A possible consequence of the uncertainty that comes with investments in stocks, bonds and other financial assets is that people may end up holding a disproportionate amount of their savings in cash and cash-like products (savings accounts, CDs, money market accounts, stable value funds, ect.). Depending on the interplay between interest rates and inflation, amongst other factors, individuals holding extensive savings in these low yielding assets may lose purchasing power over time. Currently in 2017, we live in a low interest rate environment and there is high potential for inflation to increase.
On the other hand, even average investment returns, by historical standards, (on a modestly increasing principle base) compounded over time can bring about large increases in wealth levels for individuals. At a 5% annual return, an individual able to save $500 a month for 50 years would end up with a terminal value of $1.2 million dollars on that contributed principle base of $300,000.
How to Invest in Equity Markets
A primary goal for the average investor should be to protect the purchasing power of a capital base from erosion, with a secondary goal of safely and steadily expanding the purchasing power of that capital base.
This is different from speculation, which focuses on generating abnormally positive returns on asset purchases per a given time period.
Equity markets are the most visible way to invest money. By allowing individuals to buy units of ownership shares in companies called stock, equity markets allow shareholders to participate in the growth of the company as a proxy owner. Equity markets are essential to investment portfolios as other less risky asset classes alone may not able to generate the returns necessary to prevent capital erosion. In long periods of low interest rate environments for instance, generating returns from equity and other non-fixed income classes becomes critical to preventing cash value erosion.
The simplest strategy to invest in equities could be to purchase stock in large individual companies with steady streams of dividends or impressive and consistent rates of price growth.
Many more complex strategies exist that may still be considered to be on the investing end of the spectrum and not on the speculative end. These strategies generally attempt to enhance returns based on identifying statistically significant variables to price change over time, and altering capital allocations based on those factors. These strategies have varied levels of success, and it is important to understand that as complexity increases, so does the speculative nature of each investment.
One of the simplest, yet most effective strategies for investing capital lies in the idea that the probability of loss to the principle base can be reduced by holding a more diverse set of assets, called diversification.
Diversification can seem to imply purchasing the entire universe of assets, though historically, this has shown to be an inefficient method of diversification. At a more precise level, diversification is a tool that allows individuals to match their risk to different benchmarks.
For instance if an individual purchases equity in all the individual pharmaceutical companies that are available, the risk of principle loss goes from being dependent on individual companies doing poorly, which is a common occurrence, to the risk that the entire pharmaceutical sector performs poorly, which is a less common occurrence. In this case, the individual has benchmarked his risk to the pharmaceutical sector.
The business of indexing is the professional application of building a diversified portfolio to match a chosen benchmark. These businesses create products called index funds which allow investors to easily invest in a chosen benchmark. Some companies replicate complex benchmarks and may lean on the speculative end of the spectrum.
In terms of capital appreciation, one of the most impressive benchmarks in our modern history has been the US economy. A popular benchmark of the US economy is the S & P 500, a list of the 500 largest US Companies as determined by the Standard and Poor’s company. Between 1990 to 2017, the companies in the S & P 500 have collectively grown 634% in market capitalization – an annualized return of about 7.5% per dollar invested. $100,000 invested in a portfolio of the S & P 500 companies would have compounded to over $6,340,000 in these last 27 years.
Why Diversify Further
Given the knowledge that an individual could put all their savings into a broad market index fund and generate wealth – why do more than that?
Unfortunately, all investments are still uncertain to a degree and even the most successful indices can experiences drastic declines in value during extreme economic conditions. While a single investment in the S & P 500 would have yielded 634% if held from start to finish – there were times when that investment would have lost more than 50% of its value over very short periods of time. Psychologically, it is very difficult to hold on to a portfolio through large swings in value. This frequently leads to emotional decisions with adverse effects of the capital base.
The reason for diversification beyond equity markets lies in the concept that other asset classes are subject to different risk factors then equity in a company. Factors can be correlated, and there is evidence that by adding uncorrelated, or even inversely correlated factors, one can statistically minimize risk of principle loss by measurable amounts.
In the case of equity vs fixed income asset price changes, if a company has a bad month, that could cause shareholders to worry and send stock prices lower. Lenders however, may still view the company as profitable enough enough to pay back their contractual debt obligations over the length of a previously negotiated time period. This gives fixed income securities less price volatility, a factor that differs from investing in equity.
The logic to asset class diversification in terms of factors can be seen in simple relationships. When certain sectors are in trouble there is a natural flight in demand to other sectors. For example, during currency panics, gold prices tend to increase. In financial panics centered on short term concerns causing stock prices to go down – bond prices may go up. In economic depressions, certain industries like sin industries and producers of cheap goods tend to do well. While there are many academic studies exploring linkages, for the purposes of developing a properly diversified portfolio, one simply need to understand that further diversification into various asset classes exploits correlations between them in a way that seeks to minimize the overall volatility of the portfolio.
Like a ship with ballast chambers to protect against holes in the hull, the goal of diversification to other asset classes is to help a portfolio continue to float at reasonable levels even during times of extreme duress, preventing psychologically induced trades and thus helping the portfolio attain the best possible return.
Practical Thoughts on Capital Diversification
Diversification is likely to look different for each investor. Based on goals, age, risk appetite and initial capital, different asset allocations and asset classes may be considered.
Many investment planners will have slightly different rules to follow, but certain principles can be considered universal.
- Use low cost investment products as foundational pieces. Indices are simple and passive by nature, and purchasing these types of products at 1% annual fees is very costly in the long run. Good passive index funds will cost only 0.07% – 0.20% in annual fees, and this should only decrease in the future. Certain more exotic funds in commodities or emerging markets may have higher expense ratios.
- Equity indices are a core portion of your portfolio. This will be where you generate your higher core returns, but it’s also a riskier asset in your portfolio. The rule of thumb is younger investors should have higher exposure to equity indices, and can include riskier indices like emerging markets and small caps, while older investors should focus on domestic large cap and whole market indices.
- Older investors are also generally expected to have a higher allocation in bonds to focus on capital protection.
- However, it is often worth considering economic conditions. For instance, in the current low interest rate environment, bond prices are at near highs and likely to decline. Thus, given these conditions – higher equity allocations may be worth considering.
- Diversification should mostly be a passive process but does involve some routine trading, primarily for re-balancing. In a portfolio designed to be 70% vs. 30% between stocks and bonds, over time this allocation may change naturally due growth or decline in values. Thus, some selling or buying may be necessary to maintain the 70/30 ratio.
- There may also be tactical reasons to shift allocation. For instance, after retirement, one may want to inverse asset allocation to 30/70 stocks vs bonds to offer capital more protection.
- Shifts in allocation should be done rarely. The goal of diversification is to set it and forget it. The more the portfolio is altered the more you are likely to fall short of the mean experience.
- Speculation should be sparing. An investment in a position that declines your overall portfolio return by 50% requires your portfolio to gain 100% just to break even. Speculation should be done in a separate account with a defined amount of cash that can be lost.
With this in mind let’s take a look at an example of a diversified portfolio and how this portfolio could be constructed cheaply with current products on the market today.
Below is a portfolio suggested by Ray Dalio of Bridgewater Capital. While this should not be considered personalized financial advice, the asset allocation has been tested since its release and seems to have done well in terms of asset protection and growth.
Ray Dalio’s “All-Weather Asset Allocation”
Here is the asset allocation Dalio mentioned in his interview in Tony Robbin’s book Money.
- 30% Stocks
- 40% Long-Term Bonds
- 15% Intermediate-Term Bonds
- 5% Gold
- 5% Commodities
In the book this portfolio was said to have averaged almost 10% a year from 1984-2013 – but more importantly only had 4 down years in this 30 year period, with the worst loss in capital being a mere 3.9% in one year. Considering this portfolio survived 2 major crashes these are impressive numbers.
Let’s quickly create a portfolio with these allocations using ETFs and test the return we get.
- $100,000 starting capital
- $30,000 in VTI – Vanguard Total Index
- $40,000 in BLV – Vanguard Long Term Bond Index
- $15,000 in VGIT – Vanguard Intermediate Bond Index
- $7,500 in GLD– SPDR Gold Trust
- $7,500 in USO – United States Oil Trust
Testing this portfolio on www.portfoliovisualizer.com from 2010-2017 we get the following results. (Note: period was selected because some ETFs are relatively new)
Ending Capital: $163,000
Max Drawdown: -8.16%
Average Annual Return: 7%
This return is significantly below the SP500, which returned about 14% annualized in this period. However, the max drawdown of a pure SP500 portfolio was over 16%, which means that Dalio’s all-weather portfolio halved the worst of the volatility.
Final Note – Why ETFs
ETFs are cost effective ways to invest in index funds without restrictions. While many funds have minimum investments, restrictions on cashing out and even restrictions on entry, ETFs are freely traded and share the same low costs as their index fund counterpart products.