Allocating Within The All-Weather Sailboat Portfolio: Part 2

by: David Cretcher

In my article How to Build a Reliable All-Weather Portfolio with 4 ETFs, I outline an easy way to manage an investment portfolio by imagining building a sailboat. In the follow up, Allocating Within The All-Weather 4 ETF Portfolio, I described how the four forces in the economy act and react on the portfolio. Here, I show how to construct and weight a portfolio based on these concepts.

The Asset-Allocation Problem

The current problem investors face is typical asset-allocation portfolios auto-correlate in stressful markets. This leaves them open to large draw downs when the going gets tough.

Having an auto-correlating portfolio is like having a roomful of people from different countries. They may all speak different languages and act a bit different, but when someone pulls the fire alarm they will all behave alike. It's the same for investments, they act a little different during normal times but when the market gets turbulent they behave the same. This is shown in the below graph.

The Sailboat Portfolio

Sailboats are designed to tolerate the stress of different ocean and wind conditions, so using one to model a portfolio allows the investor to build an All-Weather Portfolio. To do this, we divide the portfolio into four broad asset classes:

A Hull of assets protecting the portfolio from periods of high inflation.

A Sail of investments harnessing the power of bull markets and investor enthusiasm.

A Keel of government-guaranteed bonds providing stability in stormy and turbulent markets.

And last, an Auxiliary Engine: comprised of securities generating income and cash-flow through good and bad markets.

These four assets balance and counter-balance one another to give the portfolio a smoother ride than a traditional asset allocation portfolio. This counterbalancing is shown in the below graph.

Front-Loaded and Back-Loaded Investments

The Four ETF All-Weather Portfolio is comprised of two ETFs with front-loaded returns and two ETFs with back-loaded returns. Front loaded investments are investments that are like owning a good business. They start returning capital to the owner from the beginning of the purchase. If you buy a front-loaded investment like a bond or a preferred stock you will be paid periodically for your ownership.

Back-loaded investments are securities, without an income stream, where the capital is returned to the owner at the time of final sale. There is only the expectation of a capital gain. Non-divided paying stocks are typical back-loaded investments. As I explained in this article, the risk of back-loaded investments is the risk of losing time. If you make a mistake and buy a security that doesn't appreciate or loses, you have lost not only money but also time. You can make a new more successful investment and make up for your loss, but you can never recover the time. This time risk is often overlooked,

Front-Loaded Investments

There are two front-loaded investments in the Four-ETF portfolio. Keel Assets with investments in US Government Bonds. And Auxiliary Power investments that are made of non-governmental fixed income. Both of these investments pay dividends or interest from the time of purchase. Because of steady payments, they do not have time risk.

Back-Loaded Investments

The portfolio has two back-loaded investments. The Sail is allocated to investments dependent on positive market performance. The investor won't know the actual performance of the investment until the time of the final sale. Until then, the investor will only know the market value, not his or her actual profit.

The second back-loaded investment is the Hull of the boat constructed Floatation Assets. These are typically US Treasury Inflation Protected Securities. These securities do pay a very small dividend but most of the upside gain will come from the inflation adjustment. The investor will not know the amount of inflation adjustment until the security matures. If there is no inflation, they will be a poor investment. Conversely, if there is very high inflation there will be a large gain. The investor will not know until the end when they mature.

A Time-Balanced Portfolio

In this way, the portfolio is both balanced and counterbalanced against time risk, inflation risk, and deflation risk in the economy. The front-loaded investments protect against time risk and provide steady cash-flow. The back-loaded investments protect against inflation and benefit from market movements.

Broad Allocation Decision - What Does Your Weather-Eye See?

To make allocation decisions, the investor makes an educated guess about the near future. Will the future be a time of strong economic growth or slow economic growth, low inflation or high inflation, bull market or bear market? The investor can then be biased to the predicted outcomes.

There Are Many Futures in the Future

To control risk in the portfolio, the investor should imagine not a single future but multiple outcomes - a future with growth, a future with economic contraction, a future with economic growth, a future with inflation, or one with deflation. How will each of these possible futures affect their portfolio and what adjustments are best to lower risk and maximize gain?

When you decide which is most likely you can weight your portfolio to benefit from that outcome.

Simple Sailboat Portfolios:

Smooth Sailing

If you foresee a benevolent low inflation economy with a bull market driven by strong interest in the stock market. In this climate a possible allocation could be:

Allocation Potential ETF's Choices





Inflationary Currents

If the investor expects rapidly increasing inflation of 5% or more, he or she can move to the weighting to Hull assets. High inflation is a generally hostile environment to stocks. Bonds struggle fighting rising interest rates. They are also repaid with less-valuable money. In this environment a model portfolio might look like this:

Sail: 10%

Hull: 75

Power: 10

Keel: 5

Deflationary Storms

In a deflating economy high-quality bonds do well, because they are paid back with more valuable money. Stocks do poorly because business and people are saving into government bonds instead of investing in stocks. TIPs suffer from low-interest payments and no inflation adjustments. This type of weather would favor a mix like this:

Sail: 10%

Hull: 5

Power: 30

Keel: 55

Storm Clouds and Low Winds

This is an economic climate with slow growth, moderate savings, lackluster interest in stock investing, and low to moderate interest rates. This situation favors a broad allocation to Auxiliary Power investments giving off steady reliable cash flow. In a slow growing economy, there is enough cash flow to pay down debts, but not enough to ignite growth.

Sail: 15%

Hull: 5

Power: 75

Keel: 10

Different Weather - Different Allocations

There are, of course, many possible combinations and the investor can further customize their allocations. I would recommend keeping at least 5% in each of the four asset classes as protection from being wrong from a false prediction.

In future articles, I will cover how to allocate within the four broad categories.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.