This is why it's so hard to stay the course. There's always a hook. For someone new to investing, as I suspect many people on this forum are, you might not have seen how these stories typically play out:
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"Investing is risky, you have Inflation, Deflation, Prosperity, and Recession, and you never know which one is coming next. Therefore you should dedicate portions of your portfolio to each of these phases, by buying X, Y, Z, and V."
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That's a great story. The trouble comes when choosing your X, Y, Z, and V. I've been reading about portfolios like this for years, and they always have one thing in common, they backtest well. Very well. Is this a coincidence? Could it be that only the portfolios which perform very well in backtesting, also have an interesting story behind them? Or is it possible that almost every portfolio has a market-beating story......
it just has to beat the market first before you pay any attention to it.
It is easy to fall victim to the Survivorship Bias. After any process that leaves behind survivors, the non-survivors are often destroyed or muted or removed from your view. If failures becomes invisible, then naturally you will pay more attention to successes. Not only do you fail to recognize that what is missing might have held important information,
you fail to recognize that there is missing information at all. Here are some possible options for each phase you may have missed:
Prosperity:
- Total US Stock Market
- Large Cap Value
- Large Cap Growth
- Large Cap Blend
- Mid Cap Value
- Mid Cap Growth
- Mid Cap Blend
- Small Cap Value
- Small Cap Growth
- Small Cap Blend
- Micro Cap
- Total International Stock Market
- Emerging Market
- Pacific Market
- Europe Market
- International Value
- International Small
- S&P 500
- Dividend Appreciation
- High Dividend
- Value Index
- Growth Index
- FTSE Social Index
- Extended Market
Inflation:
- Short Term Tips
- Long Term Tips
- Gold?
- REITS?
- Silver?
- Coal?
- Platinum?
- Diamonds?
- Oil?
- Natural Gas?
- Coffee?
- Sugar?
- Copper?
- Wheat?
- Cotton?
(There are arguments for each one of these.)
Deflation:
- Long Term Bond Index
- Long Term Treasuries
- Long Term Government Bonds
- Long Term Corporate Bonds
- Long Term Municipal Bonds
Recession:
- Money Market
- Short Term Bond index
- Short Term Treasuries
- Short Term Tips
- Ultra Short Term Bonds
- CDs
- Savings accounts
Now for the fun part. No matter which combination of these (including those I didn't mention) ends up winning, there will be an enticing story behind it all, explaining why
there must be a fundamental reason behind such success! We finally got an answer to why Gold fits in the "Inflation" bucket, despite the data showing it clearly does not track inflation, and the answer is "it's complicated". We're told that Gold and Small Cap Value aren't necessary components, yet without these components the portfolio under-performs the average.
What if I read some similar articles, and choose this portfolio in 1972, based on the same "fundamentals" here? These are reasonable choices, and from the perspective of the 1972 investor, make perfect sense. Growth has been beating Value for almost a decade, showed no signs of slowing up, and every article you could find was singing the praises of Growth.
Had it gone well, we'd be seeing articles about The Growth Butterfly, not The Golden Butterfly. Instead I'm broke at 70 years old, cursing some article I read over 30 years ago.
The scariest part? This portfolio doesn't look so bad in backtesting:
It's squarely in the box of all the other portfolios with a similar philosophy:
Indeed, these hooks can seem promising, even exciting. But they clearly fall flat here. If you choose such a portfolio, acknowledge that it's based purely on backtesting, as the story simply doesn't check out. And if choosing a portfolio based purely on backtesting doesn't start ringing red alarm bells in your head...
you really shouldn't be investing in a portfolio like this at all.
My advice to any newbies in this thread,
don’t fall into the trap. You buy the market not because it backtested well during a specific phase, and will make you rich in the process. You buy the Total Stock Market Index, simply because you want to capture the market. You want a percentage ownership of all available companies across the globe. You want your share of the world's collective profits/production. Again, indexing beat or matched half of all invested dollars in the past, I do not expect mathematical laws to change, so I expect it to beat or match half of all invested dollars in the future.
You don’t buy the Total Bond Market Index because it was less volatile in the past, but because bonds are a written contract, where you are paid periodic interest payments, and in the end you get your full investment back. In most cases (70% of VBTLX) the contract is guaranteed by the government. This makes it a relatively safe place to put your money.
These aren't stories based on how it performed in the past. You won't get confused about why these options are included in the portfolio at all, when the story doesn't seem to follow reality, only to get an "it's too complicated so I'll just tell you inflation" answer from the expert.
It's a simple definition of what these components are.
Sol put it perfectly in another thread:
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People don't choose indexing because it backtests well against an index. They choose indexing because they want to get market returns, good or bad, without taking on any additional risk by trying to beat the system. I choose indexing because I'm prepared to play the game straight and accept average returns the same as everyone else is getting, at the lowest cost to me. I'm not trying to win at anyone else's expense.
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As did Brooklynguy:
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If you use backtesting alone, you have proven nothing more than the fact that the strategy has worked in the past. It is textbook survivorship bias to draw a conclusion solely from backtesting, because you are ignoring the infinite number of conceivable and backtestable strategies that failed to work in the past. If you backtest enough strategies, you are bound to find one that worked through random chance alone.
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My advice to any newbies would be to steer clear.
Survivorship bias is the single greatest fallacy in investing, and it’s better to find out now, than after 16 years of under-performance. I will reiterate this for the newbies of the thread looking for a "consensus". I don't think newbies can responsibly handle the information on Tyler's site. Once you consider yourself an expert, have read a few books, and have watched your own portfolio in the market for a few years to know how you'll react, come back and see what you think.
You must remind yourself that when you start to pick apart winners and losers, successes and failures, the living and dead, that by paying attention to one side of that equation you are always neglecting the other. If you are thinking about opening a restaurant because there are so many successful restaurants in your hometown, you are ignoring the fact that only successful restaurants survive to become examples. Maybe on average 90 percent of restaurants in your city fail in the first year. You can’t see all those failures because when they fail they also disappear from view.
As Nassim Taleb writes in his book The Black Swan, “The cemetery of failed restaurants is very silent.” Of course the few that don’t fail in that deadly of an environment are wildly successful because only the very best and the very lucky can survive. All you are left with are super successes, and looking at them day after day you might think it’s a great business to get into
when you are actually seeing evidence that you should avoid it.