"Huh, did I miss something? Clickbait?"
Today we're talking about capital allocation (asset allocation) in the securities portfolio. In addition to equities, there is another asset class with substantial market capitalization, namely bonds. The total market capitalization of the equity market in 2021 was USD 124.4 trillion, while the bond market was worth USD 126.9 trillion. The assets of many private investors and institutions are spread between these two securities.
"Phew, bonds... boring!"
Statistically, almost every German has bonds. Not directly, but via insurance policies. In 2021, there were 82.7 million life insurance policies per 83.2 million inhabitants in Germany. Insurance companies are forced to invest their deposits "safely", e.g. in bonds with a high credit rating. Allianz, for example, had a portfolio share of 83.1% in fixed-interest securities in 2021 and only 11.8% in equities, 3% in cash and 2.1% in real estate.
"They must know!"
If we want to invest our money "safely", then it would be simple to simply imitate the insurance companies in their allocation. Unfortunately, this is not entirely ideal, as these companies have to comply with government regulations and are therefore restricted in their investments. We private investors don't have to adhere to any guidelines, so I have compiled the historical data so that you can get an idea.
"No risk, no fun!"
For the "To the Moon" faction, I can say at this point that 100% equities have generated the highest return in the last 95 years. For everyone else, we would first have to define what risk in a portfolio means. Personally, I always use two key figures, volatility and maximum loss. The following data always refer to annual figures, a rebalancing to the original ratio takes place at the turn of the year.
"Volatility?"
In financial mathematics, volatility measures the fluctuation range of returns. If returns fluctuate strongly, volatility is high; if they fluctuate only slightly, volatility is low. Over the last 95 years (1927-2022), a 100% S&P 500 portfolio, including dividends, has generated a return of 9.64% p.a. (per year) with a volatility of 19.49%. In comparison, 10-year US government bonds had a return of 4.57% p.a. with a volatility of 7.95%. So you can see very clearly that bonds are less risky according to this definition of risk.
"Are 100% bonds the least risky?"
Now we can play with the data. I am using 21 different portfolios here, which are approximated in 5% increments, i.e. 100/0, 95/5, ...,5/95, 0/100. The first figure is the equity allocation (S&P 500) in percent, the second is the bond allocation (10-year US government bonds). Which allocation has the lowest volatility? Of these sample portfolios, 15/85 is the one with the lowest volatility (7.43%). This means that the insurance groups, represented here by Allianz, are not that far away, rather quite close.
"What about the maximum loss?"
The other key risk figure is the maximum loss (maximum drawdown), which is derived from the percentage distance from the last all-time high. As I am working with performance figures here, i.e. including dividends and interest, the figure shows the highest possible loss over the entire period. With 100% shares, the maximum annualized loss was 64.77% in 1932. The portfolio was in the red from 1929 to 1936, but then plummeted again and remained in the red from 1937 to 1944.
"And what if I want to lose as little as possible?"
In the 100% bond portfolio, the maximum loss is 21.46%, at least as at the end of 2022, because the bear market mentioned in the title is in bonds, and it is now. The highest loss before that was 11.12% in 2009. Bonds have never been in the red for more than 3 years, until now, so we'll see what the next few years bring. But well, we take our data as it is and currently have the lowest loss at 17.86% with a 15/85 portfolio. This 15/85 portfolio again, apparently the portfolio managers at Allianz are doing something right.
"And what about the return?"
So far, we have only discussed the lowest possible risks, but not the associated returns. We now want to approach this from the perspective of a private investor. As a key figure, I take the return divided by the volatility, i.e. a slimmed-down form of the Sharpe ratio. This shows us how much risk we have to take per point of return. We have the highest risk/return ratio with a 25/75 portfolio, namely 0.8, which means that we get 0.8% return for 1% fluctuations. For comparison: 100% equities have 0.49 and 100% bonds have 0.58.
"And what about inflation?"
As we all know, the biggest enemy of long-term investors is inflation. That completely eats up the return on bonds, doesn't it? Not really. Over our 95-year period, inflation in the USA was 3.04% p.a., so even the 0/100 portfolio has a positive return. As a private investor, I naturally want to know what the real returns are and where I can get the most return for my risk. For this purpose, I have reduced the return by inflation and thus obtained a new best allocation: 40/60. Yes, even after inflation, it makes sense to overweight bonds from a risk/return perspective. The real return in this portfolio is 4.07%.
"Haven't you forgotten the government?"
Yes, the second biggest enemy of the investor, the tax. As the tax laws have changed frequently over the long period of time and will certainly change again in the future, I will simply use our current tax rate here (25% capital gains tax plus 5.5% solidarity surcharge). This results in a total of 26.375%. To simplify the calculation for me, I have deducted the tax directly from the nominal return and then also deducted inflation. Even after inflation and taxes, the bonds still brought in a plus, namely an outstanding 0.32% p.a.. I was a little surprised.
"And what is the optimal portfolio?"
Of course you shouldn't draw conclusions about the future based on historical data. Likewise, you shouldn't blindly trust a guy on getquin just because he's throwing data around, but I won't keep you in suspense. After inflation and taxes, the winner of the trophy for the "Low Risk But Fun" portfolio of the last 95 years is the 50/50 portfolio with a real after-tax return of 2.59% p.a. and a volatility of 10.61%. Pretty unspectacular, isn't it? But that's how the data is, and that's how we should approach investing: Ice cold, boring and rational.
"And what do we learn from this?"
Despite this article, most of us will continue to invest 100% in equities, and that's probably a good thing, as many of us at getquin still have small assets that are set to grow and also because they still have plenty of time to make up for any losses. If you're heading towards retirement at some point and can handle a little less risk, just remember this article. Until then: To the moon!
For everyone who has read this far: Thank you for your time. As this is my first article on getquin I am open to feedback. I may edit the article frequently if I notice mistakes afterwards or if you point them out to me. I have tried to write in a beginner-friendly way, if you have any questions just ask. See you in the comments.
Sources:
-https://www.sifma.org/resources/research/fact-book/
-https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
-One of my tables with 8906 data
