Investors know they should diversify their portfolios—the question is how. Conventional wisdom holds that a properly diversified portfolio is 60% stocks and 40% bonds. This allocation assumes that steady bond returns will help offset the volatility of stocks. Alex Shahidi, taking his cue from the Bridgewater All Weather Fund, argues against this conventional wisdom. In Balanced Asset Allocation: How to Profit in Any Economic Climate (Wiley, 2015) he suggests that a truly balanced portfolio will include fewer stocks and more bonds, both treasuries and TIPS, along with some commodities. His sample balanced portfolio has 20% equities, 20% commodities, 30% long-term treasuries, and 30% long-term TIPS.
Overweighting bonds is not an intuitive asset allocation strategy, so Shahidi takes pains to explain its rationale. He sets the stage with a description of Ray Dalio’s economic machine, more vividly shown in Bridgewater’s 30-minute animated video. He then explains why a 60/40 portfolio is not well balanced. First, “the impact of an asset class on the total portfolio is only dependent on two factors: (1) how volatile the asset class is, and (2) how much of the total portfolio is weighted toward it. … The more volatile asset class should get a lesser weight to make up for the fact that it is more volatile. The less volatile segment should receive a higher allocation so that its impact on the portfolio matches that of the higher-volatility asset class.” Second, “the traditional 60/40 allocation is 99 percent correlated to the stock market!” (p. 24)
Instead of viewing an asset class as something that offers returns, the Bridgewater model looks at it as “something that offers different exposures to various economic climates.” (p. 26) Some sources of volatility, such as the future cash rate and risk appetite, are not diversifiable. But the most hazardous risk to investors–shifts in the economic environment–can in large measure be neutralized through proper asset allocation.
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A simple two-factor model (growth and inflation) shows the economic bias of each major asset class. Equities want growth but not inflation, treasuries want neither, commodities want both, and TIPS want inflation but not growth.
With these basic pieces of the allocation puzzle in place, Shahidi explains each in more detail. TIPS, the most unlikely candidates for a major role in a balanced portfolio, are, according to the author, “possibly the most influential of the asset classes.” (p. 97) Their economic bias is opposite that of equities, so an outperformance in equities is normally matched with an underperformance in TIPS. In 2013, for instance, TIPS suffered big losses as equities soared. Bridgewater’s All Weather fund ended the year down 3.9%.
Shahidi admits that his basic portfolio is oversimplified, that other asset classes can be added to a portfolio and asset classes can be more narrowly defined—as long as you identify the environmental bias and overall volatility of each. For instance, your balanced portfolio can include global equities, emerging market bonds, commercial real estate, or small-cap stocks.
The bottom line is that a portfolio manager should weight asset classes to balance the economic exposure of the portfolio, not simply to equalize the risk of the asset classes (what has come to be known as risk-parity). If a portfolio is well constructed, it should be able to withstand future economic shocks.
Readers who want to emulate Bridgewater’s approach to asset allocation—professional portfolio managers as well as individual investors—will find a lot of useful information in Shahidi’s book. Just don’t expect miracles.