"Balanced" Portfolios

Are the forces in your portfolio balanced?

As I have laid out in the last few articles, the primary forces that act on assets are economic growth (Fe) and inflation (Fi).?

If you were to draw a free body diagram to show how these forces act on your portfolio, what would it look like? Is your portfolio inclined to do better in one economic scenario more than another?

The title image (also below) is my attempt to draw a free-body diagram that shows the effects of economic growth and inflation forces on a typical “balanced” index fund. Balanced index funds, which are offered by a variety of companies like Vanguard and Fidelity, are usually made up of 60% stocks and 40% bonds. The stocks are typically based on the total US stock market index and the bonds are based on the total US bond market index.

The size of the stock and bond boxes in the diagram correspond to the allocation percentage (60/40). The direction of the forces show the effect that economic growth and inflation have on each asset when economic growth and inflation exceed expectations.

The item in the diagram that is probably sticking out like a sore thumb is the number of force vectors acting against the stocks versus the number acting against the bonds. This represents the relative risk that each asset brings to the portfolio.?

The risk allocation of each asset is a function of the weighting, volatility, and correlation of the assets in the portfolio. For instance, if you split an allocation between two uncorrelated assets that have identical volatility, your risk is allocated 50/50. Alternatively, if you had a portfolio of 50% stock and 50% cash, 100% of your risk would be in stocks.?If you have two assets with differing non-zero volatilities, the math gets a little more complicated.

Here is an example:

From Jan 1987 - Dec 2023, the US stock market had an annualized volatility of 15.60%. The US bond market had an annualized volatility of 4.22%. The image below shows the risk decomposition over this time period for a 60/40 portfolio. You can see that even though stocks had an allocation that was only 1.5 times more than bonds, the stocks contributed over 16 times more risk to the portfolio than the bonds. This is why my free body diagram shows 16 force vectors acting on the stocks and only 1 force vector acting on the bonds.

This limited risk allocation for bonds tells me that the bonds are primarily serving to dilute the risk of stocks in the portfolio and not doing much to balance out the forces acting on the stocks. As you can see in the far-right column of the performance summary below, the 60/40 portfolio has maintained a correlation of 0.98 with the stock market. In other words, the forces acting on the stocks are almost completely driving the portfolio outcome. The bonds are primarily just dampening the amplitude but not doing much to balance out the forces.

Balanced funds may be close to having a balanced split of dollars between stocks and bonds. As we have seen here, that is about where the balancing act ends. The forces acting in the portfolio are far from being balanced. Like stocks, they are still highly dependent upon economic growth meeting or exceeding expectations and inflation meeting or falling short of expectations.

Now it's your turn!

I encourage you to take a few minutes to draw the free body diagram for your own portfolio.

What do you notice? Are you finding equilibrium or is your portfolio positioned to do better in one economic scenario more than another?

The data for this post and the visuals were obtained from Portfolio Visualizer. The data can be accessed using the link below. This data was shown for educational purposes only and does not constitute advice. Past performance is not a guarantee of future results.

Data Source:

https://www.portfoliovisualizer.com/backtest-asset-class-allocation?s=y&sl=77AAGowizJ1FnulKnF4ksP