Asset allocation

Earning a bob or two with Dylan

Nov 23rd 2012, 14:31 by Buttonwood

SORRY to see that Dylan Grice is deserting his strategist post at Societe Generale, where the team never fails to keep readers entertained. He is off to join an investment management firm as did his predecessor, James Montier, who is now at GMO.

His final piece, in typical style, invokes the cockroach, that consummate survivor, which follows the rule that a gust of wind indicates a potential predator and accordingly scurries off in a different direction. The cockroach has survived several mass extinctions, including the one that wiped out the dinosaurs. The calamities that affect investors occur when they herd into an asset class, as they did in equities in the late 1990s and as they are doing in government bonds today.

So Dylan prescribes a native diversification strategy for those who do not know what the future holds (which means all of us). A 50% bonds/50% equities split would have worked well over the last 20 years, but would have been disastrous in the stagflationary 1970s. So he suggests a four-way split – 25% equities, 25% government bonds, 25% cash and 25% gold.

The annual return from this strategy would have been highly respectable – 5% real since 1971, compared with 5.5% in equities and 4% in government bonds. But the volatility is much lower – the maximum drawdown was 20% in the early equities, compared with 50% (twice) for equities and 40% for government bonds. Investors would have found it easier to sleep at night.

Many years ago, in the FT, I proposed a similar native strategy, involving just equities, bonds and cash; one took the expected return from the three asset classes and dividend the portfolio accordingly. The expected return on bonds and cash is the current yield; the expected return on equities was the dividend yield plus nominal GDP growth. So if cash yielded 4%, bonds 5%, equities 3% (with nominal GDP growing at 4%), expected returns were 4/5/7. The three returns added up to 16, so one put 4/16 in cash, 5/16 in bonds and 7/16 in equities. The beauty of this system is that it made you rebalance when asset classes looked expensive; at the time (back in 2005), it also had a record of low volatility.