MadMoneyMachine wrote: I believe TSM is too LC weighted to obtain the risk I want for the Prosperity portion of the PP.
Guys,
I find I am thinking about the Stocks component much more than I had.
Aggressive Stocks: the original mandate for Prosperity
As others have done, I too wondered if there is a better approach to achieve the "aggressive" mandate suggested by HB in the Stock portion for "Prosperity". Whatever that word "aggressive" means, it seems to imply higher returns than less aggressive securities. I don't think it means this must come from "Growth Stocks". I think it is the behavior of the security type that is the issue. Remember, any benefits from SV derive not from the class itself but because of the migration of a few its stocks into a Larger and/or Growthier direction. Now, many of us do not believe higher returns possible without higher risk. So what Stock types do provide this sort of "aggression" in "prosperity"?
I know many of us have looked at this repeatedly. And for different reasons, many of us (me included) have settled on TSM as being the best representation of what the Stock component ought to be, just as HB might agree. Further, many of us agree that the greatest diversification and explanatory power of the PP comes from its quartile composition. But since this site permits a more focused analysis of the PP, and because 25% of any portfolio is still a large amount, I've been thinking on Harry's original mandate a bit more. Since the OP and others mention Small Cap Value, and Craigr mentioned the Aggression issue, I decided initially to look again at the SV class.
The following yearly analysis (going back as far as I could find stocks data, around 1927 up to recently but not sure the endpoint) shows the powerful effect of Beta exposure—that which is common to all stock types. (I did not look at Emerging Markets or International Small Value yet.) I believe Larry discussed these findings before. I mention this data simply to offer some framework other than pure CAGR and Risk calculations.
• TSM and SV both had 24 years where the returns were Negative.
• 18 of those 24 years both TSM and SV were Negative (same time).
• There were 6 years where TSM was Negative and SV Positive.
• There were 6 years where SV was Negative and TSM Positive.
• There were NO extended periods where SV was Negative and TSM Positive.
• The years where SV was Negative and TSM positive = 1939,1948,1953,1960,1987,1998.
• The years where TSM was Negative and SV positive = 1970,1977,1981,2000,2001,2007.
• There were no 2 consecutive years where SV went down and TSM up.
• There was 1 string of 2 years where TSM went down and SV up (2000-2001).
Over the period examined, Small Value had higher returns, much like what Fama showed.
Tracking Error and other concerns
Speaking only about Stocks for the moment, any allocation is making a bet on its composition. Past returns may not assure future returns, but that applies to everything.
The nature of CAPM means, necessarily, that a massive weighting will be to Large Caps (which always dominate "the market"). That is not indifference; it matters. CAPM may called "neutral" owing to its structure, but that structure defaults to a huge commitment to a particular market segment. (Madmoneymachine indicated this, above.)
Those who fear Tracking Error understandably want to own "the market" in its CAP weight. With conventional portfolios, that argument makes lots of sense. But the Tracking Error issues would not concern me in the PP. First, the PP—as a portfolio— already has enormous Tracking Error, and it is doubtful that the low Beta exposure of the PP stock component would alter that significantly, but over time, returns may be improved without incurring significant risk (measured partly by Standard Deviation, which clearly is not the only risk).
My concern has not been losing out on higher expected returns that SV (in some addition) might provide. My concern was the periods of under-perfomance (even months) where additional SV losses may test my resolve especially when the other PP asset classes are also tanking (I'm thinking short term acute periods not just whole years). As the PP concept is conservative, the Large Cap domination made some sense. But consider the Stock component was originally supposed to be "aggressive and growthy".
But, if the Beta exposure within the PP is low (and it is pretty low), this may be less a concern than I imagined. My other reason was the past success of the PP, using TSM (an indexed version of HB's original active funds). But if looking back matters at all, we can see any number of Stock arrangements could have increased portfolio returns without sacrificing much in Standard Deviation or drawdown. Thus, "aggression" paid off. And if one believed an adjustment in the Stocks component were justified, should the adjustment be absolute or relative to where an investor is in their own retirement picture? That is, would a younger investor feel better with a "more aggressive" portion than one already in retirement (More SV in the former, less, if any, in the latter)?
(I have not looked back to 1972 to see how SV would have impacted the PP in each year. And I plan to look at pure Large Growth Stocks too)
Now if looking back does not matter, then strike every mention of past from all obelisks, remove the yearly returns charts, etc. But I think each part of this (how to view past correlations, risks, and returns) holds some portion of the truth without any part being absolute.
No answers here, but for the moment, I think TSM is likely the best choice. Though, I am less sure of that than before, even as I am certain the basic PP quartile approach is the factor with the greatest impact. And maybe at day's end the Stock type does not matter much. But the Aggressive Stocks mandate is something I'd want to discuss a bit more.
Roy