A mix of only stocks and bonds will have significantly more risk than my suggested blends of stocks, bonds, TIPS, REITS and commodities. I should be able to achieve higher returns with lower risk by using 4 (or 5, if you count TIPS as separate) asset classes, compared to just 2. The couch potato portfolio would really suffer in an inflationary environment like the 1970s. It also provides on foreign currency hedging against a dollar collapse. This is a common problem with most recommendations on passive portfolio investing. The typical financial advisor and investment writer is a little behind the times on this subject IMHO.
I understand that, but how many business cycles have we been through since 1945? Please read the article, I found it enlitening. If small caps and large caps have had the same ROR and small caps have been more volatile since 1945, I think there is a large hole in the agrument that small caps outperform. Also has anyone thought of what effect baby boomers retiring and becoming huge net sellers of securities instead of net buyers? I don't think the market has ever seen such a large amount of money dumped on the market. 5yr
There's some debate on small caps, and I am aware of the controversy. However, even if their return is no higher, the fact that they are not fully correlated with large caps means that adding some to the portfolio should improve the risk/return characteristics of the portfolio. Note that despite the historical data cited, theory does suggest that the higher risk should have a payoff. Even if you are a small cap sceptic, the chance of theory being right, and the extra diversification, means that you should probably have at least a small allocation. For example, if you were going to have 25% long domestic stocks, you'd almost certainly be better to go 20% long S&P, 5% long Russell 2000, rather than 25% long S&P, even if small caps have returned no more than large caps over the long run over the data period you cite. To answer the question about their returns, the best way IMO would be to look at foreign markets e.g. UK, Europe. Just looking at US data is risking misleading results due to the data sample of only 1 country. If small cap stocks have outperformed big caps over the last 60 years since WWII in foreign developed markets, then this would lend credence to my view that the higher risk will come with higher return. This would suggest that the US data is probably down to chance/the data set. However, if foreign developed markets also have small cap returns no better than large cap returns, then this would indicate your theory is correct and the small caps probably do not actually outperform over the long-run. Since WWII, US big caps have outperformed UK and European big caps by about 2% per annum, if memory serves. This is most likely a data-mining/small sample problem, rather than some kind of inherent superiority of US large cap stocks. If we assume US big caps will return roughly the same as the world developed market big cap stocks in future, and that historical US small cap returns are accurate, this would indeed suggest small caps will outperform in the long run in the US versus the S&P 500. Anyway, the implication for the weightings is not too big. You might allocate your 20% domestic stock as 15% S&P 5% Russell, rather than 10%/10%. Not a huge difference. Thanks for raising the point though. Right now I really haven't done enough research to be able to have a conclusive answer. Small caps definitely do suffer more during bear markets, so erring on the side of conservatism, and taking account of the article, you might want to underweight small caps somewhat (but still have some in).
Growth portfolio: this is designed for someone who wants good long-term returns, and is willing to ride out bigger drawdowns to achieve them. It has a large stock allocation, with other assets added only up to levels sufficient to achieve minimum diversification requirements. If you generally like to be invested in stocks, but would appreciate a way to smooth volatility without compromising returns too much, this should be an appealing portfolio for you. STOCKS: 65% Domestic: 35% World: 20% Emerging:10% REITS: 15% BONDS: 15% Treasury: 7.5% TIPS: 7.5% COMMODITIES: 5% RISK: this portfolio definitely has more risk. In 2000-2003 it would have lost about 30% on the stocks, gained about 8% on the other assets, for a 22% drawdown over 3 years, peak to trough, losing less than half the S&P over the same period. In 2007-08 you would have lost about 12-13%, peak to trough. In 1929-32 you'd be down about 50-60%, or 25-35% in inflation-adjusted terms. Still, the risk levels are not exactly reckless, especially for more risk-tolerant investors. You can expect a 10-15% drawdown maybe every 5-6 years, and a 20-30% one during a secular once in a generation bear market. Many investors would find that tolerable, especially if they had the fortitude to add at the bear market lows when stocks are cheap. RETURNS: expected long-run returns should be 6.5% for the stock portion, 1.125% for REITS, 0.15% for commodities, and 0.75% for bonds, for a total of about 8.5%. This is only 1.5% per annum less than a pure stock portfolio, and should double roughly every 8 1/2 years. 30 year returns would be 11.5 times the original investment (the balanced portfolio would multiply 8.75 fold over 30 years, and the conservative portfolio 5.6 fold. A 10% per annum pure stock portfolio would return 17.4 fold, doubling every 7 1/4 years). FURTHER COMMENTS: whilst more vulnerable to bear markets, this portfolio is vastly less risky for the aggressive investor than just going 100% long stocks (or 90% S&P 10% bonds). The REIT/bond/commodity blend is a much better ballast for the stock portfolio than just 30-35% bonds, giving protection against inflationary, deflationary, and stagflationary scenarios, providing more diversification during bull markets, and juicing returns a bit thanks to the REITs better long-term return vs treasuries. For anything than a true gung-ho pure stock investor, this is probably as risky as you would want to go. Although you'll take hits every few years, and have the occasional 20-30% drawdown during the true market busts that come along every generation, these drawdowns are definitely survivable. And in compensation, you'll be earning an extra 1-2.5% per annum over the more conservative portfolios - might not sound a lot but over the long run it adds up nicely. Overall I think this is a pretty nice portfolio for younger, high-earning, or otherwise more aggressive investors. Even if you are retired and living purely off savings, this portfolio is unlikely to totally impoverish you when things go wrong.
The mechanics of portfolio investing - suitable ETFs. So, hopefully now you have a general idea of the rationale behind these portfolios, and are probably gravitating to one of either the safe, balanced, or growth portfolios. What next? Well, you want to decide the most suitable exchange traded funds to match your asset classes. For an ETF, the main considerations are: 1) Liquidity. A liquid ETF has price-visibility, frequent trading, low spreads and thus lower costs. Generally the sector ETF that has the highest market-cap traded per day is the one to go for. 2) Expenses. You want to choose the lowest cost ETF in most cases. Fees reduce returns, and add nothing to an index-tracking ETF. 3) Tracking of a suitable index. You want an ETF that replicates the performance of the broad asset class as closely as possible. For example a bond ETF should not be focused exclusively on 20+ year bonds (which are more risky) or short term bonds - a 5-10 year maturity is probably better. A stock ETF should not follow an obscure index, or have a large tracking error. 4) Reputation of the ETF provider. This is a more minor consideration, but it's generally a good rule of thumb to stick to ETFs from the main providers. They will be better supported and less likely to "die out" over time. 5) Index makeup methodology. Some index makeups lead to undesireable risk or performance bias issues e.g. the Dow Jones is weighted by nominal price, not market cap. The Russell 2000 does not cover the top 1000 companies so it automatically boots out its best performing stocks each year. After some research, these are the ETFs that I have selected for my own investment portfolio, categorised by asset class. I am in the UK but will just list the US ETFs, since most ET members are American. If you live elsewhere, just find your local equivalents. STOCKS: US big cap: SPY - S&P 500 index tracker US small cap: IWV - Russell 3000 tracker Foreign big cap: EFA - MSCI EAFE World developed index Emerging markets: EEM - MSCI Emerging markets REITS: US REITs: RWR - Wilshire REIT BONDS: US Treasury: IEF - Lehman 7 to 10 year Treasury US TIPS: TIP - Lehman US Treasury Inflation Protected Securities COMMODITIES: DBC: Powershares DB Commodity Index Tracking Fund
Rebalancing - the other "free lunch" in investing. Rebalancing is probably the least understood portfolio investment tool, at least for the typical retail investor. Simply put, rebalancing means checking your portfolio after significant moves, or at regular time intervals (e.g. quarterly, half-yearly, or annually) and re-adjusting the % allocations so that they go back to the original portfolio target allocations. For example, take a simple 70% S&P, 30% bond allocation. If you had this on in 1992, then by early 2000 the great outperformance of the S&P 500 would have meant that you had almost all your assets in stocks. I haven't checked the exact figures, but you might have 90% of assets in stocks and 10% in bonds, after the 8 year raging bull market. This is clearly way riskier than your original target of 70% stocks and 30% bonds. Varying asset performance has meant that your original allocation drifts far from your intended mix of risk and reward. Thus, rebalancing is necessary to keep your portfolio on track. Each year (or 6 months, or 3, or whenever there's a big move), you need to see where your allocations have "drifted" to, then rebalance to get them back on target. For example, in the above case, you would sell 20% of your portfolio that is in stocks, and put that 20% back into bonds, to get back to the 70% stocks 30% bonds weighting. Obviously you would do it way more than once every 8 years So - rebalancing is necessary to keep your portfolio at the target asset weightings, and target risk/reward levels. However, there is also a hidden benefit to rebalancing. Without going too much into the maths & theory, rebalancing can provide profits from market volatility. To use an extreme example, imagine a 50/50 stock/bond split. Let's say stocks rise 100% in 1 year, then fall 50%, to end where they started. Bonds fall 20% in year 1 and rise 25% in year 2, to get back where they started. What would be the effect of a rebalance at the end of year 1? Asset Year 0 Year 1 Rebalance Year 2 Stocks: 50k 100k 70k 35k Bonds: 50k 40k 70k 87.5k Mix: 50/50 71/29 50/50 29/71 TOTAL: 100k 140k 140k 122.5k Drawdown: 0k 0k 17.5k Now the same if you don't rebalance Year 0 Year 1 Year 2 Stocks: 50k 100k 50k Bonds: 50k 40k 50k TOTAL: 100k 140k 100k Drawdown: 0k 0k 40k The rebalanced portfolio gains 22.5%, compared to a 0% gain for the unrebalanced portfolio. The drawdown is 17.5k rather than 40k. By selling high and buying low, taking advantage of the huge volatility, rebalancing here adds returns whilst lowering drawdowns. Rebalancing in the midst of the volatility managed to generate a 22.5% return, despite both markets returning 0% over the 2 year period! Now, imagine using that method during the 1997-2003 boom/bust period in US stocks. You would have been booking profits on stocks in 1998, 1999, 2000, and buying into weakness in 2001, 2002, 2003. The markets were virtually net flat over that 6 year period, but rebalancing would have generated some extra returns by effectively dollar-cost averaging - buying less at high prices, selling more; and vice versa when prices fell. Not bad eh? Obviously I have used a huge volatility move here to make it easier to see the effect. In real markets, swings will be lower, but all that means is that rebalancing adds profits and reduces drawdowns - just at more modest amounts. To take a real-world example, I read a study which showed during the 1990s a rebalanced stock/bond portfolio would have added about 0.7% per annum to returns compared to an unrebalanced stock/bond portfolio, whilst having lower risk over the same period. Without rebalancing, the bull market in stocks resulted in a big drift to a stock-heavy portfolio, right as the bubble reached its peak. You would be overweight stocks at precisely the wrong moment. Rebalancing is the portfolio investors secret weapon - it keeps asset allocations on target, smooths results, and boosts long-run returns whilst reducing short and long-term risk. What's not to like? Transactions costs and tax considerations mean you should not rebalance all the time. But ideally you should do it at least once per year. In addition, whenever one asset class has had a big move and/or starts to look overvalued, rebalancing is the perfect way to exploit the possible market overshoot - book profits and ploughing them back into the cheaper alternatives. It's the perfect way to satisfy your urge for "action", allowing you to fade extreme moves without taking the risk of making an outright bet. If you were long stocks in 1999 and early 2000, rebalancing into bonds and REITS would have been a great move. Ditto going from bonds to stocks in 1998 or 2003. Regular rebalancing ensures that you sell tops and buy bottoms with regularity.
Regular saving & paying off debts: Make regular monthly contributions to your investment account, maximising tax shelters and other benefits, such as pension funds, IRAs, 401k or your local country savings vehicles. Start early and keep contributing! Simply putting 10% of your after-tax monthly income to work in the markets will make a huge difference to your wealth and financial security over the long run. If you can manage 15-20%, that is even better. Even if you only do this for 5 years and then stop, it gives you a huge benefit compared to someone who saves nothing. Make sure you maximise your tax and savings allowances and investment-friendly vehicles. Tax-free is better than taxable, the difference in the long-run really does add up. Use a low cost broker to keep returns even higher. Regarding debt - always pay this off (except mortgage debt, which is relatively cheap) before you invest a penny in the markets. Paying off debt at 8%+ is equivalent to an after-tax return of 11%+ depending on your tax bracket. What's more, it is entirely *risk-free*, it improves your liquidity and financial resilience, it is not taxable, and it boosts your credit score. There is no better "investment" in the world than paying off unsecured non-mortgage debt. Where else can you get a tax-free, risk-free 10%+ per annum? Paying off a credit card balance on an 18% APR is equivalent to an after-tax return of 22-30% per annum - better than most hedge funds, and with no risk whatsoever! Get debt-free (except for mortgage on your residence) before you invest! Spending & frugality - a lot of people think saving is boring. Nothing could be further from the truth. The great thing about regular saving, is that once you hit your monthly target, you can then BLOW EVERY FURTHER DOLLAR (or £ or â¬) YOU EARN, TOTALLY GUILT-FREE. You can party like mad, blow it on vacations, coke, hookers, sports cars or whatever - as long as you have made your target contribution, that's fine (although if you are married, your wife/husband may disagree!). What's more, you are doing this, knowing that eventually you will be comparatively rich due to your investments. Believe me, that is a great feeling.
So, let me summarise the main points for a long-term portfolio investor: 1) Seek diversification - a free lunch, maximising returns relative to risk, reducing volatility and smoothing drawdowns especially in serious bear markets. 2) Rebalance regularly - increase returns, reduce drawdowns, and keep portfolios at your desired target allocations, thus keeping risk and reward at the levels you want, year after year. Gain the staying power to patiently buy panics and crashes, and sell bubbles and speculative frenzies, without having to put your balls on the line. 3) Buy & hold using passive low cost ETFs - avoid the high fees, taxable gains, churning and underperformance of active fund managers. Avoid manager risk, and the effort taken to select hot managers who flame out the next year. Stick to simple, low-cost, tax efficient, market-performing index ETFs. 4) Construct a portfolio suitable to your risk tolerance and financial situation. Only take risk that you are comfortable with, so that when the market is tanking and other investors are panicking, selling their stocks at the lows, you can stay the course, secure in the knowledge that your drawdowns will be lower, and the long-run prospects bright even through vicious bear markets. 5) Estimate drawdowns and long-term returns based on the historical data and economic characteristics of the assets you invest in, and the allocations you give to each asset class. This gives you knowledge and the confidence to ride out the swings and dips. 6) Avoid market timing on your long-term passive account. You can set up another portfolio for speculation or trading, meanwhile let your passive investment account slowly compound predictable, low risk, near-certain long-term gains significantly above bonds, t-bills, and money market accounts. 7) Make regular monthly contributions to your investment account. A minimum of 10% of after-tax income, and ideally 15-20% (more if you can!) will go a huge way to accumulating long-term wealth. Whenever you are tempted to buy a luxury or run up credit-card debt or tap that home equity, compute the 20 year return on the money you are planning to spend, if you put it into your investment account. Then ask is it really worth forgoing that gain? Remember, investment gains aren't just for when you hit 60+. They can be used as a buffer or to provide income in middle age too. 8) Forget the media, and pundits trying to call each twist and turn of the market. With a nicely diversified portfolio, rebalancing, and regular monthly contributions, you can sleep well at night, virtually automating your way to millionaire retiree status with little effort. The idea investor sleepwalks his way to a large nest egg, enjoying relaxing steady gains with minimal workload or stress. 9) If you feel the need to play - set up a separate account and trade that. Do NOT make speculative, timing, or other trades in your investment account. Don't buy your favourite stocks. Keep that for your *trading* account. That way you can play the market swings without stress, guilt, or serious risk to your financial health. 10) NEVER WITHDRAW from your investment account. Resist the temptation! Keep it in there and it really will add up and come to a mind-boggling amount by the time you retire.
Great contributions Cutten.. Especially in this environment, I second your motion of expanding timeframes. Just closing out a 2 year XLE position. Looking to rebalance and reallocate into more international exposure. Markets are global now, can't just stay concentrated in the US.
Great thread - thanks for taking time to put all the pieces together! I know you said that options were pretty much out in the beginning of the thread, but I was curious as to whether it would ever make sense to use them strictly as a means of reducing risk and smoothing the equity curve. For example, my experience has been that short-term ATM SPY options are very efficiently priced, meaning that over the long haul, assuming I could sell them at the mark and had zero trading costs I would expect to come out very close to even. Assuming that's the case, if I held SPY shares for my domestic equity exposure and wrote an approximately equivalent amount of SPY straddles each month or two (say 1 straddle/100 to 200 shares), I would guess that my combined return would lag the market during the good years but not fall as much during the bearish times, resulting in less overall volatility but ultimately the same long-term return. Would this make sense, especially as I got closer to retirement? Seems like it might be worth trading the loss of return due to trading costs and slippage of the straddles for the reduced risk/portfolio volatility.