In order to achieve financial independence you need to have enough in financial assets to fund your life. This amount of financial assets is what we call “The Number”. After digging into figuring out what my number was I realized it has multiple variables and assumptions involved that people may not think about. So it’s a little bit of work to figure out, but with the right approach, good data, logical assumptions and some guidance anyone can do it. To help you out I made a Google Sheet that captures all of this so you can figure out your own number in just a few minutes!

The Number

So what is the number and how do we calculate it? The number is the total amount of money we’ll need to be able to consistently tap our portfolio to fund our life. To calculate the number we need to know how much money we’ll need in the future, inflation during the entire period of time and our future tax rate. Yikes. But don’t worry, we’ll do most of the heavy lifting on the math and assumptions for you!

There are a few critical variables to determine a reasonably accurate number. I specifically use the word reasonably as all of these key factors have variability that you’ll want to do some sensitivity analysis on. Here are the primary variables:

• Retirement budget – how much do you need to fund your life
• Inflation and its impact on your purchasing power
• Rate of return on your investments
• Taxes – Types of accounts and where you live
• How much can you draw from your assets

In addition to these inputs there is the element of time. Not so much about when you are going to die (though that is important!) but when do you want to start drawing on your assets to fund your life. I’d say that is the key takeaway from this blog, the number is not static! The effects of inflation and time mean that our target number is constantly moving.

A couple of assumptions to be clear on before we move on. Our analysis of the number in this blog will assume we are building a system that could provide for you in perpetuity, so it does not matter when you die. To be clear we are not assuming any other forms of income other than your financial assets. So no social security, pensions, rental income, etc. We also assume there are not early withdrawal penalties from retirement accounts so if this analysis shows you retiring before age 59.5 you’ll have to consider that.

Retirement Budget

Budgets are not boring. Budgets are an exercise in establishing what you care about, your priorities in life. This is obviously unique to each individual. The goal here is to do a detailed budget that captures all of your needs and wants in life. As an example my wife and I want to travel more in retirement so we significantly increased that line item in our retirement budget compared to our budget today. The second tab of the Google Sheet has a budget template that you can make your own. When you update this budget tab it will flow through the rest of the sheet to calculate your number. For this exercise budget in today’s dollars, we’ll account for the impact of inflation…..which is critical!

Inflation

Inflation means the dollar you have today won’t buy as much stuff (goods and services) in the future. We have a certain amount of goods and services we want in retirement. If inflation is high while we are in our saving years, our number gets higher. A higher number takes more time to get to. Thus, we don’t like high inflation. Some may say, “well, how about deflation then!” Very good question. Yes this would make your number lower but it would most likely come along with other issues that would delay our ability to achieve the number as quickly as we would like. With inflation we want the Goldilocks scenario which is right around 2%.

So what number should we use to model inflation? The Philadelphia Federal Reserve performs something called the Livingston Survey where they ask a bunch of professional financial forecasters what they think inflation will be in the next 10 years. As of the writing of this blog it is 2.26%. They continually update this forecast. This is as good of an assumption as any. That being said these people are not wizards, they could be wrong. In fact they will most likely be wrong, the question is just by how much and in which direction. Based on this, when you are playing around with the Google Sheet be sure to change inflation to see how it impacts your number and timeline.

Rate of Return On Your Investments

This is a sticky one. Your rate of return will largely be driven by four factors: (1) When you are investing, (2) your asset allocation, (3) how much you pay in fees (4) your ability to avoid behavioral finance pitfalls (i.e., can you stick with your plan and not panic sell or euphoric buy).

As far as when you are investing there is an element of luck here. Some generations get tailwinds and some get head winds. However, over a long enough period of time generally things should smooth out. Let’s assume a 30 year investing window looking only at the S&P500. If you invested from 1980 to 2010 your annualized return (with reinvested dividends) was 11.08%. From 1990 to 2020 it was 10.09%. So not a huge difference and both are healthy rates of return. That being said, the impact of increasing your rate of return by even 1% can have a significant impact on how quickly you can achieve hitting your number. I pulled this return data from the Of Dollars and Data website, it is a pretty fun tool that also shows the inflation adjusted returns.

So you can’t control when you are investing as it’s just a function of when you were born. The remaining factors that impact your investment rate of return are in your control. We’ll start with asset allocation. I won’t belabor this as we have many blogs on this. Our homepage shows the portfolios Steve has built that do a nice job of balancing risk and return. All this is to say you need to have an asset allocation plan and stick with it. That plan can change over time as you age, that is fine. But have a plan. Your choice in asset allocation will be a major factor in your rate of return.

You also can control what you pay in fees. Again, I won’t belabor this as we have a good blog on the corrosive nature of fees. All things being equal, keep fees low and it will improve your rate of return.

The last major impact on your investment return rate is your cave man brain. If you can manage it well you will protect and possibly improve your returns, if you do not you can kill your returns. Check out our blog on the behavioral elements of investing for more details.

So now, what the hell should we assume for our rate of return. For myself and my asset allocation I use 8% (7.7% actually but I’m rounding up for simplicity). This is a blend of historical data like was shared above with some conservative assumptions. Like all the other key variables that impact our number we’ll run some sensitivity analysis on this.

Taxes – Types of Accounts and Location

As it relates to the number, we need to figure out what your tax rate will be in retirement. This is impossible as we do not know what tax policy will be in the future. In addition to this, there is complexity that will impact your ultimate tax rate such as the types of accounts, your tax bracket, where you live, how much is coming from dividends, how much is long term capital gains and how much is ordinary income. This is one of the reasons why I love Roth accounts. It future-proofs your tax situation as distributions are not taxed. My advice would be to get as much money into Roth accounts as you can. I understand it may not ALWAYS be the best financial move based on rates today versus tomorrow, but that is the point, no one knows what they will be tomorrow! To be clear the estimated tax rate in the Google sheet is just an estimate and should not be used for any real tax planning. Here are some of the different types of income and their associated rates.

• Federal Ordinary Income 12% to 24% for most people
• State Ordinary Income – Varies by State
• Long Term Capital Gains 0% to 20% depending on filing status and income level
• Dividends 0% to 20% depending on filing status and income level

Withdrawal Rate – How much can you tap your number?

A major factor in determining our number is to know how much we can safely draw from our number to fund our life. Many people use the 4% rule which was developed by William Bengen. This means that each year you can safely take 4% of your assets to fund your life and you should never run out of money. So if you had $1M in assets you could take $40,000 in the first year and then increase your withdrawal due to inflation each year. Mr. Bengen recently updated his popular 4% rule to the 4.7% rule, which is great as it means our number can be lower and thus we can retire sooner!

I trust Mr. Bengen, but let’s do a back of the envelope calculation here. As I shared earlier, with my asset allocation I think I can earn 8%. I estimate inflation to be 2.26%. So I assume a $1M portfolio generates an $80,000 (8%) return of which I draw $47,000 (4.7%) I’m left with $33,000 (3.3%) added to my principal. However, inflation eroded my purchasing power to the tune of $22,600 (2.26%). Even considering inflation, with the 4.7% rule I was able to add to my principal balance but more importantly I (very slightly) added to my purchasing power. Based on this rough analysis I’d say the 4.7% rule seems reasonable. I fully realize I did not consider exactly when during the year I was taking the money and the impact that would have on my 8% return. The purpose with this back of the envelope analysis was to kick the tires on the 4.7% rule and it seems reasonable.

Example of Calculating Your Number

We now have everything we need to calculate your number. Using the Google Sheet we made for this blog it should only take a couple of minutes to calculate as long as you have your data ready. The Google Sheet is read only so you’ll first need to copy the sheet for yourself by going to File:Make a Copy. Enter your budget on the “Retirement_Budget” tab and enter data specifically for you in every green cell on the “”Inputs_Outputs” tab. Then voila, you have your number and you can play around with your inputs to see how it will impact when you can retire. We’ll walk through an example to show how to use the Google Sheet.

For our example we’ll assume we are calculating the number for the Johnsons, a 50-year-old couple with two teenage kids who live in Massachusetts that want to spend their retirement visiting family around the country and seeing every national park in the US. They have two homes which will both be paid off before retirement.

The Johnsons budget is shown below. For your budget think about what are the major factors for you. Will you still have a mortgage? Will you want to travel more? Will you go out to dinner more? What will you do less? As an example I currently have two growing boys that are huge, they eat a lot. So my grocery budget will be less than it is now in retirement…I hope. Think about these things and put together a good detailed budget based on what you need and want in life.

The Johnsons have done a pretty good job, they have $825,939 in financial assets across all of their accounts. Here are all the inputs for the Johnsons:

1. Forecasted Inflation Rate
   • 2.26% per Philly Fed estimate – I would leave this alone but then we’ll play around with it to see how inflation impacts our number….really how it impacts time
2. Investment Rate of Return
   • 8.00% – See earlier comments, another one we can play around with
3. Current Age – The Johnsons are both 50 years old.
4. Roth Account Value
   • Add up all of your Roth accounts and enter into this cell, Roth IRA’s , 401k’s etc.
   • The Johnsons have $175,699 in Roth accounts
5. Traditional Account Value
   • Add up all of your traditional retirement accounts, Traditional IRA’s, 401k’s, 403B’s etc.
   • The Johnsons each have a traditional 401k with a total of $569,886
6. Other Account Value
   • Add up all of your financial assets outside of retirement accounts, so brokerage accounts, savings accounts, etc.
   • The Johnsons have a handful of brokerage accounts totaling $80,354
7. ROM for your State Taxes
   • Depending on where you live enter your State tax rate…..in addition to the nice weather in the winter, this is why people move to Florida in retirement
   • The Johnsons live in Massachusetts and plan to stay there in retirement. Massachusetts has a 5.5% income tax.
8. Dividend Yield Estimated
   • This is a little tough as it greatly depends on your asset allocation, our estimate is the current yield on AOR which is an ETF that holds 60% equities and 40% bonds. This is considered a relatively safe investment that people might hold during retirement. To be clear I’m not recommending this, in fact some people think the 60/40 is too conservative, even for retirement!
   • The Johnsons are assuming a 2.48% dividend yield
9. Annual Savings
   • This is how much you can save per year from now till you retire, again you can play around with this and see how it impacts your number and time horizon
   • The Johnsons save $15,000 into their 401k’s each year. They try to save outside of their retirement accounts but with kids and college costs they really can’t.
10. Marital Status
    • Obviously only you know this one, this only impacts the rough order of magnitude tax rate estimate
    • The Johnsons are married
11. Withdrawal Rate
    • 4.7% per William Bengen’s famous rule of thumb
    • The Johnsons assume William Bengen knows what he’s talking about

Here are the Johnsons inputs:

Now that all of the data is in for the Johnsons we can look at the results and play around with some of the assumptions to see how it would impact the number and timeline for the Johnsons to retire. A few key things. In cell D20 (highlighted in yellow) is their number today. This means if they had $2,479,442 in financial assets they could retire today. However, they do not. They have $825,939, so a good amount but not nearly enough to live off of their assets. With all of the other assumptions they could retire at age 67. This is the first time their assets (blue dashed line) exceeded their number (green solid line with green dots).

Note that their number (green line) get’s higher over time, this is due to inflation. As mentioned earlier inflation has a major impact on when we can retire all else being equal. So let’s increase inflation by 1% to 3.26%. How much will that impact the Johnsons?

Increasing inflation by 1% would delay the Johnsons retirement by 3 years! They now will have to wait until age 70 to retire.

Let’s be a little more optimistic. Let’s put inflation back to 2.26% and assume the Johnsons can save $30,000 a year instead $15,000. How does this impact their number and timeline?

Doubling their contribution amount would allow them to retire between 64 and 65, saving them a little over 2 years compared to our base case. Not too bad. Now let’s put that number back to $15,000. So now we are back to 2.26% inflation and saving $15,000 per year. Let’s increase the rate of return by 1% from 8% to 9%.

This basically has the same effect on time as doubling the annual contribution where the Johnsons can retire between 64 and 65.

Conclusion

Calculating ‘The Number’ can feel daunting, but as we’ve seen, it’s really just a bunch of solvable variables. The real value isn’t in finding a magic digit that solves all your problems; it’s in the clarity that the knowledge provides. We often avoid looking at our finances because we’re afraid of what we might find, but ignorance isn’t bliss—it’s just a lack of options.

Whether your number is $2 million or $10 million, knowing it is the only way to effectively close the gap between where you are and where you want to be. This isn’t just about retiring; it’s about buying back your freedom, one calculated assumption at a time. So, go make a copy of the sheet and play with the inputs. You might be closer than you think.

At the age of 28 when I started this blog with my former boss, Chris, and lifelong friend, I aimed to find an optimal investment portfolio. I had fun and learned some valuable insights (my 11 posts); but all my analysis and posts were too myopic – they focused on one investment mix. Chris was a bit ahead of me, maybe because he is 8 years older, and started writing about a comprehensive investment strategy of strategies (Chris’s 6 posts). But I haven’t posted anything here for over 7 years, since May 2018! What have I been up to, have I learned any valuable financial lessons worth sharing? Yes!!

After maturing to now 37, having 2 more kids (4 total), buying/selling some homes, getting another masters degree, experiencing a global epidemic, changing companies, starting a philosophical blog on the meaning of life, and living more life myself – I’ve developed and want to share my family’s comprehensive financial plan in this post (while obscuring the absolute values). I’ll share how I arrived at these allocations and strategies to provoke you to consider yours with suggested ranges based on my life experiences. I hope this inspires you to document your own plan, align with your partner on it, and go achieve your financial dreams!

Like all my posts, this has gotten a bit out of hand in length so here’s a table of contents and outline on what to expect with anchor links to each section.

• Quantify Your Goal and Chart Your Course. Choose from Many Different Savings Paths. Appreciate the Outsized Impact of Good Investment Performance.
• Develop Your Investment Strategy of Strategies. Establish Rules to Abide By. Diversify Across Strategies. Leverage Index Target Date Funds to “Tie” the Benchmark. Use an “All-Weather” Portfolio to Stabilize Your Returns and Give You Peace of Mind. Benefit from a Momentum Strategy’s “Different” Movements. Scratch Your Itch with a Small Mad Money Account(s).
• Put Cash to Work, But Not Enough to Drag Your Returns. Keep at Least 3 Months Worth of Spending in Cash Equivalents, Not Sitting in a Bank. Deploy Cash During Market Downturns. Apply Dollar Cost Averaging to Overcome Your Hesitancy.
• Live a Life Worth Living in Appreciable Assets. Consider the Home Ownership and Rental Costs in your Desired Real Estate Market. Project Your Net Worth Growth from Buying a Primary Residence. Decide What Will Bring You More Joy at your Current Stage of Life.
• Prepare the Next Generation. Pay for College with a 529 Plan. Teach Your Kids Investing with a Custodial Roth IRA.
• Keep The Discussion and Learning Going!

To also help those that want a quick glance through this long blog, here’s a presentation form of the content. And for those that want to dive deeper, you can view all the data in this Google Sheet and interactive plots with the Python code that generated it here in this Google Colab.

Quantify Your Goal and Chart Your Course

I envision when our investable assets generate enough income to cover our expenses, freeing us to pursue our passions with confidence our children can pursue theirs. That’s my vision! To quantify it, I need to understand how much money I will likely spend in or near retirement and then target a total investment portfolio value 25 times larger (so that 4% will cover expenses). This is in addition to equity in property which will contribute to net worth gains but not (likely) provide any liquid income. I hope to reach this point by the time I’m 60 so I can be present and helpful for my young adult children as they start their own families.

Understanding what this number is to reach and by when will help you build a plot like this, that assumes the more typical retirement age of 65. I’ve added a third line though, the value of your investment portfolio that will allow it to grow with no more contributions, yet reach a value 25x your annual spending in time for retirement. This equation is target = 25/1.06^years_left (assuming 6% return) and quantifies when you’ve reached a point of financial flexibility or “cruise control.”

I recommend you update this plot every year (what’s the target balance, age, and cruise control line) and then add a point representing where you currently stand on it. If you’re approaching or above that “cruise control” line (like I am) then it may be time to consider one or both of two things:

1. Make a change in your career to one less stressful which will reduce the amount of savings you generate or stop it all together.
2. Put money into home equity for an updated or different home which will reduce the amount of investable assets you have (like I am considering).

Choose from Many Savings Paths

With a firm understanding of where you are today and where you aim to be in the future, now you need to plan the steps you’ll take. There are an infinite number of paths to take, but I’ve simplified it to four extremes. Each reach the same end point but take vastly different routes. Consider four people:

1. Steady Eddy – Steady career with little-to-no debt at the start but saves 10% diligently from 25 to 65 years old when they retire (think bluer collar jobs).
2. High Earner Werner – Starts with a lot of debt at the start to pay for their degrees but they make a lot of money in their 40s and beyond, saving 15% along the way to retire at 65 (think doctors, lawyers, etc.).
3. Early Riser Taylor – Starts with some debt but quickly starts making and saving a lot of money, 20% of their income from the start which enables them to settle into cruise control at 45 and retire at 60 (think engineers, scientists, finance, etc.).
4. Thrifty Christie – Starts with some debt but lives well below their means to save 40% of their income to retire at 55 years old, abiding by the Financial Independence, Retire Early (FIRE) philosophy.

I’ve compared the assumptions and projected each personas savings over time in this spreadsheet. Each of them are expecting to spend $100K annually in retirement (meaning they seek $2.5M in assets) and benefit from 7% annual gains on investments leading up to retirement. But they take very different approaches to saving and earning income along the way, yet they reach the same point. The following plot visualizes each individuals path of earning, contributing, and growing their savings. I want you to take two main takeaways from this. (1) Each path is unique yet not mutually exclusive, and can arrive at the same point. (2) Saving, especially early, can appreciate to a point that it makes later contributions negligible, no matter how much money you make later.

Sharing candidly, I’m most like Early Riser Taylor which I suspect Chris is also. My biggest fear isn’t if I’ll make it to that cruise control line, its worrying that I’ll get there and become too blinded and ambitious to take action. Much of the motivation to write and publish this blog was to hold myself accountable and to enable my young adult children ~10 years from now to do the same! I hope by the time I’m 50, I have the opportunity and choose to shift my career toward somethings serving society more directly, while freeing more time and energy to shift from my career toward my family.

But there isn’t one single “right” persona to try and copy. You must determine your unique path, considering your career and lifestyle you’d like along the way toward and then in retirement. Life has ups and downs, its okay to flex up and down your savings as necessary. Just pay attention and always reassess along the way about what path you want to take, and what the next couple steps need to be.

Appreciate the Outsized Impact of Good Investment Performance

In the above four personas I kept the market performance and final balance fixed, just changed the paths. But market performance of 7% is not a given, it must be earned! Not only must it be earned, but improving your investment performance has a proportionally higher impact on your final balance compared to increasing your contributions along the way. I’ll use the following scenarios to illustrate this point, but given the same starting point know that: investment performance >> contribution % > salary growth.

Let’s consider you as someone starting to save at 25 years old with no debt, but also no savings yet. In this example, you will start with a salary of $50,000. We’ll vary each of the following variables +/- 33%.

• Salary Growth (4%, 6%, 8%) – Resulting in a salary at the age of 64 of $172K, $272K, or $427K. (I assumed only a 2% gain in salary from age 50 onward regardless of scenario).
• Contribution Percentage (10%, 15%, 20%)
• Investment Performance (4%, 6%, 8%)

Visualizing the impact of three input variables in two dimensions isn’t easy! So I went with this approach of generating 9 sensitivity tables showing the balance at 65, each fixing one of the variables at a single value while varying the other variables +/- 33%. I’ll give you a moment to study it… there’s a lot there! Notice how going down along the first column (increasing salary) looks pretty similar to going down along the second column (increasing contribution %). But the biggest jumps come from going down along the third column (increasing investment performance).

To hammer this home, lets start with the “worst” case scenario, when your salary grows at 4%, you contribute 10% of your salary, and your savings grows at 4% annually. You’ll reach retirement at 65 with $0.87M. If you double your salary growth to 8%, you’ll retire with $1.68M. If, instead, you double your contributions to 20%, you’ll retire with $1.75M. But if, instead, you doubled your investment performance while keeping everything else constant, you’ll retire with $1.98M. Let’s plot the above four scenarios, plus one where you were at the midpoint of each variable (6% salary growth, 15% contributions, and 6% investment performance. And finally we’ll add a sixth scenario where you maximize each variable (8%, 20%, 8%). Here’s the data, and here’s the Python code for the plots.

Your salary growth clearly matters, but the percentage of that salary you’re able to contribute matters more. And above all, the investment performance matters the most. Investment performance >> Contribution % > Salary Growth. So… how should we maximize investment performance!?

Develop Your Investment Strategy of Strategies

Maximizing your investment performance depends on two things:

1. Your specific investment portfolio composition and plan to adjust given a set of rules
2. Your ability to stick to the plan

I believe that the ability to stick to your documented plan matters more than the specifics of your plan because it removes your caveman investment brain from the equation which will likely depend too much on emotion, have recency bias, and have an inflated ego. I’ll share my plan here which is one I developed for my family, I’m not asserting its right for everyone! But hopefully by sharing the logic I applied to these decisions you can make sure you develop a plan that you will have conviction in as being the right one for your family!

Establish Rules to Abide By

Always important to start with some tenets! When needing to make a decision with limited data, what rules will you use to arrive at the right answer? Here are my investment tenets, think through your own!

1. Accurate reporting beats pride. Telling yourself and your spouse the truth about your goals and performance may hurt sometimes; but it will pay dividends in the future for you both.
2. Keep it simple yet fun. Enable yourself to stick to the plan. But empower yourself to act. 
3. Learn enough to pay minimally. Teach yourself what’s needed to avoid fees and taxes at all costs. 
4. Apply good investment theory to your unique self. Data helps, but only you know yourself well enough to use it in a way that benefits your needs.
5. Maximize your impact, not your wealth. Money is a means to an end. Use it or give it away.

I think these are self explanatory but I’ll reference them throughout the next few sections to highlight the value in establishing and abiding by a set of simple tenets!

Diversify Across Strategies

The following table lists my target allocation for the different investment strategies I embrace across my portfolio of portfolios. Note that this just represents the percentage of my investable assets, which I target to be about 50% of my overall net worth. So at any point, I expect that for the total amount of money I have across these strategies/portfolios, I also own a comparable amount of home equity. I added a column to suggest a range for you to consider setting a target allocation within. The rows are ordered according to their risk level, cash is the safest, a mad money account is the riskiest.

I arrived at these allocations, both for myself and as recommended ranges to you, through lived experiences. I’ll explain how in each subsequent section that describes the strategy / portfolio.

Leverage Index Target Date Funds to “Tie” the Benchmark

Vanguard pioneered index funds in the 1970s which buy a broad basket of securities within a given index (like the S&P500) weighted by market cap to minimize transactions, fees, and taxes. Its approach allow them to be very cheap (abiding by rule #3) while guaranteeing you’ll perform at least in the 50th percentile for that asset class. You will effectively tie the market via index funds, although data suggest you will beat the median investor (both professional and amateur) because you won’t need to get any timing decisions right. Just buy and hold the market index!

Target date funds combine a few asset classes (typically total US stocks, ex-US stocks, US bonds, ex-US bonds, and short term inflation protected securities) via index funds in a portfolio allocation that adjusts over time as it approaches retirement. They typically start with about 90% stocks that “glide” towards 50%/50% stocks/bonds at retirement (see figure below). They are super simple to invest in because its one fund (abiding by rule #2), costs about 0.1%, and all reputable brokerages will offer them (if they don’t, run for the hills). Vanguard still offers the best though! Index target date funds should represent the largest allocation of your portfolio of portfolios because of their simplicity, low-cost, and “guaranteed” performance relative to benchmarks (they are the benchmark).

How did I arrive at a 35% allocation and recommend 35% to 70%? Fresh out of school, starting my career, and devouring investment books like the Intelligent Investor and a Random Walk Down Wall Street, I feel in love with index funds, and for good reason! So, in my early 20s I effectively invested 100% of my investable assets into the available 2055 target date fund in my 401K (thanks Chris for ensuring it was a good offering!). This worked out great for the first 5 years or so, especially as the market performed well. But I got a bit lucky that there were no significant downturns in that time. After saving up more money, getting married, buying a house, and thinking about having kids… I realized I needed some of my investments to be “safer” and accessible for life events and peace of mind which led me to the 70% recommended allocation with the remaining 30% between all-weather (next topic) and cash. But then once I discovered dual momentum (two topics from now) I personally dropped my allocation to 40% to make room for dual momentum. But it’s up to you, your interests, and comfort level. If you’re like me and want to be able to add some of your own flare to your investments, at least keep 35% in target index funds. If you want the easiest portfolio strategy possible, go big on target date funds! But don’t exceed 70% to be able to use an all-weather portfolio for some stability when the target date funds go through some inevitable long cycles of low or negative returns.

Use an “All-Weather” Portfolio to Stabilize Your Returns and Give You Peace of Mind

Target date funds will perform great for the full duration of your savings timeline (~45 years) but they will be quite volatile throughout that time. Some years they may return +20%, others they may lose that much or more. Not only will it bounce up and down annually (and even more exaggerated volatility when paying attention more regularly throughout the year like monthly, weekly, even daily), they may lose money for several years in a row, especially when accounting for inflation. Seeing your hard earned savings seemingly erode is hard, no matter how young you are and how much conviction you have that they will rebound (which they will). You need a portion of your overall portfolio of portfolios to be something you can depend on. You need a portfolio stabilizer.

Let’s illustrate this point by plotting the rolling three year annualized real returns (accounting for inflation) of US stocks from 1972 (first data point in 1974) through the end of 2024. We’ll compare this to treasury bills (cash), and I’ve introduced two other lines: Ray Dalio’s All-Weather portfolio, and what I’m calling the “Engineered Portfolio Stabilizer.” Notice that most often the blue line (US stocks) outperforms the orange (Engineered Portfolio Stabilizer) and purple (All-Weather), but not always. And when stocks do poorly, they have done quite poorly, generating in excess of 10% annualized losses for three years in a row. Meanwhile the orange and purple generally stayed steady through those downturns. The time series plot is useful, but next up we’ll plot a bunch of performance vs risk metrics!

In the below four plots, I compared the performance from 1972 through the end of 2024 for a few stabilizing portfolio options I’ll elaborate on next in purple, a few key asset classes in blue, Vanguard’s conservative growth fund as a benchmark (60% bonds, 40% stocks) in yellow, and US treasury bills in green. I’ve also added in orange the “Engineered Portfolio Stabilizer.” The top left plots the average nominal return (before accounting for inflation) against the volatility of annual returns. You’ll notice that the purple and orange seem to bulge out a bit toward the upper left meaning they offer better risk adjusted returns. This becomes more pronounced when we plot the real (after accounting for inflation) annualized return against the downside risk on the bottom left plot. I prefer looking at the annualized return vs the average return because averages equally weight gains and losses when we know that mathematically this isn’t how compounding gains/losses work. For example, if one year a portfolio gains 10%, the next year it loses 10%, that average of 0% would suggest it was a wash, you’re back where you started. But you’re not, you are 1% lower. I also prefer looking at downside risk which only quantifies the volatility of losses because an investor typically won’t mind too much about the volatility of their gains. This “bulge” towards the upper left (attractive risk adjusted returns) becomes even more pronounced in the bottom right plot when we compare the average three year return vs the volatility of those three year returns, which you can visually confirm by looking at the time series plot above. Last, but not least, is the upper right plot, which I think is the most compelling, that shows you the worst case scenario. Here I plotted the 15th percentile 3-year return (85% of the time it does better than this) against the maximum drawdown. In order to benefit from the upside of a mostly stock portfolio, you would have had to endure nearly a 60% cumulative loss. And just under 20% of the time, you would have had to endure sustained losses that took longer than three years to recover. That is hard to do my friend! Unless, you had some percentage of your overall portfolio allocated to one of those “stabilizer” options that would have better preserved capital, even gaining, while a more stock-heavy portfolio sustained losses!

So what are these stabilizing portfolio options you ask! There are four I’ve compared here, each hold a sizable amount of gold. If you’re like my younger self, you may have an allergic reaction to the idea of investing in gold. It doesn’t “do” anything, there are no dividends, and no profit generated. It appreciates value because silly humans have decided it’s valuable. That being said… it does appreciate value. And it appreciates most during both inflationary periods and market downturns. So as a hedge to both stocks (that fall in market downturns) and bonds (that fall during inflation), gold is quite the hedge! One of my previous posts highlighted this: Solving the Great Diversification Debate. Note that this is only true in a portfolio that rebalances regularly (assumed annually in these plots). I minimize tax implications by rebalancing via contributions (adding to under-performers) and withdrawals (selling off out-performers).

Figure 8 compares the asset mix of each portfolio. Harry Browne’s “permanent portfolio” is the simplest with just four equally weighted assets. Tyler’s (a fellow mechanical engineer who loves investment plots) “Golden Butterfly” is attractive in that it’s just 5 equally weighted assets and effectively matches our “engineered portfolio stabilizer.” Then Ray Dalio’s “All Weather” also has 5 assets but it weights 40% to long term treasuries which did great over the last 30 years but… I don’t think it will repeat as yields rise. Our “Engineered Portfolio Stabilizer” equally weights 7 assets which include our loved consumer staples (see sector analysis), mid-cap value (see style analysis), and emerging market bonds (see bond analysis). You could also consider Vanguard’s conservative growth fund which is a “safe-ish” portfolio stabilizer but it doesn’t have gold so its effects are muted.

How did I arrive at a 35% allocation and recommend 15% to 50%? When I was younger and dumber, I would give Chris a hard time about not investing wholly into stock index funds. I thought he was old and too risk averse… come to find out he was wiser than I. As I mentioned, once I bought a home(s) and had kids, I realized that life can present itself with more expensive unforeseen costs than I thought! Homes require work, sometimes benefit from improvement projects, and sometimes require moves to larger homes to accommodate a growing family (four kids!)! Having some liquid-ish capital that you can depend on both appreciating while also not suffering major losses is a must. I recommend everyone hold a portion of their investable assets in a “stabilizer portfolio” and it’s up to you which portfolio you utilize. You may prefer the simplicity of Vanguard’s single fund or Harry Browne’s or Tyler’s which only need 4 or 5 assets. But I prefer the mix of 7 assets that build upon the historical analysis I’ve done and therefore give me conviction on the assets. Having more assets also improves the ability to dollar cost average underperforming ones as I contribute money or outperforming ones as I withdraw money. Up to you on what portfolio mix you use, but I strongly recommend you come up with something you’ll have conviction in and keep at least 15% of your investable assets in. As you near retirement, you may want an even greater allocation here, to as much as 50%, to provide the stability and peace of mind you need.

Benefit from a Momentum’ Strategy’s “Different” Movements

When I started diving into researching historical asset performance characteristics, I intended to find an “optimal” combination that provides the best risk adjusted returns. I fully expected to develop a “buy and hold” strategy. But the more research I did to this end, the more I noticed that assets tended to go on “runs” either up or down that persisted for years at a time. And so I became interested in momentum strategies that used rules to predict which assets would continue such runs, knowing that such predictions would sometimes be right and sometimes wrong. But could there be some strategies that were right more often than wrong?

This led to me developing and publishing a strategy I called accelerating dual momentum. I initially developed it by looking at data going back to 1998 and trying to avoid much of the losses in the bear markets of the early 2000s and 2008. I also wanted to benefit from the relative outperformance of international stocks in the late 90s and mid 2000s. It averaged the 1, 3, and 6 month trailing returns to pick which asset to buy the next month: US stocks, small cap international, or long term treasuries. I then found monthly data going back to 1871 and applied the same methodology on this “out of sample” dataset. I was relieved but even more excited to find that the accelerating momentum signal had worked very well going all the way back to 1871 as shown in Figure 9!

This performance and the rationale for the strategy generated global interest and many others shared the strategy and published articles reviewing its merits. TuringTrader added some performance characteristics and recommended it as one to follow. And AllocateSmartly gave a fair assessment that highlighted some of the risks while also acknowledging its merits. It even generated a response from Gary Antonacci, the author of the book Dual Momentum Investing, in an article he titled “the perils of data mining.” I found that framing somewhat comical because he arguably did the same thing but oh well. I was proud that it generated enough interest that it compelled him to dispute the strategy’s approach.

It’s been 7 years since developing and publishing that strategy in which time I’ve live traded it with my own money. How has it done in this out of sample testing! It tied Gary’s strategy from May 2018 through January 2025, each returning a cumulative 83% return and beating a 40/20/40 US stocks/international stocks/bonds portfolio that returned 67%. But they lost to a more stock heavy portfolio of 60/30/10 which would have returned 99% during this bull market period. But what have I learned about the ride!?

1. The strategy is hard to manually follow. You need a lot of conviction to make the wholesale switches from one asset to another which can happen often with the short lookback periods.
2. Whipsaws are frustrating and defeating. To switch out of an asset then back in again the next month lowers your conviction in the strategy’s approach. 
3. Long term treasuries don’t always rise when stocks fall, especially when rates are rising. It’s depressing to rightly predict stocks will fall and get out of them, but then to be in an asset that falls just as much or even more.

I’ve been meaning to make some improvements to the strategy for a while. And I’ve been recommending cash instead of treasuries to those subscribed to my newsletter in a rising rate environment. So the strategy, if applying rules to pick between treasuries and cash, would have beaten Gary’s in out of sample testing (take that sir!… I’m teasing). But we need some rules to make decisions on data, not intuition, and we need to address the other issues I’ve faced live trading (like whipsaws). Writing this post has finally motivated me to make some modifications to introduce a new strategy called “Engineered Dual Momentum!” Here are the changes and Figure 10 gives an overview of the monthly allocation decision.

1. Just use the 3 and 6 month momentum score. Drop the 1 month component to reduce whipsaws and limit and asset switches.
2. Split the allocation across multiple assets when they have a “close” score to hedge our bet and diversify within a month. Weight the allocation proportional to the score but only split across multiple assets when there isn’t a clear winner (defined as having a score at least 1% greater than the next best).
3. Introduce treasury bills to allow us to avoid long term treasuries when they have a low momentum score.
4. Soften the impact of the absolute momentum decision (if negative, automatically go bonds) by using the logic in #2 so that if it’s just slightly negative we don’t fully leave stocks.
5. [To Do] Move my IRA (you should only use such a momentum strategy in a tax free account) from Fidelity to Robinhood so I can automate the transactions via Python. This will be the subject of a future blog post so I can share the code. Maybe someday Chris and I could offer a paid service where our app integrates with each subscriber’s Robinhood account to perform the trades automatically for a modest fee ($5/month, tier up or down based on account balance).

So how has it done! Let’s first check the results from the start of 2008 through March of 2025 in Figure 11. Our new EDM strategy clearly stands on its own for its risk adjusted returns. But admittedly this is the period I have lived through and may have overfit the rules for.

So how did we do through a longer look back period? Using data from 1971 through today, we can plot how the different strategies performed relative to a fixed allocation of 40% US stocks, 20% international stocks, and 40% bonds in Figure 12. Then Figure 13 summarizes the results using our portfolio characteristics metrics. The three momentum strategies performed pretty similarly with Accelerating Dual Momentum doing the best (21x the benchmark) followed closely by Engineered Dual Momentum (18x the growth relative to the benchmark). Gary’s strategy isn’t too far behind although its returns are only 13x the benchmark. When I did some of my initial development of accelerating dual momentum, all I cared about was the final balance. But I’ve since come to learn that the ride itself matters more because you need to weather the ups and downs and past results are by no means a predictor of future returns. So I think this data suggests, if you’re interested in dual momentum, you need to select whichever strategy resonates the most with you and what you think you’ll be able to follow. Relative to our benchmarks these strategies offer the potential to provide similar risk in terms of volatility but muted maximum drawdowns and sustained periods of losses. Yet this improved risk profile still allows, historically, to have beaten the benchmark’s returns… if you can stick to it!

How did I arrive at 22% allocation and a 0% to 30% recommendation? I think momentum strategies clearly have an opportunity to outperform over the long run and therefore deserve an allocation in your portfolio of portfolios but… they won’t always outperform and they require work. You shouldn’t allocate anything to these strategies if you don’t want to spend the ~10 minutes each month to check and make the trade (if necessary) -> at least until Chris and I create an app that does the work for you! If you are interested enough to be willing to spend the time, its still best to not have more than 30% in these strategies which can go on runs of underperforming. If you keep the allocation to less than 30%, you’ll provide yourself with good diversification benefits and won’t be too much of a weighting that would give you heartburn and frustration during those periods of underperformance. Then its up to you to decide which strategy you like best. I prefer the Engineered Dual Momentum strategy that balances being reactive without being too whipsaw-y. But you may like the aggressiveness of Accelerating Dual Momentum or the simplicity of regular Dual Momentum. Its up to you!

Scratch Your Itch with a Small Mad Money Account(s)

If you’re reading this blog you probably have enough of an interest in investing that you may find it enjoyable and potentially lucrative to pick and time your own investments in individual stocks, crypto, options, etc. instead of the aforementioned passive and rules based strategies. This is why I have my rule #2: keep it simple yet fun! You should give yourself that opportunity but for a small percentage of your overall portfolio. Why small? Because individual investors typically underperform against the overall market. Most studies I’ve read claim that the average investor realizes less than a 3% average return, see Figure 14. And even professional funds underperform (hence the suggestion to invest most of your portfolio in target date funds) on average by 2.8% relative to their benchmark (source).

Less than a 3% annual return seems abysmal and possibly under estimated given the typical source: investment companies that want you to pay them to invest for you. So I wanted to find a different data source looking at how the net worth of Americans have grown over the years relative to the market. Figure 15 plots the net worth gains for the bottom 50%, the 50% to 90%, the 90% to 99%, the top 1%, and the top 0.1% while also including the value of owner-occupied real estate in the US and our benchmark portfolios. And Figure 16 compares the annualized returns for this time period of Q3 1989 to now. I know that net worth gains will also include cash flows of savings and withdrawals, but I was surprised that the gains of the net worth of the top 0.1% don’t even beat the gains if invested fully in a portfolio of 40% US stock, 20% international stock, and 40% US bonds.

I found it interesting, and validating to using net worth as a proxy for determining average investment gains, by noticing how the total amount of the 50% to 90% net worth Americans tracks closely that of home values whereas wealthier Amercian’s net worth correlates more to the stock market. This suggests that 50% to 90% Amercians have their home representing a large percentage of their overall investment portfolio compared to wealthier Americans having more exposure to the stock market than their home(s). Figure 17 provides a correlation matrix across all net worth percentiles and the benchmark portfolios by looking at the trailing 1-year gain. Again, the net worth gains isn’t the best proxy and it includes a lot of other factors such as income and spending that may outweigh the impact on investment performance. But I think this provides a useful grounding as to how well we collectively do investing. And it reminds us that even the ultra wealthy are barely beating a 60/40 stocks/bonds investment allocation meaning that typical investors are either too conservative or making poor investment decisions throughout the year. Be wary of a high allocation to “mad money” accounts when you’re trying to pick and time your own investments! You could beat the ultra wealthy in investment returns if you just stick to passive rules based investing!

How did I arrive at a 3% allocation and a 0% to 15% recommendation? I fully recognize that I’m unlikely to beat passive rules based investing meaning I have very little in a mad money account (Robinhood). Here I own some crypto and a couple stocks I’m holding for the long run. I like to have fun and be interested in my investments, but right now I’m at a point in my life that I don’t have much time to spend researching investment opportunities, hence all my focus on rules based investing. I expect that to change as I get into my 40s and 50s though and will allow myself to allocate as much as 15% into these accounts… so long as I track my performance and prove to myself it’s worthwhile. You know yourself best so put in an amount you will feel comfortable using. And again, hold yourself accountable by comparing the performance of these accounts vs the other parts of your overall portfolio!

Put Cash to Work, But Not Enough to Drag Your Returns

Now we’ve made it through the “fun” investment portfolios leaving boring old cash. But who says your cash component needs to be boring, I think it can and should be just as fun and interesting!

Keep 3 Months Worth of Spending in a Liquid High Yield Savings Account

It’s important to have some cash directly tied to your checking account for fast cash in the event of an unexpected expense but that money should still be working for you. Figure 18 shows the interest rate of typical bank accounts (orange) vs what you could get in two high interest savings accounts: Ally Savings and Popular Direct Savings. I’ve also included the interest rate on 3-month treasuries as a benchmark. I first opened an Ally savings account back in the early 2010s when they offered 1% and most savings accounts were effectively 0%. As interest rates when up in late 2010s, Ally and Popular Direct tracked that of 3-month treasuries. Then, when the Fed dropped rates, these high interest accounts lagged providing better return, but still less than 1%. Now over the last 5 years though 3-month treasuries started paying out 5% interest. This is free money! Meanwhile Popular Direct did well to track that, but Ally savings started under-performing. All the while though, a typical bank savings account was still only paying 0.5% or so. The takeaway here, is that you should be weary of keeping any money in a bank account that can’t near match what 3-month treasuries do. But if convenience is super important, then make sure you haven’t parked much money there, invest anything over 3 months worth of expenses in “cash equivalents.”

Keep Excess in Cash Equivalents, Not Sitting in a Bank

As the last plot showed, ultra safe 3-month treasuries offer a pretty attractive rate of return, better than even the most competitive bank accounts. And that’s because your bank account is investing in those treasuries, yet they need to make money too – so cut out the middle man and invest in those cash equivalents directly!

In Figure 19 I’ve compared 3-month treasuries, 2-year treasuries and ultra short corporate bonds which all can be invested in directly with the following ETFs: SGOV for 3-month treasuries, SHY for 2-year treasuries, and PULS for short duration corporate bonds. Notice that the corporate bonds took a 3 month drop of 5% from March through June of 2020 at the start and shock of Covid. It did recover and since has continued to outperform government treasuries, but there’s clearly an added risk here. The longer duration treasuries don’t look attractive though, they may be in some environments, but they will generally have more exposure and risk that generally doesn’t compensate you with proportionally higher returns than just investing in 3-month treasuries.

I invest the excess cash over 3 months of expenses that make up 5% of my investable assets directly into those two ETFs, SGOV and PULS. They may not be as convenient as a bank account tied directly to your savings, but I can sell and transfer the assets to my account within 3 days which is plenty fast enough for emergencies. That’s why I wouldn’t recommend keeping more than 3 months expenses in bank account as cash savings. You’re going to be leaving potentially 1% of free interest payments on the table, and those interest payments from US treasuries will be tax free unlike dividends from a bank.

Deploy Cash During Market Downturns

But how much cash should we hold, and should we be willing to deploy it in market downturns? To answer that question, let’s start by plotting drawdowns of the S&P500 over time in Figure 20 comparee to how well the market performed in the following month and following 3 years. There have been some rough downturns as we’ve discussed before in the “portfolio stabilizer” section that didn’t have any correlation to how well the market performed the following month. But notice there is some correlation to larger drawdowns tending to signal larger 3-year returns that follow. But that correlation certainly isn’t perfect and the highest 3-year returns of over 100% have all been off of peaks the market was already making.

But can we use the drawdown as a signal to deploy cash? Figure 21 shows the returns of a fixed and dynamic cash allocation model. Using the S&P500 drawdown as a signal, I created the following rule:

• Deploy 30% of cash when at a 10% drawdown
• Deploy 60% of cash when at a 20% drawdown
• Deploy All of your cash when at over a 30% drawdown

This model requires a means of replenishing cash reserves so I used new money, indexed at 10% of the market to grow over time too. So you’ll see the dynamic scenarios (at either a nominal 5% or 10% cash reserve) dip down in cash allocation at peak market downturns, while actually the fixed allocation scenario see cash allocations spike as a percentage of overall net worth.

So what did I learn in this? Well, no “cleverness” can overcome the drag on performance holding cash will cause. But the dynamic approach does lessen that drag impact while providing some reduced volatility and peace of mind. The average 3 year return for being fully invested (remember this isn’t a 1-to-1 with investment returns because I’m injected new cash every month) was 10.7% with a standard deviation of 9.6%, a Sharpe ratio of 1.12. But the 10% dynamic model reduced returns by 0.4% while reducing volatility by 0.9%. That is proportionally higher reduction in risk than reduction in overall return, especially when compared to the static allocation that sees returns drop by 0.6% and risk drop by 1%. So, I’ve answered the question that I should be deploying cash based upon market downturns but I’m still torn on what my baseline cash allocation should be.

How did I arrive at a 5% DYNAMIC allocation and a 0% to 10% recommendation? Hopefully the dynamism just discussed looks compelling and suits my tendency to want to “act” (rule #2, keep it simple yet fun). But being invested is still better in the long run and that portfolio stabilizer allocation is a pretty compelling risk adjusted return generator. I had been planning to stay at the dynamic 10% allocation since I started working at Amazon where I have very peaky compensation tied to stock performance (and prior to that I was at 0% cash other than the 3-month target in high interest savings). But after doing this analysis, I’ve lowered my cash allocation down to 5% and seeing both how much of a drag it can be while being reminded of the attractiveness of the portfolio stabilizer account. The trouble is, how do I reduce this allocation… my plan is to wait for the triggers based on downturn then to not replenish back up to 10%, keep it at 5%… unless I get a big cash influx.

Apply Dollar Cost Averaging to Overcome Your Hesitancy… If You Need It

So what happens when you either get a big payday (gift, bonus, inheritance, etc.) or have a big expense (home, renovations, etc.)? Vanguard published a really insightful article on Cost Averaging which I’ve included an image of in Figure 22. Because the market tends to be going up, dollar cost averaging (the act of breaking up the lump sum investment into 3 equal parts and investing a month apart) underperforms 95% of the time. And that underperformance is typically several thousand dollars on a $100K base. That is a big price to pay!

But that same article goes on to discuss individuals’ own risk tolerance and their aversion to loss. It can be hard to get a bonus for example, invest it all, and then see it drop. You may be so afraid of investing at the wrong time you don’t invest ever, or take too long! In which case dollar cost averaging can help you work through your own inertia and fear of loss. It forces you to put some of it to work immediately, while having peace of mind that you have more to deploy if/when the market drops. But if it keeps going up, then at least you have some in there benefiting from that. So I’m trying to train myself to do lump sum investing when I get a bonus but… its hard for me to work through that fear and I’ve still been doing the dollar cost averaging. But I’ve noticed that I then sometimes slip up in timely investing the other chunks. So I think the next time I get a stock vest, its all going straight into investments!

Live a Life Worth Living in an Appreciating Asset

Ok, we’ve made it through all the major allocations of your investable assets! Or have we? I’ve ignored the amount of home equity in the above allocation breakdown which leaves out a significant portion of most people’s overall net worth, their home. To establish what the value of home ownership is for increasing one’s net worth, we need to compare it to the alternative, renting. And we need to estimate how much the home will appreciate in value. We need data! Thankfully Zillow has a sweet dataset they share which I’ll use to establish some underlying assumptions.

Consider the Home Ownership and Rental Costs in your Desired Real Estate Market

When buying a home you will have a mortgage to pay off the loan principal and interest while also paying for taxes, insurance, and general home upkeep (potentially HOA fees too depending on the building). Whereas a rental payment has just one component, plus utilities which you’d need to pay as an owner too. Figure 23 plots average monthly rent costs in the US compared to the average monthly mortgage (assuming 10% down payment) and a “total mortgage” that includes insurance, taxes, and upkeep. From 2015 through 2021, the average total mortgage payments were pretty comparable to rent costs meaning on a monthly cash flow basis owning a home wasn’t more expensive, yet it had the benefit of some of your costs going to principal. But this was an era of abnormally low interest rates (some have 30 year mortgages below 3%) which have now jumped up to more typical interest rates above 6%. This now makes the monthly cost of owning a home typically higher than renting which adds some nuance to determining which is best for your long term net worth gains. Before we move on, I just want to also highlight that the delta between a total mortgage and just the principal and interest payment tracks about 28% of what rent was, even after the spike in interest rates. So we can use this as a proxy for estimating insurance, taxes, and upkeep moving forward, yet it’s still just an assumption.

Adding more nuance to the comparison of home ownership to renting is the fact that each real estate market has different home values, rental costs, and trending value/cost appreciation rates. Figure 24 plots the top 10 markets over time that shows that the general trends all correlate but have vastly different starting values and they vary over time slightly differently.

Fig 24: Changing Home Prices and Price to Value Ratios for the Top 10 Markets (Zillow Source).

Zillow provides stats on over 900 different cities across the US which I’ve reduced to the top 100 in the plots in Figure 25 that compare several key assumptions which impact the decision of ownership vs renting to maximize your net worth. The Google Sheet (tab Price-to-Rent-Summary) I’ve been using for collecting all data presented in this blog summarizes these markets all ordered by population size. You’ll notice there’s a loose trend between home value metrics and rent metrics, but they vary wildly by different cities, some being much more favorable to home ownership and some being more favorable to renting. The Google Colab I’ve been using for all plots lets you hover over different dots to see which city is which.

Fig 25: Comparing the Top 100 Markets by Population on Key Assumptions (Google Sheet Source).

Project Your Net Worth Growth from Buying a Primary Residence vs Renting

Let’s build a calculator! We can use the Zillow data for key assumptions on the real estate market (home price, price-to-rent, expected home value appreciation, expected rent appreciation, and total mortgage costs). But we also need to account for the interest rate we can expect from a mortgage (typically around 6.5% now, mostly derived by rates set by the Fed), how much of a down payment the buyer puts down, and what type of investment return they could realize elsewhere. I built the calculator in the Google Sheet, tab Mortgage-vs-Rent-Cash-Flow-Calculator, which can be visualized in Figure 26 that shows the cash flow plots for both US national averages and then San Francisco. For each they assume a 6.5% mortgage rate, a 10% down payment, mortgage insurance of 1% (until owning 20% of the home), closing costs of 2%, and an expected investment return elsewhere of 6%.

Fig 26: Cash Flow of Home Ownership vs Renting Calculator (Google Sheet) in Top 12 Markets.

Notice that buying in an average US market is better for your net worth so long as you own it for at least 3 years because the relatively small increase in mortgage costs compared to rent is paid for from the increasing home equity (remember this home equity growth is leveraged because you used debt, that first year of 4.4% price increase equates to a 44% return on your investment when you only put 10% down). And after 7 years, rent costs actually exceed total mortgage costs making the benefit of home ownership start to exponentially rise. But in San Francisco (with the other assumptions we have) it would take 8 years of owning the home to be more beneficial than renting because there is such a large gap between home values and rent costs. And that rental cost increase is only 2.8% per year so even after 30 years the monthly total mortgage cost is more than renting. This means that even with a 5.5% home appreciation and leverage, just renting and investing the money you’d save relative to home ownership is able to keep pace with the increasing home equity you’d have for owning. But these conclusions are still dependent on three other key variables: mortgage rate (which you don’t have much control over), your down payment, and the rate of return you can expect from other investments. Figure 27 varies the down payment and rate of investment return to compare the benefit to your net worth after owning a home for both 5 and 10 years compared to renting.

Two big things jumped out at me in this analysis.

1. In most markets, home ownership is typically more financially valuable than renting so long as you hold it for more than 5 years. But this time horizons varies by market.
2. If you earn more than 6% return on your other investments, there are some markets where renting will be more valuable than ownership, no matter your time horizon.
3. If you earn more than 6% return on your other investments, you typically want to minimize your down payment. The reverse is true if you are a conservative investor. This condition holds true across different real estate markets.

The first learning was expected, the second two surprised me. I didn’t realize how dependent your overall investment performance is at determining if home ownership makes more financial sense than renting. It’s much closer than I thought, and requires each of us to really sit down and analyze the financial situation to determine the best approach. But there’s one caveat. This tighter-than-expected relationship is only true at the current mortgage rates. If rates start coming down again, it tips the scales heavily in favor of home ownership. If rates start rising however, many more markets may start becoming financially irresponsible to buy in. Unless…

Decide What Will Bring You More Joy at Your Current Stage of Life

A home provides an opportunity to use and get value from your investment while it appreciates, unlike a mix of stocks and bonds in an investment account. And to me, that makes home ownership a no brainer for what I’m looking for in life for my family. I like the stability, the ability to make modifications/improvements, and we spend a lot of time in our homes. Therefore I’ve always had about 50% of my net worth in our home equity. I keep thinking that number will come down over time, but then we decide to do a renovation or move into a larger home. And the home values have risen faster than my savings rate and growth of other investments. That’s been working for my family and I expect that to continue over time. But you may be someone who prefers to travel, spend little time at home, and move often. And so renting for you may not only align best with your life’s needs, it may actually be better appreciating your net worth… so long as you are investing your other assets aggressively.

Prepare the Next Generation

What would a family investment strategy be without thinking of the little ones!

Pay for College with a 529 Plan

If you have kids, you should open 529 plans to have money grow tax free to pay for their education. Now when I first started having kids I swear that Massachusetts didn’t offer a tax deduction benefit for contributions. Either that or the fees they had I think were around 1% which ended up nullifying the tax deduction. So I opened 529 plans in the state of Utah which had the best funds in my opinion, including some small cap value and emerging markets! Massachusetts has since reduced their fees and are considering increasing the deduction up to $10K. So writing this blog convinced me I need to open at least one account in Massachusetts where I live!

Its up to you and the tax benefits in the state you’re in. This Morningstar article does a good job showing tax benefits by state, Figure 28 shows that in a map. If you’re in a lighter color state, you may want to look around at other states to see if its worth a different investment mix you could get, I still think the Utah one has the best options. But most states now should offer competitive priced target date funds which would be easy and compelling, especially if they also offer state tax benefits.

Teach Your Kids Investing with a Custodial Roth IRA

Chris (again older and wiser) reminded me about another investment vehicle for kids (thank you!). Once your child is old enough to start working a part time job (and it counts if they do babysitting or lawn mowing if you document it) you can open and contribution to a custodial Roth IRA. So if they make $3K at the age of 15 for example, you could start investing that amount, up to $7K per year into a Roth IRA. The benefits of the added years of growth are impressive due to the time value of money and compounding returns as shown in Figure 29. If you start contributing $3K a year from 15 to age 20, then $6K from age 21 on, you’d already have $69K saved by the time the child turns 25 with a 7% rate of return resulting in $1.3M more at the age of 70 than if you waited to start at age 25. Not only will this provide a meaningful difference in their quality of life in retirement, this presents an opportunity to start teaching them the value of investing at a young age! My oldest is only 9 and isn’t making any money yet, but once he does, I look forward to opening an account with him and working with him to pick some investment options!

Keep the Discussion and Learning Going!

This post is a doozy getting up to 10K words, sorry about that! If you made it this far, hopefully you found it helpful, let me know! Maybe it will motivate me to do a little webinar and short video to talk through some of the content. And if you want to dive deeper, you can view all the data in this Google Sheet and interactive plots with the Python code that generated it here in this Google Colab.

At the very least, I found writing this post helpful to learn some new things myself and hopefully provide a good foundation for my children to learn from! Most of all, publishing this post should help keep myself accountable to actually following my own guidance!

Look for a future post to share the best ways to track your own performance to help us learn and adapt our approach over time. Till then, happy investing! I hope you both find some intellectual stimulation balanced with peace of mind knowing you’re on the right path growing your and your family’s wealth. But don’t forget my rule #5:

With all of the great work my partner Steve has been doing around different investment strategies and unique portfolio construction I’ve found myself in an interesting predicament.  Which of these approaches and strategies do I embrace?  I’ve always had a rock solid resolve with my investments.  Every book I’ve read and advice I’ve been given has been to pick an approach and stick with it.  I have had a diversified portfolio of different asset classes that is age and risk appropriate for me, I use low cost index funds, I rebalance regularly and I hold through thick and thin.  Prudent.  Most would say I’m a pretty damn smart person for investing like that.

Heresy Time

I’m starting to wonder if my prudence is still prudent.  Has group think set in to the point where all of our individual baskets are inside of one massive basket?  By the nature of logic it will be impossible for the sound investment approach stated above to continue to outperform as well as it has in the past.  Think about it, when Jack Bogle first released index funds to the world in the 1970’s the cost of investing via other means was very expensive.  Anyone that embraced index funds early on saw a large out performance.  However, once we all herd into the index fund basket it literally becomes impossible to out outperform…..because we all have the same performance.  Similar with diversification and rebalancing, if we are all doing the same thing it is impossible to outperform.  Now you might accurately argue that someone may not outperform, but that does not mean you will perform poorly.  A good point!  At the end of the day Mr. Bogle’s biggest gift to the world was to pry away money from the professional investment community and put it in your pocket instead, thanks Jack!  I think it is very likely that following a traditional/prudent investment strategy will lead to positive results…just not out performance like it did in the past.

Here at engineeredportfolio.com we look for ways to outperform.  That has led us to create some unique portfolios (South African and Sweden stocks!!) and to investigate interesting investment strategies such as accelerating dual momentum  (ADM).  In addition to the work we have done there are endless other approaches to choose from: robo advisors, target date funds, global equities momentum (GEM), all weather, absolute return, cypto, alpha this, beta that….you get the idea.  On top of all of this there are tax considerations.  Some of these strategies are much better suited to tax advantaged accounts like 401(k)’s and IRA’s.  And lastly there are behavioral issues to consider, will the investment strategy you choose “agree” with you or will you constantly be changing or constantly stressed by how it performs?

Which One to Choose?

The obvious answer of which investment strategy to choose is simple.  Choose the one that will outperform all others!  Even though we embrace our naivete (a little is needed for innovation sometimes) here at engineeeredportfolio.com we are not so full of ourselves to think that we KNOW our strategies will outperform in the future.  However, we also know that if we want to outperform we can’t just be a lemming.  We have to do something different if there is to even  be a chance of out performance.  The ying to that yang is that we also want to be prudent investors and both grow AND protect our capital.  And finally we have arrived at the crux of the matter…strategy diversification.

Goals and Requirements

My goal is to outperform a simple risk appropriate re-balanced diversified portfolio of stocks and bonds, aka a low cost target date fund.  Side note:  If you are already falling asleep reading this and you have little to no interest in investing there is absolutely nothing wrong with going with a LOW COST target date INDEX fund and calling it day.  It is simple and easy.  At the moment I would recommend Schwab’s target date INDEX funds (make sure you get the INDEX ones, they have actively managed ones that are much more expensive).  Vanguard’s target date funds are also good.

The requirements for my strategy diversification will be to minimize taxes, minimize fees, have at least three strategies, have no more than 50% of my total balance in one strategy at a given time, leverage my behavioral strengths, manage my behavioral weaknesses, require less than two hours a month to manage and be spread across different financial institutions with SIPC insurance to best protect my capital.

The Strategies

After a lot of careful thought and reflection on the requirements, specifically the behavioral elements, I decided on the following four strategies:  accelerating dual momentum  (ADM), Ray Dalio and Bridgewater’s All Weather, buy and hold life cycle fund and a mad money component.  The mad money component effectively says I can do whatever I want, individual stocks, crypto, alternative assets, etc.  I’ll also keep a cash position to systematically deploy for opportunistic buying opportunities.  I feel comfortable with all of these strategies and would be able and willing to have 100% of my assets invested in any of them…ok maybe not 100% in the mad money one!  That being said I’m not certain which will outperform (though I have my opinion!) and I like that all four compliment each other well.  ADM will periodically but systematically adjusting to the market momentum, scratching my behavioral itch to “do something” when the tide is turning.  All weather is effectively a buy and hold portfolio but with some uncorrelated asset classes, such as gold and commodities, that are not present in the other strategies.  I like that it should perform reasonably well in any economic environment and will help me sleep at night.  Buy and hold with life cycle funds will adjust to safer assets as I age, slowly shifting my overall portfolio to a lower risk profile over time.  Again, helping me sleep!  And lastly the mad money portion will allow me 100% flexibility with a small portion of my assets to both scratch the “do something” itch and give me some real time control and influence over my investments.  I find investing challenging and fun, so it provides me the opportunity to enjoy investing a bit while also protecting my other strategies from feeling the wrath of my “need to do something” tendencies.

The Mix – Strategy Allocation

To be clear I went with 100% gut on the allocation to each of these strategies.  I wish I could tell you I spent hours and hours pouring over data and back testing this…..but I did not.  I built this on how I thought I would behaviorally react to various market conditions and came up with the following allocation:

I think the allowable ranges are key to strategy diversification because it allows for a specific strategy to run for a while before you would be forced to trim it.  It also supports my requirement of spending less than two hours a month managing my investments.  If the ranges were too tight there would be a lot of adjusting, which could also have tax implications (more on that later).

It’s important to point out that what I’ve shown above is MY strategy allocation that I designed for my personal situation and preferences.  We all have different needs and behavioral tendencies.  You’ll need to figure out what is the right balance for you.  The only thing I might suggest that should be universal is that you not put more than 50% of your assets in a single strategy.  Yep, I’ll say it….don’t put too many eggs in one basket!

Release the Cash

The cash portion of the portfolio serves a few purposes.  First, it forces a mechanism to “take a little off the top” when one or more of the strategies are performing well.  No one ever got hurt taking a profit!  Second, it provides firepower to take advantage of a significant market downturn that hurt one or more of the strategies.  I personally find from the behavioral side that I’m much more relaxed, even excited about market volatility knowing I have cash ready to deploy.  Lastly, in the event something comes up in life where I have a major expense it provides a resource that would not require selling my investments, which may have some bad tax consequences.

I have a pretty simple rule based plan for deploying my cash which you can see below.

Basically when the market as measured by the S&P 500 is down 30% I’m all in with no cash remaining.  A good question you may ask is which strategy would I deploy the cash to?  That leads us to the next part of the plan which is using a “buy to rebalance” approach.

Buy to Rebalance

Rebalancing your overall portfolio when one strategy drops below or exceeds your target range is a good idea.  It provides a rule based mechanism to sell high and buy low.  However, depending on the account you are using to hold the investments you are selling this can lead to some negative tax consequences.  For this reason my preferred method of rebalancing is to BUY to rebalance.  This is a pretty simple concept.  In the cash deployment scenario above you would simply use that cash to buy the strategy that was under performing relative to the others, or spread around the cash to get all strategies to their target allocation.  For those that are still working and earning and income hopefully you are consistently socking away some of your income into savings.  Buying to rebalance just means putting that money into the strategy that is currently under performing relative to your target allocation.  In this way you are constantly working towards your target allocations without having to ever sell investments and creating a taxable event.

Taxes

As noted above, the first step in managing taxes is to not sell your investments.  Using the “buy to rebalance” approach can help with this, but sometimes selling is unavoidable.  The ADM strategy in particular requires selling of investments in order for it to work.  For strategies that require selling, my recommendation is to run those strategies in tax advantaged accounts like 401k’s and IRA’s.  For strategies that are sedentary, like the buy and hold index fund strategy, you can have those in taxable accounts as you will only get a tax bill for the small dividend they pay.  I actually struggled with this quite a bit when I started.  I was actively “trading” in my retirement accounts and my taxable accounts were boring life cycle funds.  But that is what makes the most sense from a tax perspective so that is what I do.  For me at the moment all of my ADM is in my 401k account and I use my 401k and IRA’s for my mad money accounts.  I have the all weather and buy and hold strategies in taxable accounts.  That seems like a lot of accounts you might say….which leads us to the next part.

Account Diversification

There is a couple of reasons to have various accounts with different institutions.  First, for most investing firms the US government provides up to $500,000 of protection per account.  This is called SIPC insurance and acts similar to FDIC insurance for a bank account.  By spreading out your investments across different accounts you can increase your effective insurance.  You also spread out any risk you might have with a single financial institution running into trouble or getting hacked, etc.  Second, I find it much easier and cleaner to manage and monitor when having one strategy (sometimes two in the case of my 401k) per account.  I use and recommend Personal Capital for monitoring my investments and having one strategy per account makes it very simple to see how things are doing.

In Conclusion

If you want to outperform (its ok if you don’t) you need to do something different than the crowd.  There are a host of investment strategies out in the world to choose from.  If you try to outperform using some different strategies we recommend you practice strategy diversification in order to…wait for it…..not put too many eggs in one basket!

What is and who is my Fiduciary?

I know some of you are saying, “I’ve heard this fiduciary word, but what the heck is it!”  A fiduciary is someone that, by law, has to act in your best interest and in the case of your 401(k) plan (this is important for later) could be “personally  liable to restore any losses to the plan, or to restore any profits made through improper use of the plan’s assets resulting from their actions.”  Check out this link where the IRS has a nice detailed explanation of fiduciaries for retirement plans.  The department of labor has defined the specific responsibilities of a fiduciary, including:

• Acting solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them
• Carrying out their duties prudently
• Following the plan documents (unless inconsistent with ERISA)
• Diversifying plan investments; and
• Paying only reasonable plan expenses (another spoiler alert)

In the case of your 401(k) plan you might expect your fiduciary to be your plan provider (Fidelity, TIAA, Vanguard etc.) but you would be wrong!  They may or may not be fiduciaries depending on what role they are filling for you.  Being a fiduciary is not a title but a role that a person has.  Long story short there can be many plan fiduciaries for you, some within your organization and some without.  The good news is that you only need to find one of your fiduciaries to start the process of enacting changes with your plan.  The reason you only need to find one is that the department of labor has been very clear that, “a fiduciary should be aware of others who serve as fiduciaries to the same plan, because all fiduciaries have potential liability for the actions of their co-fiduciaries.”

The Myth of Outsourcing Fiduciary Responsibility

Some employers, especially the small and medium businesses, believe that they have “outsourced” their fiduciary responsibilities to a provider or an adviser, absolving them of their fiduciary responsibility and the liability associated with it.  Please listen up, because this will be important later, THAT IS NEVER TRUE.  The act of choosing a plan provider or plan adviser makes that person a fiduciary and makes them personally liable.  Therefore there is ALWAYS someone at your company acting as your fiduciary.  Please note, I’m not saying your employer is doing anything shady or untoward if they tell you, and believe for themselves, that they bear no fiduciary responsibility to you.  They were trying to make a smart business decision for them (reduce risk) and most likely doing what they thought was prudent for you by having a financial professional in charge of financial decisions for you.  But in reality they may have let the fox in the hen house.  I know from personal experience that your employer was probably sold a story by the providers or advisers that by hiring THEM the provider/adviser would take on the fiduciary risk, like most good stories there is a thread of truth to that.  The provider/adviser has taken on SOME of the fiduciary roles and is thus SHARING the liability, but the person choosing the provider/adviser is always a fiduciary as well.

Why do you care?  Fees.

I won’t belabor the point here as there are millions of great articles and blogs out there on why paying too much in investment fees is bad….including one I wrote!  As far as 401(k) fees go the image below from Brightscope pretty much says it all for me.

My real focus for this blog is on the left side of the above plot, specifically the small business 401(k) plans with assets under $10M.  Note that not only are the fees paid by these small plans significantly higher on average than the larger plans (orange line) but most importantly note the wide range of plan costs.  The range of plan costs is staggering for small businesses with plans ranging from 0.20% all the way up to 4.5%!  It is this range which says to me these plan fiduciaries are not doing their jobs.  I’m NOT saying they’re bad people.  Often at small businesses people have to take on roles where they don’t have a ton of experience, training or knowledge.  They are most likely trying to do a good job they are just not informed.  Let’s get them informed!

Some will argue that the small plans should be higher cost due to the lower balances.  Bull.  Clearly some small plans are just as low cost as the larger plans proving it is possible.  I guarantee those low cost small plans have a well informed fiduciary running them.  I run a small plan.  When I got involved we were decent with about 0.70% of plan assets going to fees.  With some changes to the plan we got that down to 0.22%.  The issue is not the amount of invested assets, the issue is the education of small and medium sized business fiduciaries.  If they were properly informed and motivated they would make the necessary changes in the plans to bring the fees down to reasonable levels.

Another interesting thing to me is that there are some plans with only one million in assets paying as much or less as plans with billions in assets.   This shows there are issues with the big plans as well!  If you really want to dig into the fee information I would recommend you check out Brightscope’s detailed report.  Click here for the report.

What can I do?

Plenty.  There are two paths I’ll recommend that can lead to millions of dollars in savings to your plan over the life of the plan.

Plan A

• Request plan documents and fee disclosures from your current service provider to find out what your current fee situation is
  • If it is already below 0.50% of assets your fiduciary is going a pretty good job and you mush have some nice low cost investing options in your plan
  • If your plan fees are greater than 0.50%…
• Identify internal fiduciaries
  • If you have an HR department (not all small businesses do) go ask them
  • If you are running into road blocks figure out who chose the current service provider, that will most likely get you to the fiduciary
  • Once you identify the internal fiduciary….
• Send them this blog!
• Ask the last time the plan was bid?
  • If it has been more than 2 years from the last time the plan was bid ask that it get bid again with a focus on fees

Plan B – Become the Plan Fiduciary

If you are running into lots of road blocks consider stepping up and taking responsibility for the plan yourself.  Many times the plan was originally set up by the owner or a random employee that happened to have some free time when the decision was made to have a 401(k) plan.  Again, these people were trying to do a great thing for the employees of their small business.  They just were not equipped with the tools needed to set up a good plan.  Take the lead.  This will involve bidding the plan out to other providers and then monitoring your plan, especially the fees, on a yearly basis.  My only experience is with Fidelity.  I have found that you can work with them to create a good low cost plan.  But be warned, you will need to put your negotiator hat on and you will need to push back hard on them.  Don’t take their first offer, push them on every fee.  Ask to get the list of ALL the investment options you have (it will be thousands of funds).  If you are not good with Microsoft Excel bring in a colleague that is to help you sort the fund data to look at the lowest fee options.  ALWAYS offer index fund options in your plan.  Pay very close attention to the life cycle fund options you offer.   People will gravitate towards those so they will make up a larger portion of your assets.  Make sure they are as low cost as possible.  As an example I pushed back on Fidelity to offer VANGUARD life cycle funds because they were lower cost than the Fidelity life cycle funds they were pushing.  Make sure your stable value option is as low cost as possible, some conservative investors will gravitate towards that and they tend to be very high cost.  This advice should work with any service provider that you are currently using.  Don’t be afraid to let them know that you are the plan fiduciary and that you are focused like a laser of reasonable fees for your participants.  Also, you need to let them know you are shopping the plan around, this will motivate them to keep your business.

I don’t have personal experience with America’s Best 401(k) but I have read they can be a good option.  Especially if you not as inclined as I am to fight the Fidelity’s of the world.  My read on them is your fees will be higher than if you fight the Fidelity’s, but you won’t have to fight and you’ll still have a pretty decent plan.

In Conclusion

Things are always changing, so new companies might emerge with some great options for small business 401(k) plans.  Just google “lowest cost 401(k) plans” or “low cost 401(k) plans for small business” and I’m sure you’ll get a wealth of up to date information.  Just be careful, there will be sharks lurking in those Google waters!  Be vigilant and fee focused and you can save your small business colleagues, which often times are akin to or actually family, millions of dollars.

Warren Buffett has said that trying to time the market is the number one mistake to avoid.

Market timing is hard, if not impossible to do, as it often results in the investor buying or selling too late or too early rather than right on time.  To even consider a market timing strategy is generally frowned upon by professional investors.

But we’re not professional investors, we’re just engineers who were convinced that there must be a simple yet effective way to pick up on and follow trends in uncorrelated asset classes.  We don’t hope or expect to be right every time, but we do hope and expect this strategy to do a decent job at minimizing losses to improve the effect of compounding gains.

In this post, I will lay out the framework of a simple, intuitive and profitable strategy that has worked well over the last 150 years.  I will provide all the data used so that you can perform your own analysis.  I’ll also provide tools you can use to implement this, or a similar strategy, on your own for free.  No proprietary software necessary, no expensive financial advisor required – just you, some logic, and systematic rules-based investing (no emotion!).

Table of Contents

This post got a bit out of hand… over 5,000 words.  So here’s a table of contents to let you traverse this a bit better.

• Overview
• Background
• Concerns
• Show Me More Data
• How to Live Trade

Overview

The Rules

The rules are quite simple.  Compute an accelerating momentum score of US and international stocks, specifically small-cap ex-US stocks for the added correlation benefit.  This momentum score is the sum of each asset’s 1 month, 3-month, and 6-month returns.  Doing the sum of these three time segments lets us also take into account the curve of the trend.  If both scores are below zero, that’s bad and an indicator of a consistent downward trend in stocks – buy bonds (specifically long-term treasuries, again for the added correlation benefit).  Otherwise, buy the asset with the higher momentum trend.  Do this selection at the beginning of every month.

The Results

This relatively simple strategy has performed remarkably well over the last 20 years. Because it’s so simple, the strategy can be backtested and explored with Portfolio Visualizer and mutual fund data going back to 1998.  Implementing this strategy with a $10,000 initial investment in 1998 would have grown to over $420,000 by the end of 2017 vs just under $40,000 if invested in the S&P 500 in that time.

Strategy Background

Gary Antonacci’s Dual Momentum

This ex-trader Gary Antonacci wrote a book called “Dual Momentum Investing” where he detailed a strategy that looks at the trailing 12-month return between US stocks and global stocks.  He buys whichever is greater between the two so long as the US trend is positive (even if global stocks are up but the US is down, he’s in bonds) otherwise the strategy says buy bonds.  So you can clearly see the parallels with the strategy I’m laying out here.  Before I get into why I don’t like this implementation, let’s touch on what I do like.

• Simple – only three options, pretty straightforward rules
• Dual momentum – I’ll really like pairing US and global stocks first in a relative momentum signal, then if they’re both negative against an absolute metric to buy bonds.
• Few transactions – in 20 years there are only 23 transactions

Here’s what I don’t like about the strategy.

• 1 year is too long – looking at 1-year returns has the benefit of holding power and minimizing “whipsawing” where the trend signal is constantly changing.  But this also has the consequence of being too late to the party, by the time the signal may pick up a trend it’s already stopped and potentially reversing.
• No measure of consistency – I want to buy the asset that is swinging or accelerating up relative to the others and has some holding power to it.
• Muted diversification benefits – our historical analysis shows that US large cap stocks are becoming increasingly correlated with global large cap (they are all multinational global conglomerates now) so pairing these two against each other may miss the underlying trend and fundamentals.  Same goes for bonds, a total bond fund contains a lot of corporate bonds which are more correlated to stock performance than treasury bonds.  The duration also matters where an intermediate bond fund doesn’t swing as hard, which we actually want in this strategy.

Still, I need to give Gary credit for his research and publishing of his strategy.  I like the dual momentum idea (combining a relative signal with an absolute one).  I recently read the book before publishing this post (wanted to make sure I wasn’t missing anything obvious!) and will say that the book is a good read and reinforces the general premise of why momentum has been effective.

Accelerating Dual Momentum

Before we take a look at the strategy’s evolution, let’s first review some metrics of the asset classes we’ll consider during the time period of 1998 to February 2018.  The final balance shown is for an initial investment of $10,000.

Now let’s take the “original” dual momentum strategy and make some tweaks.  The links are to the individual backtests in Portfolio Visualizer, final balances shown are for a $10,000 investment at the beginning of 1998 growing until February 2018.

• $80,296 – Original Strategy
• $159,464 – Simple Accelerating Dual Momentum
  • Same assets as original but use 1-month, 3-month, and 6-month returns
• $206,161 – Replace Total Bond with Long-Term Treasuries
• $331,003 – Replace Global Large Cap with Global Small Cap
• $426,408 – Accelerating Dual Momentum
  • Make both replacements above, global small cap and long-term treasuries

The following table provides more performance metrics of this strategy and its permutations.  One of the most telling metrics is the reduction in the maximum drawdown of all the strategies (roughly a 20% loss) compared to a buy-and-hold of the S&P 500 (near 60% loss).  Our “Accelerating Dual Momentum” (ADM) strategy has never, historically, had a year with a loss (certainly not a guarantee moving forward).

Accelerating Momentum Signal

One of the major elements of this strategy is how it looks to find consistent uptrends that are accelerating upward.  Here’s a real example from April of 2017.  Over the preceding 6 months, US large-cap stocks had beaten small cap international stocks by a little over 5%.  But over the last 3 months, small-cap global stocks had a 9% gain vs a 6% for the US.  And in the most recent month, small-cap global continued to advance with a 2% gain while the US fell 1%.

Because our scoring doesn’t just look solely at the trailing 6-month performance but also takes into consideration the other more recent time periods we would weight small-cap international stocks higher.  In the following 8 months after this decision point, the strategy would have stayed with small-cap global stocks which outperformed US large cap by 5%.  But towards the end of this period, it now began appearing that US stocks had the more consistent gains performance and so it switches back to the US.

Tracking Error

When analyzing different potential investment strategies many, including myself, can get caught up in looking at the final number the investment grew to – it doesn’t tell the story it took to get there.  And investors need to not only be able to tolerate the volatility of absolute returns, they need to tolerate the volatility of returns relative to the benchmark.

“Tracking error” looks to quantify how a strategy does relative to a benchmark, the higher the “error” the less correlated it is to the benchmark, which is often the S&P 500.

If you’re trying to beat the benchmark you will undoubtedly lose to it every now and then (because you’ll be different than it) with the hope that it will more frequently beat it.  The question is, how long can you stand to continue to lose to the benchmark before you abandon the strategy (which may be at the absolute worst time, right when it’s about to be effective)?

Value stocks are a good example.  They have been shown to historically outperform growth, but that outperformance requires the investor to endure extended stretches of time (months, even years) when it underperforms the general market (2017 prime example).  And it can be very difficult to keep your conviction when you’re losing to a free alternative which would be an S&P 500 index fund.

The importance of tracking error will matter differently depending on the person and the strategy.  As Chris suggests in his post on combating your cave man brain – you may be better off checking your account frequently.  I agree with him, I’ve learned quite a lot by seeing what’s going on more frequently.  The trouble is… tracking error is a bigger deal if you are checking your account more often.  If you are interested in the static “engineered portfolios” then you likely can live with checking your account on a quarterly or even yearly basis – in which case tracking error will matter less.  But if you are reading this blog and interested in a monthly switching strategy… by definition you will be checking your account more frequently and tracking error will be a greater concern.

So how does this strategy do relative to the benchmark, the S&P 500? Unusually well.

Here’s a breakdown of the periods of performance relative to the S&P 500:

• In the late 90s, the strategy is in global small-cap stocks more often than the S&P 500 which allowed it to slowly pull ahead.
• In the early 2000s, the strategy was largely in treasuries while stocks were losing money – further advancing the strategy’s lead over the benchmark.
• In the mid-2000s, the strategy stayed with small-cap global stocks which did quite a bit better than US stocks.
• In 2008 the strategy was mostly in treasuries which contributed to a large outperformance relative to the market/benchmark.
• In 2009, 2010, and 2011 it was mostly in small-cap global but it’d didn’t have much different performance relative to the S&P 500 – so no loss or gain.
• In late 2011, it got back into treasuries which went up while stocks went down.
• Since then it has largely been in the S&P 500 so no loss or gain has been made.

And that’s the key – with the benchmark being one of our three options – we ride it when it’s doing well thus minimizing the chance of prolonged tracking error leading to losses.  This is also exactly why I wanted such a strategy, the US stock market has done unusually well over the last 9 years.  I’m happy to have ridden most of that but I needed to find a way to emotionlessly allocate my money to ex-US stocks and bonds if/when necessary.  At this stage, I’m looking for tracking error… I just need an algorithm to make the decisions for me.

Concerns

Let’s try and poke some holes in the strategy and discuss why some of these concerns aren’t a big deal, and why some may be justified:

• Not Enough Assets
• Treasuries in a Rising Rate Environment?!
• Too Much Work
• Cost and Taxes
• Overfit
• International Explorer Fund is an Active Fund…
• Market Timing Never Works
• Daily Volatility

Not Enough Assets

Are three assets enough?  I think these three are diverse and uncorrelated enough to say yes.

But I still wanted to get some of my favorite assets in the strategy like consumer staples, mid-cap value, and emerging markets.  Consumer staples actually works pretty well in the strategy, in fact, it’s a little better to include it – here’s the link to the performance with it in. But it will require more changes and a higher tracking error.

I thought we could pair mid-cap value with S&P 500 to find the US asset that’s doing better then pair the better one against the ex-US asset.  This approach seems to work pretty well when using the 3, 6, and 12 month returns instead of 1, 3, and 6.  Use this same logic to pair small cap ex-US against emerging markets which also works well. This “dual squared” strategy seems to work when tested in Quantopian but it’s a bit too complicated to test in Portfolio Visualizer… and this is probably not a good sign.  I want something simple that I can stick with.  I also want to minimize my tracking error and the increased options that aren’t the S&P 500 will increase the tracking error.

Treasuries in a Rising Rate Environment?!?

Treasury yields have been dropping since 1981 which means we have witnessed the greatest bond bull market in history (as rates drop, prices increase). Below is a plot of rates over time compared to the real return on your investment (taking into account the change in bond pricing as well as inflation).  Up until early 1980s bonds didn’t offer very exciting real returns.  But from that point on – watch out!  Rates dropped from historic levels and your returns would have gone up accordingly.  Now rates should head upward which may lead to negative real returns moving forward.

But I look at this plot and see the choppiness that occurred over the last 50 years.  Yes, rates have largely been dropping for 30 years but there were times it quickly dropped (and later rebounded) – and it is these accelerated moves that we’re trying to capture.  And even in the 1970s when bonds were largely losing money, there were still times they were moving the other way, ideally, during times stocks were doing poorly.

The strategy is not telling you to buy and hold long-term Treasuries on their own but instead, buy them when stocks are heading down.  Then sell them when/if stocks start recovering.  We’re only trying to take advantage of the swings.

That being said… I still am nervous about long-term Treasuries.  So you could consider playing treasuries against TIPS, specifically just looking at the trailing 1-month return between the two to decide.  This simple strategy has also done well, but it will require more switching due to the short look-back period.

Too Much Work

It may seem like there is a lot of switching between assets and therefore it’s a lot of work.  But that isn’t entirely true.  The average holding time is over 4 months which means most months you will be doing nothing.  And even when there is a change it’s buying & selling one asset.  If you are in a 401k it is one rebalance screen – literally takes less than a minute, per month.  I’m good with that.  I’ll also give the tools to let you make the calculations in seconds with Quantopian. Portfolio Visualizer seems to update pretty quickly too.  This link will always give most up-to-date information.  When I checked on April 1st 2018, Portfolio Visualizer had already indicated that small-cap ex-US is the asset to be in.

Cost and Taxes

This strategy works best for retirement accounts where taxes don’t matter.  These accounts should typically not have any rebalancing fees.  IRAs with major brokerages have commission-free ETFs too.  Even with fees, there are relatively few transactions so they become pretty insignificant.  Using Quantopian and Interactive Brokers’ fees with a $10,000 initial investment in 2004 the final balance in mid-March 2018 was $61,451 with no fees, $61,397 with fees.

If you are interested in using this in a Robinhood account that is taxable – you benefit from again no fees.  But you will have taxes to deal with.  The tax drag is still less than the historical outperformance.

Overfit Strategy

One of the concerns of “quants” and backtests is that all we did was find a strategy that worked well in the past due to some anomaly that has no chance of repeating again in the future.  I was cognizant of this risk when looking into the strategy which is helped define the simplicity of it.  An overly complex strategy with arbitrary signal ratios would be more suspect.  The relative momentum between the assets also helps in this regard.

Another way we fought the risk of overfitting was with the inclusion of multiple timing periods. Here’s a review of the performance for a $10,000 investment in January 1998 to March 2018:

• $39,063 for S&P 500
• $136,993 for only looking at 12-month relative momentum signal
• $251,954 for 6-month signal
• $282,374 for 3-month signal
• $403,440 for 1-month signal (but 149 timing periods)
• $425,417 for 1 + 3 + 6 month score (with “only” 60 periods)

A final fight against the risk of overfitting is if the strategy makes logical sense.  Although I find momentum to be a “stupid” factor (I’d prefer a more value-based one… maybe the combination of the two is best!? – the topic of a future post) it makes sense.  And the fact you can wrap your head around why its working is important – it can’t be only logical to a machine.  Although there are more and more machine-generated trades – the market is still full of human participants.  And people like chasing the asset that’s doing well.  We’ll ride that wave until a better one comes along.

International Explorer Fund is an Active Fund

The Vanguard International Explorer fund (VINEX) is the oldest (1997) and the least expensive (0.38%) small-cap international fund I could find which is why it was used in the long backtests.  But a look at the portfolio characteristics compared to Vanguard’s ex-US small-cap ETF (VSS) (started in 2009 with a 0.13% expense ratio) highlights that there are some deviations between the active fund and the index.  So did we get lucky?

VINEX’s portfolio is more mid growth compared to VSS’s portfolio which is evenly distributed between mid/small and growth/value.  They also have a different sector breakdown with currently more industrials and less defensive sectors.  But it’s an active fund so it’s moved around quite a bit over the years and maybe our strategy’s performance was due to the historically great performance that the VINEX management team provided – which may not repeat itself?

So let’s find another small-cap ex-US stock fund with a long history to drop into the strategy and see how it does.  The Oppenheimer International Small-Mid fund (OSMAX) was launched in 1997.  Comparing the results using VINEX to OSMAX from 1999 to March 2018 with a $10,000 initial investment:

• $30,371 for S&P 500
• $346,958 with VINEX
• $566,100 with OSMAX

Holy smokes, maybe I should have used the Oppenheimer fund in my original post!?  I think this gives some credence to the strategy overall, but now I’m curious why the Oppenheimer fund worked quite a bit better?

Comparing the performance of OSMAX, VINEX, and VFINX (S&P 500) in Morningstar shows that the two international funds track each other fairly well although they have noticeable periods of divergence.

A look at the portfolio of OSMAX shows that it is even more heavily in mid-cap growth than VINEX which may suggest that that asset works better.  Or it’s just complete luck that it works better than VINEX and it may be overfitting to suggest that fund.  I think we’re better off saying the index of small-cap ex-US stocks does well in the strategy and that seemingly any fund in that index would have also done well.

Market Timing

The market returned 7.7% annually from 1997 through 2016, but if just the 10 best days were missed – the annual return dropped to 4.4%.

A $10,000 investment over 10 years with a 7.7% annualized return works out to $21,000.  If you missed just 10 days that came to $14,800.  Missing just a few good days can have a significant impact on performance which is why trying to time these days is particularly risky.

There are many posts out there that discuss why market timing is a fools game.  One from Schwab discusses how even picking the best month each year is barely better than just investing at the start. This one from ValueWalk has a particularly funny image I’ve posted below.

The other point I’d like to make is that we’re not necessarily trying to have our market timing strategy pick the best asset right every time (of which we only have a 33% chance) – instead, it’s more important to not pick the worst asset (a 67% chance).  The key to long-term gains is compounding the gains which are exponentially helped by minimizing the losses.  This strategy won’t prevent you from avoiding a sudden drop, but it pulls out of the prolonged declines.

Daily Volatility

The final risk of this strategy is the risk of the assets we’ll be tasked with holding.  Although they are fairly diversified on their own and they work well in concert with the other two assets over the long haul, on a day-to-day basis there can be quite a lot of volatility.  This is especially topical in today’s investment environment.  With a president who chooses to govern via Twitter posts, we are susceptible to very volatile days.  And when we’re only in one asset we’ll be forced to ride with that volatility.  This strategy is not a hedge fund trying to minimize volatility – its main task is to maximize returns.

This may be why you choose (and I’d recommend) to use this strategy as part of your overall investment portfolio – not the entirety of it.  Add some other assets that you’ll keep fixed such as gold, TIPS, mid-cap value, consumer staples, and emerging markets for example. Then in the remaining portion of your portfolio that you feel comfortable with, adopt this momentum strategy.  That way you can benefit from some of the long-term potential opportunity this strategy presents without being subjected fully to the day-to-day volatility… unless of course you are fully aware of it and want it. Get some!

Show Me More Data!

I was ready to publish this post about a month before I finally did.  This was largely due to the fact I didn’t feel comfortable publishing such a strategy without doing a more stringent analysis on how it has performed.  I needed monthly data going back over 100 years!  Thankfully Robert Shiller publically posts data going back to 1871 that I found. I compiled this data, added in MSCI index data, cleaned it a bit, and calculated the momentum signals in this google doc.

I was a bit nervous to find the data to then do the calculations and realize that my backtest on the last 20 years was an anomaly.  The true test of a quantitative strategy is if it does well in out-of-sample testing.  But another effective way to see if it has been overfitted is to try it on data not seen before.  And now I had an extra 120 years of data… how did it do?

I was extremely relieved but even more excited to find that the accelerating momentum signal had worked very well going all the way back to 1871!  An investment in this strategy would have produced over 100x more return than an investment in the S&P 500 over that time.

A few caveats regarding this longer dataset to the more recent 20 years:

• Much of the historical data doesn’t have global equities.  They first enter the scene in 1970 but EAFE small/mid doesn’t start until 1994.  So I used EAFE large for 1970 to 1994 and ignored international equities the rest of the time – it was just US stocks vs US government bonds
• Bonds are only looking at the 10-year yield.  We found that long-term treasuries swing harder so theoretically they would further improve the long-term performance but I couldn’t find that data.  I also had to assume the yield curve was flat to calculate bond pricing.
• Again no taxes or fees – but this shouldn’t be a big deal for a monthly strategy that is used in a retirement account

Some tidbits of summary from the historical data that deserves its own future post (this one is already getting quite long!):

• Annual real (after inflation) returns:
  • 10.5% – Accelerating Dual Momentum (ADM)
  • 9.1% – GEM
  • 6.9% – S&P 500
  • 2.7% – Bonds
• Maximum drawdown (after inflation):
  • -34% – Accelerating Dual Momentum (ADM)
  • -43% – GEM
  • -77% – S&P 500
  • -57% – Bonds
• Worst 1-year loss (after inflation):
  • -21% – Accelerating Dual Momentum (ADM)
  • -33% – GEM
  • -58% – S&P 500
  • -22% – Bonds

The bond drawdown of 57% is surprising… but the performance of the accelerating dual momentum strategy is very encouraging!  Another way to measure risk is to plot the trailing 30-year return to see how the strategy does in any given investment period.

Accelerating dual momentum beats the S&P 500 in virtually every 30 year period except the 30 years immediately following the great depression.  Now the strategy may have lost relative to the S&P 500 over that time but only performed marginally lower and did so after just avoiding much of the carnage of the great depression (and some other bumps between then and 1963).

What Happens Next?

Who knows?  I certainly don’t.  And that’s the point.  I’m going to follow the trend with hope that it can help me avoid prolonged downturns and maximize accelerating upward swings – but there’s no guarantee that the strategy won’t do the exact opposite.

How to “Live Trade” the Strategy?

Portfolio Visualizer

You can use this link to check monthly at Portfolio Visualizer which asset you should be in.  Go to the timing periods tab and scroll all the way to the bottom.  This updates daily.  Then you can make the switch in whatever account you’re doing this in manually.  Should take all of 5 minutes a month.

Quantopian

You can check out my post on Quantopian where I provide the source code of an algorithm that will “live paper trade” the strategy.  Again you’d have to check back monthly but you’d have some added ability to customize as you see fit.  A caveat between this and the portfolio visualizer method, however, is that in portfolio visualizer it uses total returns with dividends.  It also takes into account the length of the month.  In Quantopian I’m looking back a fixed number of days.

Engineered Portfolio Service

Last but not least – Chris and I can get off our butts and make a real service out of all this analysis.  To start we can email those interested monthly to provide the update on what to do (I’m doing this already for a few friends, doesn’t take any more work to add recipients!).

Longer term though we envision a software service that will connect directly to your Robinhood investment account to do the trades for you.  We’d have to charge a nominal amount for this, maybe $10 a month.  I can do the monthly email for free though.  Sign up by clicking the link/image below and filling out the form for those emails and to get notified once we finally build out that software service.

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The financial “threats” we face in the 21st century are diametrically opposed to the physical threats of ancient times.  Stock market crashes, unlike hungry saber toothed tigers, often present opportunities as opposed to imminent death.  My very simple example here downplays the complex neurobiology of the human brain that drives us to make poor financial decisions, but the end result is the same:  humans are hardwired to be poor investors.

Brief Review of Financial Neurobiology

In addition to “fight or flight”, there are a host of other documented and studied cognitive psychological human tendencies that impede our ability to be rational investors.  Here is a high level list provided by the CFA Institute.

•Overconfidence and overoptimism—investors overestimate their ability and the accuracy of the information they have.

• Representativeness—investors assess situations based on superficial characteristics rather than underlying probabilities.

• Conservatism—forecasters cling to prior beliefs in the face of new information.

• Availability bias—investors overstate the probabilities of recently observed or experienced events because the memory is fresh.

• Frame dependence and anchoring—the form of presentation of information can affect the decision made.

• Mental accounting—individuals allocate wealth to separate mental compartments and ignore fungibility and correlation effects.

• Regret aversion—individuals make decisions in a way that allows them to avoid feeling emotional pain in the event of an adverse outcome.

What is a Pea-brained Human to do?

I am by no means an expert on all of the ways our brains fail us with our finances.  My opinion is that some people are wired well for today’s financial world, these lucky ones are winners of Warren Buffett’s “Ovarian Lottery.”  Unfortunately, I believe the vast majority of us are vulnerable to these behavioral traps.  But there is hope.  As far as species go we as humans are uniquely gifted with intelligence and logic, two tools that we at engineered portfolio believe you can use to combat your cave man brain and become a successful investor.  Becoming a successful investor, like most things in life, requires thoughtful planning and hard work.  The below suggestions work in tandem with one another, reinforcing each other, you need them all to have a proper mind set to tackle Mr. Market.  For those of you who don’t know Mr. Market go read, “The Intelligent Investor” by Benjamin Graham RIGHT NOW!

Understand History

When faced with a major market correction how do you feel?  As the panic sets in what are the thoughts going through your brain?  What should be going through your brain is that this is normal stock market behavior and you know this because you have studied the history of the stock market!  To date, the stock market has always recovered from every down turn, every depression and every panic.  Sometimes it rebounds quickly, sometimes it takes decades to come back.  But it always has come back.  If we are the unlucky generation to see our stock markets completely crumble and be worthless it probably means we are in the midst of some kind of zombie apocalypse so you have bigger things to worry about than your portfolio.  In fact your cave man brain might actually be more useful to you in this scenario!

I am not saying blindly buy and hold stocks and white knuckle your way through the ups and downs.  NO!  But understanding the stock market history will help you both build, adjust and stick to your plan.

Here is some basic history but I strongly urge you to read as much about stock market history as possible to arm yourself with the data you need.

• The stock market has 10% and 20% corrections VERY often.
  • In the last 30 years 10% corrections have occurred an average of 2.27 times per year
  • In the last 30 years 20% corrections have occurred an average of 0.73 times per year
• Stocks can be extremely over valued (optimism) or undervalued (pessimism) and prices tend to revert to a “mean”

Recommended Reading:

William J. Bernstein’s “The Four Pillars of Investing“.  Pillar #2 is the history of investing.  It is only about 20 pages, however I recommend reading the entire book.

Benjamin Graham’s ” The Intelligent Investor.”  Chapter 3 covers a century of stock market history (up to 1972).  I really enjoy Jason Zweig’s offering which has Mr. Graham’s original text alongside some more modern commentary.  It really shows the durability of Graham’s teachings.

Look FORWARD to a Market Crash…..WHAT?!

I should add a note to that title, look forward to AND BE PREPARED FOR a market crash.  This might seem a little crazy, but this is the mindset you should have, you want to flip fear on its head.  If you are a current purchaser of stocks and if you believe that in the end, the price level of the market ends up where ever it is going to end up, it is generally better for you if stock prices are lower today.  This plays into knowing your history.  In order to buy into a falling market you have to have confidence that the market will rebound.  Also, in order to buy into a market you need money!  When you have un-invested cash and you are armed with historical knowledge you start to look forward to when you can deploy that cash….you can’t wait for the market to drop!

I have two pieces of advice here:

#1 – Always have at least 10% of your invest-able assets in non stock assets (bonds, cash, gold etc).  Ideally you would have 10% cash ready to deploy in a downturn.  You can’t take advantage of a downturn in stocks if you don’t have the resources.

#2 – WARNING:  Some people will hate this advice.  It is generally a good idea to always have 6 months expenses saved in cash.  If you believe your job is safe I recommend putting up to 50% of your cash reserves into the market during a correction.  I would recommend putting 20% in after a 10% correction, if the market continues to fall I would put another 30% in after a 20% correction.

Automate Your Financial Life – Save!

Whether it is paying bills or saving for retirement I highly recommend automating your financial life.  At this point I spend less than 5 minutes a month paying bills or transferring money, it is all automated.  Inertia, distraction, fear and sometimes just laziness can get in the way of making smart financial decisions.  One of the smartest financial decisions you can make is to SAVE!  Don’t tempt fate, automate your savings where you can.  This is one of the big benefits of employer 401(k) plans, the money comes out of your paycheck without any work on your part.  If you want to fund an IRA, set up an automatic monthly transfer from your checking account, it becomes mindless.  I fund my taxable Robinhood account with an automatic $100 transfer every week.  If you don’t know what Robinhood is I strongly recommend you check it out as it plays into my next piece of advice, control what you can control.  Fee’s are one of the biggest things you can control.

Control What You Can Control – Fees

I hate fees.  This is a little off topic as far as behavioral finance is concerned, but I never want to miss an opportunity to say how much I hate fees!  Any rational and logical person should want to reduce their financial fees as much as possible.  You will reach your financial goals much sooner if you keep your fees low.  Please have a read on the corrosive nature of investment fees in another blog I wrote.

Advice:  For a taxable stock account check out Robinhood, no costs to buy or sell!

Advice:  When buying mutual funds or ETFs never pay more than 0.30%, ideally pay 0.10% or less.  I find Vanguard consistently offers low cost funds.

Advice:  If your 401(k) plan only has high fee options, get some fellow concerned co-workers together and petition your human resources department to make improvements.  They are fiduciaries for you and should be very receptive to your concerns about high fees.

Control What You Can Control – Asset Allocation

Again, this plays into understanding history.  Asset allocation is the “mix” of different types of investments you hold.  If you are unfamiliar with asset allocation I suggest you check out this blog.  A proper asset allocation can help behaviorally on a number of fronts.  First, a good asset allocation should minimize risk for a given level of return.  The less risk you need to take the less likely you are to succumb to your cave man brain.  Second, like understanding the market history, understanding the benefits of a good asset allocation will give you confidence and resolve through market turmoil.  My partner Steve has done some amazing work on this website on really smart and unique asset allocation.  Asset allocation is what an engineered portfolio is all about!

Advice:  Read all of Steve’s blogs.  Check out the engineered portfolios that Steve built.

Unique Advice – Check Your Accounts at Least Weekly, Ideally Daily

This is financial blasphemy to many.  The current thinking in the world is that since you have these behavioral weaknesses you should compensate for them by avoiding your finances.  The thinking is that you will do something stupid if you look at them.  I don’t disagree…..assuming that you look at them infrequently and if you only look at them when the financial world seems to be falling apart.  This is exactly what happens.  People are going through their lives:  family, work, friends, vacations etc.  They don’t really pay much attention to Wall Street or their investments.  Then all of a sudden there is a major market correction or crash and everyone is talking about “the market”.  So what do they do, they decide to see how their 401(k) is doing and they are SHOCKED at how much it has lost, they panic, they sell.

I propose a different approach.  If you are armed with knowledge and logic, daily swings in the market will not phase you.  More importantly, I believe that growing accustomed to the daily swings in the market will harden you for more robust corrections in the future.  Again, you might be rooting for that correction so you can put some money to work!  At this point in my investing life I find both up and down days rewarding.  Either it feels like I made some money or I got closer to buying some stocks on sale.  Win.  Win.

Write It Down:  Plan Your Work and Work Your Plan

I find that when I write things down they become more real and more manageable.  Documenting your plan ensures complete clarity and helps keep you committed.  It helps avoid the behavioral pit falls.  For myself I’ve created an investment policy statement (IPS).  It is five pages long and is very detailed.  I signed it to cement my commitment to my plan.  I have shared it with the guardian of my children in the event of my death with the expectation they will continue to execute my plan for my children.  This is a serious document that you should take seriously.  The elements of a good IPS include:

• Key Information/Document Goals
• Investment Goals
  • Be specific
  • Example of one of my goals:
    • We want to provide for our children’s college education up to the cost of an in state institution, approximately $100,000 per child total (2016 dollars). First child enters college in 2027, second child leaves college in 2033.
• Investment Objectives
• Assets covered by the IPS
• Current combined Asset Value
  • Update yearly
• Philosophy and Asset Class Preference
  • This is a long section where I specific my preferred asset allocations for different situations and times in my life
• Account Specific Instructions
  • This is for my spouse, heirs or guardians in the event of death

Advice:  Create an investment policy statement (IPS).  Sign it.  Review it yearly, update it and sign it again.  Be committed.

Conclusion

Our cave man brains are not going away any time soon.  If we want to be successful investors we need to find a ways to short circuit the brain wiring causing us to make foolish financial decisions.  This is not an issue of intellect but of perseverance.  Some of the most intelligent human beings in history were terrible investors.  Arm yourself with knowledge, leverage your logic and get ready to take that saber tooth tiger down.

Finding the historical returns of many different country stock markets would have been a tedious task; but thankfully the team at Credit Suisse does a summary of world equities every year in their annual yearbook!

In this post I’ll summarize the Credit Suisse yearbook and then dive a bit deeper into the returns of 4 different stock markets: the United States, Australia, Sweden, and South Africa.  All the data presented is available to view and analyze yourself, and we encourage you to do that!

A Nod to Credit Suisse

Before we jump in and analyze the data presented by Credit Suisse in their annual yearbook. I’d like to highlight the report in general. It is stock full of interesting commentary and analysis.  They also present and analyze bond performance that I won’t discuss in this blog but it is interesting. One of the big themes they stress is to not have a “success bias” by always looking at the US stock market, an apparent anomaly in relation to the rest of the world.

Breakdown of World Stock Market

Let’s start by reviewing the component of the overall global stock market that each country makes up. We think in the US that our stock market is the best, and this blog may start to persuade you otherwise. But no one can argue that the size of the US stock market is unparalleled.

The US stock market still makes up a majority of the entire world’s (publicly traded) stock market. To dive in deeper to the breakdown by country, excluding the US, I looked at the iShares country ETFs. These breakout the MSCI EAFE (designed to measure the equity market performance of developed markets outside of the U.S. & Canada) and emerging market indexes.

Returns Data by Country

Real Returns of 21 Different Countries – 1900 through 2016

Now let’s take a look at the return metrics and risk metric (defined by standard deviation of returns) for a very long time period – 1900 through the end of 2016!

Right of the bat, you may be surprised that the United States is not the best stock market across the world, even when looking at the risk adjusted returns!

Country Returns for Different Time Periods

1900 through the end of 2016 is a very long time; so let’s take a look at the returns of these various countries over a more recent time horizon.  Some interesting countries start to emerge as dominant forces when looking at the period of 1967 through the end of 2017. Most notably Sweden and South Africa start to jump out at me.

I immediately gravitated towards South Africa, Sweden, and Australia for a couple reasons:

1. Most obvious is how well the performed in all 3 of our time periods
2. They seem to consistently be outperforming the global markets
3. They have good risk adjusted metrics
4. They are geographically diversified (think the four corners of the world when including the US too)

Annual Returns

I went and pulled the annual returns data I could find for these three countries compared to the US. In recent years I could use the iShares ETFs for returns. But I had to do some digging for the older data:

• Sweden: House Prices, Stock Returns, National Accounts, and the Riksbank Balance Sheet
• Australia: The historical equity risk premium in Australia
• South Africa: FTSE Index Returns by Year

I used the expense ratio of the respective iShares ETFs (EWD, EWA, EZA) to reduce the returns and get a better indication of what an investor would have received.

What jumps out at me is how often the US is the worse of the 4 countries. The most notable exception is recent times the US has far exceeded international equities, including our 3 country focuses – expect a bit of mean reversion here over the next couple years.

Risk Metrics

Now I’ve computed a few performance and risk metrics to try and compare these country stock markets on a risk adjusted basis. In nearly every category, one of the other three countries is beating the US, except when only looking at average return vs volatility of returns – the US appears to exhibit a fair risk adjusted returns although it has less returns than the other countries.

Country Background

Australia

According to Credit Suisse, Australia is the “Lucky Country:”

Australia is often described as “The Lucky Country” with reference to its natural resources, weather, and distance from problems elsewhere in the world. But maybe Australians make their own luck.

Of the three alternatives to the US, Australia is the largest stock market and therefore it has a much higher correlation to the general EAFE index – this may make it not as desirable as a tilt in our portfolio.

Sweden

I like Sweden.  They offer some unique benefits, according to Credit Suisse –

Swedish equity returns were supported by a policy of neutrality through two world wars, the benefits of resource wealth, and the development of industrial holding companies in the 1980s. Overall, equities returned 5.9% per year in real terms.

Sweden has a wealth of natural resources, they’re part of Europe but tucked up in the corner a bit out of the way, they are a well educated people, and clearly their stock market returns have been attractive.  They only represent 3% of the EAFE index, so there could be some diversification benefit of adding a tilt here.

South Africa

Referred to as the “golden opportunity” by Credit Suisse due to their abundance of gold and other natural resources. Their stock market is very well established (since 1886) for still be referred to as an emerging market.  They do have a large poor population and need to improve the education and integration of these people into the economy. But this represents another significant resource that South Africa has – untapped potential in their people.

What’s also nice about South Africa is where they are geographically located – in Africa and an entrance into many of the “frontier markets” there. Their dependence on precious metals and gold has also generated some unique benefits in that they offer quite a bit more diversification to other stock asset classes.

Bringing it All Together

When we added these countries as options to consider in our optimizer the optimizer loved adding these countries – so much so that we actually had to limit the maximum weighting to 10%. We didn’t feel comfortable suggesting portfolios with significant tilts to South Africa and Sweden; but we couldn’t deny that the data spoke for itself and justified a small tilt!

Why are they so desirable?  It is due to the fact that not only did these countries perform well overall, they did so by moving to the beat of their own drum. Take a look again at the correlation matrix.

There you have it, our data suggests that small tilts to South Africa and Sweden to be worthwhile! Although the US stock market is the most talked about and generally considered the best… I’d argue that the data suggests some other countries, namely South Africa and Sweden, have better stock markets – they at least warrant your consideration.

But I encourage you to download the data used in this analysis to draw your own conclusions too!

Disclosures

In this post we’ll quantify the diversification benefits that gold, commodities, long term treasuries, and REITs provide to a portfolio of mostly stocks and bonds. Annual data will be reviewed going back to 1972 and daily data is also analyzed going back to mid-2006.

By the end of the post you’ll have a better idea of which alternative asset class to add to your portfolio to help reduce risk. As always, the data reviewed in this post is available to download.

Annual Returns

By Year Returns Data

First, let’s review the returns data of our 6 major asset classes (along with inflation for reference) going back to 1972.  Right off the bat you’ll notice how consistently poorly both gold and commodities performs; but we’ll see that when paired with other assets and annually rebalanced, adding these to your portfolio can be beneficial. Another immediate interest is how the performance of commodities and gold seemed to flip in the last 30 years.  In the first 30 years commodities offers much better returns to gold; but in the last 30 years, it’s been gold that has been better.

Also of note is how consistent US REITs have been.  Even through the financial crisis, with a 20 year investment horizon, they have significantly beaten our other assets.

Performance Metrics

In the following table a number of different performance metrics are provided of our asset classes.  In this table it becomes blatantly apparent at just how risky gold and commodities have been while also offering poor returns.  Long term treasuries has also been significantly more risky than an aggregate US bond investment yet provided dis-proportionally higher returns (about twice as risky, only about 25% better returns). REITs have also clearly been an excellent investment historically relative to these alternatives.

Correlation Matrix

Clearly gold, commodities, and long term treasuries aren’t great investments on their own. But we’re not interested in investing in just one asset; we are trying to engineer an efficient asset allocation and so we must look at how these assets are correlated to one another.

A correlation of close to 1 means that the two assets move in unison.  A correlation of 0 means that they tend to move completely independent of one another.  And the holy grail is a correlation of less than 1 which indicates that they move out-of-phase with each other: when one goes up, the other goes down.  And the correlation matrix suggests that even though gold and commodities have been poor investments on their own, their lack of correlation with both stocks and bonds may provide an opportunity.

Adding Each Diversifying Asset to Stocks and Bonds

In the next couple sections/plots we’ll compare the performance of portfolios that are compromised of 0-100% in increments of 10% of each asset class for total of 62 different possible portfolio combinations.  The simple combination of just stocks and bonds will also be shown to (hopefully) help demonstrate how adding these assets can significantly improve efficiency.  We’ll analyze 8 different metrics in 4 plots:

• Average annual real return
• Annualized real return
• Average 10 year real return
• Worst 15 year real return
• Standard deviation of annual returns
• Downside risk of annual returns (RMS of losses)
• Standard deviation of 10 year returns
• Largest drawdown

The returns all assume annual rebalancing – this is a must!

Long Term Treasuries

Adding long term treasuries provides a noticeable improvement to a portfolio of mostly stocks; but to a portfolio of mostly US aggregate bonds – adding treasuries seems to hurt. The conclusion here is that long term treasuries deserve a place in portfolios of high stock concentration; but should be avoided for safer portfolios.

REITs (Real Estate)

We know that real estate performed well on its own as an investment class; so it should be no surprise how adding it helps improve returns.  But notice how significantly it improves the volatility of 10 year returns!  And it also does wonders at maximizing the worst 15 year return.  This suggests that for portfolios with a longer time horizon, REITs may deserve an allocation.

Commodities

Now things start to get interesting when we add an asset with a negative correlation: commodities.  Even though commodities had offered abysmal investment performance, a small amount of it added to a portfolio of stocks and bonds can actually reduce risk while improving returns. What’s most noticeable is how impressive it helps minimize the drawdown!  Remember, this is only made possible through rebalancing.

Gold

Now take a look at what adding gold does! This blew me away when I started seeing this phenomenon with gold in an investment portfolio.  I hate the idea of investing in a yellow metal which can thank its returns only to the speculation of man. Yet!… it does wonders when added to portfolios of stocks and bonds.

Adding gold significantly helps all metrics.  Most noticeable to me is how adding gold to a portfolio of stocks will actually increase the overall returns (rather dramatically) while significantly reducing risk.  Over long time horizons gold also shines at reducing variation and minimizing losses.  What’s also noteworthy is how adding gold helps even very conservative (bond heavy) portfolios!

Gold the Winner Overall for Annual Returns

Now let’s plot them all against each other to see just how effective gold is.  The light blue portfolio is a simple 40% stocks, 40% bonds, 20% gold.

Daily Returns

The previous data looked at annual returns over the last 40+ years.  Have things changed in recent years?  And does the daily data paint a different picture?  In the next set of data we’ll use ETFs to see how things may have changed in recent times.  Note that these results do not include dividends.  We’ll look at the following ETFs:

• SPY – S&P 500 Trust
• AGG – iShares Aggregate Bond
• VNQ – Vanguard REIT
• TLT – iShares 20+ Year Treasuries
• GSG – iShares Commodities Trust
• GLD – Gold Trust

Here is the overall performance since mid-2006.  Commodities have done very bad…

Daily Correlation

The daily correlations are a little different in recent times to the 40+ years of annual returns.  Long term treasuries appears to be emerging as the new diversification king.

Adding Treasuries

In recent times adding treasuries has done a wonder on reducing risk and even increasing returns.  Note that these results assume daily rebalancing though.

Adding REITs

REITs in recent years has provided no diversification benefit when looking at daily returns.

Adding Commodities

It should be of no surprise how poorly portfolios with commodities have performed of recent.  Like REITs, they offered no diversification benefits over the last 10 years.  For the contrarian… this could look like an opportunity though.

Adding Gold

Gold, who shined so drastically for the 40+ years of annual data still have provided meaningful diversification benefits on daily returns over the last 10 years.  It has helped for both the heavy stock portfolios and heavy bond portfolios at reducing risk while improving returns.

Treasuries the Winner of Recent

Let’s compare the results with treasuries and with gold (we’ll ignore REITs and commodities to keep the plots clean).  You’ll see that of recent, treasuries have provided the superior diversification benefit.

Conclusion

Gold deserves a place in virtually any investment portfolio (that does rebalancing) to reduce risk in the portfolio.  It is counter intuitive; but it has historically offered the best diversification benefits.  In recent years, treasuries have taken the lead in providing better benefits; but this may be short lived and could change as the FED starts selling their bond reserves.  But we saw how treasuries do well as a diversifier to mostly stock portfolios on the 40+ years of data so you should consider it as a hedge for more aggressive portfolios.

I encourage you to download the data used in this analysis to draw your own conclusions too!

Disclosures

One would belief that fixed income should be easier to accurately predict returns and thus the bond/fixed-income market should be relatively efficient.  In this post we’ll put this assumption to the test.

We’ll go through the annual returns of 11 different bond asset classes (and the S&P 500 and inflation for comparison) to analyze the performance of these bond assets.  This analysis includes a look at the historical data (available to download here), comparison of moving trends, calculate 4 performance and 4 risk metrics, look at the correlation matrix, offer some additional resources and point out some investment opportunities to consider.

Annual Returns of Bonds

Trailing 3 Year Returns

The table below shows the annual returns of the 11 bond asset classes compared with the S&P 500 and inflation for comparison.  A few years and asset classes are highlighted in yellow because the data does not extend that far back in history.

• Junk bonds uses corporate bond returns for 1976-1978
• Intermediate municipal bonds use aggregate US bond returns for 1976-1977
• International bonds use 90% US bond, 10% international stock
• Emerging market bonds use 90% international bonds, 10% emerging markets

Trailing 20 Year Returns

Below is the same table; but now with the trailing 20 year returns.  Immediately emerging market bonds (even after our fabricated returns stretch) significantly outperform on a consistent basis.  Long term treasuries also seem to do well consistently.

Risk Adjusted Performance

With any investment analysis, looking at the overall returns (and trailing returns) is not a fair way to quantify performance.  What we really want to conclude is if one asset class is exhibiting higher risk-adjusted returns than another.  Many investment professionals will traditionally use only one metric to define risk and another to define return performance.  In this post we’ll look at 4 different pairings to gain a deeper understanding of how these asset classes perform.

Average Return vs Volatility of Returns

The most common plot you’ll see when analyzing investment performance is the annual average return vs the standard deviation of those annual returns. Markowitz pioneered the mathematics behind quantifying investment returns on these metrics; but more importantly, he showed that one can calculate the efficient asset allocation given these metrics and the correlations.  Because of his work done in the 1950s, investment professionals still tend to solely rely on these metrics to quantify risk/return.

In doing so, the bond market appears fairly efficient.  Note that the results shown are real returns (after inflation).  Municipal bonds look poor but, this is showing pre-tax returns – municipal bonds fair much better in after tax returns.

Annualized Return vs Downside Risk

Volatility is not the best metric to use for measuring risk.  It penalizes assets that have fluctuating years of gains.  Investors care about the frequency of how often they lost money and how severe those losses were. Dr. Frank Sortino in the 1980s recognized that volatility didn’t tell the full story on investment risk; so he developed a downside risk metric that is used in his Sortino ratio (see here for the math and more information behind the Sortino ratio.

If we plot the annualized returns against downside risk we can start to see how efficient the bond market truly is.  In the plot, there a number of assets that are skewed to the right (indicating inefficiency); but notice the big green circle in the upper left.  That big green circle is the total US bond market meaning that it holds allocations in all those other circles/asset classes.

Trailing 10 Year Returns Average vs Volatility

Those last two plots fail in showing how consistent the asset class performs.  The overall metrics could be skewed from a handful of very good or very bad years.  In an effort to quantify how consistent an asset class performs, I’ve plotted the average 10 year real annualized return vs the volatility of those returns.

Again we see that big green data point (aggregate bonds) at the inflection point on the upper left indicating that it is offering maximum efficiency… at least for the US bonds. Emerging market bond returns become even more compelling and international bonds also appear to offer unique performance benefits.

Worst 15 Year Return vs Maximum Drawdown

Now let’s look a doomsday scenario and plot the worst trailing 15 year return against the largest drawdown.  In this plot you notice a couple telling things:

• Although emerging market bonds are volatile, if you give them a bit of time they do the best job at preserving capital and limiting losses.
• TIPS (treasury inflation protected securities) also do an excellent job at preserving capital compared to other bond asset classes.  This makes sense because bonds traditionally lose money to inflation, which TIPS tries to mitigate.
• Cash isn’t as safe as you may assume.  The worst 15 year performance of treasury bills (the equivalent of a bank savings account, although probably slightly better) is a -1% annualized return (or loss) against inflation.  That’s bad!  This will be the topic of a future post; but cash savings are not what they are made out to be – an efficient safe asset allocation has historically done a better job at preserving capital when inflation is considered than just keeping it in the bank.

Performance Summary

The table below summarizes the data presented in the preceding tables and figures.  I used conditional formatting to highlight how well these asset classes performed on a risk adjusted basis relative to their peers.  A couple takeaways:

• Emerging market bonds, although risky, offer superior risk-adjusted returns
• International bonds also offer good risk adjusted returns
• In the US, aggregate bonds are very good at capturing the overall returns and therefore provide an efficient means of investing in the entire bond market
• Municipal bonds don’t look appealing; but these results have all been on a pre-tax basis.  With taxes considered, the returns of munis will be more attractive.
• TIPS are stable and a good preserver of capital
• Long term treasuries are risky… when not invested in stocks as well

Correlation Matrix

After reviewing these previous plots/tables I originally came to the conclusion that long term treasuries are way too risky to actually consider investing in.  But when we take a look at the correlation, and lack thereof, to stocks we can start to see how they could provide a significant benefit over just owning an aggregate bond index.

• Of bonds, long term treasuries offer the diversification benefit to a portfolio of mostly stocks
• Junk (high-yield) and corporate bonds on the other hand are very highly correlated to the returns of stocks.  This suggests that they don’t help for most investors that have stock holdings
• Municipal bonds are highly uncorrelated with inflation.  Therefore, in time of high inflation, these bonds tend to get punished the most.  This suggests that municipal bond investors should be sure to also invest in inflation hedges (energy stocks, gold, etc.)
• Treasury bills historically are highly correlated to inflation.  When inflation is higher, your cash savings account will return more; when inflation is low – you’ll get a lower dividend in your savings account.  But on average, one can only expect about a 1% besting of inflation with such an investment – and it isn’t guaranteed.

Conclusion

The bond market is fairly efficient, meaning that an investment in aggregate bonds will do a very good job at efficiently allocating across the various bond asset classes.  But… this doesn’t take into account what happens when invested in stocks as well. As we’ll see in the next couple posts, certain bond asset classes offer an attractive hedge to stocks even though they don’t look good on their own or in an ultra conservative account.

I encourage you to download the data used in this analysis to draw your own conclusions too!

Disclosures

Turns out there are two: international (ex-US) small cap stocks, and emerging market stocks.

In this post we’ll compare historical returns data from 1972 through the end of 2016 and highlight these two international stock asset classes that have grossly outperformed their peers.  We’ll look at correlations between these asset classes and US stocks too to see if there are better or worse diversification opportunities.

As always, all data presented is available to download.

Historical Returns Data

Cumulative Returns

Let’s jump right in and plot the cumulative return in Figure 1 of 7 different international asset classes compared to the S&P 500 and US midcap value.  Right away it becomes apparent that emerging market equity and international small caps grossly outperform their peers in the long run.  That plot is logarithmic too; at the end of 40 years those asset classes have returned ten times more profit to their investors.

Annual Returns

Now let’s look at the returns by year and calculate/compare the trailing 10 year returns as done in Figure 2.  I highlighted the worst performing international asset class dark red, the second worst in pink, the second best in light green, and the best in dark green. It should quickly become apparent to you that not only does international small caps and emerging markets outperform over the last 40 years… one of the two (often both) perform either first or second in every 10 year period.  Only in the late 1990s did an asset class other than these two perform the best: European equities.

Performance Metrics

Let’s assess if this outperformance is achieved with more or less proportional risk.

Volatility vs Average Return

First in Figure 3 I’ve plotted the easiest thing to calculate (and the one average analysts default to) when quantifying risk/reward: average return against the volatility of those returns.  In this plot the outpeformance is still obvious but it makes the markets look efficient (like they’re supposed to be) – small cap international and emerging markets are requiring a proportional amount more volatility to achieve those returns.

Annualized Returns vs Downside Risk

Investors don’t care about volatility though.  I’m not upset when an asset class jumps up 50%+ which emerging markets and small cap international are known to do.  I do care when it drops a lot and often.  Therefore we’ll use downside risk as our risk metric which takes the root mean square of annual losses.  Years that it had a gain are set to 0 in this calculation to effectively weight the frequency of losses.  Here’s some more information on downside risk and Sortino ratio.

Investors also don’t care about average returns. I want to know how much it returns in the long run so I need the annualized return data.  Averages don’t give you the real picture.  For example, let’s look at an asset class that returns 50% one year, and -50% the next year.  Someone who just calculates the average return will calculate 0.  But an investor didn’t feel an average return of 0.  They may have started with $10,000; after a year they were at $15,000.  But then a 50% loss comes in wipes him down to $7,500 – that’s not an average loss of 0% its an average loss of 13%!

In Figure 4 we see that when looking at annualized return vs downside risk, the case for international small caps and emerging markets becomes stronger.  They still carry more risk than developed markets and larger stocks; but the outperformance comes with a lower proportional increase in risk.  You may notice that mid cap value is crushing it on the top left of the plot (less risk, more return) – yeah mid cap value is awesome.

Summary Metrics

Figure 5 provides a summary table of a number of performance metrics of international stock asset classes.  US inflation and the returns of treasury bills (used as the “risk-free” investment for Sharpe & Sortino ratios) are included for comparison along with the S&P 500 and mid cap value.  The Sharpe and Sortino ratios (attempts to define the risk adjusted returns) are both significantly higher for internal small caps and emerging markets.

Correlations

Figure 6 shows the correlation in annual returns between these asset classes.  The less correlated the better diversification opportunity an investor has by adding these to his/her portfolio.  International small cap and emerging markets are about 25% less correlated to the S&P 500 compared to larger stocks in developed markets.  This makes sense, big companies are global behemoths – a large US company is going to have similar global exposure as a large European company for example.  Smaller stocks or companies in emerging markets will be more reliant on their smaller/domestic markets which offer a US investor much better diversification.

Notice also how even less correlated US mid value is to emerging markets and international small… more on that later.

International small cap and emerging markets are relatively correlated so one could make the argument that you only need one of the two if you’re trying to keep your portfolio simple.

Conclusions from the Data

Emerging Markets and International Small Grossly Outperform

I see this data and conclude that there is no reason to own large developed foreign stocks.  In my investment accounts I only have small cap and emerging market exposure for my international allocations (and small tilts to South Africa and Sweden – discussed in another post).

Value Premium Internationally

The value premium in the US is significant, especially with smaller stocks.  Foreign value stocks outperform blend or growth; but the outperformance isn’t as striking.  This data doesn’t include international small value though – maybe here the value premium is exaggerated like it is in the US.

Geography Matters

Notice the difference in performance of pacific stocks to European.  Now Japan has had a terrible run at it over the last several decades with deflation; but this should highlight that where you invest matters.  Buying an ex-US fund will offer diversification; but it may force you to buy into countries or regions that aren’t worthwhile investing in.  I dove a bit deeper into country-specific stock market performance in another post based off data from Credit Suisse.

Anyone Else Notice This?

We here at engineered portfolio aren’t the only ones to notice the discrepancy in performance of international equities.  Here are a couple resources from other institutions:

• MSCI: Revisiting Global Small Caps
• WSJ: The Case for Buying Small-Cap Foreign Stocks
• Bloomberg: History Shows Best Equity Gains Come From Emerging Markets

Vanguard of course has an article warning against the allure of emerging markets which is worth a read.  They believe in an efficient market and I tend to agree with them.  But we’ve found the market is not completely efficient.  There are opportunities if you dig a bit (deeper than the average investor) and have a steadfast investing strategy.

Where to Invest

There are a couple ETFs that you check out as possible investment vehicles to gain exposure to these asset classes:

• SCZ: iShares MSCI EAFE Small-Cap ETF – 0.40% expense ratio
• IEMG: iShares Core MSCI Emerging Markets ETF – 0.14% expense ratio
• VSS: Vanguard FTSE All-World ex-US Small-Cap ETF – 0.13% expense ratio
• VWO: Vanguard FTSE Emerging Markets ETF – 0.14% expense ratio

What about Now?

History looks great; but will this trend continue?  I don’t know what will happen in the future nor do I speculate what will happen.  But the past has shown us small caps internationally and emerging markets have outperformed international developed markets.  And so that’s where I’ll put my money.  And in this exact moment in time… it may be an opportune time to increase your international exposure as the beaten international stocks seem to be picking up the pace and running ahead much faster than domestic stocks.

Keep in Touch

We’ll continue this type of analysis with other asset classes, so subscribe to the blog if interested.  Also don’t hesitate to reach out with any questions!  And the data is available to download in a spreadsheet so that you can do your own analysis.

Disclosures