The Virtues of Asset Allocation Re-balancing - Part 2

by Wayne Ferbert on July 19th, 2013

Earlier this week, we posted the JP Morgan report on asset class performance for the last decade. We used the data to point out the effects of re-balancing on an equal weighted asset class strategy.
Some of our readers made 2 points:
1.    The visual in our post was not very high resolution
2.    There appeared to be an asset allocation presented as a 10th box with the 9 asset classes. People wanted to know what that represented.
The original we posted is right here.
But I also split the visual up to enhance the resolution.
First, let's highlight the fine print on the bottom. It effectively answers question #2. The asset allocation box is the performance of a traditional asset allocation strategy that uses these 9 asset classes. It rebalances every year end. 
That allocation was: 25% in S&P 500, 10% in Russell 2000, 15% in International - developed countries, 5% in International - Emerging Markets, 25% in Fixed Income index (Barclays index), 5% in Cash (1-3 mo Treasuries), 5% in Market Neutral, 5% in Commodities, and 5% in REITs.
The performance of this balanced and fairly traditional asset allocation strategy over 10 years was impressive. It produced annualized returns of 8.1% which beat the annual S&P 500 returns of 7.1% over the same window. But know that the S&P 500 had higher volatility than this balanced asset allocation produced.  The result: the asset allocation strategy beat the US markets by 1% annually but had MATERIALLY better risk adjusted returns also.
This is important. The Buy and Hedge Investor needs to focus on risk adjusted returns. Your returns by themselves are not enough context for your portfolio success. You need to understand the risk you took to produce those returns.
The only three asset classes that out-performed the asset allocation strategy over the last 10 years were the two International equity indexes, the REITs, and the Russell 2000. So, if you built a portfolio of ONLY these 4 asset classes, you might have out-performed this asset allocation strategy.
But could you imagine a portfolio of these asset classes alone? These are 4 of the most volatile asset classes. The risk in owning these 4 categories is higher than most of the other asset classes. That is why these 4 categories make up only 35% of the total allocation strategy in the balanced asset allocation strategy presented by JP Morgan. The other asset classes are more stable and they provide some 'ballast' against the rocky ride that the other 4 classes produce.
I hope this view of the data here hopes you recognize the benefits of an asset allocation strategy and the need to regularly rebalance it to manage for risk. It will help you produce better risk adjusted returns over the long run.

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