Asset Classes

Free investment financial education

Language

Multilingual content from IBKR

Close Navigation
Learn more about IBKR accounts
Chart Advisor: Discovering Dynamic Asset Allocation

Chart Advisor: Discovering Dynamic Asset Allocation

Posted September 16, 2024 at 9:13 am
Investopedia

By Andreas Clenow

Dynamic Asset Allocation Part One

Investopedia is partnering with CMT Association on this newsletter.  The contents of this newsletter are for informational and educational purposes only, however, and do not constitute investing advice. The guest authors, which may sell research to investors, and may trade or hold positions in securities mentioned herein do not represent the views of CMT Association or Investopedia. Please consult a financial advisor for investment recommendations and services.

Why Allocation Models are Better than you Think

Simple tactical asset allocation models outperform not only the stock markets, but the vast majority of investors. That’s a bold statement to make, but I’ll go step further. Even though the regular TAA approach performs really well, we can significantly improve it with fairly simple methods. And I’ll prove it. 

In this series of five articles, I will explain all the details. First, I’ll show the regular TAA approach, explain how it works, and how it outperforms the markets. I’ll then go into the potential problems with these classic tactical models, before showing how to improve them. You will get all the details of how I apply momentum overlay to greatly improve performance, and I will give you suggestions for research areas to push the concept to even greater length. 

So, let’s kick it off with the basics. Here’s the basic idea. Most people pick stocks or time the market, and mostly end up spending a lot of time and effort only to underperform the market. What if you could achieve a better performance without all of that time and effort, with a very simple portfolio diversification?

Let’s take the most famous example and give it a closer look. The aptly named All Weather Portfolio was proposed by Ray Dalio as a sort of fire-and-forget solution to long term asset management. You would buy six different assets and fixed weights and reset these weights just once a month. The reason for the reset, or rebalance, is that the difference in performance would soon move the actual weights too far from the target weights. That’s why we need to reset them.

Dalio’s portfolio was based on stocks, medium term treasuries, long term bonds, gold and commodities. His All Weather Portfolio holds 30% stocks, 15% medium term treasuries, 40% long term bonds, 7.5% gold and 7.5% commodities. This portfolio clearly has much more fixed income than stocks, and the reason for that is simply that stocks are much more volatile.

I know that this sounds like a very boring way to manage your money. But boring can be very efficient. Let’s have a look at the performance of this simple model over time. It’s easy to model and backtest this allocation, and we can use ETFs for each of the five positions. 

If you looked at these backtest details compared to the S&P 500 and concluded that the All Weather Portfolio failed to beat the market, take another look. Sure, the index returned 8.4% over this period while the allocation model only did six percent and change. But return without risk context is simply irrelevant. If all you want is to aim for the highest possible return, you also need to accept the highest possible risk. The logical conclusion of that is to spend all your money on lottery tickets. You’re very likely to lose all your money, but at least you have a tiny chance of winning big.

In finance we always aim for the best possible risk adjusted return. And from that perspective, the All Weather Portfolio knocks it out of the park. We have a much lower volatility, a significantly higher Sharpe ratio and less than half of the drawdown. 

Comparing the index to the AWP model is no contest. The allocation model wins easily. But that doesn’t mean that it doesn’t have issues, or that it can’t be improved. 

In the next article, I will bring up these issues, explain what problems we can see with the classic AWP model and how we could approach addressing them. After that, I will teach you a very practical approach to improving not only the All Weather Portfolio, but also most other allocation or trading approaches.

Originally posted 16th September 2024

Join The Conversation

If you have a general question, it may already be covered in our FAQs. If you have an account-specific question or concern, please reach out to Client Services.

Leave a Reply

Disclosure: Investopedia

Investopedia.com: The comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy.  While we believe the information provided herein is reliable, we do not warrant its accuracy or completeness. The views and strategies described on our content may not be suitable for all investors. Because market and economic conditions are subject to rapid change, all comments, opinions and analyses contained within our content are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy. This information is intended for US residents only.

Disclosure: Interactive Brokers

Information posted on IBKR Campus that is provided by third-parties does NOT constitute a recommendation that you should contract for the services of that third party. Third-party participants who contribute to IBKR Campus are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Investopedia and is being posted with its permission. The views expressed in this material are solely those of the author and/or Investopedia and Interactive Brokers is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to buy or sell any security. It should not be construed as research or investment advice or a recommendation to buy, sell or hold any security or commodity. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Disclosure: ETFs

Any discussion or mention of an ETF is not to be construed as recommendation, promotion or solicitation. All investors should review and consider associated investment risks, charges and expenses of the investment company or fund prior to investing. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

IBKR Campus Newsletters

This website uses cookies to collect usage information in order to offer a better browsing experience. By browsing this site or by clicking on the "ACCEPT COOKIES" button you accept our Cookie Policy.