Introduction:
Diversification of investments can help spread risk across a varying amount of holdings. Two of the most well known securities are index funds like SPY and bond funds like BND. Many believe that depending on your risk tolerance you will end up choosing one or the other. However even for the most risk averse individuals it would be advantageous to buy a mixture of both, the Efficient Frontier model brings us to this conclusion by illustrating an asset allocation that gets higher return while exposing the client to less risk than holding 100% bonds (See Figure 1).
Figure 1: Efficient Frontier Model
SPY & BND
SPY has an average monthly return of 0.732% and a standard deviation of 4.309%. BND has an average monthly return of 0.334% and a standard deviation of 1.078%. Stocks and bonds have long been thought of as negatively correlated variables and we can see the direction of this relationship stands true with a correlation coefficient of -0.013. A portfolio allocation of 85% BND and 15% SPY would get you the highest Sharpe ratio of 0.26388. This point yields 1.365% a year on average and has a standard deviation (risk level) of 1.115%. For these reasons I would suggest this portfolio allocation for an individual who is risk averse.
Adding in Treasuries
In addition to BND there are U.S. treasuries that return 0.1% a month, this will be considered the risk free rate as there is a standard deviation of 0. Treasuries can be used to achieve an optimal risky portfolio. With the three holdings the portfolio allocation that has the highest Sharpe ratio is: 16.49% SPY, 93.53% BND, and -10% treasuries, this allocation would yield a yearly average return of 1.467% which illustrates how betting against treasuries by leveraging short positions can bring higher returns.
One portfolio allocation that dominates owning just SPY is: 90.3% SPY, 67.14% BND, and -57.4% treasuries. This would yield a annual return of 2.87% with a standard deviation of 3.949% which has a higher return and lower risk level than owning just SPY. This portfolio has a Sharpe ratio of 0.18443. It should be noted that when factoring in treasuries each portfolio allocation that dominated SPY has a negative value for the holding of treasuries.
Adding in Emerging Markets
Aiming for a higher return we will add in EEM which is an emerging market ETF that has holdings of companies from foreign markets that have higher growth potential with higher levels of risk. EEM has a mean monthly average of 0.397% and a higher standard deviation of 6.53%. With three holdings the Efficient Frontier doesn’t make a smooth curve as it did with only two holdings (See Figure 2).
Figure 2: Efficient Frontier w/ EEM
When adding EEM into the options bundle, we can achieve the largest Sharpe ratio yet of 0.30847. This is achieved by an allocation of: 26.5% SPY, 83.5% BND, and -10% EEM. In this scenario we get a moderate yearly average return of 1.50% and a very low standard deviation of 1.081%. Throughout this exercise we have improved returns, risk level, or both by adding in additional holdings. Diversification is a widely used strategy to achieve these sorts of results.
Recommendation
It is my recommendation that my clients diversify holding based on their individual time horizons and risk tolerance. However in my experience the only type of investor that leverage short selling is hedge funds. Individual investors and even Financial Advisers tend to avoid this sort of thing. My boss at Merrill Lynch during my internship said you shouldn’t be investing if you’re not an optimist and short selling is an action rooted in pessimism. So what other options are there to get additional funds to be able to invest more than 100% of your money? Margin loans are one way but they also bring the additional risk of not only losing all of your money but then owing the company the amount you borrowed back on top of that.