A.I.M. Users Bulletin Board

[ls7550]

Portfolio Theory

For those who have accumulated a sizeable amount and are in retirement/drawdown and more interested in capital preservation in real (after inflation) terms than wealth expansion, consider this portfolio

Stock price only (excluding dividends) might generally be expected to pace inflation over the longer term, but in a volatile manner. Ditto gold.

Long dated treasury inflation bonds (TIPS (US), Index Linked Gilts (UK), Real Return Bonds (Canada) etc). might be expected to pace inflation and perhaps pay an additional amount.

Long dated treasury bonds generally might be expected to lag inflation, but pay interest that compares to inflation. Ditto Cash.

5 assets that each generally pace inflation, but with varying degrees of volatility. Stocks additionally pay a dividend that generally also rises with inflation so if that amounts to 5% and with equal amounts of each of the above 5 assets, that's somewhat like each of the assets earning a 1% real (after inflation) benefit.

If you have five assets that each achieve similar rewards, but do so with varying degrees of volatility, rebalancing back to equal weightings periodically will provide a higher reward than not having rebalanced - as you'll profit take when high, add (cost average down) when low. A similar characteristic to rebalancing between a high volatility asset such as stocks with a low volatility asset such as cash.

As an example consider that over a period of time when inflation was 4%, stocks were down 20% one year and up 35% the next. (0.8 x 1.35 ) = 1.08 i.e. a 8% gain over two years, which is 4% each year, which compares to 4% inflation. i.e. just paced inflation over those years in total. Blend that in equal weighting with gold that perhaps moves the complete opposite, up 35% one year, down -20% the next and both individually just paced inflation. Mix in three others that perhaps just achieve 4% each and every year (pace inflation) and if you rebalance that set back to target 20% each weightings once each year, then overall that portfolio (model) provides a two year 11.1% gain, which is 3.1% more than inflation (approximately the whole portfolio yearly outpaces inflation by 1.5%). Add on the 1% mentioned earlier = 2.5% real in total.

With long dated inflation bonds and long dated conventional bonds, their volatility is much higher than shorter dated. Typically short dated have low price volatility, high yield volatility whilst longer dated have low yield volatility, high price volatility. Whilst buying/holding long dated bonds at current levels might seem somewhat mad, you just never know and as a example in 2011 such bonds were the best performing asset in the UK, gaining around +25% (capital/price only). Such long dated bonds tend to have volatility that is comparable to stocks and gold, which in turn means that rather than perhaps a 1.5% uplift from volatility capture (rebalancing) the reward might be more like 3%. Again add on the 1% (shared stock dividend) = 4% real total.

If you assume stocks yield a 6% real reward, then if the above that holds just 20% in stocks achieves a 4% real, then for 67% of all-stock reward you are exposed to 20% of all stock risk.

Rather than using constant weighting however and periodically rebalancing all five back to equal weights, if AIM is used instead then it will only take profit (top slice) out of an asset when it is appropriate to do so, and will only add to another (add low) when appropriate. With constant weighting you might top slice out of one (good performer) to then add to others whether it was appropriate or not to top up those holdings at that time.

Top slicing can yield quite substantial amounts of cash being generated. For instance most years one of the above five assets will typically see a 20% to 30% gain, whilst the other four as a collective set might generally break-even. 20% of funds generating a 20% to 30% gain = 4% to 6% of total portfolio value being top-sliced relatively frequently. Add on stock dividends, cash and bond interest etc. and the cash 20% allocation often expands by quite a lot each year when all of those income streams are dumped into the cash pot. Cash starts the year with 20%, earns perhaps 4% (in more normal times), is provided with another 4% from stock dividends, another 4% from bond interest, another 2% from inflation bonds, and that's a bit like cash having earned a 14% interest rate.

Generally that portfolio rises in value due to capturing some price appreciation, some income and some volatility capture gains/rewards, so its diversified. The assets also have a degree of inverse/no/low correlation which helps stabilise the total portfolio value over time. Yet for the relatively low risk, the rewards are modestly good.

Scale that up towards greater risk (and reward potential), and you might utilise alternatives to the above assets. Tom's choice of a portfolio of UB&H assets for instance might exhibit similar variations in volatilities and correlations, whilst potentially yielding higher overall rewards (more stock heavy).

AIM compared like for like wont provide any magic. But as a tool that assists in managing an appropriate choice of assets, AIM helps you get one step closer to managing the portfolio successfully over the longer term.