What Is The Optimal Asset Diversification Historically? (Statistics, Facts, Backtest)

What is the optimal asset diversification historically? This is debated, but we came across an interesting study that looks at the best historical asset class diversification models over the last 100 years, all based on statistics and backtests. The main takeaway is this:

A study finds that a constant allocation of 50% domestic and 50% international stocks (no bonds!) is optimal for the full lifecycle, including retirement, for an American saver or investor.

Such a strategy produces better results than the traditional 60/40 portfolio, or any portfolio that includes bonds, for that matter. 

Let’s look at the findings, results, statistics, and how the results came about:

Diversification benefits

The study is called Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice, and is written by Aizhan Anarkulova, Scott Cederburg, and Micheal O’Doherty.

This is a study that is highly relevant for long-time savers and investors and those saving for retirement. The study looks at what is the optimal asset diversification historically for a US-based investor. The study compares international diversification for stocks and bonds. 

Bonds for diversification and safety

Conventional wisdom generally recommends an increasing allocation to bonds as retirement approaches, aligning with the notion that bonds provide greater stability and are more suitable for individuals with less tolerance for market fluctuations during their retirement years.

Also, Bonds offer correlation benefits in an investment portfolio. But is it good advice?

According to the authors, you risk losing valuable returns by allocating capital into bonds. In the long run, volatility should not matter, thus bonds should be “ignored”. Or at least you’ll expect lower returns by including bonds. 

Asset allocation and retirement planning

Asset allocation advice fundamentally revolves around anticipating the expected returns and correlations of various asset classes. While predicting future asset class behavior is notoriously complex, historical data provides valuable clues about past trends and potential future movements

One typical problem with any asset allocation, is that very little is backtested historically. This study addresses this by using a block bootstrap procedure with 38 developed markets from 1890 to 2019 (see more of the methodology at the end). 

It’s a very impressive study and covers nearly 2 500 years of monthly data and returns. 

Risk management and asset allocation

The study suggests that you should skip bonds and go all in on stocks. 

This doesn’t mean stocks are not risky – quite the contrary – in terms of volatility. 

But bonds are more risky at long-term horizons. Time horizons for most savers, spanning decades, bonds get increasingly correlated with domestic stocks, and offer little downside risk in real terms, while it might offer diversification benefits in the short term.

Bonds vs stock asset diversification

Small asset allocations to bonds, as low as 5 to 15%, result in significant underperformance. 100% stock allocation offers better returns, plain and simple. 

That said, 100% of stocks come with higher risk and volatility. The drawdowns are larger, and this might make investors commit behavioral mistakes. Drawdowns inflict psychological pain, and some investors may abandon their investments rather than stay the course.

But over long time spans, 100% in stocks is still the optimal and most rational asset allocation model, according to the study.

Should traditional asset allocation be ignored?

Obviously, bonds are an ingrained part of a diversified investment portfolio, so this study shakes up such advice. For many, bonds have been a cornerstone for diversification benefits and risk management. 

However, as Warren Buffett says, it’s important to ignore volatility as risk. The real risk is not getting good or acceptable returns. An asset might feel “safe” because its value is stable, but it might be very risky in the long run if you get lower returns. 

The future is uncertain, and over the long term you want to get the best possible returns and outcome. You don’t want to end up in the poorhouse when you retire.  

The optimal asset diversification historically

To sum up, the bootstrap study concluded that the optimal asset diversification is this:

“Given the sheer magnitude of US retirement savings, we estimate that Americans could realize trillions of dollars in welfare gains by adopting the all-equity strategy….”

The all-equity strategy in their asset allocation bootstraps was 50% US stocks and 50% international stocks. A portfolio that includes geographic diversification performs better than all US stocks. 

The latter is hard to understand because investors have short memories. Over the last two decades, US stocks have outperformed international stocks massively, but this is mainly because valuations have increased while foreign stocks have decreased. We know that markets tend to revert to the mean, so it remains to be seen if that happens over the coming decade (international stocks outperforming US stocks).    

The table below shows the wealth creation and minimum and maximum wealth creation:

The portfolio last on the right is the 50/50 equity portfolio. The other portfolios are these:

The portfolio last on the right is the 50/50 equity portfolio. The other portfolios are these:

Asset allocation strategy – methodology

The authors looks only at developed markets. They have set certain thresholds and criteria, and countries enter the sample as they meet that threshold.

A bootstrap method is used to find the optimal asset allocation. Domestic returns are in local currencies, and international as world ex. domestic. It seems bonds are always measured in local currencies.