CONSTRUCTING A ROBUST PORTFOLIO
When we build financial plans and design investment strategies, we do so based on the assumption that there will be financial crises from time-to-time, but that we can’t reliably avoid them. Instead, we build plans and portfolios we expect can withstand bear markets and keep you on track for your financial goals. While the idea of “getting out” before a crisis and then reinvesting near the bottom is alluring, it’s near impossible to execute this strategy consistently, and trying but failing is often far more costly than simply riding it out.
The primary growth engine in your portfolio is the equity (stock) allocation. Equities represent ownership in companies or assets and have higher expected returns than cash or fixed income (bonds). However, this higher expected return is a function of risk, so comes with greater volatility and larger drawdowns in a crisis. As we increase the amount of fixed income and/or cash into the portfolio the volatility and drawdowns are dampened somewhat, but they come with their own set of risks, namely inflation. As a result, a well-diversified portfolio contains a mix of equities and fixed income. The proportion of each will uniquely depend on your financial goals and willingness to accept the various risk trade-offs.
Historically, a balanced mix of equities and fixed income that is held passively (i.e. not picking individual securities or trying to time in and out of the market) has rewarded investors well and has proven to be the most reliable way to generate returns for the long-term investor. We believe this still gives you the best shot and therefore represents the core of our investment strategy. A byproduct of this strategy is that it can be implemented in a reliable, low-cost manner while allowing us to focus on maximizing your after-tax return through various tax strategies such as asset-location and tax-loss harvesting.
However, a danger for “passive” investors is complacency. Too many blindly invest in a mix of an S&P 500 index fund for their equities and total bond market for their fixed income. While this portfolio has historically served investors well for decades, it is too myopic for a long-term investor. When we design portfolios we imagine scenarios such as the Great Depression, the financial repression of the 1940s, the stagflationary environment of the 1970s, the dotcom bubble, and the 2008 Great Financial Crisis. We also examine the experience of investors in other countries who haven’t been as lucky as US investors and wonder what would happen if we took a similar path to Japan, or experienced the devastating inflation of the Weimar Republic in 1920s Germany.
We don’t know what the future holds, but often the only new things in this world are the history we haven’t read, so we try to learn and think about what could go wrong, what tools might allow us to survive those scenarios, and whether it’s worth allocating any of the portfolio toward those situations.
What emerges from this process is a core portfolio that is passive in nature, but looks a little different than the typical index fund portfolio. Instead of investing predominantly in US equities, we invest in a globally diversified equity portfolio that tilts toward smaller and value-oriented companies. We don’t know where future growth will come from, but it’s critical that we capture it wherever it shows up and the only way to do that is to own global equities.
With regards to fixed income, we avoid corporate bonds and focus almost exclusively on US government bonds, so that we don’t have to worry about the issuer's ability to pay in even the most dire of circumstances. However, the reason we have confidence in government bonds is the government’s de facto possession of a money printer which introduces the risk of runaway inflation and for this reason we invest half of the fixed income portfolio in inflation-protected government bonds. When our clients approach retirement, we build out a “bond bridge” of individual inflation-protected bonds to provide at least 10 years of cash flow that is immune from stock market volatility, interest rate changes, and unexpected inflation. Having this bridge means the equity portion of the portfolio should have time to recover before needing to be tapped for spending, even in a protracted bear market.
We then supplement this core portfolio with a few positions that we think provide exposure to assets that might do particularly well during paradigm shifts in the financial world. We hold a small allocation to real estate, which is a tangible income-producing asset that makes up a significant portion of the economy but is underrepresented in public equity markets. Gold is part of the portfolio, despite the fact that it produces no income, because it has been a monetary asset for thousands of years. It has a reputation for maintaining its purchasing power over long periods of time but where it can really shine is when the public loses confidence in debt-based monetary systems and having an asset that is no one else’s liability becomes highly valuable. Deflation can devastate a debt-based economy which is why economists and policymakers fear it so much. However, policies that help avoid deflation greatly increase the risk of high inflation and the goods that typically see the largest price increases are commodities. As such, we have an allocation to commodity producing companies in our portfolios. While all of these “alternatives” have some unique characteristics and may provide protection against certain economic events, we also expect them to provide a reasonable return in normal market environments, thereby adding diversification without materially reducing the expected return of the portfolio.
It’s because of the thoughtfully diversified portfolio described above that we do not overly fear the potential of a financial crisis. In fact, we assume they’re inevitable during an investor’s time horizon, we just don’t know when they’re going to show up, so we try to always be ready whether it seems imminent or not.
For those looking to be even more financially prepared there are additional strategies we recommend, but can’t implement effectively within your managed portfolio, so requires more effort from you.
Emergency Fund - We always recommend having at least several months worth of cash in a FDIC-insured bank account and/or short-term US Treasury bonds. This provides protection against unanticipated expenses or loss of income.
Physical Cash - There have been times in history where banks and ATMs have been closed. Sometimes these have been due to financial crises, other times natural disasters. Having enough cash on hand to get through a couple weeks isn’t a bad idea.
Bitcoin - There’s a reason gold has been a monetary asset for thousands of years. Bitcoin is the best form of digital gold that exists and has many benefits over the shiny metal. In addition to being a scarce monetary asset, its value can be transmitted electronically in a permissionless and uncensorable fashion. It’s also easy to take self-custody so that you have no counterparty risk.
Our approach to investing is intentionally not dependent on being able to correctly guess the next market movement. We’re attempting to build robust portfolios that reliably maintain and grow wealth over long time horizons, expecting volatility over shorter time horizons. By broadly diversifying, keeping costs and taxes low, and avoiding market-timing or stock-picking mistakes, we believe our approach gives you the best shot at maintaining and growing your wealth over the long run.