January 26, 2010
How could you do better than this portfolio? In December 2005, I analyzed this portfolio using Monte Carlo simulation (via Quantext Portfolio Planner, QPP) to see if I could alter the allocation to yield a portfolio that would have more expected return with less risk than this one.
To begin, it is useful to think about why such an idea might even make sense. The return and risk of a portfolio is largely determined by the expected return and risk of each component, and the correlations between them. A Monte Carlo simulation takes all of these factors as inputs and calculates a portfolio’s expected rate of return and risk level. By adjusting the components of the portfolio, we seek to exploit low correlations between asset classes in order to get the most return for the risks that we take.
A better ETF portfolio
When I modified the original portfolio using QPP, the model suggested that the following portfolio would be likely to generate more return, with less risk, than the original portfolio:
This portfolio is a fairly radical departure from the original asset allocation. The allocation to the S&P500 is dramatically smaller — down from 35% to 5%. Secondly, there are now substantial allocations to energy and utilities, as well as higher exposure to real estate (10% vs. 5% in the original portfolio). When this portfolio was designed, in December 2005, oil was trading at around $60 per barrel; this was well before the enormous run-up that took oil to $140 per barrel in July 2008. The new portfolio had far greater exposure to real assets than the original. In the spring of 2006, Ibbotson published an influential study – radical at the time – that supported the idea that a substantial allocation to commodities would increase the expected risk-adjusted return of standard asset allocations.
In my original article, I compared projected return and risk (as measured by standard deviation in return) for the original portfolio, the S&P500, and for my modified portfolio. The results from the original analysis are shown below:
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