You may have recently heard about a study conducted by researchers from various American universities that suggested a balanced portfolio is not as effective as an all-stock portfolio loaded with international names, even for older investors. At Morningstar, Larry Swedroe explains some of the problems with the research, writing:
Before jumping to conclusions, there are significant problems with the paper. To begin, it’s no surprise that riskier stocks produced higher net worth and greater bequests because riskier stocks have higher expected—but not guaranteed—returns. However, if achieving the highest expected return were the only consideration, investors should own only the riskiest stock(s), ignoring the benefits of stock diversification. Clearly, investors care about more than just earning the highest expected return—they care about risk-adjusted returns, as well as other issues we will discuss. And diversified portfolios tend to produce higher risk-adjusted returns. As one example, over the 37-year period from 1987 to 2023, a 100% equity allocation using Vanguard Total Stock Market Index VTSMX returned 10.62%; a portfolio that was 60% VTSMX and 40% Vanguard Total Bond Market Index VBMFX returned 8.74%. Despite the higher return, the balanced portfolio produced a higher Sharpe ratio (0.61 versus 0.54) and a much lower worst-case drawdown (negative 31% versus negative 51%).
Let’s examine some other problems with the paper. The first is that, while the authors noted that the all-stock portfolio produced worse drawdowns—the average drawdown of 68% for the domestic stock portfolio was the highest (higher than the 57% average drawdown for the 50% domestic/50% international portfolio)—and worse left-tail results, they failed to note that investors are highly risk-averse on average, weighing the pain of losses more heavily than the benefits of gains. Second, they failed to address the question of whether investors could stand the pain of the larger losses, stay the course, and realize the long-term benefits. Third, they failed to consider the question of the marginal utility of wealth. At some level, the benefits of potential incremental wealth gained from investing in riskier equities (versus safer bonds or Treasury bills) are not worth the downside risk, as the marginal utility of wealth declines as wealth increases and eventually approaches zero.
Given these issues, it is interesting that they noted, “Minimizing intermediate drawdowns appears to be a priority for regulators regardless of retirement outcomes. An important policy issue is the extent to which regulation should focus on minimizing the psychological pain of intermediate drawdowns versus maximizing the economic outcomes of retirement savers given the vast performance disparities across strategies.” Perhaps regulators understand these issues far more than the authors, who appear to focus only on maximizing return without considering risk, the behavioral issues related to investing in risky assets, investor loss aversion, and the marginal utility of wealth.
Swedroe continues on for quite some time with further criticisms of the paper, which you can read here.
Action Line: When you want to talk about the value of a balanced portfolio, email me at ejsmith@yoursurvivalguy.com. And click here to subscribe to my free monthly Survive & Thrive letter.
