I created and hold a very low beta portfolio that I have transposed to U.S. holdings.
With the return of very modest volatility that portfolio mix has outperformed the broader markets in 2014.
Are we again in a scenario where the balanced portfolios will potentially outperform the all-stock portfolios over the next several years?
In the scenario of a market correction, the best risk adjusted returns may come from a prudent mix of stocks, bonds and cash.
Back in May of 2013, I wrote this article based on one of our accounts that was named the Freakishly Low Beta Portfolio. You'll find that article, here.
The portfolio is uber safe or uber low volatility. In its original form of perhaps too-safe, too low growth allocation to stocks the beta was around .2.
Here's the U.S. version of my Freakishly Low-Volatility Portfolio:
|Bond ETFs||Bonds - 68% Total||Yield||% of portfolio|
|1-5 yr Laddered Crp Bond||(NASDAQ:VCSH)||2.1% (2012)||55%|
|DEX ALL CORP BOND||(NYSEARCA:AGG)||2.4%||5%|
|U.S. HIGH YIELD BOND||(NYSEARCA:HYG)||6.0%||5%|
|LONG TERM BOND||(NYSEARCA:TLT)||2.7%||3%|
|Equity / ETFs||Equities - 32% Total|
|Dividend High Yield||(NYSEARCA:VYM)||2.9%||10%|
|CAPPED REIT INDEX||(NYSEARCA:VNQ)||3.3%||2%|
As you can see, it's a very defensive mix. And in many periods, there can be a cost to playing defense. I enjoyed and used that mix as I had some very nice gains coming through and out of the recession. I beat the snot out of the market and I was in an unusual position. I found I had a meaningful amount of money that was in positive territory. Success can change your approach as well. The amount of money that you have exposed to market conditions and volatility can certainly affect your risk tolerance level. I would guess that's why those who are truly 'rich' appear to hold very large amounts in lower risk assets. They may not need higher returns on one hand, and they don't want to see large amounts disappear, even on paper. As you may know, the rich spend more energy on making money through earnings than generally concentrating on their portfolio returns. They let their hands and their brains make most of the money.
But all said, even as your portfolios increase in value, we should not let that drive the risk tolerance level bus if we still need very generous gains to meet our goals.
The above portfolio is built for times of volatility and times when the stock markets might be challenged. Here's how the above assets performed this year vs. the S&P 500 (NYSEARCA:SPY).
This according to low-risk-investing.com
Portfolio Total Return: 6.6%
The above portfolio's total return was 6.6%, outperforming the SPDR S&P 500 ETF's total return of 5.8%. The total return includes stock price appreciation and dividends. That is very close to my Canadian version of the Freakish Portfolio, as my returns to date are close to 7.5%.
The portfolio's volatility was 4.1% which was lower than the S&P 500 volatility of 8.4%.
As I have stated in articles, I did adjust my portfolio mix to currently stand at 50% stocks to 50% bonds, and that is the asset mix I used for the above calculation. I will continue to reinvest all portfolio income back into the stocks, and will eventually bring that asset mix up to the classic balanced portfolio of 60% stocks to 40% bonds.
As I had stated in the previous article, the low volatility-producing agents can be thought of as ingredients that bake a cake. One can use a few cups less or more of the low beta flour to get different results. Here's what happens when we take a balanced growth approach, with now 2/3 in stocks and 1/3 in bonds - we would have returns of 7.4% and volatility that increases marginally.
So is the Freakish Portfolio offering lower volatility than broad market indices, yes slightly. If we use spy and AGG evenly at low-risk-investing, we get portfolio volatility of 4.5%. If we add in some long-term treasuries that often provide some inverse relationship to the stock markets, the volatility decreases further. With TLT as 1/3 of the bond portfolio in tandem with the broad-based bond index the volatility decreases to 3.9%, even below my Freakishly low beta version.
If we then add in the Utilities and the REITs, we then decrease the volatility even further to 3.8%. Essentially we are adding more long-term treasuries to the Freakishly Low Beta Portfolio, so it's not surprising that the volatility is reduced even further as the long-term treasuries provide that inverse relationship to the markets.
Here's the portfolio mix with returns.
We can see that the Utilities, the REITs and the long-term Treasuries have had a great run in 2014. The above portfolio mix outperforms the broader market with returns of 9.4% compared to 6.5% for SPY. The above mix has TLT at 40% of the bond portfolio.
Now of course lowering the risk profile of a portfolio (by way of bonds) can certainly reduce the returns in certain periods when the stocks are on a great run. Here's the above portfolio mix vs. SPY from 2009 - not rebalanced.
The portfolio underperforms the broad market, the portfolio's total return was 77.6%, under-performing the SPDR S&P 500 ETF's total return of 142%.
But if we take that asset mix back to the beginning of 2008...
Well, what a difference a year makes. We now see almost identical total returns, but the low risk portfolio certainly delivers a considerable beat on risk-adjusted returns. And if that portfolio was rebalanced through 2008, the low beta portfolio would have an outright total return beat vs. the broader market.
So, if we have a significant market correction within the next 1-3 years, it's possible that a 50% bond portfolio will outperform the broader markets over the next several years. On the flip side, if the markets continue to soldier on and ignore valuations, an investor in that conservative lower risk model will have to 'suffer' underperformance anxiety.
But in the end, I will bring it back to the basic rules of investing as per the prudent teachings of Mr. Benjamin Graham - stick to your investment plan and invest on a regular schedule, practice dollar cost averaging. If you are investing on a regular schedule you are going to buy the markets when they go on sale. With dollar cost averaging, if you are investing within your risk tolerance level, it's prudent to invest with an aggressive stock portfolio, even purchasing these stocks at what many believe are somewhat rich prices. Now Ben would certainly advise that you at least hold 25% bonds - that balanced growth portfolio, he believed in the need to lower the risk profile for most investors. This would also provide that rebalancing opportunity. Ben's most famous disciple Warren Buffett is now sitting on over $50 billion in cash, one of his greatest war chests, ever. You can be the judge of how to read that signal.
My guess (and it's only a guess) is that from today, the monies in a rebalanced balanced portfolio will likely outperform the markets over the next several years. But as per the movement through the last market cycle from 2008 to present, those investing on a regular schedule in a more aggressive portfolio (with more growth potential and more stocks) will be rewarded.
Here's a chart to frame that thought. Here are the Tangerine Balanced Portfolios from inception, January of 2008.
We can see that any static funds from 2008 have almost identical returns. But for those who were dollar cost averaging over the last 6.5 years, those investors who took on more risk (more stocks) would have been rewarded with higher returns. The more aggressive investor would have returns of 18.4% over the last year, and an average of 12.37% on funds invested 3 years ago. The 5 year returns for these portfolios follow the risk-return proposition as we've been in a bull market run.
My approach recently has been to keep my low risk portfolio mix to match my current risk tolerance level, but all new investments in our self directed accounts go into equities whether that be a dividend growth index such as Vanguard's (NYSEARCA:VIG) or to my recent addition of Apple (NASDAQ:AAPL). It keeps my risk profile in check, while I dollar cost average into what may turn out to be the better performing asset class (stocks) through the next cycle.
And while I'll joke about being the Scaredy Cat Investor, I can have a very high risk tolerance level when the time is right. If I see markets get obviously cheap in a major correction I will have no problem moving to a 75% stock allocation. I will put those bond proceeds and cash to work. I would guess that the only 'real' money to be made from here over the next 10 years will come from the opportunity presented by market corrections. But I certainly could be wrong. With dollar cost averaging of portfolio income into stocks and new contributions into our Tangerine Balanced Portfolio, I will participate in market gains should investors decide to pay even more for their stock holdings. It's a hedge to the upside, a hedge to the downside. It's the ability to take advantage of a major market correction.
But once again, if you are dollar cost averaging in the accumulation phase within your risk tolerance level, as Gilda Radner from the best Saturday Night Live cast would suggest "Never mind."
For those approaching retirement or find that their holdings don't match their risk tolerance level, you might want to take a second look at the above scenarios.
Thanks for reading. Be careful out there, and always know your risk tolerance level.
Disclosure: The author is long VIG, SPY, EWC, EFA, ENB, TRP, AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Dale Roberts is an investment funds associate with Tangerine Bank (formerly ING Direct Canada). Dale's commentary does not constitute investment advice. The information should only be factored into an investor's overall decision making process.