Why Asset Allocation Works

by Mr. Cheap

People keep going on about how important asset allocation is. I left the party when they claimed that a stock & bond mix would perform better over the long-haul then an all stock portfolio. They acknowledged that the stocks would do better on average, but that the mix would somehow magically outperform the all stock.

This didn’t make any sense to me. If you leave two investments for 30 years and get the average stock return on the all-stock portfolio and the average bond return on the all-bond portfolio, how is the return greater if you mix them together instead of keeping them separate?

The only way I thought it could possibly make sense is the idea that you’d have funds available in the bond portion of your portfolio to use to buy stock after a crash. The primary advantage from this perspective would be that the bonds aren’t correlated with the stocks, so you could use one to buy the other. Asset evangelists don’t talk about this though, and since you’d have to actively capitalize on this, it seems like something they’d mention as a necessary step to get the good returns promised by asset allocation.

The realization finally hit me when reading “Four Pillars” this morning: The benefit comes from using the assets within your portfolio to determine when the other parts of your portfolio are cheap, then buying them. E.g. if you have a 90% stock, 10% bond portfolio, you’d expect that the stocks will outperform the bonds. If you’re re-balancing (say by adding money) and your portfolio has 85% stock, then clearly the stocks are selling cheap (relative to your bonds) and its worth buying more of them (which you’ll do to re-balance). When you add money, you’d normally expect to be buying more than 10% bonds (since on average the stocks will outperform the bonds and push them to a lower proportion of your portfolio), but if the stocks REALLY outperform the bonds, then you’ll buy even more then normal (and take advantage of the bonds being cheap relative to the stock).

Basically, asset allocation is just an easy way to determine when the investments you want to buy are cheap (relative to your other investments), then buy more of them. You could accomplish the exact same “benefit” from tracking when your investments are cheap or expensive and buying them directly, however this would be a lot more work. You could also just track the different assets within your portfolio and have the return for the last year and the return for the lifetime of the portfolio. When the last year’s return is lower then the lifetime return you’d put more of the money you’re adding to that portion – again not quite as easy but uses the same idea.

e.g.

Year 1 $90,000 stock, $10,000 bonds
Year 2 $96,300 stock (7% return), $10,300 (3% return)

Say we’re adding $1,000, in order to rebalance the asset allocation, we’d be putting $540 into stocks and $460 into bonds (bringing them back to 90/10).

Year 2 $96,840 stock, $10,760 bonds (after adding $1000 and re balancing)
Year 3 $96,840 stock (0% return), $11,082.8 bonds (3% return)

Say we’re adding $1000 again in order to re balance, in order to get back to the 90/10 split, we need to sell $192.52 of bonds and buy $1,190.52 of stock (we’re buying lots of stock since it had such an awful year that we now feel that its cheap).

Year 3 $98,030.52 stock, $10,892.28 bonds (after adding $1000 and re-balancing).

Part of me feels like “supporting” under-performing bond returns just for the information of when stocks are cheap doesn’t seem like the best approach, but maybe there’s more to it then I’m seeing. I’d be tempted to construct a portfolio and assign it the expected return for each asset class. When an asset doesn’t live up to expections, add money to it to bring it in line with where it “should be”. For example, in the above portfolio with 90% and 10% with an expected stock return of 7% and an expected bond return of 3%, after 10 years you’d expect the stock portion to make up 93.4% of the portfolio. *THIS* is what you’d use to re-balance, not 90%. This way you’d get the information that an asset class was under-performing and have the opportunity to buy it cheap, without unduly subsidizing the weaker portions of your portfolio.

Please correct me if I’ve missed the point. Given my current understanding, I’m far more convinced of the value of asset allocation.

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{ 7 comments… read them below or add one }

1

You could have a “hypothetical” holding of bonds, just do it all in a spreadsheet :) I have a hypothetical Lazy Portfolio of iShares that I track in order to compare to my active trading results. If Lazy outperforms me, I’ll know I can’t pick stocks.

I’m strongly biased against bonds, but to tell you the truth I know nothing about them aside from the fact that generally their return is less than that of a GIC. The “they make little money” factor is king with me.

2

In the world of leveraged buyouts, corporate bonds give you a very low ceiling for growth, while they’re as risky as stocks on the downside. I don’t like bonds :)

Great post, BTW. Why not rebalance within a 100% stock portfolio if stocks outperform bonds over the long haul? Not all stocks correlate with each other. Examples:

1. Buy more International stocks seeing that TSX and Cdn dollar have done well the past few years.
2. Buy more growth stocks (as opposed to value) since they’ve been out-of-favour since the dot-com burst.
3. Buy lagging industries such as healthcare, consumer stables, and US homebuilders. Go easy on Canadian financial and oil stocks.

This is one reason why I avoid pure passive strategies like buying index funds. Indexes don’t rebalance internally. You can rebalance with speciality ETFs as long as you’re aware of their higher MERs.

FJ

3

The more I read your blog, the more I like you. You have to be one of the FEW people who would admit “Bernstein does talk about how moving forward it may not be a given that stocks will perform better then bonds.” I’m not trying to predict the future in either direction, but if I even mention the fact that stocks MAY not always go up people start to get upset.

Good post.

4

There is a short article in the summer issue of moneysense magazine that covers this exact topic.

5 Anonymous

FJ: I guess that’s true, if the parts of your portfolio are correlated, then everything might be cheap or expensive at the same time (which doesn’t help you). I like your ideas better then putting bonds into the mix.

Jason: aw shucks :-).

MG: Will check that out, thank!

MM: If you happen to read this, thanks for the link!

6 Limoman

Well maybe.. then again maybe not..
1. in 99′ Bonds wer dropping and cheap, thus Load them up
2. Then what happened in 00-02’? Stocks Crashed
3. Your going to keep buying stocks in 00’? What about 01′ and 02’?
4. then by going into 03′ you have say 25% more stocks and less Bonds, right?
5. then what happened in 03′-07′ ? stocks went thru the roof! ave +68% by the time the dust settled. ( using VTSMX)
6. Then what happend in 08’? They lost (-37%)
7.Butt, you were forced to be buying More Bonds during this same time, right?
8. Using a 50/50 Bal. Port. of Indexes , you ended up with about +71% in to value btwn 99′-2008…
9. or how much APY? 715 Accum = 7.1% or 3.8% apy..
10. Putting the same $ into my Home and paying it off earler? Priceless! I know have an extra $10k /yr to invest in a Bear market( buying low) and a Paid for home..Nobody can take away from me..( unless I’m dumb enough to borrow against it)
11. Just put in $10k in 08′ and another $10k in 09′ and there after, since it’s like a Roth IRA.. Grows tax Free and the 1st $500k that comes out is Tax Free! So it’s better than a Roth IRA..

And it’s all going into? Balanced Funds! Let them make the decisions! and take me out of the Picture… who is the primary person who will screw it up..!

It may not be the best way, but works for me! and I don’t have to do Nottin but rebal. those 2 Bal if needed every yr or so and I don’t have to read a Bunch of books or hire some shyster FA that does nothing but put $ into their pockets.. and funds Their Retirement, not mine!

7 Asset Allocators

Anyone in Canada doing AAA (automatic asset allocation) ? Currently I’m 15% Bonds & 85% Equities as follows:
42% Equity-US & CN
10.7% REITs
25.5% EAFE
6.8 % Emerging
Basic allocation of 52.7 N. American and 32.3 are based on Efficient Frontier work of Jeremy Siegal.

I don’t want to pay a FA but would like to move toward a more automatic rebalancing. I am looking at TD eMangaged funds. Is anyone using other balanced funds with low MERs? Wouldn’t it be a great service if we could go in once & set our preferences & be custom rebalanced?

Jay

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