Asset Allocation

David Dreman on Tactical Asset Allocation

August 4, 2011

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Some investors advocate tactical asset allocation (TAA) or the practice of adjusting the portfolio mix of stocks, bonds and cash to economic and/or market conditions. In his book Contrarian Investment Strategies, David Dreman notes that while it’s true that an investor who could successfully TAA could grow money on trees, TAA is difficult to practice because “real market movements give dozens of signals, madly flashing buy, sell and hold all at once”. Mr. Dreman then compares the performance of mutual funds that employ TAA to their benchmark and finds the results disappointing.

Does it work? The figures are not encouraging. Figure 3-1, taken from Lipper and Morningstar data, shows the returns of 186 asset allocators for the 12 years to September 1997 compared to the S&P 500 and the average of all domestic equity funds. The period covers a good part of the bull market, as well as the 1987 crash, and the sharp downturn in 1990. This was the ideal time for market timers or asset allocators to prove their mettle. They should have got you out before the 1987 and 1990 debacles and back in on time to ride the resurgent bull. Had they succeeded, you would have outperformed the market handily.

As the chart shows, heroes they ain’t. While the market surged 734% over the entire period, and the average equity fund moved by 589%, the asset allocators increased only 384%, about half the gain of the averages (all figures are dividend adjusted). Tactical asset allocation has obviously not set the world on fire. In fact, it’s downright awful, even in the periods where asset allocators claimed they swept the field.

The prosecution rests.

How to Tailor the Sleepy Portfolio for your Investing

February 22, 2011

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When I started the Sleepy Portfolio, I intended to track it as my personal portfolio benchmark and as such the portfolio allocations reflect my personal investment goals and risk tolerance. I am frequently asked how an investor should tailor this model portfolio to suit their investment goals. In this post, I’ll try and answer some of the questions that frequently arise:

Aggressive Asset Allocation

I started the Sleepy Portfolio in my early thirties and allocating 20% to bonds and 5% to cash is not unreasonable for a young investor. In fact, some would consider the allocation too conservative. Older investors can dial up the “sleep-at-night” quotient by increasing the allocation to bonds. Keeping the age in bonds is a good thumb rule to start with. The bond allocation should then be adjusted for the need, capacity and willingness to assume risk.

Too much allocation to Foreign Stocks

Once an investor has decided how much to allocate to fixed income, the next question is how much to allocate to Canadian stocks. The Sleepy Portfolio allocates 28% of the equity portion to Canadian stocks. Some may consider that too much, others too little (See this post on Portfolio Allocation to Canadian Stocks for some interesting comments). Dan Solin, author of The Smartest Investment Book You’ll Ever Read allocates just 10% to Canadian stocks in his model portfolios based on the belief that investors should hold globally diversified portfolios. Others such as money manager Leith Wheeler say that Canadian investors can get most of the global diversification by allocating half their portfolio in foreign stocks. It is clear that adding some foreign stocks to a portfolio reduces overall risk. Exactly how much is a matter of much debate.

Providing a value and small-cap tilt to the portfolio

The Sleepy Portfolio keeps it simple by holding broad-market, capitalization-weighted indices. There is a large body of evidence that show that investors would have earned a premium for holding small-cap stocks and value stocks in the past. Opinions are divided on whether investors should expect the small-cap and value premiums to exist in the future. I chose to keep it simple in my own portfolios but it is not unreasonable to choose to slice-and-dice equity holdings based on size and value.

The bottom line is that while the Sleepy Portfolio is well thought out (even if I say so myself!), there are not many right and wrong answers in investing. Should you allocate 28% or 35% of your equities to Canadian stocks? Pick one and stick to it. It is impossible to say in advance which option would turn out to be the best answer.

The Claymore Portfolio Index Allocator

February 22, 2011

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The Claymore Investment website has a nifty asset allocator tool that lets investors construct model portfolios by mixing different asset classes and examine how they would have performed in the past. The tool is similar to the asset mixer available on Norm Rothery’s Stingy Investor website. The Claymore asset allocator tool though includes asset classes such as REITs and commodities not found in the Stingy Investor website. However, Claymore’s asset allocator doesn’t seem to go as far back in time as Norm’s calculator.

I tried out Claymore’s asset allocator because I was interested in finding out whether it would make sense to add commodities to the Sleepy Portfolio. According to the Claymore asset allocator, between 2003 and 1/31/2011, the Sleepy Portfolio (Cash – 5%, Short Bonds – 15%, Real Return Bonds – 15%, REITs – 5%, Canadian stocks – 20%, US stocks – 22.5%, Developed markets – 22.5%, Emerging markets – 5%) returned 6.62% with a Standard deviation of 9.13%. Allocating 5% to commodities and reducing the exposure to Canadian stocks to 15% would have reduced returns to 6.08% and risk to 8.84%.

The report produced by the Claymore asset allocator also contains a very useful table of correlation between various asset classes. The least correlated assets with Canadian equities are Short-Term bonds (-0.17), Cash (0.00) and Real-return bonds (0.32). In the 2003-10 time period, the asset class with the highest correlation to Canadian equities was emerging markets.

Asset allocation tools are useful to see how mixing different asset classes boosts returns or lowers risk but they should be used with caution. Asset class returns and correlations could vary dramatically from one period to the next.

[Quick reminder: The deadline for entering the UFile Giveaway is Tuesday, 8 p.m. EST.]