"Nothing in life is to be feared. It is only to be understood." - Marie Curie
"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets." - Peter Lynch
â€œSuccessful investing is about managing risk, not avoiding it." - Benjamin Graham
Many investors think of bonds as a diversifying asset for their portfolios. In particular, they use bonds to help combat stock market volatility. Many financial advisors happily accommodate (if not promote) this fear of stock volatility and advocate 60/40 or similar portfolios with their clients as representing a reasonable balance of risk and return.
Academic and practitioner research further supports this asset allocation approach. Indeed, there are many studies highlighting 90% of portfolio returns are determined by asset allocations. Accordingly, it is not surprising how prevalent this asset allocation model is with investors of all types.
This article analyzes the assumptions behind asset allocation models. We revisit both the purpose (risk reduction) and performance (returns) of standard asset allocation approaches relative to some alternative strategies. We also discuss how the logic is flawed when one uses the 90% explanatory statistic above to support the use of asset allocation models.
At the heart of this paper is the notion of risk. Like Warren Buffett, we find the conventional definition of risk most academics and practitioners use (i.e., volatility or standard deviation of market returns) is inappropriate. Accordingly, strategies that minimize this ill-defined risk metric may not be optimal. Indeed, we show how the mechanics of asset allocation strategies can systematically constrain performance and dampen long-term returns.
Investors who attain a better understanding of the real risks associated with stock investing (as well as the true cost of avoiding ill-defined risk) may wish to construct their portfolios differently (spoiler: higher equity allocations). This can enable them to significantly outperform 60/40 and similar benchmarks over the long term. To be sure, the views on risk we share here are not new or innovative. We are merely reiterating ideas Buffett and other great investors have advocated for years.