How to construct a portfolio using simplified modern portfolio theory

Travis Morien Compass Financial Planners Pty Ltd travis@travismorien.com http://www.travismorien.com

Before viewing this presentation:

The presentation you are about to view on building portfolios is the sequel to a slideshow on selecting managed funds. Some concepts are carried forward from that presentation and are assumed knowledge. If you havent already done so, download the original presentation from http://www.travismorien.com/investment.ppt

Part One

The asset classes

Basic principles
There are many asset classes out there and many of them are useful to investors. Some asset classes are noted for their long term stability (low risk), others for their high returns. Generally speaking, the higher the reward you are after, the more risk youll need to take. Portfolios can be constructed out of multiple asset classes that exhibit superior risk and return relationships to any single asset, because diversification can significantly reduce risk.

Why risk and return are linked..

Investment A is the obvious choice A but add risk, is the choice still obvious? A

B B would die out through lack of takers!

When two investments appear to offer identical risk, investors will prefer to buy the higher returning one. If the market is peopled by reasonably well informed investors, there simply wont be any high returning low risk investments left and nobody will buy high risk assets with a low expected return.

Risk and return continued

In a portfolio construction context risk is usually measured with some sort of measure of price volatility. There are other risks of course that need to be taken into account. Inflation risk is a major problem with the more conservative asset classes such as fixed interest and cash. Many pensioners find to their horror that they can no longer live off their savings, despite the conservatism of their strategy, simply because their returns werent high enough to maintain the portfolios real value after inflation, costs and withdrawals. It is necessary for all but the most short term oriented investors to consider at least some exposure to growth assets like shares and property, just to fight inflation.

Major asset classes: shares

Shares are part interests in businesses. How good a return you get on your share depends to a large extent on the fundamental business developments of the company itself and on the price you paid for the share. Averaged out over many companies, shares as an asset class tend to respond to interest rates and the economy. Although in the last few years many markets have fallen substantially, shares are still the highest performing asset class over the long term and by far the most tax efficient. Shares generally go up in price over the long term because businesses dont pay out 100% of their profits as dividends, they keep some to grow the value of the business itself. Over the long term, shares have beaten inflation by about 6%pa.

 There are many types of property to invest in, each are different. The highest income yield comes generally from commercial and industrial property, which often pay the owner as much as 10%pa in rent alone. Residential property is an asset class that has really been booming over the last few years, but rental yields are now alarmingly bad by historical standards meaning that investors are highly reliant on capital growth. Over the longer term you can expect property to grow in capital value at about the same rate as inflation (because the salaries with which we have to pay the mortgages only grow with inflation there eventually comes a limit when growth above inflation just cant be sustained), though local supply and demand issues mean actual returns could be higher or lower over a particular period of time.

Major asset classes: property

 A fixed interest investment is a debt that can be bought and sold. The borrowers are usually governments and companies. A typical fixed interest investment pays a regular coupon (interest payment) and will repay the principle on maturity. Some fixed interest securities have a maturity of several decades, others are shorter term. The actual price of a fixed interest investment will fluctuate in response to many things, most particularly interest rates. If general interest rates fall, the price of a long term fixed interest security will usually rise such that the yield to maturity is similar to those of other investments with a similar risk. On the other hand, if interest rates rise, fixed interest investments fall. A typical fixed interest portfolio is yielding less than 5% right now, though falling interest rates over the last decade have helped bonds to deliver very strong performance which included a growth component.

Major asset classes: fixed interest

 Cash may mean currency, but in an investment context cash is just a really short term highly liquid fixed interest investment. Longer term fixed interest investments are usually called bonds, shorter term fixed interest investments may be called notes and really short term ones are often called bills. Cash management trusts usually invest in a portfolio of high quality short term fixed interest investments. Because of the short maturity, these fixed interest investments arent as sensitive to interest rate changes and thus dont have a great deal of capital volatility. Many cash investments are returning about 4% at the moment.

Major asset classes: cash

 Shares, property, bonds and cash are the major asset classes, but there are many others to choose from. Hedge funds are sometimes called a distinct asset class as they pursue unconventional strategies that give them performance very different to the asset classes that they invest in. Private equity is basically a shares investment, but in companies not listed on a stock exchange. Agribusinesses are agricultural investments in things like tree farms and vineyards. Some people also consider commodities like gold to be an asset class of its own, and many people consider collectibles, race horses and fine wines to be useful alternative investment asset classes.

Other asset classes

The point of portfolio construction

A portfolio is often more than the sum of its parts. Because not all asset classes perform the same way over the short term, a portfolio of many asset classes usually offers a superior overall relationship between risk and return to any single asset. A portfolio consisting only of shares would have done badly in the last few years since the US market crashed, but property and bonds have performed very well. This is quite typical, more defensive asset classes often do well when equities are falling. A diversified portfolio has a reasonable long term growth rate because over time all asset classes offer a positive return, but being invested across different asset classes smooths out returns and offers a more predictable growth rate.

The last twenty years have seen very good returns for all major asset classes, well in excess of inflation, but the risk and return are highly variable.
GROWTH - CUMULATIVE RETURNS
1500

S&P/ASX500 Index A$

Percent Return

1000

MSCI World Index A$

ASX 300 Prop Index A$

UBS Comp Bond A$ 500 UBS 90 Day Bank Bill A$

Aust CPI Index A$ 0 12/84 5/87 10/89 3/92 8/94 1/97 6/99 11/01 4/04

Time Periods: 1/85 to 3/04

Part Two

Creating diversified portfolios

How diversification reduces risk

There are two mechanisms by which diversification reduces risk: dilution and interference. Dilution is easy enough to understand, if you swap half your shares for cash then you lose half your equity exposure and therefore half your equity risk. If the market crashed tomorrow youd only lose half as much. Interference (a term I pinched from physics where it is used to describe the way waves interact), is where negative movements in some assets are partly cancelled by positive ones in other assets. A good example is with property vs. shares, in the recent bear market in shares property did very well while shares tanked, the opposite may be true in the next few years.

Interference and correlation

Correlation is the word given to the extent to which assets move together, this is measured with statistical formulae. Correlations can range from -1 (perfectly negatively correlated) through to +1 (perfectly positively correlated). If asset B tends to move in the opposite direction to asset A then these two assets are said to have negative correlation, and they can be highly effective at cancelling out each others volatility. If the assets both trend upwards over the longer term a combination of them will have a return equal to the average of the two assets returns but with substantially reduced volatility.

Negatively correlated assets cancel the greatest amount of each others volatility.

Negative correlation isnt essential

Assets dont need to be negatively correlated to have some volatility smoothing. As long as the correlation is less than +1 the assets will be at least a little bit different and at least some volatility will be cancelled. Most real world assets are positively correlated because most prices are related somehow to important macro factors like global economic growth, interest rates, oil prices etc. Even if negative correlations are rare, substantial volatility reduction is possible by using assets with a low positive correlation. For example, the annual correlation of Australian listed property with Australian shares from 1982 to 2003 has been about 0.68, but the correlation of property with international shares was about 0.30, the correlation of Australian shares with international shares was about 0.64, so a mixed portfolio would be quite effectively diversified.

The efficient frontier is the name given to the line that joins all portfolios that have achieved a maximum return for a given level of risk (portfolios that are efficient). If you programmed a computer to chart every possible portfolio that could be constructed out of a group of assets and plotted a point on a risk vs. return chart, the resulting plot usually looks much like the chart below. The top of the curve is the efficient frontier, anything below that curve is an inefficient portfolio, anything actually on the curve, or close to it, is an efficient portfolio.
Return Efficient portfolios on or near the efficient frontier

Risk Inefficient portfolios below efficient frontier

Efficient vs. inefficient portfolios

It is impossible to predict in advance which portfolios will be the most efficient as this would require knowing in advance asset class performance and correlations. A portfolio that has been diversified into a variety of asset classes should be close to efficient over the longer term, provided it is rebalanced regularly.

Rebalancing
Rebalancing a portfolio is the process of adjusting a portfolio to bring it back to its original asset allocation. Since assets perform differently at different times, the portfolio is likely to drift from your desired asset allocation. Failure to rebalance means that a portfolio can change risk profile over time and may no longer be appropriate.

A simple rule of portfolio construction

If you have two assets with roughly equal expected returns, putting 50% into each is a way to hedge ones bets (and spread the risk) without compromising expected return. The lower the correlation of those assets, the more the risk will be reduced while not reducing expected returns at all. Actually, this holds true with a greater number of investments as well. For example, if you have five equally attractive assets you could invest one fifth in each.

Since 1982 Australian shares (ASX500 index), international shares (MSCI world index) and property securities (ASX300 listed property index) have had roughly the same return
GROWTH OF DOLLAR
30

25

S&P/ASX500 Index A$

Value of Dollar

20

15

MSCI World Index A$

10

5 ASX 300 Prop Index A$ 0 12/81

9/84

6/87

3/90

12/92

9/95

6/98

3/01

12/03

Time Periods: 1/82 to 12/03

So using our simple rule of thumb that if the three assets have similar returns well use a third in each, we get the following portfolio which has outperformed all three with much less volatility! (Rebalanced monthly)
GROWTH OF DOLLAR
30

25

S&P/ASX500 Index A$

Value of Dollar

20 MSCI World Index A$ 15

10

ASX 300 Prop Index A$

5 One third in each 0 12/81

9/84

6/87

3/90

12/92

9/95

6/98

3/01

12/03

Time Periods: 1/82 to 12/03

Diversifiable vs. undiversifiable risk

There is such a thing as diversifiable risk, as you add extra assets to the portfolio the volatility tends to decrease but only up to a point. When a portfolio reaches a certain level of diversification the only way to reduce risk is to add lower risk assets which will reduce volatility by dilution, this usually reduces the return. Risk which cannot be diversified away is undiversifiable or systemic risk. Holding every stock in the market (i.e. with an index fund) smooths out the maximum amount of diversifiable risk for shares, but you are still left with the risk of the market itself, that risk cannot be reduced unless you spread your portfolio across more asset classes. According to financial theory, investors only get rewarded for taking on systemic risk. Having an under-diversified portfolio results in greater risk but no extra expected return. This is one definition of speculation. (There are others.)

Diversification can also increase returns

A higher return may often be obtained from rebalancing the portfolio as a result of reversion to the mean. If you believe that at some point in the future two assets will give the same cumulative return then it would make sense to invest in the asset class with the worst recent performance and sell the one with the best performance! Rebalancing does precisely this, although it is normally seen only as a risk management technique. This is why the diversified portfolio did a little better than all three component asset classes. A small rebalancing premium is quite common because last years worst performing asset class often outperforms last years best performing asset class this year.

Improving the efficient frontier

Investors desire higher returns with lower risk. There is however a limit to what can be achieved with a particular set of assets, that limit is drawn on charts as the efficient frontier. By adding more assets we can change the shape of the efficient frontier. Assets carry two items of interest to us, their returns and their correlation with the rest of the portfolio.

Refining our asset allocation

There is wide acceptance that so-called value stocks outperform growth stocks, and small companies tend to outperform large companies, at least over the longer term. Their higher long term performance is very interesting, but so too is the fact that they often have a low correlation to large growth companies, the dominant stocks in the market. They provide what asset allocation buffs call an independent source of risk and return. This may enable us to improve the efficient frontier.

Fama and Frenchs Three factor model

Your returns mostly come down to asset allocation:
The mix of stocks vs. bonds The average company size The value characteristics of the stocks - how cheap stocks are compared to book value.

Picture credit: Dimensional Fund Advisors

Over the long term value stocks and small companies have outperformed large companies. These are the returns of global value, large company and small company indexes calculated by Dimensional Fund Advisors from January 1975 December 2003:
GROWTH OF DOLLAR (LOG PLOT)
1000

Global value 19.70%pa Global small caps 20.29%pa

Global Va Gross A

Value of Dollar

100

Global Lg Gross A

10

Global large companies 14.98%pa

Global Sm Gross A$ 1 12/74

7/78

2/82

9/85

4/89

11/92

6/96

1/00

8/03

3/07

Time Periods: 1/75 to 12/03

Adding value and small caps to a large cap growth equity portfolio gives a better return than a large cap only portfolio, but the volatility is actually lower, not higher. A mixed portfolio is more efficient.
G R O W T H O F D O L L A R (L O G P L O T )
100

Large cap Large + value + small Annualised Return %pa Totalr gCumulative Return La e Monthly Standard Deviation Monthly Average Return Annualised Standard Deviation*
P o r tfo lio

20% Australian large 20% Australian value 10% Australian small 20% global large 20% global value

14.00% 2433% 4.19% 1.19% 14.53%

16.33% 4072% 3.93% 1.35% 13.62%

Value of Dollar

10% global small

10

50% Australian large 50% global large

Data from Dimensional Fund Advisors DFA Returnw program, gross return of indexes tracked by DFA equity trusts. See http://www.dimensional.com.au *Annualised standard deviation is presented as P o r tfo lio an approximation by multiplying the monthly or quarterly standard deviation by the square root of the number of periods in a year. Please note that the standard deviation computed from annual data may differ materially from this estimate.
T ilte d

1 1 2 /7 9

1 /8 3

2 /8 6

3 /8 9

4 /9 2

5 /9 5

6 /9 8

7 /0 1

8 /0 4

T im e P e rio d s : 1 /8 0 t o 8 /0 4

Total stock market vs. slice and dice

The stock market is dominated by what would be classified as large growth companies, also known as blue chips. As a portion of market capitalisation, the very largest companies dominate the market and so an exposure in market weightings tends to have a very small amount of small company and value exposure. Many asset allocators believe a portfolio should have more small company and value exposure than the market gives. Although small companies might only make up 5% of the market by capitalisation, they make up the vast majority of listed companies by number. Despite the tiny market weighting, asset allocators often allocate a larger amount of 10 to 20% to small caps and similarly overweight value companies.

Computer backtest optimisation

A common tool used is called a mean-variance optimiser or MVO, a computer program that backtests portfolios to find the ones that lie on the efficient frontier. It looks at historical correlations, mean returns and volatility. The idea isnt as good in practice as it sounds in theory because past performance is no guarantee of future results. The program usually only does what inept investors have always done chase past performance, wags have dubbed MVOs error maximisers. A non-technical approach goes back to the basics try to build your portfolio from many independent sources of risk and return. This simply means you should diversify into many different asset classes.

So how do you go about constructing a portfolio?

The usefulness of historical correlations and returns is usually overstated, but can form a crude guide as long as we dont take them too seriously. Dont get too hung up on quantitative data, but try to find assets that are very different (e.g. property vs. shares.) Our first example of a diversified portfolio had a one third allocation to Australian shares, one third to international shares and one third to property. Since over the longer term these asset classes deliver approximately the same returns but operate on somewhat different cycles, that isnt a bad allocation to start with for a high growth portfolio.

Decisions, decisions
Active funds or passive/index funds? How much to growth assets, how much to income assets? Balance of value stocks to growth stocks? How much large cap shares, how much small caps? How much money to put in developed markets vs. emerging markets? Currency hedged or unhedged international shares? Listed or unlisted property? Short or long maturity fixed interest?

 Within the one third allocated to Australian shares in our simple starting portfolio, we can allocate money between large cap growth, small cap growth, large cap value and small cap value. We can also allocate along the lines of industrials vs. resource stocks. Within the one third allocated to international shares we have the same asset classes above, but we can also allocate to developed markets or emerging markets. One might even consider allocating some of the shares investments to private equity (unlisted shares), which may often provide a very high return yet at substantial risk. A small allocation to a risky asset with low correlation to other asset classes can actually reduce the volatility of the overall portfolio. Long/short managed funds can also be useful as they usually have a very low correlation with the indexes.

Risky assets vs. risky portfolios.

It is important to think about risk in a portfolio context, not an asset context. Portfolio building should be seen more like cooking we are more concerned with the final product than the taste of each ingredient. Pepper tastes great on a steak, but makes a lousy meal by itself. Small percentage allocations to riskier assets like emerging markets, private equity, commodities, hedge funds and agribusiness can actually reduce the risk of the overall portfolio because they dont operate on the same cycles as major asset classes. Small allocations to such assets can have a great impact on the efficient frontier.

Are risky assets like emerging markets too risky for conservative portfolios?
Emerging markets are by themselves a very risky asset class, their monthly volatility is about 50% higher than global large companies (DFA indexes). On the other hand, their correlation with the global large caps indexes is quite low. Despite the high volatility of emerging markets, their low correlation with global large cap equities means a small percentage allocation of emerging markets to a global portfolio can actually reduce the volatility of a portfolio while potentially increasing returns.
Addition of emerging markets to a global large cap portfolio
12

Annualised return

11 10 9 8 7 6 5 4.24 20.0% 15.0% 10.0% 7.5% 5.0%

25.0%

2.5%

0.0%

4.26

4.28

4.3

4.32

4.34

Monthly std deviation

January 1988 to January 2004, DFA Emerging Markets index plus Global Large Company index.

A little volatility can go a long way

In a sense, the high volatility of the riskier asset classes is one of their most valuable attributes for a portfolio. The high volatility of asset classes like emerging markets and commodities means they punch well above their weight in contributing risk and return to the portfolio. A 5% allocation to a risky asset class with low correlation to mainstream asset classes might contribute as much diversification as a 20% allocation to a less volatile asset class, so only a small amount needs to be invested to improve portfolio diversification.

Review of the return vs. volatility of major asset classes from January 1988 to January 2004.
20 18 16 14 Anualised return % 12 10 8 6 4 2 0 0 1 2 3 4 5 6 7 Monthly std deviation % Cash Global bonds Aus bonds Unlisted property trusts Listed property Global Value Aus large Global Small Global Lge Aus small Aus value Emerg Mkts

 Obviously some asset classes have been more efficient than others over this time frame, but which asset classes will be best over the next 10 years is another matter entirely. Australian value stocks for example continued to provide strong gains over the last few years as the rest of the stock market, especially international stocks, did poorly. In 2003, Australian small caps rose 40% (nearly twice what large companies returned) despite underperforming over the previous decade. There really is no way to forecast which assets are going to outperform, although that doesnt stop people from trying!

Adding conservative assets

So far weve only shown what happens when growth assets of the various flavours of shares and property are added together. Although we can substantially improve on large cap growth share portfolios in terms of risk and return there are limits to how conservative a portfolio of growth assets can be, to push the efficient frontier more toward lower risks the income asset classes (bonds, cash, mortgages) will need to be added. We have to accept that over the longer term this will probably cost the investor money due to a lower expected return, but the risk reduction potential is tremendous and this may be more suitable for conservative investors.

Half the risk doesnt mean half the return!

Risk to reward ratios get more favourable for conservative portfolios. Putting half a share portfolio into cash will basically halve the risk, but since cash doesnt return 0% you wont halve the return. If you gear a portfolio though you do double your risk (if you use 50% leverage), but because you have to pay interest on the loan you wont double your return. Conservative portfolios therefore can greatly reduce risk without necessarily having the same amount of reduction in the return. This can be seen on the efficient frontier, which is usually curved instead of straight.

A property of efficient frontiers is that the left side of the chart is usually a lot steeper than the right side. Addition of even a small amount of cash to a share portfolio (here we have used the ASX500 All Ordinaries share index from January 1980 to January 2004) can significantly reduce volatility with very little impact on returns and the addition of a small amount of shares to a cash portfolio can significantly increase returns without increasing volatility much.
Percentage cash in an A ustralian shares portfolio

Annualised return %

13 12
All cash

11 10 9 0

90% 100%

80%

70%

60%

50%

40%

30% 20%

10%

0%

All shares

M onthly std deviation %

Part Three

Risk profiling and portfolio design

So why not always use a medium risk portfolio?

If diversification makes it relatively easy to substantially reduce risk for only a small cost in return, why not do it all the time? The answer lies in compounding interest. Over a long period a small increase in returns makes a big difference to the final portfolio value. The difference between a portfolio that returns 8% over 20 years and a portfolio that returns 10% over 20 years is very substantial. Ten thousand dollars invested at 8% for 20 years will grow to $46,610, one thousand invested at 10% for 20 years will grow to $67,275 - a very significant difference! If you are young then your time frame on retirement assets is likely to be 30 years or more. Growth assets are also generally more tax efficient and therefore the gap between aggressive and conservative portfolios widens after tax.

Over a short period of time there is very little difference so it may not be worth taking a risk, but if you do have a long term horizon then serious thought should be put into ways to get an extra percentage point or two out of the portfolio. An extra point of risk is often hard to notice without a computer, but an extra point of return makes a very big difference in the long term! Risk is important but being overly conservative can be a costly mistake over the long term.
$200,000 $180,000 $160,000 $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0
1 3 5 7 9 1 1 1 3 1 5 1 7 1 9 2 1 2 3 2 5 2 7 2 9

8%

10%

Choosing a level of risk vs. return

Risk profiling is a tricky business that depends on the time horizon, risk tolerance and return requirements of an investor. As a financial planner I spend a lot of time working on this with clients, but it is a complex area and it is outside the scope of this presentation. Some model portfolios with different levels of risk and their risk/return profiles are shown on the next few slides.

Three dimensional approach to risk profiling

Most advisors discuss risk tolerance in terms of potential volatility only, often using short multichoice questionnaires. In my opinion, this is inadequate and doesnt really address the clients needs. I think there are actually three dimensions to risk profiling:
1. Time frame when is the money required? 2. Volatility tolerance how much volatility? 3. Conventionality given the different cycles of value and small cap shares and that they may underperform large growth companies for extended periods of time, how much of a value and small cap tilt is acceptable?

Example model portfolios

Growth assets Income assets Australian Value Equities Australian Large Equities Australian Small Equities Global Value Equities Global Large Equities Global Small Equities Listed Property Australian Bonds International Bonds Bank Bills (cash) Annualised Return Monthly Standard Deviation

High growth Growth

100.00% 0.00% 15.00% 15.00% 5.00% 15.00% 15.00% 5.00% 30.00% 0.00% 0.00% 0.00% 14.12% 3.39% 85.00% 15.00% 13.00% 13.00% 4.00% 13.00% 13.00% 4.00% 25.00% 5.00% 5.00% 5.00% 13.76% 2.93%

Balanced Low growth Conservative

70.00% 30.00% 10.00% 10.00% 3.00% 10.00% 10.00% 3.00% 24.00% 10.00% 10.00% 10.00% 13.25% 2.41% 55.00% 45.00% 8.00% 11.00% 0.00% 8.00% 11.00% 0.00% 17.00% 15.00% 15.00% 15.00% 12.84% 2.01%

30.00%

70.00%

4.50%

6.00%

0.00%

4.50%

6.00%

0.00%

9.00%

20.00%

20.00%

30.00%

11.86%

1.25%

Historical risk and return for model portfolios, February 1985 - December 2003
14.50% Annualised return 14.00% 13.50% 13.00% 12.50% 12.00% 11.50% 0.00% 1.00% C onservative 2.00% 3.00% 4.00% High growth Growth B alanced Low growth

Mo nth ly stand ard d eviatio n

February 1985 to December 2003, monthly distribution of returns:

Note the higher peak and narrow spread of the conservative portfolio compared to the higher risk portfolios, but note also that the riskier portfolios peak further to the right showing that on average they have had better returns.
Number of occurences 80 70 60 50 40 30 20 10 0
% % % -9 % % 1% 3% 5% 7% to 6% 8% -2 1% -1 5% -1 3% -2 5% -2 3% -1 9% -1 7% -1 1% -7 -5 -3 -1 to to to to to to to to to to to to to to to to 0% 2% -4 % -2 6% -2 4% 2% -2 0% -1 8% 6% 4% 2% -2 -1 -1 -1 -1 -2 % 0% -8 -6 4% % % to 9%

High Growth

Growth

Balanced

Low growth

Conservative

Maximum drawdown is another way to look at risk which is more meaningful to most people. Drawdown is calculated as the loss from the highest previous high. The losses each portfolio experienced in past bear markets can be clearly seen and compared.
30.00% 25.00% 20.00% 15.00% 10.00% 5.00%
Jan-85 Jan-86 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-97 Jan-98 Jan-00 Jan-01 Jan-87 Jan-94 Jan-95 Jan-96 Jan-99 Jan-02 Jan-03

Maximum drawdown

0.00%

H h G th ig row Low g th row

G th row C servative on

B alanced

Compared to the individual asset classes, the historical drawdown of the diversified High Growth portfolio was much less. Individual growth assets have tended to have up to twice the downside risk.
60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00%
Jan-86 Jan-82 Jan-83 Jan-84 Jan-85 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03

Australian shares

Global shares

Property securities

High Growth

Typical downside risk as measured by maximum drawdown

A High Growth model portfolio would have lost about 25% in the crash of October 1987 and by the bottom of the next largest three subsequent bear markets (September 90, January 95, February 03), losses were about 12%. Every 15% of allocation to income assets reduced the average magnitude of the drawdown at the bottom of each significant bear market by an average of about 15% (not surprisingly!) at a cost of about 0.5%pa in annualised returns. It is also worth noting that the drawdown periods tended to last slightly longer in the aggressive portfolios as it took more time to make up the greater losses. Bear in mind the inferior tax efficiency of the conservative portfolios, so for taxable investors the gap between each portfolio would be slightly greater.

Designing a portfolio risk tolerance

First, determine the time frame of the investment. Examining data from model portfolios and adding on a margin of safety, decide how much downside risk over that time frame that you can accept. Remember, the consequence of risk is more important than the probability of risk. Risk should be assessed in terms of how much damage it would do to your ability to pay for something you need at some time in the future. Dont get too obsessed about daily, weekly, monthly or even annual volatility if your investment horizon is 20 or 30 years! Of course if your investment horizon is quite short term, you probably should be obsessed about short term volatility!

Designing a portfolio value vs. growth

Value stocks and small companies tend to outperform large cap growth companies over the longer term but they do have risks of their own. Value stocks outperformed by a huge margin during the bear market of the last few years, in fact Australian value stocks even outperformed property trusts during a time which is generally remembered as a property boom. The trouble though is that during the tech boom of the late 1990s, value stocks lagged by a large margin. We know with hindsight this was a bubble, and most of those gains were lost, but this wasnt that easy to spot at the time. The newspapers were all touting the new economy, and value investors seemed like they were obsolete. As a dimension to risk profiling, this one is about how willing you are to ignore underperformance and the prognostications of pundits.

Designing a portfolio value vs. growth

Personally I am happy to have a very strong tilt toward value stocks, but not everyone feels that way. The numbers for value vs. growth strongly favour value for more than half a century in the US and many foreign markets where data is available, the track record of value is impressive. But how many years will you persist with value investing if it underperforms the general market? One year? Five years? Ten years? How do you know there isnt really a new paradigm and markets havent really changed? Most people prefer to hedge their bets, allocating some but not all of their portfolio to value stocks, buying growth stocks and having a balanced exposure. This may not be the highest returning strategy for the very long term, but it seems more conservative for most people.

Is value more risky than growth?

Many academics argue that the outperformance of value stocks vs. growth stocks is a risk premium, i.e. that investors are merely being rewarded for taking on more risk. Others who dont believe in the efficient market hypothesis think that the outperformance of value is caused be systematic errors made by analysts who overestimate the future profits of growth stocks and underestimate the future profits of value stocks, this would be an inefficiency, an opportunity to earn a higher return without higher risk. Various people have put forward various theories about the extra risk of value, but one of the most obvious troubles with the value = risky theory is that value based portfolios tend to be less volatile, not more, in fact growth portfolios, which have lower returns, can be much more volatile. This debate has gone on for years and will continue to go on for years more, to some people the idea of a free lunch in value stocks is theoretically impossible, so they hypothesise new forms of risk.

Citigroup BMI value and growth indexes, July 1989 to Jan 2004 (Australian shares)
Although the value index in this example outperformed the growth index by more than 3%pa, if there is much extra risk in value stocks then it doesnt show in the volatility or drawdown figures.

Longer term in the US: Fama and French large value vs. large growth indexes January 1926 to December 2003. Again, if there is extra risk it isnt obvious in the drawdown figures. Value outperformed growth by more than 2%pa over the entire period but this didnt translate into meaningfully greater downside risk. Value was marginally more volatile though, 7.45% per month vs. 5.48%.

Risk of value stocks

The main reason why many academics say value stocks are more risky is because in theory they would have to be more risky for the efficient markets hypothesis to remain valid. Many explanations are given, but some tend to be almost metaphysical, claiming that the risk cant be measured but is there somehow and somewhere. Interestingly, prior to academics discovering the value premium, nobody claimed value stocks were more risky, this claim was made by efficient market supporters only after the higher returns were proven. It is an interesting issue, but from a personal investors point of view it is a question of whether the value premium is likely to persist for ever and whether they are willing to tolerate periods of underperformance where growth does better than value.

Value vs. growth

In the late 1990s, growth stocks outperformed value stocks. If you had switched out of value and into growth following that period of outperformance you would have been hurt badly by the bear market that followed, where value stocks outperformed growth by a big margin. Growth stocks often outperform in rising markets, especially in the latest stages of bull markets when most people invest the most money. Typically, value stocks offer more consistent performance. If you cant tolerate underperforming the market or dont want to bet on a value premium continuing, stick with normal large cap blue chip shares. Strongly tilted value and small cap portfolios arent suitable for everyone.

Conclusions
Asset allocation is an overlooked and underrated field of investment, but studies show it is more influential on the behaviour of a portfolio than stock selection or market timing, more importantly you can exercise more control over asset allocation whereas the others are often a matter of luck. Used properly, asset allocation is the major risk management tool in an investors arsenal, but it can also be a source of higher returns. Asset allocation can be a complex area with many fine points that are often overlooked and is particularly important for pension portfolios.

Recommended reading
Common Sense on Mutual Funds by John Bogle The Intelligent Asset Allocator by William Bernstein The Four Pillars of Investing by William Bernstein A Random Walk Down Wall Street by Burton G. Malkiel The Intelligent Investor by Benjamin Graham Contrarian Investment Strategies: The Next Generation by David Dreman Against the Gods: The Remarkable Story of Risk by Peter Bernstein John Neff on Investing by John Neff

Web sites of interest

http://www.stanford.edu/~wfsharpe/art/active/active.htm http://www.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm http://marriottschool.byu.edu/emp/srt/passive.html http://www.diehards.org/ http://www.investorsolutions.com/ArticleShow.cfm? Link=art_It_Dont_Get_Much_Worse_Than_This.cfm http://www.investorhome.com/cherry.htm http://library.dfaus.com/faqs/ http://library.dfaus.com/articles/dimensions_stock_returns_2002/ http://www.indexfunds.com/ http://faculty.haas.berkeley.edu/odean/ http://www.efficientfrontier.com/ http://www.tweedy.com/library_docs/papers.html http://www.travismorien.com

Disclaimer:
Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. Investors should seek the advice of their own qualified advisor before investing in any securities. Please note that returns quoted in this article are based on historical performance of indexes, not actual products. Real world products (index funds) are available to track the majority of indexes quoted in this presentation, but returns will be affected by fees and taxes. Past returns are not a reliable indicator of future returns.