by | Mar 22, 2017 | Investing, Stock Market

The Asset Allocation Quilt

My grandmother used to make quilts.  She started as a teenager and sewed and quilted for eighty years or more.  She stitched colorful squares together to make beautiful patterns and then hand stitched the details.

Something about the symmetry and repeatable patterns of hand-made quilts draws your eyes to the details.  The squares repeat in a uniform fashion.  The intricately stitched patterns further enhance the beauty of these works of art.

A Different Type Of Quilt

You’ll find lots of colorful squares on this asset allocation quilt, but it doesn’t share the structure and uniformity of the masterpieces my grandmother used to make.  Each of those squares represent a different common asset class many investors will own in their portfolios.  But the way they are stitched together is not determined by their color.

It creates an interesting if not chaotic picture.  Different colored squares appear in almost random fashion.  Each year we add another row, but the order of future rows remains a mystery.

The Goodies Within…

It is interesting to try and find a consistently repeatable pattern on the asset allocation quilt—one which could be used to make a meaningful decision about which asset class to buy or sell.  Unfortunately, no such pattern exists.  Even if it did, it would eventually stop working as people figured it out.

Can you find an asset class which “zigs” when another “zags”?  Look at gold in relation to the three US stock categories.  Other than 2010 (gold and US stocks did very well) and 2015 (both gold and US stocks didn’t do well), that relationship fits that pattern in 8 of the past 10 years.  (Of course there are no guarantees it will continue the same way in the future).

Were you able to locate an asset class which did not have a single down year during the last decade?  Short term bonds generated positive returns in each calendar year.  On the surface, you might be impressed.  At least until you look at the columns summarizing the compounded returns for the past 3, 5 and 10 years.

For most asset classes, time reduces the risk associated with volatility.  For most people, risk carries a singular definition—market value fluctuation.  You can scan through the table and pick out some pretty ugly calendar years for most of the asset classes.  But when you look at the compounded returns, some of those more volatile asset classes created the best compounded returns.

Diversification

Diversification can be stated very simply: you sacrifice making a killing to not be killed.  Small cap stocks performed better than any other asset class over the past 5 and 10 year periods.  Longer term averages confirm this pattern as well.  But this asset class moves in extreme ways.

Looking in the rear view mirror, we see buying and holding a portfolio of small cap stocks over the past decade would have been the best thing to do.  It might be the best thing to do over the next ten years too, only time will tell.  But to do so means you must endure some extreme swings in value.

Most investors find the swings of a concentrated portfolio to be too difficult, so they are willing to sacrifice having the best overall returns if they avoid a portion of the significant dips.

Looking Ahead

Please be cautious when using the asset allocation quilt to form your expectations about the future.  The quilt over the next ten years will look different than this one.  Too many details factor into the future returns of any asset class.  This only gives us a small look at the results without considering the details behind it.

We can only describe the future as unpredictable as well as warn you of the potential extreme decreases in value.  But we can also inform you of the exciting and interesting possibilities.

Disclaimer:  This is not intended to be specific investment advice nor a recommendation of any of the securities used as proxies for the returns of specific asset classes.  Investors should expect decreases in value for most asset classes at some point in the future.  Past performance does not predict future results.  You should carefully consider all risk factors, tax and legal implications before making any investment decisions.