Build A Reliable All-Weather Portfolio With 4 ETFs

by: David Cretcher

If you're looking for an easy way to build an all-weather portfolio, here is an easy solution to building a risk-managed portfolio in four steps with as few as four ETFs.

Have you had a bad experience with "diversified" asset allocations? Maybe you had diversified allocations that looks like the one below. Notice the lack of meaningful diversification during the crash and the mimicking behavior of the investments during the rally. That's because if you buy six different colored dogs, it won't keep them from barking at the same time.

If you want true diversification, forget about the colorful pie charts that are enthusiastically sold to investors. They are usually just a pack of different colored dogs. The above chart is a chart of large, mid and small caps, foreign stocks, and high-yield bonds. It will make a colorful pie chart, but unfortunately a poor diversification. I cover in more detail why typical asset allocations don't work for the average investor in this presentation Why Asset-Allocations Fail.

If you want true diversification instead of baking a pie, think about building a sailboat. I know that sounds odd, but what better way to weather a storm. If you had to be stranded in the ocean, what vessel would you pick? You wouldn't pick a power boat because you could run out of fuel. After all, there's a reason people circumnavigate the world in sailboats. They're reliable.

Here's a four-step process to build a simple reliable "sailboat portfolio."

First, you'll need a hull. Hulls keep the crew above the water level and provide a dry place for the crew. If the water rises faster than the hull, then the boat will get swamped. In an investment portfolio, the flooding occurs from inflation. If your portfolio goes up slower than inflation, then its value gets swamped. For a hull, you'll need an inflation linked ETF like TIP, IPE or ILB. More aggressive investors may use a closed-end fund like WIW.

Second, you'll want a sail for your boat. Sails harness the natural power of the wind. In an investment portfolio, wind is the invisible force in the economy that drives up the PE ratios in stocks. A stock market with a tailwind will see PE expand. That is stock value will increase without any increase in underlining earnings simply because, for whatever reason, more people want to own stocks and they want to pay more to do it.

To get real growth out of multiple stock investments, investors need to have a significant PE expansion in the stock market. Historically, if the PE is flat or declining, stocks are mediocre investments. A sail for your portfolio can be made with a basic broad stock market ETF like VTI or SPY. This will harness the wind of a bull market.

Third, because ocean winds and currents are unpredictable, sailboats have heavy keels to counter the forces of wind gusts. Keels smooth out the ride and provide stability to the boat. Likewise an all-weather portfolio needs a counterbalance to poor stock markets to smooth the ride and stabilize the portfolio.

Since people can only spend, save or invest their money, if investors are not investing and consumers are not spending, then they must be saving. So part of the portfolio should be allocated to investments that do well when investors are saving instead of investing. The favorite place for people and institutions to save is in US Treasury bonds.

A government bond ETF like PLW or TLT or any number of ETFs that invest in treasury bonds will work as ballast for your portfolio. Aggressive investors might use the zero coupon EDV. You can see this dynamic of money moving from investment to savings in the below graph from Yahoo Finance. Notice how the money moves from one asset to the other as people increase and decrease their savings.

Last, you want some auxiliary power in case you land in the doldrums. Sailors know there won't always be wind and install small auxiliary engines to power the boat when winds are light. Investors also need a source of auxiliary power for when winds of the stock markets are not favorable.

For this you'll want an investment that puts out a steady dividend through good and bad markets providing growth without stock market appreciation. A preferred ETF like PFXF that doesn't have financial companies would be a good choice. But any ETF that provides reliable dividends and low correlations to the stock market would work. More conservative investors might like MBB.

Remember race car engines are less reliable than locomotive engines. It's the same with preferred stocks and bonds. High-yield or junk bonds put out a lot of income, but they are more prone to breaking, just like a racing engine. Look for reliability.

When you put all of this together, you will have a portfolio protected against inflation that captures upward stock movements, deflationary savings increases, with a source of income when everything is in the doldrums.

Below is what a portfolio of the above four ETFs has looked like over the last five years. Notice the counterbalanced diversification. The portfolio covers four potential economic scenarios - inflation, deflation, a stock market rally and an muddling along.

Courtesy of Yahoo Finance

How much you allocate to each component of your sailboat portfolio depends on how you feel about the markets in the future - just like a sailor decides on how much sail to hang based on the weather. If you don't want to think about it, you can simple allocate one quarter to each class and re-balance regularly, or you can be more aggressive and weight the portfolio.

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.