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Allocation to optimize reward vs. risk

As part of the 2020 Investment Outlook Seminar, Bob Landaas and Dave Sandstrom explain how the investment mix is essential to optimizing risk-adjusted returns. A transcript of their conversation follows.

Bob Landaas: Joining us now is the advisor, Dave Sandstrom, to talk about asset allocation.

Dave, when I started managing money in the mid-‘70s, it was widely viewed that Wall Street added value through market timing and stock selection. In 1986, a famous study came out—the Brinson, Beebower, Hood study—that showed maybe it’s more asset allocation than market timing and stock selection.

And then, of course, 1990, Harry Markowitz, work he did at the university of Chicago led to the Nobel Prize in economics for his theory of asset allocation.

Of course, Dave, it wouldn’t be a seminar without us talking about our well-known 30 -year look-back chart of asset allocation.

Would you please step the viewers through that latest version?

Dave Sandstrom: Sure thing, Bob. The efficient frontier chart that we have on the screen now is really basically a risk/return trade-off chart.

We embrace risk. We like risk. We need risk to make adequate returns. But we also need to know for every additional unit of risk that we’re taking, how much is that return? Am I getting compensated appropriately for that extra unit of risk?

And, as the chart shows here, you can see, as you move up off of a 100% bond portfolio, and you pick up a 20% sleeve of stocks, you see a nice bump in return. Yet, we’re not looking at a large increase in our risk.
And that kind of continues across the curve. You look at 40% stocks, another nice bump in return. And then, as we move out, though, you’ll see something interesting happen.

Once we get to about 60% in stocks, we see now that our risk line is going to continue to go up, and yet our return line is flattening out.

And if you look here at the numbers in the chart, you can see that that 60/40 portfolio, for the last 30 years, returned 8.9%. The 100% stock portfolio returned 9.8%. Now, that is less than a percentage point, and yet you had to increase the risk in the portfolio by nearly 60%.

Bob, I think that you can see from that, that’s an awful lot to pay for such a small percentage of return.

One of the things that we have to look at when we’re looking at these efficient portfolios is how the assets in those portfolios react to each other, something that we talk about with that is correlation.

Bob: Dave, the correlation theory is fairly easy to explain. It’s how different types of assets move relative to one another.

When one zigs, you want something else to zag so that, in aggregate, the portfolio’s doing pretty well.

Correlation theory, of course, changes over time. In financial crises, correlation moves closer to one. Asset prices move together: They go up together, down together. But in normal market years, correlation can add a huge degree of safety, if you study asset allocation.

To me, asset allocation is like the old game of pick-up sticks. When you put that one more stick on the pile, when will it all come cascading lower?

So, you literally analyze at what point is the next unit of risk not worth the reward that you get? If you dramatically increase volatility for a puny increase in return, it’s clearly not worth the effort.

Dave: And some of those assets, Bob, that we like to place into the portfolio are ones that are negatively correlated to the stock market. Not too many of them out there, but you can see something like Treasury bonds, or even investment-grade corporates, have a tendency to do well in times of market duress.

And having some of those in the portfolio not only limit the total downside risk that you have during these types of sell-offs, but it also provides you with an important source of liquidity during market turmoil, where those assets are going up instead of down. And, of course, we never want to sell our life savings at a discount.

Bob: You know, and that’s really the key to understanding asset allocation is to learn to love your underperformers.

The definition of asset allocation, of course, is going to be you’ll have some asset categories in your account that are doing better than others. And often times, the tendency is to want more of what’s doing better and less of what’s underperforming—when, in fact, if you stick to the asset allocation model, you’ll eventually find that the underperformers eventually graduate to lead the markets higher.

So, it’s important to just stay with it. Most people want to talk to me about market timing and stock selection, and the studies have clearly shown that it represents less than 8% of how well you do. It’s measurable, but it’s not a big number.

So, you really focus on asset allocation, and the essence is to make sure that you’ve got your bases covered, so that no matter what plays out in the future, that you have a portfolio that’s balanced properly to reflect that.

Dave: And, Bob, especially during times of prolonged market upside performance. So, we just went through that in 10 years. And then, people get tired of seeing those underperformers in the portfolio.

You get people saying, “Why do I own all these bonds?” Well then, of course, we get to a stage where we see something like what happened recently with the pandemic, and people then understand quite clearly how important it is to hold those negatively correlated assets in their portfolio.

And, Bob, when you look at that 60/40 portfolio, it plays very well into something that we look at when it comes to withdrawal strategies. One of the things that we employ is something called the 4% rule. And when you look at that 60/40 portfolio containing 40% of things that are not going to be affected by that downturn in the stock market, you’ve just set yourself up for about 10 years of portfolio withdrawals that you are feeling pretty comfortable about where they’re at.

So, you’re absolutely right, when you have to love those underperformers. It can be really accented by times of duress, like we’ve just gone through.

Bob: You know, of course the key to asset allocation is to think long term.

Asset allocation means not to try to time your account. Asset allocation means not to dramatically overweight one particular style over another.

That’s a challenge these days, as you know, Dave, with growth stocks dramatically outperforming value by a pretty wide margin.

So, it takes a little bit of courage to hang on to those underperforming value stocks, historically one of my favorite areas of the market. But it’s important to own both. Yes, own value stocks, even at a time when they’re underperforming. And own your growth stocks. Don’t load up on them, because market leadership rarely repeats itself for more than a handful of years.

Dave: And, Bob, I think that when sometimes investors get a little intimidated by the charts and the math and the coefficients of correlation studies. But at the end of the day, I think you can sum it up by saying that if you take half your money and try to grow it, and take the other half and behave yourself, I think you’re going to find that you’re going to stay out of trouble.

Bob: To me, one of the keys to asset allocation beyond correlation theory and beyond the risk/reward ratio is the concept of humility. It’s pretty difficult to forecast during a pandemic. It’s challenging, perhaps even impossible, short term. So, that’s to me the beauty of asset allocation is that your portfolio is designed to take you through thick or thin.

Market timing is challenging. Forecasting is almost impossible, with so much uncertainty out there. So, you can rest assured of knowing that your model should stand the test of time.

And of course, the chart that we’ve shown now, we’ve been bringing out every year at these seminars, for decades. And folks with good memory will know that the results rarely change. There are times when the 30-year pattern leaves out some bad markets, includes good markets, but you’re talking about tenths of a percent normally, and, I’m just mesmerized by having done this for so many years, that the risk/reward ratios hardly ever change over time.
Well, thank you, Dave for those words of wisdom.

Dave: No problem, Bob. Thank you for having me on.

Bob Landaas is chief executive officer of Landaas & Company.

Dave Sandstrom is vice president and investment advisor at Landaas & Company.

Learn more
2020 Investment Outlook Seminar, a Money Talk Video
Efficiently allocating assets, a Money Talk Video with Steve Giles
Mind correlation to control risk, a Money Talk Video with Paige Radke
Retirement spending: Safe rates, a Money Talk Video with Art Rothschild
The importance of humility in investing, a Money Talk Video with Art Rothschild
(initially posted October 29, 2020)

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