1. Compound Annual Growth Rate (CAGR)
2. Standard Deviation (i.e. Risk)
3. Deepest Drawdown (maximum drop since 1970)
4. Longest Drawdown (length of recovery period)
5. Safe Withdrawal Rate in retirement (SWR)
In Part 3, I am going to discuss how I actually invest the bulk of my money and how my portfolio has historically beat the performance of the Total U.S. Stock Market index fund based upon the above 5 criteria.
At the outset, let me say that I am not an investment advisor and I share my investment philosophy solely for the purpose of being transparent with my readers. As I’ve said before, you’ve got to be you and invest in the way that works best for you based upon your personal risk tolerance and return needs. Before I get started explaining my investment strategy, I must take a moment to give credit to a few authors/investment gurus/bloggers who have influenced the creation of my portfolio:
- John Bogle – the creator of the first index fund and founder of Vanguard. I recommend his book: The Little Book of Common Sense Investing.
- Paul Merriman – his teachings on worldwide diversification of stock holdings with an emphasis on small and value stocks were very influential. You can learn all about Paul, read his excellent articles, and listen to his podcast at www.paulmerriman.com
- Harry Browne – the author of Fail-Safe Investing and creator of the Permanent Portfolio, which contains the following 4 Asset classes in equal portions: Stocks, Bonds, Cash, and Gold. I also recommend Craig Rowland’s book, The Permanent Portfolio, which is an update on Harry Browne’s theories.
- Portfolio Charts – Tyler at www.portfoliocharts.com has one of the best investment sites on the internet for testing asset allocations based upon numerous factors. I highly recommend that you visit this site to test your personal asset allocation choices. All of the data I report when comparing portfolios comes from his amazing site.
Before I compare the Total U.S. Stock Market index fund to my personal investment strategy, I will discuss the concept of Asset Classes and the role each Asset Class plays in a well diversified portfolio.
According to Investopedia, an Asset Class is defined as “a group of securities that exhibits similar characteristics, behaves similarly in the marketplace and is subject to the same laws and regulations.” For purposes of this article, I am going to focus on 4 Asset Classes:
These 4 Asset Classes, which have their own unique risk profiles, work amazingly well together when combined in an overall investment strategy. Further, each of these 4 Asset Classes take turns in the spotlight during the following 4 economic conditions:
- Tight Money Recession
Below I will discuss each of these Asset Classes and describe the role each one plays in my portfolio.
Stocks perform well during periods of economic prosperity. This economic condition is characterized by low unemployment, stable interest rates, low inflation, and economic expansion. While stocks are an amazing engine for wealth creation during times of prosperity and associated “bull markets,” they are also volatile in nature and drop precipitously when a market crash eventually occurs. Many of you are familiar with the dramatic crashes that occurred in 1987, 2000, and 2008. However, the fact that market crashes occur should not prevent you from owning stocks. Rather, declining stock prices should be viewed as an opportunity to purchase more index funds shares while they are “on sale. As Warren Buffet puts it, “Be fearful when others are greedy and greedy when others are fearful.” At the same time, not all investors are comfortable riding out 40-50% declines in their portfolio. Although young investors can benefit from the purchasing opportunities created by major stock market declines and wait for the eventual recoveries, older investors who are in, or close to, retirement may desire a more stable portfolio. Still others are fearful of market declines and, regardless of age, have no desire to stay invested if they have to experience significant downward market swings.
I have allocated 60% of my portfolio to stock index funds. My stock index fund selection was heavily influenced by the writings of Paul Merriman. You can learn more about Paul’s recommendations by visiting www.paulmerriman.com. Paul recommends dividing your stock portfolio roughly 50/50 between U.S. and non-U.S. stock funds and cautions against “home country bias”– the tendency to avoid international diversification in favor of your home country’s stock market. He recommends dividing your stock allocation amongst the following sub-asset classes:
U.S. Index Funds
- Large Cap Blend (6%): The ideal index fund here is the S&P 500. If you use Vanguard, the ticker symbol is VFIAX. This fund holds the stocks of the 500 largest companies in the U.S. The term “blend” simply means that it contains both growth and value stocks. Before we move on, let’s take a look at a couple of definitions:
Growth Stock– a share in a company whose earnings are expected to grow at an above-average rate relative to the market. A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects.
Value Stock– a stock that tends to trade at a lower price relative to its fundamentals (e.g., dividends, earnings and sales) and thus is considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio.
- Large Cap Value (7%): As the name suggests, this fund consists of the stocks of approximately 321 companies that are deemed to be trading at a discount relative to their fundamentals (dividends, earnings, and sales). The Vanguard ticker symbol is VVIAX and the fund’s annual expenses are just .08%. By purchasing value stocks, you are practicing the oft cited adage of “buy low, sell high” simply by purchasing these discounted or out of favor companies.
- Small Cap Blend (7%): Small cap stocks have a solid historical record of beating the performance of the S&P 500. This is based in large part on the fact that small companies have a lot of room for growth. No one knows which company is the next Google or Apple. However, by purchasing the 595 stocks represented by Vanguard’s VTMSX (or a similar fund of your choice) with an expense ratio of .11% per year, every day investors can gain access to a large group of companies that may be the mega stocks of tomorrow.
- Small Cap Value (7%): Small Cap Value stocks combine the robust potential of small companies with a value component to supercharge returns on a long-term basis. Historically speaking, Small Cap Value stocks have performed better than Large Cap Blend, Large Cap Value, and Small Cap Blend stocks. As you can imagine, the fund can be very volatile. Nonetheless, by holding the 827 companies in Vanguard’s VSIAX fund (or a similar fund), you spread the risk and, combined with all of the other Asset Classes I hold in my portfolio, the volatility is dampened. With an annual fee of .08%, it is also very lost cost.
- Real Estate Investment Trusts “REITS” (3%): A REIT is a mutual fund that invests in real estate. By owning REITS, you indirectly own commercial properties, including apartments, hospitals, office buildings, hotels, and shopping malls. REITS have a long-term history of great returns and are heavily non-correlated with the S&P 500. Vanguard’s VGSLX gives you exposure to 158 REIT securities with an annual fee of .12%.
International Index Funds
- Large Cap Blend (6%): The international equivalent of the S&P 500 is the Vanguard Developed Markets index fund (VTMGX). This one fund gives you exposure to 3,795 large companies in Europe, the Pacific, the Middle East, and Canada at a cost of .09% per year.
- Large Cap Value (10%): I use Vanguard’s International Value Fund (VTRIX), which invests in 151 non-U.S. companies from developed and emerging markets that are viewed as temporarily undervalued by the market. The expense ratio comes in at .43%. I allocate such a large percentage to this fund because it contains both small and large value companies.
- Small Cap Blend (5%): Similar to it’s U.S. counterpart, Vanguard’s international small cap fund invests in 3,446 small companies in established and emerging international markets. At an expense ratio of just .27%, VFSVX is a bargain.
- Emerging Markets (6%): Emerging Markets funds invest in a group of developing countries located in areas such as Eastern Europe, Africa, the Middle East, Latin America, and Asia. Emerging Markets represent approximately 25% of the world’s total market capital, are considered negatively correlated to the U.S. stock market, and have historically produced very robust returns. By their very nature, Emerging Market funds are risky standing alone but are an important part of a well-diversified stock portfolio. Vanguard’s VEMAX offers exposure to 4,248 emerging market stocks with a .14% expense ratio.
- International REITS (3%): The international REIT fund offered by Vanguard (VGRLX) provides diversified exposure to real estate stocks in established and emerging markets outside of the U.S. Vanguard’s offering includes 670 real estate stocks with an annual fee of .15%.
As discussed in Part 2, bonds are debt investments whereby an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. During times of prosperity, bonds provide regular income to your portfolio and buffer the effects of stock market volatility on your portfolio. But it in periods of deflation that bonds really shine.
Deflation is a contraction in the supply of circulated money within an economy, and therefore the opposite of inflation. In times of deflation, the purchasing power of currency and wages are higher than they otherwise would have been. At the same time, interest rates tend to drop. Bonds prices move opposite of interest rates. So in periods of deflation when interest rates are declining, your bond becomes more valuable. Conversely, during periods of inflation, bonds decline in value as interest rates are rising.
For example, if an investor owns a bond that pays 4% per year for 30 years, and the market rate for bonds drops to 2%, then the 4% bond increases in value because it pays a better interest rate over the same period of time.
I allocate 13.33% (1/3 of my non-stock allocation) to 30 year U.S. Treasury Bonds. Why? They have no default risk, they are fixed rate in nature, and because of their long maturity, they provide maximum volatility that allows me to profit from periods of deflation. You can buy bonds directly from the U.S. Treasury, on the secondary market, or through a bond fund. I prefer Vanguard’s VUSTX or Ishares’ TLT ETF.
Most of us think of cash as something you save only for the purpose of funding an adequate emergency fund. I use cash as an important Asset Class in my overall portfolio diversification. Cash plays several important roles in my investing strategy. It dampens portfolio volatility generally. It also guarantees that I will have funds on hand to take advantage of sharp market declines in the other assets in my portfolio. There is nothing more frustrating than not being able to take advantage of market opportunities due to lack of liquidity. Cash is a very important Asset Class in times of what Harry Browne called a “tight money recession”. This economic condition occurs when central banks raise interest rates during a weak economy in an effort to reduce inflation. During those times all of the other assets in the portfolio are usually declining. By having cash on hand, you have the means to weather the recession without having to sell declining assets, as well as the “dry powder” to snatch up the declining assets while they are “on sale”. As a bankruptcy attorney, I can state without hesitation that lack of cash reserves is the number one reason individuals and businesses file bankruptcy. I have witnessed first-hand as multi-million dollar net worths declined to near zero due to lack of liquidity during a severe economic recession.
I allocate 13.33% (1/3 of my non-stock allocation) to cash. However, I don’t actually bury it in my backyard. Rather, I own Treasury Bills that, by definition, have a maturity of less than one year and are backed by the U.S. Government. A Treasury Money Market Fund such as Vanguard’s VUSXX is suitable, as is iShares’ Short Treasury ETF – SHV.
Last, but certainly not least, is Gold — one of the most maligned assets out there. When people hear that you invest in Gold they stare at you funny and start looking around your property for the underground zombie apocalypse bunker or your tin hat collection.
In any event, gold has been recognized as a store of wealth for thousands of years. When the U.S. dollar declines in value against other world currencies, investors flock to the security of gold. For example, the price of gold nearly doubled between 2008 and 2012. Further, gold is a great inflation hedge, as its price tends to rise when the cost of living increases. Gold is negatively correlated to stocks and usually takes off during stock market plunges. Gold is also viewed as “insurance” in times of geopolitical uncertainty because people buy gold when world tensions rise. Finally, gold bullion has no counter-party risk unlike stocks, bond funds, and cash instruments.
I allocate 13.33% (1/3 of my non-stock allocation) to gold. I purchase it in the form of gold crowns on my teeth …. kidding. Actually, gold can be conveniently purchased in coin form such as the 1 oz. Gold American Eagle. If storage is a hassle, gold can also be purchased through an ETF such as SPDR Gold Shares GLD. However, owning gold though a fund such as GLD does involve counter-party risk.
Putting it all together ….
In sum, I hold 60% of my portfolio in stocks around the world and divide the remaining 40% between Bonds, Cash and Gold. And here are the results based upon historical data when you compare my portfolio to the Total U.S. Stock Market index fund:
As you can see, based upon historical information, my portfolio beats the Total Stock Market Index Fund in every category. Note that the returns are “Real Returns” — adjusted for inflation. Investing is a very personal decision. I prefer broad, worldwide, diversification. I also don’t spend time monitoring the portfolio, trading, or worrying about market conditions. I am satisfied with my risk/reward allocation. I rebalance annually, unless I feel that an earlier rebalancing is dictated by overall portfolio performance. If you don’t want to deal with all of the math of allocating your investments into so many buckets, you might consider using a service such as Motif, which allows you to put together a custom portfolio of your own for a flat fee of $9.95. Thereafter, you can rebalance your custom portfolio with the click of a mouse.
Thanks for reading. I would love to hear about your investments.