Author Topic: What gives you confidence in a portfolio?  (Read 5434 times)

Tyler

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What gives you confidence in a portfolio?
« on: April 30, 2016, 11:14:57 PM »
The thread on the Golden Butterfly has been a great discussion and highlights several very different perspectives on asset allocation.  It has also raised an interesting question regarding how one can reliably identify a good portfolio through all of the options, competing information, and associated uncertainty.  I think this topic deserves its own thread from a portfolio-independent perspective.

So here's my question -- what evidence would be required for you to be personally convinced that one portfolio option is superior to another?  Feel free to define "superior" in whatever manner is most important to you.  I'm especially interested in personal stories of how you arrived at your own asset allocation and the concerns that may influence your choices in the future. 

Taking it a step further, what evidence would convince you to personally change portfolios?  If you can't think of an answer, why is that and how did you settle so confidently on your own asset allocation?

I'm curious because I'm interested in how to better communicate with different types of investors.  I also think this will be helpful for new investors to hear different methods of logically approaching the problem.  So be honest and tell your story!
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steveo

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Re: What gives you confidence in a portfolio?
« Reply #1 on: April 30, 2016, 11:46:22 PM »
Tyler - great question.

1. Simple. I don't want 10 different assets that need to be utilised.
2. Low fees. I want something where the cost to purchase is really low.
3. Broad index options. Within an asset class I require broad diversification. I don't want to be exposed to individual stock (or whatever) risk.
4. Long term growth is important but this is a personal objective for me right now. If I had a lot of money I think stability would be more important.

Based on this I have chosen a simple 3 fund portfolio for my prior to retirement age fund. 50% domestic stocks, 25% international stocks and 25% bonds. Everything is in broad index funds (ETF's because they have the cheapest fees). I also have retirement funds that I don't self-manage. This is in a 90/10 growth fund which is basically 50/50 international/domestic stock plus significant infrastructure projects with a 10% bond component.

If I had all of this money in one pool and I reached a lower WR I would definitely consider adding a commodity fund. The only reason I don't is that I think stocks will perform better over the longer term and bonds will help me buy more in the event of a down turn or I can use the bond component as living expenses. The commodity funds I've seen also have higher fees which I don't like.

I lot of the above points are specific to where I live. I'm Australian and we have ridiculous house prices so I really have no need for a REIT or any further real estate investments. We also have pretty locked down retirement fund options. I think these options though are pretty good - they are typically low fee and index based.

I think an interesting point is that I don't mention backtesting. I'm not really interested in how certain asset classes performed in the past unless it provides me with a good principle on which to invest.
« Last Edit: May 01, 2016, 02:40:08 AM by steveo »

Seppia

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What gives you confidence in a portfolio?
« Reply #2 on: May 01, 2016, 02:01:32 AM »
I have exactly the same approach
Broad - low fee - simple
My objective is to own businesses without the hassle of managing them, so stocks are my preferred asset.

I profoundly dislike gold as it's unproductive, don't care for commodities in general as the expected return is low/zero, and will probably add at a later stage an apartment and a small piece of land as my only "apocalypse edge".

This has resulted today in AA that is extremely heavy in equities.
I used to be 50/50 USA - rest of the world when I was living in the States, but since I moved back to Europe I'm adding only to the European index, as I want to have a certain home bias.

I know this is not at all popular here, but I also don't mind overweighting a certain geographical area depending on relative valuation and currency highs / lows. For example USA equities are a no-no for me now.
I'm obviously keeping all those I have as one of my principles is to never sell.

I also keep a certain percentage in cash (approx 15%), as the famous "emergency fund" + to be used to go all in in case of a dramatic (30+%) market crash to average down.

I'm not sure any evidence would move me away from the above, as mine is more of a philosophical choice.
When I read (for example) that small cap value has over performed the rest of the market my first thought is "ok so it will probably underperform in the future".

I would not care if gold added stability in the past because I really cannot see any logical use I would personally have for gold.

And so on.
« Last Edit: May 01, 2016, 02:07:35 AM by Seppia »

Travis

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Re: What gives you confidence in a portfolio?
« Reply #3 on: May 01, 2016, 07:47:51 AM »
I have what is more or less a 3-fund portfolio which has done well for me since I became a MMM/Vanguard convert a couple years ago.  Due to my 401K options it is a slight variation in that I have a government-sponsored bond fund, S&P500 fund, Total Market fund, and Total World fund (ex US).  It comes out to roughly 20/60/20 between the bonds/US stocks/int'l stocks.  The reason I'm confident in it is:

1. It's simple.  After a few months of education here and a couple other forums and books I think I can handle it all myself.
2. I subscribe to the notion that in investing you're probably not as smart as you think you are, and you're definitely not smart enough to consciously do better than the market.
3. It's a comfortable level of risk given my current career and won't require me to alter it for a few years.  I'm not really taking on any more risk than other indexers at my age.
4. It's extremely low cost.
5. Thousands of others seem to be doing just fine with an almost identical portfolio, and my portfolio and risk/return horizon was subjected to a blind test by a financial management company. (They wanted me to hire them to manage my money using a proposed portfolio that had an identical risk/return and market sector distribution.  They wanted to use 70 stocks and index funds, I did it with 4. The salesman blamed it on a software glitch on his system.)


I don't think my portfolio is in any way "superior," but it accomplishes my goals, is low cost, average level of risk and return, and I don't have to think too hard about it.  It would take a lot of data to get me to radically alter it (though I'd be willing to adjust my AA), especially given the market's history of people who think they've found a sure thing or the magic bean or whatever. 
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ender

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Re: What gives you confidence in a portfolio?
« Reply #4 on: May 01, 2016, 08:52:20 AM »
This is an interesting question!

Simplicity of understanding is probably the number one most important thing for me to consider a portfolio. An entire industry exists to take my money and invest it for me. Generally they charge more the harder it is for me to know what/how it works.

Understanding why someone is trying to convince me of something is important. I know why Bogle and vanguard work. It makes sense conceptually that they would be right, in addition to anecdotally and quantitatively that being the case.

I am also fairly ok with the idea of perhaps not having the 100% best portfolio but having a high probability of being an 80% or 90% portfolio. Clearly some people will beat 3 fund portfolios over my lifetime. But it's pretty likely most won't.

So to change away from that simplicity probably requires an equally compelling and believable story. Reasons that make sense, don't have baked in assumptions, and can be easily understood.

And last, the biggest "enemy" in all this is me. Buying and holding vs buying and selling at my whim. We can talk about better portfolios but the human factor is critical - if I'm more inclined to sell a "better portfolio" for reasons later, it makes it worse for me. Allocations I believe in personally and conceptually make this a lot easier than something I don't have any faith in from the beginning.

This factor is important. We all like to think we're perfectly stoic investors but the reality is we all are on a continuum. There's a lot of risk associated with incorrect self assessment here...
« Last Edit: May 01, 2016, 09:07:14 AM by ender »

Monkey Uncle

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Re: What gives you confidence in a portfolio?
« Reply #5 on: May 01, 2016, 09:00:37 AM »
Per the evidence question: pretty much all we have is historical performance, despite the fact that "past performance does not guarantee future results."  Just about everyone agrees that stocks should have a higher long-term return than bonds, but that's just based on past performance.  Yes, there is a fundamental reason why stocks have higher returns, but you can come up with all sorts of fundamental reasons why one asset class should outperform another.  The longer the time frame and the broader the asset class, the more confidence we can put in conclusions drawn from past performance.  Because of this, I accept the assumption that stocks will outperform bonds over the long term, but I'm a lot more skeptical of the assertion that U.S. small cap value stocks will outperform German large cap growth stocks (just to make up a random example; I don't know if anyone is really saying that).

Beyond the long-term, widely accepted return patterns of the major asset classes, I don't think anyone can reliably predict which asset classes/sectors will perform well in the future.  Therefore, I tend toward a portfolio that is diversified across countries, asset classes, sectors, and market caps.*  You could do a lot worse than dumping everything into VTSAX or a 3-fund portfolio, but you're making a big bet on large cap stocks when you do that (because the underlying indices typically are capitalization-weighted).  I'd rather be diversified across countries and market caps, and ideally, have some real estate exposure to boot.  That way I'm not hitching my wagon to the assumption of the S&P 500 outperforming everything else in perpetuity.  Diversification may be a little more complicated, but it doesn't have to be insurmountably complicated.  Two or three US stock funds, two international stock funds, one REIT fund, and one bond fund ought to do the trick.

What evidence would change my mind?  A hundred years of data showing that all-VTSAX or a 3-fund portfolio produced a higher long-term SWR and lower draw-downs than a more diversified portfolio.  That would certainly start raising some questions.

*Disclosure: I need to put my money where my mouth is.  Right now my portfolio is not as diversified as I'd like it to be.
« Last Edit: May 01, 2016, 01:16:18 PM by Monkey Uncle »
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dandypandys

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Re: What gives you confidence in a portfolio?
« Reply #6 on: May 01, 2016, 09:00:50 AM »
This thread https://www.bogleheads.org/forum/viewtopic.php?f=10&t=88005 gave me the confidence to decide that the 3-fund was the way to go, and some back and forth with Taylor on what in my 403b would work to replace total bond and total international- what a nice man! Now i am reading his book- Beginners guide to Bogleheads.

MustacheAndaHalf

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Re: What gives you confidence in a portfolio?
« Reply #7 on: May 01, 2016, 09:51:36 AM »
I'd like to see which portfolio has the best long-term adherence, in a research study.  If people claim that 100% equities will do great, but nobody sticks with that more than a few years, then there's a more fitting portfolio for that group of people.  Studies need to control for factors like age or retirement, so one study might not cover all investors.  But it would be interesting to see which portfolio has the most people adhering to it over the years.

forummm

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Re: What gives you confidence in a portfolio?
« Reply #8 on: May 01, 2016, 10:10:49 AM »
Low fees
Broadly diversified (globally, asset class, etc)
Invested in things that produce returns like businesses. Gold is not one of those things. Maybe it's a hedge against inflation, but so are businesses, and especially businesses of a certain kind (like REITs). But gold has no intrinsic value, little use in industry, is subject to continued belief that it's valuable for some reason, and vulnerable to advances in mining.

capitalninja

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Re: What gives you confidence in a portfolio?
« Reply #9 on: May 01, 2016, 12:16:34 PM »
* Low expenses
* Diversification that smooths volatility while not materially affecting return over any given 5 - 10 year period. I attempt to achieve balance across sectors. I don't allow any given sector to have more than a 20% weighting.
* Consistent dividend income
* Adequate return
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barbaz

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Re: What gives you confidence in a portfolio?
« Reply #10 on: May 01, 2016, 12:40:45 PM »
Apart from the things that were already mentioned, what would convince me is evidence that the market is fundamentally inefficient.

A good example right now are European AAA bonds. Many insurances and funds are required by law (or by their own statute) to hold a certain amount of AAA bonds. But since the crisis of '08 and Germany's current no-debt politics, the supply of such bonds is declining which caused prices to skyrocket. Unless you want to bet that supply drys out further, a private investor should probably not buy these overpriced bonds. You can get much higher risk-free returns with saving bonds, even in this current low-interest environment.

jpeizie

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Re: What gives you confidence in a portfolio?
« Reply #11 on: May 01, 2016, 01:23:56 PM »
In addition to simiplicity, low cost, and broad diversification, which have already been mentioned, I also factor in volatility so that I have a reduced risk of a market crash forcing me to work longer than expected and reduced sequence of returns risk in retirement. In other words, I'd rather have a portfolio that I expect to take me 15 years to reach FIRE than a portfolio that I think will only take me 10 years but then a market crash forces me to work an extra 5.

Exactly what point is my sweet spot between risk/return and volatility? I don't have a good answer for that. Which means I'm probably vulnerable to being tempted to change my allocation in the future!

As a failed psychologist, I'm quite convinced the market is inefficient. But that's a different thread!

Telecaster

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Re: What gives you confidence in a portfolio?
« Reply #12 on: May 01, 2016, 03:51:06 PM »
Two things,

1) Does the logic behind it make sense?   

2)  Actual past  performance over a reasonable time frame.



LAGuy

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Re: What gives you confidence in a portfolio?
« Reply #13 on: May 01, 2016, 04:59:31 PM »
For me, are the individual parts good investments in and of themselves? Most portfolios are trying to reduce the volatility of stocks by adding something that has a negative correlation. But in and of themselves those things are almost always horrible investments. As a generic statement, "Are bonds a better investment than stocks?" "Is gold a better investment than stocks?" If the answer is "no" or "no, but" then why would you want to own a sub par investment?

mrpercentage

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Re: What gives you confidence in a portfolio?
« Reply #14 on: May 01, 2016, 06:05:07 PM »
Knowing I will not have to sell it, ideally ever, because it yields high enough.
Low fees--- I like zero. Zero is good. I pay taxes on dividends-- so what. I will never be penalized or have a forced distribution.
Being comfortable with what I own. If I have to watch it-- no bueno
I like things that offer direct deposit for my dividends into my checking account with no effort what-so-ever.
I like fractional shares so I always know it will compound if I am reinvesting.
I also use some low cost index funds and premium closed mutual funds.
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Monkey Uncle

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Re: What gives you confidence in a portfolio?
« Reply #15 on: May 02, 2016, 04:47:25 AM »
For me, are the individual parts good investments in and of themselves? Most portfolios are trying to reduce the volatility of stocks by adding something that has a negative correlation. But in and of themselves those things are almost always horrible investments. As a generic statement, "Are bonds a better investment than stocks?" "Is gold a better investment than stocks?" If the answer is "no" or "no, but" then why would you want to own a sub par investment?

You do it to reduce sequence of return risk.  Here's an example, constructed using Tyler's calculators over at portfoliocharts.com, using data from 1972 - 2015.

100% Total Stock Market (capitalization-weighted index covering the entire US stock market)
Real CAGR = 5.87%
Worst year = -37.1%
Longest draw-down = 13 years
40-yr safe withdrawal rate = 3.9%

Now let's diversify to remove large-cap bias and US bias.  Divide evenly between US stocks and international stocks, with the US portion divided equally among large cap blend, mid cap blend, and small cap blend; and the international divided evenly between international developed and international emerging markets.
Real CAGR = 6.37%
Worst year = -40.6
Longest draw-down = 10 years
40-yr safe withdrawal rate = 5.4%

So the diversification increased the SWR a good bit, with only a little increase in downside volatility.  But that -40.6% year was pretty scary, and 10 years is still a long time to see your net worth lower than it used to be (note that the draw-down from the heat map calculator is not applying any withdrawals, so if you were withdrawing assets to fund retirement, the draw down would be longer).

Let's add some bonds in an attempt to tame the beast.  Put 30% of the portfolio in total bond market, with the rest divided among stocks in the same proportions as before.

Real CAGR = 5.74
Worst year = -26.9%
Longest draw-down = 9 years
40-year safe withdrawal rate = 5.2%

That tamed the volatility some, with a minimal hit to the safe withdrawal rate.  And note that the SWR was substantially higher than if we had just dumped everything in a cap-weighted US stock index.

You could also consider adding a REIT and/or commodity index in place of some of the stock exposure.  Because of the low correlation between these assets and stocks, the volatility would have been reduced substantially and the SWR would have increased relative to both of the stock-only allocations.  Of course, no one knows if history will repeat itself in this regard.  The more you get into slicing and dicing more narrowly defined asset classes, the more the exercise starts to resemble data mining.  But the point is that a reasonable amount of diversification has the potential to lower volatility without materially impacting the SWR (or perhaps even increase it).
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Aphalite

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Re: What gives you confidence in a portfolio?
« Reply #16 on: May 02, 2016, 06:50:53 AM »
As most others have said, at a basic level:

1) low fees/low turnover
2) ability to leverage deferred taxes (if not in retirement accounts)
3) ability to naturally combat inflation (businesses or real estate)
4) some diversification (I don't require as much as most others here)

I'd also add:

5) correlation of businesses, I don't want risk to be concentrated - either by industry, by geography, related to my cash generators (I think Joshua Kennon had mentioned that banks and oil have fairly correlated performance in the past)
6) safe/recurring models (so with regards to businesses, no unicorns not backed by earnings - greater fool theory, and with regards to real estate, no spec real estate) - basically, the portfolio should be back by earnings and not just momentum
7) liquidity or some type of distribution (dividends or else) in case the public market shuts down for a length of time

There's probably more but those are the things I think about off the top of my head

barbaz

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Re: What gives you confidence in a portfolio?
« Reply #17 on: May 02, 2016, 12:39:03 PM »
For me, are the individual parts good investments in and of themselves? Most portfolios are trying to reduce the volatility of stocks by adding something that has a negative correlation. But in and of themselves those things are almost always horrible investments. As a generic statement, "Are bonds a better investment than stocks?" "Is gold a better investment than stocks?" If the answer is "no" or "no, but" then why would you want to own a sub par investment?
Bonds (or gold) are not worse nor better. They just have a different risk and return profile. You answered your question yourself: "to reduce the volatility" of my portfolio. That's a perfectly valid reason.

beltim

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Re: What gives you confidence in a portfolio?
« Reply #18 on: May 02, 2016, 01:03:41 PM »
I need a logical explanation for why a portfolio should behave in the future the way it has in the past.  For stocks and bonds, this is easy.  For other assets like gold or other commodities, that explanation becomes difficult.  And without that explanation, weird things can happen that will result in a portfolio not behaving the way it should.

I understand how assets with low correlations to each other reduce risk.  I also understand how in some circumstances assets with low correlations to each other can increase returns (although this is uncommon and usually depends on the two assets having similar long-term returns).  But if some combinations of these assets can have returns greater than the average of the components, why couldn't a combination of those assets have returns less than the average of the components?

I puttered around with some sample portfolios to see if I could find a situation like that.  I found one, and it turns out it was pretty easy to find as long as one of the assets had a negative return.  And that, in a nutshell is why I don't own gold: without any intrinsic value, I have no confidence that gold will not have a negative long-term return.  And with a negative long-term return, continual rebalancing into that asset will reduce returns below the average of the components.

Indexer

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Re: What gives you confidence in a portfolio?
« Reply #19 on: May 03, 2016, 04:31:15 PM »
1. An asset allocation matching my goals/time horizon/risk tolerance.
2. Diversification, lots of it. Total market index funds accomplish this well.
3. Low cost.
4. Tax efficient.

So right now I'm about 60% VTI and 40% VXUS. Pretty simple...