The 25x4 Allocation Is Questionable (2024)

AAII staff are making appearances at a couple of upcoming conferences you may be interested in. From February 21 to 23 at the MoneyShow in Las Vegas, Raymond Rondeau gives a keynote, his VIP MoneyMasters course and a session on practical wealth-building tactics. In addition, Wayne Thorp shares expertise in advanced stock screening. Find out more here. On February 26, Rondeau is giving a talk as part of the MetaStock online Traders Conference on “The Most Important Trading System Factors for Today’s Markets.” For more on this free digital event, click here.

Kiplinger’s said some strategists are suggesting investors use the 25%/25%/25%/25% allocation instead of the traditional 60%/40% allocation. This strategy allocates 25% to stocks, 25% to commodities, 25% to bonds and 25% to cash. The 60%/40% portfolio allocates 60% to stocks and 40% to bonds.

If the 25x4 allocation strategy—as it also seems to be called—sounds somewhat familiar to you, that’s because it mimics the Permanent Portfolio strategy. Developed by Harry Browne, the Permanent Portfolio strategy allocates equal amounts to stocks, bonds, cash and gold. It was intended to deal with four economic states: prosperity (stocks), deflation (bonds), recession (cash) and inflation (gold).

The 25%/25%/25%/25% allocation strategy is a twist on the concept. It holds a range of stocks as opposed to just large-cap stocks. One strategist’s report that I saw called for using small-cap and emerging markets stocks for the stock portion. A broad-based commodities basket is used instead of merely gold.

The bigger question is whether this allocation works. We can do a simple analysis using four broad-based exchange-traded funds (ETFs). Those ETFs are the Vanguard Total World Stock Index ETF (VT), the Invesco DB Commodity Index Tracking fund (DBC), the iShares Core U.S. Aggregate Bond ETF (AGG) and the Vanguard Short-Term Treasury ETF (VGSH). They provide exposure to global stocks, a variety of commodities, a variety of U.S. bonds and a cash proxy in short-term Treasury bonds.

The 10-year annualized returns of these ETFs were 8.6%, –0.2%, 1.6% and 1.0%, respectively. These numbers equate to a 3.3% annualized return for a portfolio that started equally allocated across all four funds. In comparison, AAII’s Moderate Asset Allocation Model—which has a 60% weighting to stocks and a 40% weighting to bonds—has a 10-year annualized return of 6.0%.

Capital appreciation is likely to be low based on historical trends. Cash and cash equivalents like money market funds and certificates of deposit (CDs) provide no capital appreciation. Commodities are highly volatile. Gold itself has a questionable record as being a hedge against inflation. Bonds can provide capital appreciation but not as much as stocks.

I’ll add that the Permanent Portfolio fund (PRPFX), which counts Browne as one of its founders, doesn’t use a 25x4 allocation. Rather, its target weightings are 20% gold, 5% silver, 10% Swiss franc assets, 15% real estate and natural resource stocks, 15% aggressive growth stocks and 35% dollar assets. Its 10-year annualized return is 5.6%.

There is a strong argument for diversification. It lessens the odds of being wrong and increases of the odds of being allocated to the right asset class at the right time. It can also help to smooth the volatility of a portfolio. The problem with the 25x4 portfolio is how it is allocated. Three-quarters of the portfolio are large bets against bad economic and market conditions. This “insurance” comes at the cost of future wealth creation.

An investor who is worried about a loss of capital could build a ladder of bonds and/or CDs instead. An investor desiring growth of capital and/or one who has a long investing time horizon should consider a large allocation to stocks. (The AAII Aggressive Asset Allocation Model calls for putting most of the portfolio in stocks.) Commodities can play a role in terms of adding diversification, but 25% is a large allocation. Generally, I see strategies call for between a 5% and 15% allocation to commodities—not 25%.

Optimism among individual investors about the short-term outlook for stocks decreased in the latest AAII Sentiment Survey. Meanwhile, both neutral sentiment and pessimism increased.

Bullish sentiment, expectations that stock prices will rise over the next six months, decreased 6.9 percentage points to 42.2%. Bullish sentiment remains above its historical average of 37.5% for the 15th consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, increased 2.6 percentage points to 31.1%. Despite the increase, neutral sentiment is below its historical average of 31.5% for the ninth time in 11 weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, increased 4.2 percentage points to 26.8%. Bearish sentiment is below its historical average of 31.0% for the 15th consecutive week.

The bull-bear spread (bullish minus bearish sentiment) decreased 11.1 percentage points to 15.4%. The bull-bear spread remains above its historical average of 6.5% for the 15th consecutive week.

This week’s special question asked AAII members about their perception of inflation.

Here is how they responded:

• It is slowing, but by not enough: 44.4%
• It is returning to a more acceptable pace: 40.5%
• It is still rising too quickly: 11.4%
• Not sure/no opinion: 3.1%

Dr.Lightning from Ga posted 3 months ago:

(Darn, all my nice pagination eliminated by the website.) Mr. Rotblut, while I indeed agree in part with the concept of your conclusion, you are horribly incorrectly selling short both the 25x4 and the HBPP. I admit that you are certainly more experienced and educated in this stuff than I am -- I say this sincerely -- you also seem to be making a grave error that I see made all the time.RECENCY BIAS & DATE RANGE SENSITIVITY: Your single reference to the annualized 10 year return is akin to disliking stocks in general because they were way down on a single day. It's inappropriate and just flat wrong. I'll show this using Portfolio Visualizer (PV). When I put in VT/DBC/AGG/VGSH at equal allocations, I can scroll down on the Summary tab and see the "Performance Summary" with 10yr at 3.29%. This is consistent with your 3.3% statement. Unfortunately, those ETFs are limited to only 14 years because VGSH is younger. Therefore, I switch to PV backtest by Asset Class. There's not an easy world stock market, so I use the following asset classes: "US Stock Market", "Commodities", "Total US Bond Market", and "Short Term Treasury". When I look again at the "Performance Summary", I see the 10yr at the exact same 3.29%. I assert that this suggests my PV Asset Class result is close enough to your PV ETF result. (The other time periods do differ somewhat, but not by too much.) I also add 60/40 for those same Asset Classes for stocks and bonds, to get 10yr of 7.78% Next, note that Commodities on PV only goes back to 2007. So I'll switch that to Gold, which on PV goes back further than the 1987 of Total US Bond Market. With this change, the 10yr rises from 3.29% to 4.87%. That's a decent improvement. Note as well that it moves closer to Harry Browne's final Permanent Portfolio design as described by Rowland & Lawson (R&L) in "the permanent portfolio" book. That PRPFX you mentioned in fact bears little resemblance to what I call the "true" HBPP, and really doesn't belong in this conversation at all! But there's still something missing here, the rebalancing method. R&L point out a rebalancing method that PV can reproduce with rebalancing bands using 99% absolute deviation (effectively disabled) and 40% relative deviation (matching R&L's 15%-35% deviation for rebalance, and also allowing subsequent tweaks to be consistent in rebalancing). Adding this not-so-subtle aspect of R&L's description of the HBPP raises the 10yr to 5.28%. It's indeed still well behind the 60/40, which was at 8.66% with more simple annual rebalancing (and didn't see the dramatic improvement that rebalancing bands gave to HBPP). Notice so far that for the same RECENCY BIAS time period of the most recent 10 years, the HBPP has now improved from 3.3% to 5.3%. It's catching up with the 60/40. Meanwhile, the max drawdown of HBPP with rebalancing bands was -14%, but 60/40 w/o rebalancing bands was -31%. When in retirement, this provides an absolutely *huge* reduction in sequence of returns risk. (Remember, in the end I'll still agree partially with your conclusions, Mr Rotblut.)My point here is to now look at some period *other* than the most recent ten years (RECENCY BIAS) that included a very strong bull market and just now finished recovery from the most recent bear. By switching to the Asset Class page of PV, I can go back further than just 2009 of VGSH. I think the PV tab for "Rolling Returns" is the best place to look. Then look at the "Rolling Returns" section showing Roll Periods of 1,3,5,7,10,15 years. Here we can see that reduced volatility. The HBPP as entered only has a single red result, and that's a 1-year worst case drawdown of -11.76%. The 60/40 worst case takes more than 5 years to recover. This is again about sequence of returns risk while in retirement. Meanwhile, the Average return for the HBPP floats between 6.41% and 6.68%. It's very flat across all roll periods, again because of the reduced volatility. The 60/40 Average is indeed higher, nevertheless and as you mention, varying rom 8.86% @ 1yr down to 7.8% at 15 years, with 8.48% at 10 years. So for the longer term, the Average 60/40 performance still beats HBPP by 7.80% vs 6.68%. (I didn't round to more reasonable 6.7% just so readers could match my text to running PV themselves.)PROBABILITIES:Mr. Rotblut, I believe you very correctly mention probabilities. The US and the world in general certainly generally sees more prosperity over the last XXX years. Well, Tyler who creates the very useful portfoliocharts.com came up with the Golden Butterfly (GB) improvement to the HBPP by adding small cap value and then re-distributing to 20% for each class. Tyler points out that this is due to that probability of prosperity. So now go back to PV and add "US Small Cap Value" and redistribute equally at 20% each. You find the RECENCY BIASED 10yr return has now gone up from HBPP 4.87% to GB 5.89%. (This is also helped out by rebalancing bands 99%\40%.) So we're getting yet closer to the 60/40 8.66% over 10yr. This is only But now go look at the Rolling Returns. The worst case is again just a single year, but at GB's -16.89% rather than HBPP's -12.01%. The Average is still flat, but a third of a percent better, including 7.85% at 10 years. So note that, eliminating RECENCY BIAS and now indeed adding some more respect for PROBABILITIES, we've caught up from the 3.29% for the recent 10 years that you quote to 7.85% on Average. The 60/40 was only 8.48% with annual rebalancing, so we're only behind now by 0.63%. Plus, the volatility / max drawdown is very dramatically reduced. Again, this is a *huge* bonus for retirement sequence of returns risk.RETIREMENT WITHDRAWALS:With a fixed retirement withdrawal strategy, it turns out that Tyler's Golden Butterfly actually *beats* the traditional 60/40 stock/bonds portfolio. So in this regard, Mr. Rotblut, you have definitely sold very short the original HBPP and indirectly the GB. RECENCY BIAS and lack of consideration of related PROBABILITY improved Golden Butterfly is the cause. Remove those, and consider a fixed retirement withdrawal strategy, and I suggest your statement is sufficiently close to "wrong" to be called "wrong". I say that with all due respect, as you really do otherwise know far more than I do about this stuff.*However*, let's not limit ourselves to a fixed retirement withdrawal strategy. With one or many dynamic withdrawal strategies, one can weather the increased volatility of the 60/40 portfolio. But one can also further improve on the GB probability considerations. I haven't completed this analysis myself, but it actually looks like an improved GB portfolio, such as 30/30/0/20/20 LargeCap/SmallCapValue/Treasuries/Gold/Cash(STT) with rebalancing bands gets that Average 10yr performance all the way up to 9.17% (with rebalancing bands) and is ***well ahead*** of the 60/40 at 8.48% (annual rebalancing). (Do note that 60/40 gets better in this average case with rebalancing bands, up to 8.87%. By my 30/30/0/20/20 still beats it.)So this is average growth, not even worrying about retirement withdrawals and sequence of returns risk. 30/30/0/20/20 beats 60/40. Meanwhile, when it does come to retirement withdrawals and sequence of returns risk, 30/30/0/20/20 was up 1.23% in the worst case 5 years, while 60/40 was still down at -1.29%. With or without dynamic withdrawal strategy, 30/30/0/20/20 appears to win over 60/40, and it's just a second generation optimization from the HBPP.In summary, Mr. Rotblut, I assert that your general conclusion that 60/40 beats this specific 25x4 you cover is generally correct. However, you've unwarrantedly undersold the 25x4 via RECENCY BIAS. You then mentioned a PROBABILITY difference but failed to follow it up with the Golden Butterfly, or even further in the same vein to something like the 30/30/0/20/20 that now actually *beats* the 60/40. I realize you only wanted to spend a limited amount of space on the post, but the post as is leaves the reader slightly misdirected. To your credit, you did finally allow commodities to play a smaller role, and my 30/30/0/20/20 does exactly that. But your investor reader worried about loss of capital can do much better. And it even looks like the longer term investor can do much better than the 25x4 you start with, although I do agree that yet more stock allocation may help. Of course, even the longer term investor still has difficulty when reaching the end of that longer term. Transitioning would be key, as also addressed by Cloonan in ...Level 3. Knowing what the transition might look like, and not settling for chutes and ladders, would help!

John L from NJ posted 3 months ago:

Well Dr. Lightning with enough data mining you can prove almost anything. Unfortunately history doesn't predicted the future. And successful investing is all about the future.

Craig B. from Wisconsin posted 3 months ago:

The commentary and analysis by Dr. Lightning has to be the most in-depth, interesting and challenging to absorb that I've personally encountered on the AAII website. Perhaps it will lead me to some changes but more likely, I'm selling out of all positions in my IRA accounts and buying a Vanguard Target Date 2030 Fund and will enjoy my fish fry and beer all the more. :) Seriously, this is a valid elucidation of scenarios otherwise not considered and perhaps of enough value to tweak the portfolios just a tad. Or a lot. Thank you both for presenting these important concepts.

Craig B. from Wisconsin posted 3 months ago:

What is the most expedient way to gain access to Swiss Franc assets?

Charles Rotblut from Illinois posted 3 months ago:

Craig,

Our ETF Guide shows one ETF that tracks the Swiss Franc. It is the Invesco CurrencyShares® Swiss Franc (FXF). I don't know anything about this fund.

-Charles

Barry from TX posted 3 months ago:

Charles, this short article on a key basic step in the PRISM portfolio wealth creation process – diversification - can help a lot of people. It is easy to understand and implement, yet it embeds the “magic” of diversification which is the key principle of the mean-variance assumptions that started the whole modern financial industry 73 years ago. However, the Title “25x4 Allocation Is Questionable” is an unnecessary misdirection. It diminishes the focus on the power of simplicity and understates the “drag” on returns that higher portfolio costs create by using increased complexity in portfolio construction and/or active investment vehicles. A 2x2 matrix organization geometrically sets up the basic algebraic math of the dynamics that drive the trade-offs between returns and risk. The goal in every portfolio construction task has always been to balance returns and risk – at the level that closest approximates your risk tolerance. This fundamental relationship is investing’s “law of gravity”: if you want higher returns you must take higher risks; if you want to minimize risk, you should expect lower returns. The distraction that leads so many investors astray is a goal to “beat the market.” 50 years ago John Bogle asked, Why bother? A long trail of historical data tells us that 70%-90% of professional fund managers fail to beat the market return each year and the few “lucky ones’ do have low persistence rates due to the other gravitational law called regression to the mean. The goal is to try to come as close to achieving the market return as you can. If you do that, you are in that top 50% of all investors – even if you do not have their training and enormous research resources.

John L from NJ posted 3 months ago:

Barry - I agree 100% that: "The distraction that leads so many investors astray is a goal to “beat the market.”". In a futile attempt to beat the market; significant amounts of money is wasted on active investment managers, advisor fees, newsletters, and financial advice subscriptions. All this expense could be avoided by investing in a small number of low cost index funds and staying the course. Sadly this is also a dark side to the AAII which in addition to investment education sometimes feeds this "beat the market mania" by offering multiple investment newsletters and occasionally publishes "you can beat the market articles" (i.e. Shadow Stock Portfolio). In fairness however the AAII aren't the bad guys. In a recent survey, a large majority said the number one thing they look for in their financial advisor is the ability to "beat the market". I suspect that without a few "beat the market" articles the AAII journal would have many less subscribers.