Introduction
This book describes an approach to investing that I developed for myself, and I thought it might be useful for others. It may not be for everyone. All investors have different risk tolerances and core beliefs. People are unique. This approach isn’t for everyone.
The portfolio utilizes six low-fee ETFs to create an investment regime designed to deliver a satisfactory rate of return in multiple economic environments. Like the title says: this portfolio is designed to avoid financial bubbles, limit losses during recessions/depressions, and safely grow wealth over a long period.
Each ETF represents an asset class. On their own, all of the asset classes are highly volatile. When lumped together in a portfolio, volatility is reduced, and the portfolio still earns high returns. Because the asset classes all deliver returns during different environments, volatility is reduced, and the portfolio delivers a consistent result.
I’ll cut to the chase: these assets, when lumped together in a portfolio, deliver a return similar to owning 100% US stocks but with significantly less volatility and more shallow drawdowns. Most importantly: all of these asset classes are available to everyday investors in cheap and tax efficient ETF vehicles. You can jump right to the back-testing data at the end of the book to see these results.
Who I Am & Why I Wrote This Book
“The only true wisdom is knowing that you know nothing.” — Socrates
I’m not Warren Buffett. I’m not Stanley Druckenmiller. I am not a sage of investing. I’m just an anonymous financial blogger and a corporate drone who tries my best to figure out what’s happening in the crazy world of finance. In more practical terms, I’m trying to deploy my savings. My savings isn’t much in the grand scheme of things, but I take growing and protecting my savings very seriously.
I have been fascinated with investing since my teen years during the internet bubble in the late 90s. I’ve been trying to figure this out for a long time, and I still struggle to do it. Back in 2016, I started a blog where I tracked the actual performance of one of my brokerage accounts. In this brokerage account, I express my opinions about individual companies and the economic environment. My track record leaves a lot to be desired at the moment.
I often pick the wrong stocks, and I’m often wrong about the future. I put a lot of emotional effort into managing this account. The fruits of my efforts have mostly been the loss of hair. I am a stubborn guy, so I keep trying and plugging away. I find the game fun, and it challenges me mentally. I enjoy it. Other people might choose a fantasy football team; I try to figure out the economy and which stocks will perform the best.
With that said, my results made me realize that I should develop an approach for most of my money that doesn’t try to predict the future because I get it wrong so often. I also wanted something much less stressful than owning 100% stocks. After all, the stock market has maddening levels of volatility and terrifying drawdowns.
Personal Finance
The focus of this book is on investing, not personal finance. This book outlines an approach to investing that works for me. Of course, an investment strategy is meaningless unless a person actually has savings to deploy. The reality is that investing is only a small portion of the battle. Saving money in the first place is the critical step in the process of building wealth. The importance of investing pales in comparison to the importance of personal finance. It took me a long time and some horrible experiences to realize this truth, but it is indeed the truth.
The core issue in personal finance is consistently spending less than you make. If someone consistently spends more money than they make, they are going to accumulate debt. Debt has the damaging effect of making compound interest work against you. When compound interest is working in your favor, it snowballs over time and builds wealth. When compound interest works against you, it slowly ruins your life.
It’s hard to find an investing strategy that can achieve a 7% rate of return after inflation over the long run. Meanwhile, the average credit card interest rate is 18%. It is virtually impossible to find an investment strategy that will yield 18% over a long period, so someone paying this type of interest regularly is in a terrible situation. Bill Burr once remarked that the mafia became irrelevant because their businesses became legal. He’s right. 18% is the kind of interest rate that mafia loan sharks used to charge degenerate gamblers in the 1950’s. Now, banks can do it legally thanks to the repeal of usury laws.
Also missing from the discussion is an approach to happiness in general. When I was young, I used to think that wealth was about luxury and extravagant spending. Many rich people feel the same way, but none of that luxury brings them any happiness. Once a person meets an income that helps them achieve their basic needs, additional income doesn’t bring them any satisfaction. A good exercise to figure out what’s really important in life is to make a list of all of the things in life that bring you joy. I’m willing to guess that most of these things are free.
The goal, as I see it, isn’t to buy more stuff or increase prestige. The goal is to have enough money and a cheap enough lifestyle that you can do whatever you want. You want to own your time and energy. Money isn’t about stuff — it’s about freedom. I came to this truth through personal experience.
The Unknowable Future
When most people think about investing, they think in terms of “beating” the stock market. There are two basic ways to attempt to beat the stock market: 1) Pick the asset classes that will perform best. Stocks or bonds? US Stocks or international stocks? 2) Pick the individual stocks that will outperform.
Both of these things are an attempt to predict what will happen in the future. In the absence of a Flux Capacitor and 1.21 gigawatts of electricity, this is a difficult feat to accomplish. Warren Buffett has focused on strategy #2. Buffett does this by finding stocks that are cheap relative to their fundamentals. He then tries to make a reasonable prediction about the future. He likes companies that have a “moat” to defend themselves from the competition while simultaneously earning large profit margins.
Why not duplicate Buffett’s or Dalio’s methods? The problem is, few investors succeed in picking stocks or choosing the right asset classes. There are plenty of people who have consumed Warren Buffett’s letters, but few that have been able to replicate his returns. Dalio has written much about his approach, but there are few investors who have been able to pivot to the right asset classes at the right times.
If great investors like Warren Buffett and Ray Dalio make mistakes and everyone (including experts) are terrible at predicting the future, then what are the odds that you and I are going to get things right? The simple conclusion is that the future is almost entirely unknowable.
For this reason, I set out to design a portfolio that keeps prediction to a minimum. My goal was to create a portfolio with different asset classes that would perform well in different economic environments without attempting to predict which economic environments will arrive. I wanted to design a portfolio that would be able to handle all of these outcomes. I wanted a portfolio that could survive anything that the world could throw at it. For this reason, I set out to design a portfolio that keeps prediction to a minimum. My goal was to create a portfolio with different asset classes that would perform well in different economic environments without attempting to predict which economic environments will arrive.
The Trouble With Index Funds
It should be noted that when I refer to ‘index funds’ in this section that I am referring to a very specific kind of index fund: 100% US market cap weighted stocks. The portfolio I outline later in the book uses index funds, but applies them to different asset classes and segments of the stock market.
If the future is unknowable, and it is hard to predict, then what is the best way to invest? When most people consider buying stocks without making decisions about the economy or stock selection, they turn to index funds. These are funds that charge low fees and own the entire stock market. Buy an index fund, and you won’t outperform the stock market, but you’ll do average.
Over time, average returns in the stock market are quite spectacular. Not only do US stocks perform well, but the theory behind an index fund is intuitive and easy to understand. All of these participants are trying to figure out which stocks will perform best in the future. Some investors succeed in doing this, but most do not. Research indicates that the typical active manager underperforms the market. The underperformance of active management is probably best documented in Burton Malkiel’s book, A Random Walk Down Wall Street.
The evidence is loud and clear: active management sucks. Active management consistently underperforms the market and charges too much in fees. Due to fees and the inability of active managers to outperform, index funds seem like a pretty good bet for a long term investor. Index funds charge low fees and deliver decent performance. It seems likely that corporate America will continue to grow earnings and sales, and an index fund investor can expect to share in those rewards.
So, why don’t I invest in US market cap weighted index funds? I don’t invest in index funds for a few reasons: 1) I want to weight my portfolio towards cheap stocks and away from popular stocks. 2) I don’t want to experience horrible drawdowns 3) I don’t want to experience long periods of losses
Asset Allocation
How do we prevent drawdowns? How do we avoid lost decades? More importantly, how can this be done in a way that will grow wealth over a long period and do so in a way that minimizes fees and taxes? The answer, I believe, is in asset allocation.
The US stock market is only one ingredient in the vast menu of components available for an investor. The world is full of different kinds of asset classes. The beauty of these various asset classes is that they all do well at different times. There are asset classes that do well when US stocks suffer, like US treasury bonds. There are also asset classes that should perform well when US treasury bonds are doing poorly, like gold.
A portfolio of different asset classes can smooth out the returns and volatility of a portfolio, while still delivering a satisfactory performance over the long run. We can build a portfolio that won’t go through the horrible drawdowns of a 100% US stock portfolio. We can also build a portfolio that can deliver a more consistent return than a single asset class, with no lost decades. To do this, we need to look at some of the ingredients that are available for investors.
Here are a few of the asset classes available on the menu: Short term US treasury bills, Long term US treasury bonds, Investment-grade corporate debt, Junk-rated corporate debt, Foreign sovereign bonds, International developed stocks, Emerging markets stocks, Real estate, Gold, and Cash. The above asset classes are only a small snippet of the asset classes available to the average investor. One of the most classic diversified portfolios available to average investors is the 60/40 portfolio: 60 % US stocks, 40% US bonds.
Something particularly interesting about this portfolio is that it performs better than the sum of its parts. When rebalanced annually (an investor lets the portfolio run every year, then returns the portfolio to the 60/40 weighting at the end of the year), the actual return of the portfolio is higher than 9.1%. The real return of this portfolio is 9.6%. It’s not much of a difference, but it is still astounding: the portfolio adds up to a result that is greater than the sum of its parts.
Small Cap Value
Why do market-cap-weighted indexes go through cycles of extreme bull markets and flat bear markets? I think a significant reason is because of the way that market capitalization weighted portfolios are constructed. Because indexes are buying more of the most popular stocks as they go up, the index is doubling down on the most expensive stocks. Meanwhile, indexes are systematically selling stocks that are going down.
The best investors in history are known as value investors. They are attempting to purchase stocks for less than those stocks are worth. In the early 1990s, economists Kenneth French and Eugene Fama attempted to identify factors that lead to the out-performance of stocks. The determined “value” was a critical factor in returns. French and Fama were attempting to replicate quantitatively what the best investors of the past did through analysis and research.
This asset class is called “small-capitalization value,” and it has a historical track record of outperforming the market as a whole. I think this difference is understated, as that period includes the bubbles of the 1990s and 2010s. From 1972 through 2019, small-cap value has delivered 14% from 1972 through 2019, compared to 10% for US stocks. My opinion about small-cap value is a controversial one. It is certainly possible that the “anomaly” won’t persist into the future.
An investor in a small-cap value strategy will lag the stock market during bull markets but should experience a more consistent return than market-cap-weighted US stocks over the decades. However, while small-cap-value is the best form of offense in a portfolio, a portfolio needs a defensive strategy to protect the portfolio during severe drawdowns. I will explain the logic behind my defensive allocations in later chapters. My preferred defensive assets are long term treasuries and gold. Additionally, I do not want to rely on small cap value as my sole source of “offense” in a portfolio. I believe that global diversification is necessary.
International Investing
We live in a world that would be unimaginable to previous generations. You can hop on a plane and go anywhere on the planet quickly. Thanks to all of this integration, international financial markets have also opened up to investors in the United States. It is a big blue world, and we don’t have to invest solely in the United States. Unfortunately, the performance of international markets leaves much to be desired. Most US investors would have been better off avoiding the rest of the world. The track record of international investing isn’t particularly encouraging.
International stocks have a much better track record when viewed over a more extended period. An investor looking at the recent track record of international investing might want to give up entirely on the asset class, but a broader perspective reveals that international investing is better than it looks on the surface. I think it is vital to own foreign assets. International investments offer essential diversification benefits. A key benefit of owning international stocks is currency diversification. Owning stocks in foreign currency is a nice counterbalance against owning stocks priced in dollars.
Another critical element of international investing is political diversification. While the US has been the most attractive environment for capital, will that always be the case in the future? Could our political environment fall apart? International investing helps diversify this political risk. Even if the US falls apart politically, there should still be other countries that will stay strong. I think it makes sense to spread political risk across the globe.
While I pivot my domestic portfolio away from market-cap weighting, I want to do the same thing with my international investments and make a pivot to small-cap value. Unfortunately, I was unable to find a low expense ratio vehicle to own international small-cap value, so I settled for international small-caps without the value tilt.
Real Estate
Real estate is a unique sector of the market, and my asset allocation has a specific focus on real estate. Real estate can be purchased directly, but an easier way to do it is via financial markets and purchase REITs (real estate investment trusts). REITs have outperformed market cap weighted US stocks. I prefer to invest in real estate via the stock market rather than buying properties on my own.
There is also the benefit of liquidity. Moving away from REITs as an investment vehicle, real estate itself is an attractive sector and deserves and a seat at the asset allocation table for several reasons. The first key advantage of real estate is inflation protection. The inflation protection is a critical reason that real estate performed well in the 1970s while US stocks performed poorly.
Another reason that I like real estate is because it doesn’t participate in bubbles as often as the stock market. Real estate is less sensitive to the bubbles that usually plague the rest of the stock market. Of course, real estate is by no means immune to bubbles, as we saw in Japan in the 1980s or the United States in the red-bull-and-vodka soaked bubble of the mid-2000s. I also think it is essential to diversify with real estate investments globally, just as it is important with stock investments. The same case for diversifying internationally with the stock allocation applies to REIT’s.
Long Term Treasuries
Small-cap value, international small-cap stocks, and real estate are outstanding allocations when the economy is growing, but it will not protect from severe economic troubles, such as 1973–74, 2007–09, or 1929–32. A prudent investor needs to be aware that there will be times when the economy will not be growing.
For this reason, I hold an asset in my portfolio that performs very well during market crashes. The asset that performs best during a market crash is long term treasuries. Whenever stocks do poorly, long term bonds tend to do well. Long term treasuries are nearly always up during bad years for stocks. Long term treasuries are bonds issued by the federal government with extended maturities. When the world is melting down, investors worldwide want to hold safe assets. For this reason, I hold an asset in my portfolio that performs very well during market crashes. The asset that performs best during a market crash is long term treasuries. Whenever stocks do poorly, long term bonds tend to do well.
During the worst crash of all time from 1929 to 1932, long term treasuries delivered outstanding results. I think of long-term treasuries as an insurance policy against market declines that pay interest over the long term. Of course, while long term treasuries have a track record of performing well during market declines, there are risks in owning them. There are four potential risks to owning treasuries. The largest risks are inflation and higher interest rates. Persistently low interest rates are another outcome that can harm the long term returns of treasuries. While it is unlikely, it’s not impossible.
Gold
While long term treasuries perform well during recessions, they are not without risks. The critical risks against long term treasuries are inflation and higher interest rates. Is there an asset that can counterbalance this risk? Is there an asset that holds up during stock declines, but also performs well during periods of inflation?
This asset exists, and it is a controversial one: gold. Gold had its best performance during the last time high inflation and interest rates were a problem: the 1970’s. The 1970’s were a lousy period for most asset classes, but gold performed spectacularly. In terms of the portfolio, gold should do well in both periods of extreme fear and high inflation, serving as a nice asset to balance against the risk of “offense” assets and long-term treasuries.
The fact that gold does well during periods of inflation and fear means that it is an excellent diversifier against both stocks and bonds. Gold is almost entirely uncorrelated to the stock market. This lack of correlation with stocks and bonds is why gold is such an excellent diversifier in a portfolio. Critics of gold will say that it isn’t going to earn as high a rate of return as my stocks. I agree. The thing is: gold isn’t in my portfolio for a high rate of return. I own gold because of its diversification benefits and safety. It’s an insurance policy against things going catastrophically wrong.
Performance
What happens when you put all of these assets into a portfolio? Do they interact with each other in a desirable way? Does this weird portfolio work? Since 1970, this portfolio has generated an average 7.7% rate of return after inflation. This is almost as high as the US stock market, which has delivered an average real return of 8%.
This result is accomplished with much less severe drawdowns and less volatility than the US stock market. The worst year for this portfolio was 2008, in which it lost 19%. By this metric, the weird portfolio outperforms all other passive asset allocations. This result is achieved with less risk than the overall stock market. Instead of having all of its bets on one potential outcome (US prosperity), this is a diversified approach prepared for multiple economic outcomes. This portfolio has elements that will perform well in all economic environments.
Meanwhile, the portfolio protects from political upheaval in the United States. If the US were to turn its back on the economic policies that made the country great, the portfolio has assets held in other countries. In the worst-case scenario — a total global economic collapse — the portfolio owns gold, which has retained its value throughout human civilization. Gold will at least retain 20% of a investor’s wealth during that kind of horror show. A total impairment of capital will be avoided.
Implementation
I believe I have a group of asset classes that will deliver a consistent rate of return over the very long run. Now, how do I invest in this portfolio from a practical perspective? There are two main ways for the average investor to access broad-based diversified asset classes: passive and actively managed funds. My preference is towards passively managed funds. There are two main options for retail investors like me: ETFs and mutual funds.
I invest mainly in ETF’s. I do this because ETF’s have some critical advantages over mutual funds. With a mutual fund, the investment company is investing the investor’s money directly. With an ETF, the fund trades in an open market on an exchange. This unique structure creates some very critical advantages over traditional mutual funds. First, it reduces fees. Second, ETF’s have less of a tax burden than mutual funds. I also predominately buy ETF’s from one company, Vanguard. I choose to invest in Vanguard ETFs because I trust the integrity of the company. There are multiple gold ETF’s, but the one I choose to invest in is the Aberdeen Standard Physical Gold ETF (SGOL). Investing in these ETFs is simple. These ETFs are available through any brokerage account. I simply calculate the percentage of exposure I want in each asset class and then invest that amount in each ETF. Why does regular rebalancing increase the rate of return? The answer is simple: it forces an investor to buy low and sell high.
Alternative Approaches
My approach to asset allocation isn’t the only approach. There are no market cap weighted index funds. It is overweight in odd segments of the market, like small cap value and REITs. The asset classes are controversial. Small-cap value is controversial. There are many reasonable criticisms of my portfolio. Here are a few that you might want to investigate and learn more about: 1. The classic 60/40 portfolio, 2. The All Seasons Portfolio, 3. The Bogleheads Three-Fund Portfolio, 4. 100% US Stocks, 5. The Permanent Portfolio.
As you can see, there are plenty of different asset allocation approaches, and mine isn’t the one true faith. Investing is a personal process that ought to be tailored to your own goals and tolerance for risk. You have to do you. With that said, I hope that my approach has given you something to think about when looking at different investment approaches. I hope you found this approach and my explanation of it useful, even though it might not be for you. I wish you and your loved ones the best of luck in investing & life.
Back-testing the Portfolio: Data Visualization
Below is a back test and visualization of how this portfolio has performed since the 1970’s. These charts are courtesy of the excellent blog at Portfolio Charts. I think this gives a good sense of how this portfolio performs in different economic environments while reducing volatility and drawdowns creating a consistent rate of return. Keep in mind that all return information is inflation adjusted.
Average Returns: This portfolio has generated a 7.7% average rate of return since 1970. Severity & Length of Drawdowns: The worst drawdown for this portfolio was 19%. Annual Returns: Drawdowns do not last long and the portfolio usually rebounds to its long term rate of return of around 7% after inflation relatively quickly. Perpetual Withdrawal Rate: The perpetual withdrawal rate for this portfolio is 5.4%. Stress: This portfolio also delivers its return with a low amount of stress, as measured by the Ulcer index.
Disclaimer
The information on in this book is for information and discussion purposes only. It describes the author’s approach to investing, which may not be suitable for all investors. This book does not constitute a recommendation to purchase or sell any financial instruments or other products. Investment decisions should not be made with this book and it does not take into account the investment objectives or financial situation of any particular person or institution.
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