Category: Investing Insight

Investing insight to make you a better investor.

Volatility and Allocation

Think in terms of volatility buckets, not assets

This post is part of our series on diversification and asset allocation. Previously:

  1. Diversification and its Malcontents

  2. The Permanent Portfolio

  3. Sequence Risk and Asset Allocation

  4. Static vs. Tactical Allocation

  5. Tactical Allocation

The thrust of our previous posts on allocation was that Indian investors shouldn’t blindly copy strategies that worked well in the US. There are a lot of qualitative arguments to be made to support a India-dominant view for allocation strategies. In this post, we introduce a quantitative aspect to the discussion.

It is Volatility, Stupid!

In finance, more than any other field, it is very easy to get correlation and causation mixed up.

A man goes to the doctor and says, “Doctor, wherever I touch, it hurts.”
The doctor asks, “What do you mean?”
The man says, “When I touch my shoulder, it really hurts. When I touch my knee – OUCH! When I touch my forehead, it really, really hurts.”
The doctor says, “I know what’s wrong with you. You’ve broken your finger!”

There are no universal laws for an asset class that holds across geographies and economic systems. The reason why a 60/40 Portfolio “works” in the US has more to with the quantitative aspects of the assets being mixed than what they are called. US bonds have benefitted greatly from a 30 year slide in yields, benign inflation and a flight-to-safety bid. None of these hold true for Indian bonds. So, expecting a 60/40 Indian portfolio to behave like a 60/40 US portfolio just because you mixed the same assets together is idiotic.

The most import aspect while considering assets for diversification are their volatilities. Specifically, the correlation of their volatilities at their left tails.

To keep things simple, consider a 2 asset portfolio: Eq and X. Eq has some average return that will be held constant during this analysis. What changes is its standard deviation (aka, volatility.) X is a stable asset with zero volatility (think of it as a fixed deposit.) How does different allocations to Eq change portfolio returns and volatility?

  1. Low volatility is supportive of higher allocations

  2. Higher allocations to the higher volatility asset progressively reduces the predictability of portfolio returns

Volatility is Volatile

Asset return volatility is itself volatile.

The past performance of a diversified portfolio is based on the realized volatility of its components. However, volatility itself is unpredictable over long periods of time.


While considering assets to diversify into, look at the volatility of the asset rather than what it is called.

Don’t expect the quantitative aspect of an asset class to transcend economic systems – different markets need different treatments.

All investing is forecasting. And all allocation is forecasting volatilities.

The Permanent Portfolio

Pain is eternal

This post is part of our series on diversification and asset allocation. Previously:

  1. Diversification and its Malcontents

  2. Sequence Risk and Asset Allocation

  3. Static vs. Tactical Allocation

  4. Tactical Allocation

The Permanent Portfolio – an equal weighted allocation to stocks, bonds, gold, and cash – was devised by free-market investment analyst, Harry Browne, in the 1980s. The basic idea is that no matter what the macro environment, the portfolio will not totally crash and burn.

The American Experience

Turns out, the theory largely worked for US investors.

If you look at the rolling 3-year annualized returns of the Permanent Portfolio, never has it given negative returns. In sharp contrast to equities and gold, US bonds have been spectacularly stable. So naturally, an equal weighted allocation to all for assets delivered decent returns with low drawdowns.

Did it work for Indian Investors?

Indian investors need to be careful with their bond allocations.

The Permanent Portfolio allocates 50% towards fixed income. This is a problem for Indian investors because unlike US bonds, Indian bonds do not have a “flight to safety” bid – they tank along with stocks during market panics.

A density plot of annualized 3-year rolling returns highlights the left-tail problem with the Indian Permanent Portfolio:


Beware of people preaching simple solutions to complex problems. If the answer was easy someone more intelligent would have thought of it a long time ago – complex problems invariably require complex and difficult solutions. – Steve Herbert

This is another instance of a “copy-paste” solution disappointing Indian investors.

The common thread connecting the misfiring of the 60/40 and the Permanent portfolios is the vastly different paths taken by Indian bonds. Is there a better way to crack this nut? Stay tuned.

Euclidean Distance for Pattern Matching

Most of us have learnt how to calculate the distance between 2 points on a plane in high school. The simplest one is called the Euclidean Distance – a pretty basic application of the Pythagorean Theorem. The concept can be extended to calculate the distance between to vectors. This is where it gets interesting.

Suppose you want to match a price series with another, ranking a rolling window by its Euclidean Distance is the fastest and simplest way of pattern matching.

For example, take the most recent 20-day VIX time-series and “match” it with a rolling window of historical 20-day VIX segments and sort it by its Euclidean Distance (ED.)

Here, the ED has dug up a segment from November-2010 as one of the top 5 matches. Take a closer look:

While not a perfect match, it “sort of” comes close.

Sometimes, a simple tool is good enough to get you 80% of the way. This is one of them.

Decoding the 60/40 Portfolio

Get onboard with the embedded assumptions before diving head-first.

The 60/40 allocation – 60% in equities, 40% in bonds – is the bedrock on which most portfolios in the US are built. Jack Bogle was its biggest proponent and it serves as a benchmark in most portfolio discussions.

This post is part of our series on diversification and asset allocation. Previously:

  1. Diversification and its Malcontents

  2. Sequence Risk and Asset Allocation

  3. Static vs. Tactical Allocation

  4. Tactical Allocation

Historical Performance

From a cumulative performance point of view, it is easy to see why it is attractive.

Even with an annual rebalance, the 60/40 delivered. How did it achieve this remarkable feat? Should investors expect similar magic with the same allocation to Indian equities/bonds?

The biggest difference: Volatility

Ever since Volcker got done slaying inflation in the 80’s, US bond yields have been on a secular decline with declining volatility and increasingly occupying the place of a “flight-to-safety” asset.

Indian bonds, however, are in no way comparable to US bonds when it comes to volatility.

Volatility of US Bond returns (3-year, rolling) with those of Indian Gilts:

On a cumulative basis, Indian bond investors have taken a lot of pain for a 50bps out-performance.

Indian bonds haven’t exactly acted as a safe-haven in times of stress for Indian investors. Adding equities into the mix brings out the extreme volatility of Indian stocks:

However, the silver-lining is that Indian asset volatility have been moderating since 2015.

The 60/40

Over a long enough timeline, it looks like the 60/40 should work in India as well.

But, what if, most of the long-term returns that can be seen since 2000 was front-loaded? Rolling-returns over different windows should give us an idea:

The 5-year window shows returns stabilizing around an average of 5% (in USD.)

Embedded forecasts

All investing is forecasting. As much as one would want to follow a 60/40 allocation for its popularity, it behooves to ask: what are the embedded forecasts about Indian equities and bonds in such a strategy?

  1. Bond volatility will continue to go down.

    • The market will continue to deepen.

    • Inflation will be range-bound.

  2. Equities will be loosely efficient.

    • The gap between growth assumptions and equity valuations will be within a gradually tightening band.

  3. Ease of doing business:

    • Contract enforcement

    • Flexible labor laws

    • Infrastructure

    • Bankruptcy protection and resolution

    • Policy stability

Basically, India will move towards an environment with a predictable tax regime, a rules-based fiscal policy, and regulations that are fair and strictly enforced.


There are millions of permutations and combinations of securities for investors to allocate. The question that every investor should ask themselves is how much time, effort and money they are willing to spend chasing returns that beats low-cost, set-it-and-forget-it strategies like the 60/40.

If you are in investor who craves simplicity & low-cost and your beliefs about the future is mostly in line with the assumptions presented above, then this is the strategy for you.

Diversification and its Malcontents

Study history but use commonsense.

Every advisor you speak to likely extolls the virtues of diversification. “Buy stocks, bonds, gold, real-estate in x/y/z proportion.” Since no one can predict future returns of individual assets, by buying all of them, investors can protect themselves from steep drawdowns.

But what exactly is “diversification?” Is it right for you? Over what assets should you diversify? And how long should you wait before you expect to see the benefits of such diversification?

There are several theories on sex and all of them are lies. – Santosh Kalwar

Before we dive into the how/what/when, let’s set the backdrop through which we’ll discuss the topic.

American Exceptionalism

Most portfolio research is conducted with US Dollar assets trading in America. It is then ported over unquestioningly to other markets. However, there is no other country like America – the only country in the world that can print US Dollars that every other country in the world needs to hold as a reserve asset. This gives US assets a steady, unrelenting bid.

For example, government bonds are supposed to be low-volatility assets with limited downside. However, Indian investors have a completely different experience compared to Americans with it comes to investing in them. Here’s the rolling 3-year standard deviation of weekly returns of Indian 10-year gilts (in USD) and a US fixed-income fund for comparison.

Not only are Indian bonds more volatile, they have +30% drawdowns that take years to recover.

In a flight-to-safety, Indian bonds get sold and American bonds get bought.

The 60/40 Buy and Hold

Since the mid-90’s, an American investing in American assets did spectacularly well. Not just in equities…

… but in bonds as well.

An US-based advisor can be excused for beating the drum of buy-and-hold. After all, US equities and bonds have always recovered. And they can afford to keep-it-simple with a static 60/40 allocation between stocks and bonds.

However, look at the performance of Emerging Market (EM) equities and bonds. An absolute disaster both in terms of returns and volatility.

So, when advisors wax eloquent of the 60/40 portfolio, what they really mean is US Equity/US Bond 60/40 portfolio. Investors in the rest of the world, especially in EMs like India, will do well to formulate a strategy that works given their reality rather than blindly following US-centric allocations and strategies.

King Dollar

While the US Dollar has appreciated against most currencies since 2010, it is nothing compared to how much it has appreciated against the Indian Rupee.

A falling currency is a headwind against a portfolio trying to preserve purchasing power and presents a performance hurdle of sorts.

While USDINR is not the worst currency pair out there, it pays to think of portfolios in Dollar terms.

The Streetlight Effect

A policeman sees a drunk man searching for something under a streetlight and asks what the drunk has lost. He says he lost his keys and they both look under the streetlight together. After a few minutes the policeman asks if he is sure he lost them here, and the drunk replies, no, that he lost them in the park. The policeman asks why he is searching here, and the drunk replies, “this is where the light is.”


The Center for Research in Security Prices (CRSP) was founded in 1960. They went live in 1964. Initially, the center’s database consisted of monthly share prices of common stock trading on the NYSE, dating back to 1926. Over time, the database grew in size, introducing other exchanges and securities, as well as daily updates.

In India, the Total Return NSE mid-cap index prices are available only from 2005. In search of robustness, researchers use US datasets by default. However, every market is different because the political backdrop in which they operate are different. It is called the political economy for a reason. So, before taking US financial research at face-value, it behooves us to understand the qualitative drivers behind the numbers: are regulation, politics and market structure similar enough for the data-set being analyzed that the conclusions can be applied to the target market?

Besides, with limited datasets, it is easy to play games by cherry-picking data and begin/end dates to fit a narrative. Here is a sample:



While trying to figure out the right asset mix and investment strategy, Indian investors have to recognize that they may be looking through a tinted window, at a small dataset.

The Allure of Commodities

The theory behind investing in commodities is that they offer an inflation hedge unmatched by most other asset classes. While the relationship between commodities and equities varies considerably – at times there is a negative correlation – on average, they show a low but positive correlation.

Here comes the BUT: the dataset used to analyze these relationships largely covers prices before commodities were financialized, democratized and packaged into ETFs that can be traded by mom-and-pop investors by the click of a button.

While some advisors may hold onto the trope that commodities “work” if actively managed, historical performance of such funds have been a disaster.

The best way to become a millionaire is to start with a billion dollars and invest in commodities.


While diversification is often recommended as a “free lunch” that every investor can partake, a lot depends on the assets that go into the basket. Each one of them have “worked” in the past for different reasons. Increasing financialization means that assets that were uncorrelated in the past because of trading friction suddenly become correlated during market panics. Currency depreciation is a real problem for Indian investors, silently eroding purchasing power.

Portfolio construction should be done against this backdrop – not blindly throwing together a bunch of assets and hoping that it works. We will discuss some of these approaches in subsequent posts.