The myth of the all-weather portfolio

For quite some time now financial advisers of all stripes have been in search of the elusive “all-weather portfolio.”  That is, an asset allocation that serves to protect investors in bad times (bear markets) and performs well in good times (bull markets).  Does an all-weather portfolio really exist?

Prior to the economic crisis many would have answered in the affirmative and would have pointed to the large university endowment funds as examples of investors who had achieved this goal.  However the aftermath of the credit crisis and ensuing bear market indicate these funds have failed to achieve this goal.

Maybe it isn’t that case that asset allocation models are broken.  It may simply be the case that we are asking too much of asset allocation as a discipline.  In what other investing endeavor do we expect to have the best of all possible worlds?

This discussion comes about in response to a post by Rick Bookstaber after his appearance on the show WealthTrack focusing on the prospects for asset allocation.  (We recommend that you check out both Bookstaber’s post and the show itself.)  On the topic of all-weather portfolios Bookstaber writes:

I don’t think there is some magic asset allocation that protects you from the buffetings of financial storms without it also trimming your sails during fair weather.

This conclusion arises in part by the phenomenon that is rising correlations during periods of market stress that we have already discussed at some length.  It is difficult to achieve the benefits of diversification if (nearly) all risky assets are trading in the same direction.

Alternative asset classes turned out to be a major disappointment of this crisis-fueled market cycle.  One reason why advisers felt comfortable including alternative asset classes in an asset allocation was because were in the midst of a period of low volatility and few bear markets.  In this light alternative assets were viewed as both portfolio diversifiers and return enhancers.  Unfortunately neither of these came to pass.

Indeed we may be seeing the seeds of another asset class disappointment down the road.  Two of the panelists on WealthTrack, including Bookstaber, chose inflation protected bond ETFs (TIP & WIP) as their “one investment.”  While Bookstaber disputes the notion that TIPs are a separate asset class he notes that do load on inflation and that makes them attractive in an asset allocation framework.

Apparently some one is listening because investors are pouring pouring money into TIPS mutual funds.  However TIPS are no panacea.  Like any other asset class TIPS are prone to being under and overpriced due to changes in demand for the asset.  It remains to be seen whether the run-up in TIPS relative to plain-vanilla treasuries will be rewarded.

The fact that there is no perfect asset class or asset allocation should not be surprising.  The question for investors is what to do about it?  There are two general approaches to this question.

The first is to accept the limitations of asset allocation.  Develop a low cost, well-diversified portfolio of assets with the intent of re-balancing the asset allocation over time.  Provided that this approach includes some risk-free assets, it has the ability of tempering the losses in bear market.  However one need accept that no asset allocation plan can prevent losses in each and every time frame.

The second approach is admittedly more aggressive and is for investors unwilling to settle for the more restrained approach.  This strategy tries to take a more active approach to asset allocation.  Rather than simply re-balancing your portfolio over time it includes trying to time broad market moves, like that of Mebane Faber’s timing model.  This dynamic approach comes with its own risks as well.  Market timing introduces active risk that is not there in a more passive approach.

It makes sense from time to time to re-visit our strongly held beliefs about investing.  For many, asset allocation seemed like a free lunch:  higher returns and lower risk.  In the interim we have learned that avoiding risk is more difficult that it first appears.  To answer the question we asked at the beginning of the post:  there is no all-weather portfolio.  There never was.  What remains are approaches that recognize the inherent limits of asset allocation and the risks of active investing.

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