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by Majromax 700 days ago
Applying optimal portfolio theory to the long history of market returns suggests that the most risk-efficient allocation is something like 60% stocks and 40% bonds. The diversification reduces volatility faster than it reduces the overall return, so equity-like returns can be regained by using leverage on the portfolio.

Following this advice today is tricky thanks to the persistent yield inversion: you obviously can't improve returns by using short-term borrowing at 5% to invest in long-term bonds at 4%.
2 comments
mattmaroon 699 days ago
Wouldn’t the most risk-efficient strategy both depend on a large number of factors and also, in any case, start off with a higher allocation of equities and move over time to a higher allocation of bonds?

The stock market has never not outperformed bonds over a 45 year period, maybe even half that, so if you’re 20 and putting 40% of your savings in an account you can’t touch until your 65, you’re kind of just chucking money down a well right?

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Majromax 699 days ago
> Wouldn’t the most risk-efficient strategy both depend on a large number of factors and also, in any case, start off with a higher allocation of equities and move over time to a higher allocation of bonds?

Not really. The most risk-efficient strategy optimizes the ratio between expected return (less the risk-free rate) and volatility (standard deviation), regardless of the absolute value of those parameters.

If that optimal allocation has too much risk, such as for the near-retiree, then the investor can keep a fraction of their portfolio in the mix and the other half in cash (money market, paying the risk-free rate). If the allocation has too little risk, then the inverse applies: borrow on margin (at approximately the risk-free rate) to invest more than 100% of net assets into the mix.

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mattmaroon 698 days ago
Right but a 25 yr old’s retirement account has practically zero risk. If you functionally can’t withdraw the money for decades anyway, there’s approximately zero chance a dollar invested in bonds will outperform a dollar invested in equities.

Ending up at 60/40 might be a good plan, but starting there seems a waste of money.

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throwaway2037 699 days ago
I am not sure that anyone recommends that 22 year olds put 40% of their retirement portfolio in bonds! That is insanely conservative.
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Majromax 699 days ago
That's where leverage comes in. Under more ordinary conditions, the 22 year-old would have something like 80% in equities and 50% in bonds, using leverage to have a net 130% invested.

Under current conditions, that allocation is more questionable. The yield inversion means that the expected value of a leveraged bond investment is about zero (borrowing at a higher short-term rate to lend at a lower long-term rate), so any portfolio gains come from anti-correlation of bond and stock prices. However, the current market worry is more about stagflation than a traditional recession, such that inflation leads to both higher interest rates and lower equity returns (through equity de-leverage).

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throwaway2037 698 days ago
Where do you get the leverage and what does it cost? To be clear: Leverage isn't free. It is borrowed money -- financing -- for your positions. For most retail people, they will struggle to pay less than 5% per year, and usually much more. Here is a list of margin rates from Interactive Brokers: https://www.interactivebrokers.com/en/trading/margin-rates.p...

A never once, did I am read any sensible long-term retail strategy that recommended the use of leverage, let alone persistent leverage. This is a strange post.

What does your portfolio look like?

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