Step-By-Step Guide To Building An All-Weather Portfolio In Today’s Environment

June 14, 2017

Step-By-Step Guide To Building An All-Weather Portfolio In Today’s Environment

  • I’ll explain what an all-weather portfolio is and why it’s important to think all-weather in this macro environment.
  • It’s important to understand the difference between portfolio asset class diversification and risk diversification.
  • I’ll use imaginary risk calculations to illustrate how to properly build an all-weather portfolio.

Introduction

History has taught us that we always have to expect the unexpected. For example, I don’t know whether the U.S. economy is going to continue to expand or whether interest rates will be lower or higher in the future. I can make estimations, account for probabilities, and then invest accordingly, but still, I have to be prepared for anything.

Even by excluding the complicated risk-related portfolio implications, an average investor can create a portfolio that will do well in the long-term, and thus protect their capital and give a satisfying rate of return. The basis of such a safe portfolio is Ray Dalio’s all-weather portfolio. An all-weather portfolio is a portfolio that performs well across all environments, be it economic expansion or contraction, be it rising or declining interest rates.

Macro Environment

In the last 35 years, we’ve had continuously declining interest rates, declining inflation, and huge asset price increases. The following figure shows how since the 1980s, both inflation and interest rates have been consistently declining while asset prices, in this case U.S. real estate, have just gone up and up.


Figure 1: U.S. home prices (blue), interest rates (red), inflation (green). Source: FRED.

The figure above holds for pretty much all the developed world. Now, the issue is that many take low inflation and low interest rates for granted. But, if you take another look at the above chart, you can see that up to 1980, both inflation and interest rates had been constantly rising. What will happen in the next ten or twenty years? I don’t know exactly but I want to be prepared for anything the economy, politics, or nature throws at me and, at the same time, enjoy a satisfying rate of return on my capital with low risk.  Sound too good to be true? Well, it isn’t, but you have to keep an open mind because 30 years of declining interest rates and rising stock prices sure have put blinders on the large majority of market participants.

Understanding The All-Weather Strategy

Different asset classes perform differently in different environments. For example, interest rates affect stocks, bonds, and real estate like gravity. When interest rates are low, asset prices are high and vice versa. However, an economic contraction negatively affects all of these as demand and earnings contract, but nominal government bonds provide excellent protection is such an environment.

What most investors are largely overweight at this point in time are stocks. If you have a portfolio with 60% in stocks and 40% in bonds, like the majority of global pension funds have, you run the risk that your portfolio halves if interest rates increase or there is some kind of natural economic turmoil. That wouldn’t be a nice thing, would it?

To explain the all-weather portfolio strategy, we have to analyze three things: returns and risk adjusted returns, all possible economic scenarios and what most people do the other way round, and understand that proper portfolio diversification has to be focused on risk and not on asset classes.

Risk & Adjusted Returns

Let’s start with returns and risk adjusted returns. Now, most see that stocks usually yield 6% in the long term while bonds will yield 2% and emerging market stocks 12%, and that the risk is the lowest for low yielding bonds, a bit higher for stocks, and even higher for emerging markets.


Figure 2: Expected rates of return and risk for various asset classes. Source: Bridgewater.

However when you adjust those returns for their risk, as they are pretty comparable assets, it all comes down to similar risk adjusted returns.


Figure 3: Risk-adjusted returns are pretty close to each other. Source: Bridgewater.

So as long term historical returns show that proper risk allocation can lead to healthy returns in any economic environment, it’s extremely important to set up an all-weather portfolio so that no matter what happens, the returns are there and the risk is low.

Possible Economic Scenarios & Risk Allocation

An all-weather portfolio is set up in such a way that the same amount of risk is allocated to each of the four possible economic environments. We can have an economy that is above or below expectations, and there can be rising or declining inflation. All other factors are mostly related to how the economy is doing and inflation, so the all-weather strategy covers everything.

The point is to allocate an equal proportion of your risk, not portfolio, to asset classes that do well in all four macro environments. It’s also important that all asset classes do well over the long term. Stocks will go up, bonds will bring yields, and commodities will rise alongside inflation or increasing demand. So all assets in an all-weather portfolio naturally lead to positive returns, be it through yields, dividends, price appreciation, etc. However, each asset class performs differently in various macro environments.

In an economic expansion and falling inflation, equities, commodities, and credit will do well. However with rising inflation, inflation-linked bonds, commodities, and emerging market debt will do better.

With the economy performing above expectations and rising inflation, nominal and inflation-linked bonds will do well, while with economic contraction and declining inflation, equities and nominal bonds will do well.

The point of an all-weather strategy is to allocate equal proportions of portfolio risk to each possible macro environment.


Figure 4: All-weather risk allocation. Source: Bridgewater.

What this provides to an investor is low risk and the collection of returns from various asset classes during any macro environment.

From 1928 to 2013, such a portfolio allocation would have lost money in 14 years while the S&P 500 would have lost money in 24 years. The average loss for the S&P 500 would have been 13.66% while the average loss for the all-weather portfolio would have been just 3.65%. It’s difficult to calculate all-weather returns since 1928 as gold was convertible and it was difficult to own commodities. But from 1984 to 2013, an all-weather portfolio delivered 9.7% annual returns. This is an excellent yield for the low risk, and is similar to what the S&P 500 returns were even though since 1984, interest rates and inflation consistently fell, which is excellent for stocks.

Portfolio Creation

The above-mentioned returns have been achieved by purely mechanically investing in the various asset classes, thus from the so-called Beta, or the risk premium on the various asset classes. Now, you can add some Alpha to an all-weather strategy through buying irrationally priced stocks, bonds, or miners, food traders, or producers instead of just buying commodities.

So let’s create a portfolio with the correct allocation of risk for an all-weather strategy. This is extremely important to understand as many misunderstand the difference between asset diversification and risk diversification. If you have a 50% stock and a 50% short term government bond portfolio, your risk is highly skewed to the stock portfolio as it can easily drop more than 50% while the bond part could drop 10% at a maximum. Thus, even if the portfolio is divided 50/50 between stocks and government bonds, the risk division is terrible as more than 80% of risk is carried by the stock part and less than 20% by the bond part.

(Elaboration: If I invest $50,000 in stocks and $50,000 in bonds and I know stocks can drop 50% while bonds can drop 10%, the total risk is $30,000, or $25,000 for stocks and $5,000 for bonds. Thus, stocks carry 83.3% of the risk while bonds 16.7% of the risk. At different valuations, bonds and stocks carry different risks.)

Let’s create a portfolio with a proper, all-weather risk allocation. We have to allocate 25% of risk to stocks, commodities, corporate and emerging market credit, 25% to inflation-linked bonds, emerging market credit and commodities, 25% of risk to nominal bonds and 25% of risk to equities and nominal bonds again. Let’s say the total risk of the portfolio should be at $400,000. This way, we can easily allocate 25% of risk, or $100,000 to each special portfolio described above.

WARNING: RISK DESCRIPTIONS PER ASSET CLASS ARE NOT CORRECT AND CREATED JUST FOR THIS ARTICLE AS AN EXAMPLE, SO THIS CANNOT BE USED TO BUILD AN ACTUAL ALL-WEATHER PORTFOLIO. THE POINT OF THIS ARTICLE IS TO SERVE MERELY AS AN EXAMPLE OF THE PROCESS FOR THE CREATION OF SUCH A PORTFOLIO. PLEASE CONSULT YOUR FINANCIAL ADVISOR OR PROPERLY CALCULATE THE RISKS FOR EACH ASSET CLASS IF YOU ARE ATTRACTED TO AN ALL-WEATHER PORTFOLIO.

25% Of Risk To Stocks, Commodities, and Corporate & Emerging Market Credit

If interest rates go up and earnings contract due to a recession, I wouldn’t be surprised to see stocks drop more than 50% or even 70% from current levels. With a price earnings (P/E) ratio of 10, the S&P 500 would now be at just 950 points. Therefore, for the sake of this article, let’s say that stocks could drop 70%. Different stocks have different risk probabilities, so portfolios can be different, but we are already talking about Alpha.

Commodities are also very volatile, especially commodity stocks. Therefore, let’s keep the same risk possibility of a 70% decline. Corporate credit and a well-diversified portfolio of emerging market debt with various maturities is less risky and I would say it could maximally fall 25%. This depends on the maturities and credit risk of the basket or individual bonds you buy. So, if I split the risk of losing $100,000 on stocks, commodity stocks, and bonds, I know I can lose 70% on stocks and commodity stocks while I can lose only 25% on the bond part. Thus, If I am allowed to lose $33,333 on stocks and stocks can lose 70%, then the stock part of the portfolio can be $47,618. The same applies to commodity stocks. If the bond part can lose 25%, then I can allocate $133,332 to bonds.

Thus, stocks $47,618, commodity stocks $47,618, and corporate and emerging market debt $133.332.

25% Of Risk To Inflation-Linked Bonds, Commodities & Emerging Market Credit

Now, I have to invest so that the other three parts of my portfolio have the same risk, and thus can maximally lose $100,000. Let’s say inflation-linked bonds can lose 10% and emerging market credit can lose 25% while commodity stocks can lose 70%. An equal principal as above leads us to a portfolio allocation of $333,000 to inflation-linked bonds, $133,332 to emerging market bonds, and $47,618 to commodities.

25% Of Risk To Nominal Bonds & Inflation-Linked Bonds

As above, if the maximum loss is 10%, then a million can be allocated to this asset class.

25% Of Risk To Equities & Inflation-Linked Bonds

In this case, half a million to bonds, and $71,428 to stocks.

To sum up, we have:

Stocks = $47,618 +$71,428 = $139,046

Commodity Stocks = $47,618 + $47,618 = $95,236

Corporate & Emerging Market Debt = $133,332 + $133,332 = $266,664

Inflation-Linked & Nominal Bonds = $333,333 + $1,000,000 +$500,000 = $1,833,333

The total portfolio with my imaginary risk allocations would be $2,334,279 where 5.95% of the portfolio would be in stocks, 4% in commodity stocks, 11.4% in corporate and emerging market debt, and 78.5% in government and inflation-linked bonds.

The above portfolio is extremely skewed toward bonds, especially short-term bonds because I find the S&P 500 extremely risky at the moment. However, by buying stocks in better companies, currently cheap commodity stocks, and riskier bonds, the portfolio allocation would quickly change.

Conclusion

The goal of this article was to properly describe the creation of an all-weather risk focused portfolio. I‘ve seen many articles that talk about an all-weather portfolio, but never one that shows the actual steps. This article digs pretty deep, but still omits proper risk calculations because what is even more important are the individual portfolio preferences in relation to individual investment goals.

However, if you feel attracted by such a low volatility strategy due to the fact that it’s pretty automatic as it was created by Ray Dalio for his trust funds with the goal that they should perform well decades after Ray is gone, you can build an all-weather portfolio too. But, please consult a financial professional in doing so.

Another very important point is rebalancing. An all-weather portfolio requires rebalancing at least every year according to changes in risk. But this can be done with a few hours of work and your financial advisor.