The Practical Approach To Constructing An All-Weather Portfolio

August 23, 2017

The Practical Approach To Constructing An All-Weather Portfolio

  • Creating an all-weather portfolio is pretty technical. Today, I’ll try to make it as practical as possible and give actual investment examples of where to invest.
  • It’s all about risk. Counter to general knowledge, bonds carry large risks at the moment.
  • I’ll describe 4 different investments that will behave differently in 4 different economic scenarios, but all of them offer a yield all the time.

Introduction

Two months ago, I wrote a pretty detailed technical article on how to build an all-weather portfolio. The results were quite discouraging as a huge part of the portfolio would have ended up in short term bonds, especially treasuries.

In today’s article, I want to deviate a bit from the pure technical side and approach the creation of an all-weather portfolio from a practical side that includes actual stocks to buy and doesn’t put as much in treasuries.

As it’s all a game of risk balancing, there are several options to create an all-weather portfolio.



Quick Reminder On What An All-Weather Portfolio Is

The main goal of an all-weather portfolio is for it to keep risk as low as possible while consistently offering satisfying risk adjusted returns in every economic scenario.

When we sum up everything that can happen in an economy, there are four scenarios that cover it all. An economy can grow below or above expectations while inflation can also be below or above expectations.


Figure 1: All possible macroeconomic weather scenarios. Source: Bridgewater.

So to create an all-weather portfolio, you have to allocate 25% of your portfolio risk to each potential scenario. You can read more about the technical side of things in my previous article on creating an all-weather portfolio.

Let’s create a practical all-weather portfolio that you would be happy owning. I’ll try to add a few percentage points to your potential yearly returns by adding positive asymmetric risk reward investments to the puzzle. Additionally, we won’t look at volatility as a measure of risk but at the actual risk of permanent capital loss, which is pretty different than the academic description of risk.

Practical All-Weather Portfolio Creation With Stock Examples

The usual all-weather portfolio described in the media is 30% stocks, 40% long-term bonds, 15% intermediate bonds, 7.5% gold, and 7.5% commodities. However, that can’t be applied to the current environment because while this distribution would be good in an average historical environment, we are pretty far from that now. This is especially true as right now, the 40% long-term bond allocation carries far more risk than the stock allocation because if interest rates rise, long term bonds would be severely hit.

Scenario #1: Growing Economy & Inflation Below Expectations 

This is the environment we are currently in. If we look at Europe and Japan over the last few years, economic growth has been there but was anemic and inflation was significantly below expectations. In the U.S., economic growth has been a bit better but still just above 2.1% with inflation below the targeted 2%.

The best asset class for such an environment is, of course, stocks. However, we have been in this environment for about 8 years now and asset prices have grown not thanks to economic improvements or growth in earnings, but merely thanks to growth in valuations. That makes general stocks very risky, especially since we know that at current valuations, future 10-year returns, historically, haven’t been positive.

By looking at the 2001 and 2008 S&P 500 drops, I can easily say that what you can lose by investing in stocks in the next 10 years is 50% of your investment. With a 4% earnings yield, stocks aren’t the best risk reward situation.

Now, you do want to be exposed to stocks that offer a higher earnings yield at lower risk. This can be done by increasing emerging market exposure as stocks there are still cheaper, by looking at small caps that offer higher yields, or by looking at sectors that are out of favor like insurance stocks. As for where to look for such stocks, the iShares Russell 2000 Value ETF (NYSEARCA: IWN) is a good start.

Scenario #2: A Growing Economy & Growing Inflation

To be exposed to a growing economy with inflation above expectations, which is a scenario not to disregard as emerging markets’ demand might spur global inflation, the best thing to do is to own emerging market bonds or dividend stocks alongside commodities. I prefer commodity stocks because they offer you a yield and their earnings increase disproportionately when commodity prices increase.

As these assets are also risky and can easily fall 50%, it’s important to have a similar allocation to them as for the stocks I described above. The iShares MSCI EAFE Value ETF (NYSEARCA: EFV) is a good place to look for underpriced global commodity stocks.

Scenario #3: A Slowing Economy & Low Inflation

For this part of the portfolio, we have to ask ourselves, what will do well in the next recession? The answer is simple, treasuries.

Now, the amount of treasuries you want to own depends on your risk reward appetite for the whole portfolio. If you are generally risk adverse, you have to look for short term treasuries as they are practically risk free. However, to allocate 25% of your portfolio risk to such an asset class would mean that all other asset classes in your portfolio would make up only a small part of it as the risk for stocks is at least 50% while it’s maybe 5% for short term treasuries.

Longer term treasuries offer much larger upside if interest rates go lower while the downside is also larger if interest rates increase. If you look at a 20-year treasury, I would say that the risk reward is similar to stocks with the downside is potentially 50% with higher inflation and interest rates while the upside is also high if interest rates fall further. Nevertheless, the current 2.65% yield is already something.

Scenario #4: A Slowing Economy & High Inflation

The answer to this one is easy, gold. If global economies continue to slow down despite future monetary stimulus or high inflation, anything related to gold would skyrocket. I wouldn’t be surprised to see gold above $5,000 per ounce in such a scenario. Think $5,000 is too much? Well, don’t forget that gold was trading at only just $260 per ounce in 2001.

How can you invest in gold? The options are physical gold for the risk averse with a significant allocation to gold ETFs that allow for liquidity and rebalancing. If you prefer more risk, you should go for gold miners or a gold streaming company that is less risky than actual miners.

Conclusion & The Key To An All-Weather Portfolio

What I’ve described above are 4 different asset classes that all offer a significant return at the moment but aren’t correlated as their prices will behave differently in different macroeconomic situations. For example, in a global recession with inflation, gold stocks will go up while regular stocks will fall. Or in a scenario with low inflation, stocks will do well, treasuries will do well also, while gold won’t do well. Nevertheless, if you own a gold streaming company or a low-cost gold miner, you will receive some kind of dividend even in such an environment.

Now, the key to an all-weather portfolio is constant rebalancing. This means that as soon as one part of your portfolio becomes more than 30% of your portfolio risk, you rebalance it down to 25%. You also do the opposite when the risk is lower. For example, when stocks in general trade at a CAPE ratio below 10, history has shown that average 10-year returns are around 10% and negative returns are out of the question. Thus at such a point, stocks offer extremely low risk and should make up a large part of your portfolio alongside high yielding treasuries. In such an environment, gold prices would probably be sky high so you would sell that part of your portfolio risk to buy stocks.