How Do We Do Better Than The Market Benchmark in Bad Times?

Author: | Date:

Editor’s Notes: This is the 3rd installment on portfolio design for students of the Early Retirement Masterclass. In launching the course, we faced a host of immediate problems, many of them similar if not exactly the same faced by hedge funds though on a less complex level and with far less autonomy.

The challenges were follows:

  1. How do we ensure students are able to achieve long term success behaviorally?
  2. How do we design, build, and implement a portfolio that achieves the above more easily for the students?
  3. Are there additional steps we can take to be more defensive so that they experience drops that are less than the market value?
  4. How do we bake design a portfolio for current interest rate environments while also experiencing stronger resilience/performance if interest rates rise? ie; how do we counter the fact that REITs perform well in low interest rate environments and less well in rising interest rate environments?

These are some of the challenges we faced and the series of portfolio design is meant to answer a lot of these questions.

We hope you glean great information from within, and are able to execute on them. If not, you are always welcome to sit in on one our talking sessions and find out more with direct questions yourself.

This article focuses on Part III. Parts I and II can be found here;

The third psychological component to a good investment strategy is that, in a bear market, the investor should lose less money as the benchmark market index.

Consider the daunting prospect of investing in SGX stocks (after eliminating REITs, China stocks, and then stocks smaller than $50 million in size) over different periods for the past 10 years.

For the past 5 years, the stock would have not only returned you -2.2% on average, the portfolio would have been too volatile for a regular investor’s taste. Faced with a five-year period like this, most rookie investors will soon lose their patience and move onto some other area of their lives.

The conventional approach in personal finance is to simply introduce bonds into a portfolio. But this approach can reduce returns significantly – a price that many investors may not want to pay.

In the book The Snowball Effect by Timothy Mcintosh, a big problem for US investors comes from secular bear markets – A time period when stocks just tread water. The central thesis from this book is that during the secular bear periods, dividend stocks continue to provide a steady stream of income to investors that can cushion the fall from falling stocks.
Naturally, I took this idea and back-tested it, shortlisting half of the stocks that gave the higher dividend yield and doing the back-tests again.

While dividend stocks did not do that well for the past 5 years, by shortlisting dividend counters, you can mitigate the usual losses suffered by retail investors as the period corresponded to the taper tantrum era when the Fed was raising rates. Another advantage to this strategy is that this can be done with lower risk.

So, in theory, one way of cushioning the downside is to tilt a portfolio towards higher yields. But how does a real portfolio work in practice?

While the ERM program does not always short-list high dividend counters as a factor in a core strategy, a blended portfolio containing the investment decisions of all 11 batches does somewhat result in a portfolio that provides decent dividends.

A snap-shot of results on 11 February 2020 is as follows:

[NB: In practice, the portfolio is leveraged at an equity multiplier of 2 so the actual yield I am experiencing is 7.64%]

Also, of interesting note, is a beta of 0.44. While not all portfolios deliberately choose stocks based on market beta, the end result is that this portfolio does not gyrate as much as the rest of the markets. It also has decent dividend yield of 5.57%. Given that this is a blend of stocks, business and REITs, the yields are on the high side.

Let us observe the year to date performance so far.

We are still currently undergoing the Wuhan virus outbreak and the portfolio’s time weighted returns are negative so far in 2020. It has, however, done better than the STI ETF.

Observing the actual performance of the portfolio since inception (red line) compared to the STI ETF (orange line), losses have been less drastic than the drop in the STI ETF with the overall effect of dividends pushing the overall portfolio upwards.

In conclusion, the final feature in portfolio design for beginning investors is to cushion the portfolio from bearish events.

To meet this objective, we avoid the easy way out that is suggested conventional approaches towards financial planning which is to add bonds to a portfolio. Instead of introducing bonds, we can tilt the portfolio towards dividend yields instead.

The final outcome is a portfolio that participates in the significant upside of market moves but has a modest cushion to protect beginning investors against the downside.

You can register for a seat to preview our class here. Or register for tickets directly here.

Leave a Comment