In this third and final part of our series, I want to show you how to build an evidence-based portfolio.
As a refresher, in part 1, we talked about what evidence-based investing is.
We said it is mostly a passive strategy made up of stocks and bonds.
We talked about the factors the evidence show exist that offer the potential for higher expected returns.
Part one focused on stocks.
In part two we talked about the role of bonds.
We said that federal, state, and local governments all issue bonds. Corporations issue them as well.
There are two factors available in the bond market – term and credit.
Like stocks, bonds have risks.
If you haven't read parts one and two, I encourage you to do that before moving forward.
Know your purpose
Not surprising that with a title of Money with a Purpose and a tagline saying “Knowledge to Help Align Your Money with Your Life” that I'd start with that, right?
Here is why this is SO important.
Any investment strategy needs time to work. An evidence-based approach is no exception.
In fact, I would say time is more critical in this style.
The best way to give your strategy time is to have it tied to a goal.
That could be to fund kids college, to build wealth for retirement, or to provide for early financial freedom.
If your portfolio matches a personal goal, you are more likely to stick with it.
Don't focus so much on returns
There will always be someone you talk to or something you hear or read that will make you think you're not doing well.
That brings in FOMO (remember? fear of missing out). FOMO is at the root of many bad decisions.
If you're looking at returns and not your progress toward a goal, it's a recipe for disaster.
Every portfolio should have a purpose and a goal. Each goal needs a targeted date for completion.
The portfolio for each goal may look different from each other. They may be the same.
The goal needs to align with your values.
If those align, your odds of success will be higher.
Assessing the risk of investing is a controversial subject loaded with opinions.
How much risk is enough? How much risk is too much? What risk measurement method should you use?
How much risk is enough
The simple answer is enough to provide the return that will help you reach the goal you're trying to achieve.
I don't say that flippantly.
You start with the goal and the time frame.
The goal has a dollar amount you've decided you need. It also has a time set when you need to use the money (or begin using it).
When you have both of these settings, you can work backward to determine the return needed.
You would then measure the risk involved to achieve that return.
Let's look at an example.
We'll assume you want to have $250,000 in twenty years and $50,000 to invest today.
To reach the desired $250,000 in twenty years, you would need to have an annual average return of 8.38%.
Here's what a portfolio might look like to get that average return.
This chart from Vanguard, offers a look at the average, best and worst years. Looking at the worse year provides a look at the risk.
Ask yourself how you would feel if you saw your portfolio fall by 22.5%. To put it in dollar terms, if you had $100,000, your value would drop to $77,500.
How would that make you feel?
If the drop in value makes your stomach queasy, it's likely you will bail on your portfolio when times get rough (and they will!).
And you've failed what I call this the stomach test.
I realize this is an oversimplified example. But it's the type of analysis you want to do when deciding on your portfolio.
Personal Capital is a great free tool that can help you do this.
Build an evidence-based portfolio
Now it's time to put it all together and learn how to build an evidence-based portfolio.
A market-based portfolio should have a global footprint.
As of the end of June 2018, the world markets looked like this:
US Stocks – 53%
International Developed Stocks – 35%
Emerging Markets Stocks – 12%
A good market-based portfolio would match those percentages.
However, most people, especially in the US, would never be comfortable having that much invested in foreign stocks.
It's common to have a “home country bias,” meaning investors would have more than the market percentage in US companies.
That may be 60% US and 40% foreign. Or it could be a more conservative mix of 70% US and 30% international.
Most investors carry less than half the market weight in emerging market stocks, usually in the 3% to 5% range.
Choose your investment vehicles
Will you use individual securities or mutual funds and ETFs to build and implement?
My advice is ETFs and mutual funds.
It's extremely hard to get enough stocks and bonds to achieve the diversification needed to implement the strategy.
Individual securities are much more challenging to implement and time-consuming to manage.
Also, with asset class and index funds, you know what's in them.
That makes it much easier to complete the asset classes for your portfolio.
Actively managed funds, on the other hand, are more difficult.
Because performance gets measured against an index, managers often go outside their stated stock selection criteria to chase higher returns.
The result is finding securities outside of what they're fund is supposed to own.
For example, you might look at the holdings of a large-cap fund to find small and mid-cap stocks make up a significant percentage of the stocks.
If you're building an asset allocation portfolio (which is what we're talking about here), owning a large-cap fund that adds stocks outside of that asset class can throw off the targeted allocation (more on that shortly).
That's why I say it's always best to use asset class or index funds. They will stay true to what they're supposed to be.
Ok now on to the next step.
Choose your level of risk
Start with a high-level baseline of how much you want in stocks and bonds.
Typically, you would build your portfolio in increments of 10%.
Here's an example:
As a starting point to measure your risk, use the Vanguard portfolio allocation models to get an idea of the worst case scenario.
Let's say you're looking at a 60/40 mix as a starting point. The worst one-year performance for that mix in the Vanguard list for this mix was -26.6%
So, your $100,000 investment is now worth $73,400.
Now check yourself.
Does that number freak you out?
What if your portfolio is a $1 million? It's now worth $734,400.
Spend some time diving into these numbers before deciding to move forward.
Once you're comfortable, it's time to look at the sub-asset classes and apply the factors.
Sub-asset class selection
The sub-asset classes are secondary categories within stocks and bonds.
I'll summarize, talk about why they're important, and offer a sample allocation.
Below is a table of the sub or secondary asset classes:
|U.S. Market Equity|
|U.S. Large-Cap Neutral|
|U.S. Large-Cap Value|
|U.S. Small-Cap Neutral|
|U.S. Small-Cap Value|
|International Market Equity|
|International Large-Cap Growth|
|International Large-Cap Value|
|International Small-Cap Growth|
|International Small-Cap Value|
|Emerging Market Equity|
|Emerging Markets Large|
|Emerging Markets Value|
|International Real Estate|
|Real Estate (directly owned)|
|Short-Term Fixed Income (includes cash/money market)|
|Intermediate-Term Fixed Income|
|Fixed Income — Inflation Protected|
|Short-Term Fixed Income|
|Intermediate-Term Fixed Income|
It is by no means necessary to have money in all of these sub-asset classes.
There are core funds available that offer exposure to many of these asset classes.
Vanguard's Total Market Index fund (VTSMX-mutual fund, VTI-ETF) includes all of the US asset classes. It has over 3,600 stocks that represent large, small, and mid-cap stocks in both value and growth styles.
It's a market-weighted index. You could choose this fund as a core holding for your US broad market stock allocation.
They have a comparable international total market fund (VGTSX – fund, VXUS-ETF).
I would urge caution in considering the VGTSX. As of 6/30/2018, 20.8% of the stocks in the fund were emerging market stocks.
My suggestion is to use a separate emerging market fund to gain exposure to this asset class.
If you take this approach and own a total international stock fund, whether Vanguard or another, be sure to include your emerging markest from this fund when you calculate the total.
Either way, run the stress test on the end product.
Please understand I'm not recommending any of the funds I mention here. They are meant to offer examples of the types of funds you might use.
You should always engage in careful due diligence when choosing funds for your portfolio.
Incorporating the factor premiums
The final piece of the assembly process is to determine whether you want to incorporate the factors identified in Part 1.
In summary, the three main factors are the market premium (stocks > bonds), the value premium (value > growth) and the size premium (small > large).
The market premium is the easiest to capture.
Go back to the chart from Vanguard and look at the risk/return for each percentage of stock exposure.
To capture the value and size premiums, you would add more money to those asset classes.
That money would come out of the overall stock portion.
Same for the value premium.
You would replicate this for the international and US markets.
Here's an example of how that might look.
Looking at the US allocation, you see 13.2% going into a US marketwide portfolio (ex. VTI). That covers the entire US market as described earlier.
The second allocation to US stocks is in the small-cap value asset class.
Doing this adds significantly more money in the small-cap value class. A couple of examples are VISVX-Vanguard, and JKL – iShares.
You will also notice an additional percentage allocated to the large value category.
The purpose is to capture potentially higher expected returns from the value premium. Fund examples are Vanguard large value – VTV and iShares large value – JKF.
You would follow the same exercise in the developed international markets.
It's also possible to capture small value in emerging markets. I typically don't recommend it.
The risk is not commensurate with the reward over a core emerging markets fund.
That's just my opinion. I've seen it done both ways.
Rebalancing – the final piece of the puzzle
Referring to the allocation chart, you will notice three columns with percentages.
The center column, labeled strategic, represents the targeted percentage of your money in each listed asset class.
The minimum and maximum numbers on either side of the target represent the rebalancing triggers.
You set these triggers to keep the targets within a range. In this example, the range is 25% on either side of the target.
Using the US market equity as an example, if the funds in that class grow to above 16.5% or drop below 9.9%, you would at least consider rebalancing.
However, be careful with this.
That's a significant one day drop.
Depending on how it impacts your funds, it could cause one or more of your allocations to be outside the minimum or maximum range.
My advice and practice are to be slow to engage in rebalancing so close to the upper and lower ranges.
After most steep one-day or even multiple days of falling markets, the dust settles, and the market reverses those losses.
Waiting it out saves transaction costs and the headaches of buying and selling.
The point of the exercise is to have a system in place to manage the rebalancing.
Five benefits of rebalancing
- Can give you piece of mind – Having a system in place to manage the ups and downs of the market means you don't have to look at your portfolio every day (at least it should). Knowing this should allow you to stay much more calm about your portfolio.
- You will systematically be buying low and selling high – And isn't that the key to successful investing? You may not have the money to buy a few billion dollars of Goldman Sachs and a few other companies like Warren Buffet in 2008. But you will be selling funds that have gone above their limits and putting money into additional funds whose value has fallen.
- You will better manage your risk – I have to admit that this is probably the hardest one to get your head around. Selling what looks like winners to buy what appear to be losers seems counterintuitive. However, if you follow this discipline, your portfolio will stay within the risk levels you decided worked for you.
- It will be easier to stay on track for your goals – As I said earlier, portfolios need to match a goal. Otherwise, the temptation to chase some arbitrary return may cause you to make bad decisions and make unnecessary changes to your investments.
- I will be easier to get through bad markets – Why? you have a system in place to manage it. Those who had a system in place during the last financial crisis came out much further ahead than those who didn't. During that time, money poured out of stock funds and into Treasury and other government securities. Those with rebalancing in place did just the opposite. They were buying stocks and funds during that time while selling the fixed income that went up. That's a textbook example of why it works..
No system I know of is foolproof.
An evidence-based investment strategy is no different.
Emotions can still bring panic.
It was extremely hard to stay disciplined when everything around you was saying the world as we know it is coming to an end.
That's the way it felt in 2008.
And you can certainly build a good portfolio without the factors and premiums.
The evidence-based portfolio is another tool in the toolbox of personal finance and investing.
I hope you learned something from the series. Even more, I hope it helps you become a better investor.
If you take away nothing else from this series, I hope you will consider these two crucial points.
- Any portfolio you choose should be tied to a purpose – a goal. The longer you have to achieve that goal, the more aggressive your portfolio can be. At the end of the day, though, you must be able to stay disciplined in the strategy when the bottom falls out.
- Put a system in place to get you through the bad times – There are several ways to do that. Having a substantial amount of liquid cash will help a lot. Having a rebalancing strategy and system in place to help manage the emotions during the turmoil will also assist in staying disciplined.
Following these two things regardless of your investment strategy puts you in a better position to be a successful investor and reach your goals.
Now it's your turn. Do you have a system in place? If someone asks, can you tell them your investment strategy? Have you stress-tested your portfolio?
Let me know in the comments below.
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