An “All Weather Portfolio” could have been maintained throughout the 20th Century using stocks and lightly leveraged bonds to produce a return equivalent to pure stock market investment but at a fraction of the draw-down and volatility.
Let me first make a few caveats. I have made no allowance for transaction costs and have used annual data which greatly smooths the results. The data used is that produced by Aswath Damadoran at NYU Stern.
I have used his Total Return Indices for the S&P 500, for the 3 Month US T Bill and for the US 10 Year Bond. I have made the (incorrect) assumption that were futures contracts available throughout this period for all three instruments, and that these instruments could have been used to provide exposure which would have matched the cash indices. And further, that these returns could have been bettered by lightly applying some of the leverage implicitly possible in the cautious use of futures contracts. Any of my assumptions may be disputed or indeed proved incorrect or at least to some degree inaccurate.
Constant maturity bond indices such as those used here probably exaggerate profits and underestimate volatility and draw down: nevertheless the conclusions remain valid in general terms.
My back test assumes periodic re-balancing to maintain fixed proportions of the three underlying investments. Dealing costs would have been minimal.
I believe that in principle a number of points can be made which any of the possible errors or misconceptions listed would not entirely invalidate:
- More or less any hedge fund portfolio can be simulated with a couple of simple instruments: stocks and bonds.
- Rising interest rates do not destroy bond returns since 90%+ of fixed interest returns come from coupon which, over time, make up for any short term price losses. As you can see from the charts of the respective yields on T Bills and the 10 Yr Bond, this period has a dramatic rise and then fall in interest rates. The All Weather Portfolio sails through both periods with equanimity.
- The intelligent investor would be better off using the All Weather Portfolio – he can achieve the same return as on a pure stock investment at a fraction of the volatility and draw down.