Diversification in Asset Allocation: The Only Free Lunch in Investing

It's widely known that the core objective of constructing an investment portfolio is to achieve long-term returns while managing maximum drawdowns. And the method to accomplish this goal is through effective asset allocation.

 

Asset allocation involves categorizing assets based on factors such as homogeneity, exclusivity, and correlation. Major asset classes typically include stocks, bonds, currencies, commodities, and alternative investments (such as real estate, VC/PE, and infrastructure investments). The usually low correlation between different asset categories allows asset allocation to diversify investments, thereby enhancing the risk-return ratio.

 

The Importance of Asset Allocation

 

Brinson et al. (1986) studied 91 large pension funds from 1974 to 1983 and highlighted through attribution analysis that asset allocation could account for 93.6% of a portfolio's performance. The father of modern portfolio theory, Markowitz, famously remarked, "Diversification in asset allocation is the only free lunch in investing." The late Chief Investment Officer of Yale University and founder of the Yale model, David Swensen, asserted that "asset allocation is the core element of the investment process and the most significant determinant of investment returns." These statements all underscore the importance of asset allocation.

 

Examining the annual growth rates of major asset classes over the past decade reveals that some asset class always performs well at each stage of the economic cycle. Therefore, rotating and allocating between different assets can significantly improve the risk-return characteristics of an investment portfolio, constructing portfolios that align with investors' risk tolerance.

 

What's Inside Major Asset Classes?

 

Stocks

 

Stocks typically deliver the highest long-term returns among assets, albeit accompanied by considerable volatility and among the highest maximum drawdowns.

 

The Credit Suisse Global Investment Returns Yearbook 2018 reports that the long-term return of US stocks from 1900 to 2017 was 9.6% annually.

 

The long-term stock returns of major developed countries and emerging markets worldwide are generally above 8%.

 

Nevertheless, stock markets in various countries are susceptible to significant drawdowns during crises, often ranging from 40% to 60%. Consequently, relying solely on stocks for investment entails substantial risk.

 

Bonds

 

Bonds serve as the most suitable asset for hedging against stock market risks and are thus commonly included in portfolios.

 

Among the many types of bonds, this discussion primarily refers to long-term government bonds backed by various countries, with the US ten-year government bond being the most crucial. Its yield, typically around 2% to 4%, is known as the 'North Star' of global asset prices.

 

Bonds generally have minimal fluctuations, but in extremely rare situations, such as the 1979 oil crisis, the US ten-year government bond index experienced a cumulative drawdown of over 20% in just over two years.

 

Gold

 

Gold is often perceived as a safe haven asset to be acquired during economic downturns, leading to the popular adage, 'buy gold in troubled times.' However, this perception may not entirely align with reality.

 

The chart below shows the trend of gold prices during major wars globally over the past forty years, and you'll find that the impact of wars on gold prices isn't significant.

 

In general, during severe financial crises or war crises, gold can play a certain hedging role, but this doesn't mean its price will rise during crises.

 

Commodities

 

Commodities include well-known items such as oil, natural gas, copper, aluminum, wheat, corn, sugar, etc., which can basically be categorized into three major types: energy, metals, and agricultural products.

 

Overall, commodity prices tend to rise in the long term. However, some masters don't like commodities, such as Buffett. In his view, anything that doesn't generate cash flow isn't an asset; it's just a chip—because you're always expecting someone to buy what you have at a higher price.

 

So, how about the long-term returns and drawdowns of gold and commodities? From 1973 to 2017, the overall return rate of gold was around 6.9%, while commodities ranged from 5% to 6%, higher than bonds but lower than stocks. The volatility and drawdowns of these two assets are higher than those of stocks and bonds; gold's maximum drawdown once exceeded 60%, while commodities as a whole fell by over 80%.

 

Real Estate

 

In a 2017 study, several scholars computed the long-term return rates of real estate in major developed countries worldwide, encompassing property appreciation and rental income. Excluding inflation, these returns generally range between 8% and 10%, similar to stocks. In terms of volatility and drawdowns, real estate is somewhat similar to stocks but slightly higher. Overall, the long-term risk-return profiles of real estate and stocks in many developed countries are quite similar.

 

Investing in houses requires significant capital. For those with limited funds, Real Estate Investment Trusts (REITs) offer a practical alternative.

 

In simple terms, a stock-type fund aggregates everyone's money to buy stocks, while a Real Estate Investment Trust aggregates everyone's money to invest in real estate projects, and you can own a share of the investment based on how much money you put in.

 

The Key in Asset Allocation: Risk Control

 

In asset allocation portfolios, the primary risk dimension is “economic growth and inflation risk.” According to Bridgewater's All-Weather model, risk is evenly distributed among four economic environments, delineated by variations in economic growth and inflation. It's worth noting that this idea not only contains the embryo of factor allocation but also aligns with Merrill Lynch's cycle theory of the clock model.

 

The Merrill Lynch Clock was proposed in 2004 by Merrill Lynch Securities. Based on the study of 30 years of historical data from 1973 to 2004, it connects asset rotation and industry strategies with economic cycles, serving as a classic theory and practical tool in asset allocation. The Merrill Lynch Clock divides the economic cycle into four stages based on the high and low levels of two macro indicators, the economic growth rate (GDP) and the inflation rate (CPI): recession (low GDP + low CPI), recovery (high GDP + low CPI), overheating (high GDP + high CPI), and stagflation (low GDP + high CPI). As shown in the figure, the classical economic cycle from recovery to recession starts from the upper left corner, and the four stages advance clockwise. During this process, stocks, commodities, cash, and bonds become superior to other assets in turn.

 

In the practical application of asset allocation, selecting assets is the first and most critical step, which significantly influences the final outcome. In the selection process, on the one hand, consider the macro factors reflected by assets and whether these macro factors can bring risk premiums; on the other hand, risk premiums are not fixed. Under varying economic conditions, the risk premiums associated with assets may exhibit divergent shifts in cost-effectiveness. Therefore, strategies such as time-series momentum, cross-sectional momentum, or relative value can further optimize asset allocation to enhance its effectiveness. Current industry practices reveal that many major asset class indices employ comparable methodologies.

 

In Summary: Don't put all your eggs in one basket.