Key History Lessons For Asset Allocation

September 11, 2018

If we look at the result representing no losses over rolling five-year periods (the far right side of the top-left graph), we see a much more diversified portfolio than before. Equities have been pared to just 40% and comprise U.S. large-cap, small-cap and world ex-US equities. Bonds are no longer dominated by just long-duration exposure, but now include a mix of short- and intermediate-term Treasuries as well as corporates. The precious metals allocation is cut in half.

Are we more confident that a diversified, 40/60 portfolio is much more likely to avoid losses over a five-year period than a concentrated 55/45? Absolutely.

Ironically, we had to introduce randomness into our process to create confidence: Adding uncertainty to a certain past created more certainty about an uncertain future.


We began with a simple question: How should we construct a portfolio if we want to be confident we will not experience any losses after a certain length of time?

We turned toward history as a guide and found ourselves uneasy with the results. While short-horizon results were intuitive, longer-horizon results were significantly overweight small-cap equities. The result arose from the time horizon in question, which represented a period that the realized size premium was significant. This led to the construction of a portfolio that implicitly assumed such a premium would exist going forward.

Unfortunately, the certainty of history can, in many circumstances, be a poor guide to an uncertain future.

To combat the risk that past realized returns are the result of significant embedded noise, and that our process was unintentionally maximizing exposure to this noise, we introduced more randomness. Specifically, we employed a process called subset resampling, which randomly selects a subset of the investable universe and optimizes over that subset in an effort to reduce estimation error.

We would argue the results align much more closely with our intuition. For example, over rolling five-year periods, subset resampling created a far more diversified portfolio and reduced exposure to equities by 15%.

While there are many lessons to be learned about balancing certainty and opportunity, we would argue that the biggest lesson of this commentary is simple: Past results may be a downright misleading guide to the future.

Newfound is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in 2008, Newfound offers a full suite of tactical ETF-managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed income and alternative asset classes. For more information about Newfound Research LLC, call 617-531-9773, visit or email [email protected].

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