Inflation Bites: Action vs. Acceptance

Image: Consumer prices in Germany broken out by sector, from Destatis

When I woke up this morning, it really hit me for the first time: we aren't in total control of our expenses. I kind of freaked.

Electricity

In the past month, we've been hit with two disturbing price increases. First, we were hit with a price increase for our electricity. It's gone from 31.345 cents/kWh to 39.827 cents/kWh, which is a 27% jump. It would be even worse if we changed contracts, since existing customers get slightly better deals than new customers, so there's nowhere to run.

Right now, we're trying to get our electricity use under control; shorter more precise showers, bulk food prep, and turning electronics off and unplugging them are some of the steps we're taking. So far, it's only made a slight difference.

I've considered buying more efficient electronics (a new stove or refrigerator), but would these new objects actually pay for themselves fast enough to be worth it? I doubt it.

Rent

Even worse, our rent was raised by 17%. Back when we signed our lease, we agreed to have our rent tied to the Verbraucherpreisindex (the German consumer price index). The landlord explained this to us, and I even remember him telling us, but I didn't totally understand what it meant because, well, not understanding everything you're hearing is just part of the immigrant experience¹.

However, I didn't really understand what I was signing. I feel both like an idiot and like I'm sitting on a time bomb. If inflation continues rising in Germany, we could not only be priced out of our existing apartment, but we could be priced out of our neighborhood entirely, forcing us to downsize our living space and move much further from my employer.

German housing sucks right now. I looked around the city to see what prices are like for buying apartments and houses, and it's all bad news. From an American perspective, houses are laughably small and are often comparable to apartments in terms of actual living space. However, they are still expensive and often situated away from good public transport.

Apartments are probably a better option, but they come with mandatory building expenses and neighbors. To be fair, both apartments and houses are often joined to a neighbor's structure, and although I'd like to have some real privacy, privacy is out of our budget.

Let's not forget that mortgages have also gotten more expensive, so previously affordable mortgages are now priced out. Naturally, my German savings account still pays me nothing.

Running the Numbers

As I mentioned in a previous article, you take a huge loss up front when you buy property here. If we saved up €50,000 for a down payment on a place, it's likely that most of that would just go to the Grundsteuer, the Makler, the registration costs and so on. It's a pure loss up front, and it's the kind of thing that leads to sunk cost fallacies: no matter how much I'd want to make a life change, I'd always have this huge expense in the back of my mind.

So I'm trying to look at the numbers rationally and chill out. The rent increase is about 112 EUR. Divide €50,000 by €112, and that's 446 months or 36.16 years. So does it make sense to spend €50,000 to save myself from 36 years of this rent increase?

No, damn it, it doesn't make sense².

Remodeling as Further Disincentive

Another number to consider: if we moved, we'd likely have to remodel in some fashion. German houses and apartments often come without floors, for example, or toilets or kitchens. All of that costs money. So let's say we moved and remodeled, and it cost us €20,000 on top of the €50k we already spent on taxes and fees. That another 178.57 months of this rent increase or just under 15 years.

The risk, of course, is that this isn't the only rent increase. The German CPI jumped by 17% year over year in May, so let's extrapolate into the future. If rent increased again by 17% from our new level, that would be a €129.61 increase. Combined with the previous raise that's a €242 additional payment. So €70,000/242 = 289 months or 24 years. So would it make sense to save and then spend €70,000 up front in order to spare myself 24 years of a worst case scenario rent increase?

I don't think so. But now I'm less certain. And if it happened for a third and fourth year in a row, the numbers start to get worrying very fast. I have to remind myself however, that even if we owned a place, a world in which prices are rising by 17% every year is a world where we're still on the hook to buy things that are increasing 17% every year. If a water heater breaks or if the roof needs repairs or whatever, that would be on us.

I don't have a good answer, and I think I'll have to live with that. My hope is that our incomes will also rise to meet this new challenge, but I can't guarantee it.

Accepting a Loss of Control

Image: various price changes from Destatis

I'm not happy with it, but I have to live with being out of control to some extent. Otherwise I'll drive myself crazy. We do have control over some things, such as our groceries, which have also gone up in price. In that realm, we still have some maneuverability, so we'll have to do what we can there to feel like we have some power.

Hopefully, this doesn't go on forever. And hopefully, I won't be writing a similar article a year from now, chastising myself for not seeing the signs of impending doom via inflation and taking decision action. I'm not sure what action is best besides trying to earn more and spend less.

I'm sure you're feeling some pain from inflation. This is a difficult period for everyone. Just make sure you look at the numbers before taking some kind of drastic action to save yourself from it. It might not be worth it.

---

1. This is a relatively new method for German landlords to extract higher rents since the default method is for rent increases to be determined by the city. ↩︎

2. I would like to own property one day, but the upfront costs continue to dissuade me from going too far down this path. ↩︎

May 2022 Update: Net Worth, Pension Valuation, Crypto, ETFs

In May, our month over month net worth declined by .73% in USD and 2.31% in EUR to $122,613 and €114,165 respectively. Our liquid net worth was $89,945/€83,747 after closing on the last day of May.

May was a surprisingly busy month. Some major changes:

• I've valued my defined benefit pension and added that to the illiquid part of our net worth.
• I've exited all cryptocurrency positions.
• I've transferred a sizable amount of money away from individual stocks to my so-called Wiseguy Portfolio.

Valuing a Pension

Defined benefit pensions are still a thing in Germany, and since I've been working here, I've been steadily adding value to mine. My employer has never mentioned my pension to me (which is just baffling), but I can see the withdrawals from my paycheck every month, and the pension plan custodian contacted me shortly after moving here. I knew it existed, but it's only been the past few years that I've paid much mind to it.

The pension works like an annuity:

• My employer and I both pay 50/50 into the plan.
• The contributions are payments for promised future income streams.
• The income I can expect from each contribution is the contribution amount multiplied by an annuity rate, which is - I believe - calculated by combining my expected retirement date, current expected returns, and life expectancy. This exact formula is opaque, but they publish their annuity rates regularly.
• If I die before my wife, she's entitled to half the annuity stream until her death.
• The payouts are adjusted by cost of living changes. Theoretically, there's not much risk from inflation.
• I am required to pay into this plan as long as I'm working within this career.

Every year, the pension provider sends me a letter telling me the previous year's contributions and my expected yearly pension. From that I can divine a value of this income stream.

To do that, I first value the income stream as if I were about to enter retirement. That's done by using a present value calculation, which discounts future cashflows to a start date. My assumptions are a 2% discount rate (debatable), and my life expectancy limits the years of payments (also debatable).

That value then gets discounted to today. For that I'm using the years until my legal retirement age as the number of periods, and I'm using the 10-year Treasury bill as the discount rate.

All this adds up to a value that is much less than the value of the contributions that my employer and I have spent on this plan. Since I can't touch that money no matter what, it's only a minor intellectual annoyance. But the value of this annuity only really makes sense if my wife and I live well beyond our life expectancies.

Since I'm using fluctuating Treasury rates as my discount rate, and since that discounting process has an outsized impact on the value of the pension today, our net worth has been negatively impacted by the upward movement of interest rates. Had I been factoring in the pension all along, its value would have cratered these past few months.

This is purely a "time value of money" phenomenon and doesn't mean a loss of current purchasing power. However, I want the net worth calculation to accurately reflect how assets and cash flows sources are accruing over time, and similar to valuing a home - the value of which is at least somewhat fictive - this pension should be included. Otherwise it means that the money spent on it is basically lost, which is not the case.

Leaving Crypto

Image: the collapse of Terra was a scary event for anyone in the vicinity of crypto. I feel bad for all the people who've lost money in that scheme.

Crypto is in a world of pain right now, and since it's so speculative, I didn't want to stick around. It's as simple as that. I took a small loss, and the cash helped me buy a present for my wife.

Using ETFs

As I've written about extensively, I'm going to be adding most of my savings to a basket of ETFs that I'm calling the Wiseguy Portfolio. I sold off some of my stocks to get started on this. Some positions were closed entirely, and some others were merely trimmed since they were outsized positions that were larger than I could actually handle when the going got rough.

It's easy to think you can handle a bunch of risk, but it's harder to actually live with the consequences of taking on too much risk. It's better to underestimate what you can handle. Additionally, is extra risk necessary for your goals? Do you need to hit a home run with a specific investment or are steady gains enough?

Increasingly, I also feel like the time spent analyzing stocks is mostly a waste of time. I've been asking myself a lot recently whether I'm getting much value from it. Does the worry pay for itself? Could my ears be doing something more productive than listening to earnings calls? In my daily/weekly/monthly stress allotment, should I be using so much on this one activity?

I went into stock picking because Germany and the United States both had punitive tax regimes towards "foreign" funds. Germany's system has relaxed a lot, and the worst thing about using ETFs is that I need a U.S. broker to whom I'm lying about my actual residence, and I have to keep track of all tax information myself and translate it back to euros (thanks MiFID ii!). But if that's the worst thing, it sure beats the terror of wondering whether company x will ever regain some high price that I was anchored to.

Spending and EOC

Since it's summer, and since that means a lovely European summer break, we've spent some money on vacations. It hasn't been too much, but it's definitely a cost.

I've been re-listening to the Millionaire Next Door, and it's been hitting me differently this time around. I always learn something from it, and this time it has to do with Economic Outpatient Care. Am I spending more than I otherwise would because I get monetary gifts (usually small ones) from my family? Do I feel wealthier than I am thanks to subsidies from family? It's a question I have to untangle, and if I come to any conclusions, I'll share them here.

Until next time, stay healthy, and give your friends and family big hugs.

The Wiseguy Portfolio

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.

VTSAX and No Chill

As I've been debating my ETF allocation, a regular suggestion has been to buy the Vanguard Total Stock Market Index Fund (VTSAX or ETF:VTI) - which holds all the publicly traded stocks of the United States - and buy nothing else.

Aka, VTSAX and chill.

To be sure, this is easy to implement, and it would be exceedingly tax efficient. Buying one fund and never selling is the height of simplicity. And since you're never rebalancing, you don't have to worry about tax costs eating into your gains over time (aside from pesky dividend taxes). Those are real benefits that I'd be stupid to dismiss.

It's also been difficult to beat. The U.S. stock market has been on an amazing run, and while I've been running backtests of different asset allocation strategies, it's been very hard to find strategies that outperform the market cap-weighted U.S. market. Especially in the years since the Great Recession, buying any asset other than the U.S. market has been an exercise in frustration. You have likely underperformed year after year after year. Value has been crushed. Ex-US stocks have gone mostly nowhere. Small caps have had mediocre returns.

Modern FIRE

During this period, the modern FIRE movement got its legs. Obviously, it existed before this great bull run, since the term comes from 1992‘s Your Money or Your Life. However, I believe this modern version with the blogs and internet forums has been aided by this incredible period of somewhat easy returns. Both Mr. Money Mustache and J. L. Collins began blogging in 2011, which was an amazing time to be buying U.S. stocks.

Both recommend VTSAX/VTI as the singular vehicle for investment. As the blue line in the above image shows, they've been 100% correct. Anyone who recommended anything else has been wrong.

But what about now?

Valuation

First, in the early part of the long bull market (interrupted occasionally by short and intense drawdowns), the U.S. stock market was fairly inexpensive.

For one, the S&P 500 had fallen to below its 200 month moving average. I repeat: below its 200 MONTH moving average. This had only happened before after the second crash of the 1970's and (if you extrapolate backwards) in the years following the Great Depression, both of which were incredible times to be loading up on stocks.

Secondly, in 2009-2011, it was possible to buy the U.S. market for CAPE ratios between 15 and 20. Today, however, it's near its second highest ever level:

An easy rebuttal: using the CAPE ratio for the past few years has been dumb. It's been warning for years that the market was expensive, but buying the U.S. market has been the winning trade. Admittedly, that's a fair critique. CAPE is an awful timing tool.

However, for anyone with a "buy and hold" mindset, stocks are long duration assets. That means that we stock investors shouldn't be focused on short term results. And focusing on a few years of outperformance is focusing on short term results. We need to look over time.

Over Time

In that vein, here's a chart that shocked me:

This is a comparison of three portfolios' performance since 1972 with a starting balance of $10,000. Dividends are reinvested, and the portfolios are rebalanced quarterly. The yellow line is U.S. Stocks, blue is a 60/40 portfolio (60% U.S. stocks, 40% 10-year Treasuries), and red is a 40/60 portfolio.

What do you notice?

For one, up to the end of April 2022, U.S. stocks have outperformed the more balanced stock/bond portfolios. Since 1972, U.S. stocks have returned 10.52% annually. 60/40 has returned 9.49%, which is clear underperformance. And when I see comparisons of the 60/40 portfolio to a pure stock portfolio, that's the framing I usually see.

However, that might not be the best framing. If you look at the box over the chart, that's the performance at the bottom of the 2008/09 crash. Notice that at that bottom, the pure stock portfolio had worse performance than the more balanced portfolios. That's 37 years of holding on to a volatile asset class only to be beaten by a much more conservative mix of stocks and bonds.

This makes it clear that we have to question our assumptions about the relative outperformance of one asset class vs. another. If you read my Update posts, you should know that I value my net worth at the end of the month, and I subtract out my freshly received salary. To me, I'm measuring what I've accumulated after all expenses are paid. It doesn't make sense to inflate my net worth if I'm about to spend it down.

I'm starting the view the stock market the same way. There's clearly some kind of cycle that happens over time, and measuring outperformance based on the results in the middle or peak of a cycle leads to lofty expectations. Yes, as of right now, U.S. market cap-weighted stocks are trouncing everything else. But that has been true in the past as well, and it didn't automatically mean that it continued into the future.

Will a pure U.S. stock portfolio's returns fall below a 60/40 mix after two decades ever again? I have no idea. Going back to the beginning of the 20th century, it appears that a pure stock portfolio does eventually pull away from that more diversified stock/bond portfolio. However, we don't know what time scale that requires. And we have to consider the specific events in the early 20th century that might have influenced that result, which we might not be so glad to repeat.

Market Cap Weighting Downsides

Part of the inescapable issue with VTSAX and all such indexes is the market cap weighting. The most valuable companies get the most dollars allocated to them. However, since market caps are driven by more than the business results, this can mean money allocated to the wrong companies at the wrong time. Looking at the largest S&P 500 holdings over time makes this clear: they were darlings for a time, and then they weren't.

Yes, yes, the indexes are eventually self-cleaning, and those companies will eventually become smaller and will get efficiently de-emphasized. Valuations eventually get sorted.

Without a second asset class, though, you just have to wait for that to happen, and you have to live with the volatility and year or decade long reshuffling to correct these imbalances. An upside of even a simple stock bond mix is that you can sell off the stocks as they get too expensive to put into something else. This makes the overvaluation of the market a benefit since it can be sold to buy something else.

That leads to the so-called rebalancing premium, whereby two assets together can outperform either one individually. You can’t do that with one asset all by itself.

We're All Making Bets

If you're buying VTSAX and chilling, you're making a series of bets:

• You are betting that the U.S. stock market is more or less efficient.
• You are betting that the U.S. is the best place to invest.
• You are betting that large cap stocks are basically where the majority of your money should be.
• You are betting that the downsides of rebalancing (taxes and complication) are significant enough to warrant putting all your money into a single asset class rather than diversify.
• You are betting that other asset classes aren't worth bothering with.
• You are betting on positive returns coming from earnings growth that justifies the current valuation.

It's easy to wave this all away by using words like "passive" and "efficient" and "indexing", but you're kidding yourself. You're making a very aggressive bet on one asset class.

It's one I'm not comfortable with. It is possible that I'm wrong. But since the future is unknowable, we have to consider a variety of future scenarios. You pays your money, and you takes your chance.

That’s a long post to say: I won’t be putting all my money into VTSAX. It's too concentrated in one style for my taste.

If you are, then you'll probably be ok. Just realize that the returns you're hoping for won't be smooth, and there may be long long periods of no growth or sideways choppiness that will be no fun. You'll probably also have times where other markets do better, which will tempt you to bail on your strategy.

If you're cool with all that, then enjoy your very simple tax-efficient U.S. stock allocation.

Asset Allocation Conundrum

When I decided to focus on a diversified ETF strategy, I hoped asset allocation questions were settled science.

Nope. Not even close.

Accepting Lower Returns

One aspect of this that's a hard pill to swallow is that it will likely force me to accept lower returns. When I buy an individual stock, my hope is that it will appreciate by 15% a year for the foreseeable future. Naturally, volatility won't make that a smooth ride, but generally 15% is the goal.

Expecting a 15% CAGR when you're allocating to a basket of assets is foolish. After backtesting various portfolio types, it's probably wise to expect a 4-9% CAGR. Some years will be better, but due to overvaluation and volatility, sometimes there's no escaping bad returns. There might be an extended period of 0 return.

If I can get 15% on a stock but only 4-9% on ETFs, then why get the ETFs? Well, it's because the stocks aren't guaranteed to work. Additionally, they expose me much more to my own thinking errors, behavioral mistakes, and biases. Perhaps my analysis is simply wrong or under-baked. Basically, I need some money set aside into broad buckets that will perform well enough in case my stock picking doesn't work out.

That's where asset allocation comes in, and - even accepting lower returns going forward - it's tricky.

Why Not Just Do Something Lazy?

So what would be the, you know, "Ah, screw it" portfolio?

As a baseline, there's J.L. Collins 100% allocation to VTSAX (ETF: VTI). Lazy and easy, and you won't feel a lot of FOMO (fear of missing out) since it's the whole U.S. stock market. It's also very hard to beat:

But what if you want some "hold onto your butts" assets for the scary times? Something like the Bogleheads' 3 fund portfolio fits:

For sure, lazy has a lot going for it. It would be easier for me to manage, and should I get hit by a car, it will be easier for my wife to manage. There are some portfolio varieties that just have too many funds in too many strange percentages. If it requires a computer to manage, then it's probably not the best choice.

And the lazy portfolios don't perform strangely. If you spend years envying the S&P 500, how long can you reasonably hold out before you just buy the S&P 500?

That said, are there ways to achieve slightly better risk-adjusted returns without it becoming too complicated?

International

I should have been prepared for difficult questions since I've been an active listener of Meb Faber's podcast. He has idiosyncratic views about asset allocation. For example, he argues effectively that a global allocation is not only valuable but even dangerously underutilized in many modern portfolios.

To make a long story short, being concentrated in one country in a market-cap weighted portfolio leaves you open to major country risk as well as valuation risk. There will be periods of underperformance, and there's the risk of a total country disruption that leads to a total loss.

What's hard to get over, however, is that international additions to a pure 100% US market allocation have been a performance drag in recent memory. It's one thing to know that allocating all your assets to a single country (even the US) can be risky, and it's another to actually allocate money to underperforming geographies:

Adding international exposure looks like a leap of faith based on the following ideas:

• The US is likely overvalued relative to international markets, which may lead to sustained international outperformance during times when the U.S. is working through overvaluation.
• The existential risk of single country concentration is high enough that putting up with potential lower returns is worth the risk. Countries don't stay on top forever, and whole country's stock markets have gone to 0.
• Adding international adds even more diversification.

With those ideas in mind, I will probably add an international component.

Drawdown Protection Portfolios: 60/40, Weird, and Permanent

If I want lower drawdowns in a lazy way, there's not much lazier than the 60/40 or 40/60 portfolio:

One of the accounts I follow on Twitter is ValueStockGeek. While occasionally, he'll put out some information on a specific company he's interested in, the most surprising content he writes is about his Weird Portfolio. I encourage anyone interested in this stuff to read what he's written on it, but long story short it's:

• 20% US Small Cap Value
• 20% International Small Cap
• 20% Gold
• 20% REITs (divided between US and ex-US)
• 20% Long term treasuries

It's his variation on Harry Browne's Permanent Portfolio, and it's more aggressive than Browne's risk-averse allocation (25% US stocks, 25% Long Term Treasuries, 25% Gold, 25% cash).

Notice the slow and steady return of the blue line (the Permanent Portfolio) vs the more jagged yellow line (the S&P 500), with the red line (the Weird Portfolio) somewhere in the middle.

Both alternative portfolios are trying to consider inflationary and deflationary environments, and how those periods impact the various components. When both portfolios succeed, they leads to lower but steadier growth with much gentler drawdowns. The Sharpe ratios are considerably higher than a pure stock allocation. The Permanent Portfolio's returns are low but with much lower risk, while the Weird Portfolio has more acceptable total returns.

Backtests point to something like an 8-9% return for the Weird Portfolio. In the Great Recession, the drawdown was higher than the Permanent Portfolio's, but it was much lower than a 100% stock allocation. Combine that with a 9% return, and it feels like a revelation.

My concerns with it however are:

• Small cap value outperforming over time is necessary for the growth to be satisfactory. It hasn't out-performed during this last decade, though its longer term record is very good:

• The drawdown protection via gold and treasuries has to actually work.

Nevertheless, I find it compelling despite my concerns and will integrate some of this into my own approach.

Other Compelling Portfolios and Final Thoughts

Look around enough, and you'll see all sorts of smart portfolio constructions. Take a look at the Ginger Ale Portfolio for one idea. For my taste, it's too many ETFs, but to each their own. Or stroll through the Boglehead forums to read intelligent debates about portfolio construction.

Nothing is guaranteed, and we have to make best guesses about our own psychology and how best to navigate an unknowable future based on the available research and how assets have behaved in the past. Avoiding blunders is paramount.

The strongest takeaways for me are:

• U.S. Market exposure is basically good enough on its own. It prevents FOMO and will probably perform well. It has risks though.
• Some "hold onto your butts" assets make sense.
• A tilt towards small cap and value makes sense.
• Too many assets gets unwieldy.
• Some international exposure is likely worth it despite recent underperformance.

This only begins to scratch at the surface of asset allocation decisions that someone could obsess over. I think I have a basic plan, when I make a decision I'll write more.

Applying for Another US Brokerage Account

Today I applied for another US brokerage account. In so doing, I hit one of those pain points for US citizens living abroad.

Right now, I have two brokerage accounts: I have my main Interactive Brokers account, and I have a Robinhood account, which was actually the very first brokerage I opened. When I first opened that Robinhood account, it was years ago when Robinhood was the hot new thing. I was vacationing in the US, and it was no problem to open the account. I began my stock purchases, and when I hit the $10,000 threshold for Interactive Brokers, I moved everything over there. Interactive Brokers has thus far been pretty great.

The problem with Interactive Brokers is they are bound by the laws of the EU as well as the US. Since they have my German address, which means I'm shuffled into their Irish - previously UK - subsidiary, I'm unable to buy any funds that are US-sourced. Under the MiFID II rules, brokers in the EU can't allow EU residents access to funds that don't follow these rules. This rules out all US funds, including ETFs.

Interactive Brokers does allow the purchase of European funds, but this is where my citizenship bites me. If I buy EU ETFs, I'll have to report them as Passive Foreign Investment Companies (PFIC) in my yearly US tax return. It's unfair and ridiculous, but it's the current legal reality, so I can't go that route.

Why now? I've been happily buying individual stocks for years now, but increasingly, I feel like I'm out of my depth. I've saved enough money in these stocks that the risk is starting to feel real. I've also learned a lot about investing, and what I'm learning is that the experts are experts, and even they have a hard time doing this.

Therefore, I would like to begin indexing in some form, but all my outlets in Europe are ruled out.

I could use the Robinhood account for this purpose, but I'm concerned about Robinhood's viability as a company. They also just raised their fee for an ACATS transfer. Robinhood also doesn't offer things like automatic rebalancing. Really, the whole app is very casino-ish.

I'd also like to cut down on the chain of transfers I have to do. If I want to buy ETFs in Robinhood, I'd have to: get paid, transfer the money to Interactive Brokers, convert from euros to dollars, withdraw that money to my bank, transfer that money to Robinhood. Each step can add days of waiting, and since my US bank offers a brokerage, I hope that I could open an account with them just to simplify.

Naturally, though, my application was not instantly approved. For some reason it triggered their extra diligence check. I'm worried that their research into me will not only result in being denied the brokerage but also result in my bank account being closed, which would be bad. Not quite disastrous but definitely bad.

Citizenship Worry

And so I'm once again staring into that bottomless well of worry about my continued relationship to the United States. These rules are unjust and unfair, and citizens living abroad should not have to put up with this. We are punished for living abroad. Congress could fix this at any time: enact Residence Based Taxation (RBT), create a PFIC exception for people living outside of the United States, create a FATCA exception for citizens living outside the United States. But they choose not to out of either inertia or ill will.

What's all the more frustrating about this is that I'm forced to lie. In filling out applications for banks, credit cards, and now this brokerage, I have to use an address where I don't truly live. I also can't name my actual employer, since this employer doesn't exist in the US. So I lie. But what's the alternative?

The United States compels its citizens to use its financial system no matter where those citizens reside, but they don't provide guarantees that the companies there will allow us. We must have a financial relationship with the United States, but when we do exactly that, we're breaking the terms of service or lying on our applications, and from then on, we're worried that we'll be found out and shut down.

In any case, I'll add an update here with the result. Hopefully, my worries are unfounded, and I'll have the new account in a week.

Update April 2022: Net Worth, Rough Month, Indexing, Covid

Rough Month. Ouch.

Our net worth declined by 11.42% in USD and 6.48% in EUR to $110,276 and €104,329 respectively. The euro loss was offset by the appreciation of the dollar relative to the euro. At the same time, our euro debt was reduced in value relative to the dollar.

This was our worst month financially since March 2020.

Stock Decline: Sleep Test and Indexing

Obviously, the main driver was the stock market declines. I wish I could say I bathed in glory and withstood the desire to sell anything. I wish I could say I wasn't scared. I wish I could say that the online chatter didn't influence my decisions.

I sold some stuff. I was scared. I let myself be influenced by noise.

That said, I tinkered rather than dismantled. I knew that at any moment, the whole thing could turn around, so it was unwise to go to cash 100%. So if my tinkerings were mistakes (as they almost certainly were), they will be small mistakes rather than absolute disasters.

One thing that's become abundantly clear though is that my overall portfolio is not passing the "sleep test". I am often worried about it. It is often gnawing at me, prompting me to take action in one way or another.

It's stupid. I'm saving money in order to improve my life, but if I'm stressing over it, then what's the point?

So I'm going to start indexing most of my new money. I'll start with about $7,000 and put most new money into that on a monthly basis. I intend to write more about this decision, but long story short is: I need a pool of money where I don't worry about individual securities. Right now, I have to worry about each individual name in my portfolio. Might this company perform poorly? Have I overweighted this company? Maybe this is a secular decline, and I'm missing it?

I hate all this. This worry is a negative in my life, and so far my stock picking ability has not shown itself to be superior, so it's an emotional negative for not much gain.

Covid Caught

As a backdrop to all this, I've caught the coronavirus. Last Friday, as the worst day of selling was ravaging my portfolio, I was sitting home alone having called in sick to work. I had the sinking suspicion that I'd caught it, but since I'm both vaccinated and boosted, all my self tests came back negative.

Only on Sunday did the test faintly show positive. Now I know why they say the self tests take fifteen minutes: the control line appears quickly, but it takes much longer for the T line to show up. If you just wait for the C line, you might miss the eventual faint T line, which tells you that you're positive.

My employer requested that I get a "Bürgertest" (a free fast test administered by an official testing center) and, if positive, a PCR test. Both came back positive, and so I'm at home at least until next Monday.

Financially, this is a set back. I was set to do some extra work for my employer that would have paid me a fair amount of money. Someone else will do that now. On the upside, at least I can't go out and spend money, but that's little comfort.

Ironically, I caught it at work, where a mini super-spreader event occurred. Restrictions have been lightened in the past few weeks, and we had a week and a half of vacation. Simultaneously, our thrice-weekly testing regimen was changed from PCR tests to antigen tests. Someone must have had a false negative and come to work, where they infected me and around 20 other colleagues. Go team.

Health-wise, this thing was awful. Saturday and Sunday were especially unpleasant with coughing, sneezing, runny nose, body aches and pains, a high fever, and an overall sense of fatigue and foreboding. It's gotten progressively better since Monday, but my voice is still froggy, and I'm still congested. If this is what it feels like with the vaccine, then what the hell does it feel like without it?

So far, my wife hasn't caught it, but unfortunately, it may be just a matter of time.

Final Thoughts

I don't know how to guess about May. But during May I'll be thinking about how to pass the sleep test. What actually worries me during drawdowns? What is so scary?

I'll also try and come up with an asset allocation plan that's simple and effective for my new indexing allocation.

Until next time, stay healthy, and remember that relationships are wealth.