And if you can convince the folks at the bank that you have a viable business at hand, the bank will lend you money. And lending means a periodic interest expense that you as a business owner will incur depending upon the terms you signed up for. Plus the money you borrowed to run and grow your business will have to be returned someday.

So your business must earn enough to not only cover all the expenses associated with building and selling your products but also enough to cover the interest expense plus eventually paying the loan off. And then whatever is left over are your profits.

What could you have done instead of borrowing that capital from the bank? You could have convinced the same folks at the bank to give you the money in return for a small piece of your business.

So now the folks who provided you with the much needed capital are partners in your business.

Plus there is no ongoing interest expense because the partners (investors) in your business now are in the same boat as you. And the money doesn’t have to be paid back…in theory. They are now part owners and they want you to succeed because if you succeed, they succeed.

Plus look at it from the bank’s point of view and their risk-reward situation. Their risk if you borrow the money is that your business fails and the bank not only loses the interest income but also the capital they lent.

But if your business turns out to be a startup that becomes the next Apple, they don’t get to participate in all that upside. All they are left with is collecting that measly interest income instead of the gusher of profits that would have flowed to them if they owned a stake in the next Apple. Or Amazon. Or Google.

Because with an equity stake in the business, they own a piece of that business and hence a piece of the profits made by that business.

So owners of businesses inherently make more than lenders because:

• As Naval Ravikant, the founder of AngelList says and I am paraphrasing here – when you are the owner of a business, you own the upside as well as the downside. But when you are a loaner to a business, you do own a guaranteed revenue stream (interest payments) but you also own the downside. So capped upside as a loaner with all the downside.
• Public businesses are run by some of the smartest folks around. We do occasionally hear stories about abuses here and there but in aggregate, these folks are running our businesses the best they could. And no business manager will borrow money at a cost (interest payments) that exceeds profits. So if you own a collection of them, you are bound to out earn a loaner.

The only advantage of being a loaner (lender) is that regardless of what happens to the profits in a business, the lender must get paid their ongoing interest and towards the end of the lending term, the entire loan amount (principal).

So there is a bit of a stability in the value of your investment being a loaner but that’s in the short-term. And that’s assuming the business survives.

As an owner, if business conditions deteriorate, profits decline and the value of that business declines. If that continues for long, the business could permanently shut down and the value of your ownership stake in that business will go to zero.

So stockholders (owners) suffer as well as the bondholders (loaners).

But that is if you own just one business.

The stock market and the bond market allow you to spread your money into hundreds of businesses and not all of these businesses will shutter.

If they did, the stocks will go to zero but so will the bonds. And you’ll have far worse things to worry about than worrying about money if that happens.

So if you are saving money towards goals that are more than a decade out, being an owner must pay out better than being a loaner.

But being an owner (stockholder) over a shorter-term means you are exposed to the full brunt of the volatility in business cycles and volatility as we know cuts both ways.

Thank you for reading.

Cover image credit – Jose Francisco Fernandez Saura, Pexels

This and the Capital Asset Pricing Model that Dr. Sharpe subsequently developed led to him winning the Nobel Prize in economics in 1990.

The Sharpe ratio…

In English, it is the excess return of a risky investment over and above the return that a safe investment yields per unit of risk (volatility) of that risky investment. This is another way of stating that what counts is not just returns but risk-adjusted returns.

The risk-free rate of course is not constant. Many use T-bills (Treasury bonds with a maturity of less than a year) as the benchmark for the risk-free rate but that’s not always right. Stocks as we know are long-duration assets (perpetuities in theory) so if you own an all-stock portfolio, you need to match that with a comparable duration asset like say a long-term bond with a 10-year or a 30-year maturity for instance.

And if you add shorter duration bonds to that all-stock portfolio, the duration of the risk-free asset and hence its return to calculate the Sharpe ratio needs to be adjusted accordingly to match duration for duration.

But in today’s never seen before interest rate world, the risk-free rate of return difference between long and short maturity bonds is not going to make or break things. In fact, you are free to ignore duration entirely and use a flat 1 percent rate of return in lieu for the risk-free rate.

So that was a bit of a technicality but what Sharpe ratio tells us is that you better get compensated for the risks you take in your portfolio. And the higher the Sharpe ratio for a portfolio, the better designed a portfolio you have. Within reasons.

Because you can play games using leverage etc. to prop up the Sharpe ratio of a portfolio but we know the thing with leverage. When things blow up, they blow up spectacularly.

But Sharpe ratio or anything to do with long-range portfolio construction and prediction does not work with individual stocks. Or individual bonds. Or a single piece of real-estate. Or your entire angel investment portfolio.

It only works with broad-based asset classes that you can derive meaningful statistics from to build a portfolio around which then forms the core part of your financial plan (more on that later).

So someone just starting out in his career could have owned an all-stock portfolio that is globally allocated, across size and value factors. Of course an all-stock portfolio means being exposed to the full brunt of the volatility of stocks but that’s expected.

And this is what you would have had to endure over the years. We are going to run through three different portfolios with this one being the one with a lower Sharpe ratio than the other two. A lower Sharpe ratio isn’t necessarily bad but if you are comparing two likewise portfolios, you’d want to the pick one with a higher Sharpe ratio as long as you understand what’s in that portfolio.

The exact mix of this all-stock portfolio is irrelevant because you can always implement your own tweaks based on which corner of the market you think offers a better value but this is what you should expect. Or at least this is what you did get going back in time.

Now these are rolling returns which means that say for the 3-year bar in the plot above, you’ll start out in 1987 and end in 1990, then move to 1988 and end in 1991, then to 1989 and end in 1992 and so on. That way, you are not picking and choosing timeframes.

So what stands out is there was a year when this portfolio declined in value by 41 percent but then there was also a year where the portfolio gained an equivalent amount. But there was never a 5-year period where this portfolio lost you money. So that’s the perk of remaining invested for the long-term.

And depending upon how lucky or unlucky you were, the difference in returns between different 20-year periods is huge. I mean there was a 20-year band in the same 1987-2020 time-period where you did almost 12x your money (+1072 percent) in one versus just 4x your money (+323 percent) in the other.

And that worst 20-year band most likely corresponds to the last 20 years that ended in 2020 as can be seen with the exact annualized returns that you were able to achieve with this all-stock portfolio.

But this 20-year band saw a lot. Starting out of the gate was the Dot-com crash followed by the housing market crash of 2008 and then of course the pandemic. Not saying that the next 20 years can’t be worse but just saying.

So if you endured through this, you should be able to endure through anything the market throws at you except for world-ending calamity. But then, your portfolio would be the least of your worries and hence.

Now someone mid-career who had amassed a reasonable amount of money towards retirement could start to temper down on the volatility by allocating say 20 percent towards bonds. Bonds are less volatile and don’t generally yield more than stocks but the lower volatility of bonds and their inclusion in a portfolio shows up in the increase in Sharpe ratio of that portfolio. Again, not necessarily good or bad but a metric you can use to compare across similarly constructed portfolios.

And the best and worst-case returns below.

The annualized returns for the same portfolio going back in time.

Not that much different from an all-stock portfolio but that was for the last 20-years where stocks were literally cut in half twice in one decade.

Now someone nearing retirement could have increased the allocation to bonds to say 40 percent. The Sharpe ratio for this portfolio as expected goes up so if you are comparing two portfolios with a similar stock/bond mix, you’d know which one’s more efficient.

And the best and worst case performance data below…

…as well as what this portfolio did going back 20 years.

Again, the anomaly with the last 20 years shows up with stocks not doing as well as they did historically and with bonds absolutely crushing it. This is unlikely to be repeated for a portfolio with 40 percent allocation to bonds over the next 20 years though.

So what kind of portfolio should you own? But before that, a bit on what I do with my (our family’s) money.

We use a core and explore approach to how we deploy our savings. The core is the can’t miss, can’t fail segment of our money that must be there when we need it and hence is invested accordingly. That makes up about 90 percent of all the money we have though that percent allocation is higher now for reasons I’ll elaborate on more below. And it’s invested in an all-stock portfolio like the one shown above for three reasons:

• 4 percent is what is typically used as a safe withdrawal rate from a portfolio to live on during retirement though that might need some adjustments considering the interest rate environment we find ourselves in. But a 4 percent withdrawal rate means your portfolio cannot afford a lot of volatility and hence bonds become an important component of that portfolio. But if say a 2 percent withdrawal rate is plenty to live on during retirement then there’s no need to add bonds as dividend income alone can fulfil your income needs and that is where we expect to find ourselves at.
• There is unlikely to be a repeat of bond market performance of the last 40 years over the next 40. So if you don’t need bonds, you should not need bonds. Yes, the right kind of bonds can and do make the ride smoother but if you don’t care about the ups and downs, you don’t need bonds either.
• And though an all-stock portfolio will have an inferior Sharpe ratio than a portfolio with a decent allocation to bonds, that in and off itself is not necessarily bad. Because there is no guarantee that adding bonds will enhance the volatility reduction benefits bonds provided in the past. So though Sharpe ratios are important to compare two similar portfolios, that is where that comparison stops. Just because a portfolio’s Sharpe ratio is lower does not automatically imply inferiority.

I also do a bit of exploring with our money and that’s where the tiny explore portion of our money is invested. We haven’t done much to this in the last many years due to the valuation environment we find ourselves in but we will at some point again when wonderful businesses could be had at reasonable valuations when this current cycle turns. And turn it will.

But of course there is no need to do the explore if you are not meeting your plan goals. And it also comes down to whether you enjoy doing all the work needed to explore because work it does take.

Plus since statistical calculations can’t be done with the explore segment of my portfolio, Sharpe ratios and things like that goes out the window. This is an attempt to eke out a bit more than what the core-only portfolio can deliver but of course there are no guarantees.

The explore portion of our money is currently invested in a bunch of businesses that are small, cash flow rich with predictable business models. At least, businesses that I can do some modeling and projections on. Businesses like Raven Industries that make precision agriculture products and engineered films. It’s been in the news lately as it is getting acquired in an all cash deal.

Other companies that were acquired since the time I first built this portfolio almost a decade back…

• Pall Corp., a maker of water filtration systems was acquired by Danaher Corp. August 28, 2015 was the last trading day for the stock.
• Mead Johnson Nutrition Co., maker of infant formula such as Enfamil brand, was acquired by Reckitt Benckiser Group. June 14, 2017 was the last trading day for the stock.
• Clarcor, a maker of filters for automotive and heavy industrial applications was acquired by Parker-Hannifin. February 27, 2017 was the last trading day for the stock.
• Kaydon Corp., a maker of industrial bearings and shock absorber systems was acquired by SKF. October 15, 2013 was the last trading day for the stock.
• Bio-Reference Labs, a provider of clinical laboratory testing services for the detection, diagnosis, evaluation, monitoring, and treatment of diseases in the United States was acquired by Opko Health. August 19, 2015 was the last trading day for the stock.
• Sigma-Aldrich, a company that develops, manufactures, purchases and distributes a range of biochemical and organic chemical products, kits and services that are used in scientific research was acquired by Merck. November 17, 2015 was the last trading day for the stock.

Then there are business like International Flavors and Fragrances. And W.W. Grainger. And Copart. And C.H. Robinson Worldwide and a few others that we’ll continue to own for a long time.

Hope this helps.

Thank you for reading.

Cover image credit – RF Studio, Pexels

And as it is with anything exotic and of the swash-buckling kind, the media couldn’t get enough of him. The New Yorker pronounced him the stock market’s ‘certified golden boy’. Investors’ money of course followed. And by the boatload. Assets under management in his fund grew from a mere $12.3 million in 1959 to $340 million by the time he called it quits in 1965 to venture out on his own.

He then launched the Manhattan fund seeking to initially raise only $25 million. And we know investors chasing performance never gets old and hence they clamored to get into his fund. He ultimately wound up with 10x more money than initially planned.

And you probably know how that movie ends. The Manhattan fund had two middling years and then the roof caved in. By July 1968, it was the sixth worst performing fund in the country. And just a year later, it had lost 90 percent of its value never to recover again.

About a generation later, in March of 2000 just as the bubble created by the Dot-com boom reached its zenith, Merrill Lynch, the then world’s largest brokerage firm jumped on the bandwagon with not one but two new funds to sell. The first was a “Focus Twenty” fund. The other was an “Internet Strategies” fund.

The offering of course was an incredible success. It always is towards the tail end of a mania. The funds collectively pulled in $2 billion at the onset.

But then again, we know how that movie ends. It was a money-making bonanza for Merrill but a disaster for their clients. The Internet Strategies fund tanked almost immediately. By the end of 2001, less than two years after the launch, investors lost 86 percent of their money.

The Focus Twenty did the same with a cumulative lifetime return through 2006 of minus 79 percent.

I bet if I were to try harder, I could come up with countless such stories across the many booms and busts the world over. They might all start differently but they end the same.

Something similar appears to be transpiring with some hot funds and investments du jour of the day. And you don’t have to look hard to find bubble assets. In fact there are many. Maybe I am too old-fashioned but sometimes amazed at all these businesses selling at twenty, thirty, fifty times revenues with never a sight of profits. And profits are the only thing that matter eventually.

One or two of these bubbly assets could grow into their valuation if ever but these many, never.

So we know how this movie will eventually end and that end’s not going to be pleasant. But you have a choice to make. You can either be a willing participant in the making of that movie or you can watch it on Netflix whenever it comes out. I prefer the latter.

Thank you for reading.

Cover image credit – Jonathan Borba, Pexels

But whether it is different or not can only be known in hindsight. But when a majority of investors believe that this time is indeed different and are getting rich of it is when the chasm between asset prices and their underlying value grows. That’s happened in the past and will continue to happen in the future. That’s human nature.

So is this time different? Similarities are aplenty between the current stock market boom, especially in tech, with the Dot-com boom at the turn of the last century. New public listings were seeing euphoric rise in prices then as they are seeing now. Investors were willing to fund anything and everything that moved back then whether a viable business existed or not. Something similar appears to be the case now.

And a viable business of course means not just revenues but profits and cash flows. And sustainable at that.

So though there are a lot of similarities, there are BIG differences.

The price to earnings ratio of the stock market today stands at around 30, about the same as it was during the late 1990s. So the earnings yield of the stock market hence is 3.33% (earnings/price), about the same during both periods.

Now if you had money to invest, did you have viable alternatives to bypass the craziness with the stock market back then? You indeed did.

Back in the day, a 10-year Treasury bond yielded 6.5% so you could have locked in that yield every year for ten straight years. And mortgage rates are tied at the hip with Treasury bond rates so real estate had to yield the same or more. And it did.

No such luck now with yields on that same bond at less than 1%. There is no suitable alternative. Yields are low on pretty much everything and prices are hence, sky high.

One more thing that’s different between now and back then is the sheer size of the market debuts of many businesses going public today versus in the past.

Amazon went public in 1997 at a 438 million dollar valuation, literally a small-cap. Microsoft, a decade before that had its public market debut at $700 million valuation. Apple at a billion.

So public market investors at the time were literally getting in on the ground floor. They were the venture capitalists of the day.

And we know the venture capital business model. Most investments go nowhere with only a tiny fraction of them making up for all the losers. And that is what happened back then. You had to spray your money at many businesses going public at the time to get one Microsoft or Amazon or Netflix. That’s how it works. That’s how it was supposed to work. That was the 1980s and the 1990s.

And then the market crashed. Investors who were happy making money when all was great cried foul. So the politicians intervened to ‘protect’ the mom and pop investors from themselves but in that process, they killed that golden goose of letting investors participate in the growth phase of many of the businesses of today.

Now part of that intervention was justified because of the Enrons and the Worldcoms and the Tycos of the day but I believe that the pendulum swung too far in the other extreme.

But if investors were a little prudent back then and knew how to behave and participate right in the markets, the situation could have been different. And we sure hope the story ends for the better now but it looks less and less likely with each passing day.

And hence going public today means dealing with all the bureaucracy associated with quarterly filings and reporting to ‘protect’ investors. That takes time away from actually running and growing a business so a big hassle for newly formed companies. Plus the inability of investors to think beyond the next quarter doesn’t help either.

So businesses are making their public market debuts a lot later in the cycle than they did in the past. These are big businesses. Many are a decade old enterprises with established brands generating boatloads of revenues. The only thing that is amiss are profits.

So that’s a troubling sign. And valuations are outright outrageous but investors don’t care. No price is too high because this time is…

The only silver lining with owning these newly public businesses is that a lot of the losers that would have existed in their midst in times past have already been weeded out in the private sphere.

So private investors are absorbing a lot of the failures and only the ‘real’ ones are getting to you and me. But then we miss out on the growth phase of many of these businesses so both good and bad. I think it eventually cancels out but the process of going and remaining public needs an overhaul.

So my advice, if you care, to you is this:

• Limit this craziness to a portion of your portfolio that if it all goes to zero, will not disrupt your life. Start today and slice off say 10% of your chunk and go at it. That’s your Vegas money. Don’t add more. You don’t have to do any of it but if you must insist.
• Future returns are going to be low. There is no way that risk-free rates could be zero and yet you continue making double digit returns. That’s theoretically not possible. So don’t get used to this and plan to save more.
• The party will be over at some point. Low interest rates amplify asset volatility and the only side we are getting to see is the positive side of that volatility. The negative side is coming. That’s not to fear though. Just expect it and embrace it by sticking to your plan.
  

Rounding this off with this snapshot of a tweet from Chris Sacca, an early investor in some of the hottest brands around (Twitter, Uber, Instagram). I like him a lot. He means well. And there are many more in this business today who mean well. They are a different crop who care about all stakeholders and for them, making money is just one aspect. That should remain and that’s great.

So that’s that.

Thank you for reading.

Until later.

Cover image credit – Andrey Grushnikov, Pexels

Spreading your money into different types of investments to reduce risk of you losing your money when you need it the most. When picking out an asset mix, you want to choose investments in the right proportion that maximizes return while controlling for risk. That describes asset allocation.

Stocks, bonds and cash are the common components that make up an asset mix. And depending upon how much time you have to retire, that asset mix could look something like shown below.

How do they decide on the mix? Fluctuation in the value of a portfolio is a key part of choosing an asset mix. Stocks fluctuate a lot more than bonds or cash, but they tend to make the most over time. Bonds don’t fluctuate as much as stocks and cash is just cash. It stays the same. 

And if you look at the plot above, you see a pattern. The more years you are away from retirement, the more stocks you own. Then why not buy more stocks when you are in retirement? Keep in mind that stocks tend to drop more frequently so when you need the money to live on, you might be forced to sell stocks at a low point. And once you sell and when eventually stocks recover, you will not participate in the recovery. And that is why you also own bonds and cash.

So that’s asset allocation.

Thank you for reading.

Cover image credit – Andrea Piacquadio, Pexels

Craig L. Israelsen, professor of all things financial planning at the Brigham Young University likens the art of portfolio construction to making salsa. I mean you can add your own flavor to a recipe but ultimately, the ingredients that constitute a wholesome salsa don’t differ much. And so shouldn’t the ingredients of your portfolio.

The recipe is your portfolio’s asset allocation. There are complex elements to it but inherently, not that complex.

Some of the elements that make up a salsa, say salt for example, may not be very exciting. And they are not supposed to be. They are neutralizers.

A well-designed portfolio should have its own set of neutralizers.

But then we’ve got a world where the only thing that matters is how you compare against the S&P 500 index. At least lately. Or God forbid, the Nasdaq. Talking about Nasdaq…

Comparisons against these indices didn’t happen as much during the decade of the 2000s when indices similar to these sucked wind but they happen now because we forget. We are too busy. We take mental shortcuts instead of thinking deeply about what we own and why.

And since when do we compare salsa to 500 ground-up tomatoes? We have created a misconception around what diversification is. The S&P 500 is a diversified set within an asset class. That’s not true diversification. That’s intra-diversification. It’s depth, not breadth.

And Nasdaq’s worse. Yes, yes, a lot of companies that make up that index will go on to change our world but it’s still mostly a narrow subset of the investible universe. And there are other means to own it.

So getting both breadth and depth is true diversification. A multi-asset portfolio that encompasses a need appropriate allocation is what you want.

A 60-year old’s portfolio should look different than that of a 30-year old.

A 60-year old’s portfolio with a solid pension should also look different than that of a 60-year old’s without a pension.

Back to the S&P 500, this is what you get when you own just it.

So the biggest 25 businesses take up almost 45% of your money. Even in a winner take all kind of an economy, that’s too much concentration in just a few businesses if this is all you’ll do with your money.

And large businesses don’t stay large forever. They become stodgy, bureaucratic and unmanageable and eventually get replaced by smaller, more nimble rivals. It is only a rare breed that can maintain their market power for decades on. A prime example of that process and there are many is General Electric which at one point was the largest market value business in the world but now is a shell of its former self.

The current bunch of the large cap universe could be an exception but history says otherwise. There is always something around the corner that would dislodge the hot ones of today. It might take longer but it’s going to happen.

Plus a portfolio invested only in the S&P 500 index leaves out stalwarts like these and 3,000+ others…

Not a collection that screams of deep value but it is a collection.

So what’s a flavor of depth and breadth? Maybe this…

That’s for domestic equities. The ingredients and the proportions can change based on where you are in life but seems even-keeled and at least pointing in the right direction. You do something similar for international equities. Then you bring in bonds and cash, real estate and alternatives. Now that’s salsa.

On bonds, the last 40 years have been the best 40 years in the history of the fixed-income world. That’s not going to be repeated so caution on what type and duration to own is warranted.

And the portfolio you design should be a function of how much you’ve saved, what you’ll continue to save plus growth in value. Expecting just your portfolio to do the heavy-lifting without a pitch from your savings is not going to cut it in this yield-starved world. Encounter anything that promises that, run.

And last, as Carl Richards, the author of The Behavior Gap says, you can have the best portfolio ever designed in the history of the world and you make one behavioral mistake a decade, you might as well have stuffed all that cash in a mattress.

So don’t.

Thank you for reading.

Until later.

Cover image credit – Karolina Grabowska, Pexels

So what’s a wrong market environment? This…

Are you seriously telling me that people are willing to lend money today to the U.S. government for 30 looooong years to earn a puny, pathetic 1.3% a year for that entire duration? What does that tell us about the state of our economy and our future? Nothing good as such.

That grey curve by the way, literally hugging the floor for close to a decade, that’s what the Federal Reserve had to do to keep the economy afloat in light of the banking crisis of 2008. And short duration rates are the only rates the Fed or the European Central Bank and other Central Banks around the world control. The longer term rates are decided by the markets. If investors in aggregate expect that the lowering of rates by the Central Banks will ignite inflation out in the future, they will expect to be paid for taking on that risk. And hence, longer-term rates are usually always higher than the shorter-term ones.

But before all of that, a bond as we all know represents a loan an investor makes to an entity. That entity could be the U.S. government, a local municipality, a corporation or a foreign country. They need money and you have money so you lend it out at an agreed upon interest rate that the market decides.

And interest rates and bond prices move in the opposite direction. As interest rates rise, bond prices fall and vice-versa. So say you buy a 30-year bond today yielding 1.3%. If you hold that till maturity (for all of 30 years), you will get that yield every year and at the end of that term, you’ll get your principal back.

But say rates rise to 3% next year and for some reason, you decide to sell that bond. Would you be able to sell at the same price you bought it at? Hell no. You will have to discount that bond to a price that equates to what the market yields are. So you’ll take a hit on a supposedly safe investment.

The lower the rates and the longer the duration, the harder the price falls when interest rates rise. So if you are buying a bond with a duration longer than say 5 years, expect a lot of volatility if interest rates change.

You add bonds to a portfolio to dampen the overall volatility of a portfolio and if that is the intent, short-duration bonds are your only choice now. Short-duration bonds yield zilch today and hence any portfolio that includes them in a proportion that was historically deemed reasonable will not return as much. And that’s the reality.

But don’t show that light to the many city and state pension funds that are still assuming a 7% rate of return in their calculations. And even with that, they are so deep underwater that bailouts would be the only recourse. Or a significant haircut in what as a pensioner you should expect. So it’s best to plan for it and don’t assume that the income that’s promised will be there for you when you need it.

So what are some of the other implications of the interest rate predicament we find ourselves in? For one, it inflates prices of everything around us. Take for example that rental property you were exploring a few years back. You might have been balking at the 8% net yield thinking it was low.

But then the interest rates cratered and suddenly you are on board even at a 5% yield. How did the yield get to 5%? The price of that property rose. Or maybe the landlord marked down the rents. Ha…

Or say that iffy investment you were trying to make in your business just a few short years back. It doesn’t look as iffy anymore. You will gladly pursue that high risk, low reward deal because the hurdle rate is so damn low.

Or take stock market valuations for example. I hate to pick on Apple but let’s use that as a way to prove a point. It’s a 1.7 trillion dollar market value company that trades at a price to earnings multiple of 30. That’s an earnings yield of 3.33% for a company that did $260 billion in revenue last year.

But that yield is not that far away from what a 30-year bond yields today. Granted, the bond will never yield more than the stated yield but a business can for sure grow its revenues and profits. And that is the expectation.

Buying a stock in a sense is like buying a bond but without a maturity date. It basically is an annuity that pays indefinitely (perpetuity) because businesses in theory can last forever. But they don’t and we all know that. Someday, even the mighty Apple will not be Apple and will be replaced by something new. And history is replete with that scenario panning out.

Investors are willing to pay that much more for a company that size is because of something called TINA (there is no alternative).

But then Apple is a cash generating powerhouse so maybe it deserves that valuation. Time will tell. But the rest of the market and especially with tech has completely gone off the rails. I am not saying a crash is imminent because there is a theoretical backstop to that with all this liquidity being pumped into the system. That money has to go somewhere.

But it should not come as a shock to anyone if there is one because the fact that you have money in your pocket does not mean you pay whatever you want for an asset. Fundamentals rule, eventually.

And there is one place this interest rate situation impacts all of us and that is with housing. The interest rates first…

Your mortgage of course will be at a rate a percent or two higher than what the Treasuries yield (imagine a 10% mortgage rate back in the 1990s…) but let’s just go with this.

And since bond prices rise if and when rates fall, this is the corresponding rise in the price of a 30-year bond over time…

So if you bought a home in 1990, the value of that asset quadrupled just because the rates dropped and dropped and dropped, all other factors remaining constant of course.

So you have about the same risk of buying a home now as you have with any long-term bond.

But then a home is where a heart is and if it was not a quality of life ONLY decision in the past, it better be one now. Because that interest rate magic is going to work against you if and when rates turn, all other factors remaining constant again of course.

So that’s about it. Thank you for reading.

Until later.

Cover image credit – Cottonbro, Pexels

So a very clean bell-shaped distribution.

But instead of say having access to 1 million data points, what if we had only 100 data points? The underlying population is still normally distributed but because of the smaller sample size, the distribution might not quite look bell-shaped which is what we were expecting.

It could look something like this…

So that’s the difference between dealing with sample data vs. population data. You could be dealt any hand possible based on the size of the sample you collect and the differences between sample to sample can sometimes be big. A given sample could precisely represent the population or could be a completely different distribution altogether even though the underlying population distribution is still normal.

So now that we got that straight, what does that have to do with our money? The plot below is the performance distribution of the two dominant asset classes that we have reliable data on over the past 90 years. Stocks here are represented by the S&P 500 index and bonds by the 10-year Treasury bonds. You could replace S&P 500 with a diversified global stock portfolio and you’d get more or less the same distribution but because global stock market data going that far back is not readily available, we use S&P 500 as a proxy.

Stocks are more volatile than bonds. We know that and we can see that from the comparison of the spread between stocks and bonds. And I don’t know about you but neither of these distributions look bell-shaped to me. That’s because though we have data on 90-years of performance for these two asset classes, they still represent a small subset of the population of all the returns that have happened before and all the returns that will materialize in the future. So the underlying distribution of the stock and bond market returns could still be normal and if we assume that, here’s what the distribution of returns could look like for the two asset classes over a span of say 1,000 years .

Almost bell-shaped. So the underlying distribution can be assumed to be normal even though the 90-year sample does not look anywhere close to normal. And unfortunately, we have to make that assumption to assess the impact of these statistics on our portfolios. And our lives.

So now that we got that straight, say you are a young whippersnapper with a 40-year investment time horizon. Your time horizon in reality is much longer than that but let’s just stay with this for now. You have some cash that you’ve saved up and you want to plunk that down in a portfolio of stocks that yields on average say 7% during that 40-year time frame. Why stocks? Because you are young and you can afford any level of volatility (these words could come back to haunt you) the market throws at you. And 7% for an all-stock portfolio is lower than what the markets have yielded historically but we know the valuation and the interest rate drill and hence 7% sounds about right as an assumption.

So what would you have in 40 years if a single $1,000 were left to compound at 7%. $14,974 or rounding that off to say $15,000. So that’s 15x your money.

What’s missing? That 15x assumes a constant 7% return each and every year. That of course is not real. Markets don’t move in averages. They can fall a few years in a row, then be up a few years and so on. That’s volatility and the difference with different levels of volatility on the final accumulated wealth can be yuge.

To prove that, we simulate by drawing 10,000 samples of 40-year interval from a population of portfolio returns that is normally distributed but with varying levels of volatility.

And here are the results starting from the worst-case (losing your shirt) to the best-case (making a killing).

So with a 50% volatility, 85% of the portfolios lose money over this 40-year time frame. This is akin to a more venture type of investing and you might want to do that with some portion of your portfolio but not with your entire portfolio.

Or this could also be an outcome of a very concentrated portfolio of stocks.

Historically, the standard deviation (volatility) associated with a broadly diversified stock portfolio is around 20%. With bonds, it’s about 6%. You mix the two and you really have to try hard to push the volatility beyond 15%. So in theory, you almost never lose money with that portfolio. Or at least you didn’t historically.

But avoiding capital loss is not your only goal. You are doing all this to also make some money because you can be a wage-slave for only so long.

So some more data on just how much are you able to grow your wealth by with different levels of volatility but with the same average return.

One thing is clear. Off the chart volatility kills as is evident by the 50% volatility mark in all the plots. You lose most of the time. Plus the probability of you making a killing are so infinitesimally small that you’d rather not try. But then this is where a collection of most small businesses and start-ups lie so not trying is also not good for you and me and the economy. It is these risk takers and investors willing to fund these ideas and businesses that creates this quality of life we take for granted. So we take those chances and we should but with a small portion of our portfolios.

And you don’t have to take crazy risks to do well over time. A portfolio with 5% volatility takes you quite far almost all the time. Yes, you are less likely to make a killing as shown by the ‘no bar’ in the ‘more than 50x plot’ above but you are likely to always match and exceed inflation.

And sometimes that’s all you need, especially during retirement.

Plus any portfolio with volatility less than 15% always made you money and at most times, a lot of money.

And if you are dollar-cost averaging through this 40-year investment timeframe, even an all stock portfolio works, especially during the early phase of your accumulation cycle.

But what you haven’t asked and what you should be asking is, who would go for portfolios with crazy volatility yet only earn 7% returns on average? We know the risk-return trade-off. The more risk you take, the more in terms of a return you should expect.

So then we analyze situations where returns are different – lower returns for a less volatile portfolio and higher returns for the more volatile one. That is, you are getting compensated for taking those crazy risks.

But do you really get compensated for taking those risks in the long run? Back to the data again…

The situation improves a bit for the crazy volatile portfolio but you still end up losing your invested capital 60% of the time.

So the probability of you making a killing with a highly volatile portfolio improved but not by much. In fact, a vast majority of portfolios that return 5% with 10% volatility do better that the portfolios that return 15% but with 50% volatility.

So the moral of the story is to shoot for decent returns that will allow you to meet your goals but ignore volatility at your own peril. And in fact, if given a choice between a higher return but a more volatile portfolio compared to a lower return, less volatile portfolio, choose the latter. Not only will you sleep easy but you’ll sleep easy while getting rich.

Until later.

Cover image credit – Paulo Valdivieso, Flickr

How do I know? Let’s run through some of the events the world has persevered through and yet capitalism marched on. The plot below is the growth of a dollar invested towards the end of 1914 in a basket of U.S. stocks and left there untouched since.

That story likely repeats for global stocks as well but because of limited data going that far back, we’ll use the data we have as a proxy.

And all these markers are events, mostly bad where if we were in the midst of them, we had every reason to bail. But had we not and remained invested, we did well.

Also, the y-axis above is log scale so those bumps that appear to be baby bumps are in fact deep craters that almost looked like it was the end of the world. But we are still here. You are still here.

A cursory look at the market returns we would have to endure through to get here.

These are annualized returns that measures the value of a dollar invested from the start of each year to the end of that year. This does not capture the intra-year (within that year) volatility which many a times is massive. What I mean by that is that we might end a year with say a 7% portfolio return but we would have endured a 30% intra-year drawdown first to eventually recover enough and avail of that 7% return.

And that has happened and will continue to happen. Persevering through that and sticking to our well-crafted investment plans is the only choice we have. And that is the right choice.

It’s one thing to look at the annualized returns and think, no biggie. I can handle that.

But a year is a long, long time watching the value of our portfolios decline day after day, month after month. Only when passing through that phase do we really realize how excruciatingly painful it is. We are likely experiencing that now. But endure through that we must. That is part of the deal.

If one year decline is rough, multi-year declines like the period post the Dot-com crash or the 70’s bear market or during what we had to endure through during the Great Depression is 10x worse. Things eventually recover but we have to continue investing through that by sticking to our plans no matter what. That is the only choice. And that is the right choice.

But who has a 100-plus year timeframe to invest? Okay, so let’s break this timeline into smaller chunks.

1915-1950

Why the quote unquote around only? Let’s chronicle the events that transpired during this time span to find out. And a 35 year timeframe matches a typical career span so even better.

1914 Austrian Prince Archduke Francis Ferdinand travels to Sarajevo to inspect the imperial armed forces in Bosnia and Herzegovina, annexed by Austria-Hungary in 1908. The annexation had angered Serbian nationalists who believed the territories should be part of Serbia. A group of young nationalists hatch a plot to kill the Archduke during his visit to Sarajevo. After some missteps, 19-year-old Gavrilo Princip was able to shoot the royal couple at point-blank range while they traveled in their official procession, killing both almost instantly. The assassination sets off a rapid chain of events as Austria-Hungary immediately blames the Serbian government for the attack. As the large and powerful Russia supported Serbia, Austria asks for assurances that Germany would step in on its side against Russia and its allies that include France and Great Britain. On July 28, Austria-Hungary declares war on Serbia and the fragile peace between Europe’s great powers collapses, beginning the devastating conflict now known as the World War I.

1914 The outbreak of war forces NYSE to shut its doors on July 31, 1914 after large numbers of foreign investors start selling their holdings in hopes of raising money for the war effort. All of the world’s major financial markets follow suit and close their doors by August 1. It would be about 4 months the markets remain closed. Imagine that happening today.

1915 One millionth Ford automobile rolls off the assembly line. Concerns around the fact that the demand for oil will outstrip supply and that the world will run out of oil soon. And then what? The Peak Oil theory will remain a concern like forever and here we are today with the likes of Tesla relegating the fact that the world will ever run out of oil as a non-issue. Stocks gain 81% that year.

1915 The Armenian genocide. Between 600,000 to a million dead.

1917 U.S enters the war. Stock market declines by 22% that year.

1918 Worldwide influenza pandemic strikes (Spanish Flu). It continues till December of 1920 infecting around 500 million people, a quarter of the world’s population. Estimated death toll ~ between 17 million to 50 million and possibly as high as 100 million, making it one of the deadliest pandemics in human history. An estimated 675,000 Americans die. Stocks gain 11% that year.

1918 Germany signs the Armistice at Compiègne ending World War I. 20 million dead worldwide with 21 million wounded.

1918 Russian revolutionaries execute the former czar and his family leading to a Russian Civil War between Reds (Bolsheviks) and Whites (anti-Bolsheviks). Reds win in 1920 and hence the onset of worldwide communism.

1927 German economy collapses. Stocks gain 37% that year.

1929 The stock market crash on Oct. 29 marks the start of the Great Depression and sparks America’s and likely the world’s most famous bear market. The S&P 500 falls 86 percent in less than three years and does not regain its previous peak until 1954 (in price). Stocks decline 8% that year.

1930 Unemployment soars, trade suffers from Smoot-Hawley tariffs. U.S. imports from and exports to Europe fall by some two-thirds between 1929 and 1932 while overall global trade declines by similar levels in the four years that the legislation is in effect. Stocks decline another 25% that year.

1932 Six million die in Soviet famine. Stocks continue their decline (another 9%) after a horrific 44% decline the year before from the already depressed levels.

1933 Germany and Japan withdraw from League of Nations. Stocks soar 50%.

1934 Dust Bowl problem continues. The worst drought in 300 years plagues 75% of the country. Stocks remain almost flat for the year.

1935 Nazis repudiate Treaty of Versailles. Stocks gain 47%.

1937 Beijing falls to the invading Japanese forces. Stocks decline 35%.

1938 Hitler annexes Austria. A 29% stock market gain.

1939 Germany invades Poland. Stocks close flat for the year.

1940 France falls under Nazi occupation. Stocks decline 11%.

1941 Pearl Harbor attack. US enters World War II. Stocks decline another 13%.

1944 The Battle of the Bulge called “the Greatest American battle of the war” by Winston Churchill. Fought in the Ardennes region of Belgium, this was Adolf Hitler’s last major offensive in the war against the Western Front. Hitler’s aim was to split the Allies in their drive toward Germany. The German troops failure to divide Britain, France and America with the Ardennes offensive paved the way to victory for the allies. Lasting six brutal weeks, from December 16, 1944, to January 25, 1945, the assault, also called the Battle of the Ardennes, took place during frigid weather conditions with some 30 German divisions attacking battle-fatigued American troops across 85 miles of the densely wooded Ardennes Forest. As the Germans drove into the Ardennes, the Allied line took on the appearance of a large bulge, giving rise to the battle’s name. The battle proved to be the costliest ever fought by the U.S. Army (about 100,000 casualties). Stocks gain 19%.

1945 Hiroshima and Nagasaki nuclear bombings. 200,000 dead. Stocks gain 36%.

1946 Worst work stoppages since 1919. Less than a year after the end of World War II, stock prices peak and begin a long slide. As the postwar surge in demand tapers off and Americans pour their money into savings, the economy tips into a sharp “inventory recession”. Stocks decline 8%.

1950 North Korean communists invade South Korea. Stock market gains 31%.

So this 35-year timeline that includes the Great Depression, two World Wars, pandemics and every unimaginably bad thing that could have ever happened to this world and we still came out okay being invested in capitalism.

And if there was ever such a thing as financial planning in those days and you panicked and deviated from the plan you had in place and sold at any point in time, well that would have been a sin. Not the greatest of sins but a sin. Why?

The financial underpinnings of the world were still in the early formative stages. The Federal Reserve bank that acts like a stabilizing force during times of economic upheaval today didn’t even exist up until 1913. And even when it did, there was not a lot of data and expertise on how to navigate around pandemics and wars and recessions. Everybody was learning. The system was learning with the world waffling back and forth between two distinct economic systems.

So you were forgiven if you had committed that ultimate sin but had you not and dollar cost averaged into the markets during those 35 years by investing a dollar each year, this is what you’d have.

So instead of $15, you end up with an amount 13x more. That’s hail to the power of an ironclad gut, a long-term mindset and dollar cost averaging. And notice that reduction in volatility because of your consistency in adding to your portfolio no matter what.

Let’s finish off this timeline thingy by recounting the major events that happened 1951 hence and the journey of that dollar that you (or your prescient ancestors) started in 1914.

1951-2020

1951 Seoul falls to Communist forces. Stocks gain 24%.

1953 The Korean War ends with the signing of the Korean Armistice Agreement. The agreement creates the Korean Demilitarized Zone (DMZ) to separate North and South Korea and allows the return of prisoners. However, no peace treaty is signed and the two Koreas are technically still at war, engaged in a frozen conflict. The Korean War is relatively short but exceptionally bloody. Nearly 5 million people die with more than half of them, civilians. Almost 40,000 Americans die in action in Korea with more than 100,000 wounded. Stocks remain flat for the year.

1957 Asian Flu Pandemic (a Chinese origin H2N2 avian influenza) claims 2 million lives. Stocks decline 10% that year.

1958 The Great Chinese famine kills 30 million. Stocks gain 44%.

1959 The Cuban Revolution – communism at America’s doorstep. Stocks gain 12%.

1961 The Bay of Pigs invasion – a failed attempt at ousting Fidel Castro from power. Stocks gain 27%.

1962 Cuban missile crisis sparks Cold War jitters. President Kennedy is assassinated. Stocks decline 9%.

1964 U.S. involvement in the Vietnam War accelerates post the Gulf of Tonkin incident. U.S. also conducts large-scale strategic bombing campaigns against North Vietnam and Laos. Stocks gain 16%.

1968 The Tet Offensive. American public’s resistance to the Vietnam War grows. Despite heavy casualties, North Vietnam achieves a strategic victory with the Tet Offensive as the attacks mark a turning point in the Vietnam War and the beginning of a slow and painful American withdrawal from the region. Stocks gain 11%.

1973 Israel’s Yom Kippur War and the subsequent Arab oil embargo sends energy prices soaring. A lengthy recession ensues. Inflation rate tops 10%. Nixon resigns post the Watergate scandal. Stocks drop 14%.

1975 Vietnam War ends with about 1.4 million Vietnamese and 58,000 Americans dead. Stocks gain 37%.

1979 Iran hostage crisis. Stocks gain 19%.

1980 After nearly a decade of sustained inflation, the Federal Reserve raises interest rates to nearly 20 percent, pushing the economy into a recession. The combination of high inflation and slow growth (stagflation) was a big factor behind Ronald Reagan’s victory over President Carter. Stocks gain 31%.

1983 Terrorist explosion kills 237 U.S. Marines in Beirut. Stocks gain 22%.

1987 Black Monday. Dow falls 22.6% in a single day, the worst in one day since the Panic of 1914. Yet, while the days after the crash were frightening, by early December, the markets bottom out and a new bull run commences. Stocks go on to not only make back all the losses but end the year +6%.

1990 Iraqi troops invade Kuwait. Stocks decline 3%.

1991 The Persian Gulf War. Stocks deliver a 30% return.

1997 The Asian currency crisis. The crisis starts in Thailand on July 2nd with the collapse of the Thai baht after the Thai government is forced to free-float the baht due to lack of foreign currency reserves that previously supported its peg to the U.S. dollar. Capital flight ensues almost immediately beginning an international chain reaction. At the time, Thailand had borrowed heavily that made the country effectively bankrupt even before the collapse of its currency. As the crisis spreads, most of Southeast Asia and Japan see slumping currencies, devalued stock markets, depressed real assets and a precipitous rise in private debt. Stocks earn 33% that year.

1998 The Russian financial crisis. Long Term Capital Management blows up on excessive leverage. Stock market gains 28%.

2000 The bursting of the Dot-com bubble. Stocks decline 9%.

2001 September 11 terrorist attacks. Stocks decline another 12%.

2003 The 2nd Iraq War begins. Stocks gain 28%.

2005 Insurgency spreads. Stocks gain 5%.

2007 A long-feared bursting of the housing bubble becomes a reality and the rising mortgage delinquency rate quickly spills over into the credit markets. By 2008, Wall Street giants like Bear Stearns and Lehman Brothers start toppling and a financial crisis erupts into a full-fledged panic. By February of 2008, the market falls to its lowest levels since 1997. Stocks earn 5% that year.

2008 Lehman Brothers files for bankruptcy. The global financial system is on the verge of collapse. Stocks end the year down 37%.

2016 Donald Trump elected President. Stocks gain 12%.

2018 End of the year stock market decline approaches 20%. Stocks end the year down 4%.

2020 The ongoing Coronavirus pandemic. A 26% decline so far.

I understand any amount of chronicling of history is not enough in light of the mayhem we have seen in the markets and in our portfolios lately. And these are also the times that remind us of the role bonds and cash play in our portfolios if drawing income to live on is a necessity. For the rest of us, we did right by sticking with the portfolios we own.

But these are also the type of events that separate us from folks who commit the ultimate investing sin if there was ever and that is to panic sell. There is no reason to and there is no need to. Granted, there will be some restructuring in the global economic landscape in light of this pandemic. Weaker companies will fail and the stronger ones will come out even stronger than before. And you don’t want to be there picking winners and losers because you are statistically much more likely to own losers than winners. You want the market to sort this out and it will over time.

This world of ours has endured far worse and we see that. We would come out of this just fine. I bet we would be looking back in a decade on this entire episode and say that was nothing. The world has seen far worse. 

And if you are in your twenties or thirties or even in your forties and you are new to this market volatility, I say this: you will have many such episodes in your life when your portfolio massively declines in value, sometimes for a reason and other times, without any. But you have to remain invested because that is part and parcel of this whole process of getting from point A to point B and beyond.

And for the finance nerds out there, when we invest in stocks, we are in fact buying perpetuities that promise to deliver a stream of cash flows this year, next year and many years beyond that, discounted at an appropriate discount rate to the present day. This episode we are living through will impair a few years’ worth of those cash flows but the longer term cash flows will eventually come through. They have to.

Markets tend to overextend on the way up and on the way down. That’s natural. But remember, things are never as bad as they seem when all hell is breaking loose and you are in the midst of that. At the same time, things are never as good as they seem when everything is going great.

So plan for things to go bad when things are going well. And when things look miserable, keep in mind that things will eventually get better.

So don’t go crazy not having any safety buffer to tide you through in situations where your income gets disrupted temporarily. At the same time, don’t panic.

And if you are a market participant (you have to be, you have no other choice), you’ve got to own stocks. There is no plan you can theoretically design in today’s interest rate environment where you can avoid that asset class completely. But when you do own stocks, you’ve got to be prepared for declines every now and then because as Charlie Munger says…

“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament and who can be more philosophical about these market fluctuations.”

Not sure about being philosophical…okay, I can be a bit philosophical but if it makes you feel any better, this is a small collection of businesses amongst the thousands you own if you own a global market portfolio. And they are selling at a discount. So buy if you can.

Some companies will burn and die but capitalism will survive. It has to because… Pascal’s Wager?

The only folks who get absolutely demolished in bad times are the ones who take on excessive leverage. The only leverage that you should very reluctantly sign up for in your own personal life is your home mortgage. And very, very reluctantly at that.

And leverage, especially with stocks, never. Because I am with The Oracle on this…

“It’s insane to risk what you have and need for something you don’t really need. You will not be way happier if you double your net worth.”

And Black Swan events like these is when we see the folks flirting with leverage get completely wiped out. Those 10 AirBnB rentals that you thought you could lever up and make a killing? Not happening. That’s the nature of blind risk and capitalism has a way to cleanse the system every once in a while. That’s ultimately healthy but you don’t want to be a part of that process.

But never in my wildest imagination did I predict these unfolding of events not only with the markets but with our lives. I have been hoping and praying that there would be a correction to clean out the excesses because I feared that the longer the good times rolled, the more remote a chance of a decline will seem, the more overconfident investors will feel and the more risk they’ll take. Which means that that eventual fall, which is a near certainty, would be far more deep and wide.

But what about all those folks who got out just in time before the markets crashed and will likely get back in before they recover?

Yes, of course. And I have a bronze colored bridge I’d like to part with at the right price.

You might get lucky timing the getting out part once or maybe twice in your life but you also have to get the getting in part right. And markets don’t usually recover when you think they’ll recover. They make big and sudden moves which will catch you off-guard and you then miss the boat. Plus these moves tend to happen at the bleakest of times when all hope is lost.

And say you got out in time before the crash and you got back in at the bottom. So you got lucky twice. What’s the lesson you learnt? That the moment you have that inkling of a disaster on the horizon in the future, you’ll get out. And that disaster never happens. Or it happens but it’s not as severe and the markets zoom past the point you sold. What happens then? You wait? Wait for a decade?

Because that is precisely what many investors did this past decade and hence missed out on all those gains before these recent spate of events.

So don’t mess around. Remain invested.

Good investing is a lot about psychology and behavior combined with a decent dose of history with a sprinkle of math and finance. Any one of them missing from the mix and it’s going to be real hard to meet your goals.

And getting sucked into a fad here and a fad there and assembling investments with no particular rhyme or reason beyond hoping that you buy low and you will get to sell higher is not what it’s all about. I have seen folks talk about this airline stock or that cruise stock. Fine. A few of them will work out but what’s the definition of working out? A double or a triple? Pre-tax?

And you for sure didn’t stake the kind of money that’ll change your life. So if you didn’t, don’t bother. Stick to your plan.

I am not saying you have to but maybe you’ve got to have someone who knows these things watch over your financial life. Because as Phil Demuth, author of several excellent books and the founder of Conservative Wealth Management opines…

“If you manage your own money, you are potentially vulnerable to every crackpot investing idea that comes along. It only takes one.”

Only one. Maybe you will but most don’t get many shots at this. So act wisely.

And what I am truly worried about is the long-term health of our retirement system because when I see stats like an average retiree nearing retirement has only $50,000 saved, I say holy s#*@. We are screwed. Because as William Bernstein says…

“I’ve flown airplanes, and as a doctor, I’ve taken care of kids who can’t walk. Investing for retirement is probably harder than either of those two activities, yet we expect people to be able to do it on their own.”

And that’s why we all yearn for those pension systems of the past where we had someone other than us pool assets together with our fellow savers and design a plan with enough safeguards to make sure that the money lasts longer than any of us individually.

That don’t exist and we’ll have to live with that. In the meantime, a few tips to navigate around this and future market turbulences.

• Always, always keep emergency reserves that cover at the minimum 6 months of living expenses. And depending upon the type of work you do, maybe you need more but 6 months is the ideal minimum. Granted, it is a tall order for many folks who cannot afford to set aside literally anything because they can’t. But I know you can. How? Because you got this far reading this.
• Never panic. You will encounter many a market crashes and recessions through your investing life. You just have to acknowledge that fact and design a plan that lets you survive those events. You need to realize your own volatility to heartburn ratio and this is the time to take notes. The higher that ratio, the more equity risk you can handle and the higher the returns you can expect. A lower ratio means that you’ll sleep alright but then you have to be prepared to save ungodly sums of money to maintain the same standard of living as before through a likely long retirement.
• It’s obvious but try to avoid taking on too much debt of any kind, especially of the lifestyle kind. Screw that big home with an albatross as a mortgage if it bogs you down. It’s unfortunate that we as a country through our tax policies and incentives have turned shelter into an asset class. And a retirement plan. That’s stupid and real bad in the long run, not only for you as a home owner but also for future economic growth. And environmental costs aside, it locks people in place, decreases social mobility and increases risks in the system and in our lives. Let others participate in this game but you remain mindful of the debt you take on.
• Never borrow and invest, ever. We’ll see the repercussions of that soon as a lot of over-leveraged real estate ventures and businesses go belly up. I mean all these folks were running their ’empires’ in a way that they could not sustain a couple months of income disruption? Come on.
• And stay far, far away with that mindset of Keeping Up with the Joneses. Design your life around being happy with as small an overhead as possible. The freedom and the peace of mind that comes with that will be priceless. You’ll sleep better, play better and work better. All good.

So that’s all I have to say for now. Thank you for reading.

Until later.

Cover image credit: Josie Stephens, Pexels

When outcome is essential and matters more than relationship, use trust, but verify. When relationship matters more than any single outcome, don’t use it. 

So true that. But since there are no relationships to care for when it comes to being a good steward of our money, we should trust little and verify a lot. And that task becomes a lot easier with a bit of intuition and access to data.

So there is this thing called rebalancing and it means exactly as it sounds. Say we start with a 60/40 stock-bond portfolio and over time as the markets evolve, that allocation drifts to say 65/35. If the intent is to maintain a constant allocation, we’d sell the stock component of the portfolio, taking out the excess and buy into the bond portion to bring the allocation back to 60/40. That’s rebalancing.

And it sounds like a great idea. We sell something that has gone up and buy the other that has gone down – a classic buy low, sell high approach. So that’s great. But then I read something along the lines that rebalancing between stocks and bonds works but rebalancing within a category is not ideal or does not work as effectively.

Take stocks as a category for example. You’ll likely own some large company stocks, mid-size company stocks and some small ones. And then you’ll own developed market international stocks and emerging market stocks and so on. Not all of them will move in the same direction all the time. Some will zig while others zag. Or some will zig some while others will zig more and so on. So if you rebalance within a category, you would be theoretically doing the same thing that you ideally would want to do – buy low and sell high.

But now there’s this doubt and we need to get to the bottom of it to make sure all’s okay. So as we would do and as we should do, we test both approaches at once to validate that what we’ve done all along was not inferior to what we should have done.

So we go back to data and test whether an invest & forget approach works better than say rebalancing annually. Ideally we would and should rebalance as often as there is an opportunity to rebalance but let’s just assume we do it once each year. We’ll use data on annual returns for four asset classes to test the two approaches.

• Large company U.S. stocks
• Small company U.S. stocks
• International stocks
• U.S. bonds

We invest $100 in a portfolio comprised of these four asset classes at the start of the entire time period in varying proportions of 10% increments and assess whether rebalancing does what it is supposed to do. A snapshot of different portfolio combinations is shown below.

Each row is one portfolio and with 10% incremental allocation spread across four asset classes means 258 different portfolio combinations we get to try this on.

Starting with year 1, in year 2 in case of the rebalancing approach, we sell whatever has deviated to the upside from the original allocation and buy what has declined to bring the allocation back in line. For the invest & forget approach, we split and invest the original $100 into the allocation we started out with and let the money ride till the end of the period. The end of the period by the way is 2018 and the dataset contains 49 years of data starting in 1970. So we are comparing the ending values of each portfolio at the end of 2018 to test the rebalancing vs. invest & forget approach.

The first thing we should do to get a good feel is to look at how the ending values are distributed between the two options.

So clearly rebalancing works as is evident from a slight right shift of its distribution as compared to invest & forget. The spread is a bit wider though with rebalancing which is not desired but a bigger question is, are we comparing the same portfolios when comparing outcomes between the two? What we should ideally compare is the ending value of portfolio 1 in the invest & forget case with the ending value of portfolio 1 in the rebalanced case, the ending value of portfolio 2 in the invest & forget case with the ending value of portfolio 2 in the rebalanced case and so on.

So that’s what we have done next and this is what we find when we do a portfolio by portfolio comparison of the ending values…

• Out of 258 portfolios, each with a different asset allocation, the ending values of 243 portfolios that were annually rebalanced equaled or outperformed those of the invest & forget ones. So a 94% outperformance rate if the portfolios were rebalanced as compared to invest & forget.
• 79 portfolios out of 258 that were annually rebalanced outperformed invest & forget ones by more than 10%.
• And the ending values of three out of 258 portfolios outperformed invest & forget by more than 25%.

So rebalancing works or at least worked almost all the time. But what if the bond allocation was held constant at say 40%? The original thesis was that rebalancing is more effective between categories (stocks vs. bonds) versus within categories (within stocks or within bonds). So trying that out…

Apparently the same story here with the shift in distribution for the rebalanced case more to the right than for the invest & forget approach. Oh and by the way, because the bond allocation is held constant with only the remaining three asset classes in the stock category allowed to vary, only 60 portfolio combinations are possible.

A portfolio by portfolio comparison of the ending values yields the following results…

• Out of 60 possible portfolios, each with a different asset allocation and a fixed bond allocation, the ending values of 59 portfolios that were annually rebalanced equaled or outperformed those of the invest & forget ones. So a 98% hit rate making the case even stronger for the rebalancing approach.
• 25 portfolios out of 60 that were annually rebalanced outperformed invest & forget ones by more than 10%.
• And one outperformed invest & forget by more than 25%.

So if you had to wager, rebalancing still wins.

What if you owned an all-stock portfolio? Would rebalancing still outperform invest & forget?

Appears to be a yes. And again as before, only 60 portfolio combinations are possible so a portfolio by portfolio comparison yields the following…

• Out of 60 possible all-stock portfolios, the ending values with the rebalanced approach equaled or outperformed invest & forget each and every time. So a 100% hit rate in favor of rebalancing.
• But none of them outperformed by more than 10% so not a big thumping vote for one over the other.

But what if the returns of the past do not repeat in the same sequence? Could the outcomes be different with a different sequence of returns?

To assess that, we sample returns for each asset class randomly and recreate the asset class returns dataset each time and compare the ending portfolio values between the two approaches. And just to make sure that we have at least attempted to try every which way to convincingly make one approach fail over the other, we do this 500 times. The results…

With portfolios constructed out of a combination of the four asset classes (large company U.S. stocks, small company U.S. stocks, international stocks and U.S. bonds)…

So a very strong vote in favor of rebalancing even with randomized returns sequences.

With a 40% constant allocation to U.S. bonds and the allocation to stocks allowed to vary…

Rebalancing wins here as well.

And for the stocks only portfolios (large company U.S. stocks, small company U.S. stocks & international stocks)…

So you’d be crazy to not rebalance your portfolios from time to time.

But here’s a thing. This whole thing is fundamentally based on the fact that mean reversion will always happen. That is, if an investment has deviated from its normal course either on the upside or the downside, it will always revert back to its mean course over the long term.

But what is long term? Ten years, twenty-five years, hundred years? We can only know this in hindsight maybe long after we are dead so that’s one thing to consider.

And what if an investment ceases to exist? Individual companies we know live and die all the time so to guard against that risk, we’d diversify into a sector. Could an entire sector vanish or never, ever revert back to its mean trajectory of growth? Of course.

What about countries? That’s easy, Japan.

The post-war rebuilding which eventually culminated into a real estate led economic boom of the 1980’s Japan was so big and went on for so long that just the fact that it all eventually came crashing down does not quite do enough justice to the sheer scale of that bubble. Edward Chancellor in his book, Devil Take The Hindmost chronicles the reasons for the boom and what led to its eventual implosion.

One of the key drivers for the boom…

Between 1956 and 1986, land prices increased 5,000 percent, while consumer prices merely doubled. During this period, in only one year (1974) did land prices decline. Acting on the belief that land prices would never fall again, Japanese banks provided loans against the collateral of land rather than cash flows.

Land prices will never fall again, wonder where we have heard that before? So the banks lent money just because the value of the land rose. And the more it rose, the more they lent, creating that self-fulfilling feedback loop of ever increasing prices, leveraged to the hilt. Things got so crazy that by 1989,

The grounds of the Imperial Palace in Tokyo were estimated to be worth more than the entire real estate value of California (or Canada, if you preferred).

And the post-crash recovery didn’t quite materialize or hasn’t yet materialized due to structural reasons that are unique to Japan, though there are signs that things might be finally on the mend. But then they have a long way to go.

Back to the rebalancing or not rebalancing question at hand, so if a portfolio design is done not considering the fact that there might not ever be a mean reversion, we are doomed.

And I might have insinuated before that I am strongly in one camp or the other but I am not completely sold on either. So I employ a mix of both. And that’s because I don’t know the future. No one knows the future but try one must with as much supporting research and evidence. And a bit of intuition.

Thank you for reading and persevering through.

Until later.

Cover image credit – Matthew T Rader, Pexels