Do-It-Yourself investing, without an advisor or overpriced funds by your local bank. Yes, it’s possible, and it’s surprisingly easy with the new financial products and services that have appeared over the last decade. I’ve been ask the “how to invest” question many times. And it popped up again recently. So let’s dig in, investing is not rocket science!
With this 3 part example (part 2 here and part 3 here) for fledgling investors, we’ll go through the entire process of selecting a simple asset allocation, finding the best investment vehicles and a platform to implement the strategy. Finally, we’ll have a look at what to do during a financial crisis. Here, we start with constructing a basic portfolio.
DIY Investing Pitfalls
Let’s begin with a word of caution. In the world of investing, you will encounter a lot of so-called backtesting. Basically, a portfolio or investment strategy is tested on historical data. It’s tempting to just choose the highest performer and be done with it. But you might have heard this before: past performance is not indicative of future results. Or as another popular analogy goes, it’s like driving while looking in the rear view mirror.
The data might be flawed, biased, insufficient or incomplete. For the examples in this post we go back to early 2008, at the start of the financial crisis. Just before the big market crash. It’s hard to get older data for many funds since they are relatively recent products. That’s not even a full market cycle.
So what can you do? Instead, focus on understanding the underlying principles, the role of luck, and the psychological biases that plague us.
Finally, a full disclosure: I’m not affiliated with any financial institution. Also, I’m not a professional. For all you know, I’m just some random dude talking about finance. Do your own diligence as another popular saying goes.
DIY Investing Kept Simple:
This blog post focuses entirely on passive investing. So we’ll only consider investing in funds that replicate broad indexes. An index tracks a defined basket of holdings, usually a subset of a market. For example, total US stocks or global investment-grade bonds. In other words, no active management. No stock picking. No complex strategies. Simple and cheap.
Research has shown that we humans are very poor at understanding and predicting complex systems such as the economy. The core principle of passive investing is tagging along the market rather than trying to predict the future of its individual components.
In the end I neither want to condemn nor condone active investing. But if you want to keep things simple and understand what you are doing, passive investing is your default choice.
Choosing Investment Vehicles:
In the examples below I’m using so-called Exchange Traded Funds or ETF as investment vehicles. ETFs are funds that hold an array of stock, bonds, and/or other types of securities. You can buy and sell shares of ETFs the same way you would for stocks. But instead, you are instantly diversified across hundreds or even thousands of securities. Ideal for a simple DIY approach.
Finance is a competitive industry. At first glance, choosing between thousands of ETFs can seem overwhelming. But don’t worry. It’s much simpler than you think. We’ll cover ETF selection in part 2 (coming soon).
Depending on your country of residence and tax circumstances, other types of funds might be more appropriate. For example, Sweden has a tax-efficient wrapper called an ISK. However it comes with restricted investment choices. This will affect your decisions and you will have to do a minimum of research on the topic. But for the large majority of investors, ETFs remain the simplest and best option.
In the examples below I will only use 3 metrics to look at historical performance. First, the annual returns in percents. This one should be easy to understand. Higher is better. But as we will see, not at all cost. It’s also often referred to as compound annual growth rate, or CAGR.
The other two metrics illustrate the downsides of investing, literally. The maximum drawdown measures the biggest loss, peak to through. And the maximum drawdown duration the longest time before a new high mark is reached. For both, the lower the better.
I find both drawdown metrics to be excellent predictors of the psychological pressure you will be under when your investments tank. Although you might have had a stellar performance over the last decade, you are likely to only focus on the last high mark during a crash.
I won’t use other popular metrics such as the sharpe ratio or volatility here, as they can be misleading initially. Finally, all the graphs below use an investment sum of 10000 US dollars. The historical data is from Interactive Brokers and all the calculations by me.
A Basic Investment Portfolio:
Broad Stock Market Indexes
Let’s start with one of the simplest portfolios possible, a broad index of stocks. The CRSP US Total Market Index covers nearly the whole investable US stock market with around 4000 constituents. There is a low-fee ETF that tracks this index: VTI.
Since 2008, we have annual returns of 10.1%. And that includes the last crash. But there is a catch. The maximum drawdown is 42%, and the maximum drawdown duration 27 months. Ask yourself this question: how will you feel the next time your hard earned cash melts by half and then takes years to recover? Will you stay relaxed? Most people don’t.
Stocks are historically by far the best performing asset class. And as such make a tempting investment. But if we go further back in time some drawdowns have lasted decades. The worst on record for the US is from 1803 to 1871! It’s important to have a long term vision, but 68 years is a looooong time!
Diversifying With Bonds:
The 60/40 Portfolio
The ups and downs of the stock market drive a lot of investors into government and other types of bonds. Maximum drawdowns for this asset class tend to be much lower, although returns are also muted. Nevertheless, it’s important to mention that bonds on their own can also suffer from extremes. Not good.
The solution? Combining bonds with stocks. They often behave differently, resulting in better overall drawdown metrics. This is what a lot of advisors and banks offer to their clients. But with a hefty fee on top, or using expensive funds with juicy commissions.
One of the most popular portfolios has 60% invested in stocks, and 40% in bonds. It’s often referred to as the 60/40 asset allocation. So let’s add a broad bond index, such as the Bloomberg Barclays US Aggregate Bond Index. We’ll use the following ETF for data: AGG. We’ll assume monthly rebalancing. In other words, once a month the holdings are adjusted to maintain the desired percentages of the asset allocation.
The returns remain at a very reasonable 7.98%. More importantly, the maximum drawdown drops to 26.9% and the maximum drawdown duration to 18 months. That’s already much better.
If we push this to 40% stocks and 60% bonds, we keep trading returns for volatility. The returns are now at 6.7%, but the worse drawdown is less than 20% (17.9% to be precise) and just over a year (14 months). This is something more people are likely to stick with.
And this brings us to another very important point. It’s much better to sacrifice returns for lower expected drawdowns if you think you might panic during the next market crash. There is a lot of research showing that investors tend to sell (and buy) at the worst moment. In which case you might as well stay away from the market altogether.
Global 60/40 Portfolio
You might have noticed that so far the selected indexes just cover US markets. But to put things into perspective, US stocks and bonds only account for roughly half of their respective global markets. And it gets proportionally a lot worse for people over-invested in smaller economies. There is even a name for that: the home bias. Not good.
History as plenty of examples for the (mis)fortunes of a single country. We can avoid having to predict the outcome of a single economy by opting for a global investment strategy instead. So let’s keep the 60/40 stock and bond portfolio. But for each asset class, we’ll take international indexes instead.
For the stock part, the FTSE Global All Cap index, represented by the ETF VT. And for the international bond portion of the portfolio, a 50/50 of the SPDR Bloomberg Barclays International Treasury Bond ETF BWX, and the AGG ETF we used previously. There is a single ETF, BNDW, covering the global bond market, but it’s only been around for 18 months. That makes it unsuitable for our backtest.
We get returns of 5.6%, a maximum drawdown of 28.8% and a maximum drawdown duration of 16 months. The US markets had a good run since the financial crisis, so don’t be too surprised by the comparatively lower returns. The US dollar did well too. Nevertheless, keep in mind inflation has been remarkably low in recent years, so all in all these are still decent returns for a highly diversified portfolio.
Other Asset Allocations:
Doing Your Homework
There are many ways to refine and create more complex asset allocations. But you’ll have to do some reading. I warmly recommend Meb Faber’s aptly named book, Global Asset Allocation. It’s a short and easy read, a few hours no more. No need for previous financial knowledge. It will give you a good idea of some of the most popular asset allocations, and their performance since 1973. Spoiler: in the long run, it doesn’t matter much which one you pick. Also, you might want to consider adding “real” assets such as commodities and real estate to the mix.
You can also play with different asset allocations using online backtesting tools, such as Portfolio Visualizer. Or even do your own backtesting using spreadsheets or custom codes if you have the relevant skills. You can get inspiration from books, but also from funds offered by your local bank or advisor. But ultimately, keep in mind that the perfect portfolio will remain elusive.
Factoring in Inflation
Inflation, or if you prefer the purchasing power of your money, decreases over time. This also affects significantly the performance of our investments. Portfolio Visualizer can adjust the backtest for inflation by ticking the little box under the graph. The data used is from US government statistics.
For our model global 60/40 portfolio, we loose over a third of our returns to inflation.
There are indeed a few very important takeaways when it comes to investing. Meb Faber looks at inflation-adjusted (or real) returns of the different asset classes between 22 countries since 1900 in his book.
- Cash: median real returns of -3.9%
- Long-term government bonds: median real returns of 1.7%
- Stocks: median real returns of 4.8%
Going all-in on stocks is again tempting, but unwise as we discussed above. Nevertheless the main point is quite simple: don’t leave your savings in a bank account!
Inflation is a complex subject. It varies a lot over time and between countries. The global nature of the portfolio should shelter you well from episodes of localized high inflation and currency devaluation affecting individual countries.
Historically, adding real assets to the portfolio mix also protected well against inflation. Generally, you can do so by allocating some money to real estate (REIT) and commodities ETFs. You can also include inflation-linked government bonds (called TIPS in the US).
Overall, average real returns of around 3-4% are a realistic expectation. And a good withdrawal rate if you are planning for early retirement / financial independence.
Keys Considerations For Picking An Asset Allocation
I consider our global 60/40 portfolio as described above to be suitable for most investing newbies. You can obviously tweak it a little now or later.
Rather than chasing the highest returns, you want an asset allocation that is:
- Simple. Easy to understand and manage. And easy to forget most days.
- Personalized. Be honest. Know yourself. Pick a strategy you will stick to when the market gets choppy.
- Highly diversified. Don’t waste your time trying to predict the future. Develop your skills and other income sources instead.
- Global. We are citizens of the world. Our investments need to reflect that.
In the second part, we will move forward with implementing our portfolio. First, we will look at the importance of fees and taxed. And subsequently, how to find low cost ETFs and broker accounts.