Asset Allocation for Time Horizons of One and Ten Years

Roland E. Suri, Suri Consulting, Zurich, Switzerland, August 23th 2012

SUMMARY
Allocation of assets to classes such as stock funds, bond funds, REITS, Gold, and Commodities is one of the most important choices for investors. A sensible weighting of asset classes needs to take into account the expected future returns of asset classes as well as the risks and the expected correlations between them. In the current study, publicly available data (US, 1972 to 2011) and an Excel spreadsheet is used to analyze two sample portfolios according to Modern Portfolio Theory by (1) calculating the Betas of several asset classes with regards to these portfolios using asset class correlations of historical data, and (2) estimating the expected asset class returns that are implied in these portfolios. This analysis is explained in simple terms and performed by using one year real returns and 10 year real returns. The betas of risky asset classes (Small Cap Value, Large Value, Gold, REIT, Commodities) versus the capitalization-weighted market stock fund (Total US Market) became much smaller for 10 year returns than for one year returns. The opposite was true for bond funds. Thus, diversification with these risky asset classes was more effective for a 10 year time horizon than for a one year time horizon. This effect was most pronounces for the Small Cap Value fund. These funds are usually considered risky, as they historically provided higher average returns than the total stock market. However, when 10 year returns are considered, the small cap value fund offered diversification benefits and its risk became almost as small as that of long-term government bonds.

INTRODUCTION
ASSET ALLOCATION
Portfolio diversification among asset classes needs a consistent strategy. The most common mistake for investors is to change the asset allocation depending on financial news. Even the most sophisticated investors (big university endowment funds) usually do not try to time the market (see reference 1). It was proposed to decide in advance the weighting of each asset class in the portfolio and then to rebalance regularly to restore the target allocation. This has the advantage that one regularly buys the assets that have fallen in value and sells the assets that gained value. The

asset mix would be proportional to the size of the investable assets (see reference 2). However, if a Japanese investor had followed this advice at the time of the Japanese stock market bubble of 1991, his subsequent real returns would have been disastrous. Many investors thus favor a tactical asset allocation that gives approximate weights to the most common asset classes depending on the risk tolerance of the investor. The tuning of these weights is then done by looking at the expected risks, expected correlations, and expected returns. I use here the approach of calculating the Betas of several asset classes for a given portfolio. This approach does not give the efficient portfolio, but instead suggests a step into the direction of the efficient portfolio. This tells an investor in which asset classes to diversify given his current portfolio and his assumptions on future returns.

THE BETA IN MODERN PORTFOLIO THEORY

The Beta is a widely known parameter in the Capital Asset Pricing Model (CAPM) of Modern Portfolio Theory and describes how much an asset moves in parallel with movements of the general stock market. In the current study, the Beta of an asset class is defined with respect to movements of the investment portfolio. The correlations of US asset classes from 1972 to 2011 are used. By calculating values of Beta for several asset classes with respect to a typical investment portfolio, I use a simple method to estimate the projected asset class returns that are implicit in an investment portfolio. Expectations on future asset class returns can then be used to improve the asset allocation. An investor could iterate this process many times by calculating the Beta for the diversified portfolios. He would thus perform mean variance optimization and would end up with the efficient portfolio. This is the portfolio with the least risk for a given return. Such portfolio returns and optimal portfolios can be calculated online over the riskcog web interface. Unfortunately, this approach is very sensitive to the assumptions (reference 3). I give a simple example of the method used here. The risk-free rate of return is often given by the return of 90 day Treasury Bills. Lets assume a risk-free real rate of return of zero and a portfolio fully invested in Vanguards Total Stock Market Fund (VTSMX). Thus, the beta of the Treasury Bills is zero and the beta of the total stock market is one. To reduce the risk of the portfolio, the investor considers two options: a) 99% total stock market, 1% Treasury Bills b) 98% total stock market, 2% REIT fund If one evaluates one year returns 1972-2011, the REIT index fund lost (or won) on average 5% over a year when the total stock market lost (or won, respectively) 10% over this year. The beta of the REIT fund is thus 0.5. The REITs had some ups and downs that were unrelated to the total stock market, but the investor does not care about this as he only considers buying a small proportion of REIT funds. Options a) and b) have thus the same risk. For simplicity, lets assume the expected return of Treasury Bills is zero. The expected returns of options a) and b) are equal if the expected return of the REITS is exactly half of the expected return of the total stock market. If an investor decides for option a), he apparently assumes that the REIT fund will return less

than half of the total stock market return. The Inferred Return of the REIT fund is thus half of the return of the total stock market. One problem with this approach is that most long-term investors care about down-side risks caused by rather infrequent crises. In such crises returns of risky assets become more correlated (reference 4) presumably because investors sell risky assets indiscriminately. Unfortunately, this reduces the benefit of diversification when it is most needed. The analysis thus tends to overestimate the advantage of diversification. This issue could be addressed by changing the definition of risk. One would only look at major market crises in longer data series. If a specific asset class follows downturns in general stock market prices in half of the crises and remains resilient in the other half, one would estimate a Beta of 0.5.

RISK AND RETURN USING ONE-YEAR REAL RETURNS

Simba's spreadsheet1 provides returns from 1972 to 2011 for 28 low cost index funds that are available to private investors. From these 28 index funds, I selected a subset of broad asset classes for which I suspected good long-term risk-return characteristics or good diversification properties (TABLE 1 ).
Table 1 Selected Asset Classes with similar ETF Products, their mean annual real returns 1972-2011, and the corresponding standard deviations.
Total US Stock Market ETF Product Mean Return Standard Deviation VTSMX Small Cap Value VISVX Large Cap Value VIVAX EAFE85/ EM15 (International stocks) VGTSX TIPS Total Bond Long Term Govt Bond VUSTX REIT Gold Commodities

VIPSX

VBMFX

VGSIX

GLD

PCRIX

6.9% 17.7%

10.6% 19.6%

8.8% 17.4%

7.8% 22.4%

3.0% 7.4%

3.7% 6.9%

4.4% 12.8%

8.0% 16.0%

4.8% 28.1%

7.1% 17.9%

For these asset classes, the Betas are given with respect to the yearly real return of the total US Market (TABLE 2 ). Let us assume an investor allocates 100% of his assets in a capitalization-weighted index fund of the US stock market (Total US Stock Market). The smaller the value of Beta, the better was historically the diversification property of an asset for this portfolio. According to Table 2, Gold offered the best diversification properties, followed by Commodities and TIPS. Since this investor does not choose to diversify his portfolio with these other asset classes, he apparently expects that they will deliver lower returns than the Inferred Return. If he expects for one of the neglected asset classes a higher return than the Inferred Return, he should increase his exposure to this asset class. Data for this paper from https://sites.google.com/site/bogleheadinvestor/files/BacktestPortfolio-returns-rev11a.xls?attredirects=0&d=1. See this discussion on bogleheads.org for the latest version and background information.
1

The Inferred Return is given by the formula return of risk-free asset plus Beta times return of Total US Stock Market. I assumed a risk-free real return of zero2 and an expected real return of 5.4 % for the US stock market 3 (which is the average real world stock return). Estimating these numbers is difficult and other investors may use different values for their own calculations. According to TABLE 2 , Inferred Real Returns of Small Cap Value, Large Cap Value and REIT are quite low as compared to historical real returns of these assets. This suggests increasing the positions in these asset classes. Buying some Gold and Commodities4 is recommended if positive returns are expected for both asset classes.
Table 2 Betas and inferred real returns for several asset classes with respect to Total US Stock Market.
Total US Stock Market Beta Inferred Return* 1.00 5.4% Small Cap Value 0.78 4.2% Large Cap Value 0.91 4.9% EAFE85/ EM15 TIPS Total Bond Long Term Govt Bond 0.28 1.5% REIT Gold Commodities

0.75 4.1%

0.10 0.5%

0.17 0.9%

0.49 2.6%

-0.58 -3.2%

-0.17 -0.9%

* Assumptions: Projected 5.4% real return for total US stock market and a risk-free rate of zero.

Bill Schultheis recommends a diversified portfolio with 40% Total Bond , 10 % Large Cap Value, 10% Large Cap Blend, 10% Small Cap Value, 10% Small Cap Blend, 10% REIT, and 10% EAFE85/EM15. The return and risk of this so-called Coffee House portfolio is analyzed on the bogleheads.org Excel sheet (1972-20011, rebalanced yearly). The Betas are shown in TABLE 3 . Since the portfolio includes investments in Total Bond, Large Cap Value, Large Cap Blend, Small Cap Value, REIT, and EAFE85/EM15, the corresponding Betas are increased as compared to the previous table. The inferred returns were calculated as before (projected 5.4% real return for Coffee House portfolio and a risk-free real return of zero). This portfolio is more reasonable than the previous portfolio because the inferred returns for Small Cap Value, Large Cap Value and REIT are more consistent with historical values. The Beta of 1.45 of the Total US Stock Market relative to the Coffee House Portfolio indicates that drops (or increases) of the US Yearly return of three month treasury is 0.1% (as of 08/02/12). Inflation of the year 2012 was estimated by the IMF to be 2.1%. A more accurate estimate of real risk free of return would thus be -2%. 3 I simply extrapolated historical real stock returns to estimate future returns. However, I personally expect much lower future returns for US stocks. A good approximation of the future real stock returns is given by the ratio of the stock index price divided by earnings averaged over 10 years (see figure 1.3 in Reference 1). Price-earning values using this Shiller method of averaging earnings over 10 years is 22 for US (July 5th, 2012) and 12 for Europe (June 28, 2012). The annualized 10 year real returns 1881 to 1989 in the US subsequent to these Shiller PE10 values were around minus 3% for a PE10 of 22 (US) and plus 10% for a PE10 of 12 (Europe) (see figure 1.3 in Reference 1).
2 4

Unfortunately, correlations of commodities to total stock markets increased in 2009.

stock market by 14.5% historically caused a drop (or increase, respectively) of the Coffee House portfolio of 10%.
Table 3 Betas and inferred real annual returns (1972-2011) with respect to Coffee House portfolio.
Coffee House Portfolio Beta Inferred Return* 1.00 5.4% Small Cap Value 1.56 8.4% Total US Stock Market 1.45 7.8% Large Cap Value 1.47 7.9% EAFE8 5/ EM15 1.27 6.9% TIPS Total Bond Long Term Govt Bond 0.67 3.6% REIT Gold Commodities -0.36 -1.9%

0.24 1.3%

0.38 2.1%

1.14 6.1%

-1.05 -5.7%

* Assumptions: Projected 5.4% real return for Coffee House portfolio and a risk-free rate of zero.

RISK AND RETURN USING TEN-YEAR REAL RETURNS

Most investors are only hurt if real returns disappoint for time periods longer than one year. TABLE 4 shows average and standard deviation of annualized 10 year real returns for the selected asset classes. Surprisingly, the standard deviation of Small Cap Value was smaller than that of the Total US Stock Market and almost as low as that of Long Term Government Bonds. Other definitions of risk also favor Small Cap Value stocks: Inspection of the data shows that the worst 10 year real return of Small Cap Value was higher than that of the Total US Stock Market or Long Term Government Bonds (+3.6 versus -3.1 or -5.6).
Table 4 Selected asset classes, their mean annualized 10 year real returns (data 1972-2011), and the corresponding 10 year standard deviations.
Total US Stock Market Mean Return Standard Deviation 7.1% Small Cap Value 10.1% Large Cap Value 8.1% EAFE85/ EM15 TIPS Total Bond Long Term Govt Bond 4.7% REIT Gold Commodities

7.3%

3.8%

4.0%

8.8%

0.5%

5.1%

4.9%

3.9%

4.4%

6.0%

2.5%

2.1%

3.6%

2.8%

7.1%

3.8%

Table 5 shows that the Betas for stock funds become smaller for the time period of 10 years than for one year. Apparently, these asset classes are quite correlated for short time periods and behave more independently over longer time periods. This enhances the diversification effects of these risky asset classes for long-term investors. An investor with 100% in total US stock market and 10 year time horizon has thus stronger arguments to diversify in risky assets (Small Cap Value, Large Cap Value, Gold, Commodities, and REIT) than an investor with a one year time horizon. Since Small Cap Value, Large Cap Value, EAFE85/EM15 (international stocks), and REIT have lower Inferred Returns but equal or higher historical returns than the US stock market,

I would suggest to add these asset classes to a portfolio with 100% in US stock market. Gold and Commodities should be bought if one expects that they will deliver positive real returns.
Table 5 Betas and inferred 10 year real returns for several asset classes with respect to Total US Stock Market.
Total US Stock Market Beta Inferred Return Recommendation 1.00 5.4% sell Small Cap Value 0.40 2.1% buy Large Cap Value 0.85 4.6% buy EAFE85/ EM15 TIPS Total Bond Long Term Govt Bond 0.40 2.2% REIT Gold Commodities

0.65 3.5% buy

0.25 1.3%

0.30 1.6%

0.21 1.1% buy

-1.30 -7.0% (buy)

0.01 0.1% (buy)

Table 6 shows Betas and Inferred Returns for the Coffee House portfolio (40% Total Bond , 10 % Large Cap Value, 10% Large Cap Blend, 10% Small Cap Value, 10% Small Cap Blend, 10% REIT, and 10% EAFE85/EM15). For the Coffee House portfolio the weight of Small Cap Value appears too small as compared to Large Cap Value because Small Cap Value provided higher historical returns (see Reference 6). Gold may be bought for diversification purposes even if slightly negative real returns are expected. Commodities should be bought if one expects positive real returns.
Table 6 Betas and inferred real returns with respect to Coffee House portfolio.
Bill Schultheis Coffee House Beta Inferred Return Recommendation 1.00 5.4% Small Cap Value Total US Stock Market 1.85 10.0% Large Cap Value EAFE8 5/ EM15 TIPS Total Bond Long Term Govt Bond 0.78 4.2% REIT Gold Commodities

1.01 5.5% buy

1.65 8.9%

1.77 9.6%

0.53 2.9%

0.63 3.4%

0.69 3.7% buy

-2.47 -13.3% (buy)

-0.29 -1.6% (buy)

CONCLUSIONS
Mean variance portfolio optimization is usually performed to reduce the standard deviation over one year returns. For most investors, the risk over a longer time horizon may be more relevant. The above results suggest that Betas with respect to the total stock market over 10 year time periods become smaller for risky asset classes (Small Cap Value, Large Cap Value,

REITS, and Commodities) and larger for bond funds. Therefore, long term investors should overweight these risky asset classes and reduce their bond holdings. Standard Modern Portfolio Theory would assume that the Beta over 10 years is similar to the average of the one year Betas. However, it has been shown that return differences between asset classes over five year periods are surprisingly large when compared to the Betas calculated over one year periods (see reference 5). Apparently, these risky asset classes are quite correlated for short time periods and behave more independently for longer time periods. Furthermore, the risk of diversified stock portfolios is reduced for long time horizons due to mean reversion (see reference 7). Both effects may contribute to the reduction of 10 year Betas for risky asset classes and the increase of these Betas for bond funds. These effects of looking at 10 year returns were most pronounced for the Small Cap Value fund. The risk of Small Cap Value was smaller than that of the Total US Stock Market and almost as small as that of Long Term Government Bonds. This result is surprising because Small Cap Value historically provided higher average returns than the total stock market (see reference 6).

REFERENCES
1) Robert Shiller, Irrational Exuberance, Princeton University Press, 2000 2) David F. Swensen, Unconventional Success: A Fundamental Approach to Personal Investment, Free Press 2005. 3) John L. Maginn, CFA (Editor), Donald L. Tuttle, CFA (Editor), Dennis W. McLeavey, CFA (Editor), Jerald E. Pinto, CFA (Editor) Managing Investment Portfolios: A Dynamic Process, 3rd Edition, ISBN: 978-0-470-08014-6, April 2007. 4) David B Chua , Mark Kritzman , Sbastien Page. The Myth of Diversification. The Journal of Portfolio Management Fall 2009, Vol. 36, No. 1: pp. 26-35. 5) Statman and Scheid, Correlation, Return Gaps, and the Benefits of Diversification, The Journal of Portfolio Management, 2008 6) Fama, Eugene F. and French, Kenneth R., Value Versus Growth: The International Evidence (August 1997). Available at SSRN: http://ssrn.com/abstract=2358 or http://dx.doi.org/10.2139/ssrn.2358 7) Jeremy J. Siegel. Stocks for the Long Run, McGraw-Hill Companies; 4th edition (November 27, 2007, ISBN 978-0-07-149470-0)

AFFILIATIONS AND POTENTIAL CONFLICTS OF INTEREST

I took care to give a balanced view and to provide correct information. However, errors cannot be fully excluded and I cannot be hold responsible for them. Investment decisions should always take all individual circumstances into account. I have never received payments from a financial company. I provide truly independent investment advice. For information on my consulting services see https://sites.google.com/site/drsuriconsulting