Few people can stomach a huge fall in the market value of their investments, even if it’s only temporary. So investors need to take steps to make sure it doesn’t happen. But at the same time they need to make money. I’ve previously made a recommendation designed for these unusual market times. Today I’ll take a closer look at why it makes sense.
Finance and investing are full of complex theories and claims, often founded on even more complex mathematics. However, a lot of them don’t stand up to much scrutiny – at least to those that have retained some common sense.
Here are a few examples that I’ve come across over the years:
- “Dividends make up 90% of stock investor profits”. Wrong. Dividends are important but capital gains are usually the bigger factor (especially for value investors). For example, US stocks returned 9.5% a year since 1900. Of that, 46% came from dividends (less than half) and capital gains were 54% (more than half).
- “Economic (GDP) growth doesn’t matter for stock returns.” Also wrong, or at least misleading. Over the short term it’s true that stocks can fall when GDP growth is strong, and vice versa. But in the long run economic growth, company profit growth and a rising stock market all go hand in hand.
- “Price volatility is the same as risk, and therefore a bad thing.” Not if you’re a private investor, and not if you approach it the right way. In fact wild price swings can be a gift from the market. (For more on why see here and five guidelines on how to profit here.)
Even if certain sacred cows are overdue at the slaughterhouse, this doesn’t mean that all of the theories aren’t useful. That’s even if they aren’t perfect.
One example is the idea of the “efficient frontier”, first developed by Harry Markowitz in 1952. Here’s a short definition from Investopedia (I’ll translate in a minute):
“The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.”
“Risk” in this case means volatility, or price swings. “Expected return” means likely future return – the average of a predicted range of outcomes.
The idea here is to set up a portfolio that gives the maximum level of profit for the minimum amount of price swings.
Let me clarify an important thing here, as there’s potential for confusion. You may think that I’m contradicting myself.
When it comes to individual investments, big price swings can be a great thing (see here and here). From time to time prices fall for the wrong reasons, which is a buying opportunity. Then prices can rise too far, which is a selling opportunity. The difference is a tasty profit.
But – and this is important – when it comes to an overall portfolio of many investments, few people can stomach huge moves. So, in the interests of nerves and fingernails, steps should be taken to reduce the chance of big swings in the overall sum total of your investments (see here and here).
Understanding this subtle distinction is essential. You can use market volatility to boost profits from individual investments. But you must hold many investments, in several different markets and asset classes, to eliminate the chance of volatility scaring the pants off you.
In short, you must diversify.
To get this magical “efficient portfolio” financial analysts look at likely future returns, and also how prices of different things have moved in the past. Specifically they look at how prices of things have moved relative to each other.
The idea is to find a mixed bag of investments with decent profit prospects in the long run, but where the components are likely to move in different ways in the short run.
For example, if stocks crash then government bonds will usually go up in price. Prices swings are “hedged”. The overall value of the portfolio is insulated from big and sudden price swings in individual investments.
Here’s a chart from Research Affiliates which helps to explain. The blue dots along the curve are a range of these “efficient portfolios”.
The horizontal axis shows how much the portfolio is prone to price swings (for the mathematically minded it’s the standard deviation of the expected future profit distribution). The vertical axis shows the expected real (above inflation) return for that mix of investments (the mean or “average” of the expected future profit distribution).
All the blue dots are meant to be the best profit you can expect to get for a given amount of likely price swing. They include a great many different types of investment – from emerging market currencies to high yield (junk) bonds to commodities to stocks.
All that changes from left to right is the mix. If you want more profit you have to put up with the likelihood of bigger price swings.
Interestingly, none of those blue dots – not one – includes any US stocks. In other words the analysts reckon that US stocks are overpriced for the risk involved in owning them (at the index level). This is consistent with my view.
So what about my own suggestion for what to own? Where does that fit into this chart?
Unfortunately there’s no option to choose gold, which I suggested should be 10-20%. But there is an option to choose “commodities”, which is an asset class usually dominated by oil, gas, and industrial metals such as iron ore and copper.
Like gold, commodities are often linked with general price inflation. In fact they cause a lot of it when they go up.
So, as an imperfect proxy for gold, I’ll include 10% allocation to commodities. At least that way there’s a bit of extra diversification. I’ve then put 30% into short term US treasury bonds – which behave very similarly to cash or bank deposits.
The remaining 60% I’ve split between 40% in emerging market stocks and 20% into “EAFE” stocks. EAFE stands for Europe, Australasia and Far East. Basically it means an index of developed market stocks outside North America (which is dominated by the expensive US stock market).
Most of it’s made up of Japan and countries in Western Europe. Those are often troubled economies, but stuffed with multinationals that sell globally, and better priced than the US market.
In reality I’d construct a portfolio more carefully than this, but I’m limited by the choices in the model. Not all emerging market stocks are attractive, let alone non-US developed market ones. And it contains general commodities instead of gold. But it’s a reasonably good approximation. I’ve called it the “target proxy”, and it’s the red triangle in the chart below.
You can see that this very simple portfolio is right up close to the blue dots that are on the efficient frontier curve. It’s a pretty optimal mix of expected price swings and likely profits.
That’s a great result for such a simple construction. According to this model my target proxy portfolio is expected to make 4.8% above inflation over 10 years. So if inflation is 2% it should make around 6.8%.
Such a return is not massive. But that’s not surprising given the 30% sitting in ultra low return cash deposits (or treasury bills).
It’s also not what I’d expect to happen. Remember the cash has dual roles. It provides stability (“ballast”) right now. But it also provides the ability to invest in future, when there are more assets available at a reasonable price (“ammo”).
At some point I’d expect stock markets to take a dive (tick tock tick tock…). At that point the cash can be used to scoop up bargains and boost future profits as markets recover.
Like much financial theory, this idea of efficient portfolios isn’t perfect. It’s a tool, not a crystal ball. But that doesn’t mean it should be completely ignored.
In the current environment I’m sticking with my recommended investment allocations.
Stay tuned OfWealthers,
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