Tuesday 29 May 2007

Is it Better to Invest 100% in Stocks or to Gear a "balanced" Portfolio?

I happened to come across the website for Shearwater Capital the other day. Their investment approach seems sensible and their published fees reasonable, but that isn't what caught my eye. I was more interested in their model portfolios and using the data on the 20-year performance to evaluate the effectiveness of gearing as an investment strategy.

Looking at their "Aggressive" portfolio (80% stocks/20% bonds, which is similar to my target asset allocation) you have a Twenty Years Annualized Return of 12.3% with a Thirty Three-Year Model Annualized Standard Deviation 11.8%. The "Very Aggressive" portfolio (100% stocks) has a Twenty Years Annualized Return of 13.7%, but the Thirty Three-Year Model Annualized Standard Deviation shoots up to 14.6%.

This shows that, as can be expected from modeling of the efficient frontier of a portfolio composed mainly of stock and bonds, the optimum return-risk outcome is achieved from a portfolio comprised mostly of stocks, but with some bonds included. The mix within the stock component is usually around 60% domestic:40% foreign, although in various ten-year periods you would have done better with the opposite ratio (so a 50:50 split may be a good bet).

Moving from the "Aggressive" to "Very Aggressive" asset mix boosted returns by 11.38%, but the "risk" (variability of returns, as measured by the Standard Deviation) increased by 23.73%.

For this reason, if you are seeking higher returns over long time periods, it seems a better strategy to use gearing of an "Agressive" portfolio, rather than moving to a "Very Agressive" portfolio.

Taking the Twenty Years Annualized Return of the "Very Conservative" portfolio (100% bonds) as a proxy for the interest rate cost of gearing (via margin loans or a real-estate backed investment loan such as a HELOC), one can make a rough estimate of the Twenty Years Annualized Return and Thirty Three-Year Model Annualized Standard Deviation that would result from a 100% geared (50% LVR) "Aggressive" portfolio:

20-year 33-year
Annualized Annualized
Return Std Devn
Ungeared "Aggressive" 12.3% 11.8%
Estimated Cost of Loan 5.9% 2.4%
Estimated 100% geared 18.7% 23.6%
Estimated 22% geared 13.7% 14.4%
Ungeared "Very Aggres." 13.7% 14.6%

Using gearing could therefore increase your average returns by 52.03% at the cost of increasing standard deviation by 100%. This is somewhat better than shifting your asset allocation from "Agressive" to "Very Aggressive". However, the absolute "risk" has increased 100% compared to 23.73%, so the strategy of making use of 100% gearing ratios should probably be called "Hyper Aggressive". A more modest use of gearing (say, 22%) would produce similar average return as a "Very Aggressive" asset allocation, but with a slightly lower standard deviation.

It was interesting to see that the returns for the 100% geared "Aggressive" portfolio are very similar to the long-term increase in value of my own investment portfolio. When I started out I didn't use gearing and had a more conservative asset allocation, but this was offset by the relatively large impact my savings had at that stage. These days my savings have a more modest impact on my overall increase.

One final note, when using gearing the cost of funds (interest rate and any annual fees) can have a major impact on the long-term performance of this strategy, so it is worth shopping around.

Enough Wealth


uniquecoffeetables said...

There is no point gearing into anything other than a 100% aggressive portfolio.

Gearing into cash/fixed interest will always end up worse off, as these asset classes will never outperform interest costs.

If this 80/20% allocation provides the best return, the 80% in aggressive assets should be geared and the 20% in defensive assets should not be geared.

This would provide optimum outcome

mOOm said...

I agree that gearing a more diversified potfolio gives better return/risk than gearing a pure equity portfolio. Ideally you would add sources of alpha if you can identify them :) I wrote about this here:


for example. Because of fungibility of money it is purely semantic whether you are gearing the 80% that is in shares or gearing the whole 80/20 portfolio. It doesn't make sense to include cash in such a portfolio as then you have positive and negative positions in cash. It can make sense to have longer term bonds. There are big differences in interest rates which can make a big difference. Buying geared funds gets you a very low interest rate though you can't pick your own stocks. Futures, warrants etc. also have very low interest rates built in but may not be as good tax wise depending on your strategy/country whether it's a retirement account or not etc. Going forward bonds probably won't be as good in the next 25 years as they were in the previous when interest rates were fallig.