ITA Wealth Management

One of the most compelling arguments for spreading investments over several asset classes is articulated by Roger Gibson in his book, “Asset Allocation: Balancing Financial Risk.” Gibson conducted a study showing the performance of 15 different equity portfolios over a period from 1972 through 1997.  The portfolios were only identified by geometric symbols so as to hide the true identity of each.  The results were plotted on a Return vs. Risk graph, where return was compounded and risk was the standard deviation of the portfolio.

The 15 portfolios were combinations of the S&P 500, EAFE Index (Europe, Australia, and Far East), National Association of Real Estate Investment Trusts (NAREIT), and Goldman Sachs Commodity Index futures contracts.  So here we have four major asset classes; U.S. equities, international markets, REITs, and commodities.  Bonds are missing from this study, but the results are still instructive.

If you have Gibson’s book in your possession, re-read pages 158 through 169.  Assuming you don’t, I will quote and paraphrase from this section, wishing I had easy access to the graphs and tables as they add clarity to Gibson’s study.  [This book is again reasonably priced so I would add it to my Holiday shopping list.]  Gibson writes, “I originally did this research toward the end of 1998.  As a result, 1997 was the last calendar of data included in the analysis.  The year 1972 was chosen as the beginning point because it was the earliest year for which data were available for all four equity asset classes.  As fate would have it, 1998 was a year when there were strikingly different returns across the four asset classes.  The returns ranged from a stellar 28.58 percent for the S&P 500 to -35.75 percent for the GSCI–the biggest drop in commodity prices in over a century.

As expected, the marked disparity in 1998 returns trigger some significant repositioning of the 15 equity portfolios in volatility/return space.  This is a wonderful illustration of “end point sensitivity.”  As a result of one additional year of data, REITs fell from first place to third in return among the four asset classes while the S&P 500 moved into first place.  Among the 15 equity portfolios, the S&P 500 (only one asset class) moved from thirteenth place in compound annual return to second!  This underscores the danger of naively extrapolating an asset class’s relative performance into the future.  The performance of the GSCI was so bad that the vertical axis had to be rescaled; otherwise, it would have fallen off the graph….Despite this repositioning, however, the basic conclusion of the analysis remains the same.” Here Gibson refers to one of his many tables.  “Even though both REITs and the GSCI had very rough years, the multiple-asset-class strategies delivered superior volatility-adjusted returns relative to less well-diversified strategies and portfolio ABCD (all asset class portfolio) was the best, as evidenced by the Sharpe ratio.

Later Gibson writes, “Each of the single-asset-class portfolios had one or more years when the loss was worse than -20 percent.  By comparison, the worst year for portfolio ABCD was a modest loss of -7.63 percent.  Portfolio ABCD also experienced fewer years of negative returns than did any of the single-asset-class portfolios.”

We recommend diversifying over many asset classes for two reasons; 1) to increase return and 2) to reduce risk.  In addition to the major asset classes Gibson studied, we include bonds and emerging markets.  Two additional asset classes to consider are international bonds and international REITs, but only for larger portfolios.  For the majority of portfolios, the Gibson Four plus bonds and emerging markets is sufficient to build well diversified portfolios.

Photograph:  Woofie

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How many of you belong or have ever belonged to an investment club?  I’ve been an active part of two, advised others, and helped to start one more.  Why do clubs continue to under-perform the market?  There must be a myriad of reasons, but I will focus on a few experienced by the clubs to which I belonged.

1)  Investment clubs, when they first begin, are largely made up of beginning investors who don’t know what they are doing.  Despite going to national meetings and using software designed to provide guidance, the results continue to under-perform market measurements such as Vanguard’s Total Market Index – the VTSMX.

2)  Investment clubs build their portfolios through the effort of selecting individual stocks.  This is a big mistake as the mathematics (arithmetic according to Sharpe) show the odds are not in the favor of investors who build portfolios through stock selection.

3)  Of club portfolios I’ve been able to see, most are not well diversified and this hurts overall performance.

Many clubs do not have a clue as to how poorly they are performing.  Fortunately, in late 2000, a service began to provide this essential information.

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