What makes a portfolio “better”?

A truly “better” portfolio is one that rewards you fairly for the risks you take.  Too often, pundits and authors of popular finance encourage investors to take more risk than they need to, then to grit their teeth and wait for the pain to subside when their portfolios eventually suffer. But large losses can derail the magic of compounding, and investors should and can demand a better way. A better portfolio is one which delivers better returns for the level of volatility (up-and-down swings) and potential drawdown (large losses) it experiences.

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Understanding the incumbent

For decades, the investment industry has relied on a simple formula: ask investors how much risk they think they can tolerate, then reduce stock exposure in favor of bonds. As indexing grew in popularity, so did observations that adding bonds to a stock-heavy portfolio appeared to deliver smoother returns, smaller drawdowns, and improve the overall risk–reward trade-off—in other words, a better portfolio. 

The most visible outcome of this thinking is the widely-adopted 60/40 portfolio (60% stocks, 40% bonds), a starting point for investors that aims to balance reasonable returns with less drama. [Narrator: It’s not necessarily the single best mix of stocks and bonds, but more on that later.*]

This “better” 60/40 portfolio, and all portfolios like it, are pitched thusly:

• Stocks drive long-term returns but suffer large swings and deep drawdowns.
• Bonds act as a stabilizer, reducing volatility and providing balance.

Using Vanguard index funds as proxies (limited by available fund history), we can compare stocks alone to a 60/40 portfolio from May 1992 to December 2024:

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Adding bonds to our portfolio of stocks results in:

• Returns lower by 2% per year (about 20%), but risk and drawdowns lower by twice as much (40%).
• A significantly better Sharpe Ratio—measuring return per unit of risk.
• The portfolio became less volatile, making it easier for investors to stay the course through market cycles.

It’s worth noting that, with the addition of bonds, a 60/40 portfolio still experienced a 31% drawdown—a painful decline which would test most moderate investors' tolerance for risk.

While 60/40 is better than 100% stocks in risk-adjusted terms, it delivers lower returns for an obvious reason: because it takes less risk.  So, is reducing risk the only way to improve a portfolio, or can we make portfolios better without settling for less?

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The problems with bonds these days

Although bonds have sometimes reduced stock market volatility, they do not always solve the problem. Decades of declining inflation and interest rates made bonds an attractive solution, but during rising rate environments (inflationary periods), central bank tightening, or fiscal uncertainty, bonds do not deliver the same performance or protection investors expect—because in these conditions bonds tend to move in the same direction as stocks.

Put simply, the ability of bonds to provide stability to a portfolio depends on the economic environment. Bonds moving in the same direction as stocks is far from unique historically, and when stock-bond correlations rise, diversification benefits fade. 2022 illustrated this perfectly—both stocks and bonds fell significantly, reminding investors that bonds don’t always ‘zig’ when stocks ‘zag.’

Beyond correlation risk, bonds face several structural issues that limit their effectiveness:

• Non-economic players dominate the market. Central banks and government policies distort yields, making bonds less predictable as an investment.
  
  
• Poor tax treatment. Bond interest is taxed as ordinary income, which subjects their returns to a major haircut in taxable accounts.
  
  
• Low return per unit of risk. Over the long run, bonds tend to deliver lower returns than stocks but still carry drawdown risks, especially when inflation erodes purchasing power.

Instead of relying solely on bonds, thinking more broadly about diversification allows us to incorporate additional investments that better complement both stocks and bonds, providing better protection across different market environments. 

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‍A Rare Bird: finding true diversifiers

Truly diversifying assets are rare. Many asset classes (e.g., different segments of the stock market) move in the same direction during major market events.  One unique way large, sophisticated institutions (and Magnolia) achieve meaningful diversification is through the use of Trend Following (via Managed Futures)— systematic strategies designed to capitalize on market trends across a wide range of asset classes: including stocks and bonds, but also commodities, currencies, and other alternative assets.  

Trend Following strategies:

• Buy assets enjoying positive price trends; 
• Reduce exposure to, or sell short, assets in negative price trends,
• Capitalize on price trends in asset classes not held in conventional market portfolios, and 
• Adapt to changing market conditions

Because trend following strategies dynamically adjust their exposures according to market movements, rather than hold static allocations, they are largely uncorrelated with stocks or bonds. Trend following has a long and consistent track record as a unique and powerful diversifier. It is widely available to investors of all kinds, and belongs in most portfolios as a way to achieve more consistent “all weather” performance across different economic and market cycles. 

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‍A 20-Year Look: US stocks & 60/40 with trend following (2004–2024)

To illustrate trend following’s impact on portfolios, let’s compare the stocks to a 60/40 mix with portfolios that incorporate trend following. The most recent 20-year period (2004–2024) experienced major market events like the Tech Bust, the Global Financial Crisis, and the extraordinary bull run that followed.

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In both cases, we see improvements to the portfolio in all of the ways we want.  Adding trend following:

• Reduces risk and drawdown significantly more than it reduces returns
• Improves portfolio efficiency–the return for unit of risk (higher Sharpe Ratio).
• Enhances diversification—especially in market downturns

And while many institutions have long allocated capital to trend following, it is absent from most individual portfolios despite being widely accessible: the strategy is available in every type of investment vehicle: ETFs, mutual funds, separately managed accounts, and limited partnerships.

The diversification benefits are persistent over time and, importantly, they tend to shine brightest during periods of market stress–like the Tech Bust, the Global Financial Crisis, and the recent Fed rate hike cycle– when investors need them most.

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A smarter, more resilient portfolio

A better portfolio is one that benefits from meaningful diversification, something stocks and bonds alone can’t deliver. Adding diversifying strategies and asset classes like Trend Following makes a portfolio fundamentally “better.” These deliver a more favorable risk/return profile, with less stomach-churning drawdowns, and more fully compensate investors for the risk they take.  

While better portfolios bear less risk for a given level of return, investors can instead target higher returns for the same level of risk as a conventional portfolio. By scaling up the exposures of a well-diversified portfolio, we can help an investor achieve higher return objectives by making their better portfolios bigger.   

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Sources:
Stocks : VTSMX (Vanguard Total Stock Market Index Fund),
Bonds: VBMFX (Vanguard Total Bond Market Index Fund),
Trend following: SG Trend Index (SocGen Trend Index).
‍Portfolios are rebalanced annually.
Returns, volatility and drawdowns based on end of month values.  

*The single best stock-bond allocation (for risk-adjusted returns) has been closer to 20% stocks and 80% bonds, not 60/40.

** The largest drawdowns for 100% US Stocks and 60/40 on a daily close basis are actually -55.38% and -34.01% respectively. 

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