Getting started with a recession-proof portfolio
Updated: Sep 22, 2020
In an earlier blog post, I highlighted the need to pay more attention to allocating and balancing your portfolio to ensure that you are reaping in the most returns based on your tolerated risk.
With the likelihood of a recession increasing based on the economic outlook, it's probably important for us to look at our portfolio again and understand if our portfolios are able to withstand a recession. Ultimately, are our portfolios recession-proof?
I have with me two textbook examples of recession-proof portfolios.
Firstly, Ray Dalio's All Weather Portfolio. For those of you who do not know who Ray Dalio is, he is one legendary character in the world of investing. He is the founder of Bridgewater Associates, which is the largest hedge fund of the world. You could think of him as the Steve Jobs of Investing. In an interview between him and Tony Robbins, the concept of All Weather Portfolio is introduced as a portfolio which could be managed easily by any investor and supposedly perform well in various market conditions. These various market conditions could be represented by 1) Higher than expected inflation, 2) Lower than expected inflation, 3) Higher than expected economic growth and 4) Lower than expected economic growth.
Here is the breakdown of the All Weather Portfolio.
15% intermediate term treasuries
40% long term treasuries
30% US Stocks
7.5% Commodities (diversified)
How does it perform relative to S&P 500? Here are the results for the past decade (2011 to present)
Portfolio 1- represents the All Weather Portfolio (VTI, VGLT, VGIT, IAU, DBC as representations of individual components) (Source: Portfolio Visualizer)
While you have a lesser CAGR value for the All Weather Portfolio (7.54%) as compared to the Vanguard 500 Index (12.12%), you also suffer a lesser max drawdown for the All Weather Portfolio. Overall, the sharpe ratio for the All Weather Portfolio is still better than Vanguard 500 Index.
If you look closely at the end of the graph (this is when the sharp drop in stock market happens in March this year), you will notice that there is a drop in portfolio value for Vanguard 500 index. In the same period, there is hardly a dent in the All Weather Portfolio and that gives testament on its ability to withstand "all weathers".
Despite it being a stable portfolio for most economic periods, young investors who could tolerate a bit more risk tend to opt for other portfolio choices which might give higher returns despite having a riskier profile. Nonetheless, I'm of the opinion that the All Weather Portfolio could still form the basis for sound investing with possibilities to make possible tweaks in various areas to suit your needs (eg. adjusting risk parities, including leveraged ETFs etc). I might explore more of this in a later post.
The second typical portfolio which I like to introduce is the Golden Butterfly Portfolio by Tyler of portfoliocharts.com
Similar to the All Weather Portfolio, the Golden Butterfly Portfolio is also meant to be a recession proof portfolio to withstand various economic situations with a little twist.
Here is the breakdown of the Golden Butterfly Portfolio.
20% short term treasuries
20% long term treasuries
20% US Small Cap
20% Total US Stocks
The immediate difference you can see here is that the Golden Butterfly Portfolio has a heavier weightage on gold and stocks with a particular emphasis on Small Cap (which arguably beats Large Cap historically). This pushes the portfolio to achieve better returns during economic growth periods, which may suit certain investors if they believe the economy is growing and like to capitalise on the growth. Hence, the Golden Butterfly Portfolio differs from the All Weather Portfolio in the sense that it favours the economic growth period more as compared to other economic environments.
How does it perform relative to S&P 500 in the same period then? Here are the results.
Portfolio 1- represents the Golden Butterfly Portfolio (VTI, VGLT, VGBR, IAU, VGSH as representations of individual components) (Source: Portfolio Visualizer)
Similar to the All Weather Portfolio, the Golden Butterfly Portfolio has a lower CAGR but a lesser max drawdown and higher Sharpe Ratio as compared to Vanguard 500 Index. Also, the Golden Butterfly Portfolio has hardly a dent as compared to the Vanguard 500 Index during the sharp drop in stock market during March this year, just like the All Weather Portfolio.
As compared to the All Weather Portfolio, here is how it stands.
CAGR: 7.54% (AWP), 6.83% (GBP)
Max drawdown: -6.13% (AWP), -7.15% (GBP)
Sharpe ratio: 1.24 (AWP), 0.94 (GBP)
In this comparison, the All Weather portfolio edges out.
The above portfolios are two examples of recession proof portfolios which you might like to take a closer look as most of the countries in the world looks into entering a possible multi-years recession. There are several more of such portfolios (eg. Permanent Portfolio and Ivy Portfolio which are worth a look too if you are interested to discover more of such all economic climate portfolios.
With suitable tweaks in the choice of ETFs and inclusion/adjustment of risk parities in these textbook portfolios , you might be looking at creating your own version of recession proof portfolio that is suitable for your risk appetite and be on your way to emerging unscathed in the next economic downturn.
More on such topics will be discussed in upcoming blog posts.
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