What is a good and optimal allocation in a portfolio? The answer is simply 10% in cash, 60% in bonds and 30% in stocks. It does not offer the highest performance, but it offers an average of 8% or 9% annual performance over the last 20 to 30 years, which is quite a reasonable.
Looking at the US market, analysing 80 years (1929-2008)\* of financial data, the average annual perform-ances are different over this long period:
• in cash: +3.8% (when invested in US 3 month Treasury Bills)
• in bonds: +5.6% (when invested in US 10 year Treasury Notes)
• in stocks: +6.3% (when invested in the US Dow Jones index)
But what is more important is the risk. Over that long period the worst year for cash would have been 0%; for bonds it was -7.7% and for stocks -52.7% (in 1931, as 2008 was ‘only’ -33.8%).
So while performance is important, risk is more so. With that in mind, which allocation is then the right one? The one with higher performance with the lowest risk. Like in a restaurant, one always tries to choose the best quality but for the best price.
Over this long period of 80 years 0% cash, 25% bonds, 75% stocks would have delivered a return of 6.1% with the worst year being -40.1%; 10% in cash, 60% in bonds and 30% in stocks would have delivered gains of 5.6% with the worst year being -17.1%. Meanwhile 75% in cash, 15% in bonds and 10% in stocks would have equated to performance of 4.3%, with the worst year being -3.9%.
So 75% of stocks is quite risky but 10% in stocks lowers performance significantly so the 10-60-30 is the best allo-cation in terms of reasonable performance and reasonable risk.
Here are some more comparisons with a 10-60-30 allocation:
• 80 years (1929-2008): +5.6% & worst year -17.1%
• 30 years (1979-2008): +9.1% & worst year -3.0%
• 20 years (1989-2008): +8.3% & worst year -3.0%
• 10 years (1999-2008): +5.0% & worst year +1.7%
Looking at these different periods one can see a 10-60-30 allocation offers attractive performances as well as low volatility. But using more complex and sophisticated analysis, such as Sharpe ratios and vola-tility, does the allocation work just as well? It does. The 10-60-30 allocation has the highest Sharpe ratio over 30 years (1979-2008) at 0.45 versus a Sharpe of 0.25 for 10% cash, 0% bonds and 90% stocks and a Sharpe of 0.40 for a 10-90-0 cash-bond-stocks allocation.
While past performance is no guarantee of future success, the past cannot be ignored given that market participants are humans with weaknesses and recurring behavior patterns.
During the search for the optimum asset allocation the question has been: “what are reasonable or pru-dent return expectations in light of risks taken?” While the 10-60-30 portfolio (US) is by no means optimal strictly in terms of return, it is not far from the best. On average the top-performing portfolio in our anal-ysis was 10-90-0 (10% cash, 90% bonds and 0% stocks), however this is the only point in which this allocation mix excels. As far as return is concerned the 10-60-30 is 0.03% behind the winner, yet its worst year was only -2.99% (1994), some 3% better than the the worst year for the 10-90-0 allocation, which posted -6.41% in 1999.
Sharpe ratios
In terms of Sharpe Ratios, the 10-60-30 portfolio also appears attractive, capturing the majority of the topmost portion of the Sharpe Ratio curve. However, it should be noted the Sharpe Ratio within the US is unusually high in the more recent time period of 1999 – 2008 relative to the other, longer time periods. Furthermore, the Sharpe Ratios spike upward as the percentage of stocks diminishes.
This spiking effect is due mostly to relatively high bond returns in the period 1999-2008. As the alloca-tions move from left to right, or high equity holdings to low equity holdings, the numerator of the Sharpe Ratio changes rather quickly compared to other time periods.
Volatility
Concerning portfolio volatility, a 10-60-30 portfolio is very close to the lows in all periods except for 1928-2008. The lowest portfolio volatility seen within the US is 2.7% out of the period 1999-2008. For the US these volatility levels are less than half the levels of the other periods examined. The 1999-2008 decade, likely due to extremely low short-term interest rates, experienced an excess amount of liquidity, which probably also helped smooth returns.
Optimal cash Allocations
All of the prior allocations examined held consistently a 10% cash position. But let’s look into whether one should in fact hold a higher percentage of cash. While adding additional cash to the portfolio does improve risk measurements by lowering volatility, the return falls as well. The attraction of marginally better risk figures is not worth sacrificing returns.
Allocation is the crucial element for a portfolio, especially in terms of performance and risk. As seen above, 10-60-30 has offered a reasonable performance of +8% or +9% over the past 20-30 years with a low volatility even though it hasn’t been the highest performing portfolio. Everybody remembers 2008 and a 10-60-30 allocation portfolio would have made a return of +1.7% during that painful year.
Once the allocation question is solved, a portfolio may be even further optimised by selecting other asset classes within these three basic asset classes (cash/bonds/stocks), like for example corporate bonds, or gold and hedge funds.
