Ask the Spud: Is There an Optimal Portfolio?

Q: I’m new to passive investing and am deciding how to allocate between the asset classes. The best split between Canadian equity, international equity, etc. should be determinable based on studies of their past returns, volatility and correlations. Obviously this would vary over time, but approximate weightings should be achievable. Based on this research, how would you weight the individual asset classes? – R.T.

It would look impressive if I designed my model portfolios based on an analysis of historical volatility, correlation matrices and expected returns based on Shiller CAPE or some other data. But instead I generally recommend a roughly equal allocation to Canadian, US and international stocks. Nice and simple, with no advanced math required. This is isn’t because building a “portfolio optimizer” is difficult: it’s because it’s a useless exercise.

Investors have a tendency to resist simple solutions, and this bias is exploited by fund managers and advisors who use algorithms and models designed to determine the “optimal” asset mix that will maximize returns and minimize volatility, sometimes down to two decimal places. That sounds more sophisticated than simply splitting your equity holdings in three, but there’s no evidence it produces better results.

One of the most fundamental ideas in portfolio design is the so-called efficient frontier—the sweet spot where you’ll enjoy the highest rate of return for each unit of risk. The problem isn’t that the efficient frontier doesn’t exist: the problem is it’s only knowable in hindsight. You can learn what would have achieved the highest risk-adjusted return in the past. But if you’re building a portfolio for the next five or 10 or 20 years, you can’t simply punch numbers into a spreadsheet and determine the optimal asset allocation for your target rate of return or level of volatility. That’s because the standard deviation of returns changes over time, as does the correlation between asset classes. And estimating future stock returns, in particular, is notoriously unreliable.

Optimize this

In a 2013 article called Stop Playing With Your Optimizer, Brad Steiman of Dimensional Fund Advisors offers a dramatic example of what can go wrong. If you wanted to build an “optimal portfolio” of five asset classes—fixed income, Canadian equities, US equities, international equities and emerging markets equities—you could model it with 20 individual inputs. You’d start with the expected return and volatility of each of the five asset classes, and add the correlations of the 10 possible pairs.

In his example, Steiman used historical data for volatility and correlation and then assumed expected returns of 8% for Canadian, US and international stocks, 9.5% for emerging markets, and 5% for fixed income. With those inputs, the model determined the optimal portfolio with a target standard deviation of 12.5% would include an allocation of about 25% to Canadian stocks.

Then he ran the optimizer again, assuming that 19 of the 20 parameters turned out to be precisely accurate, but the expected return on Canadian equities was slightly off. If the return on this asset class was overestimated by just 0.5%, the optimizer increased the allocation to Canadian equities to 45%. And if the estimate was underestimated by 0.5%, the optimizer called for just a 2% allocation. No wonder Steiman calls portfolio optimizers “mistake maximizers.”

Determining an appropriate asset allocation is one of the most important decisions an investor will make. But a portfolio is not a chemical formula: there is no need for each component to be measured with precision. It’s more like a recipe: as long as you use high-quality ingredients and to get the proportions roughly correct, there is a lot of room for flexibility.

52 Responses to Ask the Spud: Is There an Optimal Portfolio?

  1. Prasanna August 4, 2014 at 1:49 am #

    I know. This statement from Manulife does not make any sense at all. I will check directly with Manulife why they have this news item also on all our quarterly statements that I receive as well.
    thanks
    Prasanna

  2. Phil May 5, 2015 at 6:48 am #

    Good day Spud

    I have read your site (and Hallam), got the books, done some research, hooked myself up with a DBS retail account in Singapore, and a trading account, moved $$ to the trading account and now ready for the first buy.

    Comments on my hybrid asset allocation would be greatly appreciated.

    I have come up with a hybrid permanent/fundamental/swap with a twist line up.

    For grounding, I am a Canadian living and still working in Thailand.

    My proposed line up:

    Horizon HXT 12.5% (Cdn equities, lower % as Cda small % of global mkt)

    Horizon HXS 25% (US Equities)

    Vanguard VSB 35% (Cda Gov. Short Term Bonds – ST as inflation to me has only one way to go)

    iShare CIE 15% (International, lower % as I live and work in Thailand now)

    Gold 12.5% (I plan to guy actual gold rather than a fund)

    I am not sure if buying actual gold is more/less expensive than buying a billion fund – does anyone have a comment? I figure to buy gold as it is very liquid here and is useful even in emergencies where it would be readily available and easily converted into cash/goods/services if required, but still perform the same as the fund.

    The mix represents the fact I live in Thailand and earn salary in bhat, so I lowered my international exposure to equities. Bonds I want to keep short term as inflation can only go one way in my mind now – the % is low given I am 50, but I do have a pension coming to me also so I feel the increased risk is mitigated by the fact I will have that guaranteed income stream coming.

    I own my home in Thailand already and on top of what I have available to invest now (+$500K), I put away another $2k per month, and will do so as long as I keep working – likely another decade I would think (although i would cut that shorter if I can!!).

    Again, all comments welcome

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