I'm what you would call an eager, but skeptical stock market investor. After a brief foray into individual stock investing seven years ago, I decided that researching companies was boring, and that I had better things to do with my time. Through a series of comical attempts to try and understand the markets, I determined that a well diversified portfolio of broad-based, low cost funds (of the indexed variety) made the most sense for me. I stuck with that philosophy whole-heartedly for about six weeks until I saw something shocking on Twitter. USA today recommended index fund investing. Now, I don't know how to say this without sounding like a complete and utter snob, so I'll just go ahead and say it. Following the advice offered in a tweet by USA today seems like a dumb idea. Even if I started following the advice before it was offered by USA today, and even if I could site several academic articles (which I actually read) that reach a similar conclusion. So, I had to decide. Would I follow USA today's advice, or would I keep looking? I decided to stick with the status quo, but keep looking to see if I found something better. Downside Risk- The most useful counterpointNow, I'm not yet 30, I have no aspirations of early retirement, so I really have a lifetime of wealthbuilding ahead of me. That said, as I studied investors who fell outside of the index fund orthodoxy, I learned that index fund investing falls short in one area- downside protection. I'm going to use a quick mathematical illustration that I learned from Meb Faber to explain why it pays to obsess over downside protection. If your portfolio falls by -75% over the course of one year (which it can, if you have an all stock portfolio like me), you need to produce a 300% return to get back to your starting value. That's the equivalent of 15 years of 10% returns compounded. Realistically, you'll get pounded by a second bear market before achieving recovery. If that mathematical illustration doesn't make you nervous about stock market investing, you're not going to benefit from anything else I have to say. And that's totally okay, because I might be wrong about everything from here on out. But I will say this, everyone who thinks about investing at more than a surface level, considers drawdown risk the primary weakness of modern portfolio theory. They may continue to adhere to it because they remain convinced that it is superior to the alternatives, but it's not because they don't see a weakness. Anyone who doesn't see the weakness started investing in 2009 or later- I promise you that much. What you can do insteadNow that I've studied it, I see that there are many useful alternatives to an index fund portfolio. Here are a few: Select individual stocks with an eye towards stable value companies Work to develop a portfolio of high dividend yielding stocks to maximize passive income Adhere to a permanent portfolio theory Use equal weight rather than market cap weight indexes Choose an actively managed mutual funds Any number of rules based multifactor model I went with the last one. The five factors of investingAcademic investors recognize five factors that influence performance. They are: Size- Smaller does better over time Yield- Higher dividend yields perform better over time Value- Stocks trading at low multiples per earning do better than those at high multiples. So basically, don't buy Amazon ;) Since I have zero patience for looking at individual stocks, and I'm not particularly excited about using equal weight or smart beta indexes in my portfolio, I plan to ignore all three. Instead I'm focusing on the remaining two factors: Momentum: A security going up, tends to keep going up (or down since momentum works both ways) Volatility: Price movement breed price movement- price stability breeds price stability I'm timing the markets, baby!First, I'm going to explain my asset allocation. My portfolio has exactly for components:
Up to 50%- VTI (US total stock market index) Up to 25%- VEA (Developed market index (except US)) Up to 25%- VWO (Emerging market index) And cash which is up to 100% of total allocation And my portfolio has two rules which I stole from the Alpha Architects (Not sure if they produce Alpha or not). For any asset class: If the 12 month return is below 1%, move 50% of the asset class to cash (on the 1st or 15th of the month) If the current price on the 1st or 15th of the month is below the 180 day moving average price, move 50% of the asset class to cash. I'm also supposed to rebalance on the 1st of each month. Here's to not being lazy! So up to 100% of each asset class will be in cash. Up to 100% of the total portfolio will be in cash. I assure you I will miss some upside with this portfolio. If things go right, I'll also miss some downside. Keep your fingers crossed for me.
4 Comments
9/26/2017 09:29:51 pm
Nothing unplanned about this finance strategy. Wow. I would have been happy to go along with the USA Today advice - especially if I'd come to the same conclusion on my own first. But let's see what kind of magic your downside protection strategy produces. Fingers crossed : )
Reply
Well, so far nothing has changed, but we're in the middle of a bull market. I'll be curious how well I do missing out on returns after a bear market (or worse, after a false bear market).
Reply
Glen
9/27/2017 05:36:55 pm
I think you are overly pessimistic about index funds. From the main premise of your article:
Reply
Hannah
9/27/2017 09:04:58 pm
Thanks for your thoughts- I agree that indexing is a great choice, and -75% is on the outside edge of possible. That said, the emerging markets ETF took a -66% dive and still hasn't recovered fully.
Reply
Leave a Reply. |
About HannahI'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life. Archives
July 2017
|