In my eBook I had touched on three different Bedokian Portfolio variations1, each broadly suited for investors of different age groups and/or risk profiles. Let us revisit what are the three:
- Young investor aged 21-35 / Aggressive investor: 40% equities, 40% REITs, 10% bonds, 5% commodities, 5% cash (we call this Portfolio 1).
- Middle-aged investor aged 36-55 / Moderate investor: 35% equities, 35% REITs, 20% bonds, 5% commodities, 5% cash (also known as the balanced Bedokian Portfolio, which I use most of the time as an example)(Portfolio 2).
- Retiree investor aged 56 and above / Conservative investor: 20% equities, 20% REITs, 40% bonds, 10% commodities, 10% cash (Portfolio 3).
What would be the performance of these three portfolio combinations? Using U.S. market data from the Portfolio Visualizer (www.portfoliovisualizer.com), let us assume a U.S. Bedokian Portfolio investor with an initial amount of USD 10,000 and does annual rebalancing. Since the site’s earliest data on REITs was from 1994, we shall use the period of 1994-2018, a 25-year span. We will also include the S&P500 ETF as a benchmark, since this roughly represents the U.S. equity market as a whole.
Fig.1 – Portfolio returns, table view, 1994-2018. Inflation is not factored in.
Fig.2 – Portfolio returns, graphical view, 1994-2018. Inflation is not factored in.
Let Us Compare
Looking at the whole thing, it is no doubt that investing in the S&P500 for 25 years will trump every Bedokian Portfolio combination out there, even the most aggressive one (Portfolio 1). Yes, the results are there and I do not dispute it. However, this just highlights the fallacy that most investors would tend to fall for, and that is looking at just the returns.
If we run a similar test, but making 2009 as the end year, the results would be vastly different:
Fig.3 – Portfolio returns, table view, 1994-2009. Inflation is not factored in.
Fig.4 – Portfolio returns, graphical view, 1994-2009. Inflation is not factored in.
And in 2009, naturally the returns-only investor would proclaim that the aggressive Bedokian Portfolio was the best.
Returns are very subjective and will change from time to time, depending on what you are invested in and when you are looking at your investments. A well-known way to have good returns all of the time would be tactical asset allocation, where you adjust the weightage of the asset classes, sectors and/or individual companies to capture the best returns. Problem is, this meant a very sound grasp of what is coming, and I can say not even the best investor or fund manager can do it 100% of the time.
Risk And Returns
There are two ‘Rs’ in investing, one is returns and the other is risk, specifically market risk. These two attributes form the very basic premise of the Modern Portfolio Theory (MPT), where investors build portfolios to optimize returns based on a given level of risk, and it also advocates the advantages of diversification.
There are a few ways to measure risk. One is to use standard deviation, which measures the past volatility of an asset class or security. The higher the standard deviation, the more volatile the asset class/security is (and thus, more risky). Another is the Sharpe ratio, where it is the measure of the excess returns above the risk-free rate over the standard deviation. The higher the Sharpe ratio, the better it is.
Lastly we have the Sortino ratio, which is similar to the Sharpe ratio, but it uses only the downside standard deviation instead. Like the Sharpe ratio, the higher the Sortino ratio, the better it is.
Let Us Compare Again
Reevaluating the numbers in Fig.1 and Fig.3, taking risk and returns in mind, Portfolio 3 stood out as the best with a lower standard deviation, and higher Sharpe and Sortino ratios. This concludes the suitability of Portfolio 3 for the conservative and/or retiree Bedokian Portfolio investor.
The results also highlight a common adage in investing; higher returns typically require higher risks. In Fig.1, the S&P500 ETF gave the highest returns, but also the highest risk based on the three risk measurements. But in Fig.3, Portfolios 1 and 2 gave the higher returns with lower risk than the S&P500 ETF (hence my bold on the word ‘typically’). This reinforces the importance of diversification at the asset class level, where risk is tapered and correlation may bring higher positive returns and lower losses.
Still, I acknowledge every person’s personality and characteristics are different, and so is the respective person’s risk appetite and investment style. The usual disclaimer applies and of course, the phrase: "past performance does not indicate future returns".
1 – The Bedokian Portfolio, p72.
Assumptions on Portfolio Visualizer Data
Asset class representations used in the data: Equities = U.S. Stock Market; Bonds = Total U.S. Bond Market; REITs = REIT, Commodities = Gold; Cash = 1-month Treasury Bills. All dividends are reinvested and transaction costs (e.g. commissions) are not included.
To see the results in its entirety for the 1994-2018 period in Portfolio Visualizer, click here.
To see the results in its entirety for the 1994-2009 period in Portfolio Visualizer, click here.
Standard Deviation – https://www.investopedia.com/terms/s/standarddeviation.asp
Sharpe Ratio – https://www.investopedia.com/terms/s/sharperatio.asp
Sortino Ratio – https://www.investopedia.com/terms/s/sortinoratio.asp