A Practical Permanent Portfolio for the Long Term
Update October 5th: As explained in this post, I chose to have 30% of my portfolio in bond ETFs and gold, rather than allocating 50% of it to ETFs. Why? Because it doesn’t make sense for me to invest in a small-cap US ETF or a total stock market ETF, as outlined above, if I already have most of my portfolio in small stocks chosen with the Piotroski method. I would only be diluting the quality of my portfolio if I did that. The information is this post is still relevant if you want an easy to use portfolio based on ETFs, which ensures maximum diversification and peace of mind in a way that a stock-picking portfolio simply cannot.
You may already have noticed that this blog, and especially the posts on stock market investing, are geared towards science-based investing. My method of choice for stock-picking is the Piotroski F-Score (sometimes called ‘Z-Score’) which focuses on a 9-point test to determine whether a stock has been improving its financials over the last year.
But when you invest, it’s not just important to think about what works, but also about what is actually practical for you. In order to avoid carrying too much risk, I’ve set trailing stop loss orders at around 15% of the stock price to make sure there can be no 2008-style surprises. Sometimes a stock may be sold this way even though I would have preferred to keep it, but it is more practical for me to use stop loss orders because they make me sleep easily at night.
So investing in a way that’s practical for you means thinking about the kind of volatility and losses you’re willing and able to endure. If you’re not certain that you can withstand a 20% decline in your portfolio value, don’t invest in a way that makes such declines possible, i.e. diversify properly and use stop loss orders. It’s not an exact science, because even with stop loss orders your order is executed at the next available market price, so there’s still a chance you’ll lose more than the stop loss level, but your loss will be limited in either case. That’s what it’s about: reducing the probability of huge losses.
Another strategy you can use is to split your portfolio in different asset categories. Some recommend a 50/50 split between stocks and bonds, and that’s a good starting point. I’ve personally decided to setup an Index ETF portfolio after reading more about the Boglehead’s strategy.
So what is an Index ETF portfolio?
An Index ETF is a fund traded like a stock, so you can sell and buy it whenever you want during the day. It represents a specific index of stocks, so it’s a basket of stocks, which means diversification is built-in. You could, in fact, invest your whole investment budget in a single Index ETF mirroring the SP500. It would not be the worst strategy out there: you’d have limited volatility, limited risk and you’d be sure that if a crisis like 2007/8 happens, you’ll bounce back, because the US stock market as a whole will not go away anytime soon. The same thing is true for European indexes or Asian indexes, basically anywhere that’s geopolitically stable is a good bet.
Basically, a portfolio made up of index ETFs is a ‘permanent portfolio’ that you don’t have to trade in or out of or keep track of frequently because it just takes care of itself if you leave it alone. Sometimes you should rebalance (every 6 or 12 months) to make sure the allocation is still balanced the way you wanted, but other than that there is not much you need to do.
Why would I want to invest half of my budget into an ETF portfolio, if I’m making such fabulous gains by picking individual stocks? Well, stocks rise when the market as a whole rises. During bear markets or crises, it’s difficult to gain anything this way. Throughout the years, I will probably earn more if I stick to picking individual stocks, but the highest return is not the only criterion for me. A major factor is also my ability to continue with this investment strategy. Allocating half of my funds to an index ETF portfolio makes sure that, even if my ups will not be as high as they could be with pure stock-picking, my downs won’t be as low, either. So I’m reducing the overall volatility and risk of my portfolio.
What will my ETF portfolio look like? It’s based on the ‘Coffeehouse portfolio
’ which is described in a popular investment book and also referred to by the Bogleheads
. I’ve modified it a bit for my needs:
- 40% bonds
- 10% gold
- 10% emerging markets
- 10% developed markets
- 10% REITs
- 10% small-cap US stocks
- 10% total US stock market
This ensures a relatively low volatility, and the bonds and gold will reduce the risk of huge crashes, because those are typically safe-haven assets for people when the stock market gets choppy.