The QD Portfolio - Exhibit I

[quigleydoor]

Some people were interested in reading more about the asset allocation policy I have been using, since it has earned steady returns with low risk. (I previously boasted that my retirement funds have earned 12% annualized returns since mid-1999, with only 2% maximum drawdown. For the record the actual maximum drawdown, between 12/2000 and 9/2001, was 22%. However this was fully recovered by 6/2002.) The point is, diversification has worked well.

My allocation policy has become more sophisticated or nuanced over the years, as I have combined the results of different authors' research. The first really compelling research that I acquired was a paper by Christopher Moth, an international bond portfolio manager at Delaware International Advisers. That paper is no longer online, but you can read my synopsis of it in this Morningstar thread. (I tried to upload a PDF of the paper, but the iTulip server is too busy.)

Quoting from my 8/16/2005 post on Morningstar:

I'd like to clarify what I think the original poster is doing. He/She recognizes the fragility of the financial system, and is interested in preserving value in the face of many possible disaster scenarios. Instead of relying on supposedly risk-free government paper to preserve value, he/she is using a diversified approach. If USD securities become worthless, then maybe foreign ones will be okay. If the whole system caves in, there will still be commodities which retain some value.

I hold the same view, and have used the Christopher Moth paper (cited in my previous post) as a touchstone. I use his best return/risk asset allocation as my core portfolio:

American stocks (S&P 500)	31%
US Treasury bonds (SSB GBI)	24%
Foreign government bonds (SSB WGBI ex-US)	22%
A basket of commodities (GSCI)	23%

Moth states that this portfolio has an expected annual return of 11.5% (not adjusted for inflation, not reflecting management fees) and a risk of 7.5% (measured as standard deviation of quarterly returns). This is based on a regression analysis of data in the period 1973–2000—a period which experienced a bad streak of stagflation as well as the best, longest bull markets for stocks and bonds in the 20th century (1982–2000).

My over-arching belief is that I cannot guess what is going to happen, or how long it is going to take to happen. While I am pessimistic about the financial system's health, I am also impressed by how long the central planners (erm, I mean central bankers) have kept the game going. They might have a few more tricks up their sleeves. So instead of positioning for stagflation or for more bull markets, I maintain a core portfolio which I can expect to do well in many possible futures.

In addition to the core, I keep a growth portfolio, about 10% as big as the core portfolio, where I speculate.

Since reading Moth, I have come across other studies which do not emphasize foreign bonds as much. In another post I will discuss some of the reasons behind that difference (not all of which I agree with, or understand).

[Jim Nickerson]

Re: The QD Portfolio - Exhibit I

American stocks (S&P 500)	31%
US Treasury bonds (SSB GBI)	24%
Foreign government bonds (SSB WGBI ex-US)	22%
A basket of commodities (GSCI)	23%

What are SSB GBI AND SSB WGBI? Amazon put in the link to your -SSB WGBI.

[quigleydoor]

Re: The QD Portfolio - Exhibit I

What are SSB GBI AND SSB WGBI? Amazon put in the link to your -SSB WGBI.

SSB GBI = Salomon Smith Barney US Government Bond Total Return Index
SSB WGBI ex-US = Salomon Smith Barney World Government Bond Index, excluding the US portion

Christopher Moth used these indices in his asset allocation portfolio modeling study. See the attachment.

When reading the paper, take note of a critical typographical error in Exhibit 9. Exhibit 9 is the key to the whole paper: the risk characteristics of various asset allocation policies. At the top of the table, you see labels "Allocation" followed by letters A–K. You should delete the word "Allocation" and shift the letters one column to the left. This will fix the table and clear up some confusing statements in the text.

[DemonD]

Re: The QD Portfolio - Exhibit I

QD, thank you so much for the info. I am very much appreciative of applicable information you have brought out here. And then on top of the main allocation a 10% pure spec stock position sounds sensible. I will definitely be following up with this.

[quigleydoor]

Re: The QD Portfolio - Exhibit I

QD, thank you so much for the info. I am very much appreciative of applicable information you have brought out here. And then on top of the main allocation a 10% pure spec stock position sounds sensible. I will definitely be following up with this.

In a little while, I plan to write up something about another asset allocation research study which I have found useful. In the meantime, my gears are grinding on this note from Mohamed El-Erian in yesterday's FT:

The experience of the past few years, when virtually any risk asset has massively out-performed, is increasingly not a good framework for thinking about the future appropriateness of portfolio construction.

Specifically, it is yet to be established with a sufficient degree of confidence that, by diversifying across risky asset classes, investor portfolios will continue to sufficiently mitigate risk.

Instead, long-term investors would be well advised to consider taking additional steps, including using well-focused hedging instruments.

Indeed, we may well be in the middle of a regime shift: exiting a world in which the difference among individual investors’ performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes, and entering a world where more sophisticated risk management capabilities will increasingly be the main differentiator.