Rewards of Multiple Asset Class Investing

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Random Walker
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Rewards of Multiple Asset Class Investing

Post by Random Walker » Fri Jan 20, 2017 12:44 pm

Image

This is one of my favorite diagrams from all my investing reading. It is from Roger Gibson's Asset Allocation. It is entitled The Rewards of Multiple Asset Class Investing. The specific asset classes are not what is significant, the improved results with more asset classes is significant. Although the diagram shows only 4 asset classes, the concept can be easily extrapolated to other asset classes, styles, factors. The point is that weakly correlated, non correlated, negatively correlated sources of return combine to bring the portfolio geometric return closer to the average annual return of its components. Volatility is a portfolio killer, and dampening volatility by diversification across diverse sources of return is the winning game.
In Reducing The Risk Of Black Swans, Larry Swedroe describes improved portfolio efficiency in terms of decreased standard deviation, improved Sharpe ratio, decreased fat tails. In Asset Allocation, Roger Gibson describes improved portfolio efficiency in terms of Sharpe ratio and bringing the geometric return closer to weighted average annual return of portfolio components by dampening volatility. I believe these are just different views of the same thing.
I think diversifying across multiple sources of return is the winning game. The two most influential short reads on my investing are posted below. The first is a short paper by Gibson which effectively summarizes his book. The second is Larry's Effective Diversification in a 3 Factor World.

http://www.amcham-shanghai.org/amchampo ... esting.pdf
http://thebamalliance.com/pdfs/Effectiv ... wedroe.pdf

Hope this helps and interested to read others thoughts.

Dave

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Random Walker
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Re: Rewards of Multiple Asset Class Investing

Post by Random Walker » Sat Jan 21, 2017 10:34 am

Just thought I'd give my own post a bump :-). I really think the above diagram is amazing. Seeing how much more likely a 4 asset class portfolio is to do well than a portfolio with fewer asset classes, hard not to get excited about diversification across asset classes, styles, factors. Of course, I expect there is decreasing marginal benefit and increasing cost with each additional more esoteric addition to portfolio.

Dave
Last edited by Random Walker on Sat Jan 21, 2017 11:20 am, edited 1 time in total.

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Johnnie
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Re: Rewards of Multiple Asset Class Investing

Post by Johnnie » Sat Jan 21, 2017 11:17 am

I'm putting the last touches on transitioning into Merriman's Ultimate Buy-and-Hold Equity portfolio, with 10% each in S&P500, SC, LCV, SCV, REITS, ILC, ISC, ILCV, ISCV and EM.

It's criticized by Bogle and Bogleheads for being complicated, and they're right: regular normal people would struggle and likely need to pay someone to do it.

Not many "regular normal" people here though! As a wonky investment nerd who's a decent excel-driver this process has been lots of fun for me. I know we're not supposed to peek, but I've been fascinated watching the "cross-rates" as the different asset classes respond to whatever is moving markets at any given moment. The diversification is awesome - there have been very few days or weeks when everything moved in the same direction.

Merriman makes a strong case that in the past this mix meaningfully improved overall returns with a negligible increase in SD. He issues the same warning we hear all the time here, PPINGOFR. ("There is no risk in the past" as he puts it.)

No one knows what the future will bring, but this portfolio makes me feel I've taken all reasonable steps to get the best possible return for the risk. I don't get that feeling with Total Market.

I'm four or five years from retirement, if it's up to me.
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TheTimeLord
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Re: Rewards of Multiple Asset Class Investing

Post by TheTimeLord » Sat Jan 21, 2017 12:13 pm

Taking a shot in the dark here but this just looks like a case of adding a high volatility asset class like commodities and depending on a rebalancing premium for returns. Because D seems to be the key to outperformance in a portfolio but it is the worse performing class. So the addition of a high volatility asset class not multiple asset classes or ABCD would have won.

Just taking a guess looking at the pattern.
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stlutz
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Re: Rewards of Multiple Asset Class Investing

Post by stlutz » Sat Jan 21, 2017 12:54 pm

Looks like two very different concepts are getting mixed here.

The chart in the OP was focused on mixing different asset classes. Stocks and commodities are very different things from one another. Subsequent posts have been focusing on the benefits of concentrating one's holdings in the best performing assets within each asset class.

Owning the best securities will always give you the best returns. Diversification will make it more likely that you'll get the benefits that are available from taking X amount of risk.

selftalk
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Re: Rewards of Multiple Asset Class Investing

Post by selftalk » Sat Jan 21, 2017 1:29 pm

Johnnie, if you go to the lazy portfolio on marketwatch.com you will see the Merriman portfolio ( Fund Advice) with maybe 12 different items or so in it and it has yet to perform better than the Second Graders portfolio consisting of the total stock market, the total bond market and the total international market in various time periods. It`s only 3 funds that beat consistently the portfolios of much numerous other asset classes in other portfolios. I hate to burst your bubble but you simply do not need many different funds / etfs.

staythecourse
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Re: Rewards of Multiple Asset Class Investing

Post by staythecourse » Sat Jan 21, 2017 1:31 pm

Interestingly, "Asset Allocation" by Roger Gibson is the very first book I pulled off the public library rack to start learning about investing. Thank god I picked that one then Jim Cramer or some other nonsense.

It is a great chart, but wanted to deviate this thread just a bit (if okay) and see if someone who has a few minutes on their hands would like to update the chart from the end of that time period to the current time period using the same asset classes. Interested to see what discussion we can have about the differences between the two. Think that will stimulate more conversation on this chart. If i remember correctly the asset classes are: US stocks, Internatinoal stocks, commodities, and REIT. Likely from 1972 to the time of that publication.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

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Portfolio7
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Re: Rewards of Multiple Asset Class Investing

Post by Portfolio7 » Mon Jan 23, 2017 3:34 pm

It seems to me that diversification can be a great thing, but also that diversification doesn't always appear to provide a 'free lunch'

My portfolio is a slice and dice that has worked well in the past. I've de-optimized it from a 'historical diversification' standpoint, to attempt to bullet proof the portfolio as much as possible. No matter what asset mix I choose, I'm vulnerable to some risk, and protecting against one risk will open me up to other risks.

It seems likely that the risks of the next 50 years will be different in scope and duration vs the past 50 years.

It's a balancing act, not just against the magnitude, but also the likelihood of various risks. Optimizing past diversification qualities is just a starting point (a useful one) to gain an understanding of past trends. I think it's important to keep in mind, however, that the future is something else entirely.
"An investment in knowledge pays the best interest" - Benjamin Franklin

heyyou
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Re: Rewards of Multiple Asset Class Investing

Post by heyyou » Tue Jan 24, 2017 12:11 am

protecting against one risk will open me up to other risks.
Amen to that.
I like seeing that what worked better until 2009, is not what is doing well now. Broad diversification is needed over longer periods to capture whichever assets are doing well.

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Random Walker
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Re: Rewards of Multiple Asset Class Investing

Post by Random Walker » Tue Jan 24, 2017 12:26 am

People speak of tilting as taking on additional risk. I think of it more as diversifying across types of risk; or more accurately diversifying across different sources of return. For me it is a small leap to extrapolate from the 4 asset classes in the above diagram to multiple factors instead of single market beta factor.

Dave

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Tyler9000
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Re: Rewards of Multiple Asset Class Investing

Post by Tyler9000 » Tue Jan 24, 2017 1:23 am

Great post, Random Walker. I love this topic! That really is an interesting chart, and I appreciate the references.

Here's a similar one of my own making that you'll probably also find interesting. It maps my version of risk and return for every possible equally weighted combination of up to 5 assets out of 26 possible options (covering US stocks, international stocks, bonds, and other unique assets like commodities, gold, and REITs). That's over 83,000 portfolios on one chart.

Image

Obviously the listed portfolios are not all equally-weighted, but they provide nice reference points in the cloud.

Supporting your point about the benefit of multiple asset classes, one of the most interesting takeaways to me is that maximizing your risk adjusted return is not just about using multiple funds but using different types. For example, look at the red square -- that's the total US stock market (VTI). The light purple cloud represents all possible portfolios consisting only of stocks, regardless of the stock index. They cover all factor funds and international options. Interestingly, diversifying stock funds does generally follow the old mantra of increasing both risk and return over simply buying a cap-weighted total market index. In contrast, by mixing in other types of non-stock assets you can often achieve similar returns but with a fraction of the downside risk. In order to move into the superior risk-adjusted gray points to the right, however, you have to diversify out of stocks. Bonds and other diverse assets are critical components to any efficient portfolio.

After playing with this data for a while, I totally agree with your conclusion that there is great benefit to diversifying funds across different asset classes and also with your gut instinct that at some point you start to get diminishing returns for further diversification. If you study the portfolios to the far right, you can see a trend that it's not so much about total quantity of funds but about covering all of your economic bases.

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Random Walker
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Re: Rewards of Multiple Asset Class Investing

Post by Random Walker » Tue Jan 24, 2017 10:30 am

Tyler9000,
Great addition. Some serious work went into that chart. I like the idea of plotting risk as "worst yrpear since 1972". There are multiple ways to define risk and I think looking at SD alone doesn't give a full sense at all of what risk really is.
In your chart the promised land is in the north east corner; seems the portfolios closest to that territory share the common theme of leaning towards risk parity portfolios.

Dave

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Random Walker
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Re: Rewards of Multiple Asset Class Investing

Post by Random Walker » Mon Sep 18, 2017 11:09 pm

Thought I would pull up this old post of mine on the rewards of multiple asset class investing. Sorry, the link to Gibson's short essay no longer works, but his diagram alone is very worthwhile. Really like extending his concept to many more uncorrelated sources of return to improve portfolio efficiency.

Dave

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billthecat
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Re: Rewards of Multiple Asset Class Investing

Post by billthecat » Mon Sep 18, 2017 11:21 pm

Isn't this the premise of services like Schwab's Intelligent Portfolio robo-advisor?
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garlandwhizzer
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Re: Rewards of Multiple Asset Class Investing

Post by garlandwhizzer » Tue Sep 19, 2017 2:10 pm

Great post, Random Walker. It makes a very important point in favor of wide diversification off asset classes in a portfolio.

Garland Whizzer

blindpuppy
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Re: Rewards of Multiple Asset Class Investing

Post by blindpuppy » Tue Sep 19, 2017 4:03 pm

This is a very intriguing topic. As a simpleton investor, I have nothing particularly constructive to add. However I do wonder what the above suggests for the average Boglehead with a 3 fund +/- tilt portfolio.

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Portfolio7
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Re: Rewards of Multiple Asset Class Investing

Post by Portfolio7 » Tue Sep 19, 2017 5:57 pm

blindpuppy wrote:
Tue Sep 19, 2017 4:03 pm
This is a very intriguing topic. As a simpleton investor, I have nothing particularly constructive to add. However I do wonder what the above suggests for the average Boglehead with a 3 fund +/- tilt portfolio.
I think of a 3-Fund portfolio as the go-to approach for investing. It seems like the ultimate skeptic's portfolio, for those who believe only the most supportable investing wisdom. It's simple. It's a very high probability bet (relative to anything else) to derive a result superior to most investors over the long run. I believe the above information should have no implication for the average Boglehead.

I think other investment approaches attempt to take advantage of market insights that may or may not be real, may or may not continue. Some of them, like factor investing, appear promising, and may explain some of the results in the chart. I believe that none of these approaches are guaranteed to beat a 3 funder over the long term. I also think there is no guarantee that going forward, those market segments will continue to outperform. Some people believe they will, for various reasons, but it's an additional risk on top of the Market Risk you take in a 3-Funder (unless perhaps you really believe in the FF Factors.)
"An investment in knowledge pays the best interest" - Benjamin Franklin

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Random Walker
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Re: Rewards of Multiple Asset Class Investing

Post by Random Walker » Tue Sep 19, 2017 9:46 pm

Blindpuppy,
I agree with about 1/2 of what Portfolio7 wrote. I agree that costs are certain and something we can control. So it's hard to go wrong with a simple 3 fund portfolio as a starting point. BUT what is in the diagram above is also irrefutable. The addition of weakly, non, negatively correlated assets to a portfolio do improve its efficiency. Portfolio7 is certainly correct in saying that the potential benefits of other sources of return are not at all guaranteed. The bet on the single market factor is not at all guaranteed either. For Bogleheads, the above concept is very important and actionable. Portfolios start with equities. The cheapest and best diversifier is bonds. Next an investor may go to the next level of complexity by tilting to the factors: size, value, Momentum, profitability. After that the investor may add more esoteric stuff like alternative lending, reinsurance, Style Premia. As additional levels of complexity are added, the marginal benefit probably decreases and the marginal cost certainly increases. What a potential new addition does for a portfolio depends on its expected return, volatility, correlations to other portfolio components, and of course costs. Each investor needs to decide for himself where to draw the line on costs for the sake of a more efficient portfolio.
I do think a typical 3 Fund TSM Boglehead should have an appreciation for the above chart and realize that he is making a bet on a single factor on the equity side, market beta. He is minimizing costs, which is very very important, but he should nonetheless know the implicit tradeoffs he is making.

Dave

dcabler
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Re: Rewards of Multiple Asset Class Investing

Post by dcabler » Wed Sep 20, 2017 8:04 am

Tyler9000 wrote:
Tue Jan 24, 2017 1:23 am
Great post, Random Walker. I love this topic! That really is an interesting chart, and I appreciate the references.

Here's a similar one of my own making that you'll probably also find interesting. It maps my version of risk and return for every possible equally weighted combination of up to 5 assets out of 26 possible options (covering US stocks, international stocks, bonds, and other unique assets like commodities, gold, and REITs). That's over 83,000 portfolios on one chart.

Image

Obviously the listed portfolios are not all equally-weighted, but they provide nice reference points in the cloud.

Supporting your point about the benefit of multiple asset classes, one of the most interesting takeaways to me is that maximizing your risk adjusted return is not just about using multiple funds but using different types. For example, look at the red square -- that's the total US stock market (VTI). The light purple cloud represents all possible portfolios consisting only of stocks, regardless of the stock index. They cover all factor funds and international options. Interestingly, diversifying stock funds does generally follow the old mantra of increasing both risk and return over simply buying a cap-weighted total market index. In contrast, by mixing in other types of non-stock assets you can often achieve similar returns but with a fraction of the downside risk. In order to move into the superior risk-adjusted gray points to the right, however, you have to diversify out of stocks. Bonds and other diverse assets are critical components to any efficient portfolio.

After playing with this data for a while, I totally agree with your conclusion that there is great benefit to diversifying funds across different asset classes and also with your gut instinct that at some point you start to get diminishing returns for further diversification. If you study the portfolios to the far right, you can see a trend that it's not so much about total quantity of funds but about covering all of your economic bases.
Very cool chart. Question - the description says that the data has "up to 5 assets". Would be interesting to break it down tinto separate charts for 2, 3, 4 and 5 assets to more clearly see how there might be diminishing returns for adding more assets. I've done something similar in the past, but I didn't restrict it to equal weighting, but I think I did it with a Monte Carlo designed AA. Of course you quickly get some pretty nonsensical AA's (0.1% of an asset for example) unless you restrict the minimum % of an asset to 5 or 10%, etc. Fun stuff!

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Random Walker
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Re: Rewards of Multiple Asset Class Investing

Post by Random Walker » Wed Sep 20, 2017 9:32 am

Dcabler,
I think some of the answer to your question regarding 2,3,4,5 assets is implicitly in the original chart I posted. The higher compounded return for a given volatility reflects minimizing the effects of really bad bear markets. Volatility really sucks returns out of portfolios. In the extreme case, one has to make 100% return to recover from 50% loss.

Dave

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Tyler9000
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Re: Rewards of Multiple Asset Class Investing

Post by Tyler9000 » Wed Sep 20, 2017 4:16 pm

dcabler wrote:
Wed Sep 20, 2017 8:04 am
Very cool chart. Question - the description says that the data has "up to 5 assets". Would be interesting to break it down tinto separate charts for 2, 3, 4 and 5 assets to more clearly see how there might be diminishing returns for adding more assets. I've done something similar in the past, but I didn't restrict it to equal weighting, but I think I did it with a Monte Carlo designed AA. Of course you quickly get some pretty nonsensical AA's (0.1% of an asset for example) unless you restrict the minimum % of an asset to 5 or 10%, etc. Fun stuff!
That's an interesting idea. Varying percentages of so many options requires more horsepower than I have access to, but looking at charts with different numbers of assets (similar to Random Walker's chart) is doable. It will take a little time, but I'll see what I can do.

dcabler
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Re: Rewards of Multiple Asset Class Investing

Post by dcabler » Wed Sep 20, 2017 4:19 pm

Random Walker wrote:
Wed Sep 20, 2017 9:32 am
Dcabler,
I think some of the answer to your question regarding 2,3,4,5 assets is implicitly in the original chart I posted. The higher compounded return for a given volatility reflects minimizing the effects of really bad bear markets. Volatility really sucks returns out of portfolios. In the extreme case, one has to make 100% return to recover from 50% loss.

Dave
Sorry Random Walker - I was referring to Tyler9000's chart, not yours. I should have been clear.

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packer16
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Re: Rewards of Multiple Asset Class Investing

Post by packer16 » Wed Sep 20, 2017 6:13 pm

I agree that there is a reward but you have to count the cost. Is reducing portfolio volatility really worth reducing expected return when you can use withdraw strategies to do this for you? You really need to look at the whole picture accumulation/withdraw strategies in combination with asset returns to determine whether additional asset classes (esp the volatile & low returning ones, like commodities) are really needed. With factors whose basis is in correlation & not economics (pretty much all of them) you also need to make the assessment if you are willing to bet on this correlation continuing. You also need to determine if the implementation of factors through indexes & funds represents true factors or more index hugging.

Packer
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