Reading more like a white paper, this concise book is an analytic review of the best known asset allocations, comparing their historical return and risk statistics. Faber arrives at a remarkable conclusion—that asset allocation doesn’t really matter much. Any reasonably diversified portfolio will yield a Sharpe Ratio of around 0.5 and return somewhere within 1% (annualized) of another. I found that result to be surprising, since the finance literature often espouses that asset allocation drives ~90% of portfolio returns. It seems it’s the nuance of the causation within that canard that misleads some to overly focus on allocation, which to a large extent is unknowable and so uncontrollable, and neglect fees and taxes, which are more concrete and important. The lesson is to choose a simple and cheap asset allocation, and to just stick with it.
- Stocks usually outperform bonds in the long-term, but not always. There have been 50+ year periods (1803-1857) when stocks have underperformed bonds. For the last 80 years, stocks beat bonds in 86% of rolling 10-year periods, and 96% of rolling 20-year periods (equity risk premium ~5%). But going back a full 200 years, stocks beat bonds in 71% of 10-year periods, and 83% of 20-year periods (equity risk premium ~2.5%). “Stocks for the long run” is probable, but not guaranteed.
- Simple rules of thumb (over long periods):
- stocks return 4 – 5% (real), bonds 1 – 2%, bills 0%, and cash negative
- Sharpe Ratio of asset classes 0.2 – 0.3, 60/ 40 portfolio 0.4, global asset allocations 0.5 – 0.6
- The 20thcentury U.S. stock market may have been an anomaly—unusually strong.
- Stock market near-complete wipe-outs: U.S. in the late 1920’s, Germany during 1910’s (WW1) and 1940’s (WW2), Russia in 1917 (revolution), China in 1949 (communism), Japan in 1990’s, global in 2008.
- 10-year CAPE (Cyclically-Adjusted Price Earnings) Ratio aligns highly with subsequent 10-year returns. Valuation matters. The long-term average is 16x. Once CAPE >30, future returns are forecasted to be negative.
- The U.S. now represents only 50% of global market cap, and only 20% of global GDP. Non-U.S. investors have larger home-country biases than Americans.
- Over the past 40 years, generally all asset classes have positive real returns. However, over 5-year periods, returns varied tremendously. And any asset class can have catastrophic losses. Returns are unpredictable, but volatility is fairly consistent.
- Risk Parity/ ‘All Season’ Portfolios:
- Only two assumptions hold in the long-run: 1) risky assets should return above cash, and 2) the actual risk will be driven by how economic conditions unfold relative to current expectations. Nothing else can be assumed.
- Diversified into four scenarios: 1) inflation rises, 2) inflation falls, 3) growth rises, 4) growth falls.
- Using leverage, asset class betas can be transformed to equalize risks, thereby increasing portfolio diversification without having to sacrifice returns.
- Permanent Portfolio: 25% to each stocks, cash, bonds, and gold. High gold allocation is controversial. Performance has been low volatility, but also relatively lower returns.
- Global market-cap weighted portfolio: 20% U.S. stocks, 20% foreign stocks, 50% bonds, 10% real assets.
- Warren Buffett’s suggested allocation: 90% S&P index fund, 10% short-term Treasury bonds.
- Excluding the Permanent Portfolio, all allocations are within 1% (annual) return of each other. Excluding Buffett’s allocation, all portfolios had Sharpe Ratio 0.4 – 0.6. Conclusion: the precise asset allocation percentages do not matter much.
- What does matter are costs. Including fees, the best allocation portfolio would underperform the worst, if implemented in an expensive way (active mutual funds, advisors). And taxes matter a lot. Look for tax-efficient vehicles, trade seldomly, use tax-deferred accounts, and tax loss harvest at year-end.
- Diversification is the only free lunch. At a minimum, investors should use the global 60/ 40 portfolio. Consider further including real assets. Also consider tilting to proven factors like value and momentum. Finally, just stick with your chosen asset allocation!
Finished: 1-Mar-2017. Re-read: 30-Oct-2018. Rating: 9/10.