Intro
Since starting this portfolio i have been thinking about how my portfolio will perform over the long run. The more i thought about it the more i realise how susceptible my portfolio was in the event of a sustained period of poor or negative performance as a result of a 'black-swan event'. A black swan event is essentially an unpredictable event characterised by rarity and severity of impact. This got me to thinking on ways i could construct my portfolio in a way where i could perform well throughout any phase of the business cycle, which i will explain my thoughts and new portfolio below.
History of Stock Market Crashes
As mentioned above, stock market crashes are unpredictable and over the years have resulted in periods of sustained draw-down from the peaks.
Over the last 90 years or so the market has been in a bear market almost onequarter of the time. Half the time you’re down 5% or worse.
Stocks don’t make new highs every single day, so most of the time you’re going to be underwater from your portfolio’s high water mark. This means there are plenty of chances to be in a state of regret when investing in stocks.
This is why stocks are constantly playing mind games with us. They generally go up but not every day, week, month or year. No one can predict what the future returns will be in the market.
No one knows what the future holds for economic growth. And we certainly can’t predict how investors will decide to price corporate cash flows at any given point in time out into the future.
But predicting future risk is fairly easy — markets will continue to fluctuate and experience losses on a regular basis. As an investor in stocks you will spend a lot of time second-guessing yourself because your portfolio has fallen in value from a previously seen higher level.
In a sense risk is easier to predict than returns.
Market losses are the one constant that don’t change over time — get used to it.
Minimising Portfolio Risk
According to Ray Dalio, there are only four things that move the price of assets:
Inflation
Deflation
Rising economic growth
Declining economic growth
And, there are only four different possible environments, or economic seasons, that will ultimately affect whether investments (asset prices) go up or down. Unlike nature, however, there is not a predetermined order in which the seasons will arrive.)
These seasons are:
Higher than expected inflation (rising prices)
Lower than expected inflation (or deflation)
Higher than expected economic growth
Lower than expected economic growth
When you look at the typical portfolio, their is a strong chance that it will do well in the good times and bad in bad times. However, by adapting our portfolio to take advantage of these different seasons to minimise the impact a black-swan event will have on the portfolio.
This chart breaks down which type of investment will perform well in each of these environments:
Proposed Portfolio
The following Portfolio is the new proposed passive portion. It is a leveraged version of Ray's proposed allocation.
This is designed to match a higher risk tolerance by utilising 2x leveraged bond ETFs and as a result has increased my exposure from 100% to 140% of the original weightings.
Furthermore, Small-cap and value factor ETFs were chosen over total market indices as their is empirical evidence from Eugene Fama and Kenneth French that these two classes have tended to outperform the market as a whole. Whether or not this is true is debatable, yet at the very least back testing has suggested it does hold.
Vanguard Diversified High Growth Backtesting Results
To run the performance of this portfolio, i have back-tested using Portfolio Charts. For Comparison's sake, VDHG results have been Backtested to provide context to the validity of this portfolio. The below assumptions have been made
Time Frame 1970 - Present (49 Years)
Proposed Portfolio Backtesting Results
The below assumptions have been made
Leveraged Backtest but does not include financing costs, therefore my return is expected to be lower.
Time Frame 1970 - Present (49 Years)
Does not take into account currency fluctuations, yet these are assumed to be near neutral over time if i dollar cost average.
Conclusion
The proposed portfolio is one that is much more robust and properly diversified than VDHG as it can flourish in any economic environment. Therefore, draw-downs are very minimal and returns are consistent, leaving me with a smoother ride at little to no sacrifice.