One of the most popular ways to test your portfolio strategy is to backtest it. Backtesting involves using historical data to see how a portfolio would perform. As you already know, past performance is not a great indicator of future performance, especially if we are concerned with short-term future performance. Historical data does, however, give us a good idea about the volatility of a particular investment and how that investment behaves in a portfolio with other investments. The longer the dataset you use goes back in time, the better idea you’ll have about how your portfolio will perform under different market conditions.
This all sounds complicated, and it was in the recent past. The process is rather painless (and a little addictive) when you use web-based tools that let you put in ticker symbols and adjust settings with drop-down menus. Portfolio Visualizer (https://www.portfoliovisualizer.com/) is a good example of these robust, free tools that are available. You can do all of this stuff in Excel, but it is much more work. Your brokerage will likely have similar tools on its website.
These backtests also allow you to maximize your portfolio based on some pretty sophisticated criteria. You can use the Portfolio Optimization tool to run as many “what if” scenarios as you like. You can also use Portfolio Visualizer to generate graphs and tables.
Let’s use one of those graphs to demonstrate some important points about trying to maximize risk and simultaneously minimizing risk. The easy answer to this is that it can’t be done. If you want higher returns, you have to take on more risk. Perhaps the closest thing to a free lunch on Wall Street is the strange habit of becoming less volatile when you put them in a basket together. Let’s look at optimizing our return on a portfolio of large-cap U.S. stocks mutual fund that tracks the S&P 500 (VFINX) and a fund of intermediate U.S. bonds (VFITX).
If you are a daredevil and don’t feel fear, we can see that the best return you could get during the period of from 1992 to 2018 was to ignore the bonds and just (you guessed it), “buy the SPY.” In other words, you could have made a CAGR of 9.51% of you allocated 100% of your portfolio to S&P 500 stocks. Adjusted for inflation, you would still have made a real return of 7.06%. That sounds good until you consider that during one of those years you would have lost 37.02% of your portfolio’s value.
The compound annual growth rate (CAGR) is the measure of growth over multiple time periods. It can be thought of as the growth rate that gets you from the initial investment value to the ending investment value if you assume that the investment has been compounding over the period. Never pay attention to average returns; they are incredibly misleading.
We can learn a couple of lessons from this. First, don’t ever panic and sell at the bottom. During the worst day of that year, you were down over 50%. The psychological pressure to get out of the market was no doubt huge. If you held on through the entire investment period, you were handsomely rewarded. What will happen if we add some bonds in there to calm down that scary volatility? Your return will shrink, right? The answer is what you would expect: It depends.
If we restrict the overall volatility of our portfolio to 10%, we find that we need a 70% stock and 30% bond mix. Using this allocation, you were only down 25% during your absolute worst year. Your CARG did drop to 8.59%. The bottom line is that over very long investment timelines, you will make a little more profit if you take on a lot more risk and can stay the course.
Let’s consider another example that will make the idea of why we’d even bother with portfolio allocations in the first place. Let’s say that Professor Doe is 62, about to retire in three years (We’ll set his retirement date at December 2003), and realizes that he hasn’t saved enough to meet his retirement goals. On January 1, 2001, he transferred all of his assets into an S&P 500 mutual fund to get some high profits those last 3 years. It turns out that this wasn’t a good plan for Dr. Doe. He realized a gain of -4.17% over the period.
Had he gone with a 50%/50% blend of stocks and bonds, he could have made a modest 2.33%. Had he used a risk parity strategy (like the one I advocate in the last final section of this book) he would have realized a gain of 5.30%. Had he further diversified with a risk parity weighted REIT, he could have made 8.31% during the period. When the stock market is in full on bull mode, risk reduction strategies like risk parity cannot keep up, but they can still do very well. When the stock market is down in a big way, risk parity can keep your losses in the single digits while the rest of the world melts down.
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Last Updated: 6/25/2018