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All Weather Portfolio

2020.03.22 18:55 GMT

Amid the market crisis caused by COVID-19, it's worth to look at the best investing strategies and how they would perform in comparison with the market returns. The All Weather portfolio is the strategy that can perform better because it balances two main economic forces- growth and inflation.

The strategy was engineered by Ray Dalio who is an American billionaire investor, hedge fund manager, and philanthropist. Dalio is the founder of investment firm Bridgewater Associates, one of the world's largest hedge funds. 

Cash is King?

Ray Dalio wrote in his book "Principles: Life and Work":

“I knew that no matter what asset class one held, there would come a time when it would lose most of its value. This included cash, which is the worst investment over time because it loses value after adjusting for inflation and taxes. I also knew how difficult was to anticipate the swings that cause those losses. I’ve devoted my life to it”.

Dalio explains in his book that there are two big forces to worry about: growth and inflation. Each could either be rising or falling. By finding four different investment strategies, an investor could construct an asset-allocation mix that was balanced to do well over time while being protected against unacceptable losses. Later this approach became widespread and was named risk-parity trading. 

 

Since 1996, the All Weather portfolio has been stress-tested through bull and bear markets in equities, two recessions, a real estate bubble, two periods of Fed tightening and Fed easing, a global financial crisis and periods of calm in between. Through these varied environments the All Weather asset allocation mix has achieved a Sharpe Ratio in line with the 0.6 expectation over 85 years of backtesting. At the normal 10% targeted risk All Weather has outperformed major asset classes as well as the traditional portfolio, with much less risk per unit of return.

Source: Bridgewater Associates

 

How to construct the All Weather Portfolio?

Investing into Bridgewater's funds is barely possible. The investment firm is closed for new investors. But you can easily replicate the All Weather portfolio by yourself.  In an interview published in Tony Robbins’s book “MONEY Master the Game: 7 Simple Steps to Financial Freedom”, Dalio presented an asset allocation mix that Robbins says “stands the test of time”.

The asset allocation of the portfolio is broken up like this:

  • 40% long-term bonds
  • 30% stocks
  • 15% intermediate-term bonds
  • 7.5% gold
  • 7.5% commodities

You can construct such a portfolio with low-cost exchange-traded funds (ETFs). An exchange-traded fund (ETF) is an investment fund that trades much like stocks on a stock exchange. An ETF is made of assets such as stocks, commodities, or bonds and generally operates with an mechanism designed to keep it close to its net asset value while minimising the administrative and management costs known as expense ratio. Companies like Vanguard and BlackRock dominate the market of passive investing and offer a wide lineup of ETFs with lowest fees.You could construct an All Weather portfolio with the following ETFs.

  • 30% Vanguard Total Stock Market ETF (VTI)
  • 40% iShares 20+ Year Treasury ETF (TLT)
  • 15% iShares 7 – 10 Year Treasury ETF (IEF)
  • 7.5% SPDR Gold Shares ETF (GLD)
  • 7.5% PowerShares DB Commodity Index Tracking Fund (DBC)

Let's use Portfolio Visualizer to backtest portfolio asset allocation. You can view the results of the backtest here

First of all, we set the portfolio allocation exactly like in the book.

 

Portfolio Allocation - All Weather

 

Unfortunately, the backtesting period is constrained by the available data for Invesco DB Commodity Tracking (DBC) since Mar 2006. Our testing is limited but the most important is that it includes the Great Recession of 2008 and we can stress test the portfolio through at least one recession.

The All Weather portfolio is named "Portfolio 1" and it's compared against Vunguard 500 Index Investor that replicates the S&P index. Let's have a look at the summary of portfolio returns. As you can see, the average yearly returns are quite similar; the All Weather portfolio has an average return 7.65% against 7.86%. However, our portfolio has a much lower volatility 7.32% (Stdev), the lowest worst year performance -3.03% and the best maximum drawdown -12.20%. Finally, the Sharpe ratio is almost twice bigger than the ratio of the benchmark.

 

 

If we compare the charts, we can also notice that the grach of the All Weather portfolio is much smoother and less volatile. Pay also attention to the performance of portfolios between 2007 and 2009. We can see a similar performance in February when market fell by -8.24% while the All Weather portfolio gained +0.40%. But of course it does not guarantee that the All Weather portfolio beats the market in any economic conditions. In the worst-case scenario of the total economic collapse the portfolio will perform poorly but it's still expected to outperform market. On the contrary, it lags behind the benchmark during the period of economic expansion and bull markets. For exmaple, the benchmark had better returns between 2017 and 2019. All in all, the All Weather portfolio is the best trade-off between risk and return. 

 

 

 

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