Classic Bernstein 1 — Asset Allocation and Time Horizon

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Classic Bernstein 1 — Asset Allocation and Time Horizon

Post by SimpleGift »

PREFACE: This is the first in a possible series of posts over the next few months highlighting William Bernstein’s classic investing and portfolio insights from the 1990's and early 2000's. Many new Bogleheads on the Forum today have never been exposed to his early work, including his digital journal Efficient Frontier (still available online, but not updated). Personally, his early writings in the 1990s did more to convince me of the wisdom of passive investing than any other source (for which I’m very grateful) — and much of this early work is still quite helpful and deserving of attention, I believe.

We’ll see how this goes and whether an occasional post on an early Classic Bernstein topic provides value to the Forum. Meanwhile, if any Forum members recall a specific, long-ago Bernstein insight that was especially key to your own grasp of passive investing, kindly let me know via PM, and it’ll be considered for the series. Thanks!

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This first post focuses on the two charts below from Mr. Bernstein’s early book, The Intelligent Asset Allocator (2000). Using a mix of six equity classes (S&P 500, U.S. small stocks, European stocks, Japanese stocks, Pacific Rim stocks and precious metals equity), plus five-year Treasury notes, Mr. Bernstein generated 800 random portfolios with different allocations of these seven asset classes, and then calculated the returns and risk (standard deviation) for each portfolio.

The chart on the left shows the returns/risk of all the random portfolios for the 5-year period from 1992-1996. The chart on the right shows all their returns/risk for the 27-year period from 1970-1996.

Image
Source: William Bernstein, The Intelligent Asset Allocator (2000)

EDITED TO ADD: The chart below shows the same data for the 27-year period above, but this time it’s color-coded by bond composition, changing color with every 10% change in bond allocation:
A few interpretations of his results:
  • a) Over short periods, one’s mix of assets matters a great deal, but become less important over long time periods.

    b) Over long time periods, the stock-to-bond ratio of one’s portfolio determines nearly all the return/risk, while the specific equity classes within the portfolio matter much less (as long as they're somewhat diversified).
Your thoughts?
Last edited by SimpleGift on Wed May 04, 2016 1:59 pm, edited 2 times in total.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by CoAndy »

Good read. Thank you for taking the time to post it. :beer
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by snarlyjack »

Simplegift,

I would be interested in learning about William Bernstein's
studies concerning the efficient frontier. I think it would
be quite interesting!

Thank you for posting the studies :)
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by saltycaper »

Simplegift wrote:
  • a) Over short periods, one’s mix of assets matters a great deal, but become less important over long time periods.

    b) Over long time periods, the stock-to-bond ratio of one’s portfolio determines nearly all the return/risk, while the specific equity classes within the portfolio matter very little (as long as they're somewhat diversified).
Your thoughts?
Unless I am misinterpreting something, statement "a" and the second part of statement "b" may be true on a percentage basis, but I don't think they are true on a dollar basis, and I care more about dollars than I do percentages over the long term.

That said, I have been directed to Dr. Bernstein's website many times when searching for information and have found it eminently helpful (and entertaining).
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by White Coat Investor »

My favorite Bernsteinism from his Efficient Frontier days is The Retirement Calculator from Hell Part III:

http://www.efficientfrontier.com/ef/901/hell3.htm
But even this method, advanced as it is, can still mislead. Let’s take a look at some output. Assume that you have a $1,000,000 nest egg with an expected 4.5% real return and a 10% standard deviation—about what a reasonable person can expect from a 60/40 globally-diversified stock/bond mix. Here are the 40-year success probabilities for the following before-tax monthly withdrawals:

[Insert table with Trinity Study like data]

The hard part, of course, is how to interpret this kind of output. Realize that these probabilities are merely an imperfect estimate of the investment risk you are taking. In other words, they assume the continuity of financial and political institutions over the period studied. Consider the implications of the above 97% success rate at a withdrawal of $2,500 per month ($30,000 per year). For this to be a useful estimate of your true chance of not running out of money, the "success rate" of your ambient political, economic, and military environment must be at least 97% over this 40-year period. Do you think that this is likely? Only if you are an historical illiterate (which, I’m afraid, subsumes many finance academics).

Let’s examine a small sampling of possible political, economic, and military failure modes:

The mildest scenario is that of catastrophic inflation, as experienced in Germany and Hungary in the 1920s or, more recently, in much of the developing world.

Political failures are slightly worse, since these threaten the basic human motivation to work and produce. The state, for whatever reason, can decide to confiscate your assets or, worse, society’s means of production. Anyone who judges this unlikely should turn on CNN during any G-8 or WTO conference.

Local military action. Probably the lowest-probability item on this list, but something to think about on other continents.

The Big One: Some deranged prime minister or colonel in central Russia, Pyongyang, or South Asia could let loose the four horsemen upon the planet.

So, think about what a 97% 40-year success rate means: the absence of all of the above for approximately the next 1,200 years. (A 97% success rate means a 3% failure rate; those 40 years divided by 0.03 is 1,200 years.) Ignore for a minute the uncertainties of the less-developed world and think only about the winners: Germany—in this century alone, three episodes of military and/or economic disaster, the first two associated with mass starvation. Japan—wartime devastation even worse than Germany’s. England—near brushes with disaster in 1812-1814 and in both world wars. And even the United States—repeated banking failures, civil war, and the near-bankruptcy of the Treasury in the 19th century. The near collapse of the capitalist economy in the 1930s. And oh yes, I almost forgot—the entire globe barely missed mass incineration in October 1962.

History’s best-case scenario was the Roman Empire, which survived more or less intact for about seven centuries (if you ignore the odd sackings of the capital after 200 A.D.).

A wildly optimistic historian might give us another few centuries of economic, political, and military continuity. Back-of-the-envelope, that’s about an 80% survival rate over the next 40 years. Thus, any estimate of long-term financial success greater than about 80% is meaningless.
I love to trot that out when we see Bogleheads talking about their 2.5% SWRs.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by staythecourse »

Simplegift wrote: b) Over long time periods, the stock-to-bond ratio of one’s portfolio determines nearly all the return/risk, while the specific equity classes within the portfolio matter very little (as long as they're somewhat diversified).
Your thoughts?
Simplegift,

I am not sure we can infer that just from these 2 graphs, can we? Those graphs, I believe, were mixed with different equities AND different ratio of 5 yr. treasuries and have no labels of which ones are which. If they were labelled and the first and second graphs BOTH showed the same general distribution of stock/ bond ratios along the EF then I think you comment stands, but not sure it does without labels to prove it. The theory would suggest so as the largest differences in returns and correlation coefficients are at the super asset class level of stocks and bonds and NOT at the sub asset equity level (US stocks vs. EM stocks). I just hate "assuming" based on theory when someone (Dr. Bernstein) already ran the numbers for us in this mini study.

I would love to find out if that theory holds up with the work Dr Bernstein did on these graphs. It would be great if Dr. Bernstein could elaborate in more detail what the prevailing reasons were that explained the different dispersion of returns of the different portfolios in the longer time horizon graph? In the short run I am assuming (maybe incorrect?) that the LARGE dispersion of different outcomes is likely due to if one was "lucky" in holding a higher % of the winners then someone else who was "unlucky" holding a higher % of the loser asset classes.

Good luck.

p.s. I love "journal club" style discussion so appreciate you throwing it out there for discussion.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by triceratop »

Jim,
I don't find Bernstein's Retirement Calculator From Hell example convincing, for a few reasons.

First, in the event of global catastrophe -- deranged South Asian dictator, 1962 crisis, etc. -- your portfolio does not matter as you will not be present to experience the unfortunate failure of the portfolio [Aside: you know a finance nerd when global thermonuclear war is considered and one thinks of its impact on the market portfolio].

Second, a number of those problems are solved by diversification, both across asset classes (internationally) and domicile (domicility?) of assets. In fact they're the textbook definition of why you diversify; to ignore the benefits of diversification as a way to find a failure case of a portfolio is peculiar. It simply shows the consequences of investing domestically and in local currencies (equities, bonds). There is a classic case of a writer being located abroad in Argentina during an inflation crisis and ending up quite wealthy as a result.

Third, the interpretation of a 97% success rate is not correct. To illustrate why, consider the following question: At the height of the Roman Empire, what was the likelihood of its survival for another 30 years? It surely had nothing to do with the inevitable decay of society over centuries, because that is on an irrelevant timescale.

His examples of the many fiscal crises experienced which are possibly repeatable are well taken. And to the extent to which humans understate risks generally and in our portfolios, I agree with Bernstein. I simply find some of the arguments a bit simplistic, if ultimately compelling.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by SimpleGift »

staythecourse wrote:
Simplegift wrote: b) Over long time periods, the stock-to-bond ratio of one’s portfolio determines nearly all the return/risk, while the specific equity classes within the portfolio matter very little (as long as they're somewhat diversified).
Your thoughts?
The theory would suggest so as the largest differences in returns and correlation coefficients are at the super asset class level of stocks and bonds and NOT at the sub asset equity level (US stocks vs. EM stocks). I just hate "assuming" based on theory when someone (Dr. Bernstein) already ran the numbers for us in this mini study.

I would love to find out if that theory holds up with the work Dr Bernstein did on these graphs.
You're right, I did assume that, in the long-term, 27-year returns chart (on the right in the OP), the differences at the super asset class level of stock and bonds determined the nice efficient frontier curve displayed in the chart (the higher the stock allocation, the higher the returns and risk) — and that the exact mix of equity sub-classes were unimportant in shaping this efficient frontier curve over long periods.

However, it’s possible I’ve misinterpreted the chart, as Mr. Bernstein was not exactly explicit about the full meaning of this little study. I’d certainly look forward to learning more from the source himself, if Bill was ever inspired to comment in these threads.
Last edited by SimpleGift on Sat Apr 30, 2016 12:48 am, edited 1 time in total.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by jjface »

Small differences in average return make a lot more difference over the long term. Compounding.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by diyfp »

Simplegift wrote:
A few interpretations of his results:

a) Over short periods, one’s mix of assets matters a great deal, but become less important over long time periods.
I haven't read the book but based just on these two graphs, I would say the exact opposite.

Over short periods (the left graph) there doesn't seem to be much of a relationship between y and x (annualized return and standard deviation). It's just a big cloud of dots.

Over long periods (the right graph) we start to see a pattern emerge: small values of x tend to go with small values of y and large values of x tend to go with large values of y.

So for short periods, no obvious relationship between standard deviation and annualized return.

For long periods:
Small standard deviation --> small annualized return
Large standard deviation --> large annualized return

That's all I can say based on the graphs without reading the book or seeing the data. :D
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by SimpleGift »

diyfp wrote:
Simplegift wrote:
A few interpretations of his results:

a) Over short periods, one’s mix of assets matters a great deal, but become less important over long time periods.
I haven't read the book but based just on these two graphs, I would say the exact opposite.
I believe Mr. Bernstein's point is that in the short-term (chart on left), one's portfolio returns are dominated by the asset classes that just happen to perform best or worst during that particular 5-year period. Over the longer 27-year period (chart on right), one's portfolio returns are mostly determined by the stock/bond allocation — as the returns of the six equity sub-classes tend to even out over long holding periods. At least this was my take from reading his short study.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by AlohaJoe »

Simplegift wrote:b) Over long time periods, the stock-to-bond ratio of one’s portfolio determines nearly all the return/risk, while the specific equity classes within the portfolio matter very little (as long as they're somewhat diversified).[/list]
Your thoughts?
I don't have any great references handy unfortunately, but I was under the impression that the ~20 years of financial research that has come out since Bernstein's book has come down largely (albeit with noted detractors) on the side of this not being the case and that we live in a multi-factor world.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by SimpleGift »

Upon reflection, it seems there might be a couple of less-direct inferences that can be drawn from Mr. Bernstein’s two charts in the OP:
  • a) Since the best performing asset classes (or factors) can’t be known in advance, it’s impossible to specify exactly what the best asset allocation will be in the coming decades. As long-term investors, all we can do is choose a portfolio allocation that meets our expected return and risk requirements (i.e., the stock/bond mix) and will do reasonably well under a variety of market conditions (diversification among asset sub-classes or factors) — and then quit worrying about it!

    b) Much more important than picking the “right” asset allocation is sticking with one’s chosen allocation through thick and thin. With a long enough time horizon, and a well-considered, consistent investment approach (to avoid behavioral mistakes), long-term investors have historically been rewarded.
Far from being simply theoretical, these portfolio principles have proven their worth in practice for many Bogleheads over decades (myself included).
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by skjoldur »

Interesting thread.

I would be very glad to see a series of threads on 'classic Bernstein.'
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by LadyGeek »

If the series gets going, I recommend adding the posts to the wiki. We already have pages for Grok's tips and Madsinger monthly reports.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by btenny »

Until I got and read Asset Allocation by Gibson back when I really did not understand the "market". I had been investing for 20+ years in stocks and bonds and mutual funds so this was really enlightening. I had read many books before that one but did not "get it" on how bonds/stock ratio really created a "portfolio" and controlled the probably returns. I learned a ton. I think a simple graph of returns versus bond stock ratios would add a lot to this discussion.

I have not read Bernsteins version on Asset Allocation but am sure all new or old investors should read one or more of these books. So yes a few threads on this subject would be good. Plus putting them in the Wiki would also be good.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by ANC »

What this points out to me is the need for many investors with short-time horizons to reduce the dispersion of likely results. Some go about this instinctively by de-emphasizing what they see as unstable investments (such as small cap and em stocks and anything with unhedged currency exposure) while over-emphasizing the ones they see as stable (such as bonds or dividend-paying domestic stocks).

Others see the best choice as keeping their relative allocations in all six classes stable, while raising their stakes in cash or like investments such as short-term bonds, including short-term TIPS. Many target date funds do this.

Since the investments dropped in the first approach could turn out to outperform the ones that are overweighted, I suspect Bernstein is leading us to the second choice. I hope future posts in this series shed more light on this.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by siamond »

Simplegift wrote:
  • a) Over short periods, one’s mix of assets matters a great deal, but become less important over long time periods.

    b) Over long time periods, the stock-to-bond ratio of one’s portfolio determines nearly all the return/risk, while the specific equity classes within the portfolio matter very little (as long as they're somewhat diversified).
Your thoughts?
diyfp wrote:I haven't read the book but based just on these two graphs, I would say the exact opposite.
Totally agreed. You get random results in the short term (no surprise), and you get clearly distinct results in the long run, depending on one's AA. A 1% difference in annualized returns translates in a LARGE difference at the end, dollar-wise.

The myth that only the stocks/bonds ratio matters (or mattered) is just that, a myth. Or to be more generous, this is an extremely coarse grain view of historical outcomes, but finer-grain considerations did matter too, because of compounding. Playing around with the Simba spreadsheet or the wonderful PortfolioCharts.com Web site makes the point very clear.

If I remember well, Dr Bernstein's point was to determine your stocks/bonds ratio first, then to refine the breakdown of each category, but I seriously doubt that he stated that the 2nd step didn't matter. After all, he's a big supporter of tilts, international exposure, etc.

PS. and please, let's speak of std-deviation here, as the charts rightfully do, as equating risk to std-deviation is really not quite applicable for many people...

PS2. I love the idea of such a series. Let's just try to stay focused on one topic at a time though.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by bertilak »

siamond wrote:
Simplegift wrote:
  • a) Over short periods, one’s mix of assets matters a great deal, but become less important over long time periods.

    b) Over long time periods, the stock-to-bond ratio of one’s portfolio determines nearly all the return/risk, while the specific equity classes within the portfolio matter very little (as long as they're somewhat diversified).
Your thoughts?
diyfp wrote:I haven't read the book but based just on these two graphs, I would say the exact opposite.
Totally agreed. You get random results in the short term (no surprise), and you get clearly distinct results in the long run, depending on one's AA. A 1% difference in annualized returns translates in a LARGE difference at the end, dollar-wise.

The myth that only the stocks/bonds ratio matters (or mattered) is just that, a myth. Or to be more generous, this is an extremely coarse grain view of historical outcomes, but finer-grain considerations did matter, a lot, because of compounding. Playing around with the Simba spreadsheet or the wonderful PortfolioCharts.com Web site makes the point very clear.

If I remember well, Dr Bernstein's point was to determine your stocks/bonds ratio first, then to refine the breakdown of each category, but I seriously doubt that he stated that the 2nd step didn't matter.

PS. and please, let's speak of std-deviation here, as the charts rightfully do, as equating risk to std-deviation is really not quite applicable for many people...
My understanding of the charts/graphs is:
  • The scattered graph (short time span) shows that the selection of specific investments matters a lot because there are a LOT of results and they show no pattern. Some are really good and some are really bad. This means that in the short term it matters what you pick. Even though the specific investments really matter, you, unfortunately have no way to predict the "right" ones for the short term. What DOESN'T matter is the relationship between risk and reward -- that relationship is all over the map, in the short term.
  • The graph with the nice pattern says that in the long run it matters little exactly which dot you pick -- you will be somewhere on the risk/reward curve. Unlike the short term, in the long term you have control over your return by adjusting the risk.
In other words I agree with the analysis in the first post, as quoted by Simplegift above.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by siamond »

Funny how one graph can lead to very different interpretations. I find quite hard to believe that Bernstein would agree with the 'myth' I referred to. Would be good to hear more about his own train of thoughts (in the book) when he provided such graphs.

I actually didn't read this precise book from Bernstein, but I wanted to do it for a while, so... I just ordered a used copy of it! Thanks for triggering me, Simplegift.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by SimpleGift »

^^^ You’ve stated the case so well, bertilak, that I wish your explanation was in the original post! Thank you.

In his text accompanying the two charts, Mr. Bernstein isn't entirely explicit about their meaning — so there's some room for interpretation, which makes for a good discussion and learning opportunity.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by HomoLudens »

Thank you for this post. I am pleasantly surprised. I thought that I was one of the few people reading the old, but still gold, Efficient Frontier journal. Now, I am happily disabused from this misconception. Aside from the practical articles that deal with asset allocation and retirement planning, I have three favorites:
1. "On Stuff": For those interested in commodities futures.After reading it, they will be less interested.
2. "The Dark Side of the Moon": This one was written in March 2008 if I am not mistaken. A classic Bernstein analysis with a premise, discussion, and conclusion. It was written at the height of the financial crisis. It's a delightful read. On the top of that, it refers to Pink Floyd's eponymous album whose last lines are " There is no dark side of the moon really. Matter of fact, it's all dark".
3. "The societal risk premium": For anyone interested in emerging and developed markets alike ,especially the former. I find the concept itself very useful. I think this article should be read in conjunction with Walter Russell Mead's book "God and Gold". Mead's book is much more philosophical, but both Bernstein and Mead, I suspect, will agree that we should never assume that emerging markets will follow the developmental trajectory of either Great Britain or the United States. If they assume the opposite, they will do it at their own peril.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by btenny »

I am not sure I agree. The 5 year chart shows me that you get lower return deviation with lower stock mixes and thus lower risk of having a really bad year or few years if your investment horizon is short (5 years). Thus low stock/high bond ratios gives you a much smoother "ride" and a more predictable retirement income but a lower probability of high returns in any given year.

But the 27 year chart shows me that I give up a ton of return to achieve this low short term risk. I give up 5% or more in returns that is compounded over a long time for this lower risk. So if I want to invest while I am young I need to take risk with high stock ratios to achieve good returns. It also show me I need to increase my stock ratios if I am old and investing for my grand kids future and I don't need the money in the short term.

I also think color coding the charts into 30/70 stocks/bonds in red, 50/50 in blue, and 70/30 in green and so forth would improve the visualization of the data dramatically.

Good Luck
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by staythecourse »

Simplegift wrote:In his text accompanying the two charts, Mr. Bernstein isn't entirely explicit about their meaning — so there's some room for interpretation, which makes for a good discussion and learning opportunity.
I may be imagining it, but I do believe Dr. Bernstein was very specific on his interpretation of the data. If I remember correctly, at the end of each chapter in "IAA" he has a synopsis of the important points in the chapter. Somehow I believe one of those bullet points at the end of that specific chapter mentions something about how in the long run folks can be off by quite a bit off in the exact % to each asset and still be close to the EF as the dispersion of returns are much closer on the long end of time horizon.

Will have to find a copy of my book, but if someone (ahem Simplegift) would be kind enough to post the bullet points at the end of that chapter I think it will shine some light on this discussion.

Good luck.

p.s. If Dr. Bernstein would be kind enough to shed some light on 1. His methodology and 2. What his inference of the results of these 2 graphs would be beyond appreciated. :D
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by diyfp »

staythecourse wrote:...but if someone (ahem Simplegift) would be kind enough to post the bullet points at the end of that chapter I think it will shine some light on this discussion.
Here you go. :beer

Image
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Peter Foley »

Thanks for posting. You provided a very good explanation of what the graph shows.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by ray.james »

SimpleGift, thank you for sharing this. I started with Ben Graham Intelligent investor and after 50 pages left investing; until Dr Bernstein single post on efficient frontier convinced me. His data driven observations triggered something in logical brain.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Peter G »

The three points I took from his text regarding the graphs are:
Over short periods your ‘precise stock allocation matters’ a lot, but less so over long periods
The graphs don’t show it, but the efficient frontier is made up of a different composition at different time periods, and you can’t know what next year’s will be.
As well, the graphs don’t show that changing your asset allocation is likely to lead to worse results than holding the same one.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by SimpleGift »

Thanks all for your feedback. There appears to be sufficient interest in a “Classic Bernstein” series of Forum posts and, as time allows in the year ahead, I’ll try to be equal to the responsibility — we’ll see how it develops.

A repeat request: If any Boglehead happens to recall a specific insight from Mr. Bernstein’s early writings in the 1990’s and early 2000’s (the Efficient Frontier journal days) that was especially key to your personal understanding of passive investing, please don’t hesitate to share that topic with me via a PM, so it can be considered for the series. All suggestions are appreciated!
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Bill Bernstein »

Thanks all for the kind words and observations.

I largely agree with all the points, except that it's certainly still possible to totally destroy the economic and social fabric of a society without largely annihilating the population: See "Middle East."

And I also disagree with my self of 19 years ago; as pointed out by one of the posters, a compounded small return difference makes a large total return difference, so the thinness of the cloud in the second graph is deceiving. The relative unimportance of allocation to risky assets makes sense only when they all have similar returns: See "Japan."

Best,

Bill
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by staythecourse »

diyfp wrote:
staythecourse wrote:...but if someone (ahem Simplegift) would be kind enough to post the bullet points at the end of that chapter I think it will shine some light on this discussion.
Here you go. :beer

Image
Much thanks. This is full evidence my memory is quite faulty in relation to my previous post. I will have to see why I thought what I thought. Maybe I confused it with somewhere else in the book or maybe just making it up??

Either way much thanks.

Good luck.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by staythecourse »

Bill Bernstein wrote:Thanks all for the kind words and observations.

I largely agree with all the points, except that it's certainly still possible to totally destroy the economic and social fabric of a society without largely annihilating the population: See "Middle East."

And I also disagree with my self of 19 years ago; as pointed out by one of the posters, a compounded small return difference makes a large total return difference, so the thinness of the cloud in the second graph is deceiving. The relative unimportance of allocation to risky assets makes sense only when they all have similar returns: See "Japan."

Best,

Bill
Much thanks for shedding some light on your current views. It, of course, makes sense that small differences lead to large CAGR differences over time.

Couple of questions:
1. I am assuming (hopefully correct) that on graph 2 the higher the % allocated to stocks the better the return per unit of risk a portfolio had. If that is true, I am trying to figure out if that is DEFINETLY true or because you used 5 yr. treasuries as your only bond allocation which are pretty stable over time in relation to S.D. Using any asset class that is so stable in S.D. will cause a EF dominated by its more volatile components so no surprise they sort of line up based on equities. I wonder what the results would be if one added something a bit more volatile bonds like HY bonds or EM bonds which may approximate closer to the returns of the poorer performing equity asset classes? Wonder if that would give us the same EF of the random portfolios where higher the equities higher the risk/ adjusted returns.

2. If the EF moving up to the right is dominated by equities then what were the biggest determinants? % of equity to bond? How many equity assets that were held (6 vs. 2 for example)? Holding higher % of the winners then the losers over the time period?

3. Have you done the same mini study up to the current to see if the results and their conclusion/ inferences are any different then the original set of graphs?

Much thanks.

Good luck.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Riprap »

Bill Bernstein wrote:I largely agree with all the points, except that it's certainly still possible to totally destroy the economic and social fabric of a society without largely annihilating the population: See "Middle East."
Venezuela too.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Bill Bernstein »

In the case of the example published in 1997, yes, there's a very close relationship between the % overall stocks and return, both at the 27-year and 5-year horizons.

But this is just one time-dependent example. Were you to do this exercise today, it would be quite easy to come up with portfolios with an inverse relationship by going heavy on Japan stocks vs 5-year notes, since the latter had higher returns.

With all due respect, I think folks are being a bit too literal about the precise appearance of the "clouds." These are merely demonstrations of a theoretical principle by exploring one of an infinite number of possible investment universes: "Past performance is no guarantee yadda yadda . . . "

I.e., you can *expect* a positive slope between risk and return. But the expected is not always what you get.

Bill
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by longinvest »

Bill Bernstein wrote: I.e., you can *expect* a positive slope between risk and return. But the expected is not always what you get.

Bill
Dr. Bernstein,

Thanks for the reminder!
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by sschullo »

triceratop wrote:Jim,
I don't find Bernstein's Retirement Calculator From Hell example convincing, for a few reasons.

First, in the event of global catastrophe -- deranged South Asian dictator, 1962 crisis, etc. -- your portfolio does not matter as you will not be present to experience the unfortunate failure of the portfolio [Aside: you know a finance nerd when global thermonuclear war is considered and one thinks of its impact on the market portfolio].

Second, a number of those problems are solved by diversification, both across asset classes (internationally) and domicile (domicility?) of assets. In fact they're the textbook definition of why you diversify; to ignore the benefits of diversification as a way to find a failure case of a portfolio is peculiar. It simply shows the consequences of investing domestically and in local currencies (equities, bonds). There is a classic case of a writer being located abroad in Argentina during an inflation crisis and ending up quite wealthy as a result.

Third, the interpretation of a 97% success rate is not correct. To illustrate why, consider the following question: At the height of the Roman Empire, what was the likelihood of its survival for another 30 years? It surely had nothing to do with the inevitable decay of society over centuries, because that is on an irrelevant timescale.

His examples of the many fiscal crises experienced which are possibly repeatable are well taken. And to the extent to which humans understate risks generally and in our portfolios, I agree with Bernstein. I simply find some of the arguments a bit simplistic, if ultimately compelling.
I agree. World wide diversification will address much of the risk of individual countries. IMHO, resorting to Armageddon scenarios doesn't do much good in reminding people that its good old fashion uncertainty we have to keep in mind no matter what we do. Uncertainty will always be there, no matter what our asset allocation, stock bond split, yadda, yadda, or what happens in Japan, or the Middle East.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Tyler9000 »

Simplegift wrote: A few interpretations of his results:
  • a) Over short periods, one’s mix of assets matters a great deal, but become less important over long time periods.

    b) Over long time periods, the stock-to-bond ratio of one’s portfolio determines nearly all the return/risk, while the specific equity classes within the portfolio matter very little (as long as they're somewhat diversified).
Your thoughts?
Great topic, Simplegift. Bernstein's work has been hugely influential for me and I'm happy to see it continue to benefit others.

A) When you study the distrubution of returns looking at all possible timframes (since 1972, source data via the Simba spreadsheet), it's immediately evident that short-term returns are more uncertain than long-term returns. It's not that asset allocation does not matter, but trying to predict where any portfolio will fall in that range is extremely difficult.

Image

An interesting side observation is that "long-term" is quantifiably different for different portfolios. Some portfolios approach their long-term trend more quickly than others. Play with this calculator for a little while and you'll see what I mean.

B) As Siamond points out, the overall equity percentage doesn't always tell the full risk/return story for widely diversified portfolios. Inspired by Bernstein's work, I expanded his analysis you reference in the OP to study every possible combination of up to 5 of the 26 assets in the Simba spreadsheet (over 83k combinations). I also did it from a start-date-independent perspective and took a slightly more tangible approach to "risk". You can read more about the methodology and surf the cloud of results here. IMHO, the results are very interesting.

Image

Obviously not all of the lazy portfolios on the list are equally weighted, but seeing where they fit in the cloud is a nice reference. Details for each can be found here.

Average returns can sometimes be deceiving depending on the data set, but only looking at the worst return situation for each individual portfolio really levels the playing field and highlights the risks investors are worried about. What I personally take away from this is that smart asset allocation is more sophisticated than simply adding up the percentage of stocks, especially once you account for uncertainty. Note that the portfolio highlighted at the bottom left is 100% stocks, while the one at the top right is only 40% stocks. An investor who chooses a more consistent portfolio that meets their needs even in its least flattering light will generally be happier in the long run, and by not being tempted to switch portfolios at the wrong time they will likely be wealthier as well.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by SimpleGift »

^^^ Superb analysis and visual presentation, Tyler. Thank you for sharing it.

Since we can’t know in advance exactly which asset classes and factor premiums will be the ones that outperform in the decades ahead, your summary advice is also excellent:
Tyler9000 wrote:An investor who chooses a more consistent portfolio that meets their needs even in its least flattering light will generally be happier in the long run, and by not being tempted to switch portfolios at the wrong time they will likely be wealthier as well.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by saltycaper »

Tyler9000 wrote: A) When you study the distrubution of returns looking at all possible timframes (since 1972, source data via the Simba spreadsheet), it's immediately evident that short-term returns are more uncertain than long-term returns.
This part is not true. Well, it is true if you look at uncertainty of annualized returns, but that's not what matters most. What really matters is total return, and that uncertainty increases over the long term. I believe that is why Dr. Bernstein notes the second graph in the original post is deceiving.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by garlandwhizzer »

Simplegift wrote:

a) Since the best performing asset classes (or factors) can’t be known in advance, it’s impossible to specify exactly what the best asset allocation will be in the coming decades. As long-term investors, all we can do is choose a portfolio allocation that meets our expected return and risk requirements (i.e., the stock/bond mix) and will do reasonably well under a variety of market conditions (diversification among asset sub-classes or factors) — and then quit worrying about it!

b) Much more important than picking the “right” asset allocation is sticking with one’s chosen allocation through thick and thin. With a long enough time horizon, and a well-considered, consistent investment approach (to avoid behavioral mistakes), long-term investors have historically been rewarded.
Great and thoughtful post, Simplegift, thanks. I think these two points provide an excellent approach to investing. Investors tend to agonize constantly over finding the magic fund or etf and creating the perfect alpha generating portfolio. In the long run following these two principles works better for most of us.

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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by btenny »

Reason why I tell my kids to do 60/40 even at a younger age. They will stay the course and stay invested through thick and thin.

Good Luck
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Tyler9000 »

saltycaper wrote:
Tyler9000 wrote: A) When you study the distrubution of returns looking at all possible timframes (since 1972, source data via the Simba spreadsheet), it's immediately evident that short-term returns are more uncertain than long-term returns.
This part is not true. Well, it is true if you look at uncertainty of annualized returns, but that's not what matters most. What really matters is total return, and that uncertainty increases over the long term. I believe that is why Dr. Bernstein notes the second graph in the original post is deceiving.
Good point -- you're right. Annualized returns get more certain the longer the timeframe you consider, but portfolio values get more uncertain the longer out you look.

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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Riprap »

Tyler9000 wrote:
saltycaper wrote:
Tyler9000 wrote: A) When you study the distrubution of returns looking at all possible timframes (since 1972, source data via the Simba spreadsheet), it's immediately evident that short-term returns are more uncertain than long-term returns.
This part is not true. Well, it is true if you look at uncertainty of annualized returns, but that's not what matters most. What really matters is total return, and that uncertainty increases over the long term. I believe that is why Dr. Bernstein notes the second graph in the original post is deceiving.
Good point -- you're right. Annualized returns get more certain the longer the timeframe you consider, but portfolio values get more uncertain the longer out you look.

Image
I think some Bogleheads are familiar with the work of John Norstad who presented the same findings. I guess it's sort of a Boglehead classic paper. The chart at the bottom shows a pretty wide range of outcomes.

http://www.norstad.org/finance/risk-and-time.html
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by afan »

I have not read Bernstein's post, so these comments are only about the two graphs pulled from his longer report.Those graphs plot return vs volatility, not vs percent stocks, or composition of the stock portfolios. So all one can make of the graphs is that the short term showed little correlation between volatility and return, while the longer term revealed high correlation between them. That, alone, does not tell us how one got to a particular point on the volatility axis. It could be a large weighting of TSM. It could be an even larger weighting of low volatility stock, or a small weighting of high volatility stock. Since we don't know the composition of the portfolios at each point, we should not assume that we can interpret the volatility as a simple reflection of percent stock.

I interpret the graphs as showing that returns are noisy, so you need a lot of data to find relationships. That is always true of noisy data. But these two graphs provide no indication of the effects of tilting vs a TSM approach over short or longer horizons. The graphs do not plot portfolio composition, so one should not assume we know which portfolios are where on either graph.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Oliver »

Riprap wrote:
Bill Bernstein wrote:I largely agree with all the points, except that it's certainly still possible to totally destroy the economic and social fabric of a society without largely annihilating the population: See "Middle East."
Venezuela too.
Argentina 100 years of decline

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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by SimpleGift »

afan wrote:Those graphs plot return vs volatility, not vs percent stocks, or composition of the stock portfolios. So all one can make of the graphs is that the short term showed little correlation between volatility and return, while the longer term revealed high correlation between them. That, alone, does not tell us how one got to a particular point on the volatility axis. It could be a large weighting of TSM. It could be an even larger weighting of low volatility stock, or a small weighting of high volatility stock. Since we don't know the composition of the portfolios at each point, we should not assume that we can interpret the volatility as a simple reflection of percent stock.
Just happened to run across some further analysis by Mr. Bernstein that addresses your concern. The chart below shows the same data for the 27-year period in the OP, but this time it’s color-coded by bond composition, changing color with every 10% change in bond allocation:
Bottom line: One’s overall commitment to stocks versus bonds is the most important asset allocation decision, while one’s mix of equity asset classes (or factor premiums) is relatively less so — as long as they are reasonably diversified.

PS. For the sake of clarity, I've edited the OP and added this chart to the text.
Last edited by SimpleGift on Wed May 04, 2016 4:11 pm, edited 2 times in total.
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Re: Classic Bernstein — Asset Allocation and Time Horizon

Post by Dulocracy »

I very much appreciate the article. I especially enjoyed the, "don’t spend it all in one place." Of course, when I am getting a success of returns, I am asking what my chances of success are, presuming the 4 horsemen do not appear. If they do, this is not the appropriate planning method for that scenario.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
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Re: Classic Bernstein 1 — Asset Allocation and Time Horizon

Post by LadyGeek »

A complete list of Simplegift's series is now in the wiki: Classic Bernstein
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