Disclaimer: None of this is investing advice. Do your own research and think critically before making any financial decisions.
This post was inspired by a recent conversation with friends and my desire to update the classic 60/40 portfolio strategy to our present conditions. I hope you find it of interest.
My recent posts have been quite negative on the medium-term future and present conditions. I think such an attitude is very much merited considering the level of moral hazard, arbitrariness, speculation, and misallocation that have built up since I started investing back in 2015. What an innocent time that was, where the S&P 500 lived in the 2000-2100 range and its P/E ratio of 20-24x-ish was cause for mild concern if one looked at it on a purely historical basis (over the past 140 or so years, median is 14.84x and mean 15.88x).
Fast forward to today, February 14, 2021, and the S&P 500 has since stridden to the 3900s and boasts a P/E of 40 times. It is very important to stress: We are here because of politics, not because of any fundamental paradigm shift. Or perhaps more accurately, the only true paradigm shift that has occurred, is to be found in central banking.
Had Bernanke normalized monetary policy around 2012, as I believe he should have, or Janet Yellen when she succeeded him in 2014, we would not be here now. And make no mistake, this complacency does not flow from ignorance or accident but was a calculated decision made for political ends, likely around 2008 and 2009. This decision will prove not to have been in the interest of the American people at large, or indeed in the interest of anyone who is not a member of the Ivy elite and/or who does not have a majority of their meaningful wealth (aka measured in millions USD rather than the low 100’000s) in non-monetary assets (particularly stocks but also real estate, commodities, private equity etc.). Further, I personally believe it will not even prove to be in the absolute interest of those privileged groups either, making them relatively better off in a worse world. Yet, as much as I resent it, this is the world we are most likely to live in and there is very little that the median investor can change about that.
Now, there is nothing wrong with negative sentiment when it is warranted by the circumstances. Sometimes life can be cruel, and you find yourself dealt a bad hand. It is ok to be angry about this, to be frustrated and depressed. However, this on its own does nothing to solve your problems.
So, if you as an individual cannot do much about the bad hand as such, what can you do?
You can do your darndest to play the hand as well as humanly possible.
In terms of personal finance that means:
Avoid speculation at all cost. Leave the crypto, the crazy SPACs, the ARK ETFs to the others. Ignore options & futures contracts for every purpose other than insurance. Do not overdo it on that particular type of insurance either, ideally avoid owning the kind of portfolio that requires significant hedging at all. No short selling, no margin, no recourse leverage of any kind; either implicit or explicit. Have a sufficient nest egg in cash (not money market funds, not bonds) to pay for at least 6 months of living costs of you and all your dependents but aim for 12. If, like me, you are young (under 50) and in good health, be grateful (!) and continuously cost average a fixed percentage (no more than you can afford to lose on your very worst day) of your disposable income into 3-4 low-cost index funds such that your portfolio roughly reflects global market caps with direct US exposure making up no more than 60%. Do not bother with bonds, gold, commodities, or REITs. Try to match up your liabilities and assets/income streams (e.g. if you live abroad but your income is in a different currency). Avoid debt if at all possible, especially credit cards but also student loans for any non-vocational schools or below global top 50 universities (if you are from a high-tuition country, attend a more sensibly priced university abroad if you can). And most important of all: LOWER YOUR RETURN EXPECTATIONS. This strategy is not going to make you rich but hopefully it will protect you from becoming even poorer.
Now, it is easy to make up a basic approach, but I would like to give you a handful of simplified reasons to help understand what the above strategy is meant to accomplish.
The reason for having a nest egg in cash is simple: Life is unpredictable and unexpected costs, or loss of income will occur. Most likely they will come up when you are at your most vulnerable fiscally, physically, and mentally. The nest egg will give you space to breathe when shi* hits the fan and allow you to think about important life decisions rather than panicking and self-sabotaging. Liquidity management is absolutely essential no matter how rich or poor you are.
If you live in a first world economy, you can keep up to 2 months’ worth of the nest egg in cash somewhere safe (not under your mattress) if you want to be super prepared against extreme tail risk situations. However, for convenience and safety and most other purposes, keeping your nest egg in a deposit insured bank account should be good enough. If you live in a lower stability/development economy, you likely know better than I do how to handle cash efficiently within your context. If your nest egg is in renminbi, ideally try to convert it into one of the other major currencies at a sensible rate (major sums will likely be rather difficult). Always watch out for fraud and avoid drawing attention to owning significant amounts of cash/assets, even from members of your family & friends that you do not trust unconditionally.
The continuous cost averaging of a predetermined fixed percentage of your disposable income into equity is a compromise between the two most plausible outcomes that we face. Holding more than you need (i.e. significantly more than the nest egg) in cash is a guaranteed loss in real terms, as any positive inflation diminishes your real purchasing power. If – as I think is likely – monetary policy and politics continue down the present path, having most of your net worth in monetary assets will expose you to the full brunt of the ongoing net regressive redistribution of wealth. Stocks will mechanistically benefit from such an outcome. Owning stocks in other words, is your insurance against a scenario where asset inflation continues at the expense of everything else and wherein you do not own any of the asset classes that thusly rise. While for this purpose you could conceivably own certain other financial asset classes, I think stocks are the best choice by far on most dimensions.
The other reasonably plausible future outcome is in some sense the opposite extreme: a really harsh financial crisis (worse than 07/08) hitting all major financial asset classes (including house prices). That is why the nest-egg is non-optional. It is quite feasible that even such a globally diversified stock portfolio could decline by 60% or more in a matter of a few weeks or faster and in order for you to be able to hold and not sell anything, you must not think of your portfolio as a source of income or emergency buffer. This too, is crucial.
The cost averaging guarantees that you pay the average price over time. While at present valuations that may seem silly, you cannot know how long the present politics continue and only by owning financial assets can you prevent the first of the two undesirable outcomes I have laid out. Had you decided not to cost average/enter the market in say, 2015, because of elevated multiples, you would have done terribly compared to almost any metric so far. This strategy is not optimal for any one trajectory but instead works reasonably ok under most conditions and even more importantly, is possible to execute consistently and without undue emotional turmoil by most. If a crisis happens, the cost averaging will give you a slice of the recovery, too, so long as you stick with it under all conditions.
Anyone having read this far will understand the reasoning for the geographic diversification and the choice of low-cost index funds. In principle and on a historic basis, one could own much more US exposure, but I really would not recommend it.
That is most of the important stuff pertaining to the financial side of things. However, life is not only about money (anyone who knows me will be shocked at seeing this platitude coming from me, but it is true). One ought to think about life holistically.
In terms of lifestyle choices that means:
Stay healthy. Do not smoke (it is genuinely the worst thing you are legally allowed to do to yourself globally). Maintain a healthy weight. No crash or fad diets. Drink in moderation. Be sensible in your consumption of stimulants and recreational drug use. Avoid strongly habit-forming drugs/behaviors altogether.
Do not gamble with any non-trivial sums, ideally at all. Exercise, exercise, exercise – it is very good for physical and mental health and will help you lead a happier, more contented existence. Sin a little every now and then but never a lot.
Work on yourself. Get a hobby or two. Develop a new skillset. Take walks/hikes. Do not stay inside for more than three days at a time. Read books for fun. Take an hour or two every week to just sit/walk and think.
Invest in your relationships, romantic and otherwise. It does not matter how rich you get, you will be miserable if you do not create meaningful bonds with others.
Though much of the above may seem like moralistic advice, it is not. Investing is at least as much about self-exploration and behavioral management as everything else combined. To maximize your risk-adjusted returns, leading a sustainable lifestyle is of the essence.
I hope this proves useful to someone. Also, again, not investment advice.
Tom
Ps: If you live under a rock and do not know about xkcd.com, I highly recommend you check it out.
The Financial Flâneur 