Leveraged Portfolios Battle: Picture Perfect Portfolio Challenge Introduction

Imagine taking all of the classic portfolios, from the 60/40 to the Ray Dalio All-Weather and everything in between, and instead of waxing nostalgic and relentlessly coddling over them with unwarranted admiration we instead turn up the heat, smash them against the wall and light them on fire to see when/where/if they fall apart under the harshest conditions of stress.

Does that sound interesting to you?

It sure does to me.

We do this in all other spheres of life when it comes to product creation.

Think about all the way cars, before they hit the market, are tested in crash simulation scenarios.

Why haven’t we done this with portfolios?

Good question.

We say the 60/40 is the best game in town for investors looking to balance performance/risk but have we taken the time to prove it?

I don’t think so.

What is the necessary ingredient to provide stressful conditions for portfolios?

Leverage.

And how do we dial up the intensity even further?

More leverage.

We’re going to dial things up 1X no leverage (100% canvas), 2X leverage (200%), 3X leverage (300%) and 4X leverage (400% canvas).

Leverage is the most polarizing term in all of finance.

Some love it. Some hate it.

Some cannot fathom a portfolio without out. Others would rather impale themselves upon a sword as opposed to stretching the canvas of their portfolio beyond 100%.

It sure is a fascinating world out there my friends.

Do we even know why we have these strong opinions?

Hmmmm.

I’m not so sure to be honest.

Aside from stress testing every single one of these classic portfolios, the secondary reason for doing this is to see when/if/where leverage can be applied to enhance returns and manage risk.

The only reason this humble little investing blog from a freakin’ travel vlogger even exists in the first place is to pursue just one thing.

The Picture Perfect Portfolio.

I don’t think we know what it is and one of the ways we’re going to get closer to finding out is by thinking a bit outside of the box.

So let’s get crackin’ we’ve got some eggs to break (errr…I mean portfolios).

Leveraged Portfolios Battle

Hey guys! Here is the part where I mention I’m a travel vlogger! This Battle of the Leveraged Portfolios series is entirely for entertainment purposes only. Most investors should not use leverage. There could be considerable errors in the data I gathered. This is not financial advice. Do your own due diligence and research. Consult with a financial advisor. 

Picture Perfect Portfolio Challenge Introduction

Gladiator warrior gear for the Picture Perfect Challenge of Leveraged Portfolios Battle
Source: Pixabay

Meet The Classic Portfolios

Come on down!

You’re the next contestant on the Picture Perfect Portfolio Challenge (aka the Leveraged Portfolios Battle)!

Lining up at each individual podium is 10 contests.

We’ve got the 100% US Total Stock market as our benchmark.

We’ve then got the 80/20, 40/60 and 20/80 as well.

And the last of our equity/bond combination portfolios?

How could we forget about 60/40!

And what of the other five portfolios lining up to play this leveraged portfolio game?

Ray Dalio All-Weather.

Risk Parity.

The Permanent Portfolio.

These Kool Kats bring a few more tools to the party.

For starters they’ve got some Gold sitting there at the table.

They’re more than just merely stocks/bonds.

And the last gameshow contestants?

The Nomadic Samuel Portfolio and the Nomadic Samuel Risk Parity Portfolio.

What the heck are those?

Basically, portfolios that sit somewhere in between the 60/40, All-Weather and Risk Parity with more optimized equities than the US Total Stock Market.

They’re there just to see whether or not adding something like US Small Cap Value equities and some different configurations with various allocations makes a difference in terms of long-term back-test results.

I’ll explain more later.

Portfolio Allocations

 

USA Total Stock Market Pie Chart
Source: PortfolioVisualizer.com

US Total Stock Market Portfolio

US Total Stock Market: 100%

Here we’ve got the US Total Stock Market.

It is our benchmark for this entire Leveraged Portfolios Battle (Picture Perfect Portfolio Challenge).

It’s a crucial component of this challenge because its worst year -37% in 2008 represents the circuit breaker for all of the games at the 1X, 2X, 3X and 4X leverage levels.

In other words, the leverage stops at each and every game level for all of the portfolios once/if they hit a worst year of -37%.

As an example, and a bit of a teaser for what is to come, the 80/20 portfolio does not go beyond 1.5X leverage for any of the games because its worst year at 1.6X leverage is more awful than -37%.

That’s where the leverage stops.

Back to the 100% US Total Stock Market, this is an investment that many in the FIRE community and young accumulators have as portfolios.

An aggressive 100% equity portfolio meant to outperform all of the other asset classes.

Balanced 60/40 US Total Stock Market and Long Term Treasuries Portfolio Allocations
Source: PortfolioVisualizer.com

Balanced 60/40 Portfolio

The 60/40 is considered to be the classic portfolio and is the current industry standard.

It is where the gas of 60% equities meets the brakes of 40% bonds.

It is meant to provide performance and stability where returns and risk management collide.

This portfolio is meant for all stripes, shapes and colours of investors.

It is the defacto choice for most accumulators and retirees.

Is it as good as advertised?

Well, we’ll find out once leverage is applied.

40/60 US Total Stocks and Long-Term Treasuries Portfolio Allocations
Source: PortfolioVisualizer.com

Conservative 40/60 Portfolio

US Total Stock Market = 40%
Long-Term Treasury = 60%

Here we’ve got the conservative portfolio mix of 40% stocks and 60% bonds.

This Portfolio is meant to be more stable than the 60/40 in terms of downside protection but with the compromise of offering lowering returns.

This is one of the most popular portfolios for retirees and also for high networth individuals who don’t want to experience the volatility of markets.

80/20 USA Total Stock Market and Long-Term Treasuries Portfolio Allocations
Source: PortfolioVisualizer.com

Growth 80/20 Portfolio

US Total Stock Market = 80%
Long-Term Treasury = 20%

Here we’ve got the growth portfolio configuration of 80% stocks and 20% bonds.

This sits in between the equity only strategy of the US Total Stock market and the 60/40.

It is typically wielded by accumulators and also by some retirees who are more interested in returns versus risk management.

20/80 US Total Stock Market and Long Term Treasuries Portfolio Allocations
Source: PortfolioVisualizer.com

Income 20/80 Portfolio

US Total Stock Market = 20%
Long-Term Treasury = 80%

Finally we’ve got the most conservative stock and bond mix of them all at 20/80.

Often referred to as an income allocation the 20% stocks and 80% bonds is a portfolio that is all about risk management versus the tradeoff of diminished rewards.

It is well known this portfolio provides lower returns but offers far more stability than all of the other equity/bond combinations.

Permanent Portfolio US Stock Market, Long Term Treasury, Gold and Cash Portfolio Allocations
Source: PortfolioVisualizer.com

Harry Browne Permanent Portfolio

US Total Stock Market = 25%
Long-Term Treasury = 25%
Gold = 25%
Cash = 25%

We’re breaking away now from just stocks and bonds with the Harry Browne Permanent Portfolio!

This is the only portfolio that is equally weighted at 25% slices of US Total Stock Market, Long-Term Treasury, Gold and Cash.

It is often heralded as the first simplified and easy-to-put-together all-seasons approach to asset allocation with elements that are designed to withstand stagflationary regimes and economic downturn.

All Weather Portfolio US Total Stock Market, Long Term Treasury and Intermediate Treasury Portfolio Allocations
Source: PortfolioVisualizer.com

Ray Dalio All Weather Portfolio

US Total Stock Market = 30%
Long-Term Treasury = 40%
Gold = 15%
Intermediate Term Treasury = 15%

Next up we have the famous Ray Dalio All Weather Portfolio!

This Portfolio has asset allocations of 30% US Total Stock Market, 40% Long-Term Treasury, 15% Gold and 15% Intermediate Treasury.

Out of all the portfolios that deviate from stock/bond only combinations none may be more famous than the Ray Dalio All Weather Portfolio.

This portfolio is designed to handle everything thrown its way; hence, the all-weather designation.

Will it stand up to the tests of significant leverage?

Let’s find out.

Risk Parity USA Total Stock Market, Long Term Treasury, Gold and Intermediate Treasury Portfolio Allocations
Source: PortfolioVisualizer.com

Risk Parity Portfolio

US Total Stock Market = 20%
Long-Term Treasury = 30%
Gold = 20%
Intermediate Term Treasury = 30%

And the last of the alternative portfolios is Risk Parity.

This one needs a bit more explanation.

Risk Parity weights its allocations based on the overall risk of each asset class (not its performance).

Given that the US Total Stock Market and Gold are riskier, in terms of standard deviation, they receive smaller slices of 20% each.

The bond components, Intermediate Term Treasury and Long-Term Treasury, on the other hand are less risky and therefore have larger slices of 30% each in the portfolio.

At least for me, it’ll be very interesting to see how the Harry Browne Permanent Portfolio, Ray Dalio All-Weather Portfolio and Risk Parity Portfolio perform relative to each other.

Nomadic Samuel US Small Cap Value, Long Term Treasury and Gold Portfolio Allocation
Source: PortfolioVisualizer.com

Nomadic Samuel Portfolio

US Small Cap Value = 40%
Long-Term Treasury = 40%
Gold = 20%

So I’ve created the Nomadic Samuel Portfolio to test out a few different things.

Firstly, I wanted to enter a portfolio with aggressive equal parts equities and bonds.

No other portfolio has the 1:1 relationship at the 40% level in that regard.

Secondly, I wanted to break the equity mold from the US Total Stock Market and instead use value darling US small-cap value.

Thirdly, I wanted to have an alternative sleeve (gold) to see if that improved the diversification and overall results.

I wonder how it will do?

Hmmmm.

Nomadic Samuel Risk Parity US Small Cap Value, Gold, Long Term Treasury and Intermediate Treasury Portfolio Allocations
Source: PortfolioVisualizer.com

Nomadic Samuel Risk Parity Portfolio

US Small Cap Value = 20%
Long-Term Treasury = 30%
Gold = 20%
Intermediate Term Treasury = 30%

Finally I’ve created the Nomadic Samuel Risk Parity Portfolio.

Its a direct ripoff of the Risk Parity Portfolio.

The only difference is that the US Total Stock Market has been replaced by small-cap value.

I want to find out whether equity optimization with value makes a different in the results.

That’s the only reason for this portfolio.

Chess board game for Picture Perfect Portfolios Challenge
Source: Pixabay

Leveraged Portfolio Game Constraints

100% Canvas Game

At the 1X level, in other words without leverage, the only constraints are that the portfolios cannot have a worse year than the US Total Stock Market at -37%.

Spoiler alert. None of them do.

All of these portfolios are then allowed to trot out onto the field just as they are.

200% Canvas Game

For the 2X leverage level, a 200% canvas this time around, we still keep the US Total Stock Market benchmark standard of not allowing portfolios to have a year worse than -37% but we also introduce a volatility constraint at 20% standard deviation.

Portfolios will continue to be leveraged until they reach 20%.

And then the leverage stops.

Why?

Well, the purposes of this leveraged portfolio battle isn’t to turn this into a wacky contest of a rollercoaster ride.

Portfolios are given the mandate of seeking performance versus risk management control.

300% Canvas Game

At the 3X leverage level, we’ve got the exact same conditions as the 2X aside from the fact we’re now allowed to move up to 26% risk.

Once again, we’re putting some volatility constraints in place for this 300% canvas simulation.

400% Canvas Game

Last but not least at the 4X leverage level, we’ve only got one constraint. And that is the -37% worst year of our benchmark the US Total Stock Market.

Portfolios are leveraged at a 400% canvas unless they’re tripped up by the worst year clause at which point the leverage stops.

Dart board scoring system for leveraged portfolios
Source: Pixabay

Leveraged Portfolio Scoring System

The scoring system is going to be old-school Rotisserie style fantasy baseball style.

In other words, every portfolio is ranked relative to its order of results by category from first to last.

It’s going to be a test of performance and risk management along with worst year to balance things out.

We’ll have the following categories:

  1. Growth of $10,000 ranked 1st to 10th
  2. CAGR ranked 1st to 10th
  3. Sharpe Ratio ranked 1st to 10th
  4. Sortino Ratio ranked 1st to 10th
  5. Worst Year ranked 1st to 10th

The maximum score any portfolio can get would be 50 points if it finishes first in all categories.

The worst score would be 5 points if it finishes last in all categories.

Design Constraints

Firstly, I want to thank PortfolioVisualizer.com for the ability to even perform this backtest.

Without the incredible tools available through their website none of this would be possible.

Let’s go over all of the design constraints of this leveraged portfolio battle.

The first one is that I’m not able to back-test Commodities beyond 2007, so both the Risk Parity and Ray Dalio All-Weather Portfolio have had their Gold allocation boosted instead. This is far from ideal but the best I can do given the circumstances.

The second is that I’ve chosen the US Total Stock Market and Long-Term Treasury as the default equity and bonds configurations for all portfolios when I’d rather be able to go global with both. Unfortunately, I can’t go as far back in time if I do that, so I’ve chosen home country bias of US only equities.

Thirdly, I’ve decided to only go as far back as 1978 so that we have roughly equal time in both the 20th and 21st century. This again is a limitation of sorts but it is what it is.

Fourthly, I haven’t included the costs of leverage as part of the results for any portfolio. The numbers you’ll notice with the games are without the expense of leverage (borrowing costs). Please keep that in mind.

Aside from that, I’m not sure of any other potential blind spots but if and when they’re pointed out to me I’ll be sure to update this list here.

Samurai silhouette art
Source: Pixabay

Let The Games Begin!

Stay tuned as the Leveraged Portfolio Battles of the 1X, 2X, 3X and 4X Picture Perfect Portfolio Challenge begin!

Ciao for now.

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