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 haven’t 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 you’ll 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
B
… 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
won’t 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 weren’t
high enough to maintain the portfolio’s 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 don’t 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.
Major asset classes: property
• 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 can’t 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: fixed interest
• 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: cash
• “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 aren’t as sensitive to interest rate changes
and thus don’t have a great deal of capital volatility.
• Many cash investments are returning about 4% at the
moment.
Other asset classes
• 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.
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
Percent Return
S&P/ASX500
Index A$
MSCI World
Index A$
1000
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
Time Periods: 1/85 to 3/04
6/99
11/01
4/04
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 you’d 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 other’s 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 other’s volatility.
Negative correlation isn’t essential
• Assets don’t 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 one’s 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
S&P/ASX500
Index A$
Value of Dollar
25
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
Time Periods: 1/82 to 12/03
6/98
3/01
12/03
So using our simple rule of thumb that if the three assets have similar
returns we’ll 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
S&P/ASX500
Index A$
Value of Dollar
25
20
MSCI World
Index A$
15
ASX 300 Prop
Index A$
10
5
One third in
each
0
12/81
9/84
6/87
3/90
12/92
9/95
Time Periods: 1/82 to 12/03
6/98
3/01
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 year’s worst
performing asset class often outperforms last year’s 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 French’s “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
Value of Dollar
Global small caps 20.29%pa
Global V
Gross A
100
Global L
Gross A
10
Global large companies 14.98%pa
Global S
Gross A
1
12/74
7/78
2/82
9/85
4/89
11/92
Time Periods: 1/75 to 12/03
6/96
1/00
8/03
3/07
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”.
GROWTH OF DOLLAR (LOG PLOT)
Large
cap
Large +
value +
small
Annualised Return %pa
14.00%
16.33%
10% Australian small
Total
Large Cumulative Return
2433%
4072%
20% global large
Monthly Standard Deviation
4.19%
3.93%
20% global value
Monthly Average Return
1.19%
1.35%
10% global small
Annualised Standard
Deviation*
14.53%
13.62%
100
20% Australian large
Value of Dollar
20% Australian value
Portfolio
10
Data from Dimensional Fund Advisors DFA
Returnw program, gross return of indexes
tracked by DFA equity trusts. See
http://www.dimensional.com.au
50% Australian large
50% global large
1
12/79
1/83
2/86
3/89
4/92
5/95
Time Periods: 1/80 to 8/04
6/98
Tilted
7/01
8/04
*Annualised
standard deviation is presented as
Portfolio
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.
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 isn’t 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 MVO’s “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
don’t take them too seriously.
• Don’t 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 isn’t 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 don’t 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?
Addition of emerging markets to a
global large cap portfolio
12
Annualised return
• 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.
11
10
9
8
25.0%
20.0%
15.0%
10.0%
7.5%
5.0%
2.5%
0.0%
7
6
5
4.24
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
Anualised return %
16
Emerg Mkts
Aus value
14
12
Global bonds
Aus bonds
10
8
Cash
Global Lge
Unlisted property
trusts
6
Global Value
Aus large
Global Small
Listed property
Aus small
4
2
0
0
1
2
3
4
Monthly std deviation %
5
6
7
• 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 doesn’t stop people from
trying!
Adding conservative assets
• So far we’ve 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 doesn’t 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 doesn’t return 0% you
won’t 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 won’t 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.
Annualised return %
Percentage cash in an Australian shares portfolio
13
12
All cash
80%
11
70%
60%
20% 10% 0%
30%
50% 40%
All shares
90%
100%
10
9
0
1
2
3
4
Monthly std deviation %
5
6
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
11 13 15 17 19 21 23 25 27 29
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 doesn’t really address the client’s
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
High growth Growth
Balanced Low growth Conservative
Growth assets
100.00%
85.00%
70.00%
55.00%
30.00%
Income assets
0.00%
15.00%
30.00%
45.00%
70.00%
Australian “Value” Equities
15.00%
13.00%
10.00%
8.00%
4.50%
Australian “Large” Equities
15.00%
13.00%
10.00%
11.00%
6.00%
Australian “Small” Equities
5.00%
4.00%
3.00%
0.00%
0.00%
Global “Value” Equities
15.00%
13.00%
10.00%
8.00%
4.50%
Global “Large” Equities
15.00%
13.00%
10.00%
11.00%
6.00%
Global “Small” Equities
5.00%
4.00%
3.00%
0.00%
0.00%
30.00%
25.00%
24.00%
17.00%
9.00%
Australian Bonds
0.00%
5.00%
10.00%
15.00%
20.00%
International Bonds
0.00%
5.00%
10.00%
15.00%
20.00%
Bank Bills (cash)
0.00%
5.00%
10.00%
15.00%
30.00%
14.12%
13.76%
13.25%
12.84%
11.86%
3.39%
2.93%
2.41%
2.01%
1.25%
Listed Property
Annualised Return
Monthly Standard
Deviation
Historical risk and return for model portfolios,
February 1985 - December 2003
Annualised return
14.50%
High growth
14.00%
Growth
13.50%
Balanced
13.00%
Low growth
12.50%
12.00%
11.50%
0.00%
Conservative
1.00%
2.00%
3.00%
Monthly standard deviation
4.00%
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.
70
60
50
40
30
20
10
High Growth
Growth
Conservative
9%
8%
to
7%
6%
to
5%
4%
to
3%
to
1%
to
Low growth
2%
%
0%
to
-1
%
-2
%
to
-3
%
Balanced
-4
%
to
-5
%
-6
%
to
-7
-9
%
-8
%
to
-1
1%
-1
0%
2%
to
-1
3%
-1
4%
to
-1
5%
-1
-1
6%
to
-1
7%
to
-1
9%
8%
-1
0%
to
-2
1%
-2
-2
2%
to
-2
3%
to
4%
-2
6%
to
-2
5%
0
-2
Number of occurences
80
30.00%
25.00%
20.00%
15.00%
10.00%
High Growth
Low growth
Growth
Conservative
Balanced
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
0.00%
Jan-86
5.00%
Jan-85
Maximum drawdown
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.
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%
Australian shares
Global shares
Property securities
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Jan-84
Jan-83
0.00%
Jan-82
10.00%
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.
Don’t 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 wasn’t 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 isn’t really a
“new paradigm” and markets haven’t 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 don’t 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
doesn’t show in the volatility or drawdown figures.
25.0%
20.0%
15.0%
10.0%
5.0%
Citigroup BMI Value
Citigroup BMI Growth
Jul-03
Jul-02
Jul-01
Jul-00
Jul-99
Jul-98
Jul-97
Jul-96
Jul-95
Jul-94
Jul-93
Jul-92
Jul-91
Jul-90
Jul-89
0.0%
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 isn’t obvious in
the drawdown figures. Value outperformed growth by more than 2%pa over
the entire period but this didn’t translate into meaningfully greater downside
risk. Value was marginally more volatile though, 7.45% per month vs. 5.48%.
F/F Large Value
F/F Large Growth
Jul-98
Jul-92
Jul-86
Jul-80
Jul-74
Jul-68
Jul-62
Jul-56
Jul-50
Jul-44
Jul-38
Jul-32
Jul-26
100.0%
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
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 can’t 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 investor’s
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 can’t tolerate underperforming the market or don’t
want to bet on a value premium continuing, stick with
normal large cap “blue chip” shares. Strongly tilted value
and small cap portfolios aren’t 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 investor’s 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.