The Five Year Trap

Most investors want to build a portfolio based on what has worked historically. There is nothing wrong with that. In fact, it would be foolish not to pay attention to how potential (or actual) investments performed in the past. How we look at the past, though, can dramatically alter our conclusions. Consider the following cases:

The year is 1999 and Jane Investor wants to build a high performance equity portfolio. She analyzes some different funds and looking at the last 5-10 years figures out:

International stocks have been a major drag on performance; it would be better to just hold US stocks.

Large cap growth stocks in the US have outperformed small caps and value stocks.

Over the next decade US large cap growth stocks proceeded to dramatically underperform almost every other type of stock fund.

The year is 2010 and Joe Investor is trying to do better than the last 10 years. He was 90% US stocks and 10% international stocks. Large cap US stocks have had a horrible decade, while international stocks have had a much more productive decade. Joe decides:

If I overweight my portfolio to international stocks and smaller company stocks I should significantly enhance my return.

Over the next decade international stocks and small company stocks underperform large cap US stocks.

The lesson is this: brief backtested periods will create a poor canvas on which to design your portfolio. Try looking back at least 25 years and consider ending your test before the last five years. Develop a static portfolio allocation approach and stay with it. If you broadly allocate your portfolio, you won’t have the top performing portfolio, but you won’t have to suffer through a decade of futility, either.

Freedom Portfolio

July is a month that makes us think of freedom. I've never lived anywhere that I didn't feel free. It is an amazing gift that we must remember to be thankful for and for which we must continue to fight. Not everywhere in the world has individual rights, but what if you focused your investing where freedom does exist?

The "Freedom Portfolio" is a portfolio I created that is 52% exposure to US stocks and 48% in 12 international country funds that represent nations that have a high ranking on the Heritage Economic Freedom Index. I used the 52/48 allocation to mirror the US presence in the Vanguard global equity ETF VT.

Heritage Economic Freedom Index

The top countries include: Hong Kong, Singapore, New Zealand, Switzerland, Australia, Ireland, United Kingdom, Canada, Denmark, Taiwan, Sweden, and the Netherlands. Some countries are not available for investment, so a few substitutes had to be made with countries that were next on the list. So how does such a portfolio compare to the performance of Vanguard's Total World ETF, VT?

Beginning in 2013 and ending in May 2018, the Freedom Portfolio generated an annualized return of 11.5% per year versus 10.27% per year for the Vanguard World Index. It must be noted, I also represented the US with a combination of Vanguard Total Stock Market Index (VTI) and Vanguard Extended Market Index (VXF) so that small caps were present in the portfolio.

Standard deviation is the statistical measure of how much volatility is present in a portfolio. The Freedom Portfolio had a standard deviation of 10.22 versus 10.15 for the Vanguard World ETF. Thus, the portfolio had over 1% increased return with very little additional volatility.

Contact me if you'd like a copy of the portfolio report. I'm glad to send you a pdf that shows the ETF symbols, percentage invested in each, as well as many statistical measures of the portfolio performance.

Small Caps Generate Big Results

In a previous post, I reviewed the DFA Micro Cap Fund, a great way to invest in small companies, some of whom will go on to have a huge impact on your portfolio returns. The simple fact is that most investors are underexposed to small caps. Many portfolio allocation models have a token exposure to anything other than large company stocks in the US. There is a general perception that small caps are just too risky to have a large allocation.

Fidelity Contrafund (FCNTX)

Is there a process that investors can go through to evaluate whether a fund is an OAK (One-of-a-Kind)? You could use another service, such as Morningstar, Lipper, Zacks, or any number of investment advisory newsletters. You could take your friend's word, your brother's word, or the word of some unknown advertisement on the web. But what if you wanted to, all on your own, measure the likelihood that Fidelity Contrafund will generate solid returns over the next 20 years?

Can a system be an OAK?

I've been student of trading approaches for stocks, mutual funds, and ETF's for a long time. It only takes one backtest to see the amazing results you could have experienced if you had only done X or Y consistently for 5 or 10 years. If an investor could earn 25% per year over 10 years, they would compound a total return of over 9 times the original amount invested ($10,000 would grow to $93, 132). Of course, the problem is that patterns in markets change and they can even change frequently.

Blackrock National Municipal Bond (MANLX)

I've reluctantly taken on a number of home improvement projects over the years. I grew up with a dad who could do just about anything and make it look professional. We even built a house in southern Colorado that turned out beautifully. It hasn't come easy for me, though. I think my mind is a sharper tool than my hands, but it has been fun to try. One thing I've learned is how helpful it is to have the right tool. There are times when I went from completely helpless to moderately skilled just by having the right tool.

Alphabet (GOOG)

In the last 25 years of investing, I've bought just about every type of investment. Actually, that's not true. I've skipped a lot of insurance products like variable life insurance, whole life, and variable annuities. However, I've invested in quite a few different mutual funds, exchange-traded funds, closed-end funds, and individual stocks. Stocks are a different flavor of investing. They are riskier and therefore represent a greater possible return AND larger potential loss.

DFA US Large Cap Value (DFLVX)

There is nothing like getting a great price on something of value. There is a lot of cheap stuff that you can later regret buying. I'm not talking about that kind of thing. I'm talking about getting that exact thing you want or need at a discount. That feels good because you get what you want but get to keep some of the money you would have otherwise had to spend.

iShares Edge MSCI USA Momentum Factor ETF (MTUM)

I really got interested in investing in the late 1990's, when tech stocks were on a seemingly endless elevator going up. I invested in a technology mutual fund that made over 100% in one year; then over the next couple of years it would make a run of 25% or so, only to give the gains right back. There was so much excitement over the internet that any company that ended in .com was lavished with attention, and more importantly, money. Eventually, the elevator returned to earth with a crash. 

The First Five

So what would it look like if we take the first five funds and put them together into a portfolio? That would give us:

20% Vanguard Wellesley

20% Dimensional Micro Cap

20% PIMCO High Income

20% American Funds New World

20% iShares Core S&P Midcap

PHK has only been around since 2004, so we can only get a 14 year backtest on the portfolio, but the results are interesting. This aggressive portfolio has returned 9.42% since 2004, which would have compounded $10,000 to $36,337.