Since I've decided to allocate the majority of my future savings into ETFs, I needed to craft an asset allocation that will:
- Grow enough to meet my future needs.
- Have gentler drawdowns than the overall U.S. stock market.
- Avoid lost decades.
- Avoid bubbles that take down the entire portfolio.
- Allow me to remain sane as the markets bounce around and as different asset classes do better than others.
- Beating the S&P 500 is not the goal, though it wouldn't be unwelcome either.
I've settled on an arrangement I'm calling the Wiseguy Portfolio.
There are two versions. The first is a more aggressive allocation with 75% stocks and 25% protective assets:
- 25% Small Cap Value
- 25% Ex-US Small Cap Value
- 25% U.S. Large Cap Growth
- 20% Long Term U.S. Bonds
- 5% Gold
The less aggressive version is a 60% stocks to 40% protective mix:
- 20% Small Cap Value
- 20% Ex-US Small Cap Value
- 20% U.S. Large Cap Growth
- 30% Long Term U.S. Bonds
- 10% Gold
The Wiseguy name is a crack at myself for trying to out think my emotions. I'm both trying to have strong exposure to factors that the evidence suggests will work over time (small, value, international), while also second guessing that because of my inevitable sense of FOMO around missing out on things like American growth stocks and the occasional big gold move.
U.S. Small Cap Value
Image: the absolute dominance of small cap value since 1972.
There are several reason to include a small cap value tilt in a portfolio:
- Both value and size are factors that tend to lead towards outperformance over time.
- By its very nature, it's unlikely to enter a bubble. If some companies grow more quickly than their fundamentals, by definition, they will leave the small cap factor, the value factor, or both.
- Even when it's not outperforming, its performance is likely to be good enough for my goals.
The downsides are:
- Drawdowns can be nasty. For example, the March 2020 drawdown for the overall U.S. market was 20%, but for small cap value it was 35%.
- There's no guarantee that small cap value outperforms ever again.
However, the bet is asymmetrical: if small cap value doesn't outperform, the likely worst that happens is that it performs well enough for my needs, likely in line with the market over time. The inverse is not automatically true.
ETFs: AVUV, DFSV, VBR
Ex-US Small Cap Value
Everything written above about U.S. SCV applies to ex-U.S. SCV as well, with the added wrinkle that it's not U.S. companies. Depending on your point of view, that's a good thing or a bad thing. Let's take a look at some factors to consider:
- First, like the United States, small caps outside the U.S. tend to outperform the total ex-US combined stock markets.
- Ex-US value tends to outperform the broader ex-US market as well.
Image: a comparison of $10,000 invested in ex-US stocks (blue), ex-US small cap (red), and ex-US value (yellow)
- The world stock market without the U.S. stock market has been under performing for years now.
- In the past it has outperformed.
- It is unlikely that the United States stock market will outperform in perpetuity.
Image found here from Reddit user /u/misnamed
- Some exposure to ex-US stocks, therefore, is a logical bet to make, and within that broader category, small cap value is probably the best place to focus.
Even with this 25% allocation, the Wiseguy Portfolio is heavily U.S. weighted. But if the rest of the world ever does outperform the United States, this portfolio will capture some of that performance.
I'll also add: the dividends from companies outside of the U.S. are often very good. They come in fits and bursts, and it's rough for your taxes, but you can get large cash flows in some years.
Image: shows the dividends from a portfolio with a $500 monthly dollar cost average into Dimensional's international small cap value fund in blue vs the Vanguard S&P 500 fund in red.
ETFs: AVDV, DISVX, VSS (no value aspect)
U.S. Large Cap Growth
Similar to the Weird Portfolio, I was considering sticking with small cap value for my stock allocation. If small-cap value works as it has in the past, it can carry a portfolio, even when adding in heavy allocations to safe assets like bonds.
However, that just didn't feel right to me. Since one of my goals with this portfolio is to avoid feeling FOMO - which I hope will help me hold on in difficult times - having zero exposure to the most high profile stocks feels intellectually possible but practically impossible. In periods where the market does well and beats everything else, I want to at least feel like I'm part of it. Otherwise, I might just give up and buy the S&P 500.
The risk with growth is bubble risk. Investors extrapolate good news to infinity, and no price becomes too high. These bubbles can take years to work out (see Japan and the dot-com bubble). Many argue that we're currently in a bubble, and the poster child for this fear is the growth stocks, many of which have plunged in value over the past year after having exploded higher in price and valuation over the prior year.
That said, there's value to these bubbles if you can rebalance out of them. As the bubble forms, it provides an area of relative outperformance within a portfolio, which can then be rebalanced. When the weaker parts of the portfolio eventually outperform, they are in a good position to take over as the previous winning assets starts to decline.
With both growth and value, there's a timing risk inherent in buying one strategy at any given time. Growth sometimes does better, and sometimes value does better. If you get it wrong, you're going to be looking at major underperformance that may be difficult to recover from. Therefore, mixing the two with a strong tilt towards value strikes me as a compromise. I don't know if we're entering a period of value or growth outperforming, so I'm hedging my bets here.
An obvious question is why not just buy the S&P 500 for this asset? I originally looked at this, but after tinkering, it became clear that it wasn't different enough when compared to a pure growth fund. The S&P 500 is loaded with growth stocks to be sure, and it definitely goes along for the ride on bubble misadventures. But it also has value stocks as well as stocks that aren't really one or the other. Since I'm trying to capture a rebalancing premium, I wanted the factors to be as different as possible. Using large cap growth as opposed to overall U.S. large cap (which is what the S&P500 is basically) was a purer way to capture this difference.
ETFs: VUG, QQQ
Long Term Bonds
Image: a comparison of a 100% stocks portfolio to a 60/40 and 40/60 portfolio. Notice how bonds smooth the ride, and stocks alone have trouble outperforming forever.
I view long-term bonds as serving three goals:
- One, they usually reduce the severity of drawdowns.
- Two, they provide interest income.
- Three, they provide an asset to rebalance into in times of strong stock growth and as a source of funds to rebalance out of during stock drawdowns.
Bonds are not the primary return vehicle in the portfolio, but because they often zig when other parts of the portfolio are zagging, they serve a useful purpose.
The arguments against holding bonds are compelling if not entirely convincing:
- Interest rates are at all time lows. Therefore, the return from bonds will be paltry.
- In 2022, bonds have dropped alongside stocks. Where is the drawdown protection in that?
Both those things are true, but I allay my fears with a few reminders. Yes, interest rates are low, but we have no idea what the future will bring. They might continue to go lower over the long term. Should they rise substantially, the limited 15% position should be protective. Since I'm a net saver over time, future purchases at higher yields are advantageous.
Second, bonds have dropped alongside stocks, but a total bond portfolio (such as ETF:BND) has dropped less. Long term bonds, admittedly, have underperformed the S&P 500 this year, but this is also an outlier drawdown year for bonds. I'm not making this portfolio for 2022 alone. It's supposed to do well enough over various regimes without impacting growth too much. There will come a day when bonds counteract stock drops as they have in the past.
Why long-term bonds (a mixture of corporate and treasuries) rather than just long-term treasuries? In my backtests, a mixture does well. Sometimes a mixture beats treasuries alone and sometimes not. Part of this is my increasing distrust of the U.S. federal government. Despite that, long-term treasuries alone will likely serve just as well.
And why long-term bonds rather than total bonds? Right now, I view my time horizon as long-term. Long term bonds tend to outperform total bonds over the long-term with greater volatility. Big surprise. It may be that as I get older, allocating a larger portion to short-term bonds or a total bond market will make more sense. But today is not that day.
ETFs: BLV, TLT, VGLT
Gold
Image: compares a 100% gold position (blue line) to 100% U.S. stocks (red line) and a 50/50 mix of the two since 1972 (yellow line). Notice the lower drawdowns and more steady rise of the mixed portfolio.
The 5% allocation to gold is a "What if?" allocation. When looking at a performance chart of gold compared to stocks, gold tends to have idiosyncratic performance that makes it an ideal rebalancing vehicle. It can outperform during periods of great financial distress and in inflationary periods. To have no gold at all risks missing out on this performance when the rest of the portfolio may be experiencing extended drawdowns. Since the Wiseguy Portfolio has "keep me sane" as a prerogative, I would hate to leave it out entirely.
That said, I won't ever hold an outsized proportion of my net worth in gold. It is an unproductive asset that requires basic supply and demand dynamics to work in the holder's favor. It will send me no dividends, and gold has no management that is trying to improve it. It is an element that has certain inherent qualities that we humans believe have value. That's why I'm limiting it to 5% in the riskier portfolio and 10% in the more risk-averse portfolio. I personally can't bring myself to approach the heavy allocations to gold that the Permanent Portfolio and the Weird Portfolio have.
ETFs: SGOL, GLD
Performance Characteristics
(Image: a backtest since 1995 using the most approximate funds that I can. In this scenario, the riskier version (red line) has returned 9.99% annually while the risk-averse version (blue line) has returned 9.56% annually. The risk-averse version's max drawdown however was limited to -33.65% while the riskier was down 41.17% in 2008-9. Both had lower drawdowns than the S&P 500's 50.97% and higher than a 60/40 portfolio's -15.06%. The safe withdrawal rate of this backtest is 9.7% and the perpetual withdrawal rate is 6.97%.)
It's hard to get a precise long-term view of how the portfolio will do. Each element will behave differently depending on the environment. In the 90's, the bonds and growth stocks would have done very well, while the international ex-U.S. stocks would have muted growth. In the 2000's, small-cap value, ex-US, and gold would have crushed growth. The 70's were like the latter, and the 80's were a mix, since ex-U.S. stocks were strong then.
Since 2009, the Wiseguy Portfolio has underperformed the S&P 500. So has practically everything else except for some individual stocks or pure growth strategies. That's just the kind of environment it's been, and after you stare at these charts long enough, it becomes clear that environments change. Some day, U.S. stocks and growth stocks won't be the dominant force they've been since the Great Recession, and I believe the Wiseguy Portfolio will do well in those environments while not doing horribly in strong growth environments.
With that, I hope the Wiseguy Portfolio and this article have at least whetted your appetite to consider your options more broadly. Wish me luck, and I wish you luck on your progress.
