I don’t know about you, but the last few months have been some of the wildest and most newsworthy I can remember. From a global pandemic and ongoing social unrest on one end to an incredibly inspiring SpaceX launch and emerging hope for a better world on the other, the roller-coaster of emotions has been all over the map. It’s unpredictable, intense, and at times utterly exhausting.
And the markets have clearly mirrored that crazy ride. It seems like only yesterday that I was writing an article cataloging one of the single worst months to invest on record, but the market has since roared back far faster than even the most optimistic investors expected. That encouraging development seems to have changed investing mindsets a bit, spurring a curious reader to pose an interesting forward-looking question:
What are the portfolios that tend to do better after a crisis?
While I don’t have a functioning crystal ball, I do have a ton of historical data at my fingertips. So let’s dig in and see what we can learn about portfolio recoveries.
As the entire world locks down in reaction to the ongoing coronavirus pandemic, our number one concern as a group is mutual solidarity in saving lives. But the ultimate impact of the tiny COVID-19 virus extends so far beyond the immediate health toll. The disruption to our global economy required to prevent its spread is having profound, deep-scarring effects on the everyday lives we take for granted. Entire industries are closing their doors, countless people are losing their jobs, and any short-term treatment for the disease may simply be a prelude to a much longer financial road to recovery.
So as we shelter in place taking care of our families and waiting for the worst to pass, it’s natural to count not only our stock of food in the pantry but also our collection of stocks in the market. No matter how you invest, I wager it isn’t pretty. It’s not just you. There’s no hiding from the turmoil, and we’re all feeling the pain.
The resulting anxiety prompts normally self-confident investors to suddenly get very curious about how others are doing in the same situation. I get it. So let’s talk real numbers and put the current financial crisis in perspective for different types of portfolios.
Something must be in the financial water lately, as even the most bullish investors have started publicly expressing worry about the stock market finally reaching an unsustainable climax after more than a decade of record growth. With increased stock volatility, inverted yield curves, and global trade worries all making news, the economic tension is palpable to the point that the dreaded R-word is starting to get some significant buzz.
Are we headed for a recession?
Recessions get people worked up for a variety of reasons. For example, the events of 2008 decimated the stock market, cost scores of people their jobs, forced many leveraged buyers out of their homes, and nearly upended the entire financial system in the process. While there are many factors that contributed to that turmoil beyond the recession that came with it, it’s true that recessions tend to coincide with a lot of negative financial events. So it’s understandable that anyone who lived through the situation might be worried about a repeat and walking on eggshells given current market sentiment.
I’m not going to pretend that I have all of the answers for every problem associated with recessions, nor am I going to claim I have any idea when the next recession will start. But as a long-time student of portfolio history I’m in a pretty decent position to bring something to the table when it comes to how to structure your investments to weather the inevitable storm. So rather than just peddle in the typical doom and panic, let’s study something productive.
Which portfolios performed the best in recessions, and what can we learn from them?
As I blindly swung my arm to swat at the tedious drone of the alarm on the night stand, it was pretty much a morning like any other. I labored out of bed, trudged my way through the early routine on autopilot, and set out on my long morning commute down highway 280 towards San Jose. I always found that stretch of road to be an interesting experience in dual realities, as the stunning views of the bay and surreal scene of clouds pouring over the mountaintops were all too often completely hidden by relentless inner thoughts of important job tasks needing immediate attention. Silicon Valley attracts a certain type of always-on engineer and actively feeds their obsessions, and my blossoming career as a successful product designer at a job I loved had long since shaped me into eager, if anxious, submission.
Generating accurate and intuitive charts to help you navigate the professional asset allocation landscape is pretty darned rewarding, and I take a lot of pride in contributing to everyday asset allocation discussions in my own data-driven way. I also spend a lot of time reading those same discussions online, as not only does it help inspire new ideas but it also helps me understand what drives people. Everyone’s motivations are different, and when you put your life savings on the line the stakes are also quite high so people tend to really tell you what they think.
While that variety of strong opinions makes the financial blogosphere particularly difficult to navigate for new investors, I personally find the abundance of different perspectives a fascinating design challenge. That’s because beyond simply crunching numbers like a good engineer, I’m also a designer at heart and love solving complex problems and bringing new ideas to the table. The Golden Butterfly is one such example, but I don’t believe there’s one perfect way to invest and my problem-solving circuits are always scanning for new ideas to help people find an asset allocation that resonates. So in that spirit, today I want to talk about a new portfolio idea that based on all I’ve read I think a lot of people may find helpful.
Yale University recently released their 2017 annual report for the Yale Endowment, and while normally this would pass without much notice they appear to have made a few waves by continuing an ongoing feud with Warren Buffett. In his 2016 investor letter, Buffett criticized how university endowments pursue market-beating returns through active management and suggested they might be better off investing in index funds instead. Of course the CEO of Berkshire Hathaway follows none of that advice himself, but he has consistently said that most investors including his own wife would be better off with a low-fee S&P500 index fund rather than paying expensive active managers so it’s certainly not out of character. In any case, Yale appears to have taken that a little personally and they dedicated an entire section in their annual report to dispute his claim and promote their own success.
To support their belief in active management, Yale provides data that proves their managers have exceeded stock market returns for the past two decades. For example, over the past 20 years they posted an average return of 12.1% versus 7.5% for the total US stock market which gives them confidence to say they “crush the returns produced by US stocks”. Ending with a flourish, they conclude that “not only has the model worked for the past two decades, it will work for decades to come.”
That’s bold. And it caused a bit of a tizzy in the financial blogosphere with several stories on the topic. So are they right?
I went shoe shopping today for the first time in a while, and I forgot just how frustrating it can be. Finding a nice pair of shoes seems like it should be a pretty simple task these days, but the number of options makes it much more difficult than you’d think! It’s kinda surreal to walk through aisles and aisles of shoes and immediately dislike about 90% of them for one reason or another, and even the ones you like may not be that comfortable once you try them on. Buying shoes can be a real pain.
Well if you think about it, finding a good portfolio is a similar experience — there are lots of good options but very few easy answers. I do my best to curate some of the best options to avoid the cheap knockoffs likely to wear a hole in the sole on the first walk, but just like there’s no one pair of shoes for every person there’a also no single best portfolio for every investor. So you’ve gotta try them on for yourself.
I once knew a guy who was really into woodworking. One of the more fascinating things about him was that he not only made his own furniture but also was quite proud of his collection of hand-made woodworking tools. I once asked him why he preferred those tools to mass-produced alternatives. Among several reasons, “They do what I want”.
Some casual investors may wonder why I spend so much time investigating things like modeling mid caps and figuring out how to measure the error of older international bond data in backtesting calculations. While I certainly find this kind of information intellectually interesting, I admit that it sometimes becomes a chore and I can see why most people steer clear. The upside to all the groundwork, however, is that it expands my collection of tools and allows me to do what I want — explore interesting portfolios previously off limits simply due to lack of data.
Like, for example, the 7Twelve Portfolio.
In the late first century, a Latin poet named Juvenal described something thought to be unlikely as “a rare bird in the lands and very much like a black swan”. At the time, black swans were thought to not exist at all and the idea was preposterous. The clever turn of phrase was both memorable and descriptive, and by the 16th century “black swan” was a common expression in London to describe the idea of impossibility. Of course there was a looming problem with this saying, and in 1697 Dutch explorers discovered that black swans really do exist in western Australia. What once was used to describe something impossible quickly changed meaning to connote ideas thought to be impossible that are later discovered to be real.
One of the most influential authors in modern financial theory is a man named Dr. William Bernstein. His background is particularly unique, as one might be surprised to learn that his Doctor title was earned in medicine rather than finance. I personally believe it’s precisely this outside perspective, intelligent but abstract, that uniquely prepared him to explore portfolio theory in such interesting new directions. I’ve long admired his work.
Regular readers will certainly recognize his name, as the Bernstein Portfolio has been a staple on the site since the beginning. His writings on Efficient Frontiers are also an inspiration for the Portfolio Finder, and I’m sure he will continue to provoke new thought in the future.
While I’ve always taken great pride in spreading the word about the Bernstein Portfolio, the difficult thing about reducing his nuanced insight into a single portfolio is that it does not necessarily represent the full breadth of his ideas. While a staunch advocate of simple, low-cost index investing, Dr. Bernstein is also a pioneer in factor investing that explores how different types of indices can work together to improve the risk-adjusted returns of a portfolio. There’s more to his story than the simple Bernstein Portfolio.
So in the spirit of spreading the word about Dr. Bernstein and his work, I’ve added a new portfolio of his to the site — the Coward’s Portfolio.