Covid-19 pandemic, record unemployment, stock market collapse, fastest recession ever… The headlines have been dire recently. Enough for certain voices to proclaim the end of DIY investing and financial independence.
Fear not, dear friends. We are not totally screwed. For sure we’ll all have to face challenges, but we will also be presented with new opportunities.
Having already covered the basics of building a DIY portfolio in part I and how to implement it in part II, I feel it is high time to cover another important topic: what to do when the inevitable recession and market rout rear its ugly heads.
The Inevitable Boom And Bust Cycle
The last economic cycle that recently came to an end was quite a stunner. From a US-centric perspective, that’s 11 years of rising stock markets, with total gains around 350% depending on the index you look at. An entire generation of young people on the job market can now barely remember the last time things were going south.
Even before the Covid-19 pandemic, we were overdue for a correction. Despite the lofty dreams of ivory tower economists and politicians of all stripes, downturns remain inevitable. The coronavirus certainly triggered and accelerated the fall beyond the wildest projections. But that the economy eventually tanked shouldn’t surprise anybody.
Let me repeat, periodic market turmoil is normal. So are drawdowns of 25%+ a well-diversified portfolio. Learning how to cope, and how to manage drawdowns, is key to a sound investing strategy.
The Best Reaction:
At this stage you should already be familiar with the psychological biases plaguing us puny humans. And the asset mix in your portfolio should reflect that by aiming to reduce the magnitude and duration of drawdowns. As an example for a simple, actionable and highly diversified portfolio, we opted for 60% global stocks and 40% global bonds in part 1. Let’s see how it did recently.
As a reminder, I used the following ETFs to construct the portfolio: VT, for total global stocks (and as our benchmark), and a 50/50 mix of AGG, for total US bonds, and BWX, for global bonds outside the US.
The updated 60% global stocks and 40% global bonds portfolio returned a CAGR of 4.9% from July 2008 to March 2020. The maximum drawdown over the last 12 years lies unchanged at 28%. The latest drop from the December 2019 highs amounts to only 13.4%. Not that dramatic after all. At least so far.
For comparison, the benchmark in red, 100% global stocks, has a CAGR of 4.3%, a maximum drawdown of 43.3% (from the 2008 financial crisis), and a drawdown of 18.5% from the last high of December 2019. So our simple 60/40 global portfolio did its job of reducing drawdowns, and even boasts higher returns than stocks alone.
Now it wouldn’t surprise me if the markets keep dropping in the coming months as the economic repercussions of the pandemic gradually materialize. But so far it’s not exactly an apocalyptic collapse.
Academic research has shown that we tend to buy and sell at the worst possible moment. So… Moral of the story: best not to look at your account on a daily basis. And less exposure to the panic-inducing headlines is good too.
Falling Markets Bring Opportunities
Another important aspect of investing is valuations. In other words, it’s better to buy assets cheaply than at inflated prices. If you only recently started investing or are planning to invest money in the coming years, market routs are actually good news.
To illustrate this, let’s take our same 60/40 global portfolio and pretend we started investing shortly after the 2008 financial crisis. The market bottomed in February 2009, but perfectly calling a bottom (or a top) is extremely unlikely. So let’s take the official end of the recession in the US, June 2009, as an arbitrary starting point instead.
The 60/40 global portfolio returned a CAGR of 6.3% from June 2009 to March 2020. The maximum drawdown is now the lastest drop of 13.4%. The benchmark returned a CAGR of 7.5% over the same period, with a maximum drawdown of 21.2%. That’s significantly better than if we start our calculations in 2008.
The take home message here is that resilient, resourceful and flexible individuals should be also be able to benefit from this downturn. At least once the dust settles, in a few months, or more likely years.
Introducing Tactical Asset Allocations
The goal of this series of blog posts is to show you how to take investing into your own hands. And that an exceedingly simple portfolio can cover your needs. However, our example 60/40 global portfolio still logged a maximum drawdown bigger than 25% since 2008. And -35% or -40% in future downturns cannot be excluded.
If you are living partially or mostly from your savings and investments, such a drawdown can be highly stressful. A proportional reduction of your expenses might not be possible. Instead, lower drawdowns would be desirable.
Expanding your portfolio mix to include more asset classes is one potential solution. However, there is another simple yet efficient approach to mitigate risk: implementing a tactical asset allocation (TAA), a dynamic strategy actively adjusting your asset allocation.
Meb Faber’s Ivy Portfolio is a good read to get started on the topic. For our example, we simply add the following rule to our global 60/40 portfolio: if the asset class is above the 8-month simple moving average (SMA), remain invested, if not, sell the position and keep the allocation in cash. For reference, the SMA is simply the rolling price average of the last 8 months at any given time.
The 60/40 global TAA portfolio returned a CAGR of 5.5%. More importantly, the maximum drawdown was lowered to a milder 8.9%. Even better, the last “crash” barely affected it. That’s quite an improvement!
Pitfalls Of Tactical Asset Allocations
Switching to a TAA can dramatically improve risk-adjusted returns. In other words, you end up sacrificing some returns for a stark reduction in drawdowns. However, it comes at a price.
This new layer of complexity implies some extra work every month. At the bare minimum, you would need an excel sheet to calculate signals and rebalance the portfolio accordingly. Not a big deal, but there is a learning curve.
More importantly, the question of optimization needs to be addressed. I choose the 8 months SMA for our example. What about the 9 months SMA? What about changing the asset mix? Have you considered the potential for data-mining bias? And which tactical asset allocation would you choose? And yes, even TAAs sooner or later have (hopefully smaller) drawdowns you’ll have to cope with.
The Big Picture
My advice basically remains the same: pick a simple asset allocation, implement it as cheaply and efficiently as possible, and stick to it. The at times gut-wrenching roller-coaster ride is best ignored. The financial freedom that comes with even a modest DIY investment strategy remains.
However, for those so inclined, tactical asset allocations offer significant improvements over classic buy and hold portfolios. The extra work and effort is well worth it, but this invariably turns investing into a part-time hustle.
More importantly, having a large array of skills to fall back on in times of crisis is still the ultimate path to financial independence. With several potential income sources, your resilience will give you a lot of extra peace of mind. Simple DIY investing is best considered a part of your arsenal.