As Ray Dalio of BridgeWater Associates put it, investors "should have a properly balanced portfolio", by which he means balancing in terms of risk rather than in terms of dollars invested. However, too frequently investors overlook their portfolio risk characteristics and focus on notional amounts instead, not realizing that even popular portfolios like 60/40, equal weight or Ivy are typically inefficiently diversified.
To illustrate this, let's consider a simple hypothetical portfolio with 50% invested in US stocks (SPY) and 50% in emerging markets stocks (EEM). Although at a first glance the allocations seem to be equal, a quick risk analysis of such a portfolio reveals that over the last 5 years roughly 62% of portfolio risk came from EEM and only 38% from SPY. This means that over 60% of portfolio volatility was accounted for by EEM, with the primary reason being the difference in individual volatilities of these two instruments. A simple robustness check shows that the weights are similar in different time frames as well, giving us more confidence in the estimated statistics.
If the original intention is to have equal risk exposures to both securities, then the imbalance can be easily overcome by overweighting SPY and underweighting EEM. Doing that in increments of 5%, we notice that a shift to 60% SPY / 40% EEM portfolio does the trick. The same kind of risk analysis now shows an almost even split between portfolio risk contributions. Furthermore, not only the change in allocations balances out risk contributions, but it also decreases the overall portfolio volatility and value at risk.
Performance-wise, both portfolios move almost identically and yield similar returns. The 50% SPY / 50% EEM portfolio gained 20.6% over the last 5 years, whilst the 60% / 40% version of it appreciated by 23.4%. Therefore, the latter portfolio achieved a slightly higher return and did that in a more "balanced" fashion, exactly what investors strive for.
Of course, the performance in terms of returns would have been different had EEM outperformed SPY. However, investment returns are extremely difficult to forecast ex ante and investors are frequently better off by simply focusing on portfolio risk parameters, which tend to remain more stable over time. A similar kind of analysis could easily be extended to larger portfolios that include more asset classes. You will be surprised to see how far off the balance some commonly referred portfolios are (e.g. 60% stocks / 40% bonds).
Analysis performed on a freely available tool at http://www.investspy.com
Written by Samory Borry
We are Creative Blogger Theme Wavers which provides user friendly, effective and easy to use themes. Each support has free and providing HD support screen casting.
0 comments:
Post a Comment