Category Archives: Personal Finance

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.

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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:

vsg

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.

slip-up-danger-careless-slippery

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.