Risk And Reward

Summary

• Since 2014 I have been sharing my experience as a European individual investor on Seeking Alpha. This is my 2020 annual report.
• The section ‚Risk‘ covers three dimensions of current risks.
• ‚Reward‘ is about things that went well for me.
• ‚Appendix‘ includes a follow-up on some numbers that were already part of previous reports.

There is little empirical evidence to support the notion that smart-money investments perform better than non-smart-money investments [...].

Saving for retirement can be both, easy and hard. Automated dollar-cost averaging with index-funds is easy to implement and should work for most. Environmentally conscious investors, however, will find that ESG-labelled indices regularly fail to meet the most basic standards (cf. A Beginner's Guide To Treehugging). They can then either turn to more high-priced investment vehicles or become DIYers. I have opted for the latter. My investment universe consists of stocks, bonds, gold and cash, although the current macro environment has limited the options as we will see.

Risk

(1) Dividends in decline

While stock prices can be subject to Mr. Market’s mood swings, dividends are, just like earnings, a proxy for the real economy. Dividends have failed to keep pace with stock prices since 2016. There was a stock market correction in late 2018 that brought both in sync for a brief moment and the same happened during the 2020 stock market crash. Subsequently, however, dividends and stock prices started moving in opposite directions indicating a widening gap between stock market sentiment and real economy.

Data by YCharts

What is true for the market has been true for my portfolio as well. While the NAV increased by more than 31%, dividends shrank by -14%.

Unsurprisingly, the above has resulted in a step change in volatility.

Data by YCharts

In such an environment a risk conscious asset allocation used to help absorbing some of the shocks. However, the options for portfolio diversification are narrowing.

(2) Disintegration of another asset class

When I started putting my retirement savings to work, I loosely followed Harry Browne’s approach and set up a „permanent portfolio“ comprising stocks, long-term bonds, gold and cash. This asset allocation turned out to be anything but permanent, though. I sold the bonds as the capital gains exceeded any returns I could expect from keeping them by far. In 2020, cash became an endangered species. Two of my savings accounts were terminated by the banks due to negative interest rates. If my day job in the corporate world is any guidance, I can expect the following next:

• Banks will lower the thresholds for charging negative interest on cash balances
• I may end up juggling with cash balances deploying an increasing number of bank accounts
• Eventually, I will keep cash balances to a minimum

My investment universe will then be reduced to stocks and gold.

I am not a macro guy, but doesn’t saving equal investment in macroeconomic accounting? So if banks don’t want me to save, it probably means very few businesses want to invest. Now, if stock markets are driven by expected return on investment, this should be bad news for stock markets. Still, stock markets go up because people like me cannot put their money in savings accounts anymore. It looks very much like a feedback loop. In this environment, stock investors may want to focus on those few companies that can still put capital to work in a meaningful way. This is where sustainable investing and self-interest overlap. One cannot retire on buybacks and narrative alone.

(3) The fat tail

Long-term stock market returns are unevenly distributed across individual stocks. There are fat tails at both ends of the spectrum, i.e. where the absolute high-flyers and duds are. While I am risk conscious on portfolio level, I take measured positions in a few stocks that are relatively high-risk. When buying into such stocks, I initiate positions so small that I hardly notice if they tank. At the same time my exposure will be just big enough to make sure the stocks can move the needle if they turn out to be winners. The graph below shows the position size for all of my stocks in ascending order as well as the respective total returns.

The top three stocks secunet Security Networks (YSN), Energiekontor (EKT) and Hannon Armstrong (HASI) combined stand for a quarter of my portfolio. In 2019, the top three’s share was just 16%. Skewness in stock returns can work against diversification. Conventional wisdom would be to rebalance and reduce the size of the biggest positions. There are also a couple of reasons against rebalancing, such as in the case of my portfolio:

• The respective companies are fundamentally in good shape
• The tax bill
• All top three stocks are income plays as well

What is interesting and a bit reassuring is that there was some fluctuation among the top three in 2020: IAR System Group (IARSD) has been replaced by HASI and EKT has caught up with YSN. It is almost as if the breakaway group has formed a Belgian tourniquet. So for the time being, I will accept the fat tail even if it may lead to temporary underperformance.

Reward

In 2020 the opposite was the case. I stayed away from the 'sell' button and both, EKT and YSN, achieved tenbagger status. Also, I did all of my (limited) stock buying in March and was particularly lucky to pick up a growth stock like Aixtron (AIXA) at the market bottom. AIXA more than doubled from there.

I have been measuring my portfolio’s performance against two benchmarks for seven years now. Number one is the diversified Arero fund of funds (consisting of 60% global stocks, 25% bonds and 15% commodities) that could be a plausible substitute for my whole portfolio. Number two is the S&P Europe 350 for the stock allocation. In 2020, it was no comparison: The IRR for my portfolio was 26.3% (Arero -3.3%) and for my stock allocation 34.3% (S&P Europe 350 -3.1%). The seven-year average returns were 12.8% (Arero: 4.8%) and 17.3% (S&P Europe 350: 5.3%) respectively.

Having said that, retail investors should not be too focused on performance benchmarks. The ability to retire comfortably is not only a function of capital gains and dividends, regular savings play a role as well. My portfolio’s NAV has grown on average by 16.6% in the past seven years, almost 4 percentage points above the average returns. These 4 percentage points make a big difference over time, as the rule of 72 suggests: At a 12% growth rate my retirement savings would double every 6 years, but at 16% they double every 4.5 years.

Final thoughts

“I’m in for the long term”, is one of the top truisms among investors. For many individual investors who put their retirement savings to work this is both, true and not true. It is true by definition, since retirement is a long term target. It is often enough not true with regard to single stock positions. There were more than a couple of reasons to trade stocks in 2020:

"Coronavirus: US stocks see worst fall since 1987"

"Many are chasing the stock market by day trading in the pandemic. It could end badly"

"European stocks are already headed for the worst week in months as more COVID-19 restrictions loom"

Since I have started investing not before 2011, 2020 was my first stress test. And although I looked up stock quotes almost on a daily basis, 2020 marked the first year that I managed to keep portfolio turnover at 0%. Clearly, the portfolio manager in me has matured. Given the more volatile market environment, the de-diversification forced upon me and my portfolio's fat tail, this may be my most important takeaway from 2020.

Appendix

Holdings

NAV

Trading activity

The information in this article does not constitute investment advice. TRI is no financial advisor and not licensed to give investment advice. The numbers given are obviously not audited. If you self-manage your savings, you are in the same boat as TRI. Good luck.