As is the case in every human activity, key to success is consistency. Whether you’re an enterpreneur or an employee, whether you teach at school or are a cardio surgeon, it’s always the rules you obey that drive your performance in what you do. In the investing world the word consistency should really be written with a capital C, whenever you use it. Thus starting one’s long journey in the unstable, volatile and sophisticated area of investements and capital markets needs a very solid base that will guarrantee that Consistency is always maintained. The key to that is a set of Rules (mind the capital R). Rules are your decalogue. If you do not follow the Rules, Consistency will not be contained in your behaviour, and you will no longer be in control of your investments, but rather the other way round – they will control you.
Today i will start a series of articles on the Rules for different kinds of exemplary portfolios I will look to run, as different goals in investing obviously carry different investment risks. Adjusting the Rules to manage the aggregate risk profile of certain portfolios is clue here. Let me start with a Pension Porfolio.
The Pension Portfolio
Let me first ask You to take a close look at the illustration at the top of the article. This little scheme I ineptly prepared on my own 🙂 is a description of how I think about a long-term cycle-adjusted pension portfolio (more on this approach please do read here: Smart Investing Approach (SIA) explained). The red line represents general sinusoidal behaviour of risk assets throughout business cycles and its prevailing emotions accompaning certain stages of the cycle. There’s always the same pattern: DISBELIEF (“last recession hit all people so hard, things cannot get better for long, don’t even tell me about investing in equities, I am still struggling to repay my mortgage and am not even sure I will have a job next month!”) later slowly turning into ENTHUSIASM (“oh yes, things are getting better finally, I feel safer with my job now, my revenues will stay as they are or maybe even get better?; and John around the corner just got a job as well!”), as economy evolves through expansion period the general mood of the public is getting better, things improve slowly to start, but then speed up, well-being improves, people start forgetting about last recessionary period and keep taking more and more risk in their investments and business activities – all this slowly builds a so called snowball effect and risk assets start to depict it, eventually ending up in EUPHORIA (“they just said on the evening news that stock market is ripping and it still has lots of space to go up! my business is doing so great and I have quite a bit of savings, which I could invest, as others do! I don’t know much about equities, but my friend Peter invested 3 months ago (his banker advised him to) and he made 30% so quick! Besides all wise-guys that know economy are saying the THIS TIME IT’S DIFFERENT FOR SURE and there’s no way we can have a recession soon!”)……And then the CRASH comes. One beautiful day people wake up hearing equity indices are down 20% in just a few days, because a sudden and not expected event happened (NOTE: I am writing this post in the middle of April 2020 – COVID-19 recession is now official and equity markets are just facing wildest swings in their entire history!). First there’s a lot of DENIAL (“It’s just a quick correction in markets, things are still going so good, let’s just get over the little trouble fast and keep doing usual business. All advisors, who surely know what they’re talking about, suggest to stay calm and use every opportunity to add to equities I hold. They just got so cheap!”). What follows is usually a chain reaction. Things start going the wrong way in every single aspect. Job market plunges as aggregate demand sinks, people lose jobs, financial institutions are seeing troubles with rising non-performing loans (or are often the reason for crisis themselves due to excess leverage, as it was the case in 2007/2008 Great Financial Crisis), even the buy-the-dip smart-guy advisors start admitting that things are not that great actually and maybe it’s time to consider avoiding risk? FEAR becomes the very prevailing feeling and everyone starts to feel it sooner or later (“What will happen now?! The stocks I bought for money I have been saving so long didn’t go to the sky as they promised, but are down 30% now (or more)! And my boss just told me our company needs to undergo restructuring and 20% of staff will be fired next month. And John around the corner just got fired too! How will I survive?!”)….Maximal fear ends up in a PANIC, when a vast majority of non-professional (and major part of professional-investors too) sell off every single asset they still hold in a copmulsive run for liquidity. End og the world is expected around the corner. And so it goes on and on since when contemporary history started.
Now I would like You to take a closer look at the green line on the picture above. This is the line that shows a scheme of expected swings of a long-term portfolio comprised of assets, which are rebalanced accoring to SIA philosophy. As You see this line is much more stable than the risky assets line (red). It also does not have all the unnecessary emotions, which are extremely destructive to one’s psyhe. On the opposite, it is described with PEACE and PEACE&PATINCE. The “patience” part will be needed in times when all the others will be full of “disbelief” or “fear” (between cycle tops and end of recessions). Why? Because the SIA is all about cycle-adjustment of exposure to riskiest assets done ahead or at the cycle peak at the latest! These adjustments can be done because of a proper mechanism that protects the portfolio from being full of risky assets after the economy (and usually all risky assets) drops off the cliff. This mechanism, in specific, is a good cycle forecasting model, which informs in advance (usually with 9-12 months notice) and with high probability that a cycle peak is imminent and lets You prepare Your portfolio accordingly (just please do stick to the RULES! Don’t act on emotions, but as rules tell you). As part of SIA I use Enhanced Aggregate Spread model by Dr.Robert Dieli, which is one of the most consistent I have ever run across. It also has two most important characteristics: (a) it’s simple in interpretation (b) gives clear signals with 9-12 months advance, which can be read from a single index plus a few coincident indicators. Please take some time to read more about EAS (or Mr.Model) in my separate post exclusively about that topic here or directly at www.nospinforecast.com.
Now that we have made it through the basics of why and how a wise (SIA-style) pension portfolio should be run, we can proceed to the detailed work on the portfolio itself.
Please note that anything below this pararaph was actually written at end of January 2020, when I started preparing my 1st posts for this blog and I also initiated the Pension Portfolio (was actually on 28th Jan 2020). I only went live with globalalphasearch.com in June 2020, as my resignation had to run its course with my last employer through the end of May 2020. I am very happy it actually happened so that we have gone through the cycle peak inbetween. Not that I am happy with what’s happening of course (I am far from that), but it will allow us to show how the SIA can protect our portfolio in bad times and avoid losses (I will show it in my next posts on the Pension Portfolio). As most of You know the equity markets made a peak for this longest-ever expansion on 19th Feb 2020. Since then we had the unprecedented plunge on markets caused by the outbreak of COVID-19 and SP500 experienced a 35% drop in just a month, whilst the world plunged into recession and central banks and governments applied extremely big (pretty much limitless) monetary and fiscal support actions to keep the world economy afloat.
Initiating the Pension Portfolio (end Jan 2020)
If you start investing for your pension, you cannot EVER think of what’s happening here and now and let current market circumstances influence what kind of assets you’re looking to invest in. Your pespective in such a case is usually 25-40 years long. You need to have a clear plan as to why and how you invest. Also mind that in case of long term investing averaging is the absolute best strategy to follow. This guarrantees you that once you start, you do not buy into an equity market peak. Should you have usd100k to invest at the start, buying an SP500 ETF or any specific stocks for all of it at just one point does not really seem like a good idea. Such a strategy would have taken 7 years and 6 years respectively to regain its full value, should you decide to implement it say in March 2000 or October 2007. So if I am to begin building a Pension Portfolio with usd100k initial capital (please do not pay attention to that exact amount, which might seem big for most people; it can just as well be USD10k or USD1k; on a bigger number it’s just slightly easier to operate) I am allocating maximum 40% of the money into equity markets, especially now that we’re way over a decade long into a secular bull marke and officially in the Boom phase according o our equity allocation determinator – EAS model. I do plan to be adding to my Pension Portfolio regularly every single month (say an amount of usd1k – everyone has to decide by themselves as to how much free cash they’re able to put aside and grow their expected future pension wallet. My personal experience (and i have been putting aside money for Pension for almost 20 years now) tells me that the regularity of those little monthly investments is the clue. Rest of the good job is being done by time and compounding (remember that word!).
Now down to the Rules in my Pension Portfolio:
- This Portfolio needs to be balanced and capture both worldwide growth opportunities (via equities exposure) and safety (via long term high grade sovereign debt exposure and inflation-hedged value holders like Gold, Silver).
- Exposure to Equities must be within the following tresholds: RC: 40-60%/E:40-50%/B:20-40%/RS:0-20% (where: RC-recovery, E-expansion, B-boom, RS-recession; more on setting the rules as to in which point of the economic cycle the US is at the moment in my seperate article on Dr. Dieli’s famous Enhanced Aggregate Spread model (Mr.Model) see here…it’s a must-read! Dr. Dieli’s work is amongst the most consistent I have ever had a chance to study).
- High grade sovereign debt exposure must constitute minimum 20% weight (no upper treshold).
- Gold (or silver) exposure must constitute minimum 20% and maximum 40% weight.
- Cash should be maximum 30% weight .
- Portfolio will be funded with usd1k monthly instalments at end of month. Distribution of the instalments will be decided appropriately to the economic cycle point in time as per rules above.
- This is an allocation-only portfolio, no single stocks picking allowed.
- No derivatives or leveraged instruments allowed.
- No commissions assumed (already now many brokers offer their trading platforms for free (or close to that) and it will soon become standard worldwide i think).
- The portfolio is USD-based. Non-USD investors must consider FX risk.
Now a few more words of explanation as to why i choose what i choose in the above rules. My pension is not the money I would ever want to speculate with back and forth. It is supposed to be my buffer, my anchor for times when I will no longer be able to (or will not want) to work and have additional monthly injections of cash to finance my every-day expenditures. This is why my Pension Portfolio needs to be balanced, although most might ask questions as to why I wouldn’t invest all or most of my savings in equities, which in the long run have the highest expected returns of around 10% p.a., which you can see on the below long-term chart showing yearly returns on S&P500 index:
The answer to why I disagree to be fully exposed to equities is pretty simple. I do not want to risk a situation where after say 25 years of saving I want (or have) to redeem my assets and there is unluckily a deep 2-3 yr long depression (or even just a regular recession which usually causes equity indices to collapse 30-50%), which as u can see on the chart above, can wipe out big chunk of my savings at a moment I will need my money the most (see years 1929-32 or 1973-74 or 2000-02. The few years just before retirement are always very crutial. Hence I prefer to always have a buffer of a mix of high grade sovereigns and gold even at the expense of lower potential returns (I will just sleep better). Both of these asset classes can be treated as safe havens in times of equity market turmoils. Additionally Gold adds the inflation-hedge skew, which is desirable. I choose to have a maximum 60% weight of equities, and this will be in times when US economy will be out of recession (RS) and into recovery (RC) to take advantage of the cheap sold-off equities to do their Alpha for me. Exposure will be then falling as we enter further periods of the cycle. Will be still high (at max 50% during the whole expansion (E)), will then be systemically cut as the economy enters boom (B) /mind this is the case right now as I write this post: EAS is sub 200 pts and the coincident indicators used in Mr.Model show signs of instability – read more about this on www.nospinforecast.com or my posts treating upon Mr.Model/.
Another thing to explain is why I choose to follow a USD-based portfolio and use forecasting US economy for decisions on equity exposure. Firstly, USD is still the reserve currency of the world and even though this might change in the future (with the continous rise of China towards world’s No.1 economy). In whichever country I would have my life based, I would still be looking to have my Pension linked to any of the world’s hard currencies like USD or EUR as close as possible. Besides, my readers here (hopefully once in the future, quite many of them) are based in all the possible locations around the world, hence running the portfolio in USD terms will make the investment results comparable for everyone. Secondly, if there’s one single place in the world that drives the equity indices returns in global scale, it’s the NYSE/Nasdaq. There can be regional recessions in any of the smaller markets, but it’s harldy imaginable any of the regional markets does well, if there’s a recession in the USA. There can be outperformers (like the EMs in a weaker USD environment), but on aggregate basis I do not look to be equity-exposed during recessions in the world’s biggest economy (which is still US, not quite yet China). Thirdly, US corporations are now more-than-ever global and thus US recessions are now even more of a sign that something is wrong in the rest of the world as well. This can be depicted by two simple charts:
Note above that in 2019 13 out of 15 biggest-mkt-companies are US corporations. And note below how US equity market cap vs. GDP ratio is blowing in recent years (this is mostly due to the above global-reach US-based coporations.
So, here we go.
The portfolio at inception
|$ Current Price
|$ Total Cost
|% Unrealized Gain/Loss Since Purch
|$ Unrealized Gain/Loss Since Purch
|$ Realized Gain/Loss Since Purch
|$ Market Value
|Morningstar Rating For Funds
|iShares 20+ Year Treasury Bond ETF
|SPDR® Gold Shares
|SPDR® S&P 500 ETF Trust
|B: 20-40% SPY+EEM
|iShares MSCI Emerging Markets ETF
|B: 20-40% SPY+EEM
For the Pension Portfolio inception investment I have decided to use highly rated (3 Morningstar stars or more) ETFs (Exchange Traded Funds), which track the performance of specific asset classes and currently take lowest possible management fees. The total expense ratio for the above ETFs is as follows: SPY 0.095%, EEM 0.680%, TLT 0.150% and GLD 0.400%. This guarrantees that the yearly management fees will not “eat” the potential returns on the respective asset classes (as is often the case in most actively managed funds, especially in less developed countries, where management fees can still be absurdly high – just imagine a pure equity fund with management fee of 3% and its benchmark equity index being flat for 5 consecutive years; your investment loses 15% of value only to pay the asset manager’s fee then (all assumed they are at benchmark)!. Cash is cash, so has an obvious 0% expense ratio for holding it. All the above ETFs are world’s top class in regards to AUM (Assets Under Management), liquidity and issuer risk. Equity exposure cannot exceed 40% portfolio weight according to our Rules, hence I put 19.63% in SPY and 19.41% in EEM to capture the Emerging Markets growth opportunities a bit more and increase the geographical dispersion of assets. As we are currently in the Boom phase of the economic cycle (again more on why and how we decide about it here: https://www.nospinforecast.com/ or in my other posts about Mr.Model) I expect to be constantly diluting my exposure to both SPY and EEM in the forseeble future and increase the weights of TLT and GLD respectively (bear in mind this portfolio will be funded with usd1k per month to depict the idea of averaging, or average $ cost, and to show the power of small monthly instalments adding together to a big investment over years). As we enter recessionary and then recovery readings, I will adjust the portfolio accordingly as per rules above. The changes in equities exposure will then determine the weights of other asset classes in the portfolio.
Back To Now (End March 2020)
Inception date of my Pension Portfolio, as all of us see right now, was like one in a decade coincidence you might say. Slightly over half a month after I started it, global markets peaked. But was it really so surprising? No it wasn’t! The EAS model was telling us for a long time now the US economy is in the boom phase and urged caution in allocating too much of the portfolio in equities, which I actually did not do. As you see at inception my portfolio had a total of slightly less than 40% in equities (via SPY and EEM). I assumed the boom phase would yet last for some time, as the forecasting model was at that time not giving contraction readings within a 9-month forecast period (October being the end of projection month). Also, as you see above, I wrote I planned to be “systematically reducing equities exposure in comig months”. I eventually did not have time to be doing that, bacause in March contraction readings were now close to 100% certain. The effect of having acted according to specific top-down rules, which protected me from buying into equities too much of my portfolio at the start (even though I started close to maximum equities exposure allowed for the boom phase by the rules I set) and a balanced exposure to other safe assets (which as a rule have low or negative correlation with equities), was that the portfolio was only -3% (as measured by Morningstar Personal Return) as end of March, the month of the historic COVID-19 sell-off (mind that at end of February and March the portfolio was injected with USD1k monthly instalments as planned and allocations of these instalments were: in February – as per end January inception weights, in March – 30% in cash, 37% in TLT, 33% in GLD). At the same time S&P500 Total Return Index (including dividends reinvestment) was -8,2% in February and -12,4% in March. That means that my portfolio outperformed by 8pp and 9pp respectively. That’s not bad :). BUT, please remember that we do not want to be benchmarked (as per SIA)!!! There will obviously be times when in the next bull market my Pension Portfolio will underperform S&P500, becauce it will be capped at 60% equity allocation. But again, I do not care! I look at it from a different perspective: I don’t experience FEAR (or DISBELIEF) now, as most market participants now, becuase I have a system protecting me against it. I am looking to stay with PEACE&PATIENCE now until forecasts tell me we’re out of contraction into recovery. It’s simple. It’s all about making this process work for me in a way that bring the assumed effect – long-term smooth wealth growth, minimalisation of workload needed to run the portfolio and minimalisation of negative portfolio swings, causing unnecessary negative emotions. This is SIA!!!
At the end of March (Tuesday 31.03.2020) I have rebalanced the Pension Portfolio to depict the transition from the boom phase of the economic cycle into the contraction phase. Please mind that I am not using the word “recession” here, because the offical start date of recession is only to be determined by the US National Bureau of Economin Research (NBER) and this will happen some time in the future only. We might by then just as well be out of contraction, should it eventually turn out deep (as most expect), but short. Anyway, as of end of March we have all the contraction eligible readings in front of us: EAS sub 200, Private Payrolls YoY growth <1.00% (it’s already clear March Payrolls data due at the start of April will be deep deep in the red), YoY Industrial Production <1.00% and falling DeltaDelta <0.0% (S&P500 as od end March is -10% YoY so will surely drive DeltaDelta int he red). I am effectively cutting equity exposure to 10% by selling appropriaqte parts of my SPY and TLT holdings and switch them to cash.
In the next posts on the Pension Porfolio I will update You with how it performs. I am planning at least one post on this per month in the future at each month-closing day or the start of each next month.
Disclaimers: None of the ideas, views and thoughts presented here shall ever be taken as a recommendation to buy or sell stocks,bonds,FX,commodities or any other financial instruments as stated in REGULATION (EU) No 596/2014 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC or the Polish Act of 10 February 2017 amending the act on trading in financial instruments and some other acts. The article is for educational reasons and purely presents private views of the author, thus the author shall not be held accountable for any losses of a third party resulting from any potential trading activities in any instruments, both specifically or by category of assets. The author uses his best knowledge and data from sources believed to be reliable, but makes no representations as to the accuracy of the data.Full Disclaimers&Liability Limitations page.