Thinking About Adding Risk? Read This First On Smart Asset Allocation - Interesting article

Summary

• Investors considering increasing portfolio risk should first consider asset allocation breakevens

About this time in a market cycle, after several years of strong stock market returns, there is a tendency for investors to become more tolerant of risk. One may find his or herself questioning the reasoning behind their current asset allocation and strongly considering adding more stocks and other "risk" assets to their portfolio.

Instead of writing about how to select an appropriate asset allocation, we want to bring to light a few important points that often go overlooked when changing an asset allocation, specifically when adding more risk to a portfolio.

The table above contains the historical results of large U.S. stocks, U.S. bonds, and portfolios containing varying percentages of each from 1926 to 2014.

A few things should stand out. An all-stock portfolio generated the highest return, compounding capital at nearly 10% per year. This higher return came with much greater volatility: stocks experienced declines in greater frequency and in far greater severity than bonds.

Although stocks handily outperformed bonds over the entire 88 year history, there were periods where stocks underperformed for many years. Investments made in stocks during the late 1920s, mid 1960s, and late 1990s failed to beat bonds for stretches of ten or more years. About 20% of the time since 1926, stocks have underperformed bonds for 5-year stretches. So despite stocks' higher average returns, the benefits from adding exposure have at times required lengthy time horizons to pay off. How then, should an investor approach raising their allocation to risk?

Asset Allocation

Above are the expected returns to different asset allocations assuming future returns that are consistent with historical returns. It is not our forecast of future asset allocation returns (we think returns will be lower). But for the sake of this discussion, starting with average returns removes any potential bias.

Let's start with an asset allocation of 60% stocks and 40% bonds. Assuming annual stock returns of 10.0% and bond returns of 5.0% (returns consistent with history), a 60/40 portfolio has an average expected return of about 8.0% per year. What if we wanted to increase the portfolio's exposure to stocks to 80%? An 80/20 portfolio would have an average annual expected return of 9.0%.

Should an investor make the switch to gain the extra 1.0% per year? Only if they have at least a decade to invest.

It might surprise you, but a passive* investor needs a time horizon of at least 10 years to have a high likelihood of outperforming their 60/40 portfolio when moving to an 80/20 portfolio. Why? Because stocks fall precipitously once or twice a decade.

Recessions and bear markets–both of which have historically occurred once or twice a decade–wipe out many years of the excess returns that are hoped to accompany the more aggressive asset allocations. During recession-driven bear markets, stocks have on average fallen about 30% and bonds have risen about 5%. In a typical recession, a 60/40 portfolio would be down about 16.0%, while an 80/20 portfolio would be down approximately 23.0%. Because losses have a magnified impact, raising risk in an asset allocation requires fairly long time horizons to ensure success (to overcome a future bear market setback). Here's the math.

If a $100,000 60/40 portfolio compounds at 8.0% per year for 9 years it will have risen to just shy of $200,000. An 80/20 portfolio will have risen to $217,000 (9.0% per year). If a typical bear market then immediately began, the 80/20 portfolio would decline to $167,000 (down 23%) while the 60/40 portfolio would fall to $168,000 (down 16%). Under these return assumptions, an investor in an 80/20 portfolio will have less money during a typical bear market than a 60/40 investor, should the decline occur any time before the 10th year.

The grid below contains the number of years necessary to ensure that a shift up the risk spectrum is rewarded if future returns are the same as historical returns.

Asset Allocation

What if we think future returns are going to be different than historical returns? Recommended time horizons change.

Stocks have risen over 21.0% per year since the bottom in 2009. Bonds are up a mid-single-digit percentage. What if the strong returns continue? What are breakevens if stocks return 15.0% per year and bonds 3.0% per year?

Under this bullish forecast, an investor still needs an investment horizon of five years before it makes sense to shift from a 60/40 portfolio to an 80/20 portfolio. If a bear market occurs any time before five full years of 15.0% stock returns and 3.0% bond returns, it would have been better to maintain the 60/40 portfolio.

What if future returns are instead below historical averages? If returns over the next decade average 6.0% for stocks and 3.0% for bonds, then an investor's required time horizon stretches beyond a decade.

Asset Allocation

In the discussion above, we assumed a perfectly passive investor, one that selects an asset allocation, rebalances once per year, and makes no attempt to change their allocation to manage risk or to increase returns. Why does it make sense to approach this discussion with a passive investor in mind (when we are active investors)? For a couple of reasons.

While an active investor may attempt to manage risk successfully, their efforts may fail. By assuming no active skill and therefore average market returns, probable outcomes are evident and should therefore come with less surprise in the event that they do occur.

More important, by assuming passivity and average results, an investor is armed to make better active management decisions.

The breakeven time horizon to move a 60/40 portfolio to an all-stock portfolio (assuming historical returns) is 9 years. If there is reason to expect a recession-driven bear market well before the 9th year or that the stock market is priced for low future returns, then an investor is more likely to patiently wait for better opportunities, even if the stock market continues to rise.

With this in mind, we have a sound basis to mentally distance ourselves from the short-termism that drives markets. We can (and should):

– Aggressively buy stocks during bear markets and early in the market cycle

• Once the stock market bottoms, it tends to rise 20%+ per year during the following two to three years.
• Do not attempt to buy at some unknown and hoped for bottom, but buy consistently when there is "blood in the streets" (even if it is your own).

– Reduce the exposure to risk assets as a bull market ages and when future expected returns are low

• The portfolio may very well underperform a more aggressive investment stance, but understand likely portfolio breakevens:
• Stocks could rise 10.0% per year for 9 years and a 60/40 portfolio would still be larger than an all-stock portfolio in the middle of a garden-variety bear market.

– Hold cash when ideas are scarce.

– Think long-term (and win across a complete market cycle)

• Do not try to outperform the stock market or the benchmark every year.
• As the breakevens above show, it can be wise to manage risk even at the expense of short- to medium-term underperformance. If future returns are compressed, be patient and wait for better opportunities before increasing the exposure to risk assets.

The point is, breakeven analysis should lead to better decision-making because it encourages a more long-term oriented approach. And that long-term mindset should reduce emotional influences, even in the face of bear market turmoil or peak cycle euphoria.

Today, stock markets hover near all-time highs and appear priced to deliver below-average future returns. How low returns might be is up for some debate.

GMO published its 7-year forecast last month and has large cap stocks returning 0.0% per year and small cap stocks losing 1.0% per year over the next 7 years. John Hussman of the Hussman Funds wrote today, "The most reliable measures we identify in market cycles across history are consistent with the expectation of near zero total returns in the S&P 500 Index over the coming decade, and the likelihood that the market will fall by half over the completion of the current cycle."

We are less bearish, expecting stock market returns over the next seven to ten years to be somewhere between 3.0% and 5.0% per year. The medium-term outlook, on the other hand, is still bright; we expect fairly solid stock market returns over the next two to three years as the U.S. and world economies continue to grow.

Our portfolio of 17 carefully chosen individual companies is priced to deliver double-digit annual returns.