Traditional advice: Risk = Reward
Back in college, the traditional financial advice that I learned was that risk equals reward.
The logic is that equities are going to return more than bonds because equities are riskier.
Therefore, the traditional advice goes, if you want to compound wealth over time, then you have to go for the gusto and put everything into stocks. Otherwise, you’re a loser with no appetite for risk and won’t earn decent returns.
The FIRE movement has largely embraced this approach and encourages early retirees to put 100% of their wealth into US stock index funds.
Charlie Munger agrees with this logic:
“This is the third time that Warren and I have seen our holdings of Berkshire go down, top tick to bottom tick, by 50%. I think it’s in the nature of long-term shareholding, of the normal vicissitudes in worldly outcomes and markets that the long-term holder has his quoted value of his stock go down by say 50%. In fact you could argue that if you are not willing to react with equanimity to a market price decline of 50% 2-3 times a century, you are not fit to be a common shareholder and you deserve the mediocre result that you are going to get, compared to the people who do have the temperament who can be more philosophical about these market fluctuations.”
Charlie Munger might be okay with losing 50% of his money every 15 years.
Of course, this is easy to say when you’re a millionaire or billionaire that will always have plenty of money to live on no matter what happens. Even if stocks go down 80%, it wouldn’t have any impact on Munger’s abililty to put a roof over his head and food on the table.
I’m not okay with losing 50% every 15 years. You probably aren’t, either.
As a value investor, I don’t believe that volatility is risk, but I do think it accurately represents your level of heart burn and ability to sleep at night. I’d like to reduce my heart burn and sleep soundly.
Now that the Q1 results are final, many people will look at their stock-heavy portfolio returns returns and freak out a bit. Many will say to themselves: “This is the price of owning stocks and earning high returns. Risk equals rewards.”
There is a problem with this: it’s not true.
It is not a guarantee that stocks will always go up. It’s not even true over very long stretches of time. There have been 10 and 20 year periods of time when stocks had multiple horrific declines and were flat for the entire period.
Stocks frequently have lost decades, where they deliver horrific drawdowns and no return for the all of the stress. In other words, there are decades when stocks provide return-free stress.
The 2000’s and 1970’s are great examples of this. The 1930’s are a more extreme example.
Risk doesn’t always equal reward.
The truth is that there are different, less stressful ways to invest that can earn a satisfactory return on money over time without the stress of a 100% US stock portfolio.
This is readily apparent when looking at the returns of different asset allocations during the recent quarter, their financial crisis max drawdown, and comparing them to their CAGR since 2000.
As you can see, risk doesn’t always equal reward, and this has certainly been true over the last 20 years.
Look at the Permanent Portfolio, for instance. This portfolio only has 25% invested in US stocks. Meanwhile, it has beat the US stock market over the last 20 years with a fraction of the stress. It also made money in a quarter when it felt like the world was coming apart at the seams.
There are many allocations that diverge from 100% US stock market investing that provide for a much smoother ride and still provide a decent rate of return.
Combining volatile asset classes in a portfolio can provide a high and consistent rates of return over the long run.
To earn a satisfactory return over the long run, one doesn’t need to lose 50% every 15 years. One doesn’t need to look at their portfolio while chugging Pepto Bismol.
My own allocation was down down 12.83% this quarter. While I stressed in my active account about what stocks I owned and how they were positioned for the Coronavirus and how bad the extent of the drawdown and economic carnage would be, in my passive account I was able to take a “meh” approach.
With this approach, I don’t have to worry about security selection and I don’t have to worry about what the future holds. The portfolio has it covered.
Will the economy spring back to life? I have it covered. Small value, real estate, and international small caps will likely do well in this environment.
Will we face a deflationary and horrific recession, like the early 1930’s? I have it covered. Gold ought to hold up even though it won’t go gangbusters. Long term treasuries should do very well in this environment, as investors scramble for the safety of treasuries and interest rates will probably go negative in the US further up the yield curve.
Will the Fed’s actions fuel horrible levels of inflation? Will they actively pursue inflation as a means of reducing the US debt/GDP ratio? I have that covered, too. My long term treasuries will be crushed in this environment and stocks will likely be punished, too. But, it’s hard to imagine how gold won’t do extremely well in this environment. Real estate will probably do well, too. Rents will increase with the inflation rate, along with the replacement cost of that real estate. The dollar will probably weaken, but that’s alright, as I have a global portfolio and foreign assets will benefit from a weaker dollar.
Will civilization implode? If that happens, I don’t think my portfolio matters much, anyway.
With the balanced approach, it doesn’t matter if my analysis is wrong, which it may very well be. With a balanced approach, I know that I have built in protections for different types of economic environments and should be able to earn a satisfactory return on my money over the upcoming decades.
Combining uncorrelated asset classes in a portfolio can achieve a better result that doesn’t require forecasting the future accurately, doesn’t require superhuman security selection, nor does it require Pepto Bismol when looking at the brokerage statement. Most importantly, it can often be implemented without paying a manager high fees.
Not only that, but safer portfolios with even lower rates of return than US stocks can have higher perpetual and safe withdrawal rates. This is evident using the ranking tool at the Portfolio Charts blog.
US stocks, even though they can deliver high rates of return, actually rank worse in perpetual withdrawal rates than most asset allocation strategies. This is because of the high volatility and long stretches in which they do not deliver a return. In other words, an investor does not even need to earn the super charged returns of US stocks when using a safer portfolio. This is useful for someone contemplating early retirement. The perpetual withdrawal rate matters more in this scenario than the CAGR over a long period of time.
In the case of my portfolio, the data since 1970 assumes it can sustain a 5.4% perpetual withdrawal rate. If I need my portfolio to generate $30,000 a year, this means that I need at least $555,555.56 to retire. In contrast, to obtain a $30,000 income from the stock market’s 3.5% perpetual withdrawal rate, one needs to save $882,352.41. The two portfolios have have similar CAGR’s – but the volatility and consistency of return for my portfolio creates a higher perpetual withdrawal rate.
My approach is not the only approach. There are many solid asset allocations. Harry Browne’s Permanent Portfolio is a particularly stress-free stud of a portfolio. The portfolio made money this quarter amid all of the horrifying headlines.
Or, maybe you want to go for the gusto and own 100% US stocks. I don’t think this is the optimal approach, but whatever. It’s your money.
You do you. There isn’t anyone else on Earth with your same goals or the same tolerance for risk.
It is worth examining other approaches that have a lot less stress and can still earn a satisfactory return over time.
If you want to explore different asset allocations, there is no better resource than the Portfolio Charts blog.
Another great backtesting resource is Simba’s backtesting spreadsheet at the Boglehead’s forum.
In terms of the allocations that I’ve examined since 2000 and described in the above chart, here they are:
Harry Browne Permanent Portfolio – 25% US stocks, 25% Gold, 25% Long Term Treasuries, 25% Cash. Here is a book on the approach.
David Swensen Individual Investor Portfolio – 30% US stocks, 20% REITs, 15% International Developed, 5% Emerging Markets, 15% TIPS, 15% Short Term Treasuries. I wrote about this portfolio here. Swensen’s book on the subject is great, and I highly recommend this read.
Ray Dalio All Weather – 30% US stocks, 40% Long Term Treasuries, 7.5% gold, 15% intermediate term treasuries, 7.5% commodities. Tony Robbins wrote about this portfolio here.
Boglehead Three Fund – 50% US stocks, 30% International Stocks, 20% Total US Bond Market. You can read about this portfolio with this book.
My asset allocation – 20% US small value, 20% international small, 20% global real estate, 20% gold, 20% long term treasuries. You can read about my approach here.
Wellesley – Want a portfolio that you don’t need to rebalance and can put zero effort into maintaining? Just buy the fund and let it ride? Wellesley has a pretty long track record since 1970 of helping investors do just that. The expense ratio is only .23%. Wellesley investors lost only 7% this quarter and lost only 10% in 2008, while stocks went down 37%. It has also beat the US stock market since 2000.
PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings. Read the full disclaimer.