Sunday 22 March 2015

The Anti-Fragile Portfolios

Most investors will worry about a bear market. However, if you have an anti-fragile portfolio, then you should not need to worry about it. In fact, you should maybe even relish it should one comes along. What is an anti-fragile portfolio?

First of all, let us define what is "anti-fragile". The word "anti-fragile" comes from the book bearing the same name written by Nassim Nicholas Taleb. It is used to describe things that will become stronger from shocks. It is different from "robust", which just means things can withstand shocks but will neither gain nor lose from them. As Taleb himself is a former trader, he gave examples of what instruments are anti-fragile. One such instrument is options, which will rise substantially in price should an unexpected shock (also known as a "Black Swan" event) occurs. Thus, an example of an anti-fragile portfolio is a barbell portfolio comprising mostly of, say, conservative government bonds and a small portion allocated to instruments that would gain substantially from shocks.

Actually, some of the commonly known investment strategies do have some anti-fragile properties. I realised it unintentionally with my unit trust investments which are invested using Dollar Cost Averaging (DCA) strategy. 2 unit trusts -- an index fund and a balanced fund, were invested using DCA. During the Global Financial Crisis, the index fund fell by 55% while the balanced fund fell by 40%. Yet, when they recovered to their original prices, the more volatile index fund returned an annualised gain of 7.0% compared to only 3.1% for the less volatile balanced fund. You can refer to Dollar Cost Averaging Works Best with Volatile Stocks/ Unit Trusts for more info.

Another investment strategy that has some anti-fragile properties is portfolio rebalancing. When setting up my passive portfolio, I had run some simulations and back-testing to see what sort of stocks and bonds would provide the greatest returns in the long run. The results show that stocks and bonds with the greatest volatility actually provide the best returns. You can refer to Volatility is Your Friend for more info.

It should be highlighted that the above 2 investment strategies have some major differences compared to a barbell portfolio. With the latter, you will make small gains during normal times and significant gains when shocks happen. With DCA and portfolio rebalancing, the portfolios will drop in tandem with the stock market but will show large gains when the stock market recovers. I call them "anti-fragile" because they have the ability to bounce back from a market shock and emerge stronger.

When I set up my passive portfolio in Dec 2013, I had not picked the most volatile stocks and bonds. The stock component was a global index fund while the bond component was a global bond fund. Both funds were global in geographical coverage so as to reduce country-specific risks. So far, the returns from this portfolio has been pretty good, at 12% over a 14-month holding period, although the anti-fragile property of it has not been tested yet.

This time round, I'm setting up a more spicy passive portfolio with components that are more volatile. In Oct last year, I blogged about the US stock market being one of the best performing stock markets over a 26-year period in Not All Market Indices Are Equal. So, the stock component is the LionGlobal Infinity US 500 Stock Index fund. The bond component is Fullerton Asian Bond Fund. Like the non-spicy passive portfolio, the mix is 70% stocks and 30% bonds, to be rebalanced whenever the allocation exceeds the original allocation by 8%. Both components are non-global and therefore subject to more risks. So, if my analysis is correct, this spicy passive portfolio should perform better than the non-spicy one over the long run. Let us see if it really is.

P.S. I am currently in the busy phase of my project, so I won't be able to respond to your comments. Hope to seek your understanding on this.

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