While I may be most known for my undervalued dividend blue-chip stock recommendations, over 5.5 years as a professional analyst/investment writer (and 23 years of investing experience), I've learned that there is far more to great portfolio returns than just knowing what companies to buy and at what valuations.
Achieving your financial goals requires a well-crafted and comprehensive roadmap to success which involves 6 steps.
Dividend Sensei's 6 Steps To Achieving Your Long-Term Financial Goals
- know your goals (how much money you actually need, over what time frame)
- the right asset allocation that's most likely to help you reach your goals
- the right risk management rules for your temperament and time horizon
- the right stocks/ETFs to own in the equity portion of your portfolio (i.e. the investing strategy that most suits your goals and personality and thus is sustainable over the long-term)
- buying those stocks/ETFs at the right time (i.e. good to great valuation)
- patiently waiting for your comprehensive investment strategy to work (there are no "get rich quick" schemes that actually work)
Note that actually picking stocks or ETFs (if you prefer passive investing) is step 4 and actually pulling the trigger on investments is step 5.
These steps must be done in order, otherwise, you risk wasting both your limited capital and time (the most valuable thing of all) and potentially failing to achieve your goals, such as a comfortable retirement.
Today I want to explain why step 2, capital allocation, is so crucial to achieving optimal realistic portfolio returns. More importantly, I want to highlight a powerful free website that can help you determine the right mix of stocks/bonds/cash equivalents that can both reduce your risk, help you sleep well at night during inevitable market downturns, and thus boost your long-term returns.
Why Capital Allocation Is So Important To Long-Term Investing Success
Market history can give us a rough idea of what's likely to happen if we wait long enough.
But while it might be tempting to just say "go 100% small caps or the S&P 500" we can't forget that the market's great historical returns are due to its much higher volatility relative to less risky assets like bonds.
“The best way to measure your investing success is not by whether you’re beating the market, but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.” - Benjamin Graham
This means that the best approach you can take isn't to swing for the fences and try to achieve the highest possible returns, but rather optimal returns for your individual needs, personality and risk profile.
Over the past 20 years, a standard 60/40 stock/bond portfolio didn't deliver the best total returns among the various asset classes. However, it did deliver 93% of the S&P 500's return and with far less volatility (a 60/40 bond/stock portfolio delivered 89% of the returns with even less volatility). Buy and hold investors who steadily put money into these diversified portfolios had a much easier time achieving those historical returns compared to someone who was 100% in stocks.
In fact, the reason that the average investor achieved just 1.9% CAGR total returns (not even keeping up with inflation) is because high market volatility caused them to panic sell at the bottom and not get back into stocks until long after the biggest gains were achieved (early in a bull market).
In other words, the historical evidence is clear that timing the market, which not even Wall Street pros can do with consistency, is a fool's errand the typical investor should avoid like the plague.
But how exactly do you know the right asset allocation for you? Well, history can provide a rough guide, based on how various mixes of stocks/bond have done during bear markets.
But the trouble with such aggregate data is that it encompasses many bear markets, each of which was slightly different in duration and severity.
Here's a table of how a standard 60/40 stock/bond portfolio did during recessionary bear markets since WWII. As you can see the average max decline was 43% smaller for the diversified portfolio. As a result, the time before the portfolio achieved a new record high (recovery) was nine months shorter.
For retirees living on the 4% rule, that nine months might mean the difference between being able to pay expenses by selling bonds (which tend to appreciate during bear markets) and having to meet expenses by selling quality stocks at a loss.
But what if you personally can't stomach a 20% average bear market decline (or 30% during a financial crisis)? Well, then you probably need to have a more conservative capital allocation, meaning more bonds and fewer stocks.
But other than paying a certified financial advisor a lot of money to create a highly personalized and detail personal investing plan, how can you estimate what mix of stocks and bonds is right for you? This is where Portfolio Visualizer comes in.
Portfolio Visualizer: A Great Free Tool For Estimating The Right Asset Allocation
Portfolio Visualizer is a free site with email registration that can allow you to backtest (among many other features) and optimize various portfolios, both ETFs and mutual funds and individual stocks.
The backtesting feature works better with ETFs, which naturally washes out the issue of valuation and is where the ability to test various investing strategies really shines.
For example, let's say you're at step 4 of my 6 step financial planning process, and trying to determine what stock strategy is right for you. Investing in a broad US market index fund/ETF like the Vanguard S&P 500 ETF (VOO) is a fine default option and what Warren Buffett recommends for 90% of people (he calls it "betting on America").
Alpha Factor Returns Over Time
(Source: Ploutos Research) -data as of May 2019
But there are several time tested strategies that, while not always outperforming the S&P 500, over time have proven to be great sources of consistent alpha. And the good news is that there are low-cost ETFs that you can use to invest in these alpha strategies in a very hands-off fashion.
Alpha Factor ETF Returns Over Time
(Source: Ploutos Research) -data as of May 2019
- iShares Core S&P Small-Cap ETF (IJR): expense ratio 0.07%, yield 1.5%
- Invesco S&P 500 Pure Value ETF (RPV): expense ratio 0.35%, yield 2.3%
- Invesco S&P 500 Low Volatility ETF (SPLV): expense ratio 0.25%, yield 2.0%
- SPDR S&P Dividend ETF (SDY): expense ratio 0.35%, yield 2.4%
- Invesco S&P 500 Equal Weight ETF (RSP): expense ratio 0.2%, yield 1.8%
You can mix and match these ETFs, and include them as part of a broader portfolio.
For example, if I were a passive investor I'd have started out looking at 100% of my stock allocation (my personal ideal asset allocation) in dividend growth (my personal passion).
SDY Total Returns Over Time Vs S&P 500
The ETF has been operating since January 2006, which is why that's where the chart begins. As you can see, while dividend growth stocks don't always outperform, they tend to keep up with rallies and fall slightly less during corrections and bear markets. Or to put another way, dividend growth investing isn't about swinging for the fences but winning by hitting a lot of singles and doubles and striking out less (offense wins ball games, defense wins championships).
SDY Historical Return Statistics from January 2006 to May 2019
(Source: Portfolio Visualizer)
But where this website is especially useful is risk management. For example, you can see that since its inception, SDY has done slightly better than the market, but by just 0.37% CAGR. However, this dividend growth ETF has been 14% less volatile than the S&P 500 (beta 0.86) which can be very useful to conservative income investors worried about big declines.
The Sharpe ratio is the total return over volatility, and SDY is slightly better than the S&P 500 at this. But what actually matters to most people is the Sortino ratio (total return - risk-free return (such as 10-year US Treasury) dividend by negative volatility).
After all, few people would complain if their stocks were volatile to the upside and earned them greater capital gains. It's the downside volatility that people really fear. SDY's Sortino ratio is 6% better than the S&P 500's since inception and thus makes it a potentially great choice for anyone looking to put their discretionary savings (money you won't need for three to five years) to work in a strategy that's likely to outperform the market over time.
SPLV Historical Return Statistics from January 2012 to May 2019
(Source: Portfolio Visualizer)
The low beta ETF is a great choice for conservative income investors like retirees, looking for slightly better yield than the broader market but 24% less volatility. As you can see, this ETF's worst single-year performance was 6.8% just half as much as the S&P 500's (it becomes even lower volatility during downturns). Of course, since its inception data is 2012, we can't be sure how it will fair in a bear market. But the Sortino ratio is 2.35 meaning that for every 1% of downside volatility SPLV has historically delivered 2.35% of total returns above the risk-free rate since it began trading seven years ago.
Or to put another way, as far as reward/risk ratios go SPLV is a great choice and the second best alpha factor ETF you can choose (relative to the market's Sortino).
- IJR Sortino ratio since inception 0.72 (vs market's 0.53)
- RPV Sortino ratio since inception 0.56 (vs market's 0.73)
- SPLV Sortino ratio since inception 2.35 (vs market's 1.83)
- SDY Sortino ratio since inception 0.83 (vs market's 0.78)
- RSP Sortino ratio since inception 0.79 (vs market's 0.79)
Using Portfolio Visualizer we can determine that, as far as reward/risk (Sortino) ratios go, small caps, dividend growth, and low volatility are the best strategies, at least since the inception of these ETFs (ranges from 2001 to 2012)
But of course, these are all stock strategies, and even SPLV's low volatility might be too high to let you sleep well at night during a future bear market. Which is where the true power of Portfolio Visualizer comes in.
Say you're someone whose approaching retirement and so very concerned about minimizing volatility. You can select SPLV to represent the equity portion of your portfolio and something like the iShares Core U.S. Aggregate Bond ETF (AGG) as your bond allocation (beta 0.01 since 2004 inception).
You can use the portfolio optimization feature to determine what mix of these two ETFs was best (since 2012 when SPLV was created) to achieve several goals
- maximize Sharpe (risk-adjusted return) ratio
- minimize volatility relative to whatever benchmark you want (such as the S&P 500
- maximize returns (relative to your preferred level of volatility)
- minimize peak decline while achieving a specific target return (what pension/endowment funds do)
- maximize Sortino (reward/risk) ratio (relative to your personal total return target)
Optimal SPLV/AGG Allocation To Maximize Risk-Adjusted Returns (50.5% SPLV/49.5% AGG)
(Source: Portfolio Visualizer)
This 50.5/49.5 SPLV/AGG portfolio offered the best risk-adjusted returns since 2012. The beta (volatility relative to S&P 500) was 36% lower than a pure S&P 500 portfolio and the worst annual loss was just 4%, in a year when the market fell 13.6%. The Sharpe Ratio (what I personally consider the best risk metric) was a sky-high 2.54, or 39% better than the S&P 500 over the past seven years.
Of course, this portfolio only actually delivered 7.8% CAGR total returns, which is about half that of the S&P 500. If you have a certain total return target rate, say the market's historical 9.1% CAGR, then this optimization feature can tell you that you'd need a 100% SPLV portfolio to achieve those returns.
But the way I think this optimizer is most useful to the average investor (who wants to minimize declines while ensuring decent returns) is the minimize drawdowns option.
You can select a target rate of return and the software will tell you what allocation of your stocks/bond ETFs (I'm just using SPLV and AGG as examples) will have historically delivered that return with the smallest annual decline (you can also select the smallest month to month decline, but you shouldn't be worried about such ultra-short-term periods).
In effect, the total return/minimal decline optimizer feature lets you
- think like a pension/endowment fund manager (what return do I need to achieve to hit my financial goal)
- while maximizing the chances of remaining disciplined and sleeping well at night by minimizing scary declines
Optimal SPLV/AGG Allocation To Minimize Annual Decline While Achieving Market's Historical 9.1% CAGR Total Return (61.8% SPLV/38.2% AGG)
(Source: Portfolio Visualizer)
Here's the optimal allocation of SPLV (low volatility stocks) and AGG (bonds) that can be expected to deliver the market's historical return over time. The historical volatility is 31% less than the S&P 500 and the reward/risk ratio is 2.51, 37% better than the S&P 500's.
Now you might be thinking "sure this is all well and good but the historical data on SPLV only goes back to 2012, how would this work during a bear market?" That's a fair question. So let's look at one more example.
Let's use SDY as our stock allocation (inception 2006) and AGG as our bond allocation (2004 inception). This will allow us to optimize a portfolio that achieves a target return while minimizing the peak annual decline between 2006 and 2019, which includes the Great Recession, a 57% market decline (second worst in US market history).
For our target return let's use a conservative and realistic 7%, which is what most pension/endowments use and which is a realistic return investors can probably expect in the future.
Optimal SDY/AGG Allocation To Minimize Annual Decline While Achieving Conservative 7% CAGR Total Return (52.7% SDY/47.3% AGG)
(Source: Portfolio Visualizer)
This 53% SDY (dividend growth stocks)/47% bond portfolio managed to achieve our target 7% return target since 2006 but with 17% less volatility than the S&P 500. But more importantly, during 2008's 37% market crash, it declined just 8.9%, or 76% less than the broader market.
The Sortino of 1.08 means that the reward/risk ratio for this portfolio, which is appropriate for conservative pension funds (and thus the average retirement portfolio) was 38% better than the S&P 500 over the past 13 years.
Does that mean this website (which has a lot more features by the way) is perfect? Of course not. Optimal asset allocations will change over time, and you don't have to try to be perfect. And of course future market returns will be slightly different, and you need to rebalance your portfolio once or twice a year to make sure you don't stray too far from an appropriate allocation for your needs.
But as far as free tools to help you construct the right portfolio for your long-term needs, I consider Portfolio Visualizer to be the best I've yet found.
Bottom Line: Achieving Your Financial Goals Is About Far More Than Just Good Stock Picking
Great investing is harder than many people think because your portfolio is actually a business. And like any business, there are multiple steps you must take, each one offering its own nuances that take time to understand and master.
Proper asset allocation is the cornerstone to good portfolio construction, that can get you the necessary long-term returns to meet your goals, but without excessive volatility that can cost you sleep during market downturns and cause you to lose discipline and abandon your long-term financial plan.
After all, who cares if your neighbor bet the farm on Beyond Meat (BYND) and quadrupled his money in what's almost certainly an epic bubble. You need to do what's right for you and if you are overweight risk assets like stocks, then high volatility during corrections and bear markets could cost you a fortune.
As Peter Lynch, the second best investor in history behind Buffett famously said
And as Warren Buffett, the greatest investor of all time points out
Buffett doesn't actually mean that you shouldn't own any stocks if you can't stomach a 50% crash like we saw in the 2000 and 2007 bear markets. Rather that aphorism simply means you need to own enough low-volatility and countercyclical assets (like bonds) to smooth out your portfolio's inevitable declines so that you don't panic and sell at the exact wrong time (such as during periods of peak fear, uncertainty, and doubt).
Historical market studies (and the advice of the greatest investors in history) are very clear about this. Proper asset allocation, not market timing, is how you protect and grow your wealth over time.
Portfolio Visualizer, while not a perfect tool, is a great free way to test out various investing strategies and optimize your asset allocations based on your personal needs and risk preferences. Remember that the time to rebalance your portfolio and think about risk management is before, not during a significant market downturn.
As far as investing tools go, I consider this free site to be one of the best I've yet found when it comes to helping you craft your personal investing roadmap, and maximize the chances of achieving your long-term financial objectives.
Disclosure: I/we 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.