In the December Journal of Financial Planning, Michael Kitces, Sauro Locatelli, and I published a study entitled, “Improving Risk-Adjusted Returns Using Tactical Asset Allocation Strategies.” The title is a mouthful, but we were basically asking if changing the asset allocation of a portfolio can increase your returns relative to the amount of risk that you take, compared to just buying and holding stocks in your portfolio. Around here we call changing the asset allocation “tactical asset allocation.”
Modern finance has a number of statistical tools for measuring risk adjusted returns, and one of the most popular methods is called the Sharpe Ratio. The Sharpe Ratio uses standard deviation as the measure of risk (or volatility), and divides portfolio return by portfolio risk in order to get a number that allows you to compare portfolios. If one has a higher Sharpe Ratio than another, it is presumed to have better risk adjusted returns. In our study, we reached two conclusions that shouldn’t be surprising to anyone, unless you believe that markets are efficient (this would include a large number of Ph.D.s in finance, but that’s a story for another column…) First, we found that adding stocks to a portfolio when they’re cheap and reducing stocks when they’re expensive significantly adds to portfolio returns. We spend a lot of time in the paper explaining the rules for what is cheap and expensive, and also outline some basic rules for how to add and subtract stocks from the portfolio.
This case study is an example of how statistics can be misinterpreted and lead to a false conclusion. No surprises so far. Actively managing stocks in the portfolio added to returns, but it also added volatility to the portfolio, and that reduced the risk-adjusted returns as measured by the Sharpe ratio. In other words, we didn’t seem to add enough returns to make it worthwhile to take the added risk as measured by standard deviation. Here is where our portfolio sleuths solved the mystery. Standard deviation measures both upside and downside volatility of a portfolio, and most of us are not at all concerned when our portfolio exhibits a lot of upside volatility. (“Oh no… I’m making too much money! My portfolio is growing too quickly!”) It is possible to separate the upside volatility and the downside volatility of a portfolio — measuring risk adjusted returns using only the downside volatility is called the Sortino Ratio. Guess what? When measuring the results using the Sortino Ratio, our portfolio detectives discovered that the Sharpe Ratio was falling because we were adding too much upside volatility. At the same time, the Sortino Ratio was actually soaring, which indicates that the tactical portfolio was doing an excellent job of managing risk in bear markets.
This case study is an example of how statistics can be misinterpreted and lead to a false conclusion. In this case, having a lower Sharpe Ratio didn’t mean that you should own the buy and hold portfolio. Rather, it meant that we were adding a lot of upside returns versus downside returns. The much less well known Sortino Ratio tells us that we did, in fact, create a portfolio strategy that earns excess returns while better managing downside risk. And that’s a very good thing.