All Weather Portfolio is designed to survive all economic environments, using different types of assets that perform differently during those different “seasons” and the portfolio idea was created by Ray Dalio, founder of Bridgewater.
Ray questioned, "What kind of investment portfolio would they hold that would perform well across all environments?" He tried to break down economies & markets into their components pieces and study the relationship of these pieces.
He learned that the market move based on a shift in conditions relative to the conditions already priced in (Surprises). Asset classes react in an understandable way based on the relationship of their cash flow to the economic environment. Ray learned that by balancing assets based on these structural characteristics, the impact of economic surprises can be minimized (Inflation shift or growth bust). It's a passive strategy that doesn't require predicting future conditions.
Any return stream can be broken down into its components part and analyzed more accurately by first examining the drivers of these individual parts. And it's the essential groundwork for structuring all weather strategy. After analyzing these return sources of assets, then it could be combined to form the portfolio.
Any investment product return components are,
Return = Cash + Beta + Alpha
a) The return on cash is controlled by the central bank
b) The excess return of a market above the cash rate is the beta.
c) The tilt or manager stock selection is the alpha.
Expected return
- Beta: aggregate & overtime outperform cash (one of few sure things in investment)
- Alpha: a zero-sum game
The key is fixing the beta allocation, not trading the market well. This can be done by asking what proportion of asset classes to hold to make a static portfolio reliable. To do that, we need to separate the beta from cash & alpha.
Environmental bias & risk balancing assets
All asset classes have environmental bias and it needs to be balanced to reduce risk. If risks didn't offset, the portfolio would be exposed. For example of stock, it's exposed to the risk that the growth in the economy would be less than discounted (expected) by the market.
Framing growth and inflation as the environment drivers that mattered and mapping asset classes to these environments. Stock and bonds offset each other in a growth environment, but both hurt in rising inflation. The best portfolio was balanced to inflation surprise, also balanced to growth.
The key was to put equal risk on each scenario to achieve balance. The value of the investment is primarily determined by the volume of economic activity (Growth) and it's pricing (Inflation). Surprises impact the market due to changes in the conditions of these two economic environments. Inflation-linked bonds do well in rising inflation. Thus, the ideal portfolio allocation of All Weather strategy would be..
Assumption,
- All asset classes would rise overtime (beta)
- Central bank print money - > will be spent on equity (ownership) or bond (borrow).
- Thus, the net return of the assets in aggregate are positive over time relative to cash
- Environmental exposures cancel each other out, which leaves just the risk premium to collect.
To implement this portfolio idea, you need to use tools called leverage and diversification. If you use these tools properly, your portfolio would be less risky than unlevered and undiversified one. As an example, if you invest $10 in the SPY (S&P 500 ETF) and $10 in US bonds, the portfolio risk is dominated by the SPY because it is much riskier than the bonds. Instead, you should invest $5 in the SPY and $15 in bonds, then the portfolio is much more balanced, though with a lower return. And then, you need to add a bit of leverage and the portfolio has the same return as the stocks but less risk.
Ray suggested that these weightings would not be exact or perfect, but it requires us to construct each portfolio in a different environment with the same risk. I will cover this topic next time.
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