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My investment beliefs and portfolio

My investment beliefs and portfolio

How I codified my investment beliefs

When people know you're into finance and investing, they tend to ask what your favorite trade or investment is. I always feel a little odd answering the question, because I never have a cool stock or trade to share (as much as I am dying to short TSLA right now). Instead, I tell them the truth: a couple years ago I developed my own investment guidelines and principles that I used to create a long term portfolio of 10 equally weighted low fee index ETFs. Each index is something I believe in, over a 10 year time horizon, although I attempt to achieve different things with different funds. Every year, I invest a little more, quasi-rebalancing by investing in the funds that are the most underweighted. I rarely make more than 3 trades a year, and they're usually always buys. 

It's actually mind numbingly boring, and most people are sorry they asked by the time I tell them how little I trade. But, I'm guessing that if you're reading this, you're on the same page. By sharing this I hope you'll poke holes in my theories, share your own portfolios and goals, and help me to be a better investor in general. 

Note: The document that follows is essentially a verbatim copy of the investment guidelines document I wrote for myself two years ago, in 2015. I structured it as if I were pitching the ideas to other investors. If I'm investing my own money, I need to be able to articulate and sell the benefits of my investment guidelines and portfolio. I use Personal Capital to keep track of my portfolio and check my allocation from time to time. 

Real Finance Guy Core Investment Beliefs

tl;dr: The activities and creativity of humanity will continue to create perpetual, but uneven growth for the foreseeable future.

Since 1950, world GDP has grown from $5 trillion to well over $50 trillion in 2010, a compound growth rate of over 3.5%. Although that number may not appear very impressive, it belies significant variations in the growth rate between different regions, countries, economies and industries. Compounded over time, this relatively modest growth rate has led to a massive increase in world GDP.

To take an example that may be more relevant to investors, a $10,000 investment in large cap US stocks (S&P 500) beginning in 1972 would be worth over $674,000 at the end of 2014. A similar investment in European stocks would have yielded $615,000. An investment in emerging markets would be worth $4,500,000, albeit following a significantly more volatile and unpredictable path. All of these investments would have delivered a compound growth rate in excess of 10%.

The other interesting factor at work here is the disparity between when returns happen for different regions and asset classes. For instance, over the past 7 years (2008-2015), the S&P 500 had a CAGR of 7.15%. Emerging Markets, on the other hand, returned -1.48%. That means that you would have around 10% less in 2015 than in 2008 if you had invested a bulk sum in emerging markets, but almost double your initial investment had you chosen the S&P 500.

In short, there is no perfect investment. What’s more, trying to time investments is exceedingly hard, even if you choose investments that have performed very well in the past.

My core investment philosophy is simple. I believe the economy of the world will expand, and I have no way of predicting how, where, or when that will occur. Instead of trying to guess, I will try to purchase indexes of securities at relative low points in their long term cycles. Over time, I will seek to create a balanced portfolio that will reflect the growth in the world economy from as many different regions, countries and industries as possible. I will buy low, and make every attempt to hold every security I own indefinitely. Over the long run, even though I will make mistakes, the growth in the underlying world economy will compound my initial investment many times over.

If I am able to invest at attractive prices, in a well diversified set of indexes, it should be possible to beat large cap US stocks in CAGR, while maintaining a lower standard deviation of returns.

Goals

My investment goals are relatively simple. As stated before, I intend to invest for the long term, so capital appreciation is my primary goal. In order to support my ideal of holding all of my investments indefinitely, my secondary goal is the protection of my assets: I don’t want a tough drawdown to scare me into selling everything. Third, to support rebalancing without sale of assets, the portfolio should produce a modest amount of income as well.

Asset Allocation and Investments

It is a challenge to efficiently choose investments that will most accurately reflect the core investment beliefs I have outlined above. The universe of investments, like the world economy itself, is exceptionally diverse. However, there are a small set of fundamental truths that I can use to help guide my decisions.

  1. High reward=high risk. Generally, investments that have a high rate of return have a high variability of return as well. In other words, investments that have historically had high returns have also been more likely to suffer large downswings in value on occasion. This makes sense from an economic perspective as well, because investors will generally bid up the price of investments that are “sure things” to the point where they return relatively little.

  2. There are no guarantees. For the past century, the United States has been a paragon of innovation and growth. From 1750-1900, the same was true of Britain. From 500BC to 500AD, the Roman Empire. Admittedly, these are long time horizons, and the North American economy looks as robust as ever. But… that can change quickly, as the British learned after World War I.

  3. What goes down will eventually go up. Assuming that my core investment beliefs (the world economy will grow) are true, there are very few asset classes that will return 0% or less on a long term basis. In fact, assets that have performed very poorly over a defined length of time have a significantly higher probability of performing well over subsequent time periods.

All of these truths point to an investment and asset allocation imperative: diversification. Diversification in the retail investment world has often simply meant a 60/40 split between stocks and bonds, with the S&P 500 comprising the stock portion of that split and perhaps the Barclays Total US Bond Market index representing the bond portion. Although this very simplistic example is rarely implemented in real life, it does represent the essence of the investment beliefs of the status quo: that the US economy is preeminent and will continue to be.

However, as noted, there are no guarantees. It is highly probable that the US economy will continue to grow, and robustly. An investment strategy that ignores the rest of the world will likely miss out on growth in Latin America, Africa and Asia, where populations and economies have been expanding at a significantly more aggressive rate than the developed world.

Similarly, an asset allocation that ignores commodities, derivatives, real estate and other types of investments may miss out on opportunities in those areas. Those asset classes may be more volatile and illiquid than US stocks and bonds, but it seems odd to ignore them completely.

To summarize, the investments I choose must be fully diversified across geography and asset class, and chosen not just based on the fashions of the time or historical returns. I must also take into account what assets and indexes will become more valuable as economies beyond the developed world begin to have a larger effect on the economy at large.

There is one more thing to consider before I choose actual investments: risk. As my time horizon exceeds 30 years, it seems more prudent to focus on overall return at this point in time than variability in return. In other words, risky assets are more attractive within a very long time horizon than they are within a very short time horizon.

The following table explains my chosen asset class and geographical distribution.

Asset Class

  • Equities 60%

    • Over the long run, equities have provided the highest return by asset class. It makes sense to focus on equities in a portfolio with a long time horizon.

  • Fixed Income 20%

    • Fixed income investments can significantly lower the volatility of the overall portfolio, providing some measure of downside protection. At the same time, income can help ease yearly rebalancing and reduce the need for asset sales.

  • Commodities 10%

    • Commodities are highly volatile and unpredictable. However, if the continued growth of the world economy is to be expected, it is only reasonable to assume that the finite resources my planet has to offer will become significantly more valuable over a 20-30 year time horizon. Commodities have also been in a long term bear market over the past 3-5 years, and valuations are very attractively timed for the investment plan I have in place.

  • Real Estate 10%

    • In some ways, an investment in a Real Estate Investment Trust (REIT) combines the advantages of all three other classes. As with commodities, real estate in attractive locations will only become more scarce (and valuable) on a per capita basis over a long time horizon. Many REIT investments also offer an attractive income stream. However, they function very much like an equity in that they are companies that are managed, often leveraged, and therefore capable of higher rates of return than brick and mortar real estate investments. Having a small percentage of the overall portfolio devoted to real estate provides further diversification as well.

Geography

  • US 60%

    • The US economy is robust, with many independent growth drivers. There are many risks to the preeminence of the American economy, chief among them being demographics, but few indicators that point to a massive deceleration or cessation of growth.

  • Developed Ex-US 10%

    • The developed economy outside of the US is extremely diverse, spanning from Australia and Japan to the UK and EU. In fact, this group of countries is so diverse it is difficult to enumerate a specific strategy for them. I have allocated a smaller percentage of the overall portfolio for these markets because Europe and Japan comprise a large portion of the related indices, and both of those markets have large macroeconomic factors inhibiting growth. In Japan, the main contributors to anemic growth are demographics, a lack of innovation, and (potentially) crippling government debt loads. Europe’s future growth is also uncertain, with the stability of the Euro zone and its southern members of particular question. Debt levels, unemployment and innovation are almost universally poorer than in America, justifying a lower level of investment in this area.

  • Emerging Markets 10%

    • Emerging markets have been a horrible investment over the past ten years… but a fantastic one over the past 30. Over the long term, smaller economies with robust workforces and large commodity resources have shown their capability to grow at double or even triple the rate of the developed economy. The fact that the main emerging market economies (BRICs) are all currently in a bear market only makes a long term investment in these countries more attractive at the present time.

  • Frontier Markets 10%

    • Everything that holds true for emerging markets is even more representative of Frontier markets. The risk is exceptionally high, but over the long run the risk of not being in these markets and ignoring the potential growth drivers of this century is even higher.

  • All/Non-geographic 10%

    • Commodities are more difficult to pin down to specific geography - that's what this bucket denotes.

Investments

With these asset allocations in mind, I have chosen a mixed basket of low fee, index tracking ETFs that provide the desired exposure to each asset and geography. Each investment will comprise 10% of the overall portfolio.

    • VB - US Small Cap Blend

      • Index: CRSP US Small Cap Index

      • Fee: 0.09%

    • VO - US Mid Cap Blend

      • Index:CRSP US Mid Cap Index

      • Fee: 0.09%

    • VV - US Large Cap Blend

      • Index: CRSP US Large Cap Index

      • Fee: 0.09%

    • VEA - Global Ex-US Developed

      • Index: FTSE Developed ex North America Index

      • Fee: 0.14%

    • VWO - Global Ex-US Emerging

      • Index: FTSE Emerging Markets All Cap

      • Fee: 0.15%

    • FM - Frontier Markets

      • Index: MSCI Frontier Markets 100 Index

      • Fee: 0.79%

    • GNR - Commodities

      • Index: S&P Global Natural Resources

      • Fee:  0.4%

    • TLT - Long Term Treasuries

      • Index: Barclays U.S. 20+ Year Treasury Bond Index

      • Fee: 0.15%

    • VCLT - Long Term Corporate Bonds

      • Index: Barclays U.S. 20+ Year Treasury Bond Index

      • Fee: 0.12%

    • VNQ - REIT

      • Index: MSCI U.S. REIT Index

      • Fee: 0.12%

Average Annual Fee = 0.22%

For the more visual, here's a quick breakdown:

 

Benchmark and Success Metrics

There are two main goals that this portfolio will seek to achieve. First, to outperform the US Large Cap market, as defined and measured in the CRSP US Large Cap index, and invested as the Vanguard US Large Cap ETF, VV. Second, to deliver that outperformance with less volatility and more income.

Volatility is a difficult metric to measure specifically, so this goal will be split into two components:

  • Max drawdown, year to year (have a smaller maximum drawdown than the Benchmark from inception)

  • Sharpe Ratio (have a higher Sharpe ratio than the benchmark)

Investment Schedule

History shows us that it is nearly impossible to time the market. By attempting to sell only at market highs, and buy only at market lows, the human tendency is to sell too early and wait too long to buy. In short, if you want to invest, the best strategy is to be invested. Over the time horizon of this portfolio (20+ years), the most important factor is to be invested as quickly as possible. my fund will seek to do just that with the resources available.

Terms for Change in Strategy

The portfolio manager may choose to augment the strategy at any time following the completion of at least 5 full investment years (ending December 31st each year). The first Strategy Reconfiguration window will start December 31st, 2020. The second will open on December 31st, 2026 after a full ten year investment cycle.

The manager must reevaluate the strategy of investment at each Reconfiguration Window.

Conclusion

In short, I am invested for the long term. I think the world economy is going to grow over that time period. But, I am not exactly sure where, or how. I think this portfolio fairly well captures that, but I am curious to know what you'd do differently?

Other posts about my investments

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Real estate tax deductions for condos

A plan for selling stock options

A plan for selling stock options