Category Archives: Personal Finance

The Permanent Portfolio

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Harry Browne

Harry Browne was a libertarian activist. He was also skilled investor. He successfully predicted the inflation of the 1970’s and took on heavy positions in gold at the beginning of the ’70s.

During the 1970’s, gold rose from $35/ounce to $800/ounce. I’m sure Harry Browne grew quite wealthy as a result.

While Harry Browne was a skilled investor and foresaw the inflation of the 1970’s, he didn’t think that most people should try to predict the market and pick stocks.

For this reason, he sought to create a simple portfolio that would deliver a decent return  over long periods of time and offer protection in different economic environments.

The Portfolio

Harry Browne called this approach “the permanent portfolio.”

The permanent portfolio is quite simple and extremely brilliant. It invests in only four separate asset classes:

permanent portfolio

Gold protects during inflationary periods or currency debasement. Cash restrains drawdowns and provides dry powder for rebalancing, along with providing a source of funds for shocks to income. Long term treasuries perform best in deflationary panics, like 2008 or 1929. The US stock market, obviously, delivers a return during periods of prosperity.

And that’s it! Four asset classes and a very small allocation to stocks.

There are few financial advisors that would endorse such a conservative approach.

It’s an unusual, iconoclast portfolio.

How does it perform?

Performance

You would think that a portfolio like this would dramatically under-perform US stocks with only a 25% allocation to equities.

Since 1970, the portfolio and US stocks had the following characteristics:

permcagr

The permanent portfolio underperformed, but one would expect that the underperformance would be a lot more significant with only a 25% exposure to US equities.

The portfolio accomplished this result with massively less stress compared to solely investing in US stocks. The 2008-09 drawdown was only 13.52%, compared to 50.89% for US stocks. The same is true for other terrible years for equities.

In fact, most of the time, the permanent portfolio goes up when US stocks are going down.

badyears

In addition to those big, bad years, the permanent portfolio offered significant protection during quicker events like the crash of 1987. US stocks lost 29% during that crash, while the permanent portfolio lost a mere 5.75%.

US Stock Valuations

It’s also worth noting that valuations for US stocks (and hence, returns) were a hell of a lot lower and returns were higher in the 1970-2000 period than we can expect from the future.

After all, the period from 1970 to now includes the super-charged bull market of the 1980’s and 1990’s, which took market/cap GDP from 40% to 140%. It took the CAPE ratio from 7 to 45.

That’s not going to happen again.

It’s not going to happen because today’s stock valuations are close to 2000 levels. Poor returns since 2000 have also been buoyed by a massive decline in interest rates, which probably won’t happen over the next 20 years considering that rates are now near-zero.

I think that anyone who expects 10% returns from US stocks from these valuations is going to be very disappointed. For the next decade, I wouldn’t be surprised if US stocks deliver a flat to negative return, likely with a gut wrenching crash somewhere in the mix.

Right now, we’re only slightly below internet bubble valuations, meaning 2000 is probably a more likely starting point for returns than what we experienced in the 20th century.

So, how did the permanent portfolio perform since the peak of the last bubble?

Since 2000, the permanent portfolio has outperformed US equities!

2000

Meanwhile, it outperformed US stocks with significantly less stress. Lower drawdowns, lower volatility. It wouldn’t surprise me if this happens over the next twenty years, as well.

Withdrawal Rates

Since 1970, the permanent portfolio has a higher safe withdrawal rate, too, despite the lower returns.

More money can be safely withdrawn from this portfolio than can be withdrawn from index funds.

This happens because of the lower risk, not in spite of it. The lower risk and lower drawdowns make it much safer to withdrawal money from this portfolio in retirement.

I think that’s a pretty incredible result.

It’s a result that runs counter to everything we’re normally taught about investing. Namely, that risk always equals reward.

It’s that elusive 21st century “equity risk premium,” which doesn’t seem to exist anymore, considering that bonds have outperformed stocks over the last couple of decades.

We’re taught that if someone is aiming for retirement, that they need to take massive risks to earn a high rate of return. The evidence doesn’t back this up.

withdrawal

Overall

I don’t invest in Harry Browne’s portfolio, but my own asset allocation takes cues from this approach. I own long term treasuries to help me out during market panics and deflationary environments. I own gold to protect myself from the potential of currency debasement. I think small cap value, international small caps, and REIT’s will outperform market cap weighted indexes, which is why I own those instead of indexes.

I think the permanent portfolio is a very sound approach that makes a hell of a lot of sense.

It certainly makes more sense to me than buying a stock market index fund at crazy valuations, which are practically guaranteed to deliver low returns.

100% US stocks is also guaranteed to deliver an incredibly volatile result and massive drawdowns, as demonstrated by market history.

Too many people, in my view, think that one has to endure massive pain to grow one’s savings. The permanent portfolio is one example that there is a better way.

If you want to read more about Harry Browne’s portfolio, check out his book, Fail Safe Investing.

Random

The Black Seeds – One By One.

Featured in my favorite episode of Breaking Bad, Four Days Out.

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.

Risk Doesn’t Always Equal Reward

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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.”

Another View

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.

returns

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.

perpetual

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.

The Allocations

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.

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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.

The Case Against 100% US Stock Indexing

liberty

Why not buy a US market cap weighted index and forget about it?

In my post on gold, I catalogued all of my disagreements with the perma-bears. In this post, I am going to talk about my disagreements with the perma-bulls who advocate owning 100% US stock market cap weighted indexes and letting it ride.

100% US stocks is the preferred asset allocation of most FIRE bloggers. It’s the mantra repeated often in the financial independence blogosphere. Warren Buffett recommends a similar allocation, 90% US stocks and 10% treasuries.

I don’t think this is the optimal approach. I think investors should embrace stabilizing asset classes, global diversification, and moving away from market cap weighting.

USA: The Place to Be

I love the United States of America. I don’t find Lee Greenwood cheesy. I particularly love small towns in America. The traditional town square, modest homes with an America flag flapping in the breeze, the churches, the little communities. I listen to Ronald Reagan’s “shining city on a hill” speech and I find it inspiring. So, I’m sympathetic to the tendency to have massive home country bias and let investments ride on America Inc.

Perhaps my perception is a fantasy about a world that doesn’t really exist anymore. Perhaps I’ve had pro-America propaganda fed into my brain since birth. Whatever.

Perhaps I’m blinded by patriotism and have been indoctrinated, but I think there is more to it than that. I don’t think it’s an accident that the United States became the world’s top superpower in the 20th century. I don’t think it’s just because of abundant natural resources and two oceans protecting us from invasion.

The United States has one of the best economic systems in the world. Our founders crafted a document that created a framework which was pretty hard to screw up. It has a number of safeguards built into it that maintain a certain economic and political framework that is very hard to untangle.

The testament to that framework is the results. There isn’t any country on Earth with standards of living that are as high and widespread as ours. The US ranks 10th in per capita income throughout the world, but that’s across 327 million people. Countries with higher levels of per capita income (like Switzerland, Luxembourg, Qatar), have much smaller populations.

For all of the complaining about our very legitimate problems, this is still the best place on Earth. Unequal distribution of wealth? At least we have wealth to distribute. Keep in mind that an income of $32,400 – a very average income in the United States – places a person in the top 1% of incomes globally. An average American lives better than 99% of the human beings on Earth. Keep in mind that half of the planet lives on less than $5.50 per day.

We have it pretty good, problems aside. Not only that, but for all of the whining about our infrastructure, it’s some of the finest in the world. For all of the whining about corruption, we’re one of the least corrupt places on Earth. When was the last time you had to drive on a dirt road? Or pay off a police officer because the country is completely corrupt?

The magnificence of this country seems entirely lost in our political conversation. We tend to dwell on our problems, rather than our strengths and how good we have it.

The Extraordinary Performance of US Markets

The long term performance of our capital markets reflects the soundness of the American economic model. Since 1871, the US has delivered a 9.07% nominal return, 6.87% real. There isn’t a country that comes close over a long enough time frame.

Since 1970, US stocks have crushed it. US stocks have delivered a 10.57% real return since 1970, or 6.41% real. The rest of the world delivered a 8.65% return, or 4.65% real.

returns

Since 2010, international investing has been an outright disaster. US stocks delivered a real return of 11.49% and the rest of the world delivered 3.32%. For perspective, the US bond market has returned 3.68% since 2010. This decade, you would have been better off buying a total bond market fund instead of buying international stocks.

2010

The US is indeed a wonderful economy. US investors never had to worry about the markets going to zero, which happened to other countries in the 20th century. Corporate governance is also strong. While there are the occasional frauds, we can reliably believe that companies will stay on the up and up. Those who stray will be prosecuted. The SEC will limit most, but not all, frauds.

We also have the largest military in the world, which helps play a role in protecting the interests of US markets. There is something to be said for having fleets of aircraft carriers, drones, and nuclear weapons looking out for our interests.

A US stock investor is investing in the best performing stock market in the world. Not only that, but they’re investing in some of the best and most profitable companies in the world. Berkshire Hathaway. Google. Amazon.

The US is also diversified, with representation in every economic sector and industry. This compares favorably to other countries, which are often concentrated in a single industry or sector. Take Australia, for instance, which is concentrated in financials and natural resources.

Meanwhile, compared to alternative asset classes, like bonds, US stocks have dramatically outperformed.

bonds

An investor looking at all of this data comes to a simple conclusion: why own anything else besides US stocks? They outperform every other asset class and they outperform the rest of the world. There are clear reasons behind this. There is an equity risk premium, a theory which postulates that US stocks outperform because they’re more volatile. Meanwhile, there are plenty of political reasons to think that the US stock market will continue to outperform. There are also all of the advantages that I’ve described above.

A US index investor invests in all of the publicly traded companies in the country. Some will be extraordinary winners, some will be extraordinary losers. A 100% US index investor can also expect to pay low fees, and fees can be a massive drag on returns.

Buy an index fund and you’ll own your own piece of corporate America, which is always working overtime to deliver a return for you, the shareholder. There are ups and downs, but the market always recovers.

So, why not simply invest in 100% US stocks and call it a day?

Going International

While international stocks haven’t performed as well as US stocks, they can help an investor smooth out their returns during periods of time when US stocks are doing poorly.

I think this is due primarily to the unique relationship between the US dollar and the performance of the US stock market. US dollar strength tends to coincide with strong periods for US stocks.

usd

Notice the periods of time when USD is strengthening vs. other currencies: the late ’90s, the mid ’80s, the 2010’s. They’re all periods of time when US stocks are doing awesome.

Meanwhile, look at the periods of time when the dollar was weakening: the 1970’s, the 2000’s, the late ’80s. These were all periods of time when international stocks outperformed US stocks. Currency movements are a big part of this out-performance. It’s the interaction of the dollar with global currencies that provides an important diversification benefit.

This is best revealed when looking at returns from a decade-by-decade perspective.

decade

As you can see, international stocks tend to outperform during bad decades for US stocks. I might be wrong about my thesis about this (that it is related to currency movements), but the facts remain. International stocks can help even out returns and provide a more consistent return.

Political Risk: Millennials, The Allure of Socialism, & Political Diversification

I think international stocks also provide protection against the US embracing bad political policies. While the Constitution is strong and prevents politicians (and voters) from screwing up a good thing, it isn’t guaranteed.

Consider that 70% of Millennials say they’d vote for a socialist. Granted, this is a survey and the results are suspect,  but it largely jives with my conversations with people of my age cohort and younger.

The reality is that socialism is a guaranteed disaster and fails everywhere it’s tried in the world.

I suspect that Millennials aren’t really socialists. They are largely blinded because they have been surrounded by the fruits of capitalism their entire lives and take it for granted. It’s like the way a fish views water: it’s just the way things are. It’s hard for a fish to imagine being taken to the surface and drowning. Fully stocked grocery stores, utilities that work, a persistently growing economy, persistently improving consumer technology. That’s just the way life is from their perspective. The reality is that it is the fruit of our economic system.

With that said, I understand where Millennial socialists are coming from.

I suspect that Millennials really want to move away from a boom and bust economy. I graduated from grad school in 2006 and experienced sheer terror in 2008. I worked for a bank and was worried it was going under.

I watched people all around me pack up boxes and wonder for their future. Many of them were older and had a lot of debt. A bulk of their income went to their mortgages, as a lifetime of lifestyle creep bit them in the behind.

I was lucky enough to keep my job, but the experience shook me to the core. At the time, I was working 60-70 hours a week with no overtime. I wasn’t working like that to become the CEO of the company. I was working that way to ensure I’d stay off the lay off list because I knew that there weren’t any other jobs for the taking.

The whole experience lit a fire under me. Get the hell out of debt. Develop a bullet proof savings war chest in case I ever lose my job. I never wanted to experience that kind of desperation ever again.

Meanwhile, other Millennials graduated into that economy facing similar prospects. Many of them were in a worse situation due to student loan debt. I was lucky enough to get through college with academic scholarships, but I still had debt at the time and felt similar levels of desperation.

Facing that kind of economy in debt is enough to drive a person to think that the US economic system is broken. The fact that Millennials struggle to reach important milestones – like owning a home – further exacerbates this reality. Owning a home and having a stable job are important elements to making people feel that the “system” works. The fact that Millennials feel shortchanged in both regards makes it clear why they think the system is broken.

It’s all further exacerbated by the expectations that were instilled in Millennials when they were young. Growing up in the ’90s, we were surrounded by prosperity that we assumed was “normal” and would last forever. We walked into a storm with insanely inflated expectations of ourselves and the future.

The feeling of inadequacy is made worse by the fact that, thanks to the internet, we’re constantly exposed to our peers who are doing “better” than us. They are probably fronting to make themselves look better on social media, but it’s easier for a Millennial to feel like they’re falling behind when we look at the picture-perfect lives of our peers on social media.

If you look at your “successful” peers on social media, you only see the good stuff. No one is posting about the troubles they have paying the daycare bill, or the fight they had with their spouse the other night. No one is going to post that they are house poor and have little disposable income after they pay the mortgage. They’re not going to post when they were passed over for a promotion at work. No one posts about the bad things in their lives. It’s all smiling faces and good things. It’s easy to look at that and feel like you’ve been left behind. It’s also important to realize that it’s not the full picture and everyone is struggling with something. No one’s life is perfect, despite what they portray on social media.

Anyway, while I completely understand where Millennials are coming from in thinking that the system is broken, they are still completely wrong in their politics. They’re especially wrong because they fail to realize how fortunate they are to simply be born in America. As mentioned earlier, simply being lucky enough to be born in America virtually guarantees you’re going to be in the top 1% of incomes globally.

Even if they don’t really want socialism (I suspect they just want a stronger welfare state, less debt, and an economy that isn’t so boom and bust), I think they are voting for people that do actually want socialism and want to undo the entire system that made our way of life possible.

Warts and all, it’s still the best system in the world. Blowing it up isn’t going to make life any better.

This is another reason to own international stocks. If the US does something insane like go socialist, the rest of the world won’t. Just like every company in an index doesn’t succeed, every country in the world doesn’t always succeed. Own all of the countries and you get some important diversification in case something in one country goes wrong.

If you’re going to own a lot of different companies, why not own a lot of different countries for the same reason?

Owning international stocks isn’t just about creating more consistent returns. It’s also about diversifying political risk against the possibility that the US economic system – which has worked so well for so long – could be upended by bad politics and an angry electorate.

I hope the US remain the premier world economy. I think it probably will stay at the top. But what if I’m wrong? That’s why I own international stocks. If the US goes down the wrong path, I don’t think that the entire world will follow. Diversification among countries is just as important as diversification among companies.

Bonds aren’t a waste of time

I wrote about owning bonds in my post, are bonds for losers?

While stocks are virtually guaranteed to outperform bonds over the long term, bonds can help contain drawdowns.

I think bonds are worth owning for their ability to cushion drawdowns. I think most people underestimate their capacity for financial pain and bonds can help limit that pain.

On the surface, going 100% stocks is the way to go. Since 1871, stocks have offered a real return of 6.87%. Bonds offered a return of 2.51%. 60/40 offered a 5.54% return. Why not go for the higher returns and just go all-in on US stocks?

The drawback of owning 100% stocks is that they can undergo truly horrific drawdowns that can take years to recover from. US stocks were flat in real terms from 2000-2012. 12 years of sideways markets is rough. From 1964 to 1981 (17 years), US stocks only delivered a real return of 1.32%. Another flat period is 1929 to 1948, which lasted 19 years.

Can your long term investing plan sustain multiple decades of flat real returns? It is really easy to look at the last decade of returns and assume it will go on forever. I assure you, it will not. Stocks have gone through long stretches of poor returns in the past and they will again in the future.

It’s easy to look at a long term chart of US stocks, or a long-term CAGR, and brush off these drawdowns. Living through them is a completely different matter.

In the early 2000s, US stocks suffered a 44% drawdown. From 2007-2009, stocks suffered a 50% drawdown. Imagine you had a 100% stock portfolio. Also, imagine you had a significant amount of money saved up, like $500,000. A 50% loss is $250,000. That’s a decent house in most parts of the country. Would you have been able to “stay the course” in the face of those kinds of losses? I think most people are kidding themselves if they think they will behave rationally in those situations.

For most people, I think the answer is no. Just imagine what it’s like to experience these kind of drawdowns:

EPhLPwhX4AAUr2N

These kind of severe drawdowns can make a person behave irrationally. A big part of the problem is that these drawdowns aren’t just numbers on a brokerage statement. Markets are reacting to very real and very bad circumstances in the real world.

After a nasty drawdown, it’s easy to get caught up in the mentality that the economy is ending and something is fundamentally wrong.

In 1929-32, it looked like the US was unraveling at the seams. We went from the ’20s, a time in which anything seemed possible (imagine starting a decade without plumbing or electricity and ending it with a stock market boom), to soup lines and hobo villages.

In the 1973-74, there was a widespread feeling that the post-World-War II prosperity was unraveling. The country was running out of oil. The decade prior was a political horror show: the assassinations of JFK, Martin Luther King, Robert Kennedy. Protests in the streets. Dead students at Kent State. We lost a war for the first time in history and lost 50,000 of our young men. Our President was unmasked as a corrupt man who resigned from office instead of face impeachment. Double digit inflation further eroded our standards of living. They called it malaise and it was a widespread feeling that America’s best days were behind us.

The early 2000’s debacle was marked by a feeling that the ’90s was nothing but a bubble economy and we were now going to pay a price. The turn of the millennium and the late ’90s was associated with extraordinary optimism about the future. We had a glorious party and now we were hungover. Add to that the experience of 9/11, this feeling became particularly palpable.

We all remember 2008, but at that moment, it felt like the entire economic system was falling apart.

During a serious stock drawdown, you get the general feeling that the world is falling apart. Stock aren’t drawing down for no reason. They’re drawing down for reasons of psychology that go beyond CAGR’s and numbers on a brokerage statement. Serious drawdowns are caused by a cultural mood. The mood is going to affect the psychology of an investor.

Moments like these also increase the odds of personal struggles, like the potential loss of a job or a house, which further add to the stress of the situation.

It’s easy to see why most investors won’t behave rationally during these situations. In many cases, they’re going to wind up selling their stocks are the worst possible moment when stocks are bottoming. Bear markets start with a feeling of uneasiness towards the boom, they intensify with a general feeling of malaise, and they capitulate when the situation feels utterly hopeless. Of course, the moments when everyone feels hopeless that are the best times to buy stocks.

drawdown10k

I own bonds to smooth out the ride and keep myself behaving correctly. My age might suggest that it’s not a good idea, but I know that I won’t “stay the course” if my 401(k) balance drops 50% and I’m worried about losing my job. While most financial planners would say I’m not aggressive enough (the 401-k website usually gives me the yellow light because my investments are “too conservative”), I want to limit my drawdowns and I know bonds are the best way to accomplish that.

A 100% stock investor might simply throw in the towel completely. This is what many of them do.

When the losses are cushioned with something like a 60/40 approach, it is easier to stay the course and not give up.

There are, of course, other diversifiers that can help cushion drawdowns and provide diversification. I covered much of this in my post on gold.

The Drawbacks of Market Cap Weighting

The index fund is an extraordinary creation. It allows everyday investors like myself to access the public markets for a low fee. Fees are a tremendous drag on returns.

As far as I’m concerned, a monument should be built to Jack Bogle for creating such an amazing product for every day investors, who were previously swindled out of commissions and paid extraordinary fees to access public markets.

The theory behind market cap weighted indexes is intuitive and easy to understand. Active investors are making bets against each other, trying to outperform each other. This is a zero sum game: for every winning trade, there is someone on the other side making the wrong decision. This is why most active investors underperform. Only some of them can be winners. Add fees to the equation and it becomes even more difficult to outperform.

So, why not simply own the market cap weighted index and get the average rate of return?

There is one problem with this approach: nearly every strategy that moves away from market cap weighting outperforms over the long-run.

  1. Fundamentally weighted indexes outperform.
  2. Equally weighted indexes outperform.
  3. The 30 stocks in the Dow Jones Industrial Average outperforms market cap weighted US stocks.
  4. Completely random 30 stock portfolios outperform the market.
  5. Low volatility strategies outperform, while also containing drawdowns.
  6. Nearly every AAII stock screener outperforms the market.

Finally, all the research and data shows that a pivot towards smaller, cheaper stocks outperforms over the long run.

equities

Small value is the best performing asset class since 1972. However, it notably under-performed during the bull markets of the 2010’s and the 1990’s.

Large cap growth – one of the worst performing long term strategies – also dramatically outperformed in both the 2010’s and the 1990’s bull markets.

Why do non market cap weighted strategies outperform over the long haul and under-perform during bull markets?

I think all of these strategies (equal weight, small size, value, fundamental weight, random portfolios) outperform because they pivot away from the coolest stocks. The coolest, biggest, stocks – the leaders of a bull market – are systematically avoided by all of these strategies. This causes all of these strategies to under-perform in a rip-roaring bull market, which are led by those large cap growth stocks. Meanwhile, non market-cap-weighted strategies also avoid the inevitable horrific decline in these bull market leaders. Over the long run, they outperform.

I think value, in particular, outperforms because it is systematically buying cheap stocks and selling when they get expensive. I talk about that in this post.

Meanwhile, a market cap weighted index is going to buy more of the largest, coolest, stocks as they go up.

As a value investor, I think that the opposite strategy is the best approach.

The ’90s bubble is a good example. In 2000, the market was concentrated in a handful of bubble names. This drove your returns during the bull and made them worse during the bear. If you avoided the leaders of the ’90s bull during the early 2000’s meltdown, then you dramatically improved your long term returns.

For an extreme example of this kind of behavior, look to Japan. James Montier demonstrated that the magic formula delivered a 16.5% rate of return during Japan’s meltdown in the ’90s and 2000’s. The magic formula outperformed because it avoided the biggest stocks in that market and pivoted towards value. This likely caused the strategy to under-perform during Japan’s long bull market. Even in a market that overall was doing poorly, pivoting away from market cap weighting made it possible to earn a high rate of return.

Meanwhile, if every strategy outperforms market cap weighting, then why do most active managers under-perform?

I think the answer is simple: those active managers have the same biases of the index itself. They are going to pile into the same outperforming stocks that the index is piling into it. This is for career reasons. The best performing stocks are safe to own. If you own them and succeed, you’re a genius. If you own them and fail, well, you’re with everyone else.

Active managers and institutional investors aren’t the smart money. They are most of the money and, therefore, most of the market. They’re subject to the same behavioral flaws and biases as everyone else. They discard under-performing strategies, they get excited about whatever is hot at the moment.

It’s also driven by FOMO. Most of them will probably load up on these stocks in an even more extreme way than the index itself. Not only that, but the size of most institutional investors, makes them pivot towards large caps out of of necessity.

Conclusion

I don’t think owning 100% market cap weighted US stocks is the optimal approach.

I think diversification adds a lot to a portfolio. Adding bonds can limit drawdowns. Adding international stocks helps diversify political and currency risks and leads to more consistent returns.

Pivoting away from market cap weighting limits returns during bull markets, but leads to long term out-performance by systematically avoiding the most exciting large cap names.

While indexing in 100% US stocks is likely to do fine over the long run, I think a more balanced portfolio with pivots towards value is a more optimal approach.

Of course, this depends on your perspective. Portfolios are personal. I’m someone who doesn’t experience FOMO. If other investors are outperforming me, I don’t really care. If it drives you absolutely crazy to underperform, then market cap weighting might be for you. If you don’t believe value is a factor likely to persist, you might want to own more market cap weighted indexes.

You do you, but you should go into an investment strategy with a full understanding of the risks and potential rewards.

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.

My thoughts on perma-bears and gold

gold

I’ve always hated gold

I have always been against owning gold.

Why did I think gold was a terrible investment? A huge reason for my gold aversion is the influence of Warren Buffett’s writings on my life and thinking. Here is what Warren has to say on the asset:

“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

In his 2011 letter, Buffett addressed the issue more in-depth:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future. The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative.

True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production.

Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade, that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As ‘bandwagon’ investors join any party, they create their own truth — for awhile.”

To sum it up: gold has no calculable margin of safety. It produces no cash flow. The return derives from what someone else is willing to pay. It therefore ought to be categorized as speculation and not as investment.

Of course, my main aversion to gold has been my attitude towards the people who embrace it the most: the perma-bears.

The Perma Bear View of the World

Who are the perma-bears?

Perma-bears think that the Fed is an utterly corrupt institution and that they are going to lead the world to ruin. The world economy, in their view, is a debt soaked Ponzi scheme that is sure to unravel. Anyone who owns stocks or bets on a positive outcome for humanity’s future is a damned fool.

They’ve been saying this for a long time, and they are almost always wrong. However, like a stopped clock, perma-bears are occasionally right whenever we have a recession and a nasty bear market, which reliably happens once every 15 years or so.

Gold is the only asset that is beloved by perma-bears (Although, Millennial Fed hating perma bears seem to be embracing crypto).

Perma-bears hate the stock market because they think stocks are in a big bubble pumped up by the Federal Reserve. They hate bonds because they do not believe that they are truly “risk-free” assets, and the Fed has pushed yields to unusually low levels. Bonds are also in a bubble.

Stocks are in a bubble. Bonds are in a bubble. In their view, everything is in a bubble, except gold.

They also see the Federal Government’s deficits as a severe problem. They think that the US is ultimately going to deal with the debt by inflating the currency or straight up defaulting on the debt in an apocalyptic scenario that is sure to imperil the global economy.

The ultimate perma-bear book is The Creature from Jeckyl Island, which argues that the Federal Reserve is a monstrous creation that is eroding the liberty and money of Americans. It’s worth a read to get insight into the history of the Federal Reserve and the deep seated hatred of it.

You’ll often see these perma-bear types quite angry that inflation exists at all. Before the Fed, they argue, dollars were a store of value. You didn’t have to worry about the slow drip of 2% inflation eroding your wealth over time.

Since 1913, the value of a dollar has been eroded by 96% due to inflation. This usually gets the perma-bears very angry, as if the only asset allocation is cash stuffed into a mattress.

Perma-bears have always hated the Fed, but they really hated Alan Greenspan. The perma-bear goldbug crowd saw Greenspan as a dangerous departure from the already maligned Federal Reserve of yore.

After the crash of 1987, they were incensed that Greenspan “bailed out” the stock market by cutting interest rates and intervening to ensure that liquidity was available. In this view, the Greenspan era was the beginning of the end, taking us down to a path of Fed manipulation leading the United States and the US dollar towards a great reckoning. In their view, Greenspan’s 1987 cutting of interest rates in response to the stock market crash was the original sin that started it all and led us down a path to ruin. They further believe that his softening of interest rates in the mid-90’s furthered the problem and contributed to the dot com bubble. Then, taking interest rates to 1% in the mid-2000s blew up the real estate bubble.

Some take it back further, and blame Nixon for ending the gold standard, creating fiat currency, which they believe will ruin the world economy. This is despite the fact that the world economy has thrived for the last 50 years since we ended price controls and dollar pegs to gold.

Then, along came Bernanke and Yellen, who really broke the brains of the perma-bears. Bernanke and Yellen, in their view, continued the insanity by pushing Washington to bail out the banks and then undergoing successive rounds of quantitative easing, creating the “everything bubble” that is sure to destroy the global economy.

The perma-bears really had their day in the sun in the wake of the GFC, when the world was ripe to their message. They thought that quantitative easing was going to cause hyperinflation. All of this money printing was sure to wreck the world.

The trouble is: the hyperinflation never came. In fact, the 2010s was a decade with some of the most mild inflation since World War II. Ironically, this was during the most aggressive expansion of monetary policy since World War II.

inflation

The perma-bears will say all of this is nonsense. They say that the inflation is here and that the CPI is a sham statistic. They point to healthcare prices and student tuition as evidence of Fed induced inflation. They also argue that the inflation may not be happening in consumer prices, but that it is being swept up into asset inflation. They believe that the housing bubble was a perfect example of this: the Fed pumped up a big bubble in real estate even though the CPI didn’t rise in a meaningful way.

My Disagreements with the Perma Bears

Listening to the perma-bears has been a recipe for investment disaster.

They have been calling for the end of our financial system since Richard Nixon ended the gold standard, and the world economy keeps chugging along. Occasionally, gold has its day in the sun (the 2000s, the 1970s), but typically financial assets like bonds and stocks that actually generate cash flows do better over time.

I also think that the CPI is legit and I think inflation remains depressed for another reason outside of shadow statistics and asset inflation: money velocity is at generational lows.

The best explanation of the relationship between monetary policy and inflation is the equation MV = PQ, and velocity is a critical component of that inflation. Velocity has remained depressed since the GFC, which is why inflation has remained subdued even while the money spigots have been open.

The segments of the economy that are undergoing inflation (healthcare & education) are being inflated for reasons that have nothing to do with the Fed. The Fed didn’t make the decision to back student loans with taxpayer & deficit financed money, flooding the sector with cheap debt. The Fed also didn’t create the perverse incentive system around medical pricing, in which no one directly pays for anything, the Federal government floods the sector with taxpayer & deficit financed money, and prices predictably rage out of control.

Neither healthcare or education inflation have anything to do with the Fed.

m2 velocity

I also disagree with the perma-bear Fed hatred.

Looking at the history of recessions in the United States, recessions were more frequent and more severe before the Federal Reserve was created than after. I think this is due to a simple factor: inflation. By creating a mostly constant rate of inflation, recessions did not coincide with deflation after the Fed’s creation.

Before the Fed, price levels would shrink during recessions and rise during booms. Deflation makes recessions particularly nasty. With falling prices, consumers and businesses hold off on purchases, hoping that prices will be lower in the future. This then extends and deepens the downturn. At no time was this more apparent during the Great Depression itself.

My views on the Great Depression are informed by the work of Milton Friedman. This is pretty good explanation of what happened during the Great Depression from Milton’s point of view:

If you want to learn more about Milton Friedman’s views, he wrote two excellent books for non-economists summarizing his views:

Free to Choose

Capitalism and Freedom

Both books had a big influence on my thinking. I read them at an impressionable age in high school. For years, I could never get a coherent explanation of what caused the Great Depression. I remember asking a teacher: “What caused the Great Depression?” She told me: “The crash of 1929.” I replied: “We had a crash in 1987, why didn’t that cause a Great Depression?” No one could give me a satisfactory explanation and I’m pretty sure that the teacher thought I was an a-hole.

It wasn’t until I read Milton Friedman that I found an explanation that made any sense.

In Milton’s view, the Fed caused the Great Depression. The Fed fueled a boom during the 1920’s, but then did very little to contain the bust. They were also handicapped by the gold standard itself. They let banks fail. Their decisions and failures led to a shrinking of the monetary supply. They turned what would have been a nasty recession into a decade long Depression.

Imagine that in 2008, instead of trying to contain the collapse, the Fed let all the banks fail and let the money supply contract. This nightmare scenario is exactly what happened during the early 1930’s, and turned what would have been a nasty recession into a decade long Great Depression.

In many ways, the Fed’s handling of the 2008 crisis is the opposite of the way that the Depression was handled. If it weren’t for Bernanke’s decisive action, we likely would have had a decade very similar to the 1930’s. A decade of stagnation, 25% unemployment, soup lines, etc.

We complain about the Great Recession, but it was truly a cake walk compared to the economic horrors of the Great Depression. Charlie Munger summarizes it pretty well here:

“And of course, most of my schooling was in the Great Depression, but that means I’m one of the very few people that’s still alive who deeply remembers the Great Depression. That’s been very helpful to me. It was so extreme that people like you have just no idea what the hell was like. 

It was really there was just nobody had any money the rich people didn’t have any money. People would come and beg for a meal at the door, and we had a hobo jungle not very far from my grandfather’s house. I was forbidden to walk through a good amount, so I walked through it all the time.  

And I was safer in that hobo jungle the depths of the 30s when people are starving, practically, than I am walking around my own neighborhood now in Los Angeles at night. The world has changed on that. You’d think the crime would be less [now], but the crime was pretty low in those days.”

My grandfather grew up during the Great Depression, and I would often listen to his stories about how bad things were. It left quite the impression and I never forgot it. It was a time that was so rough that I don’t think most people today can even imagine it.

I think that the Fed and Bernanke helped us avoid the 1930’s fate. We could have wound up with 1/4 of the population unemployed. I also think that 21st century hobo-jungles would be more crime ridden than the 1930’s alternatives. Imagine the 1930’s hobo jungles with meth addicts and tents. That’s what a 21st century Great Depression would be like.

The perma-bears seem to think that the Fed should have let this all happen. In their view, we deserved a Depression as some kind of Calvinist atonement for the booms of the 1990’s and 2000’s.

I think that’s crazy.

In fact, I’m not so sure that the Fed caused the real estate bubble, which has been accepted as a truth by most people. For instance, did the Fed pass the Community Reinvestment Act, which effectively created the subprime real estate market? Did the Fed repeal Glass Steagall? Did the Fed create CDO’s? Did the Fed create the immoral collusion between the banks and rating agencies? Did the Fed create the post-internet bubble narrative that real estate was safe and stocks were insane? Did the Fed take Wall Street’s investment banks public, removing the strong risk management controls that existed during the partnership era?

Sure, 1% interest rates might have sprinkled some lighter fluid on an already raging bonfire of greed and mismanagement, but I don’t think the Fed caused the problem. It was a bubble that was brewing for decades for a lot of reasons.

The Fed certainly has made a lot of mistakes throughout their existence. They let the 1920’s bubble rage out of control. They failed to contain the effects of the bust. They were too loose with monetary policy in the 1960’s and 1970’s and caused massive inflation. They also deserve credit: Volcker and Greenspan both created an idyllic period during the Great Moderation, an era of low inflation and infrequent recessions.

The Fed tends to be the cure to and the cause of most recessions. They tend to tighten too much at the end of an expansion, causing the recession. They tend to loosen too much, leading to inflation and imbalances in the economy. Despite this, I think on the whole they have been a positive influence, and I think the history of US recessions confirms this.

Nor do I think bubbles are caused by the Fed. Bubbles are caused by human nature. The Fed might push it along, but there isn’t any government policy that will stop bubbles. People will always get excited about new narratives and that will always cause bubbles. Bubbles are a feature of the human race. We had bubbles before the Fed was ever created and we’ll have bubbles until the end of civilization.

Gold’s Terrible Track Record

Not only do I have disagreements with the perma-bear messengers of doom, but the data agrees more with Warren Buffett’s assessment of the asset class than Ron Swanson’s: gold is an asset with no margin of safety and no cash flows. It’s simply a bunch of volatile price action.

Ron Swanson: my favorite gold bug

Since 1980, for instance, we can compare the performance of both financial assets in simple terms. Since 1980, stocks have delivered a 11.38% rate of return, turning $10,000 into $746,067. Meanwhile, $10,000 invested in gold delivered only a 2.59% return, turning $10,000 into $27,757.

This even obscures the story a bit. While gold delivered a positive return over this 40 year period, all of the return was captured in one time period: an epic move from the lows in 2000 to a high in 2012. Around the time that gold coins began to be sold on Fox News aggressively, the gold market peaked.

Meanwhile, shortly after Paul Volcker decimated inflation in the early 1980s, gold went through a 61% draw-down from 1980 through 1999 while stocks ripped into an extraordinary bull market.

The greatest period of time for the gold market was the 1970’s. During the 1970’s, when inflation ravaged every other financial asset, gold delivered a 28% CAGR and turned $10,000 into $163,717.

What caused gold’s ascent during the 1970’s? Inflation is one key cause. Another is Nixon’s end to the gold standard in the early 1970’s. Until the Nixon shock, gold could be converted to dollars at a pre-determined price. This effectively amounted to price controls imposed by the federal government. When the link was severed and gold was allowed to float freely, the price skyrocketed after being unnaturally suppressed for decades.

These events also finally made the dollar into a fiat currency, a concept which has melted the brains of so many interested in permanent bearishness. For Boomer perma-bears, many have embraced the goldbug mantra. Crypto-fanatics are the Millennial’s answer to the perma-bear, a group that is equally maddened by the concept of fiat currencies.

So, in additon to the solid arguments or Warren Buffett, the fact that I don’t believe gold has any margin of safety, and my dismissive attitude towards the arguments of perma-bears and anti-fiat cranks, I’ve dismissed gold.

Rethinking My Position

While I haven’t changed my fundamental point of view about gold and perma-bears, I have been re-thinking my aversion to owning gold in a portfolio.

While gold on its own may be a bad asset to hold, that doesn’t mean that it can’t work effectively in a portfolio with other assets as a risk management tool.

One of the really nice things about gold is that it tends to do well when stocks are doing poorly. In addition to the 1970’s and 2000’s, gold also did very well during the worst years of the Great Depression, rising from $20.78 to $35 from 1929 through 1934. When the world looked like it was ending during those dark times, people began to hoard onto physical gold as a way to deal with the calamity.

The effect that gold hoarding had on gold-backed USD led FDR to implement Executive Order 6102. The order effectively outlawed the “hoarding” of gold and forced people to exchange their gold for a low price of $20.67. This was later amended via the Gold Reserve Act of 1934, which changed the convertibility of the gold price to $35. This was effectively a devaluing of the US dollar and was used to alleviate the effects of the Great Depression.

This arrangement and system of price controls was further solidified by the Bretton Woods agreement, which pegged all currencies to the dollar and pegged the dollar to gold at a conversion rate of $35. This amounted to government controls on the price of gold. When Nixon finally lifted those price controls and eliminated the convertibility of dollars to gold, the gold price raged out of control.

Anyway, to make a long story short: gold does really well when stocks are doing poorly. This means it may deserve a place in a portfolio. Gold’s best decades were during the 1930’s, the 1970’s and the 2000’s, which were the worst decades to own stocks.

Much of the price action in gold has been driven by the legal maneuvering of the US government, but there seems to be an innate tendency of investors to flock to the safety of “hard assets” when the world looks like it is going to hell.

These characteristics makes gold an interesting component to a portfolio.

Gold In a Portfolio

Let’s say that the price action of gold in the 1930s was a fluke because the government used gold as a way to manage the value the dollar. The price action in the ’30s was a fluke caused by the Depression and Roosevelt’s efforts to contain it. The price action of the ’70s was due to the final lifting of decades of price controls on gold.

That’s why I think 1980 is a decent starting point to think about the price of the gold. Since 1980, gold has performed terribly, as discussed earlier in the blog.

However, in a portfolio, it adds some benefits, mainly due to the fact that it is so uncorrelated with US stocks and does well during bad periods for US stocks.

Let’s look at a really crazy portfolio: 50% US stocks, 50% gold. The two assets together interact with each other in a beautiful way, reducing volatility and drawdowns. Here is the result since 1980:

portfolios

On its own, gold is a terrible thing to own. It had a horrible 61% drawdown over a 20 year period. It delivered only a 2.59% CAGR over four decades.

However, if you add it into a 50/50 portfolio with stocks, and you get a pretty decent portfolio. Volatility is reduced. Max drawdowns are reduced. It then delivers a decent rate of return of 7.66%.

Looking at my own asset allocation, I’ve compared what would happened if I replaced my 20% allocation to TIPS with a 20% allocation to gold. It significantly improves the results.

vsggold

Not only does it improve the results of the portfolio, but I believe that it reduces the risks. Currently, 40% of my portfolio is tied up in treasuries. Treasuries, particularly long term treasuries, are the best asset to own in a portfolio when markets are in trouble.

But – does it make sense to have 40% of my money in one asset class?

What if the perma-bears are right, even temporarily? What if rounds of quantitative easing cause hyperinflation? For instance, what if all of this money creation over the last decade has created a forest of dried out wood? If money velocity picks up, that could cause a forest fire of hyperinflation.

What if US government bonds are not a truly safe haven asset? Looking at the balance sheet of the US federal government, I certainly think there is a danger. Does it make sense to have 40% of my money invested in something tied to the solvency of a spendthrift government that has no plans to implement any discipline?

I think gold can be an effective way to hedge against these risks. If these risks turn out to be nothing, then 80% of my portfolio is geared towards a “normal” view of the world and I’ll do okay. Gold has historically kept up with inflation and risen during periods of strife, so they will work effectively in a portfolio. If we do have an economic disaster – gold should do extraordinarily well and 20% of my portfolio will further help me sleep at night.

It seems logical that people will continue to flock to gold as a safe haven when the global economy is in turmoil. If the perma-bears are right and the Fed unleashes hyperinflation, it’s difficult to imagine how gold wouldn’t do well in that environment. If the perma-bears are right and the US government deficit finally blows up, then it’s difficult to imagine how gold wouldn’t do well. It’s also hard to imagine why gold wouldn’t be a stabilizing force in the event of a sharp reduction in stock prices.

Conclusion

I think I have been wrong about my aversion to gold. I think I confused my disagreement with the messengers to an aversion to the entire asset class, which is effective at reducing risk and volatility within a portfolio.

I think gold can function well in a portfolio. It can also help an investor sleep at night, knowing that they will hold something that will retain value even in nightmare scenarios like hyperinflation, a Communist take over, or the global economy going to hell. It can provide piece of mind and it can help diversify a portfolio, reduce volatility, and reduce risk.

Random

This is a fun song.

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.

The Value Stock Geek Asset Allocation

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The Appeal of Lazy Portfolios

I love following the market and picking stocks. I love the challenge of it, and I find it fun. This blog tracks my efforts in this arena. I think a reasonably concentrated value portfolio of 20-30 cheap stocks with good balance sheets in diverse but out-of-favor industries ought to outperform the market significantly over time. However, it’s not for the meek, as the last few years of my results have demonstrated. You need to stomach higher volatility than the market and endure long periods where you look like an idiot by underperforming the market. I have no problem with any of this, including looking like an idiot.

With that said, I’m also a big fan of “lazy” portfolios and think that’s the optimal approach for most people. What’s a lazy portfolio? You diversify across a bunch of asset classes that will deliver returns in different economic environments. You buy and hold it and don’t try to time the market. You avoid making the big, macro bets that I love to think about but often get wrong like: (1) Will we endure another 1929-32 episode? (2) Will the dollar increase over the next 10 years or go down? (3) Are US stocks over or undervalued? (4) Will the rest of the world outperform? (5) Will we endure an inflationary episode like the 1970s?

I don’t know the answers to these questions, but neither can any of the financial gurus who claim they can.

I love speculating about future events, but I’m also conscious of the fact that my guess is as good as anyone else’s. Macro calls and market timing are hard.

Another way to generate alpha is stock picking. I’m trying hard on this front, but I’ve also bought enough value traps to appreciate the intense difficulty of security selection.

Predicting the future is hard. Hell, it’s hard enough to figure out what is happening in the present. Here is a funny post from 2008. Intrade, a betting market, had the odds of a recession at 45% on April 17th, 2008. We were already in a recession at that point, but there was still a debate about it! I recall similar discussions during the early 2000s. There was a serious debate in 2001 about whether we were going to have a recession while we were already in one. This is an excellent article about the difficulty of predicting the future. Experts, in all fields, even when equipped with classified information, can’t predict the future.

As investors, we face the challenge that the “experts” are useless. Few economists can predict what is going to happen. Few fund managers do, either. Meanwhile, we end up paying vast sums of our hard earned dollars to experts for advice that isn’t useful.

This begs the question: what should I do with my savings when the future is unpredictable, and experts know nothing? It’s a question fraught with emotion because making money is hard. It’s not a game. I worked my tail off for the money I have, and I don’t want to squander it. I’m sure you’re likely in the same boat.

I think that the best approach is a diversified portfolio of low-fee ETFs and/or mutual funds that should deliver a consistent return in most economic environments. Low fees and diversification are the answer. I prefer ETF’s because they are more tax efficient than mutual funds. With that said, mutual funds make it easier to reinvest dividends. Mutual funds, especially balanced funds, make it a lot easier to set it and forget it. People are also more tempted to trade ETF’s. It’s a controversial topic, but I am squarely in the ETF camp.

A diversified portfolio of low-fee ETF’s and mutual funds means one thing: a lazy portfolio. A mix of asset classes that only need to be rebalanced once in a while.

I wrote about a great lazy portfolio created by the superinvestor and maestro of asset allocation himself: David Swensen. You can read my post about it here. Swensen’s recommendations are solid, and my 401(k) selections are pretty close to what he recommends.

For a great menu of different lazy portfolios, check out the Portfolio Charts blog. The author maintains a great list of different lazy portfolios to choose from, depending on your views on asset allocation and the ability to stick with an approach.

Here are some popular approaches (all returns are in real, inflation-adjusted returns):

1. The classic 60/40. If you want to keep it basic, this is the approach. 60% US Stocks, 40% US bonds. A 5.8% average rate of return, 34% max drawdown. 12 years is the longest period that the portfolio remained in the red. It’s a decent approach.

Basic things are often derided, but let’s face it: like chocolate cake, Starbucks, the Beatles, or pepperoni pizza – something becomes basic because there is something inherently awesome about it. You can also implement this in a single Vanguard mutual fund, set it up to reinvest dividends and interest, and forget about it. They can do the rebalancing for you, and you don’t even have to look at it.

Vanguard has a variety of Lifestrategy balanced funds for a low fee which adopts this approach. They’re balanced with a mix of stocks and bonds, and all of the work is done for you. The 60/40 fund is the Lifestrategy moderate growth fund.

Ironically, many financial advisors put people in a 60/40 allocation and charge 1% for this allocation. Vanguard will do it for you for .13%.

2. The All Seasons Portfolio. This is the portfolio created by Ray Dalio and promoted by Tony Robbins in his book, Money: Master the Game. A 5.3% average rate of return, 16% max drawdown, and 10 years in the red. The portfolio is 30% US stocks, 40% long term bonds, 15% intermediate bonds, 7.5% commodities, and 7.5% gold. This portfolio is for people who watched 2008 and said to themselves: never again. This approach appeals to the risk-averse who never want to endure another episode like 2008 but still want to invest and grow their savings.

There are a lot of assumptions built into this approach. Much of the return for the portfolio since 1981 is an epic, multi-decade reduction in interest rates. This buoyed the profits in long-term bonds, which have delivered equity-like returns over the last 40 years with low volatility. (Bonds prices and interest rates are inversely related – when bond yields go down, bond prices go up. We’ve been in this environment since the ’80s. It probably won’t last forever.)

Interest rates won’t decline indefinitely. They typically rise during inflationary periods like the 1960s and 1970s. When inflation comes back, a fundamental assumption of the All-Weather allocation is that the gold and commodities will deliver a high rate of return when the long-term bond allocation takes a beating. This is what happened in the 1970s, but I don’t know if this will happen again. Then again, Ray Dalio is a lot smarter than I am with a multi-billion dollar net worth to back it up.

3. The Boglehead’s Three-Fund Portfolio. This is the approach embraced by Bogleheads with three simple index funds. Bogleheads.org is a fantastic discussion forum with a rich array of useful information for DIY investors. It’s 40% US stocks, 20% international stocks, and 40% bonds. It delivers a 5.7% rate of return, with a 32% max drawdown, and a 10-year money-losing period. It’s a sensible approach. You’re zeroing in on the three major asset classes and getting the market return on all of them for a low fee.

4. 100% US Stocks. Straightforward and simple, but not easy. This is the approach embraced by the FIRE community. This is also close to Warren Buffet’s recommended asset allocation (90% stocks, 10% bonds).

This approach will likely work over the long run, but it’s not easy to stick with. I don’t think the people who embrace this approach are fully conscious of the risks embedded in it. Since 1970, US stocks have earned a 7.6% rate of return (hooray!) but had a 49% max drawdown (ouch), and 13 years of money-losing (double ouch). The max drawdown is from 2008. The 13 year stretch of real losses begins in the 1970s, a decade of fantastic rock (Pink Floyd, Zeppelin) and terrible investment returns, which set the stage for two decades of supercharged performances in the 1980s and 1990s. Two decades of interest rates falling from 20% to 5% do wonders for financial assets.

The Portfolio Charts website takes the returns back to 1970. Bringing things back further, US stock-only investors suffered an 80% drawdown during the depression. US stocks occasionally have a lost decade, like the 2000s, when US stocks had two crushing 50% drawdowns and delivered a real return of -1.21%. Staying long-only US market cap weighted stocks also ignores the valuation of the market. If US stocks ever enter a truly insane bubble like Japan in the 1980s (this isn’t happening now – Japan’s CAPE ratio went up to 100 in 1989, and the US is at 28 now), you could go decades without a return.

This also assumes that US stocks will always be capital friendly and that the US economy will provide the best returns. This was certainly the case in the 20th century. It has been the case this decade. It wasn’t the case in the 2000s. It may not be the case for the rest of the 21st century. As an American, I certainly hope that US stocks maintain their strength, but hope is not an investment program.

5. The Pinwheel Portfolio. This was designed by the author of the Portfolio Charts site and is one of the best approaches on there. 15% US stocks, 10% small cap value (yes!), 15% international, 10% emerging markets, 15% intermediate bonds, 10% cash, 15% REITs, 10% gold. This is broad diversification, and it works. A 6.7% rate of return, only a 26% max drawdown, and only 5 years of money-losing in the portfolio.

These 5 portfolios are just a small little sampling of the menu of lazy portfolios that are available. You can check out the full menu of low-cost, lazy, DIY asset allocations options here at the Portfolio Charts blog.

Searching for my own approach

Outside of the blog, I have a separate asset allocation. My 401(k) is reasonably diversified between multiple asset classes. Most people would say I’m underweight the US equity market with only a 25% allocation to the Russell 3k (because I think US market cap weighted indexes are expensive, poised for low returns over the next decade, but I still want an allocation to it because I might be wrong). The rest is divided up among a bunch of asset classes: the US bond market, TIPS, REITs, high yield bonds, emerging markets, international developed. It’s a smorgasbord of what’s available. I wish my 401(k) had some value-oriented options, but I have to diversify among the asset classes available to me.

I also have separate brokerage accounts in which I buy and hold ETF’s. For these accounts, nearly all of my equity exposure is value-oriented, and I own some diversifiers. Over the years, it’s turned into a real soup of many different ETF’s. I’ve wanted to simplify these accounts for a long time into four or five ETF’s, but have been searching for the right balance. I also want to stick to a passive, diversified, approach and have been searching for the right path.

With this passive allocation, I wanted to accomplish many goals:

  1. Small Cap Value Allocation. I want to fully embrace small-cap value stocks. There is a reason that these factors (small stocks, cheap stocks) outperform. I don’t believe that they outperform because they are riskier, which is the argument of the academics. I think they outperform because small-cap stocks are more likely to be mispriced. Cheap stocks are also expected to be mispriced. Small cap value investors earn higher and more consistent returns over the long run because they are systematically buying compressed multiples and sell after those multiples go higher. It’s possible that both factors (small cap and value) have been degraded, but I don’t think this is the case, and I believe they are likely to outperform over the long term. It is a sensible approach that makes logical sense to me. Because multiples are always changing for individual stocks, I believe this approach also provides a more consistent return than the market. During bull markets, small-cap value underperforms, but it has never had a lost decade like market cap weighted US equities. With that said, small-cap value often draws down with the broader market when we encounter economic trouble and doesn’t provide any protection in a 2008 style event.
  2. Insurance against large, rapid, drawdowns. Speaking of horrific drawdowns, I want insurance during a market episode like 1929-32, 1973-74, or 2008. I don’t want to endure an event where I lose more than 50% of my money, which is going to happen to my equity allocation every once in a while. I’m not Stanley Druckenmiller or Ray Dalio.
  3. Inflation insurance. I want protection if inflation erodes the American economy and hammers all asset classes, as it did in the 1970s.
  4. No lost decades. I want asset classes that deliver a consistent return. I don’t want something that provides returns sporadically and is prone to lost decades like market cap weighted US stocks. There are fabulous decades for US stocks like the 1990s and 2010s, and then decades where US stocks are dead money, like the 1970s and 2000s. I don’t want to lose money for over 10 years.
  5. Small cap value international exposure. I don’t want to have home country bias and want some exposure to foreign equities. With that said, I also don’t want to invest heavily in a bunch of mega-cap European banks with trashy balance sheets. I don’t want to buy market cap weighted Japanese stocks at a CAPE ratio of 100 at a moment like 1989. I don’t want to buy the BRICs in 2007 at crazy CAPE ratios and expectations. I think the best way to avoid bubbles is to gear the foreign allocation towards small cap value. Like US small-cap value, international small-cap value should systematically avoid the bubbles and deliver a relatively consistent rate of return compared to their large-cap market cap weighted index brethren.
  6. No gold or commodities. I do not want to invest in commodities or gold. Yes, commodities and gold did great in the 1970s. Yes, “fiat”, blah blah blah. I agree with Warren Buffett’s perspective. Gold sits there in a vault and produces no cash flow. It is an entirely speculative endeavor because the return is wholly based on the resale value. I want to avoid purely speculative assets like art, collectibles, and cryptocurrencies. Not interested. There are other ways to manage the risk of inflation, which is what gold is really for. There aren’t any long term tailwinds to increase the price of gold over the long run. It did well in the 1970s, but then gave back all of those gains in the 1980s and 1990s. It had another great run from 2000 through 2012, which has since dissipated. Here are a couple charts: (1) gold in the 1980s and 1990s, (2) Gold in the 1970s. Gold was an excellent tool to weather the inflation of the 1970s, but it’s volatile, unpredictable, with no long-term prospects for appreciation.golds80s90s.PNGgold1970s
  7. Low fee, rules-based, approaches. I want the strategy to be low cost, systematic, with a passively constructed portfolio. I don’t want to pay high fees for my allocation. I don’t want a fund that charges me more than 25 bps. I also want approaches that are systematic and aren’t going to be impacted because the fund manager is going through a divorce.
  8. No large-cap market cap weighted equity indexes. I want to get away from market-cap weighted indexes. Over the long run, I don’t believe market cap weighting is the optimal approach for equity investing. Market cap weighted indexes wind up investing heavily at cyclical peaks in the most overvalued stocks. Market cap weighted indexes buy more of the stocks that are going up, which I believe is the worst way to invest. At cyclical peaks, you wind up holding the most overvalued names of the moment. You wind up with massive allocations to technology stocks in 2000 and massive allocations to financial stocks in 2007.
    A good example is Japan. Japanese stocks still haven’t returned to their 1989 highs. However, if you veered away from market cap weighting, there was still money to be made in Japanese stocks. While market cap weighting in Japan has been dead money since Zack Morris ruled Bayside High, an approach like the magic formula generated an 18% return. Ditto for US stocks in the 1970s and the 2000s. The indexes were crushed, but equally weighted and value approaches still delivered a profit. It’s these periods that provide the “value premium.” The value premium doesn’t happen reliably, year after year. It has delivered over these long periods when the large-cap indexes are working off previous excesses. Equal weighting and strategies like small-cap value still delivered returns in these environments, while the broader market was crushed. The broader market was crushed because the index was heavily invested in the biggest, hyped up names. Avoiding market cap weighting looks stupid during bull markets because all of the biggest stocks are going up. As for me, I have no problem looking stupid and underperforming in bull markets for a more consistent return. The benefits are only apparent when large-cap bubble stocks implode, like Japan in the late ’80s the US in the early 2000s, the BRICs in 2008, or the Nifty Fifty in the early ’70s.
  9. Insurance that doesn’t lose money over the long run. I don’t want assets that lose money over the long term or are dead money for long stretches of time, like gold. This is why my “insurance” can’t be in the form of managed futures or other egghead-created fancy strategies, which often come with an equally fancy fee. An approach like going long volatility futures is unacceptable for me. This strategy is likely going to lose money over the long run. The returns are concentrated with black swan events. I don’t want to lose money for 10 years, so I get a 50% pop if another 2008 happens.
  10. No leverage, no concentration. I don’t want to use leverage or concentration. As Charlie Munger likes to say: “All I want to know is where I’m going to die so I’ll never go there.” Well, where do most financial strategies go to die? What causes nearly all of the great financial blow ups? It’s almost always excessive concentration, leverage, or both. The guys who do this are fooling themselves. They should ask themselves this question: are you smarter than the managers of long-term capital management?

Asset classes that fit my goals

I decided on five asset classes that accomplish all of these goals.

For the return data, I used Simba’s backtesting spreadsheet at the Bogleheads forum.

US Small Cap Value

US small cap value is the best performing asset class of all time. It delivers a consistent, high rate of return. It doesn’t have lost decades and only underperforms during bull markets.

Since 1927, it has delivered a 12.05% nominal rate of return and a real return of 8.84%. This compares to a return of 9.69% for the US stock market. In terms of maximum drawdowns, the worst moment for both asset classes was the Great Depression. Small cap value lost 76.02%, and US stocks lost 67.71%. During the 2008 financial crisis, small-cap value lost 36.86% compared to 37.04% for the US stock market. During the 1973-74 moment, small-cap value lost 43.81%, and the broad market lost 40.38%.

Basically, small-cap value goes down as much as the broader market during panics. If the strategy were riskier, wouldn’t it go down significantly more than the market?

While small-cap value delivers high returns, small-cap value doesn’t provide downside protection during panics, as noted above.

Small cap value underperforms during bull markets, but it still does alright. If the US economy is doing well, this asset class will deliver a return. It then provides a consistent return, because multiples are always changing in every market, and the strategy systematically takes advantage of it. This provides high, consistent returns over the long run.

In my value-biased mind, I also think small-cap value is less risky than buying US market cap weighted stocks at a CAPE ratio of 28.

My preferred vehicle for this asset class is Vanguard’s small-cap ETF, VBR, which has an expense ratio of only .12%.

Small cap value provides a remarkably consistent real return over each decade:

smallvalue

Small cap value is also the top-performing US equity asset class over the long run:

caps

International Small Cap Stocks

I prefer to tilt towards international small-cap value, but I can’t find a cost-effective solution in an ETF for this. For this reason, I think international small-cap without the value component is the way to go. The current valuation metrics on international small caps are usually pretty cheap, anyway. I wish an ETF existed for international small-cap value, specifically, but it doesn’t exist yet.

The allocation also helps me avoid a home country bias in my equity exposure. International stocks are also a good allocation due to currency movements. A strong dollar is typically associated with bull markets. Meanwhile, a weak dollar is often associated with weakness in US stocks. Fortunately, international stocks benefit from a weaker dollar, thus providing an excellent ying to the yang of US stocks. This was most apparent in the 1990s, a terrible decade for international stocks due primarily to a strong US dollar. Meanwhile, international stocks outperformed in the 2000s, because the dollar was weakening.

Like US small cap value, international small-caps also provide a more consistent return than international stocks as a whole. Of the available menu of cheap international exposure, international small caps are the best performing option available.

international

In terms of drawdowns, this is the riskiest asset class in the portfolio. International small-cap suffered a 50.36% drawdown in 2008 compared to a 44.1% drawdown for international stocks as a whole in 2008. International stocks have sucked compared to US stocks for the past decade, but I don’t think this will last forever. Mean reversion is a force of nature and the current market environment won’t last forever.

My preferred international small-cap ETF is Vanguard’s international small-cap ETF, VSS. The expense ratio is .12%.

international

REITs

US REITs are another class that provides a consistent return. I suspect that REITs produce a more consistent return because much of the return comes from the dividend yield, which will continually be paid while market-cap weighted US equities will sway between Mr. Market’s bouts of extreme euphoria and fear.

Meanwhile, US REITs also provide excellent insurance against inflation. As much as the end-the-Fed gold bugs would like the current regime to end, I don’t think they will ever get their wish. Inflation is here to stay. In an inflationary environment, real estate should increase with the inflation rate as the replacement costs of the real estate expand. This was proven true during the inflation of the 1970s, when REITs significantly outperformed the rest of the market.

Like small-cap value, REITs will decline when the economy falters. Real estate was ground zero of the mid-2000s bubble and, and naturally, REITs suffered a serious drawdown of 50.36%.

Also, like small-cap value, REITs deliver a more consistent return than market cap weighted US stocks. I think this is due primarily to the high dividend yields of REITs. Like small-cap value, REITs also underperform during bull markets. As compensation for this, it still delivers a consistent return when large-cap stocks go through their occasional lost decade.

There are long-term concerns with REITs, such as the decline of commercial retail. However, that’s a small slice of the pie, and it’s not going away completely. I also don’t see how we can ever go without real estate like apartments and storage lockers.

My preferred REIT ETF is Vanguard’s real estate ETF, VNQ. It has an expense ratio of .12%. The dividend yield is currently 4.05%.

reitsusstocks

Long Term US Bonds

Long term US bonds are in the portfolio for three reasons: they provide positive long-term returns, they aren’t going to default, and they are excellent insurance when Mr. Market panics. When the world looks like it is ending, investors flock to long term US bonds. The Fed is also usually cutting interest rates during panics, which improves the returns of this asset class.

Since 1980, long-term bonds have been in an extraordinary bull market, delivering a 10.74% nominal return and a 6.51% real return with a maximum drawdown of only 8.66%. Since the ’80s, they have delivered equity returns without the equity risk. I think this amazing performance is unlikely to continue into the future. This performance occurred because of a multi-decade reduction in interest rates from an extraordinarily high level. (Of course, that’s likely what Japanese investors thought in the late 1990s, who then witnessed interest rates drop even further. Remember what I said about how predicting the future is hard?)

The worst period for long-term US bonds was the 1970s when rising interest rates and inflation saw them deliver a real return of -3.37% over that decade, even though they still delivered a nominal return of 4.18%.

The appeal of long-term bonds is their protection during panics. From 1929-32, while $10,000 in US stocks turned into $3,229, long-term US bonds turned $10,000 into $11,828. While long-term bonds delivered lackluster performance in the 1970s due to rising interest rates, they still protected investors during the 1973-74 drawdown. $10,000 in long-term bonds turned into $10,580. US stock market investors saw their $10,000 turn into $5,962 in 1973-74. In 2008, US long term bonds turned a $10k investment into $12,252, while US stock investors saw their investment fall to $6,296.

Long term bonds are panic insurance that I don’t have to pay a premium for. Managed futures lose money over the long run, but long term bonds pay me interest and then run up nicely during a market panic.

My preferred vehicle for long term US government bonds is VGLT, for an expense ratio of .07%

TIPs

TIPs, or Treasury inflation-protected securities, are US treasury bonds that increase with the inflation rate. The expectation is that they will not decline much during a panic and limit the drawdown. Unlike long-term bonds, however, TIPs ought to do well during an environment like the 1970s.

TIPs have only been around since the 1990s, and we haven’t had an inflationary environment like the 1970s since then. So, we don’t really have reliable data for how they would have performed during that time. I think it’s a safe assumption that they would have outperformed the rest of the bond market if they existed in the 1970s.

With that said, I like TIPs because they provide this inflation protection and they also serve as a cushion during drawdowns, although they aren’t as robust as long-term treasuries during those episodes.

My preferred vehicle for TIPs is Vanguard’s TIP ETF, VTIP. It has an expense ratio of .06%.

Putting it all together

Putting this all together into a single portfolio is an odd choice. It’s quite strange because there is zero allocation to US market-cap weighted stocks, which are included in the mix for nearly every popular asset allocation. A portfolio without this component is like making marinara sauce without tomatoes. It’s weird. In my mind, weird is good.

Deciding the appropriate weights of these asset classes in a portfolio is a recipe for significant brain damage. I like to keep things simple. I’ll equally weight them, 20% each.

vsgportfolio

How does this portfolio hold up? According to the backtesting spreadsheet, since 1985 it delivers a 9.67% nominal return with a real return of 6.9%. In 2008, it fell by only 19.96%. (The TIPs data is simulated from 1985-1997 and real after 1997.)

The portfolio’s 9.67% return compares to a 9.29% return for a 60/40 portfolio. It also delivers this return with more diversification and no lost decades.

This compares to 10.6% for a 100% US stock allocation, but US stocks suffered a more significant drawdown of 37% in 2008 compared to 19.96% for my portfolio. The portfolio also provides more consistent returns without lost decades. It predictably underperforms during bull markets for US stocks. It provides protection for different economic environments and limits drawdowns, providing for more consistent returns.

Here is how it stacks up by decade since the 1970s by period. My attraction to this approach is the consistency of real, inflation-beating returns and protection during panics. It underperforms 60/40 slightly during bull markets, which I’m fine with. Unlike 60/40, it continues to deliver a return every decade.

Note: because the TIPs data isn’t available, I substituted TIPs for intermediate treasuries in the 1970s and 1980s. The TIPs data is simulated in the 1990s. International small only becomes available in the spreadsheet starting in 1975, so this period is divided up between 1970-75 and 1975-80. This likely means that the returns would have been even better in the 1970s, as intermediate treasuries don’t offer the same inflation protection of TIPs.

consistent

As the results in the spreadsheet may be a bit suspect, I decided to plug this into the helpful tool over at Portfolio Charts to see how the strategy holds up. TIPs don’t exist on the tool, so I substituted it for intermediate-term treasuries.

The results were equally promising using this tool.

Average Returns

Real inflation-adjusted returns are 7.1%, and the portfolio only lost money 18% of the time. The 60/40 portfolio, in contrast, delivers a 5.8% average and loses money 27% of the time. US stocks provide a 7.6% return and lose money 29% of the time.

annual returns

Goals

How does the portfolio help me reach my goals? Let’s say I have $100,000 and contribute $18,500 to the strategy each year. How long will it take me to hit $1,000,000? It would take roughly 14-19 years of savings to accomplish this goal.

myportfolio.PNGThis is similar to a 60/40 approach, but notice how the range of outcomes is much tighter for my portfolio versus the 60/40. That’s because the returns are more consistent.

6040.PNG

Drawdowns

The data doesn’t include the Depression and 1929-32 drawdown. I don’t think this will happen again, but I’m certainly conscious that it can happen again. I can approximate what my portfolio would have done in this environment with a 60% small cap value allocation, a 20% allocation to long-term bonds, and a 20% allocation to intermediate-term bonds. A $10,000 investment in 1929 would have turned into $4,814 by 1932. In real terms, because there was deflation during this period, I would have been left with $6,381. That’s not bad considering the alternatives at the time.

This would have been painful, but not nearly as painful as being 100% US stocks. The 1929-1932 period turned a $10,000 investment into $3,229.

The bonds, in other words, do their job. They would have kept me in the game.

Since 1970, the maximum drawdown is 32% and the most prolonged period that the portfolio is in the red is only 6 years. The maximum drawdown for the 60/40 is similar at 34%, but the portfolio remained in the red for a much longer period, for 12 years.

medraw

6040

Performance from different start dates

The portfolio suffers short drawdowns and provides consistent, high, returns. The longest drawdown occurs during the 1970s. I’m guessing that if TIPs existed in the 1970s, the 6-year drawdown would have been shorter.

performance

cagr

Financial Independence

I am not financially independent, but I would like to become financially independent at some point. I don’t want to retire or quit working, but I’d like the satisfaction of not needing to work.

I currently have about 5 years of expenses saved up between all of my accounts with no debt but my mortgage. I’m really cheap, brown bag my lunch to work every day, make nearly every meal at home, have no kids, and maintain a low cost of living. I buy most of my clothes at Costco and Wal-Mart and spend about $80 a week on groceries. I drive a beaten up Nissan sedan and plan on driving it until it dies. I live in a modest townhouse, and my mortgage payment is cheaper than what rent would be in a suburban one bedroom apartment. I have little interest in travel, and my primary forms of entertainment are affordable: movies, music, books, and hikes in free public parks. I don’t drink. I save roughly 25% of my income. Meanwhile, I am also privileged enough to have an excellent job after slowly grinding my way up the ranks in my company for the last decade.

I wasn’t this frugal originally, but my experiences in my 20’s rattled me. I had significant debt at the time and worried endlessly about losing my job. Living in fear and not having enough cash for an emergency was not for me. I was also rattled by watching my 40-something coworkers deal with the crippling fear of losing their jobs while they had a ton of debt and expenses. I swore to myself that it would never happen to me and went down a path of frugality.

It’s not possible to stick with my asset allocation across all of my accounts (my 401-k only has market cap weighted options, and I’m using stock selection for the account on the blog), but it looks like this portfolio ought to help me reach my goal of financial independence in a reasonable timeframe. 8-16 years, depending on performance.

I’m currently 37, and I’d like to get there by the time I’m 50. With this approach, I should be able to do it.

fi

If I up my game and embrace extreme frugality, saving 50% of my income, I can get there even faster in 5-12 years. I’m not sure if I am ready to go that hardcore, but hey, discipline equals freedom, as Jocko likes to say. Perhaps I should pick up a side hustle and start eating ramen.

512

Comparisons

Using the Portfolio Charts tool, I compared my approach to other lazy portfolios. The portfolio designed here has the highest baseline long term return. Meanwhile, it is ranked 6th for the longest drawdown, 10th in terms of the ulcer index, and 3rd in safe withdrawal rate.

Notably, it ranks only 2nd in average return, bested only by the total US stock market. It accomplishes this with significantly less volatility combined with shorter and more shallow drawdowns. In other words, this portfolio almost delivers the index’s long-term return but with substantially less pain and stress.

Overall, it accomplishes my objectives, and I think it does so in a way that other lazy portfolios could not.

Ranking by baseline return (high returns):

portfolios

Ulcer index ranking (low stress):

ulcer

Conclusion

I think this a sensible approach that will help me meet my goals. If you have any criticisms or suggestions to improve upon the portfolio, then I’d love to hear it.

Portfolio Charts and Simba’s sheet are also great tools to test any similar ideas that you might have. Test your own approach. This portfolio certainly isn’t the end-all of asset allocation, just like the available vast menu of lazy portfolios didn’t speak to my needs and goals. You do you.

Here is the annual performance of the strategy versus 100% US stocks and 60% US Stocks/40% US Bonds:

vsg2019

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.

The David Swensen Asset Allocation

yale

The Yale Model

I have been looking for a good book about asset allocation, and I decided to pick up David Swensen’s book, “Unconventional Success.”

David Swensen should undoubtedly be regarded as a superinvestor. He took over Yale’s endowment in 1985 and achieved a return of 16.1% from 1985 through 2005. This is a considerable achievement, particularly considering the vast sums of capital that Swensen needs to deploy. He achieved these results by focusing extensively on moving away from the heavy allocation to bonds that the Ivy League had before the 1980s. His asset allocation is known as the “Yale Model,” which involves a widely diversified portfolio across asset classes and massive exposure to alternative asset classes, like private equity and venture capital.

“Unconventional Success” is not about how David Swensen achieved these returns for Yale. If it were, I wouldn’t have been as interested in the book considering I don’t run an endowment and never will. The book, instead, is aimed at small investors like myself.

The book is geared towards small investors who want to set up a simple, passive portfolio that will preserve their wealth and give a decent rate of return over the long run. Ben Graham would have called this “defensive investing” back in his day.

The Importance of Asset Allocation

Asset allocation is a critical topic. It is especially crucial for the FIRE crowd. While I admire the superhuman savings rates of FIRE bloggers, I think many of them are making a mistake by putting 100% of their savings in US equities, or an equivalent to VTSAX.

While US equities have been the best asset class over the long run, they are often prone to horrific drawdowns and “lost decades”. While over the long run everything will likely work out, 10 years of flat returns is a long time, especially when you are “retired” and don’t have an income.

Take the 1970s, a flat decade for US stocks. Stocks delivered a .26% real rate of return after inflation with a max drawdown of 40% during the ’73-’74 drawdown. The 2000s is another example. During the 2000s, stocks delivered a nominal return of 1.2% and a real return of -1.21%.

Again, everything worked out. If you had a long time horizon, you made out fine. If you were dollar cost averaging, it wasn’t a big deal. But if you’re retired, it is probably worth having a more diversified asset allocation.

It’s fully expected that elements of a balanced portfolio across asset classes will enter bubbles periodically (REITs in the 2000s, US equities in the 1990s, international developed in the 1980s via Japan), but in a balanced portfolio you won’t have 100% exposure to them. Another important aspect of a balanced portfolio is to have exposure to asset classes that will deliver a return in all economic environments.

US Stocks & US Bonds: The Classic Allocation

This is a blog about value investing and stock selection. That is not what Swensen’s book is about. In fact, Swensen advises strongly against individual investors picking their own stocks and believes that small investors don’t stand a chance. I do it anyway. As Han Solo says, never tell me the odds.

People often come to me for financial advice because they know I’m obsessed with this stuff. My advice is pretty simple: look at the Vanguard life strategy funds, look at the drawdown that happened in 2008, decide which one you could have lived with, keep piling money into it, and try not to look at it for 30 years.

Some mix of stocks and bonds are the standard asset allocation. Stocks supply the long run return, bonds deliver a boring rate of return but provide comfort to psychologically bear with the horrible 50% drawdowns that rear their ugly head every once in awhile. When it feels like all hope is lost, your bond allocation reaches out and says “come with me if you want to live.

Bonds give you the behavioral will to survive significant stock drawdowns. Stocks supply the long-term returns, with gut-wrenching volatility.

This has been the standard investing advice for decades. Swensen thinks that the small investor can do better. He starts by adding in asset classes beyond the standard US equity/bond allocations that dominate most individual portfolios.

The Core Asset Classes

Swensen describes his views on what he calls the “core asset classes” that deserve a place in a portfolio.

US Stocks: Swensen is talking about market cap weighted US equities, of course. No value tilts, trend following, etc. Good old market cap weighted US stocks. Since 1900, US stocks have delivered a 9.37% rate of return. This beats any other big asset class. Those high returns include horrific drawdowns, including a nearly 80% drawdown occurring in 1929-32.

US Treasury Bonds: Swensen is particular about bonds: he’s talking about US government bonds. He is not interested in corporate bonds, which he doesn’t believe deliver a high enough return relative to government bonds to justify their risk.

Bonds will not deliver a substantial rate of return but will protect investors during drawdowns. He also does not recommend owning foreign bonds, as they don’t have the creditworthiness of the United States.

He also recommends that half of an investor’s bond allocation go to TIPS or Treasury inflation-protected securities. TIPS were introduced in 1997 and are bonds that will increase in value if inflation rises. Conversely, they decrease in value if inflation falls. Swensen believes they deserve a place in the portfolio because they will protect against significant equity drawdowns, but they will also help the performance of the portfolio during a time of high inflation like the 1970s. Since 1997, TIPs have delivered a 4.78% rate of return.

Since 1997, we haven’t had a serious inflation problem, so this allocation hasn’t really had its chance to shine.

Meanwhile, the rest of the bond allocation exists primarily to shield the portfolio during drawdowns. The total bond market has delivered a 6.42% rate of return since 1900. They really help during drawdowns. From 1929-32, the total bond market provided a 24% return. During the global financial crisis, the bond market gained 11%.

Of course, that’s the total bond market. Long term US treasuries really shine in drawdowns. In 2008, while every other asset class felt like Britney Spears circa 2007, Vanguard’s long term treasury fund (VUSTX) gained 22%. This occurs because, during a meltdown, investors flock to buy US treasury bonds for safety and the Fed is typically pushing up bond prices to drive down interest rates.

International Developed Equities: Swensen recommends diversifying outside of the United States in developed international equities. Developed meaning that they are no longer growing rapidly and are in a similar position of economic development to the United States. Think of Western Europe & Japan. Since 1976, this asset class delivered a 9.04% rate of return. Like the US market, they are subject to horrific drawdowns.

Emerging Markets Equities: Emerging markets are economies that have recently entered a level of industrial level of development from an agricultural subsistence economy. The ultimate example in recent years is China. Since 1976, emerging markets have delivered a 9.04% rate of return.

Like international developed, they are not entirely correlated with US equities. From 2000 to 2010, a period of time when US equities lost money, they delivered a 10.61% rate of return. Since 2008, they have only achieved a 1.56% rate of return. For this reason, they fit nicely into a portfolio. Historically, they tend to offer high returns when US equities are not performing well.

Much of this has to do with valuations at the start of the decade. US equities were merely much cheaper than emerging markets or developed markets in 2010. Conversely, US equities were ridiculously more expensive than the rest of the world in 2000, which is why they sucked for the decade of the 2000s. The nice thing is that all of the world economies don’t usually enter bubble territory at once.

REITs: REITs, or real estate investment trusts, are companies that own a broad portfolio of income-producing real estate assets. Since 1970, REITs have delivered a 10.99% rate of return. This is another asset class not wholly correlated with US equities that can provide a decent return. Real estate also tends to increase with inflation, which is why Swensen believes REITs deserve a place in a portfolio for their inflation protection.

In particular, they held up well during the tech meltdown. From 2000 through 2002, REITs delivered a 13.78% rate of return while US equities were cut in half. Their worst moment was during the housing crisis when they declined as an asset class by 47%.

REITs also shined during the 1970s inflation, which led to an abysmal return for US equity investors. During the 1970s, REITs delivered an 11.32% rate of return.

swensen

The Building Blocks

According to Swensen, the “core asset classes” are the critical building blocks of a portfolio. They will rarely all work at once. An investor will be diversified across asset classes, and the different asset classes will all work their magic at different times.

The bonds exist as protection during stock drawdowns. TIPs have the added benefit of protecting an investor during inflationary periods. Longer termed treasuries will protect the investor during panics or truly horrific deflationary episodes, like 1929-32.

Meanwhile, the rest of the portfolio is divided up into asset classes that should deliver a very high rate of return. The nice thing about the asset classes that Swensen selected is that they don’t all perform well at the same time.

When stocks absolutely sucked during the 2000s and barely beat inflation, REITs and international equities still performed very well. During the 2010s, US stocks did great while international stocks sucked. If we have a repeat of the 1970s, stocks will probably be crushed, but REITs and TIPs will pick up the slack. Ideally, the approach should help an investor avoid “lost decades” like US stocks not delivering any return in the 2000s. You’ll always hate something in your portfolio, but you’ll also probably have something to love in your portfolio.

Most importantly, you can buy all of these asset classes directly through low-cost mutual fund and ETF vehicles. You’re not doing anything fancy with options or hedging. You don’t need to pay excessive fees to someone to do this for you. All of these asset classes are available in most 401(k) lineups, as well.

An added advantage is that these can all be easily managed. A small investor can do this themselves without any help.

DIY Asset Allocation

Swensen recommends that an investor hold no more than 30% of an asset class in their portfolio. This allows the diversification to work. It prevents one asset class from dominating the portfolio. Swensen’s specific recommendations are as follows:

US Stocks – 30%

Foreign Developed Stocks – 15%

Emerging Markets Stocks – 5%

REITs – 20%

US Treasury Bonds – 15%

US Treasury Inflation Protection Securities – 15%

Here is how you can construct this portfolio using simple, low-cost Vanguard ETF’s. You could also do this with mutual funds. My preference is for ETF’s because they maximize your tax benefit. The simplicity is key here: you could rebalance this once a year in your underwear. Investing is one area of life where it actually pays to be a little lazy and not meddle too much.

US Stocks – The Vanguard ETF for US stocks is VTI.  The mutual fund equivalent is VTSAX. Many of the FIRE bloggers recommend putting 100% of your net worth into one of these. Personally, I think that’s fine if you have a long time horizon. However, if you’re already retired, you probably don’t want to be in an asset class that could potentially do nothing for 10+ years and would benefit from diversifying into more asset classes. The expense ratio is a dirt cheap .04%.

International Developed – The Vanguard international developed ETF is VEA. The expense ratio is .07%.

Emerging Markets – The Vanguard emerging markets ETF is VWO. The expense ratio is .14%.

Side note: Alternatively, you could replace the three equity ETF’s above with one ETF – Vanguard Total World Stock Index, VT. This is a market cap weighted index of all stocks in the entire world for an expense ratio of .1%. Currently, the portfolio is 60% in US stocks, 10% emerging markets, and 30% international developed. If this ETF is 50% of your portfolio – you will get right to Swensen’s recommended allocations. 30% of your portfolio will be in US stocks, 15% will be in international developed, and 5% will be in emerging markets. Of course, these allocations won’t remain static and will fluctuate based on the performance of countries within the global portfolio, but it seems like a much easier way to simplify a Swensen portfolio with one equity ETF instead of three.

REITs – The Vanguard real estate ETF is VNQ. The expense ratio is .12%.

TIPs – The Vanguard TIPs fund is VTIP. The expense ratio is .06%.

Treasuries – Swensen doesn’t specifically recommend long-duration treasuries in the book. My preference for long-term treasuries is merely because they will do the best when the markets fall apart, which is the whole reason they’re in a portfolio. Vanguard doesn’t have an ETF for long duration treasuries, but they do have a mutual fund, VUSTX. The expense ratio is .2% on the investor shares. iShares has an ETF for long duration Treasuries, TLT. The expense ratio on that is .15%. If you want to follow Swensen’s advice and own treasuries of all durations, there is also an iShares product called GOVT.

Backtesting Swensen

How have Swensen’s allocations performed over time?

Since 1985, when the data is available for his recommended mix of asset classes (the TIPs returns are made up from 1985 through 1997 based on inflation rates), the Swensen portfolio has returned 9.77%. After inflation, 6.99%. $10,000 invested in the Swensen allocation in 1985 would be worth $238,007.

The worst year for the portfolio was 2008, in which it lost 26.58%. The total US stock market lost 37% during that period, and REITs were cut in half, while a 60/40 portfolio lost 20%. Before the global financial crisis, the worst year for the Swensen portfolio was a loss of only 6.92%. This occurred during the early 2000s meltdown when US-only equity investors saw their portfolio cut in half.

The portfolio really shined during the 2000s, when US stocks did nothing. The portfolio achieved a return of 6.88% from 2000 to 2010, or 4.34% after inflation.

TIPs didn’t exist in the 1970s, but substituting Swensen’s bond allocation for intermediate-term treasuries, the Swensen portfolio would have delivered an 8.26% rate of return and a small return of .41% over inflation. This is during a period where double-digit inflation led to losses across nearly every asset class. Moreover, the Swensen portfolio did this when bonds were crushed due to rising interest rates. The fact that it kept up with inflation at all is impressive. If TIPs existed back then, I would guess that the portfolio would have done even better.

Since the book was published in 2005, the portfolio has continued to do well. It has returned 6.68% or 4.56% after inflation.

Other Considerations

Taxes – Avoiding taxes is a significant consideration for most. The bond and REIT allocations will generate most of their return via dividends, not capital appreciation. If you hold them in a taxable account, you will have to pay taxes on the payments every year. To avoid this, you might want to consider carrying them in a non-taxable account like an IRA or 401(k).

Other asset allocations – Swensen’s allocations aren’t the holy grail of passive investing. There are other alternatives. Meb Faber and Eric Richardson cover a lot of interesting allocations in The Ivy Portfolio. Meb even has an ETF that covers his recommended asset allocation, which he dubs the global asset allocation, GAA. Another great book on the subject is DIY Financial Advisor from the great people at Alpha Architect.

Tweaking it – If you’re like me, you like to test and tweak things yourself. For instance, my preference is to gear my passive equity allocations towards value. US small cap value is the best performing asset class of all time. Since 1927, small-cap value has delivered a 10.93% rate of return. Why not gear more of my portfolio towards that? Or, you might want to set aside some of your portfolio to buy a portfolio of value stocks, like I did. If that’s not your bag, maybe you want to try trend following and momentum, even though I think that’s hocus pocus and nonsense.

There are some great resources available to experiment with your own allocation. One great resource is Portfolio Charts, a helpful visual resource where you can analyze different asset allocations from the Vanguard Three-Fund Portfolio to the classic 60-40, and it includes an analysis of the Swensen allocation. The author also maintains an excellent blog discussing asset allocation.

If you want to get deeper than that and experiment with more asset allocations, there is this resource at the Bogleheads forum. This is what I used to generate the return data listed through the blog post. You can experiment in that Excel spreadsheet with all different kinds of allocations.

Conclusion

There is no holy grail to investing. If you’re looking for a simple, low cost, easy to implement portfolio that doesn’t require a lot of work – the Swensen portfolio is a great place to go. Odds are, you’ll avoid “lost decades” and will preserve your capital over a long period.

As I stated before, 100% US equities might work for the FIRE bloggers, but I really think more of them should consider a more diversified asset allocation. They can’t afford lost decades, after all.

If you’re crazy like me, you also like picking your own stocks or pursuing a pure quant based approach like the Magic Formula or Acquier’s Multiple. Personally, I explicitly set aside this account that I track on the blog to buy and sell shares. My 401(k) and taxable account are in more of a diversified asset allocation like Swensen’s. My equity allocations are (obviously) geared towards value.

The bottom line is that you have to find what works for you. Good luck on your journey.

Random

This wouldn’t be one of my blog posts if I didn’t throw in something completely random. This is pretty funny.

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.

Are bonds for losers?

stocksbonds

Returns for US Stocks and US Bonds since 1900 in real and nominal terms

No Pain, No Gain. Deal With It.

My attitude about bonds has evolved over the years.

Years ago, I had a pretty simple attitude about them: paraphrasing our President, bonds are for losers. The returns tell the story. Stocks massively outperform bonds over the long run (and cheap stocks outperform everything).

(They’re for losers unless they are bearer bonds. As I learned from Die Hard, Heat, and Beverly Hills Cop, bearer bonds are insanely cool. It’s too bad that the government discontinued these relics of a more heist-friendly time.)

Bonds historically have poor returns and sometimes struggle to keep up with inflation. Stocks traditionally have fantastic performances but have horrific drawdowns. Stocks were cut in half in 2008. They fell by 80% during the Depression. My attitude has always been that if you can’t handle the volatility, then you just need a stronger stomach. No pain, no gain. Toughen up.

With that said, a gung-ho attitude about stocks is easy when you are in your 20’s or 30’s. It was a natural thing for me to get bullish in 2009 after the market crashed. I went “all in” that year in my 401(k) into stocks with the tiny $4,000 I had saved up at the time. Being reckless at the beginning of your working career with a small amount of savings is easy. Try it when you are 65 and have your entire life savings to deal with.

My callous attitude towards “pain” was ignorant. “No pain, no gain” is an attitude you can’t afford to have if you are older and are dealing with a lifetime of savings. You don’t have a lot of high earning years ahead of you, and you might need this money to survive.

Age

My instinct with my own money is to swing for the fences and go for the high returns. No pain, no gain.

Older people can’t have this attitude. They can’t afford a “lost decade” of stock returns. They couldn’t afford to lose half of their money tomorrow. They can’t double down and get a second job if their investments fell apart. For retired people, money needs to last. Mine has to be worth a lot in 40 years. These are completely different objectives.

My parents asked me to recommend as good retirement fund. After thinking about it, I decided that the best option was the “Vanguard Target Retirement Income Fund” (VTINX). It is a fund which Vanguard designed for people in my parent’s situation, who are already retired. It is 70% bonds, 30% stocks and mixed geographically. Fees are only .14%.

The fund isn’t going to provide a high rate of return, but it ought to preserve their capital if they have an emergency and need it. It’s automatically rebalanced so they don’t have to think about it.

In terms of the worst case scenario, I looked at the 2008 drawdown, and it was only 10.93%. That’s tough, but not fatal.

What about interest rates? What about the bond bubble?

Everyone you talk to in the financial world “knows” that interest rates are going up. “They’re as low as they’re ever going to be” is the popular refrain. It certainly makes sense to me. I was born in 1982, and interest rates have declined for my entire lifetime. Eventually, it has to turn around and go back to “normal”, right?

It makes sense that the final straw would be successive rounds of quantitative easing, which will cause inflation, which will ultimately spur higher interest rates.

The more I thought about it, the more it worried me when I thought about my parent’s high allocation to bonds. When interest rates rise, bond prices decline. That’s Finance 101. Did I steer them in the wrong direction? What if interest rates spike and their savings are in jeopardy?

I decided to look at the historical data concerning bond returns, particularly in rising interest rate environments. The period I chose to focus in on was the Great Inflation of the 1960s and 1970s.

The Great Inflation (1960 – 1982)

prime rate

The prime rate from 1950 to today

There was no period for rising interest rates like the Great Inflation of the 1960s and 1970s. Having learned their lessons from the deflationary 1930s a little too well (the Fed didn’t act enough in the 1930s, which turned a panic into a prolonged hellish period of declining prices and high unemployment), the Fed played it fast and loose with monetary policy in the ’60s and ’70s.

The US government also began to play it fast and loose with fiscal policy, which was difficult to manage with the dollar tied to gold.

 

 

The “Nixon Shock”: The end of the gold standard

Paying for the Vietnam War and the Great Society was an expensive endeavor with the dollar tied to gold. Nixon’s solution was to abandon the Bretton Woods gold standard and end the dollar’s link to gold so we would have full autonomy to spend what we wanted.

The “Nixon Shock” kicked an escalating inflation situation into overdrive, with inflation reaching the double digits by the end of the 1970s. The OPEC embargo didn’t help. Economic stagnation combined with high inflation was “stagflation,” and it contributed to widespread fears that the United States had lost its mojo.

By 1979, 84% of the American people polled said they were “very dissatisfied” with the direction of the country. The malaise, as they called it, ran deep.

Paul Volcker, the Fed chairman at the time, knew that this had to stop. He took extraordinary measures to stop inflation, pushing interest rates to historic highs. By 1981, he had driven the prime rate to 20%. The high-interest rates caused a genuinely horrific recession. The recession of the early 1980s was slightly worse than the Great Recession of recent memory. Unemployment peaked at 10.8% in 1982. In comparison, it peaked at 10% in 2009.

Ronald Reagan, to his credit, stuck by Volcker’s tough medicine even though it was not in his political interest. Reagan’s poll numbers dropped into the 30s. A lesser President would have fired Volcker or publicly criticized his actions. Reagan did no such thing. He knew that inflation had to be contained and knew it was in the long-term interests of the country to beat it.

The tough medicine worked. Inflation was defeated. As inflation eased, we were able to reduce interest rates for nearly 40 years. The bond bull market has benefitted almost every U.S. asset class for the last few decades. We have been reaping the benefits of Paul Volcker and Ronald Reagan’s tough medicine for decades.

So how did bonds do during the Great Inflation?

I digress. The question I wanted to answer was how bonds held up during the Great Inflation of the 1960s and 1970s, which is the worst case scenario for interest rates rising. From 1960 to 1981, the prime rate rose from 4.5% to 20%. My instincts told me that bonds must have been completely crushed during this time period.

They weren’t crushed. However, in inflation-adjusted returns, they barely kept up. In nominal terms, they performed surprisingly well. There was only one down year (1969) in which the bond market experienced a 1.35% decline.

bond returns

While the real returns were terrible, they certainly fared better than cash or a savings account during the highest period of inflation in US history (inflation was advancing at a 10% pace, if you can imagine that).

With all of that said, in a diversified portfolio for a risk-averse investor like my parents, they served their purpose. They provided nominal returns and controlled for the drawdowns of the stock market.

Taking it back a little further, I looked at the returns of my parent’s 70/30 Vanguard fund and broke it out by decade. This asset allocation provided a suitable buffer for the volatility in the stock market. The decades where it performed poorly were solely due to inflation. Even though they struggled to keep up with inflation, the portfolio still held up better in those decades (the 1910s, 1940s, and 1970s) than cash in a savings account would have. The next decades (the 1920s, 1950s, and 1980s), as interest rates eased, the portfolio performed extraordinarily well.

conservative portfolio

Additionally, the portfolio also protected investors during extreme market events, which is the key purpose of a bond allocation. During the Depression and the drawdown of 1929-33 (when the market declined by nearly 80%), this allocation held up well, losing only 15.88%. During the crash of 2008, the drawdown was only 7.57%. It’s also worth noting that the portfolio delivered positive returns in the 2000s, which was a “lost decade” for American stocks.

That’s what bonds are all about: in a balanced portfolio, they are for an investor who can’t take a lot of pain. They are a pain buffer. They limit the drawdowns when stocks periodically fall apart and they deliver a low return that exceeds cash in a mattress or the bank.

Bonds aren’t for losers. Bonds are for people who can’t afford short-term massive, painful, losses. They can’t look at a stock market crash and just take a philosophical approach and say “well, 10 years from now I’ll be okay.”

Yes, bonds aren’t nearly as good as stocks over the long run. Yes, they won’t do well during an inflationary period when interest rates are rising.

They’re not supposed to do those things. Bonds help risk-averse people stay the course with the equity piece of their portfolio, which will provide the real capital appreciation and long-term returns. I was wrong for scoffing at bonds as a piece of a balanced portfolio and delving into the issue made me more confident with the advice I gave my parents.

Interest rates & inflation: no one knows

Looking at the history of inflation & interest rates and taking a historical perspective towards it also gave me the sense that no one really knows where either is headed.

The confident predictions that interest rates will rise are based on the perception that interest rates aren’t “normal”, simply because they look low in the context of the last 30 years.

From a broader perspective, the last 30 years have been an unwinding of the historically unprecedented interest rates of the 1970s. Interest rates might just be around normal levels now.

You constantly hear confident forecasts from “experts”. None of them really know any more about the future than we do. They are making educated guesses, just like you and me. Just because they have an impressive title and credentials doesn’t mean they know the future.

No one really knows what the future will bring and it is wrong to steer investors away from bonds simply because we “know” interest rates are going up. At the end of the day, no one really knows anything when it comes to predicting the future.

I don’t know if the next decades will be anything like the 1960s or 1970s, but even if that’s the case, the money that my parents invested in VTINX ought to hold up, which is what I and they care about. The bond allocation ought to perform better than cash and it ought to protect them if the stock market crashes.

Again, no one knows what the future will bring. You just have to make decisions that are appropriate for your risk tolerance, not anyone else’s.

Random

  • I’ve been reading “Brat Pack America: A Love Letter to ’80s Teen Movies“. It’s a fun book delving into the history of 1980’s teen movies, which are some of my favorite guilty pleasures. It’s making me appreciate them on an even deeper level. John Hughes was the first director to make movies in which teenagers were treated like actual human beings instead of a vehicle for the nostalgia of older people. When you see them through this context, they’re pretty amazing. I don’t think modern movies treat teenagers with the same level of respect that John Hughes did. They’re unique in this sense, which is probably why they have stood the test of time and are still popular.
  • Speaking of John Hughes . . . “Oh, you know him?”

 

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.

“The Big Secret for the Small Investor”, by Joel Greenblatt

I recently completed The Big Secret for the Small Investor by Joel Greenblatt. I’ve read all of Joel Greenblatt’s books and this is his easiest strategy to implement for the average investor. What’s the big secret and who is Joel Greenblatt?

Who is Joel Greenblatt?

Joel Greenblatt, as I’ve discussed before on this blog, is one of the greatest investors of all time. In terms of investing prowess, Joel delivered 50% returns from 1985 to 1995, at which point he returned all outside capital to his investors and focused on managing his own money with his parter, Robert Goldstein. What do 50% returns look like?  $1 was turned into $51.97 over the 10 year period.performancejoel

Source: You Can be a Stock Market Genius, by Joel Greenblatt

Joel Greenblatt’s Previous Books

In addition to achieving stellar returns, Joel has done small investors numerous favors by outlining the strategies that he uses to make money in his books. Most investors like Joel are highly secretive with their strategies, but Joel has been generous enough to share the strategies that he uses, at least on a very high level. His first two books briefly summarized below:

  1. You Can Be a Stock Market Genius – Written in 1997, this book provides a nice road-map to places in the market that the average investor can investigate to find bargains. They are areas where the large professionals won’t tread due to size, complexity and opportunity cost. This is the approach that Greenblatt used to achieve the 50% returns from 1985 to 1995 described above. Joel encourages readers to look into these areas of the market where the professionals fear to tread. He encourages finding things that are off the beaten path and doing your homework. Areas covered include: spin-offs, recapitalizations, rights offerings, risk arbitrage, merger securities, bankruptcies, restructurings, LEAPs, warrants and options. This is by far the most informative of Joel’s books, but it is also the most difficult to implement. It is geared towards investors who already have a familiarity with the markets and want a road-map to the roads less traveled. At some point, I will review this book in depth on this blog.
  2. The Little Book That Beats the Market – This was written in 2005. Realizing that his original book was at too high of a difficulty level for the average investor, Joel formulated a more simple approach in this book. The little book outlines the magic formula strategy of investing. The magic formula ranks all companies in the market by cheapness (defined as EBIT/Enterprise Value) and then ranks all the companies by quality, or return on invested capital. The rankings are then combined into a list of companies that are both cheap and have high returns on capital. Joel recommends that readers buy 20-30 magic formula stocks annually and then sell after a year unless the stock is still on the list. The book was written so he could explain investing to his kids. As a result, it distills the concepts of value investing in a manner that is very readable. I find it incredible that Joel shared this research with the public. He even generously maintains a free screener at https://www.magicformulainvesting.com/

Why Write the Big Secret?

The Little Book was a best seller and the magic formula was sensational. The magic formula continued to beat the market after the book was written. If Joel outlined a winning strategy that could be easily implemented by small investors and provided them with the tools for doing so, what was the point of another book? The problem wasn’t the magic formula. The problem was human investors.

While the magic formula continued to work after Joel wrote the book, investors implementing the formula failed to achieve the results. During the two-year period studied by Greenblatt, the S&P 500 was up 62%. The magic formula beat the market during this period, earning 84%. However, actual investors choosing from the list of magic formula stocks only earned 59.4%.

In other words, investors took a winning strategy and systematically ruined it. This is likely because they avoided the scariest stocks on the list and went with the ones that had the best story.

If most investors can’t successfully implement the magic formula, should they simply passively index?

Indexing

Index investing works over long periods of time because over the decades the economy will grow, inflation will increase and the combination of economic growth and inflation will translate into higher corporate profits, which will translate into higher stock prices. Index funds are also extremely low cost.

Warren Buffett is in the final stages of a high profile bet with Ted Seides about indexing. In 2008, Buffett bet Ted $1 million (with the proceeds going to charity) that index funds would beat a group of hedge fund investment vehicles (fund-of-funds) hand picked by Ted. It looks like Buffett will handily win the bet. In Berkshire’s most recent letter, Buffett explains why he won. To sum it up: a lot of managers try to beat the market, and mathematically some will beat it and most won’t. The indexes reflect average performance, and mathematically a majority of managers can’t do better than average. Because hedge funds charge such high fees (typically 2% of assets under management and 20% of the profits), it will be nearly impossible for a group of them to beat the market.

Ted Seides tried to explain the reasons for his loss in this Bloomberg article. Reasons cited include: most investors didn’t stick with the index, there are many nuances to the returns of hedge funds, they provide protection during bear markets, etc. To save you the time from reading through the litany of excuses, I’ll leave you with this Upton Sinclair quote:

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

What is The Big Secret?

The Big Secret that Joel unveils in this book is simple: index investing works, but it is flawed and there are better passive strategies that can help investors do even better than indexing.

Indexing will deliver returns over the long run and will beat most active managers. I index myself in my 401(k). The portfolio I track here is my IRA that I have specifically dedicated to a concentrated hand picked value strategy.

However, Joel argues in The Big Secret that even though indexes deliver decent returns over long (i.e., 10-40 year) stretches of time, they are fundamentally flawed. The flaw as Greenblatt sees it is the fact that they are market cap weighted. The allocation of a stock in an index fund corresponds to the total market cap of the stock in relation to other companies in the index. In other words, stocks in an index fund are all weighted to the current relative valuations of the companies that make up an index. In other words, when a stock goes up in an index, the index buys more of it. If a stock goes down, it is weighted less heavily in the index. From a value perspective, this is the wrong approach.

This also explains the momentum that we see in the late stages of a bull market. As the indexes have a nice run, money pours into index funds. Money then flows to the largest components of the index, inflating their valuations even more. You see this happening today and you saw the same thing in the late 1990s. The irony is that the more we embrace indexing to capture average performance, then the less efficient the markets become. This isn’t a bad thing. It is an opportunity.

The opposite of this occurred in 2008. All stocks declined regardless of the prospects for the company. This was because money was pulled from stock funds with no rhyme or reason, causing all stocks to decline.

These trends go on until they can’t. Eventually the market recognizes the true value of companies. In the short run, massive money flows into and out of index funds can cause inefficiencies. As Benjamin Graham taught us, in the short run the market is a voting machine. In the long run, it is a weighing machine.

Seth Klarman discussed this phenomenon in his recent investor letter:

“One of the perverse effects of increased indexing and E.T.F. activity is that it will tend to ‘lock in’ today’s relative valuations between securities.

When money flows into an index fund or index-related ETF, the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership).

Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings.”

Passive Alternatives to Indexing

If the Stock Market Genius approach is too hard for most, if most investors struggle with the Magic Formula approach due to behavioral errors and passive indexing systematically does the wrong thing — then what can the small investor do?

Due to these issues, in The Big Secret Joel recommends a few passive choices that investors can implement. The passive aspect is key, as all of these approaches avoid buying and selling individual stocks and don’t require any homework.

The passive choices Joel recommends as alternatives to indexing are:

  1. Equally weighted index funds. While most index funds are market-cap weighted, equally weighted funds are exactly as they sound. They buy every stock in the index, but equally weight them. This prevents the fund for systematically buying more of a “hot” stock that is likely overvalued. An example of this kind of fund is the Guggenheim Equal Weight ETF (RSP). In the last 10 years, the S&P 500 returned 58.75%. Over the same period, the Guggenheim equal weight S&P 500 ETF is up 77.11%.
  2. Fundamentally weighted index funds. A fundamental index weights stocks not on market capitalization, but on the size of their business. This can be measured by revenues or earnings. This makes sense, because the size of an enterprise is a better determinant of its true value than simple market cap. It also helps investors avoid the hot stocks of the moment with high market caps while simultaneously having low sales or earnings (like Tesla, for instance). An example of this kind of fund is the Revenue Shares Large Cap ETF (RWL), which weights stocks in the fund based on their revenues instead of market cap. This fund returned 85.12% over the last 10 years, compared to 58.75% for the S&P 500.
  3. Value weighted index funds. Value funds are exactly as they sound: they concentrate the fund’s holdings into the cheapest stocks in the market based on metrics like price-to-book and price-to-earnings. While over the long run these strategies have been proven to work, in the last 10 years they’ve had a tough time. The Vanguard Value ETF (VTV) is up on 30.63% in the last 10 years compared to 58.75% for the S&P 500. Much of the underperformance is attributable to concentration in bank stocks during the financial crisis (they appeared to have low price to book values, but the book value turned out to be fiction) along with lagging the momentum of the market in the last few years. This isn’t the first time that value lagged the S&P. The last time that value strategies experienced this kind of under-performance was in the 1990s. Value went on to perform extremely well in the 2000s, while the indexes lagged due to the high market cap weightings in the technology sector early in the decade. I think history will likely repeat. Another great example of a value oriented ETF is the quantitative value ETF. QVAL implements the strategy outlined by Tobias Carisle and Wesley Grey in their book Quantitative Value. They use quantitative approaches to find value bargains (using the enterprise multiple as the value metric) and then further trim down the list to eliminate potential financial fraud, avoiding stocks with excessive short selling, for instance, and use a variety of quantitative criteria to find quality bargain stocks. QVAL launched in 2014, so it doesn’t have a long enough track record to compare it with the S&P 500, but it is worth your consideration. I would check out the book if you want to learn more.

Conclusions

Joel did small investors a great service by writing this book. I suspect that the passive strategies outlined will outperform indexes over the long run. They are much easier to implement than the magic formula or the homework intensive You Can Be a Stock Market Genius style of investing. Simply buy the funds and leave it alone.

I prefer my own strategy of individual stock selection, but I realize that this is not implementable for most investors. While I think it’s fun, it is a lot of work and most people don’t find it to be all that enjoyable.

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.

Don’t Try This At Home! DIY investing is not for everyone.

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I post a disclaimer on every post that this site is not financial advice and I don’t recommend people simply copy my strategy. Buying individual stocks carries significant risk that most people aren’t cognizant off. 90% of investors have no business buying individual stocks. I often tell people that if they can’t withstand a 50% loss of the amount invested, then they have no business investing in stocks. 50% losses (or worse) are going to occur roughly once a decade and most people behaviorally can’t handle them. With that said, many people wonder if they should try buying individual stocks for themselves.  My advice would be: for most people, absolutely not.

But . . . if you are insistent on buying individual stocks, I recommend that you first get your financial house in order and make sure that you have sound investing knowledge.  There are some great personal financial blogs out there chronicling how to pull this off.  Mr. Money Mustache is one of my favorites.  Dave Ramsey gives great advice as well.

So, before you open a brokerage account and start buying individual stocks, I would say that the below items should be taken care of first:

  1. Get out of debt.  Seriously, if you have debt, especially high interest rate credit card debt, your #1 priority in life right now should be getting out of it.  You should treat it as if you are on fire and need to stop, drop and roll.  Compound interest is a mesmerizing thing when it works in your favor as it does for stock investors.  For credit card debtors, compound interest can ruin your life.  As someone who made a number of stupid financial decisions in my 20’s, I speak from experience.  The same goes for other kinds of debt: student loans, car payments, etc.  Get that stuff paid off before you start even thinking of messing around with buying individual stocks.  Start coupon clipping.  Start cutting your expenses.  Get a side hustle.  Whatever you need to do, do it!  Get out of debt as soon as possible!  Life isn’t meant to be lived in chains.
  2. Set up an emergency fund.  Stock market investing only works over long stretches of time.  In other words, you have to lock the money up for years before you even think of using it.  If you’re constantly withdrawing money from your brokerage account, then compound interest will never have a chance to work its magic.  To be prepared for life’s hiccups and keep you from dipping into your brokerage account, you need to have a savings account covering at least 6 months worth of expenses set aside.  Be prepared for life’s unexpected emergencies, otherwise you’re going to dip into your investments and no strategy will work.
  3. Buy a house.  Rent is throwing your money away.  For what you’re throwing away in rent, you could have a mortgage.  With a mortgage, you build equity in a home and get tax deductions for the interest you pay.  Homes really are a great investment over long stretches of time.  Don’t buy dumb, ridiculously expensive homes that you can’t afford and don’t need.  Don’t try to keep up with the Joneses.  Do find a house with a mortgage payment that you can easily afford and is beneath your means.
  4. Invest in mutual/index funds.  You should have money already invested in the stock market via your company 401(k) or set up in mutual funds.  Vanguard has some great options. The IRA account I am tracking on this blog does not constitute my full net worth or investments. I invest in index funds and any stock investor should devote some of their equity investments to this approach.
  5. Read and learn about investing.  An entire section of this website is devoted to books about value investing.  You should read them all before you decide to buy an individual stock.  If you refuse my advice and only read one book about investing, then my choice would be The Intelligent Investor in its entirety before you even think about opening a brokerage account.
  6. Develop your own philosophy about investing.  Value investing isn’t for you?  That’s fine!  However, pick a philosophy.  You must have  an intellectual foundation.  One of the worst mistake that investors make is shifting between philosophies of investing and chasing recent returns with no real commitment to one philosophy over another.  This is a mistake because all styles go in and out of vogue at different times.  After one style has a nice run, that’s probably the worst time to pile in.  The key to winning in the market is finding a style that makes sense to you and sticking with it.  Consistency is key.  You’re not going to be able to stick with it unless you believe in it and it makes logical sense to you.  There will be times when you are losing money and you will want to throw in the towel.  You’ll be less likely to throw in the towel if you can look at your portfolio and remember why you made your decisions.  If you believe in your philosophy, you can weather the storm.  The mind is the true source of investment gains and folly.  Figure out a philosophy that you can believe in and stay committed to it when times get tough.

A good example of consistency being critical is Peter Lynch’s Magellan Fund.  Peter Lynch is one of the greatest money managers of all time.  From 1977 to 1990, he achieved an astounding 29% rate of return for his investors.  However, most investors lost money because they piled into the fund when it was hot and sold when it was cold.  They had no patience and the lack of patience made them lose money even though they were in one of the greatest performing mutual funds of all time.

With that said, once your financial house is in order and you have a sound knowledge and philosophy about investing, then you can feel free to roll up your sleeves and attempt do-it-yourself investing in individual stocks.

Should you do what I’m doing?  No.  

Do your own homework and choose a style that you are comfortable with. Don’t just buy something because someone else is buying it. Think independently.

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.