Chemistry’s pH scale intrigues me because it seems to offer a fruitful metaphor for making a point about portfolio design. After all, if we can have pH-balanced shampoos and hot tubs, why not have a pH-balanced portfolio?
The pH scale stands for power of hydrogen, and represents the concentration of hydrogen ions compared with distilled water. It’s a measure of the acidity or alkalinity of a solution on a scale of 1 to 14 — lower numbers show higher acidity, higher numbers show higher alkalinity and a value of 7 represents neutrality.
Just for fun, I’ve included the Color-Coded pH Scale chart below. You’ll note that at both ends of the pH spectrum, the solutions are harmful: Battery acid has a pH of about 1, while lye has a pH of 14. Right in the middle, with a pH of 7, is pure water.
In the chart above, the pH-balanced (or neutral) solution is represented by lighter colors, whereas a highly acidic solution is represented by dark orange and a highly alkaline (or basic) solution by dark blue. To achieve a neutral — or pH balanced — solution, we want to avoid the bright colors at the ends of the pH spectrum.
NEUTRALIZING A HOT TUB
If you have any experience with hot tub maintenance, you know the value of monitoring the pH of the water. You’ll also know that when a very acidic solution (low pH) is combined with a very basic solution (high pH), they counteract each other to achieve a neutral solution.
What does this have to do with investment portfolio design? Just as a hot tub needs to have balanced pH, so does a portfolio. The similarity is in the goal of seeking balance by using asset classes that neutralize (and enhance) one another.
I’ve taken the idea of a color-coded pH spectrum and applied it to the well-known risk-return graph — the same chart that underlies the notion of the efficient frontier.
In the Building Blocks of a pH-Balanced Portfolio chart below, also on the next page, the risk of each asset class (as defined by its 15-year standard deviation of return) is represented on the x axis. The 15-year annualized net return — that is, the return after accounting for inflation — is on the y axis.
I then applied the pH color coding to the graph as well, placing the dark blue and dark orange colors in the lower right corner of the graph, where we see low return and high volatility — or, in pH terms, high acidity or high alkalinity. In short, we want to avoid the lower right hand corner and seek out asset classes and portfolio designs that are nearer the upper left quadrant, with lower risk and higher returns.
As can be seen, the “efficient frontier” of the 12 asset classes in this analysis starts with cash in the lower left, then moves to U.S. bonds, then to TIPS, then to an equally weighted blend of all 12 assets (the only portfolio in the graph) and finally to commodities. These results reflect the performance of each asset class over the 15-year period from Jan. 1, 1999, to Dec. 31, 2013.
The 12-asset blend occupies a pH-balanced location near the upper left corner. Large-cap U.S. stocks (as represented by the S&P 500), developed non-U.S. stocks (MSCI EAFE) and emerging-market stocks (MSCI Emerging Market) are by themselves the most acidic or the most alkaline, as shown by their proximity to the lower right corner. When all 12 ingredients are blended together, however, the result is a neutralized, balanced portfolio.
Let’s use one more colored chart to map a portfolio along pH lines. As shown in Stability of Performance chart below, the 12 separate asset classes and the 12-asset portfolio form a familiar constellation — with the exception that large U.S. stock and non-U.S. stock are now deeply in the highly acidic/highly alkaline zone (the deeply colored corner in the lower right).
The y axis represents the average three-year annualized net return over the 15-year period — the average of 13 three-year annualized returns. The x axis represents the worst three-year annualized return among the 13 three-year rolling periods. As before, the performance being analyzed here is after-inflation net returns.
This graph is attempting to illustrate performance consistency over three-year rolling periods and resistance to meltdowns over three-year periods.
The assets on or near the efficient frontier — offering the highest return per risk — are cash, U.S. bonds, TIPS, the 12-asset blended portfolio and commodities. And some of the results are quite humbling. For instance, cash (as measured by money market mutual funds) had an average three-year net return of basically zero over the past 15 years.