How to read model portfolios

How to read model portfolios

Since August 2018, the model portfolios can be bought in pdf format.

This post describes how to read the model portfolios i.e. the asset allocation reports made with the Adaquant Asset Allocation Suite software. If you feel you need any additional information on the model portfolios, the terminology or investing in general, it is warmly recommended to read the book Investing for Non-Finance People.

Page 1: settings

General settings table describes what kind of settings were used to create the asset allocation plan. In the description you can find what risk profile was used (conservative, average, high risk) and for which currency (USD, EUR, GBP, CHF). In the estimate and cost profiles you can see currency and time period for both. Maximum Drawdown Target % is the maximum allowed drawdown used in the simulations, and is -10% (conservative investor), -20% (average investor) or -35% (high risk investor).

The second table contains asset class settings. The table lists the asset classes used in the model portfolios and the return and volatility estimates for each asset class.

Page 2: main asset class weights

The chart in page 2 contains the recommended main asset class weights in the model portfolio. In this case, for example, the recommended weight for Equities is 14.9%. This weight is the sum of all individual asset classes (Large Cap Equities, Emerging Markets Equities, Small Cap Equities) than belong to the Equity main asset class.

How to use these weights? For example, if there is no investment portfolio yet, the investments could be done with the weights proposed by the model portfolio. If there is already existing investment portfolio, there are many ways how to adapt it towards the weights proposed by the model portfolio. This is how I do it myself: since I try to save and invest on a continuous basis, I put new money on investments that lag furthest behind the proposed weight of my model portfolio. Once a year I consider larger rebalancing for my investment portfolio. If I am much too heavily invested in one asset class (current portfolio weight > 10% from proposed target weight), I consider selling some part of the investment and invest it in another asset class where the weight is below target weight.

Page 3: asset class weights

Page 3 contains target weights for the individual asset classes. These are like the target weights for the main asset classes except that the view is more refined.

Should the investor use the target weights of main asset classes or individual asset classes? Both solutions are possible and the investor may even mix the two approaches. For example, one can decide to invest only in one global equity ETF that covers the whole world including emerging markets. Or one could invest in a developed markets equity ETF, emerging markets equity ETF and small cap equity ETF separately. The difference in investment performance is unlikely to be huge in the long-term since all individual asset classes follow the performance of the main asset class relatively closely.

Page 4: return and maximum drawdown distribution

Page 4 shows the distribution of the return and maximum drawdown of the model portfolio.

For the return, the probability is almost 50% for annual return to be between 2.4% and 3.6% p.a. for investment period of 10 years. The worst performance between 0% and 1.2% p.a. has only about 4% probability. Out of 10’000 simulations done, none would have had negative performance. The average return from all simulations is 2.8% p.a.

For the maximum drawdown, one can see that the most common two results, both with around 30% probability, ares maximum drawdown between -12.5% and -10% and maximum drawdown between -5% and -2.5%. It is often the case that there are two pikes in the maximum drawdown chart. The reason is that every now and then the financial markets have a crisis where the risky asset classes have significantly negative performance. If there is a crisis in the next 10 years, then the maximum drawdown of the investment portfolio will be worse. If not, the maximum drawdown will be much better. Note also that out of 10’000 simulations, none had worse maximum drawdown than -20%. This is how it should be, because the maximum allowed drawdown was set to -20% in the settings.

Page 5: return and maximum drawdown chart

Page 5 shows the return vs maximum drawdown of all 10’000 simulations. It is expected that for the next 10 years, the model portfolio will have return and maximum drawdown that is one of the dots in this cloud.

Page 6: estimated costs

Page 6 shows the expected costs of the model portfolio implemented with low-cost ETFs. Total cost is shown (0.09% p.a.) together how individual asset classes contribute to the total cost.

Page 7: recommended ETFs

The selection of ETFs available to individual investors is nowadays massive. Running a screen for available ETFs shows that there are almost 10’000 ETFs globally.

In page 7 there are ETFs for each asset class that I think are very good choices for individual investors. They are passively managed, inexpensive and very broadly diversified. But they are not the only good alternatives, there may be also similar ETFs from other providers that are equally good.

By |2018-08-11T15:07:53+00:00August 9th, 2018|