In 1906, Italian economist Vilfredo Pareto created a mathematical formula to describe the unequal distribution of wealth in his country, observing that twenty percent of the people owned eighty percent of the wealth. The 80/20 rule has been recognized by many as a universal principle of life. Its application even wins a place in the logic of asset allocation.

Consider, for example, the mix between stocks and bonds. On average stocks are more volatile but they also have a higher average return. However, there are times when stocks have done poorly. Some people’s investments have still not recovered from the drop in technology stocks from 4-6 years ago. So if you believe in diversification, what is the best mix of stocks and bonds? For the assumptions behind the math to follow I will use US large cap stocks (the S&P 500) and an average bond portfolio (the Lehman Brothers Aggregate Bond Portfolio).

First, let me be quick to say that diversifying solely between the S&P 500 and the Lehman Aggregate Bond Index is a very bad idea. I’ve written previously that the S&P 500 is a poor investments choice, and in recent years anywhere other than the S&P 500 has beaten the S&P 500 Index. Additionally, there are many alternative investments with higher returns than these two indexes where a portion of our assets should be allocated. Finally, US stocks and bonds are only two of the six asset categories where we recommend investing.

Nevertheless, these two investments provide a good example and paradigm of the rule of thumb that should be used in asset allocation choices between qualified investments.

Consider an asset allocation continuum ranging from 0% Stocks (S&P 500) and 100% Bonds (Lehman Aggregate Index) through 100% Stocks and 0% Bonds. Each asset allocation is rebalanced annually. How would each of these portfolios have done over the past several years in the markets?

A portfolio’s performance is measured two ways: first, the average return it delivers, and second, the average portfolio volatility. Average return is computed by measuring what guaranteed return would have produced the same amount of money had it been compounded each year. Portfolio volatility is measured by measuring the annual standard deviation. We might expect a relatively straight line. The greater the amount of stocks in the portfolio the greater the risk (standard deviation) and the greater the return.

This is not the case.

The curve includes risk and return characteristics that are not on the efficient portfolio horizon.

The efficient frontier was first defined by Harry Markowitz in his Nobel Prize winning work on portfolio theory. An optimal portfolio is the highest returning portfolio for any expected volatility or conversely the portfolio with the lowest volatility for any given return. Only these optimal portfolios are on the efficient frontier. For any portfolio that is not optimal, a portfolio can get a greater or equal return for the same or less volatility.

Notice in our risk return example, the portfolio of 100% stock did not provide the best return, though it did provide the highest volatility. The highest return was with more than 10% bonds. With 20% bond, the return was still higher than an all stock portfolio, but the reduction of volatility was significant.

Similarly, the portfolio of 100% bonds did not provide the least volatility. The lowest volatility was with more than 10% stock. With 20% stocks the volatility was still lower than an all bond portfolio but the return was much higher.

Given the constraint of only these two investment choices, the efficient frontier would be between 10% stocks and 90% stocks. These are the asset allocation mixes which have the lowest volatility and the highest return. Between these extremes, the sweet spot for investing and balancing risk and return is between 20%/80% and 80%/20%.

During a bull market, investors are quick to forget that the markets also go down. Adding bonds to an all-stock portfolio can increase as well as stabilize returns. And some investors that are seeking stability forget that adding small amounts of more volatile investments can actually reduce volatility. Adding stocks to an all-bond portfolio can stabilize as well as increase returns.

Asset allocation becomes even more complex as additional investment choices are added to the mix. Some investment choices add neither lower risk nor higher return to a portfolio. These investment choices are best eliminated from your portfolio. Other choices may be able to reduce risk and increase return by inclusion in your asset allocation.

Turbulent years are coming as certain as they have come in the past. The 80/20 equation of life is the result of personal choices. The financial successful save consistently, diversity wisely and spend frugally.

Photo in public domain.