The Virtues of Asset Allocation [Chart]

The chart at the bottom of the post shows the calendar year returns for various asset classes. I’ve annotated it with some lines to show the return path of three different investing strategies.

Asset Allocation Portfolio

If you took an “Asset Allocation” portfolio of the following weights: 25% in the S&P 500, 10% in the Russell 2000, 15% in the MSCI EAFE, 5% in the MSCI EMI, 30% in the Barclays Capital Aggregate, 5% in the CS/Tremont Equity Market Neutral Index, 5% in the DJ UBS Commodity Index and 5% in the NAREIT Equity REIT Index, the ride was relatively smooth: you were never at the top, but you were never at the bottom. This is shown as the black line.

If you invested $10,000 starting in 2002 (I’ll explain why I didn’t use 2001 below), it would have grown to $18,664.07 by the end of 2010. This is a cumulative return of 86.64% with an annualized return of 7.18% a standard deviation of 14.09. The sharpe ratio is 0.44 (risk free rate of 1%).

Performance Chasing

If you instead tried to chase performance and only invested in the previous year’s best asset class (shown as the green line) the results are quite different. Now you can see why I am starting with the 2002 numbers for the performance calculations: the earliest I could start was 2002 because the chart doesn’t have the 2000 numbers to determine what the 2001 portfolio would look like.

If you invested $10,000 starting in 2002, it would have grown to $11,890.35 by the end of 2010. This is a cumulative return of 18.90% with an annualized return of 1.94% and a standard deviation of 24.90. The sharpe ratio is 0.04.

Contrarian Investing

If you had the nerve to do it, a contrarian strategy of investing only in the previous year’s worst performing asset class (shown as the red line), gave you the most amount of dollars, but also came with a wild ride.

If you invested $10,000 starting in 2002, it would have grown to $21,457.45 by the end of 2010. This is a cumulative return of 114.57% with an annualized return of 8.85% and a standard deviation of 29.44. The sharpe ratio is 0.26. Since this is less than the 0.44 of the asset allocation portfolio, it means you were not being compensated adequately for the extra risk in the portfolio (volatility) even though the annualized return was higher.

Courtesy J.P. Morgan Asset Management

Source: Russell, MSCI, Dow Jones, Standard and Poor’s, Credit Suisse, Barclays Capital, NAREIT, FactSet, J.P. Morgan Asset Management.The “Asset Allocation” portfolio assumes the following weights: 25% in the S&P 500, 10% in the Russell 2000, 15% in the MSCI EAFE, 5% in the MSCI EMI,30% in the Barclays Capital Aggregate, 5% in the CS/Tremont Equity Market Neutral Index, 5% in the DJ UBS Commodity Index and 5% in the NAREIT EquityREIT Index. Balanced portfolio assumes annual rebalancing. All data except commodities represent total return for stated period. Past performance is notindicative of future returns. Data are as of 6/30/11, except for the CS/Tremont Equity Market Neutral Index, which reflects data through8/31/11. “10-yrs” returns represent cumulative total return and are not annualized. These returns reflect the period from 1/1/01 – 12/31/10. Data are as of 9/30/11.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
Related Posts
Showing 9 comments
  • Zach

    Hi! Thanks for this interesting post. In the first strategy… were the assets rebalanced year after year?

    • Preet

      Yes, annual rebalancing.

  • Doodle

    One always hears about the smoother ride proper assets allocation provides. Certainly it’s better psychologically. But isn’t there some mathematical principle involved? If you portfolio drops 25% you only need to
    get a return of 33% to get back even. But if it drops 50% you need a 100% return which is much more difficult(=less probable). In other words, the bumpier the ride, the more likely a lower return over a time period.

    • Preet

      That principle is related in that asset allocation should help mute the drawdowns, and that becomes much more important as one shift’s from capital accumulation to capital preservation.

  • Adam Okhai

    Preet, this is a fascinating “what if” look back. Unless I missed it, I don’t think you were suggesting any particular approach for the FUTURE. It would be great to know what principles (extracted from these ‘Lessons Learned’) could be profitably applied now for the coming years. GREAT article : one goes “WoW” (followed by the thought “…..now, how do we apply this? ” .

    Thank you for sharing what you found.

    • Preet

      Sounds like a good idea for a follow up post. :)

      Thanks Adam

pingbacks / trackbacks