With investing, we all know that if you want to play it safe you buy bonds and that if you want more return and can stomach the risk you buy stocks. But what if I told you that there is a way to have your cake and eat it to, to have less risk AND more return. Normally if you hear this kind of claim from someone I would advise you to run from them and run fast. But in this case I think you should hear me out because engineering a portfolio comprised of the right mix of different asset classes can help you travel on the efficient frontier all the way to the bank.
Definitions: Asset Class and Asset Allocation
First things first, what is an “asset class?” An asset class is a group of securities or instruments that behave similarly in the market place. Stocks are probably the most well known asset class. But there are other asset classes as well such as bonds, real estate and commodities. Even within stocks there are sub-asset classes like international stocks, emerging market stocks, mid, small and large stocks. I highlighted the word “similarly” because it is this word, really the opposite of this word, that allows us to use well engineered portfolio’s and asset allocation to be more effective investors.
Before getting to the good stuff we have one more word to define, “asset allocation.” Asset allocation is the breakdown of how much of each asset class you have in your portfolio. What most professional investors and very few individual investors (you and me, sometimes called retail investors) realize is that your choice of asset allocation is the most important investment decision that you need to make. Our mission at engineered portfolio is to show you why this is the case.
Reduced Risk with Uncorrelated Asset Classes
So here is the big secret, securities within an asset class behave similarly but the various asset classes behave differently from each other, sometimes very differently. It is in this different behavior where significant gains in performance can be achieved while also reducing portfolio risk. Let’s imagine for a minute a portfolio consisting of two asset classes, asset class A and asset class B. If both A and B are going to end up at a 50% gain after five years it should not matter if you invest in A or B, you will get the same return. However, it is possible that both A and B are volatile, fluctuating wildly on their way to that 50% gain. It is also possible that A and B are completely uncorrelated, when one goes up the other goes down. Again, they both get to a 50% gain but they take very different paths to get there. If you owned both of them in equal portions you would get the same 50% gain but with substantially reduced risk and a very smooth ride to that 50% gain (A + B in the plot below).
Improved Returns with Rebalancing
So now you see how you can reduce portfolio risk with proper asset allocation, but the REAL interesting thing is that you can also improve performance at the same time! Back to our two asset class portfolio. As you’ll see in the chart, the peaks and troughs for asset A an B are very much “out of phase”, that is when one is going up the other is going down. If after the end of each year you rebalanced this portfolio by selling the asset class that was up and buying the asset class that was down to get back to your target portfolio of 50% A and 50% B you could actually IMPROVE your return over the 50% gain that each asset had individually. Think about that, you bought two volatile assets classes that individually returned 50% over five years. But by engineering your portfolio properly and rebalancing you created a portfolio with very little risk and a return of 55%!
This my friends is the big secret that most people don’t understand. Now, this example is clearly not realistic. However, the same mechanics can be applied to actual asset classes to arrive at portfolios which provide efficient risk adjusted returns along something known as the efficient frontier. The efficient frontier is the asset allocation which can provide the most return for an acceptable amount of risk to the investor. There is some fun math behind the efficient frontier which will be covered in much more detail in later posts.
Proper asset allocation can lead to higher returns and reduced risk. Future posts will provide tons of detail into the math behind all of this as well as specific portfolio recommendations to ride that efficient frontier all the way to bank so stay tuned!