Given the uncertainty that comes with investment in stocks, bonds and commodities, people may try to hold their savings in cash and cash like products. However, given today’s low interest environment and the high potential for inflation to increase, holding savings in cash may cause the purchasing power to decline over time.
Average investment returns compounded over time may also bring large increases in wealth, thus seeking safe returns in the medium term can still create large benefit in the long term. For example, $100,000 invested with a 5% average annual return will grow to $162,000 after 10 years of compounding interest. Even with this conservative rate of return, after 10 year we have not only avoided a decrease in purchasing power but increased wealth as well.
How to Invest
The primary goal of investing is to protect initial capital, with a secondary goal of generating wealth increasing returns.
This is different from speculation, which focuses on seeking large returns quickly.
While it can be said that one can invest in singular stocks – by long-term holdings in a company – any holdings in small and mid-cap companies is still speculative in nature – especially in companies valued on future growth as opposed to current earnings. Traditionally, investing in singular stocks meant purchasing blue chip companies with steady records of dividends. These income streams may be useful to certain classes of investors.
Another way one could “invest” in singular stock would be to thoroughly conduct research on a company before purchasing. It is important that research is conducted by oneself because institutional research often has unavoidable biases, and research is not conducted with an individual portfolio in mind. In other words – it is unlikely that another person’s research will pertain to your investment goals.
Proper level of research involves reading and analyzing annual statements, creating projections of future earnings, and following management chatter to create an accurate image of a company, suitably interpreted for your individual portfolio. To do this for more than one or two companies is a time-consuming issue, and even institutional analysts who cover 10 or 15 companies have difficulty staying on top of all the required reading.
These reasons and more form the basis of the myriad of literature on why picking individual companies is a difficult chore that few succeed in and where most ordinary market players will fall short. These structural difficulties do not even begin to cover further technical challenges in individual stock picking like risk management, portfolio balancing, entry timing, exit timing and investor psychology.
However, these issues may be avoided by simply achieving a properly diversified portfolio. While diversification seems to imply low returns – this is an improper understanding of the meaning. A properly diversified portfolio will grow with the overall economy.
Since 1990, the SP500 has grown 634% – an annualized return of about 7.5%. $100,000 invested in the SP500 would have compounded to over $6,340,000 in these last 27 years. It is unlikely that anyone involved in individual stock picking could have achieved this same result or better, and furthermore, investing the SP500 would be one trade with no work or follow up afterwards. The individual stock picker would likely have had to work 60-70 hours a week to come up with similar results.
This means that the singular best investment or security one could purchase in terms of value, risk and effort would simply be any SP500 index, ETF or mutual fund.
Given the knowledge that one could simply put money in a broad market index fund and generate wealth – why do more than that?
Unfortunately, all markets are uncertain to a degree and even broad indices can crash in extreme economic conditions. While a singular investment in the SP500 would have yielded 634% over the long term – there are instances when the index lost over 50% of its value in a very short period of time. Psychologically it is very difficult to hold on to a portfolio during these extreme events and it causes many investors to sell at lows.
The goal of diversification then, is to structure a portfolio in tiers. Like a ship with ballast chambers to protect against holes in the hull, the goal of diversification is to help a portfolio continue floating at reasonable levels even during times of extreme duress, preventing psychologically induced trades and thus helping the portfolio attain the best possible return.
The logic to diversification is simple – due to the interrelated nature of the economy – when certain sectors are in trouble there is a natural flight in demand to other sectors. For example, in major currency panics, gold prices increase. In financial panics centered on equities – bond prices tend to grow. 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 the value of diversification.
How to Diversify
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. 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 the aggressive portion of your portion of your portfolio. This will be where you generate your highest returns, but it’s also the riskiest portion of 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 is passive but still may involve some trading, primarily for re-balancing. In a portfolio designed to be 70/30 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 and 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 likely you will fall short of averages and goals.
- One should not invest in singular stocks. An investment in a stock 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. One should never mix speculation with investment as the lines can become easily become blurred and cause losses to investment principle.
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%
Now 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. This means you would have been more likely to achieve the full 7 percent versus a portion of the SP500’s 14% by being able to hold on through turbulence. Also, considering that the historical SP500 market return is 7.5% since inception- it is likely that in a longer time scale that the returns would have leveled out.
Now for a final experiment, let’s consider you foresaw that bond prices would likely drop given the interest rate environment and chose to have a 60% equity allocation, reducing long term bond allocation to about 10%. This would have yielded an ending balance of $191,000 by the end of 2017 with an 8% annual return. However, the max drawdown would have been 10% – showing the higher risk that comes with higher 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 these other investment products.
Theoretically there is no difference between an index fund of the SP500 and an ETF of the SP500. However, one must not abuse the conveniences of an ETF. Many fund restrictions are made to protect investor returns, and ETFs should be held for the long term – just like an investment in a fund. For investors that are fearful of their psychology or ability to hold fast in turbulence – index funds could be used instead.