In this article, we provide some background on the need to diversify among asset classes then demonstrate a conservative portfolio which produced significantly better risk-adjusted returns than the S&P 500, and finally discuss current issues related to the COVID-19 situation. The intention of this article is to shed light on the importance of multi asset class diversification; we do not recommend or endorse the portfolio demonstrated.
There are many dimensions in the macro economy that you don’t control. Some of the most important dimensions are:
- Inflation: which is impacted by printing of money among other things
- Interest rates: which is decided by central banks based on economic, political and social factors
- GDP Growth: which sometimes turns negative leading to recessions
To demonstrate the need for a multi asset class portfolio, each of the mentioned dimensions are listed below along with an example of an asset class that is highly impacted by it. Since we don’t know future actions and expectations that can impact inflation, interest rates and/or GDP growth rates, there is no way to rely on a single asset class to capture some of the upside and be reasonably protected from the potential downside of unknown economic changes.
Gold prices increase significantly with significant rises in inflation. Below graph demonstrates the historical trend till 2019.
An explanation of the above trend is that inflation rises triggers expectations of increasing future inflation rates, and further decrease in the real value of money; hence, demand on gold increases as a safe haven leading to increase in gold prices.
GDP Growth Impact on Stocks
Below graph show the relationship between USA GDP and S&P 500 from 1960 till 2019.
As you can see, stock values generally follow the trend of the economy with sharp declines during recession periods (i.e. the 2000 Dotcom Bubble and 2008 financial crisis); it is worth mentioning that it took about 25 years for the index to recover from the sharp decline that happened in 1929 at the start of the Great Depression.
For full S&P 500 historical trend, you can check https://www.linkedin.com/pulse/navigating-covid-19-through-time-diversification-mohamed-rafea/)
Interest Rates Impact on Bonds
Bond prices are highly sensitive to changing interest rates. Below graph shows percentage changes in the Federal funds rate along with percentage changes in the adjusted close prices for Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) which “invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities (short-, intermediate-, and long-term issues)”
More fund details can be found at
We will compare S&P 500 performance against the performance of a portfolio with the following allocation:
- 55% in a security tracking the VBMFX index
- 30% in a security tracking the S&P 500 index
- 15% in Gold
We did back testing from 1987 to 2019 using annual returns for the portfolio constituents. Below graph shows the annual returns.
From the graph, we can see that the portfolio returns are less volatile, and its performance during the 2000 and 2008 recessions was significantly superior to the S&P 500. To compare the risk-adjusted returns for the portfolio against the S&P 500, we used the Return over maximum drawdown (RoMaD) and Sharpe ratio measures; results are shown in the below table among other measures:
As can be seen from the table, the portfolio has significantly higher RoMaD and Sharpe ratio than the S&P 500 which means that according to both measures it produces better returns per unit of risk taken.
Amid the current COVID-19 pandemic, multiple economic dimensions experience a great deal of uncertainty. We are entering a recession that no one knows when it will end. Money supply increased dramatically due to Federal Reserve actions (some details can be found in https://www.usatoday.com/in-depth/news/2020/05/08/national-debt-how-much-could-coronavirus-cost-america/3051559001/).
The Federal Reserve is buying assets with trillions of dollars almost doubling its asset ownership in its balance sheet. Interest rates are almost Zero making them an ineffective tool to stimulate the economy.
Analyzing the above situation, we can see that safe bonds are not likely to experience big loses due to interest rate changes. Gold prices can potentially increase due to increased levels of money supply and uncertainties in the economy; since current prices reflect expectations, it can also decrease significantly with more certainty or some good news related to pandemic. Stock prices can potentially decrease due to multitude of factors such as the recession gets uglier, Q2 earnings are announced worse than expectations, US-China relations experience more tensions, etc… It can also experience very healthy increases due to some important economic factor such as good news related to the pandemic or even artificial factor such the Federal Reserve injecting money directly in the stock market (not out of the question according to https://www.cnbc.com/2020/03/29/what-it-would-take-for-the-fed-to-start-buying-stocks-during-coronavirus-crisis.html)
As demonstrated in the article, an investor can reduce exposure to risk and produce better risk-adjusted returns by having diversification among multiple asset classes. Using only three asset classes (there are multiple asset classes not included in the analysis such as real estate and commodities), we constructed a more conservative portfolio than the S&P 500 producing significantly better risk-adjusted returns.
There are almost infinite options to portfolio construction. Constructing an optimal portfolio depends on a variety of objective factors such as an investor’s risk capacity (i.e. financial capacity to handle a loss without impacting important personal goals), risk tolerance (i.e. psychological ability to deal with high volatility in portfolio value), and investment time-horizon. The portfolio decisions can also depend on expectations for the future; for example, if an investor believes that the market is too optimistic regarding COVID-19 recovery, he can decrease allocation to stocks while if he believes the market is too pessimistic, he can do the contrary and increase allocation to stocks.