Long time readers would know that I have been investing in STI ETF
on a monthly basis. It has been doing well for me (not bothered about the ups and downs of the market and yet I can make decent returns). I have taken a new direction to for my investment portfolio after gleaning more insights on the importance of investing with ‘size’ and being protected against any economic scenario.
Being right with size
When I interviewed Tom Yuen, he said the difference between top traders and average traders is the guts to trade with big size, and I quote from Secrets of Singapore Trading Gurus, “The best trader would know when to go in with size and dare to take the plunge. Having the right call is not enough. You have to make the right call with the right size.”
And Dennis Ng often mentioned that it would be difficult for traders to earn multiples of their capital because of positioning sizing. At any one time, a trader would probably risk no more than 2% of their trading capital in one trade, and hence, he cannot earn a large profit even though he is right.
Both of them made sense to me and I had the following conclusion – Trading is a job earning a stream of income and it is not a way to grow wealth (for most people). When your trading capital becomes too large, you would not be comfortable risking the same percentage of your capital into one position. For example, risking 2% of $100,000 is $2,000; while risking 2% of $1,000,000 is $20,000. Would your psychology remains stable if you are managing the trade that can possibly lose you $20,000? Most of us do not have the genetic makeup to make such big trades. Hence, limiting risk would correspondingly limit returns. You should trade if you want to pursue it as a career. But what if you can only trade $1m worth of capital and you have $2m? Where would you put your additional $1m (many would say properties. I would come to that later)?
I hope that at this point we have establish an understanding that I am not trying to recommend people to stop trading, but I want to emphasize it is a career choice and at the end of the day, it is still about earning an income. You have to agree with me that you will still need an investment portfolio no matter if you trade or not. In fact, most people fail to pay enough attention to their total investment portfolio. As long as you have excess capital, you need to know how to grow them properly.
Returns is highly dependent on asset allocation
Academics and investing professionals have been hauling criticisms at each other. Academics would rate the fund managers’ stock selections equivalent to (or worse than) monkeys throwing darts on a list of stocks. And investing professionals will argue that talk is cheap and the academics did not have enough practical results in investing to prove their theories.
I think for myself and judge objectively. I would tend to agree that the concept of asset allocation that the academics has preached. They said that asset allocation (the composition and proportion of financial assets in you investment portfolio) accounts for 80% of the returns. However, “asset allocation” has become a cliche as it has been over used or even abused by many fund management and insurance companies in order to sell their funds at high costs.
Traditionally, only stocks, bonds and deposits are considered financial assets that make up the portfolio. Real estate and precious metals are alternative assets but are equally important to your portfolio. In general, most people would have a higher proportion to stocks as they believe stocks will be the main source of growth for their capital. This is not wrong but we have seen many equity heavy portfolio, including the famous Yale Endowment Fund performed badly in the 2008 financial crisis. Quoted from “Invisible Hands”,
“Yale University saw its endowment assets fall from almost $23 billion to $16.3 billion for fiscal year 2008-2009, a decline of almost 30 percent….”
and “Harvard University saw its endowment assets decline from a peak of $36.9 billion to $26 billion over the same period, also a decline of almost 30 percent.”
Despite that, Yale Endowment fund was still able to grow at an average annual return of 14.2% for 20 years up to 2011. This shows the power of proper asset allocation. A good asset allocation allows you to tolerate a draw down on your capital that is acceptable to you, while growing your wealth over the long term.
Picking stocks is tactical; Structuring portfolio is strategic
Remember I mentioned in the previous point, you will limit your profit as long as you limit the size in each position. When you pick a basket of stocks, the returns from one stock is not going to have a big influence to your net worth. It is designed that way because that is how one reduces risk – you diversify and not put all your money in one stock in case you are wrong. You can continue to pick stocks and optimise your equity component in your portfolio, but what about other asset classes like bonds, real estate and precious metals? Are you prepared for economic scenarios where stock market is performing badly?
Picking stocks is just about winning battles. Structuring your portfolio is about winning the war. You can lose battles but you cannot afford to lose the war.
The future is not predictable – need to be prepared for all financial scenarios
Nobody can predict the future accurately. So your portfolio at any one time, must have one or two assets that will perform well in any economic scenario. There are four kinds of economic scenarios that you need to protect your wealth:
- Prosperity – economy growing, favors stocks
- Inflation – consumer prices rising, favors gold or real estate
- Tight money or recession – money supply insufficient, people have less cash and leads to recession. Favors cash.
- Deflation – Opposite of inflation and according to history, sometimes triggered a depression. Interest rates fall, favors bonds.
Dennis Ng always talk about the investment clock invented by Trevor Graham where economy moves through these cycles, just like we go through the year in four seasons. There will always be one asset class that perform well in one of the economic scenario. Likewise, you must build a portfolio that have all four components. You cannot say you are a real estate investor and you only want to buy properties. Because now is the inflationary period and commodities have been doing well. There are three other seasons that you need to go through which many people do not pay attention to. Most retail investors are herd animals, they will always chase after the asset class that is hot right now and it always prove to be too late. If you have a portfolio done properly, you will be selling the asset that has risen in value and buy the assets that have dropped in value. Only in this way you can buy low and sell high.
Timing the market and Time in the Market
Because we cannot predict the future, we do not when to move from one asset class to another. There is a price if you miss out those days where market moves the most. Kenneth Fisher did a research in S&P 500 performance from 1 Jan 1982 to 31 Dec 2005 where the average annual return was 10.6%. But if you miss:
- 10 of the 6261 trading days, your average annual return drops to 8.1%
- 20 of the 6261 trading days, your average annual return drops to 6.2%
- 30 of the 6261 trading days, your average annual return drops to 4.6%
- 40 of the 6261 trading days, your average annual return drops to 3.1%
- 50 of the 6261 trading days, your average annual return drops to 1.8%
Hence, you should not sell out any asset class in your portfolio. You should time the market by selling what is expensive and has taken up a larger percentage of your portfolio than your desired proportion, and channel the profits to the asset that is under-performing. This is the timing that you should do and always have sufficient exposure to the market at all time. Again, back to point one: always be right with size, you do not want to miss those major market moves.
How I implemented my permanent portfolio?
After reading many types of portfolio structuring, I found that Harry Browne makes most sense with his permanent portfolio concept. Since we do not know what the future may be, we will just divide the capital equally into 4 parts:
For simplicity, I bought into 3 low cost ETFs and held my cash component with my broker
- 25% – Vanguard World Stock ETF (VT)
- 25% – iShares Barclays 20+ Years Treasury Bond Fund (TLT)
- 25% – iShares Gold Trust (IAU)
- 25% – Phillip Money Market Fund
I chose VT because it is one of the cheapest ETF to invest in a global stock market. The reason why I diversify globally is because no country can consistently give the best returns over the years and no one can predict who is going to outperform next.
I chose 20 year US treasury for my bond component because there is lack of a better choice. I would have bought a long term international government bonds ETF but there isn’t one in the market. There are international corporate bond ETFs but I prefer to stick to government bonds for better stability. As for duration of bonds, I prefer longer term bonds as they are more volatile than shorter term bonds – I will have more chances to buy low and sell high.
I chose iShares Gold ETF instead of the popular SPDR Gold because the former charges only 0.22% as compared to the latter’s 0.4%.
Lastly, I opted for the Phillip Cash Management Account which they will automatically invest in the Phillip Money Market Fund for any free cash I hold with the brokerage. This gives me the flexibility to buy into any of the three ETFs any time I need to. I would not have this flexibility if I put my money in fixed deposits which get locked in for a few years.
When do I re-balance my portfolio?
I plan to re-balance my portfolio at least once a year. I will also buy if any asset falls to 20% of the portfolio and sell any asset that has risen to 30% of the portfolio. By maintaining the portfolio composition, I will always buy low and sell high.
How to implement your own permanent portfolio?
You can continue to pick stocks if you like. But that will only make up your equity component in your portfolio. Likewise, you can count properties (not the one that you are staying) as the commodity component in your investment portfolio. There are many ways to structure your portfolio and I will suggest you start studying the various compositions and how they fare in their returns and draw downs.