Studies of Life

Learning by doing.

Recalibrating to an evidence-based investment strategy

16 January 2016 by Jim

Those of you who’ve been reading my blog for a few months know that I love experimenting with stock investing strategies. While I was using the Trending Value strategy in my own portfolio, and constantly looking for a way to improve it further, I’ve begun to think that maybe the best way to improve my portfolio was not to be found in another stock selection factor, but instead in another direction.

According to many people, including the founder of Vanguard, a portfolio of passive index ETFs is the best approach for most people. I have more reason to believe Vanguard than other fund providers, because Vanguard asks significantly less for its service, which tells me it’s not in it to make a quick buck. I think Bogle really wants to educate investors.

So what if passive investing is the best choice for most people. With a bit of brains, we can surely improve on that, right? Well, not necessarily. Maybe I can prove the additional brains I claim to have by being humble enough to look at the evidence without my conclusions being affected by my emotions, and my pride. So what is the objective evidence? The following chart is part of it, and comes directly from Vanguard.

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What does it tell us?

The upper bar chart shows the investment return based on earnings and dividends of companies. This is what you get by investing passively.

The middle chart shows the return due to changes in valuation, i.e. ‘speculative return’, or the return achieved by having the valuation of stocks change. This is what you add to your return by actively choosing securities to invest in.

Add the two together, and you get the bottom chart, i.e. the total return of the market.

Looking at the average on the right, you can see that the average market return for the past 100 years was 10.4% per year for stocks, of which 9.8% would be what you get for passively investing, and 0.6% per year would be what you get for active investing. In other words, the vast majority of the return of your portfolio is explained by being invested at all. Only a smidgen of performance comes from your proficiency in choosing the right stocks.

What are the limits of this interpretation?

This is long-only investing. If you can forecast changes in valuation correctly, i.e. know when stocks values will decrease, then you could profit from those by shorting the market before it declines. And this is only based on the US stock market, i.e. it doesn’t tell us anything about other asset classes or even asset allocation strategies. Only looking at the US is fine in my opinion, because it has the oldest and most well functioning stock market, and many studies have shown that other developed stock markets behave similarly to the US. And only showing stocks is fine because most of my portfolio will remain in stocks anyway, because I believe that investing in companies is the best way to profit from the entrepreneurial drive of others to make money. By comparison, gold or commodities are not securities that produce anything of value, unlike stocks, which pay dividends and do buybacks.

Based on these limitations, I’d say the following statement is as close to truth as I can get without doing my own analysis of the data: ‘If you invest in developed country stock markets, and you want to be mostly long and not short the market, and you do not want to rely on or do not believe in market timing, then actively choosing stocks to invest in only offers a very marginal benefit compared to using a simple index ETF.

So in the stock area, for my purposes, passive investing is best. But there are other advantages. Knowing how much time I spent thinking about my stocks and when to buy or sell, using a passive approach will give me more peace of mind. And I will never worry about whether a stock can go bankrupt, because whole stock markets do not go to zero (or if they do, I have bigger problems than my portfolio).

1st rule: passive is better than active

Next up is asset allocation. Tactical asset allocation strategies have been talked about a lot recently, and there seems to be some merit to them, but I’m not a big fan of market timing or momentum investing, because it increases volatility.

According to this article by John Authers for the Financial Times, based on Meb Faber’s book Global Asset Allocation, fees matter more than asset allocation. He looked at different asset allocation strategies and their returns, which can be seen below.

Screen Shot 2016-01-16 at 20.44.35.png

As you can see, the boring 60/40 portfolio is in the middle of the pack, despite its simplicity. The best asset allocation here is the one by El-Erian (which has a huge drawdown in 2008 as you can see). The worst is the Permanent Portfolio, about which I already talked on this blog. But let’s say we don’t care about drawdown, only about raw return. So let’s compare the best strategy for asset allocation, minus different levels of fees, to the worst strategy. The result is surprising.

Screen Shot 2016-01-16 at 20.44.20.pngSo after accounting for fees, which funds and especially active ones have, or which you might generate yourself by trading a lot while jumping from one asset class to the next or by buying lots of different asset classes or securities, the best strategy is worse than the worst one. The fees ate up all the excess performance.

2nd rule: asset allocation matters less than fees

Even if we assume that fees do not matter or are extremely low, if we have a large amount of capital to invest for example, different asset allocations matter far less than I would have expected. Screen Shot 2016-01-16 at 20.57.42.png

Just look at the comparison of different passive portfolio allocations below, which come from PortfolioVisualizer. Three portfolios with varying levels of complexity do not show massive differences in return.

The difference between them is mostly their maximum draw down. The annual average return doesn’t even vary by 1% between these allocations!

Screen Shot 2016-01-16 at 20.58.07.pngScreen Shot 2016-01-16 at 20.57.52.png

3rd rule: asset allocation matters little

You should make sure that you are diversified. The benefits of diversification are proven. But beyond having some stocks and some bonds, the marginal benefit of adding yet another asset class decrease rapidly. That is why there is little difference, as shown above, between a portfolio with 2, 5 or 7 asset classes.

So what is the conclusion of the set of three rules we established?

Conclusion: Invest passively, into few cheap funds / ETFs, without jumping around, and using a simple asset allocation.

This approach gives you a good average return for very little work on your part, and causes very little worrying. It’s simple, quick and cheap.

I’ve already posted about last year’s mediocre results of my active value investing strategy. What I got was not worth the time I put into it. And I worried a lot about decision making. I don’t want to pour so much energy into my portfolio if taking the simple, humble approach detailed above yields similar or better results.

In light of this evidence here, it seems being a smart investor does not mean finding a way to be beat the market, but having the humility to accept that you probably won’t be able to do that reasonably easily, and therefore should not even try.

I might, for fun, continue to select portfolios of stocks and backtest their performance to see if there is not after all a strategy that beats the market consistently, but I think the largest share of my portfolio in the future will be allocated to a passive ETF approach. If I keep 5-10% of the portfolio for my personal bets, that’s exciting enough, without affecting my performance too much. And I will sleep better, and free up thousands of hours of my life where I can do something else than worry about my portfolio. Seems like a pretty good decision to me.

More advanced tweaking of a portfolio might yield 1 or 2 percent more per year, but with simple index ETFs, I will get close to 90% of what the top 1% of investors get, without any hassle. I think that for me, good enough is better than an eternal quest for the elusive out-performance.

Now, what do YOU think? Let me know in the comments.

4 comments | Categories: Investing, investment, Learning, portfolio, Uncategorized | Tags: , , , ,

Comments (4)

  1. I have £165k to invest. Looking at the Harry Browne PP model in the first instance as things are so volatile at the moment. Can’t get much more passive than that.

    • You’re right, and it has very low volatility. It’s a great strategy if you want peace of mind I believe. I added gold to my personal portfolio because of the PP as inspiration.

  2. Nice thoughts here…I have a question though…

    Our money is in Euros….the backtest you did with Portfolio Visualizer nd the Boglehead style investing that you seem to agree with (as do i!) uses Dollar denominated funds…(e.g., VTI, BND,VXUS). Wouldn’t the complete uncertainty about the EUR/USD exchange rate in the future put you off from such as investment?

    I am a bit skeptical as to whether i would like to have all my investments in Dollars while paying bills in Euros later in the future.

    Thanks for all your posts!

    • You’re right – they’re USD denominated funds. But there are EUR alternatives (DB-X trackers for example, and iShares ETFs). My personal portfolio has a mix of EUR and USD investments. While the exchange rate can vary in the future, I think it’s good to hedge your bets, i.e. have both EUR and USD in your portfolio. You don’t know which will do better. So if you have 50% in EUR and 50% in USD (for example) you should be fine.

      If you’re uncertain and mostly concerned with safety, though, then stick to EUR funds.

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