Saturday, December 15, 2007

Testing an Asset allocation in Bull and Bear markets

Ever wonder how your portfolio would hold up in a prolonged down or Bear market? How about evaluating the upside during a Bull market? With so many different asset allocations (Couch Potato, Intelligent Asset Allocator, Coffeehouse, Bogleheads, etc ) how do you know if you have the right mix?

One way to better understand your asset plan is to take it back in time to Bull and Bear markets. This can prepare you for what might happen in the future and help you evaluate how much risk you are willing to take. If the returns projected for a Bear market make you uncomfortable then you can use that information to adjust your holdings.

Note that there are many types of bear markets. Some hit the financial sector hard, while others hit technology stocks and so on. But in general, for a market to be considered a true bear market it will weigh down almost all types of stocks, just in different degrees.

Asset Allocation
As part of my personal financial plan, I have set up an asset allocation for my holdings. I call it the CoffeeHouse Portfolio with a Double Espresso Shot. The allocations for each holding are shown in the following table. The dollar amount of the asset is divided by the total dollar amount of the portfolio to arrive at the “weighting” for each fund or stock in the portfolio.

Now for more explanation on the allocations. The Fixed Income asset type is actually a money market account. The 40% allocation to Large CAP stocks has been broken down into three subcategories: Health care fund, defense contractor stocks and technology stocks. So, health care is actually 28% (0.7*40) of my holdings, defense is 10% and technology 2%. I broke these out because their performances vary drastically.

Market Returns
Now that we have the weightings, we need the returns for each market. The return data is based on stock or fund price data with the exception of the Fixed Income (Money Market fund). Because MM funds maintain a constant $1 price, the yield data was averaged across each time span. The stock and fund price data that was used in this table does reflect distributions as the price is adjusted when capital gains and or dividends are distributed. All of the price data was gathered using historical data from Yahoo finance.

For the Bull market example, I used the recent run from January 2006 to December 2006. The Bear market returns are from the couple of years following the irrational exuberance of the 90’s. I used prices beginning on 8/25/2000 and ending 10/7/2002 to calculate the total return during this Bear market. The next step is to multiply the asset weighting times the Bear or Bull returns for each asset class. For instance, the 5% fixed income allocation times the 3.8% bear return equates to a performance weighting of 0.19%. Each performance weighting is calculated and then added up to arrive at the total performance for the portfolio.

Bear and Bull Performance
This is how my portfolio would have performed in a Bull and a Bear market. For the Bear market, the portfolio would have returned 2.01%. It’s a small amount but at least its positive. Most people during this time frame lost a lot of money. For the Bull market, the total return was 21.98%.

If we look a little deeper into the mix, its apparent that Gold and Defense stocks were huge positive factors during both of these runs. Real Estate (REIT) was also a bright spot. One might be tempted to overweight in these sectors, but that could make this portfolio vulnerable to other types of bear markets.

When I first started this exercise, I wasn’t sure what to expect. But, I am pleasantly surprised. From this data, it appears that the portfolio has a good mix of assets that includes sectors that have low correlation to one another. This is a key to any asset allocation. However, I would like more data points. I plan to take this portfolio back in time again to several other Bear markets and post about it within the next month.

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