How To Preserve Your Capital In A Bull Market

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Includes: DIA, GLD, NDAQ, SAND, SPY, TLT
by: Ivan K. Wu
Summary

You don’t manage money in a bull market - you manage risk.

What you can learn from Ray Dalio’s All Weather Portfolio.

How I buy assets that most people hate.

Last week, I published an article titled “How My Portfolio of 7 Stocks Beat the Market,” where I went through the reasons why I own certain stocks, and my biggest mistakes. The purpose of this week's article is to explain how I manage risk in a market that never goes down.

Rule no. 1: Don’t lose money

Chances are, you’re feeling pretty good about your portfolio right now. Most people feel the same way. This is a symptom of the 9-year bull market. With the S&P 500 (SPY), Dow Jones (DIA), and the NASDAQ (NDAQ) up 25%, 28%, and 30% over the past year, Joe Schmoe can roll out of bed in the morning, firmly convinced that he is a certifiable genius and the second coming of Warren B.

And yet, the stock market is historically expensive. I’m not making any bold predictions here - just stating a simple fact. I don’t know if a stock market crash is imminent or if there will be a ‘melt-up’ in stocks due to the recently passed tax bill. I’m not even sure what stage of the bull market we’re in - and I think people who claim to know are either savants or delusional.

Me? I’m okay with not knowing things.

Where we are today:

Exhibit A. Equities are as expensive as they’ve ever been since the dot-com crash.

Exhibit B. U.S. stock market dividend yield (1.72%) is lower than the 2-year “risk-free” U.S. treasury rate (2.02%) *

In markets like this, I’m reminded of Warren Buffett’s number one rule in investing: don’t lose money. And of course, rule number two: remember rule number one.

Because an intelligent investor knows that their primary job is not managing money - but managing risk.

Here’s an example:

From a money perspective, investing $1,000 into cryptocurrency means your upside is the collective greed/stupidity of mankind (i.e. limitless), but your downside is only $1,000. Not a bad bet, you think. But the same trade from a risk perspective is the equivalent of going to an ATM, withdrawing $1,000, buying $1,000 worth of mega jackpot lottery tickets, and calling yourself diversified.

What most investors tend to miss in a 9-year bull market is that when they allocate dollars to their portfolios - they’re also allocating risk. And if we can all learn to allocate risk sensibly, the returns should take care of themselves.

Tony Robbins, Ray Dalio and the All Weather Portfolio

In his 2014 book Money: Master the Game, self-help guru Tony Robbins first popularized Bridgewater founder Ray Dalio’s “All Weather Portfolio” and the concept of “risk parity.”

Author’s side-note: I can’t vouch for the Robbins book because I haven’t read it. I prefer to get my info from primary sources, and can recommend Ray Dalio’s Principles (2017).

What’s risk parity?

Risk parity means constructing your portfolio based on the implied volatility of each asset class. A money-weighted portfolio would look something like the traditional 50-50 split between stocks and bonds. In a risk-weighted portfolio, since stocks are far more volatile than bonds, risk parity dictates that investors shouldn't be holding the same amounts of both.

The “All Weather Portfolio” proposed by Dalio looks like this:

  • 30% Stocks
  • 40% Long-Term Bonds
  • 15% Intermediate-Term Bonds
  • 7.5% Gold
  • 7.5% Commodities

And by “all weather,” Dalio means that this portfolio should do fine in the following environments:

  • Rising inflation
  • Falling inflation
  • Rising growth rates
  • Falling growth rates

How has the ‘All Weather Portfolio’ performed?

If we’re looking backwards at the last 30 years since the Robbins book was published, the All Weather Portfolio seems to have lived up to its name. Here are the relevant statistics for the 30-year period from 1984-2013:

  • 9.7% annual returns
  • You would have made money 86% of the time (so only four down years)
  • Average loss of just 1.9%
  • Worst loss was -3.9%
  • Volatility was 7.6%

In the 08-09 crash, this portfolio would have lost only 3.93% versus a 37% loss in the S&P 500. Not too shabby: fewer losses also means more capital to commit at the bottom of the market.

What’s different about today's environment?

Investing is more art than science, so I view the “All Weather Portfolio” more as a guideline than a prescription. In 2018, its one major flaw is that markets are now being distorted by central banks around the world buying trillions of dollars worth of bonds issued by their own governments. This artificially drives down interest rates, and inflates the price of stocks and bonds alike. We now live in a world where almost all asset classes are going up together.

Here’s what we can (probably) agree on in 2018:

  • Bonds are historically overpriced even relative to expensive stocks
  • It’s rational for investors to be more overweight stocks than is implied by risk parity
  • It’s also rational for investors to be more overweight gold and commodities than is implied by risk parity

And here’s what most investors are actually doing in 2018:

  • They’re probably already overweight stocks
  • They’re probably still underweight gold and commodities

So, rhetorical question: where’s value likely to be found in this bull market?

Buy what’s out of favor

It’s no coincidence that Sandstorm Gold (SAND) was my most recent purchase for my 7 stock portfolio. Yes, I think the company is mispriced, but I also think gold is out of favor and its risk profile as an asset fits into my overall portfolio. It’s also no coincidence that my top idea for 2018 is in the energy and commodities space.

So with respect for Buffett, here are Ivan’s two rules of investing in a 9-year bull market:

Rule no. 1: Preserve your capital by moving your portfolio toward risk parity

Rule no. 2: Buy out of favor assets today that will go up (or go down less) when the bull market ends

Here’s my list of out of favor asset classes:

  1. Gold (GLD): I remember back in 2011, everyone’s Asian aunt became a global expert in precious metals. “Gold is going to $10,000 because fiat currency and government bad,” they predicted. Of course, the exact opposite happened. Gold prices collapsed over the next four years. Today, a sub-section of these crazies are now occupied with crypto, which suggests to me that the average gold investor, after a 5-year bear market, is now somewhere approaching sanity.
  2. Energy & commodities: My top pick for 2018 is in this space. With the reinvigorated American obsession with themselves, I don’t think what’s happening (or about to happen) in the Middle East is being priced in at all.
  3. Cash: With inflation rates below 2%, the cost of holding cash is at historic lows, and therefore, doing as Buffett does and not what he says - it’s worth holding some in reserve.
  4. Long term U.S. government bonds (TLT): I know I just said bonds are overpriced due to central banks, but the pace of central bank bond-buying is set to decelerate this year. When the European Central Bank and the Bank of Japan finally get out of our way, what we’re left with is still a hated asset class in the eyes of most investors. Personally, I view long-term U.S. treasuries as a waiting game: as yields edge higher, the more likely I am to start buying it. My intuition (often flawed) tells me we’re not too far from this point.

How to Preserve Your Capital in a Bull Market

One of the shortcomings of being a long only investor is that my portfolio is almost certainly going to get dinged in the next bear market. It’s just a matter of how much.

But self-awareness goes a long way. For me, the risk is not panic-selling at the bottom - I’d like to think I know better than this. The real risk is not having enough capital for when the true fire sale begins. And if I happen to shuffle off this mortal coil earlier than expected, I want to manage the risks in my portfolio in such a way that my wife can be comfortable holding it over the next decade.

I’m not quite there yet - but the hope is that every day I get better - and move closer.

Next up: Top Stock Pick for 2018, Value Ideas, My Views On FAANG Stocks

Thanks for reading! I publish a new article once a week, so if you’re interested, please hit the “Follow” button at the top of the page. I’m also open to suggestions and feedback on what you’d like me to research or write about.

Here’s a look at what’s coming up in the pipeline:

  • My top stock pick for 2018: I know I promised a write-up this week on a natural gas name, but I’m still in the process of building a full position in this stock. The article is drafted, and it’ll be published in early February.
  • Ivan’s value ideas in progress: as an extremely selective investor, I leave a lot of ideas (and gains) on the table. Every month or so, I’d like to share a list of under-the-radar stock picks or research ideas in progress.
  • My first (and last) article on FAANG stocks: I don’t own any but my friends have been pestering me about my view, so this will be my first (and last) word on the subject - if only to have my opinion on the record and to shut them up. I also reveal which one I’d own if I had to pick one. Take a guess.

Disclosure: I am/we are long SAND. 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.