As stated in the title, the nature of this posting is conceptual. It is a survey for designing a portfolio that generates stable profits during every type of economic environment the investor is faced with. What is about to follow is partly a compilation of the information found in several
sources* along with suggestions and idea's put forward by co-researcher "Ram". This post is also an
open invitation to anybody who is willing to share valuable insights for improving the model.
The goal of this quest is not about generating the highest possible returns. Instead it is about creating a portfolio with a risk profile as close as possible to cash, but with yields much higher than cash. The idea is to reduce the portfolio's overall volatility by investing in assets that naturally move in opposite directions. One of the largest hedge funds in the world, Ray Dalio's Bridgewater, applies this investment philosophy in their "All-Weather-Portfolio".
AWP is based on four premises:
- The future is unknown and impossible to predict.
- Assets are responding to two drivers: economic cycle (expansion/contraction) and inflation (high/low).
- Asset classes thrive not equally during each of the four scenario's.
- Risk is distributed equally over the four scenario's.
Instead of allocating equal amounts of capital to each asset class, the
AWP-model assigns equal buckets of risk to the distinctive asset
classes. Thus "risk parity" for each quadrant is accomplished to match equal odds for the next economical and inflationary condition. AWP assumes the economy transitions randomly from regime to regime and thus the AWP needs to have one or more asset classes working well in each regime. So AWP seeks for one or more asset classes generating decent returns in each quadrant. For instance:
- Stocks for economic expansion and low inflation.
- Bonds for economic contraction and low inflation.
- Commodities for economic expansion and high inflation.
- Inflation linked bonds for economic contraction and high inflation
|
|
Economic contraction
|
Economic expansion
|
High
inflation
|
25% of risk:
- inflation linked bonds
- precious metals |
25% of risk:
- stocks
- commodities
- real estate
|
Low
inflation
|
25% of risk
- government bonds
- inflation linked bonds
|
25% of risk:
- stocks
- real estate
- corporate bonds
|
Table I
