There seems to be two camps in modern investing. I'm going to try to steel man both here. This paper is from the variance doesn't matter camp. The results from this paper showed that even in the worst cases, an all stock portfolio resulted in better utility for a model couple doing long term investing.https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4590406 wrote:We challenge two tenets of lifecycle investing: (i) diversify across stocks and bonds and (ii) reduce equity allocations with age. An optimal lifetime allocation of 33% domestic stocks, 67% international stocks, 0% bonds, and 0% bills vastly outperforms age-based, stock-bond strategies in building wealth, supporting retirement consumption, preserving capital, and generating bequests. Our lifecycle model preserves crucial time-series and cross-sectional dependencies in asset returns and addresses small sample issues in US data. Our investors prefer diversifying with international stocks, not bonds. Target-date fund investors need 61% more pre-retirement savings to match the all-equity strategy’s expected utility over retirement consumption and bequest.
However, here is where the variance matters camp (which includes risk-parity portfolios like the PP) would jump in and say but wait, what about the drawdowns. From the paper:
It's cool that this optimal strategy is only as bad as 60/40 in terms of drawdowns; however, we know that we can construct portfolios with a lower pucker factor. The variance matters camp is perhaps more aware of the psychology of investing and realizes that a portfolio is only good if you can hold onto it. So they might hold a less optimal portfolio in terms of lifetime utility but might actually end up w/ more lifetime utility because they can actually maintain the course.During the working years, each strategy produces large real drawdowns on average. Panel A of
Table V shows average maximal drawdowns of 42% for bills, 67% for domestic stocks, 54% for the
balanced strategy, 52% for the TDF, and 55% for the optimal strategy. The optimal strategy’s 55%
average drawdown would cause discomfort for even the most stalwart investors, but each strategy
that attempts to provide long-term appreciation is subject to similarly large average losses. Investors,
advisors, and regulators are likely most concerned about the largest potential drawdowns, and the
optimal strategy outperforms the alternatives in the right tail of the drawdown distribution. The 95th
percentile drawdown of 76% for the optimal strategy is favorable relative to drawdowns of 96% (bills),
96% (domestic stocks), 92% (balanced), and 81% (TDF).
I'll end w/ two final retorts from the variance doesn't matter camp:
- So you're holding a sub-optimal portfolio in terms of lifetime utility because we're human beings and we make mistakes in the face of variance. As we all know, holding a portfolio of uncorrelated assets isn't easy either. There tends to always be a loser. I will grant that we're more likely to make mistakes when the overall value of the portfolio falls, but we will still be subject to behavioral errors as we watch the components of our portfolio rise and fall.
- Rather than run w/ a sub-optimal portfolio in terms of lifetime utility in the attempts to behave better, why not hold an optimal portfolio and rely on an advisor to backstop your behavioral issues? We don't have to do this alone.
