I just read David Swensen’s book, “Unconventional Success”, over the last few weeks, which I found extremely interesting. David Swensen is the highly regarded manager of the Yale University Endowment Fund, where he has achieved 20% returns over 2 decades. He pioneered the use of alternative assets (timberland, hedge funds etc.) in mainstream portfolios, and in many ways, revolutionalized the way large pension funds and university endownments invest their funds.
Swensen holds that a properly constructed portfolio should have a bias towards equity, to capture higher returns, and be properly diversified, so that the principal is safe in all economic conditions. Specifically, he considered economic conditions such as wildly inflationary/deflationary environments, as well as recessionary economic conditions. He came up with these 3 core asset classes.
Stocks, both domestic and foreign, should be the core holding, due to the equity bias rule. He advocates holding a stock index to diversify away individual company risk, leaving only market risk. Stock markets are sensitive to recessions. Stock prices provide long term hedges against inflation and weak short term protection against rising prices. Deflation is devastating to stock prices but beneficial to bonds.
Swensen believes that bonds should be held as a hedge against adverse economic conditions, and so it does not make sense to hold corporate bonds which are sensitive to economic conditions. He believes one should only hold treasury bonds. Under normal market conditions, treasury bonds are correlated to stock prices. Interest rate hikes decrease both bond and stock prices. Treasury bonds provide maximum diversification during market crises, when stock prices dive and investors flee to safety. Bonds also perform well in deflationary environments, while being killed in inflationary environments.
Real estate returns and risks fall between stocks and bonds. Properties with long term leases exhibit predominantly bond-like qualities. Properties without tenants or with tenants on short leases exhibit predominantly equity like qualities. Real estate is a strong hedge against inflation. REITs are reasonable investment vehicles, but some REITs charge obscene fees, so due diligence is required, as always. Real estate returns are between the 5% average of bonds and 10% average of equities.
In the final analysis, Swensen advocates holding 50% of your portfolio in stocks (including some foreign market stocks to modestly diversify away different economic conditions in different countries), 25% in Treasury bonds to protect against deflation and during market crises, and 25% in real estate and/or TIPs to protect against inflation.
In order for this portfolio distribution to work, it must be constantly rebalanced when allocations increase or decrease significantly due to investment gains/losses. This is usually naturally beneficial to the portfolio, inducing one to cash out of overvalued investments and redirect cash towards undervalued assets. For example, when a stock market crash decimates the equity portion of your portfolio, additional investment in the stock market is very likely to reap returns in the future. Rebalancing is the hardest part of portfolio management, because it is both labor-intensive, and requires one to act against the crowd, entering markets when everyone else is leaving, and vice versa.
