or whatever. But that is just because bonds have low volatility.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: Claim that 50/50 portfolio is not balanced?

Post by pkcrafter » Tue Sep 24, 2013 8:19 pm

He's wrong! A truly balanced fund would only contain funds whose tickers are palindromes...
But, of course, Mr. Monk. :D
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Re: Claim that 50/50 portfolio is not balanced?

Post by Noobvestor » Tue Sep 24, 2013 9:26 pm

telemark wrote:He's wrong! A truly balanced fund would only contain funds whose tickers are palindromes...
Grr... I can't get any short ones to work. How about REDIVIDER for a self-rebalancing fund? :D
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

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Re: Claim that 50/50 portfolio is not balanced?

Post by telemark » Tue Sep 24, 2013 10:21 pm

Noobvestor wrote:Grr... I can't get any short ones to work. How about REDIVIDER for a self-rebalancing fund?
Pretty good! Or XANAX, the fund that lets you sleep at night...

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Re: Claim that 50/50 portfolio is not balanced?

Post by Valuethinker » Wed Sep 25, 2013 3:48 am

Rodc wrote: So sure, if you use bonds, especially high quality bonds of modest duration, the overall volatility is driven almost entirely by stocks. True for 30% stocks or 70% stocks or whatever. But that is just because bonds have low volatility.
One thing about bonds, they don't have quite as low volatility if you look at buying power. That postwar period when bonds were a dog of an investment really counts in the data.

So TIPS, which guarantee real buying power if held to maturity (subject to the ability to reinvest the coupons at the same real rate ie which you can never do, exactly) have low volatility.

For practical purposes in portfolio construction whilst TIPS are diversifying, I think most of us assume we are not going to have a rerun of the 1970s, because Central Banks have learned from that experience (allowing inflationary expectations to rise) and are more proactive. There was a collision of real factors (the Oil Shocks, demographics etc.) and social factors (unionization and CPI linked contracts) and political ones which made the 1970s hopefully quite unique.

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Re: Claim that 50/50 portfolio is not balanced?

Post by nisiprius » Wed Sep 25, 2013 5:02 am

larryswedroe wrote:sorry don't have time to read all thread but actually he is correct in terms of where the risks are
I 50/50 portfolio is balanced in terms of asset allocation but not even close in terms of risks. A 50% bond portfolio in good year might go up say 10-15%, but stock in bad year can go down 50%. So it clearly is not balanced in terms of risk though it is in terms of asset classes.

Larry
Yes, but the first question is "why should we care?" It's analogous to someone pointing out that the percentage of emerging markets in an international stock index is lower than their GDP percentage in the total economy, leaving the listener to infer that they ought to be the same, but never giving any reason.

And another question is "Seriously, is this news to even a relatively naïve investor, whose whole reason for investing in bonds in the first place is that they have lower risk?"

And the use of the word "balanced" is tendentious, because the word "balanced" has always been used to mean something else. It's more rhetorical garbage, polluting honest communication. It's taking some dubious theory, giving it an inappropriate word that sounds like something good that you want to have, and misappropriating a word that was already in use.

The whole idea is to take the safe assets in your portfolio and leverage them up until they become equally risky. Calling that "balanced" portfolio or "risk parity" portfolio is pure marketing.

You are sitting down on the floor of the canoe to keep it stable, because the traditional advisors in summer camp told you this was prudent. Someone says "Your weight distribution is unbalanced, because your center of gravity is too low. Our scientific studies show you want buoyancy parity, meaning the center of gravity should be just as high as the center of buoyancy. So, please stand up and the canoe will go faster."
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Re: Claim that 50/50 portfolio is not balanced?

Post by nisiprius » Wed Sep 25, 2013 6:00 am

Another issue is that in practice this approach is too complicated for me to understand. I will assume that the AQR Risk Parity mutual fund is a competent example of the genre.

At the most basic level--what do I own, and how do I think it makes money for me--how comfortable should a Boglehead be with a fund that Morningstar charts like this?
Image

When it comes to basic fund information, Morningstar literally draws a blank.

From the SUMMARY prospectus we learn that the fund can hold "instruments including, but not limited to: equity securities, equity futures, equity swaps, currency forwards, commodity futures, swaps on commodity futures, bond futures, swaps on bond futures, interest rate swaps, credit default swaps, credit default index swaps; inflation swaps; cash corporate and government bonds, including inflation protected government bonds, cash and cash equivalents including but not limited to money market fund shares..."

How much do I know about currency forwards and equity swaps? Nothing, that's how much. How about you? Got any charts showing the total returns of currency forwards back to 1926?

And of course the prospectus says that "There is no maximum or minimum exposure to any one Instrument or any one asset class" and that the fund is actively managed. So if you want to know what you own, I guess you would need to be diligent in following the semiannual reports and the quarterly holdings reports????

So, most ordinary retail investors would be buying a pig in a poke, based solely on articles explaining how cool the concept is, admiration for the manager. That is to say, mostly on faith. As for past performance... uh... it is what it is. But even if it had been going gangbusters, it would still be unsuitable for me because I lack the expertise needed to understand these funds.

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Re: Claim that 50/50 portfolio is not balanced?

Post by Valuethinker » Wed Sep 25, 2013 6:20 am

Bustoff wrote:
nisiprius wrote:Focus on understanding the risk and return of a simple portfolio and making sure they match your needs and wishes.
My primary desire is to avoid major losses. Generating gains is secondary.
nisiprius wrote:Fiddling around with portfolio construction in hopes that you can hang onto stock returns while making some really big reduction in risk is a fool's errand.
You are correct sir.
Bustoff wrote:What's intriguing is the pure proposition that the typical 50% stock/50% bond portfolio's volatility is 80% determined by equities...
nisi, Im not proposing that it works or that I have any interest in executing such a strategy. I simply want to know if the above figures are accurate.
nisiprius wrote:When comparing strategies or portfolios, it is important to compare only strategies or portfolios that have been adjusted to have the same risk as each other. What people love to do is make some tweak that increases both risk and return and point to the improved return. For example, if you start with 60% stocks, 40% bonds, and you decide to add international stocks or small value stocks to the portfolio, you have increased the portfolio risk and therefore to make a valid comparison you should decrease the overall stock allocation to compensate. People publishing illustrations almost never do this and I have to wonder why.
Me too. So what is the best way to lower downside risk if your happy to accept lower returns ?
Just in a purely statistical sense.

Let's say stocks have expected return of 8% pa (nominal) and average standard deviation of 20%

And bonds have expected returns of 3% pa and average standard deviation of 10%

You can see that a bond portfolio is going to be a lot safer than a stock portfolio. Assuming the 2 assets are not correlated, then I believe the standard deviation of the 50/50 portfolio would be 15% (2/3rds of all outcomes would be +/- 15% or less assuming normal distribution) and the expected return would be 5.5% pa. (my stats is rusty so don't take me as gospel on that calculation).

A rule of thumb we use here is that your stock portfolio can halve in any given year: -50%. That's an extreme downturn, not the worst ever recorded, but is consistent with the (35% in 6 months? S&P500 August 2008 to March 2009) worst falls over shorter periods. The Great Bear Markets, such as post 1929 (even given the huge rallies and collapses eg 1937-38) or the UK in the early 70s, or Japan 1990-2012, have been bigger than that.

So in a really bad year, we could see US Treasuries (intermediate term) say -10% (total return). The long US Treasury dropped -20% in 1994, btw. And our stock portfolio could halve in value.

The conclusion if you want safety of capital is:

- ST Treasury bonds
- FDIC guaranteed CDs
- TIPS held to maturity (protects against inflation) or a ST TIPS fund as an alternative
- ibonds

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Re: Claim that 50/50 portfolio is not balanced?

Post by Rodc » Wed Sep 25, 2013 6:55 am

Valuethinker wrote:
Rodc wrote: So sure, if you use bonds, especially high quality bonds of modest duration, the overall volatility is driven almost entirely by stocks. True for 30% stocks or 70% stocks or whatever. But that is just because bonds have low volatility.
One thing about bonds, they don't have quite as low volatility if you look at buying power. That postwar period when bonds were a dog of an investment really counts in the data.

So TIPS, which guarantee real buying power if held to maturity (subject to the ability to reinvest the coupons at the same real rate ie which you can never do, exactly) have low volatility.

For practical purposes in portfolio construction whilst TIPS are diversifying, I think most of us assume we are not going to have a rerun of the 1970s, because Central Banks have learned from that experience (allowing inflationary expectations to rise) and are more proactive. There was a collision of real factors (the Oil Shocks, demographics etc.) and social factors (unionization and CPI linked contracts) and political ones which made the 1970s hopefully quite unique.
Well, while true that is really not quite germane to the issue of the math of why stocks drive the volatility of a stock bond portfolio. The issue is that in any mix of low and high volatility the overall volatility is driven by the high volatility asset almost regardless of the percent in either component. This is all the more true the lower the volatility of the low volatility component.

In constructing a real-life portfolio, rather than simple examples to illustrate the answer to the question posed, if the goal is low volatility, you would pick the type of bonds or cash that most closely matches the liability you hope to cover, or if that is indeterminate, you might just pick a diverse mix of low volatility assets with an eye towards low correlation with the rest of the portfolio.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: Claim that 50/50 portfolio is not balanced?

Post by Bustoff » Wed Sep 25, 2013 8:48 am

Valuethinker wrote: The conclusion if you want safety of capital is:
- ST Treasury bonds
- FDIC guaranteed CDs
- TIPS held to maturity (protects against inflation) or a ST TIPS fund as an alternative
- ibonds
Thanks! I have all the above in my fixed income except TIPS. I like the promise of TIPS but lack the skill to construct a ladder of individual TIPS.
Are there any guidelines for what percentage of fixed income should be in TIPS funds?
Again, I would emphasize that my interest minimizing downside risk is that I'm content with a 2% withdrawal rate.

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Re: Claim that 50/50 portfolio is not balanced?

Post by nedsaid » Wed Sep 25, 2013 1:30 pm

I laughed pretty hard reading Nisiprius post reguarding the AQR Fund compared to the pokey old 60/40 balanced funds. His chart pretty well pricked the pomposity of the "experts" who claim they have a new and better way. Thanks for the post. It was brilliant.

The AQR fund with all the fancy investments hardly anyone understands, the quants, the computers, could not beat a traditional 60/40 portfolio. It is a classic case of taking a good idea too far. I believe in adding volatile non-correlating assets to a portfolio to reduce risk and perhaps increase returns. But the asset classes that I add like REITs, Small Value, and Emerging Markets actually generate real returns over time. But there gets to be a point when you go overboard on an idea that the whole thing breaks down.

I am awaiting the day when financial advisors will plug the idea of cash buried in your back yard or under your mattress because it does not correlate with stocks. Non-correlation seems to be the thing now a days and return on those non-correlating assets don't seem to factored in anyone's thinking anymore. A lot of these fancy investments seem to do little but drag down returns.
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Re: Claim that 50/50 portfolio is not balanced?

Post by Phineas J. Whoopee » Thu Sep 26, 2013 11:01 am

nedsaid wrote:...
I am awaiting the day when financial advisors will plug the idea of cash buried in your back yard or under your mattress because it does not correlate with stocks. Non-correlation seems to be the thing now a days and return on those non-correlating assets don't seem to factored in anyone's thinking anymore. A lot of these fancy investments seem to do little but drag down returns.
I think that day won't come, because no adviser can make a profit off your mattress or backyard. I suppose they might offer to rent us space in a safe, though, and a moving company to to transport all the physical cash so we don't strain ourselves.
PJW

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Re: Claim that 50/50 portfolio is not balanced?

Post by larryswedroe » Thu Sep 26, 2013 11:38 am

Nisiprius
First, you are somehow under the illusion it seems that I believe in the strategy of risk parity, like leveraging up bonds to get there. Never said anything like that and certainly never advocated leveraging anything. In fact the data used is highly biased by the fact that bonds have rallied so much in past 40 years.

Second, all I was pointing out is that a 50/50 portfolio isn't even close to being balanced in terms of the risks since stocks are much riskier than bonds. It's just balanced in the sense you have equal asset allocation. And I'm fine with that convention.

Third, and for what it's worth, the literature is moving to the benefits of diversifying across many factors, and that a 1/n type diversification seems to be about as good as any. So diversifying across beta, size, value, MOM, carry trade, term, default, etc does seem to be a good strategy, as you gain the diversification benefits. To that extent a more risk parity type portfolio (without leverage) is probably a good idea. If have not read Illmanen's Expected Returns I highly recommend it ---IMO one of if not the best finance books written.

Fourth, by tilting and lowering beta you move toward a more risk parity type portfolio with not so much of your risk in the beta basket, but in other factors as well, now with size, value, momentum and profitability and more in bonds as well (the tilt allows you to lower beta without lowering expected returns)

Best wishes
Larry

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Re: Claim that 50/50 portfolio is not balanced?

Post by larryswedroe » Thu Sep 26, 2013 11:43 am

Bustoff
While lowering stock and increasing bond portfolio will lower risk, it also lowers expected returns
However, if you lower stock allocation but at same time increase the exposure to small value stocks historically you have been able to create a more efficient portfolio, one with less fat tails but same returns. Lower SD (one measure of risk) with same returns. That's the "Larry Portfolio" the NY Times wrote about

Larry

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Re: Claim that 50/50 portfolio is not balanced?

Post by Jebediah » Thu Sep 26, 2013 12:05 pm

Larry, can you give an example of a 1/n AA of investable instruments that includes carry trade and credit risk?

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Re: Claim that 50/50 portfolio is not balanced?

Post by Quidnam » Thu Sep 26, 2013 12:22 pm

Clearly_Irrational wrote:He's talking about risk parity. http://en.wikipedia.org/wiki/Risk_parity
This is another iteration of Wall Street's perpetual campaign to forestall their worst existential nightmare: Pension funds, endowments, and ultra-high net worth clientele simply rolling a 60/40 indexed portfolio (or similar) and calling it a day...

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Re: Claim that 50/50 portfolio is not balanced?

Post by Jebediah » Thu Sep 26, 2013 12:54 pm

Larry,

Would something like this be true to the concept? How do you get carry trade exposure?

Jeb's Complicated, Factor-exposed, Equity-tilted, Pseudo-Risk-Parity Port

Equal weight of each:

term - 7 yr treasury fund
credit - HY bond fund
cash - Bills, iBonds, etc

value US - SCV fund
quality US - qual fund (e.g. QUAL)
mom US - us mom fund (e.g. MTUM)
size US - SCV fund
value Intl - IV + EMV funds
mom Intl - Intl mom fund
size Intl - ISC fund (e.g. VSS)


PM - gold or mixed PM ETF
Commodity - CCF ETF
carry trade - ???

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Re: Claim that 50/50 portfolio is not balanced?

Post by larryswedroe » Thu Sep 26, 2013 1:59 pm

Jeb
yes, there are also carry trade funds, including the DFA partially hedged fund.
Now whether equal weighting them is right for YOU or any individual is a different matter. But IMO diversifying across many sources or more sources is a good thing, especially if low correlating and there are premiums to be had. The right mix depends on many individual factors including ability to deal with tracking error.
And personally would skip HY for reasons I have mentioned
Larry

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Re: Claim that 50/50 portfolio is not balanced?

Post by Parallax » Thu Sep 26, 2013 2:33 pm

Hopefully I can clear up some of this information...

Most of you are pretty smart, and will figure out that this is my first post. I work in the investment consulting industry, and provide services to billions of dollars worth of retirement/pension assets. I work with every financial services firm imaginable (active managers, passive managers, hedge funds including the above mentioned AQR, etc...). That being said, I am a modified boglehead (essentially, utilize passive funds/etfs coupled with slightly more dynamic allocation ranges based on forward-looking valuation indicators). I will never recommend nor try to sell you on any sort of mutual fund or strategy type to any of you. That being said, I have no problem shedding some light on topics such as these, where someone within the industry may be able to help others better understand. As far as I am concerned, the basic advice and recommendations that can be found on this forum (I have visited it for years), are exceptional, and will provide those who adhere to the basic principles a great nest egg.

That is my disclaimer...now onto the topic....



What the hedge fund manager was referring to is that a 50/50 portfolio is not balanced in regard to CONTRIBUTION to risk. Risk being standard deviation. Since stocks are inherently more volatile than bonds, they contribute a greater percentage of volatility to the overall volatility of the portfolio. A rough rule of thumb is that within a 60/40 portfolio, roughly 90% of the risk (once again, just standard deviation) of the overall portfolio will be coming from the equity allocation. In other words, the portfolio is very sensitive to the equity market, both on the upside and the downside. This should all make sense to you.


Now onto risk parity. Risk parity is a very abused term. It can refer to paring (or balancing) risk via volatility contributions, economic regimes, macroeconomic risk factors, or anything else under the sun. The idea is actually very boglehead-like. The idea is an attempt to better balance a portfolio for whatever may come its way, without making any market timing or forecasting calls (obviously, some managers will implement a more active approach, but this is the basic idea). A 60/40 portolio is very dependent on equity market beta. A risk parity portfolio tries not to be overly dependent on any one market risk. In times like the last few years, when equity risk has been rewarded very well, they are going to lag. There are times (although we can't predict when), when they will do much better.

The Bridgewater All Weather portfolio was the original creation of "risk parity", although that strategy is based on balancing a portfolio based on economic regimes. It has beaten a 60/40 portfolio handily since it's inception, net of fees. Looking at the last few years, when really only a couple risks have been rewarded (duration and equity) isn't really sufficient to make a judgement one way or another.

At the end of the day though, a passive portfolio that incorporates as much of the global investment market as possible, is a great portfolio.

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Re: Claim that 50/50 portfolio is not balanced?

Post by Parallax » Thu Sep 26, 2013 2:36 pm

And as Larry above has mentioned...Antti Ilmanen's book is one of the best finance books written. I highly recommend it, even if only to learn about what some of the more advanced industry "thinkers" are developing.

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Re: Claim that 50/50 portfolio is not balanced?

Post by Clive » Fri Sep 27, 2013 6:16 pm

Bustoff wrote:Harry Browne's Permanent Portfolio is probably the most well-known risk-parity-like strategy and it does not involve leverage. It simply attempts to RE-balance one's risk exposures across all four economic configurations.
Those who advocate the 4x25 Permanent Portfolio suggest that they would have rebalanced as per the PP guidance of 40% rebalance bands (reduce back down to target 25% weighting when reaches/exceeds 35% weighting) during the 1970's rising price of gold era - but that they would have had the foresight to not have done so in the run up years to a Weimar Germany hyperinflation event.

Image

Even at once yearly reviews and reduce gold down from 35 to 25 (71% of previous amount of gold held after each such reduce rebalance) you'd end up with just 25% of the original amount of physical gold that you'd previously held. No different to having just bought and held 6.25% gold. And that's a conservative figure that assumes the other assets hadn't declined in value, potentially the figure could be less than 1% of the original amount of gold still being retained by the start of 1923 assuming other assets declined in value or the portfolio was rebalanced more frequently than once yearly.

The Permanent Portfolio is a weightings-parity strategy.

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Re: Claim that 50/50 portfolio is not balanced?

Post by Rodc » Fri Sep 27, 2013 6:42 pm

c_bb7 wrote:Hopefully I can clear up some of this information...

Most of you are pretty smart, and will figure out that this is my first post. I work in the investment consulting industry, and provide services to billions of dollars worth of retirement/pension assets. I work with every financial services firm imaginable (active managers, passive managers, hedge funds including the above mentioned AQR, etc...). That being said, I am a modified boglehead (essentially, utilize passive funds/etfs coupled with slightly more dynamic allocation ranges based on forward-looking valuation indicators). I will never recommend nor try to sell you on any sort of mutual fund or strategy type to any of you. That being said, I have no problem shedding some light on topics such as these, where someone within the industry may be able to help others better understand. As far as I am concerned, the basic advice and recommendations that can be found on this forum (I have visited it for years), are exceptional, and will provide those who adhere to the basic principles a great nest egg.

That is my disclaimer...now onto the topic....



What the hedge fund manager was referring to is that a 50/50 portfolio is not balanced in regard to CONTRIBUTION to risk. Risk being standard deviation. Since stocks are inherently more volatile than bonds, they contribute a greater percentage of volatility to the overall volatility of the portfolio. A rough rule of thumb is that within a 60/40 portfolio, roughly 90% of the risk (once again, just standard deviation) of the overall portfolio will be coming from the equity allocation. In other words, the portfolio is very sensitive to the equity market, both on the upside and the downside. This should all make sense to you.


Now onto risk parity. Risk parity is a very abused term. It can refer to paring (or balancing) risk via volatility contributions, economic regimes, macroeconomic risk factors, or anything else under the sun. The idea is actually very boglehead-like. The idea is an attempt to better balance a portfolio for whatever may come its way, without making any market timing or forecasting calls (obviously, some managers will implement a more active approach, but this is the basic idea). A 60/40 portolio is very dependent on equity market beta. A risk parity portfolio tries not to be overly dependent on any one market risk. In times like the last few years, when equity risk has been rewarded very well, they are going to lag. There are times (although we can't predict when), when they will do much better.

The Bridgewater All Weather portfolio was the original creation of "risk parity", although that strategy is based on balancing a portfolio based on economic regimes. It has beaten a 60/40 portfolio handily since it's inception, net of fees. Looking at the last few years, when really only a couple risks have been rewarded (duration and equity) isn't really sufficient to make a judgement one way or another.

At the end of the day though, a passive portfolio that incorporates as much of the global investment market as possible, is a great portfolio.
My hope is most here get that. The issue is why would I want to balance the risk from each type of asset. Say I have bonds and stocks. And for the sake of simplicity, suppose the standard deviation of bonds is half that of stocks. Why would I want 2/3 bonds? If I were retired that might be fine. If I were 35 that might be way to conservative. It all but guarantees low return at a time where I don't care much about short term movement and have time ramp up saving if stocks due poorly for a long time.

Also, why equal amounts of risk due to bonds and stocks vs weighting for lowest variance. Basic least squares, assuming bond and stock returns are not correlated says to weight not inversely to standard deviation (risk) but weight inversely to variance (so 4 times as much in bonds as in stocks). If there are correlations we just add in the covariance matrix, no problem.

In the more extreme case of cash in a mattress, bonds, and stocks, the standard deviation of the cash in the mattress is zero. In both cases above I'd have to go 100% cash. I don't see how that makes sense. Indeed for a cash in the mattress and stock portfolio the (nominal) volatility is essentially completely driven by the stocks from 1% to 100% stocks, and yet at 1% there is virtually no risk and at 100% there is lots. So the fact that volatility of driven by stocks in both cases seems like a big so what?

Now if I'm trying to build a portfolio of minimum variance so I can then follow up with leverage, that starts to make more sense, but still I don't get equal weight in risk as opposed to minimum variance. Can't say as I have spent anytime thinking through the differences however.

But leveraging adds a ton of risk and really is not appropriate of 99.44% of the general population. Maybe more.

It would seem to make more sense to use to balance between fairly risky assets rather than very low and very high risk assets. It would also seem to make more sense to balance between risk regimes as you note (ala the permanent portfolio, though I don't use it)
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: Claim that 50/50 portfolio is not balanced?

Post by Clive » Fri Sep 27, 2013 11:23 pm

Rodc wrote:leveraging adds a ton of risk and really is not appropriate of 99.44% of the general population.
Leveraging needn't mean borrowing to invest, it might simply mean selecting specific choices of stocks and bonds. If for instance somewhere close to 60-40 stock/bond was your target/desired asset allocation :

UK FTSE 100 index recent dividend yield of 3.56% implies an approximate modified duration of 28.
2055 1.25% Index Linked Gilt (similar to a long dated TIPS) recent modified duration = 38.
For those at risk-parity you'd be looking to hold 58% stocks, 42% bonds.

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Re: Claim that 50/50 portfolio is not balanced?

Post by Noobvestor » Fri Sep 27, 2013 11:47 pm

telemark wrote:
Noobvestor wrote:Grr... I can't get any short ones to work. How about REDIVIDER for a self-rebalancing fund?
Pretty good! Or XANAX, the fund that lets you sleep at night...
Nice! 5 characters FTW!
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

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