Looking back, it is very simple to say which allocation would have provided the best return with the least risk. The challenge lies in building the portfolio that should present the best return per unit of risk for the next 12 months. Below I explain three factors we use to decide the best allocation for a portfolio.
Once the facts have occurred and the assets have priced in the event, it is simple to justify which position would be most appropriate.
However, as Warren Buffett himself stated last year at his annual meeting: “It’s not as easy as it sounds”.
Evaluating the last eleven years, it is possible to clearly point out which asset class presented the best performance in the year.
Please note the table above. For its construction, only a little more than ten main or traditional applications were considered. In it, the asset with the best return and its performance in the year are presented in the second and third columns. Also, in the fourth and fifth columns there is the asset with the worst return in the respective year and its yield.
Note that sometimes the worst performing asset one year becomes the best the next year. I made tags to highlight these cases. The worst performing assets are often the ones we want to get out of. This could be an error.
Fixed-income alternatives such as fixed-rate bonds or bonds referenced to the CDI or IPCA have never been in the best position. But they were also not in the worst position of each year.
Nor is it enough to weigh everyone equally. The average return of a portfolio weighted among these main assets generated an accumulated result of 97% of the CDI, over the last eleven years.
To select assets, three factors need to be considered.
The first, and almost obvious, is the expected return of each asset class.
For this, it is necessary to consider the economic perspectives and the individual aspects of each application.
It is important to understand that expected return does not mean certain return. There is a risk involved in any projection.
Thus, it is necessary to consider the probabilities of adverse but also probable scenarios. Therefore, the risk involved in each application is the second factor to consider.
Finally, you need to consider diversification. It is important to understand that diversification is not the same as spraying. Just because you split it into multiple assets doesn’t mean you’ve diversified properly.
For this, the correlation between asset returns must be assumed. You don’t want that when an adverse scenario occurs, the entire portfolio will go down with it.
In our case, we consider that the average correlation of assets in recent years is maintained.
Putting all these factors together and using the model derived by the 1997 Nobel Prize in economics, Robert Merton (link), it is possible to construct the efficient asset frontier shown in the figure above.
The portfolios derived by the model are an important guide to prevent you from making allocation failures such as inadequate risk exposure.
Michael Viriato is an investment advisor and founding partner of Investor’s House
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