Blog

Guest Post: Investing In One Lesson

Thursday, September 16, 2010, 9:20 PM
by machinehead

Many of you will recognize today’s author from his insightful comments that appear frequently across PeakProsperity.com.

It sucks to try earning income from investments these days. Until about ten years ago, most folks assumed they could make an easy 5 percent from safe, risk-free vehicles such as T-bills or CDs. With $500,000 saved, you could generate $25,000 in annual income. Them days are gone! Today, thanks to the Federal Reserve's Japanese-style ZIRP (Zero Interest Rate Policy) regime, one-year T-bills yield only 0.25%, while one-year CDs average 1.25% -- a mere $6,250 annually on a $500,000 account.

Three years ago, I confronted a related aspect of this problem while serving on the board of a church which needed income. In the summer of 2007, it received a $500,000 bequest. The headquarters organization recommended putting the entire sum into their balanced fund -- meaning 60% stocks, 40% bonds. The Wall Street manager's sales pitch claimed that since market timing is 'impossible,' 'now' would be a good time to buy into the fund -- always had been, always would be. No thinking required!

But I vehemently objected to this notion, particularly in regard to the stock portion of the fund. In the summer of 2007, the dividend yield on the S&P 500 stock index was under 2% -- not only in the danger zone of overvaluation (more on this later), but also resulting in a sub-1% yield after management fees. As we now know, stocks proceeded to lose over half their value from October 2007 to March 2009.

Fortunately, we reached a compromise: the bequest would be invested in four annual installments, instead of all at once. The first 25% installment, at the end of 2007, of course lost badly in 2008. However, the result vividly illustrated the merit of holding two asset classes instead of one. While the 60% stock portion of the fund lost 37%, the 40% bond portion gained 3% as interest rates sank. The fund's net result was a 21% loss in 2008 -- on one-fourth of our portfolio. Since the rest of the bequest was safely stashed in short-term T-notes (which paid a richer 3.8% yield) outside the fund, the overall portfolio was barely dented.

Today, with much lower yields on offer, it's still possible to obtain a reasonable income. Unavoidably, this means taking price risk. However, by diversifying among asset classes, some of the price risk can be hedged. As an example, in an idealized business cycle, bond prices peak first, followed by stocks, then by commodity prices. The most recent cycle conformed to the pattern: bond prices topped in June 2003; stocks in October 2007; and commodities in July 2008 (seven months after a recession began). Since each asset class follows its own rhythm, one is often rising while another is falling, thus damping the fluctuations of a combined portfolio.

Worldwide, there are three major asset classes:

  1. Fixed income -- money lent at interest.
  2. Stocks -- equity investment in publicly-traded and privately-held enterprises.
  3. Property -- real estate, commodities, collectibles and intangible property.

According to Albert J. Brenner at aametrics.com, the global bond market was valued at $82 trillion and global equities at $44 trillion in late 2009. [Ref. 1] Global property is probably in the $80 trillion ballpark as well, since The Economist had estimated its value at $62 trillion in developed countries alone in 2002. In total, these Big Three asset classes are valued at about 3.5 times global GDP of $60 trillion.

But are they cheap or expensive? As a first glance, let's look a selection of current yields in the US -- the cash income these assets offer:

  1. Fixed income: 10-year Treasury notes -- 2.8%
  2. Stocks: Dow Jones Industrial Average -- 2.9%
  3. Real estate: average of four REIT ETFs* -- 3.2%

* REIT (Real Estate Investment Trust) ETFs (Exchange Traded Funds): symbols ICF, IYR, RWR, VNQ              

Right off the bat, it's obvious that nothing is cheap -- these are historically low levels of income from all three sources. However, the 10-year T-notes are the most extreme of the three. Having yielded a high of over 15% in 1981 and a low of just over 2% in 2008, T-notes are at the bottom end of their yield range. Treasury prices are correspondingly high, and slide when yields rise. (TLT, a long Treasury bond fund, dropped 5.5% in the first 10 days of September on a slight rate hiccup.)

As for US stocks, over the past century their average dividend yield was around 4%, with 3% formerly considered to be the threshold of overvaluation when the yield fell below this level. But since the mid-1990s, a dividend yield under 2% has served more effectively as a marker of overvalued stocks.

In the case of commercial real estate, capitalization rates (net operating income divided by price) of 7 to 10% are typical. According to Hai-yong Yu at Bloomberg, cap rates averaged 7.22 percent in the second quarter -- a little on the low side, yet 429 basis points, or 4.29 percentage points, higher than the yield on 10-year T-notes and near the record spread of 539 basis points in the first quarter of 2009. [Ref. 2] In other words, the real estate cap rate is attractive compared to low yields on T-notes and stocks. REIT ETFs pay dividends well below the cap rate, but they still beat the yield from stocks and bonds.

What can we expect in the future from these asset classes -- say, over the next ten years? For fixed income, instead of Treasuries only, let's focus on a broad index which includes all investment grade bonds, both government and corporate: the Barclays Aggregate Index. An ETF which tracks this index, AGG, yields 3.33%. If we make the charitable assumption that yields stay at their current low level, 3.33% is all that we can expect for future total return. If yields rise, total returns would be even lower for awhile, since rising yields erode the prices of already-issued bonds.

To get a sense of the risk in bonds, note that AGG's price has fallen 1% since its August 31st high -- equal to almost four months of interest income lost. If AGG's price fell back to the level of early April, it would equal a loss of 18 months worth of interest. AGG's bonds are only about one-third as volatile as stocks. But unlike T-bills and CDs, which carry no price risk when held to maturity, bond funds may experience occasional flat or losing years, especially when their yields are low.

Using a composite of valuation models, Dr. John Hussman of Hussman Funds has estimated [Ref. 3] that US stocks are currently priced to deliver average total returns of about 6% over the next decade -- with plenty of volatility: typically 16% annually. This means that even if stocks do deliver a compounded total return of 6%, one would expect three or four losing years per decade, with one or two of them being harsh double-digit percentage losses. Nevertheless, over many decades, stocks have delivered higher total returns than bonds, which is why pension funds continue to own them.

Like stocks, real estate historically has delivered about half of its total return in the form of price appreciation. While officially-measured inflation is currently low, the Federal Reserve radically expanded its balance sheet in 2008-9, and in August 2010 backed away from promises to let it shrink as mortgage securities are paid off. My belief is that the Fed will never be able to let its asset purchases run off, and that this large expansion of the monetary base will prove inflationary later on. Even modest 3.8% inflation (the annually compounded average since 1946), augmenting both property prices and rents, would produce total returns of 7% for REITs.

Thus, our ranking of expected returns is consistent with the earlier comparison of current yields. The lowest yielding asset class, bonds, also has the lowest projected returns, while REITs garner the top honors in both comparisons. This isn't surprising, since a low current yield directly reduces future return prospects, and vice versa.

Now let's make a final rough-cut comparison -- of popularity. Unscientific, but from a contrarian point of view, we want to favor unpopular assets, while underweighting those enjoying too much enthusiasm. Here is my idiosyncratic poll:

  1. Fixed income -- POPULAR: unprecedented, Bubble-like inflows are going into bond mutual funds.
  2. Stocks -- DOUBTED: outflows from stock mutual funds continue even after gains since early 2009.
  3. Real estate -- HATED: daily, harshly bearish articles bemoan the dreadful state of housing.

Although broad-brush and impressionistic, this informal popularity ranking confirms the other two rankings. We need to be cautious about bonds, while giving real estate at least equal billing to stocks.

Building a robust multi-market portfolio 

In constructing a portfolio to implement these insights, let's start with the 60/40 balanced portfolio mentioned at the beginning. The idea of a portfolio balanced between stocks and bonds goes back at least to 1935, when Gerald Loeb published The Battle for Investment Survival. It remains a core principle of pension fund management to this day.

As we've seen this decade, stocks can be very bad actors during secular bear markets, because of their extreme price swings. With economic prospects dim and dividend yields still low, it's not at all clear that this secular bear market is over. Meanwhile, as discussed, slightly higher returns are expected from real estate than from stocks.

Therefore, instead of devoting 60% of the portfolio to stocks, we're going to split it between stocks and REIT ETFs, giving them 30% each in the overall portfolio. Moreover, the stock portion is going into high-dividend funds -- not only for higher income, but also because research shows that there is no penalty to be paid in price appreciation. In other words, applying an income-oriented value screen to stocks produces excess return compared to the broad, unfiltered universe of stocks. [See Arnott, Hsu and Moore, Fundamental Indexation, Ref. 4.] Furthermore, since economic growth in emerging markets is trouncing that of developed markets by 4%, we want half of our stock allocation overseas. So, here are the proposed stock fund selections and portfolio weights:

  • 15% DVY -- iShares Dow Jones Select Dividend Index. Yield: 3.70%
  • 15% DEM -- Wisdom Tree Emerging Markets Equity Income Index. Yield: 5.74%

As for REIT (Real Estate Investment Trust) ETFs, let's select two large ones:

  • 15% ICF -- iShares Cohen & Steers Realty Majors Index Fund. Yield: 2.88%
  • 15% VNQ -- Vanguard REIT ETF. Yield: 3.56%

Now let's consider the 40% of a balanced portfolio traditionally devoted to bonds. Our analysis suggests that bonds are unattractive -- long maturity bonds have price risk, while short-term bills offer only fractional yields. One way to cut price risk while retaining some yield is in intermediate term bonds. So we'll put 10% of the portfolio into CIU, whose effective duration is 4.24 years. This means that a 100 basis point (one percentage point) rise in prevailing interest rates would clip 4.24% from the value of the fund's bond portfolio. By contrast, the duration of the 10-year T-note is 8.11 years; a 100 basis point rate rise would cost it a punishing 8.11% price decline. The proposed ETF: 

  • 10% CIU -- iShares Barclay Intermediate Credit Bond ETF. Yield: 3.99%

Since bonds are unattractive, let's consider an alternative source of income: master limited partnerships (MLPs), which derive their fairly stable high incomes from midstream energy services, primarily pipelines and storage. A diversified portfolio of MLPs is available in ETNs (Exchange Traded Notes), such as AMJ. However, most ETNs have a management fee of 0.85%, which I regard as undesirably high -- not to mention that ETNs are a debt obligation of their issuers. So for MLPs, we will depart from our use of diversified ETFs elsewhere, and select two individual MLPs:

  • 10% KMP -- Kinder Morgan Energy Partners LP. Yield: 6.35%
  • 10% EPD -- Enterprise Product Partners LP. Yield: 6.04%

Finally, although short-selling bonds in order to profit from a price decline is mathematically unattractive (owing to the required payment of the interest coupon to the lender), we can still include an asset which is negatively correlated to bonds: gold. Although gold stocks do not produce much income, they do serve as a potential hedge against financial calamities ranging from sovereign defaults to weakness in the US dollar. Since this portfolio is denominated in US dollars, we'll dedicate 10% of it to a golden insurance policy:

  • 10% GDX -- Market Vectors Gold Miners ETF. Yield: 0.21%

In total, we've constructed a portfolio diversified among five different markets: stocks; REITs; bonds; energy MLPs; and gold. Call it the 5-market model (5MM) -- not to be confused with 5.56 mm ammo! Yet it uses only eight positions, in order to minimize management and commissions. Its overall yield is a respectable 4%. No one trading symbol constitutes more than 15% of the portfolio. And each fund itself, other than the two MLPs, holds dozens of underlying issues, so that the failure of any single entity would barely affect the portfolio.

Summing up 5MM's allocations by category, they are:

  • 30% stocks
  • 30% REITs
  • 20% energy MLPs
  • 10% intermediate bonds
  • 10% gold stocks

Another way to look at our 5MM portfolio is to refer back to the original 60/40 balanced fund used as a starting point. Now our allocations to these two traditional asset classes are down to only 40% of the entire portfolio: 30% in stocks, 10% in bonds. Both these allocations are tweaked: half the stocks are US high-dividend; the other half are emerging markets high-dividend. The bonds are of intermediate duration to reduce price risk. Moreover, as explained below, the stock/bond allocation can shift between 30/10, 20/20 and 10/30 depending on stocks' valuation.

Fully 60% of the 5MM portfolio is in what would be called alternative investments from the traditional Wall Street point of view: 30% REITs; 20% energy MLPs, 10% gold stocks. Not only does this portion of the portfolio offer a solid yield, but also it has a distinct property and commodity-oriented flavor. These asset classes offer inflation protection, but also have their own price cycles, distinct from those of stocks and bonds. This reduces the chance that all categories of the portfolio would experience price declines at the same time, and measurably reduces risk in the form of price volatility.

Maintaining and modifying the 5MM portfolio 

First off, please consider the 5MM portfolio as a baseline for your own thinking. If you're averse to having 30% in stocks or 10% in gold, then reduce these categories and increase another, such as intermediate bonds. Raising the lower-risk bond allocation cuts overall risk and volatility of the portfolio. Gold stocks are the highest volatility member of the group, but serve an insurance function that the other categories don't. (Disclosure: GDX is the only issue in the 5MM portfolio that I own.) However, there's another way of cutting risk discussed below.

Other sponsors offer ETFs with similar investment objectives to those mentioned here, which could be substituted. Pay attention to their market capitalization, management fees and daily trading volume: some specialized ETFs are small-cap, costly in fees and thinly traded. 

Because of its diversified holdings, the 5MM portfolio could be held for years without changes other than annual rebalancing, to bring the proportions of each holding back into line with their targets. Annual rebalancing is done when a component gets more than a tenth out of line with its target weight. For instance, if a 15% component ends the year valued at over 16.5% of the portfolio, that position would be sold down to 15%, and the proceeds reinvested in underweight components.

A second annual structural adjustment, when indicated, is reducing the two stock fund allocations (DVY, DEM) from 15% to 10% each if the S&P 500 dividend yield is less than 2.0% at the time of annual evaluation (as it was in Dec. 2007, for instance); or to 5% each if the S&P 500 dividend yield is under 1.5% at the end of the period (as it was in Dec. 2000, to mention another pre-recession reading). Under these low-dividend, overvalued-stocks conditions, the allocation to intermediate bonds (CIU) is increased to 20% or 30%, respectively, as the stock weightings are reduced.

With the S&P 500 dividend yield currently hovering at the 2.0% level, the first de-weighting criterion might come into play when the portfolio is next evaluated at the end of 2010. Since the dividend yield is reported with a lag, use the December 1st monthly value for the end-of-year evaluation. You can track the monthly S&P 500 dividend yield at multpl.com, the site listed in Ref. 5.

A third structural adjustment recommended for retirees is to halve risk by placing half of their portfolio in one-year CDs (the longest maturity I would recommend, since rates likely will rise in the future), and the other half into the 5MM portfolio. We'll call this the 5MM/2 portfolio.

It takes an unusual combination of correlated drops across asset classes (such as occurred in 2008) to cause a double-digit annual loss in the 5MM/2 portfolio. Yet it still delivers a blended 2.75% current yield (assuming 1.5% yield on the CD portion), and is expected to add two or three percentage points in annual price gains over a holding period of ten years. If a 3.0% current yield is your non-negotiable minimum, a 40% CDs / 60% 5MM split will deliver it. Or, if you want to cut risk even further, increase the CD allocation to above 50%. Any level of risk tolerance can be catered for in this manner.

Performance simulation: 5MM and 5MM/2

Let's look at a rough estimate of how the 5MM and 5MM/2 portfolios would have performed from the end of 1999 through the end of August 2010, a period of 10.67 years. This was the worst decade for stocks since the 1930s.

Of the eight issues in the 5MM portfolio, only the two energy MLPs existed a decade ago. ETFs, a new idea in the 1990s, gained widespread acceptance in the early 2000s, and many new ones were created. For the six ETFs, performance before their issuance was simulated by substituting older ETFs (SPY for DVY, EEM for DEM, and AGG for CIU) and, before the older ETFs' existence, using indexes such as the MSCI Emerging Markets index, the NAREIT index of REITs, the Barclays Aggregate Index of bonds, and the XAU gold and silver stock index. No allowance was made for commissions and slippage at annual rebalancings, or for taxes.

Because of unavoidable errors introduced by substitutions, the simulated performance figures must be regarded as approximate, impressionistic and optimistic. As usual, past performance is no guarantee of future results. But an important added caveat applies: the preceding disclaimer is standard for actual portfolio past performance data. A simulated portfolio introduces the serious additional distortion of hindsight bias. Let's not beat around the bush about this head-fake headache.

Here is one example of hindsight bias: in constructing this portfolio, I knew that REITs, energy MLPs, emerging market stocks and gold stocks rose strongly during the past decade. Although I was extremely bearish on stocks at the time, had I constructed this multi-market portfolio at the end of 1999, I might not have included the same alternative asset classes, and perhaps not at the same weightings.

A second example of hindsight bias: although the dividend yield thresholds which dictate de-weighting stocks are simple round numbers (2.0% and 1.5%), it's likely in 1999 that I might have used the traditional 3% criterion, or some other levels less finely tuned to the known events of the past decade.

One kind of bias which is not present is optimization -- that is, iteratively varying the component weightings to tease out the highest return. The 5MM portfolio was structured and described before the performance testing was done. No subsequent changes were made to boost the results.

It's axiomatic that a portfolio selected with hindsight bias will not perform as well going forward as it did in the known, certain past. The shortfall might be two, three, even five percentage points of compounded annual return. Only robust underlying design principles, such as asset class diversification and simple rules for portfolio adjustments, can minimize the inevitable performance degradation as markets embark on new secular trends.

Now, with these critical caveats in mind, let's compare the baseline 60/40 balanced portfolio (60/40 BP); the 5MM portfolio; and its diluted version with a 50% anchor in CDs -- 5MM/2. Values in the table are the total return in each year, expressed as a percentage:

Year

Stocks/bonds

(60/40 BP)

5-mrkt model (5MM)

50% CD +

(5MM/2)

2000

 -1.32

21.13

14.11

2001

 -4.09

16.85

10.72

2002

 -9.22

  5.55

  4.26

2003

18.40

33.39

17.72

2004

  8.08

14.83

  8.75

2005

  3.83

12.35

  8.27

2006

10.70

19.53

12.47

2007

  5.71

  1.59

  3.52

2008

-20.75

-25.75

-10.91

2009

19.79

34.14

18.03

2010*

-0.91

11.76

  6.38

                                * through August 31st.

Here are summary statistics for the three portfolios:

Results

Stocks/bonds

(60/40 BP)

5-mrkt model (5MM)

50% CD +

(5MM/2)

Compounded annual return

   2.16%

12.39%

8.46%

Standard deviation

12.20%

16.52%

8.14%

Sharpe ratio

-0.03

0.60

0.73

$100,000 grows to ...

$125,657

$347,527

$237,776

To begin with, the compounded annual return (CAR) from holding 3-month T-bills over the 10.67 year period -- the so-called risk-free rate -- was 2.59%. In T-bills, there's never a losing year -- only a steady progression in equity. However, the CAR from T-bills was almost exactly equal to the compounded annual change in the CPI (Consumer Price Index) over the period -- 2.55%. In T-bills, one only kept even with inflation, not gaining any purchasing power from the interest paid.

In regard to beating inflation, stocks performed superbly in the second half of the 20th century. A typically optimistic late 20th century analysis, cited at Wikipedia, assumed that stocks offer an average 10% total return, while T-bills return about 3.5% annually [Ref. 6]. But stocks' 6.5% extra return comes at a price: namely, highly variable annual returns, both above and below the T-bill rate. A statistic called standard deviation shows that in about two-thirds of years, annual returns from stocks will be within 16% above or below the T-bill return -- a huge range of uncertainty, which is even exceeded the other third of the time. The alarming result is that a few years will deliver savage losses in stocks.

When the average 6.5% extra annual return on stocks is divided by their 16% standard deviation, the result (0.40) is called the Sharpe ratio -- after its inventor, Nobel laureate William Sharpe. Roughly, it expresses that for every percentage point of risk we accept in stocks (as measured by their standard deviation), we get an extra 0.4% of compounded annual return. This is good to a point, unless the loss years are so deep that they scare us out of stocks at their lows -- a real and serious problem.

A cautionary example is the past decade: stocks actually lost 1.5% annually, underperforming T-bills by 4% annually. The risk of holding stocks was not compensated by any extra return. Instead, their Sharpe ratio for the decade fell to -0.20. The ratio changes depending on the period analyzed. Many people thought that stocks' 0.40 Sharpe ratio of the late 20th century was permanent, but it wasn't.

As shown in the Results table above, even the 60/40 balanced portfolio (60/40 BP) underperformed T-bills, so its Sharpe ratio was slightly below zero (-0.03). This traditional mainstay portfolio did not get compensated for the extra risk it took compared to T-bills. A $100,000 investment in the 60/40 BP would have reached $125,657 by the end of last month, versus $131,334 in risk-free T-bills. Sad, ain't it?

The 5MM portfolio was a very different story. During a terrible decade for traditional investments, 5MM racked up a sparking 12.39% compounded annual return, beating the long-term 10% expected of stocks. Standard deviation was 16.52%, about the same as stocks' long-term average (note that stocks' standard deviation rose to a towering 20% in the shaky past decade). 5MM's Sharpe ratio was 0.60 -- half again higher than stocks' 0.40 level during the favorable second half of the 20th century. A $100,000 account in 5MM would have grown to $347,527 by last month, says the simulation.

These are superb results, as indicated by the 5MM portfolio suffering only a single losing year out of eleven -- in 2008. However, it was a heavy loss: 25.75% -- more than a conservative investor would accept. Unusually, all eight components of the 5MM portfolio lost value that year.

To tame this still uncomfortably high volatility, retirees are recommended to put half their portfolio in CDs, which behave like T-bills, but with slightly higher yields. The results for this 5MM/2 portfolio are shown in the rightmost column of the tables. Again, there was a single losing year, now held to less than an 11% loss -- compared to five double-digit annual gains. Compounded annual return was a robust 8.46%. Practically, this means that one could have taken 5% annual cash distributions for income, and still have obtained an average 3.46% annual gain to keep the principal value ahead of inflation.

Moreover, 5MM/2's standard deviation of 8.14% is half that of stocks: this is a 'no sleepless nights' portfolio, par excellence. Its Sharpe ratio of 0.73 is outstanding -- better than the 0.67 Sharpe ratio achieved by a 60/40 balanced portfolio during the mostly bull-market years of 1983-2004, according to historical statistics cited by PanAgora Asset Management [Ref. 7]. A $100,000 investment in 5MM/2 increased to a simulated $237,776.

To lapse into the vernacular for a moment, the 5MM and 5MM/2 portfolios just smoked the living crap out of any traditional portfolio in the past decade. They performed as if the Roaring Nineties never left. This result is an outlier, a dream, a freak of nature! Or is it?

Reasonably, one can't expect such extreme outperformance to continue, given hindsight bias and curve fitting. But even after handicapping the model by several percentage points to offset these factors, it still delivered highly respectable, robust performance under unprecedentedly poor market conditions.

Conclusion 

It's regrettable that the u-ZIRPer extremists of the Federal Reserve have starved savers of income, forcing them to take portfolio price risk that they could avoid in the past. But those who can accept extra risk are likely to be well-compensated for it over the next decade in the 5MM and 5MM/2 portfolios. Despite its deceptive simplicity -- only eight components, plus two criteria for stock weighting -- 5MM is the product of thirty years of research, study, portfolio modeling and testing. As Dolly Parton says: it cost a lot to make it look this cheap. ;-)

References

1.  http://www.aametrics.com/pdfs/world_stock_and_bond_markets_nov2009.pdf

2.  http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aze.ASffYzIM

3.  http://hussmanfunds.com/wmc/wmc100802.htm

4.  http://www.rallc.com/ideas/pdf/fundamentalIndexation.pdf

5.  http://www.multpl.com/s-p-500-dividend-yield/table?f=m

6.  http://en.wikipedia.org/wiki/Sharpe_ratio

7.  https://content.putnam.com/panagora/pdf/risk_party_portfolios.pdf


machinehead is a member of the PeakProsperity.com community and a frequent and prolific comment poster to the site. He is a private investor with a background in engineering, business and trading. His real name punched into a telephone keypad produces this hash: 6424235 9 27696464. Accept no imposters!

Related content

43 Comments

Lemonyellowschwin's picture
Lemonyellowschwin
Status: Platinum Member (Offline)
Joined: Apr 22 2008
Posts: 541
Re: Guest Post: Investing In One Lesson

OMG MH, you put my brain into a semi-permanent coma.

hucklejohn's picture
hucklejohn
Status: Gold Member (Offline)
Joined: Dec 13 2008
Posts: 281
Re: Guest Post: Investing In One Lesson

Thanks for your extended analysis as well as your always excellent posts.  But this seems unnecessarily complicated.  Call me crazy but how about an asset allocation of 100% in gold & silver & 0% in everything else.  Rationale:  Precious metals are real money.  Since all fiat currencies are tending toward zero precious metals will do quite well.  Also, after the current Great Deleveraging will be the Greater Depression where both stocks & bonds will likely perform poorly.  If income is desired some of the gold could be sold as needed.  Obviously whether it's deflation or inflation or just plain currency failure my outlook is apocalyptic.  I am be more interested in the return of my money than the return on my money.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

hucklejohn wrote:

Thanks for your extended analysis as well as your always excellent posts.  But this seems unnecessarily complicated.  Call me crazy but how about an asset allocation of 100% in gold & silver & 0% in everything else.  If income is desired some of the gold could be sold as needed.  

Good question. Here are some summary statistics for GDX (gold stocks) from end-1999 through end-Aug. 2010:

Compound annual return ... 10.37%
Standard deviation ............... 24.29%
Sharpe ratio ............................. 0.43
$100,000 grows to ........ $286,531

GDX fell short of the compound annual return on the 5MM portfolio (10.37% vs. 12.39%), and it did so with higher volatility (standard deviation of 24.29% vs 16.52%). Mind you, this was during a strong decade for gold -- the results for gold stocks (or bullion) were far weaker during the 1980s and 1990s. But even in this strong decade, GDX had double-digit losses of 24% in 2000 and 26% in 2008. That's why it couldn't keep up with the 5MM portfolio in performance.

Here's another way to look at it. Although GDX did outperform the 5MM/2 portfolio, we can construct a portfolio consisting of 25% CDs and 75% in the 5MM portfolio which will equal GDX's compound annual return, but do so with about half the volatility (12% vs. 24% for GDX). A rational investor will prefer a lower volatility portfolio with the same return, unless there are other beliefs involved (e.g., the security markets may stop trading, etc.).

The 5MM portfolio, although it holds 10% gold stocks as an insurance policy, doesn't get into such existential questions. It simply inquires, given the trading vehicles available today, how does one achieve an acceptable risk-adjusted return?

A diversified portfolio is a must to keep risk down. Putting an entire portfolio into one asset is basically a 'Hail Mary pass;' a blind throw of the dice which may make you rich some years, but in other years will painfully whack you. After a few experiences of my own along these lines, I've concluded that one-asset portfolios are not something I want to fool around with anymore.

nickbert's picture
nickbert
Status: Diamond Member (Offline)
Joined: Jan 14 2009
Posts: 1122
Re: Guest Post: Investing In One Lesson

Excellent piece MH!  I'm not currently looking to put money towards financial investments, but I'll be bookmarking this piece for further study if/when I have more discretionary wealth to manage.  Even with an expected future shift away from financial(paper) assets to more tangible assets, stocks/bonds/etc will likely still have a role to play in the global economy, even if it might be a much smaller one.

I only wish my 401k had the kind of flexibility to go in line with a portfolio like this.  I can't take the money out, and I can't put it to where it will do the most good.  More and more it seems that "responsible retirement & 401k investor" is a euphemism for "sucker".

- Nickbert

Doug's picture
Doug
Status: Diamond Member (Offline)
Joined: Oct 1 2008
Posts: 2745
Re: Guest Post: Investing In One Lesson

MH

Thank you so much, this is truly a one lesson primer on investing.  I've never read such a lucid explanation.

Doug

cmartenson's picture
cmartenson
Status: Diamond Member (Online)
Joined: Jun 7 2007
Posts: 3415
Re: Guest Post: Investing In One Lesson

As always MH, a brilliant piece.  I would rather suspect you've been carefully observing, testing and tweaking this view over the years and I fully appreciate your sharing them here, as I am sure others do as well!

What happens to stocks and bonds, would you suppose, if economic growth stalled for a period of time, say 5 to 10 years?  What's the right p/e for an index (or stock) that's not growing?

crash_watcher's picture
crash_watcher
Status: Silver Member (Offline)
Joined: Aug 12 2008
Posts: 146
Re: Guest Post: Investing In One Lesson

Machinehead

To lapse into the vernacular for a moment, the 5MM and 5MM/2 portfolios just smoked the living crap out of any traditional portfolio in the past decade.

I don't know if it qualifies as "traditional" but, Harry Brownes' Permanent Portfolio, a very simple 4-element investment portfolio, has done pretty good over a  longer period:

"In fact, over the 30+ year history of this portfolio strategy the worst loss it ever had was about 4-6% in 1981 with an annual growth of 9-10% since 1972. The portfolio has prospered and protected its money through bear and bull markets alike." http://crawlingroad.com/blog/2008/12/18/the-permanent-portfolio-allocation/

At mid-year 2010, the Permanent Portfolio was up about 6% YTD http://crawlingroad.com/blog/2010/06/ 

The Portfolio involves dividing one's investment allocation to 1/4s of stock, long term bonds, gold, and cash, and then rebalancing annually.  It is designed to hold up to both inflation and deflation, as well as recession and prosperity.

Harry Browne died on Mar 1, 2006. and his last radio show was Nov 13, 2005.  His Radio show archive is still online: http://www.harrybrowne.org/Archives/Archives-investment.htm  (you can see the titles, but can not download shows from there; but you can use this mirror site instead http://www.crawlingroad.com/finance/harrybrowne/radio/  ).  The first three episodes of the show (Aug 8, 2004, Aig 15, 2004, Aug 22, 2004) pretty well cover the Permanent Portfolio concept, and, his book, "Fail Safe Investing" goes into more detail. 

It would be interesting to see how 5MM or 5MM/2 (or equivalents) hold up with back-testing over a similar long period of time. 

Anyway, great post—Michael (that was too easy).

xeomage's picture
xeomage
Status: Member (Offline)
Joined: Aug 18 2008
Posts: 2
Re: Guest Post: Investing In One Lesson

Wow, great post with some very insightful analysis. I'm curious if there is a reason to favor GDX instead of GLD, seeing as GLD is invested in bouillon rather than in gold mining companies.

Thanks!

Quadium's picture
Quadium
Status: Bronze Member (Offline)
Joined: May 5 2010
Posts: 42
Re: Guest Post: Investing In One Lesson

mh - 2 comments:

First, as CM so often points out, the next 20 years will be different. So the fact that "5MM is the product of thirty years of research" doesn't instill much confidence regarding future 5MM performance. It is the new paradigms associated with 3E that I, and no doubt many others, are struggling with ... attempting to maintain a decent investment yield while protecting against declines that are potentially far greater than your worst year with the 5MM portfolio.

Second, I don't favor your choices of midstream energy MLPs. While they are certainly in the energy business and are likely to provide some inflation protection, since they are primarily pipeline and processing companies, they aren't really positioned to benefit directly from dramatic price increases associated with oil and gas. I prefer the upstream energy MLPs. They own large oil and gas reserves, consistently increase their reserves and production year-to-year, and have largely hedged (sold forward) their production for 3+ years at prices that protect their ability to pay their distributions. Their operations are nearly 100% on-shore in the continental U.S. The largest by far, Linn Energy (LINE) has a current yield of 8.3% via its tax-deferred distribution, which Linn has maintained or increased every quarter since its founding. Linn, in particular, though hedged, has maintained upside exposure to oil and gas prices via the use of puts for much of its hedging. (Note that Linn Energy, unlike most of the other upstream MLPs, though treated as an MLP for tax purposes, is really an LLC and thus has no general partner.)

These upstream energy MLPs have been my investment vehicles of choice during these turbulent times. The cash flow via distributions have more than met my needs and the unit price appreciation has far exceeded my expectations. Having said that, as they are currently priced near their all time highs, I wouldn't recommend investing in them without hedging against a market crash. My holdings are hedged, and this strategy is working well ... so far.

quad

Nichoman's picture
Nichoman
Status: Gold Member (Offline)
Joined: Nov 1 2008
Posts: 420
Re: Guest Post: Investing In One Lesson

Machinehead...

Excellent.  Chris has already posed the question I was considering after reading this (i.e. little...no or even negative growth).

As an aside, besides the growth question, scarcity (shortages) impacts on this?  

Please consider providing some thoughts.

Thanks,

Nichoman 

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

cmartenson wrote:

What happens to stocks and bonds, would you suppose, if economic growth stalled for a period of time, say 5 to 10 years?  What's the right p/e for an index (or stock) that's not growing?

If economic growth was flat for a decade, the US would look more like Japan -- flat-to-down stock indexes over the period, while bonds could remain at low yields.

If there's no growth, it tends to raise the dividend yield, since it would be the only source of returns. Assume that T-bonds yield 3% and stocks, because of their greater risk, need to yield 6% to be competitive with bonds in risk-adjusted return. To get from today's 2% dividend yield to 6% in a no-growth environment, stock prices would have to fall to one-third their current level. 

Six percent dividend yields have been seen before in the late 1940s, and from the mid-1970s to early 1980s. Currently, the rate of increase in the Consumer Price Index is much lower than it was in those periods. The dividend yield on the S&P 500 reached 3.6% at the market low in March 2009. A retest of the lows could drive it back to that level, or even 4%. A dividend yield of 6% is unlikely, I think, until inflation rises to high single digits, and interest rates along with it.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

crash_watcher wrote:

I don't know if it qualifies as "traditional" but, Harry Brownes' Permanent Portfolio, a very simple 4-element investment portfolio, has done pretty good over a  longer period:

"In fact, over the 30+ year history of this portfolio strategy the worst loss it ever had was about 4-6% in 1981 with an annual growth of 9-10% since 1972. The portfolio has prospered and protected its money through bear and bull markets alike." http://crawlingroad.com/blog/2008/12/18/the-permanent-portfolio-allocation/

At mid-year 2010, the Permanent Portfolio was up about 6% YTD http://crawlingroad.com/blog/2010/06/ 

The Portfolio involves dividing one's investment allocation to 1/4s of stock, long term bonds, gold, and cash, and then rebalancing annually.  It is designed to hold up to both inflation and deflation, as well as recession and prosperity.

It would be interesting to see how 5MM or 5MM/2 (or equivalents) hold up with back-testing over a similar long period of time. 

Anyway, great post—Michael (that was too easy).

Thanks for the Harry Browne reference and the interesting site link. I'm a great admirer of Harry Browne -- for his Permanent Portfolio; his book How I Found Freedom in an Unfree World, and his presidential run (I voted for him). His Permanent Portfolio is greatly to be admired for its simplicity of construction, and for the fact that it has continued to perform solidly after Harry Browne released it.

Using the numbers from the linked site, for comparability I checked the performance of the Permanent Portfolio over the same 10.67 year period as the 5MM portfolio -- from the end of 1999 to the end of August 2010. The results:

Compound Annual Return ........ 7.62%
Standard Deviation ..................... 4.82%
Sharpe ratio ................................. 1.58
$100,000 grows to ............ $218,872

The Permanent Portfolio's Sharpe ratio of 1.58 is excellent, thanks to its low volatility and 50% allocation to fixed income. On the other hand, its 25% allocation to stocks held its compound annual return to 7.62% for the decade -- about the same as the average 7.86% (compounded annually) it has earned since 1985.

The volatility of the Permanent Portfolio is low enough that it could be leveraged (purchased with about 20% margin in a margin account) to amp up its compound annual return to equal the 8.46% achieved by the 5MM/2 portfolio. If I am right about the poor prospects for long-term bonds going forward, then the weak returns from that 25% component of the Permanent Portfolio would need to be made up with continuing solid gains in gold. ;-)

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

xeomage wrote:

Wow, great post with some very insightful analysis. I'm curious if there is a reason to favor GDX instead of GLD, seeing as GLD is invested in bouillon rather than in gold mining companies.

Thanks!

GDX offers a small yield of 0.20% while GLD doesn't, but it's a minor factor. Either one would produce broadly similar results.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

Quadium wrote:

I prefer the upstream energy MLPs. They own large oil and gas reserves, consistently increase their reserves and production year-to-year, and have largely hedged (sold forward) their production for 3+ years at prices that protect their ability to pay their distributions. Their operations are nearly 100% on-shore in the continental U.S. The largest by far, Linn Energy (LINE) has a current yield of 8.3% via its tax-deferred distribution, which Linn has maintained or increased every quarter since its founding. Linn, in particular, though hedged, has maintained upside exposure to oil and gas prices via the use of puts for much of its hedging. (Note that Linn Energy, unlike most of the other upstream MLPs, though treated as an MLP for tax purposes, is really an LLC and thus has no general partner.)

Thanks; LINE would be a fine candidate for substitution in the portfolio. LINE's history on Yahoo Finance goes back to Jan. 17, 2006. It gained 98% in total return over the period.

The two midstream MLPs in the 5MM portfolio -- KMP and EPD -- gained 86% and 102% respectively in total return over the same period, or an average of 94% for both -- very close to LINE's return.

One could substitute LINE for KMP and gain a slight fillip in past performance. But it is unknowable whether leaders will continue to outperform, or laggards will catch up. 

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

Nichoman wrote:

Machinehead...

Excellent.  Chris has already posed the question I was considering after reading this (i.e. little...no or even negative growth).

As an aside, besides the growth question, scarcity (shortages) impacts on this?  

Please consider providing some thoughts.

Thanks,

Nichoman 

In previous instances of shortages -- the first two oil shocks -- gold, energy and real estate were strong performers. If shortages occur again, I would expect the 60% of the portfolio devoted to these sectors to hold its own.

Quadium's picture
Quadium
Status: Bronze Member (Offline)
Joined: May 5 2010
Posts: 42
Re: Guest Post: Investing In One Lesson

mh - I did a quick chart showing the relative performance of the three MLPs going back to Linn's founding. Although Linn has a slight edge, relative performance in unit price alone wouldn't make that much difference to the 5MM portfolio. (Note that in their latest presentation available at their website, Linn shows a total return of 129%, not 98%.) However, I like the roughly 30% higher yields and the more direct exposure to soaring energy prices. But, as the chart clearly shows Linn is also much more sensitive to declining oil/gas prices. Of course, yields were phenomenal during this dip, with 20%-30% yields quite common. Yummy if you were first investing, as I was, during that period. Smile (P.S. You should have also warned that investing in any of these MLPs exposes investors to the dreaded K-1 form at tax time, and the downside of partnerships doing business in multiple states! Yell) quad

cmartenson's picture
cmartenson
Status: Diamond Member (Online)
Joined: Jun 7 2007
Posts: 3415
Re: Guest Post: Investing In One Lesson

machinehead wrote:

If economic growth was flat for a decade, the US would look more like Japan -- flat-to-down stock indexes over the period, while bonds could remain at low yields.

If there's no growth, it tends to raise the dividend yield, since it would be the only source of returns. Assume that T-bonds yield 3% and stocks, because of their greater risk, need to yield 6% to be competitive with bonds in risk-adjusted return. To get from today's 2% dividend yield to 6% in a no-growth environment, stock prices would have to fall to one-third their current level. 

Six percent dividend yields have been seen before in the late 1940s, and from the mid-1970s to early 1980s. Currently, the rate of increase in the Consumer Price Index is much lower than it was in those periods. The dividend yield on the S&P 500 reached 3.6% at the market low in March 2009. A retest of the lows could drive it back to that level, or even 4%. A dividend yield of 6% is unlikely, I think, until inflation rises to high single digits, and interest rates along with it.

Yes, the stock market at 30% of present value seems about right.  But I would submit that bonds, in aggregate, as an entire class, also have growth built into their core valuation, due to the fact that in order for both the principal and interest components to be paid back in the future, there has to be more money in existence than there is today.  Unless you want to posit some big daisy chain of bondholders that all owe each other money, there's a sort of generalized requirement for the future to have more money floating around than the present.  

So I can imagine a future where bonds perform terribly because while the debts they represent stubbornly stick around, the risk of either unpleasant levels of defaults and/or excessive money printing (without any associated economic growth, as posited in my scenario) in order to assure their payments will serve to drive up interest rates.

With interest rates climbing, then stocks will need to yield more in order to compensate.  All told, I view stocks and bonds as claims on future wealth or money and  that if these claims badly outnumber the economic flows of the future then they will fall in value.

Of course, all of this springs from my general analysis that these aren't ordinary times and that we are at the end of a spectacular multi-decade credit bubble.  History may prove to offer fewer hints and less guidance than we might hope?

Nichoman's picture
Nichoman
Status: Gold Member (Offline)
Joined: Nov 1 2008
Posts: 420
Re: Guest Post: Investing In One Lesson

[quote=cmartenson]

<snip>

...my general analysis that these aren't ordinary times and that we are at the end of a spectacular multi-decade credit bubble.  History may prove to offer fewer hints and less guidance than we might hope?

[/quote]

Interesting.

Offer this post today on Zero Hedge about "2Q Fed Flow of Funds" report is relevant.   How long before the last domino of governments occurs?

Example:  Consider the book "This Time Is Different"

Nichoman

Nate's picture
Nate
Status: Gold Member (Offline)
Joined: May 6 2009
Posts: 461
Re: Guest Post: Investing In One Lesson

machinehead,

Great read.  The returns from your portfolio from 2000 to 2010 had the tailwind of declining interest rates.  I started investing in the late 1970's when utilities returned 12% in dividends and CD's paid 15% to 18% (depending on the term).  What investments are going to provide a positive performance in a rising interest rate and declining energy environment?   How much would stocks or REITS or MLP's have to drop to return to a 8% to12% dividend environment?  The risks are not symetrical.

The next 20 years are indeed going to look very different.  We need to find an equally outside the box set of investment choices for the next 20 years as you picked  for the 2000 to 2010 time period.  This ex-Iowa farmboy thinks farmland could represent 20% of that portfolio.  Clueless about the other 80%.

Nate

mainecooncat's picture
mainecooncat
Status: Gold Member (Offline)
Joined: Sep 7 2008
Posts: 488
Re: Guest Post: Investing In One Lesson

Chris M.,

Thanks for your usual on-point breakdown here. For a second I thought I was at the wrong website.

Diogenknees's picture
Diogenknees
Status: Silver Member (Offline)
Joined: Jun 25 2010
Posts: 109
Re: Guest Post: Investing In One Lesson

I'm late to the thread, what about DRIPS as a safe haven?

crash_watcher's picture
crash_watcher
Status: Silver Member (Offline)
Joined: Aug 12 2008
Posts: 146
Re: Guest Post: Investing In One Lesson

machinehead

Compound Annual Return ........ 7.62%
Standard Deviation ..................... 4.82%
Sharpe ratio ................................. 1.58
$100,000 grows to ............ $218,872

That's a very interesting analysis of the PP—thank you for doing it.   

The remarkable thing about the PP, to me, is its stability over a very long period (e.g., see 36 yearly returns here: http://crawlingroad.com/blog/2008/12/22/permanent-portfolio-historical-returns/).  I suspected that the PP might be less volatile (than 5MM or 5MM/2) , but it's nice to see it confirmed in the Sharpe ratio.  All things being equal, I'd prefer the slightly lower returns for the ~2x lower volatility—but that's just me.  I might make up some of the difference in lower transaction fees because there are fewer elements to rebalance.

I'd urge you to try and come up with some proxy for the elements in your 5MM that would allow you to back-test to 1972 (the year when gold ownership was allowed in the USA, I think), just to see how it stands up over a broader range of economic conditions and stresses.

If I am right about the poor prospects for long-term bonds going forward, then the weak returns from that 25% component of the Permanent Portfolio would need to be made up with continuing solid gains in gold.

You might be right.  Long-term bonds might take a beating—indeed, people have been expecting and predicting that for years.  However, for example, Vanguard's Long-Term Bond Index Fund VBLTX has average returns of over 8%/yr over the last ten years.  Not as good as GDX's +10% but still not bad.

By the same token, what happens to the REITS if entities were no longer allowed to "extend and pretend" with respect to the value of the CRE on their books?  What happens to the energy MLPs if the government, "for national security reasons" intervenes in the oil and gas market and installs price controls, as Eric T posited a few months ago?  What happens to the mining stocks if the government (hello Australia), to "simulate" the economy (and increase government revenue), institutes a heavy "windfall profits tax" on miners? 

Ah, if only we knew the future....but that's what annual rebalancing is for. 

There are many investment uncertainties ahead, and the old warning: "Past Performance is No Guarantee of Future Results" was never truer than it is today.

taxed2death's picture
taxed2death
Status: Member (Offline)
Joined: Jan 24 2010
Posts: 22
Re: Guest Post: Investing In One Lesson

I am not an economist.I am a small business owner in an industry that has been under attack from the government for decades.My industry is not the exception.Most businesses are can no longer afford employees,transportation costs,equipment maintenence,taxes,or any number of fees,licenses,or permits to conduct business.I have been investing for awhile,but it is becoming increasingly difficult to find safe investments.The bottom line is this:your money is only safe in your pocket.gold is money,silver is money,a truckload of firewood is money.paper is not money,it is I.O.U.s from a wasteful,corrupt government.

Politics aside,the facts are clear:

1-Our country is broke.

2-Our politicians and the businessmen that hire them are desperate.

and do not forget the most important one.

3-They control ALL paper assets with the stroke of a keyboard key.

I think i'll keep my funds in useful,tradeable goods for now.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

Nate wrote:

What investments are going to provide a positive performance in a rising interest rate and declining energy environment?   How much would stocks or REITS or MLP's have to drop to return to a 8% to12% dividend environment?  The risks are not symetrical.

The next 20 years are indeed going to look very different.  We need to find an equally outside the box set of investment choices for the next 20 years as you picked  for the 2000 to 2010 time period.  This ex-Iowa farmboy thinks farmland could represent 20% of that portfolio.  Clueless about the other 80%.

Nate

In a rising interest rate environment, fixed-income investments should be as short-term as possible. Stocks in commodity-oriented economies and sectors will do better than others, whose rising earnings will be offset by P/E contraction. REITs and physical commodities should do well when interest rates and inflation are rising.

I searched for farmland REITs, but there aren't any. This comment appeared in an article about the prospects for farmland:

There are not any farmland REITs due to corporate farming laws. 

Our parent company, Colvin & Co. LLC, manages a limited partnership focused on investing in farmland in the Midwest.

http://farmlandforecast.colvin-co.com/2009/02/12/why-invest-in-farmland.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

Diogenknees wrote:

I'm late to the thread, what about DRIPS as a safe haven?

All of the calculations mentioned are total returns, including reinvestment of dividends. 

DRIPS are a convenient mechanism for reinvesting dividends, but do not provide any safe haven if stock prices fall.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

crash_watcher wrote:

machinehead

Compound Annual Return ........ 7.62%
Standard Deviation ..................... 4.82%
Sharpe ratio ................................. 1.58
$100,000 grows to ............ $218,872

That's a very interesting analysis of the PP—thank you for doing it.   

The remarkable thing about the PP, to me, is its stability over a very long period (e.g., see 36 yearly returns here: http://crawlingroad.com/blog/2008/12/22/permanent-portfolio-historical-returns/).  I suspected that the PP might be less volatile (than 5MM or 5MM/2) , but it's nice to see it confirmed in the Sharpe ratio.  All things being equal, I'd prefer the slightly lower returns for the ~2x lower volatility—but that's just me.  I might make up some of the difference in lower transaction fees because there are fewer elements to rebalance.

I'd urge you to try and come up with some proxy for the elements in your 5MM that would allow you to back-test to 1972 (the year when gold ownership was allowed in the USA, I think), just to see how it stands up over a broader range of economic conditions and stresses.

By the same token, what happens to the REITS if entities were no longer allowed to "extend and pretend" with respect to the value of the CRE on their books? 

The low volatility of Harry Browne's Permanent Portfolio is indeed impressive. At the time Harry Browne published it in 1981, he had nine years of history available. Because of the 20X rally in gold during 1972-1980, the Permanent Portfolio's compound annual return was a stunning 15.4% over his test period. In the 30 years since, it has settled into a remarkably stable 8% compound annual return.

An 8% compounded return, while very adequate, took a back seat to the 10%-12% returns that stocks delivered during the long secular rally of 1982-2000. It was during the recent rocky decade for stocks that the Permanent Portfolio, which never missed a beat in delivering gains in each and every year, really shone.

I'd like to backtest the 5MM portfolio farther, but I don't know of any proxies for the energy MLPs before 1997.

Regarding REITs, banks may be 'extending and pretending' on the book value of real estate loans. But their questionable loan valuations apparently are taken into account in their stock prices. The BKX bank index languishes at a pitiful 31% of its early-2007 peak. Chart of BKX:

http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=bkx&sid=0&o_symb=bkx&freq=2&time=11

Similarly, if the carrying value of commercial real estate on REITs' books is unrealistic, presumably their prices have been marked down accordingly. I assume that the stock prices of both banks and REITs reflect investors' informed assessment of the market value, rather than the claimed book value, of their portfolios.

jpitre's picture
jpitre
Status: Gold Member (Offline)
Joined: Mar 3 2009
Posts: 366
Re: Guest Post: Investing In One Lesson

MH

First let me say that I have a great deal of respect for you intelligence & knowledge, especially in the world of investing - thanks for your detailed & thoughtful post -- I do have a comment ........

I think we agree that the next 20+ years will be MUCH different than the last 20 years. If this is so, then projections for the future based on past experience are, in my opinion, suspect to say the least. We may find ourselves in a situation that is far more serious than flat of slightly negative growth. Try on for size the idea of 20 or 50+% inflation combined with having to operate on 50% of our current consumption of oil. Not that the insiders can't still make a lot going forward, because some will do well, however the average investor is left out in the cold. The idea that there is any sort of guaranteed security in the years ahead by so called "investing" seems to me to be an illusion at best. Our economic system is more a system of manipulation and is on the edge of collapse, About the only real security left will be in one's own abilities, community, farmland/water  and assets that enable people to stay alive - maybe some value in a little gold & silver, but even that is questionable given that we are looking at a worldwide crash and not just another USSR or Japan that has/had the rest of the world still charging forward. This is a gloomy picture in some ways no doubt, but is most certainly a distinct possibility - you won't catch me investing in/with some fund manager that in all likelihood has had a part to play in the mess we find ourselves in now. Personally, I will continue to work towards hands on holdings and lifestyle that gets as close to sustainable as possible

Jim

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

Quadium wrote:

mh - I did a quick chart showing the relative performance of the three MLPs going back to Linn's founding. Although Linn has a slight edge, relative performance in unit price alone wouldn't make that much difference to the 5MM portfolio. (Note that in their latest presentation available at their website, Linn shows a total return of 129%, not 98%.) However, I like the roughly 30% higher yields and the more direct exposure to soaring energy prices. But, as the chart clearly shows Linn is also much more sensitive to declining oil/gas prices.

Thanks for the informative chart. Substituting LINN into the portfolio, with its higher volatility, would increase the standard deviation and reduce the Sharpe ratio. So there's a price to be paid in terms of risk, although it may be rewarded by superior returns.

The midstream MLPs derive a majority of their income from revenues that are not sensitive to energy prices. From the original logic of the portfolio -- replacing bonds with a source of high, stable income -- I chose Kinder Morgan and Enterprise for that reason, the lack of volatility related to energy prices.

A more risk-tolerant investor who wants more upside exposure to energy prices would prefer LINN.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

cmartenson wrote:

So I can imagine a future where bonds perform terribly because while the debts they represent stubbornly stick around, the risk of either unpleasant levels of defaults and/or excessive money printing (without any associated economic growth, as posited in my scenario) in order to assure their payments will serve to drive up interest rates.

With interest rates climbing, then stocks will need to yield more in order to compensate.  All told, I view stocks and bonds as claims on future wealth or money and  that if these claims badly outnumber the economic flows of the future then they will fall in value.

Broadly, I share your views. That's why bonds and stocks constitute only 40% of the 5MM portfolio, versus 100% of a typical 60/40 balanced portfolio. So why include them at all?

The reason is that uncorrelated assets can still do a wonderful job of taming the volatility of a portfolio. Here's an example from 2008 and 2009, involving TLT (a long Treasury ETF) and VTI (a total stock market ETF).

2008 -- TLT: +31.07%; VTI: -36.99%
2009 -- TLT: -22.31%; VTI: +28.28%

Long Treasuries popped like crazy in the late 2008 smash, nearly offsetting stocks' collapse. In 2009, the pattern was reversed -- stocks roared back from their panic low, while Treasury prices backed down from their panic high.

In setting out a long-term portfolio, one needs to take advantage of uncorrelated markets. The fallacy of Wall Street's 'buy and hold' philosophy is that stocks, as an asset class, are just too distressingly volatile for most people to hold them during the dips. This is true of most asset classes which offer high returns -- now and then, they're going to bite you. Multi-asset class portfolios do a surprisingly good job of damping volatility while still delivering acceptable returns.

Nate's picture
Nate
Status: Gold Member (Offline)
Joined: May 6 2009
Posts: 461
Re: Guest Post: Investing In One Lesson

MH,

Thanks for the direct response.  I appreciate it.

jpitre,

Spot on (x 10).  Since peak oil = peak food = peak people, the only thing that makes sense to me is community, farmland, water, and the ability to perform tasks or provide services that are absolutely needed.

Nate

hucklejohn's picture
hucklejohn
Status: Gold Member (Offline)
Joined: Dec 13 2008
Posts: 281
Re: Guest Post: Investing In One Lesson

MH -- Thanks for all your hard work.  I was one of the earliest posts advocating -- call me crazy -- partly tongue in check -- an all precious metals portfolio.  Your analysis used a portfolio of all gold stocks rather than gold itself.  Would your analysis of an all gold portfolio be significantly different?  The reason I am half serious about an all precious metals portfolio is because we are in a crisis period & being in precious metals -- bullion not the stocks -- is like going to all cash when the stock market appears risky.  The crisis period I refer to the period from late 2007 through the present through to somewhere between 2012-2015 depending upon when the government gives up on its efforts to stimulate which are instead destroying the economy.  Thanks again for all  your work.  By the way are you a financial advisor? 

cmartenson's picture
cmartenson
Status: Diamond Member (Online)
Joined: Jun 7 2007
Posts: 3415
Re: Guest Post: Investing In One Lesson

machinehead wrote:

In setting out a long-term portfolio, one needs to take advantage of uncorrelated markets. The fallacy of Wall Street's 'buy and hold' philosophy is that stocks, as an asset class, are just too distressingly volatile for most people to hold them during the dips. This is true of most asset classes which offer high returns -- now and then, they're going to bite you. Multi-asset class portfolios do a surprisingly good job of damping volatility while still delivering acceptable returns.

Ah...

In the bolded sentence a major source of discomfort I have with the current market structure has been uncovered and it centers on correlation.

Let me be clear;  this is a relatively recent discomfort of mine, having first been detected by me as a minor burr under my investing saddle which I couldn't quite dislodge (first noticed circa 2004 because I missed the early signs; I think the actual rise began in 2003 but that was difficult to detect) but which eventually wriggled out, germinated, and is now a well developed weed patch that is thoroughly unavoidable.  At least I have to wade right through it.

A recent repost of somebody else's material on Zerohedge (sorry, I forgot to preserve the link to provide here, but the article was within the last two weeks and should be relatively easily located) by a money manager who came up with this next hair raising image (among other goodies).  

Ponder this one for a few, I'll wait:

During the period roughly in question for your 5MM portfolio (barring the last two years), the degree of correlation of stocks with bonds/commodities/gold/oil/dollar has roughly remained within a +/- band of 15%, give or take.  It is only within the last two years that we breached first the 30% mark, then the 40% mark, and even the 50% mark.  Zounds.  I don't have access to the base data, but by eye I would be surprised if the mean plus a second standard deviation has not been put in the rear-view mirror.

The above chart confirms my personal trading experience; correlations are now so tightly - what ... managed? ... part of the 'new' reality?? - that they must be reconsidered from any historical perspective to include the possibility that prior safety zones of 'negative beta' (i.e. inverse correlation) no longer exist to the same degree as they did in the past.

Said more simply, the above chart suggests that reversion to the mean (a return of correlation) is a distinct possibility and that a period of 'devolution' from high correlation to low(er) correlation might, possibly, maybe, blow a model or two out of the water. 

The question, then, is what happens to the 5MM model if/(when) the correlations revert to the mean?  Is the 5MM a helpful place to be or the opposite?  Do returns increase or decrease?

I ask these questions with an open mind, and in the spirit of inquiry and learning.

Adam Taggart's picture
Adam Taggart
Status: Peak Prosperity Co-founder (Offline)
Joined: May 26 2009
Posts: 1828
Re: Guest Post: Investing In One Lesson

Chris -

Given that the major asset classes seem to now be much more correlated vs historical norms, if there were to be a substantial correction in the equity markets while we are in this abnormal state, would you expect the other asset groups - including PMs - to decline along with it? (at least initially)

crash_watcher's picture
crash_watcher
Status: Silver Member (Offline)
Joined: Aug 12 2008
Posts: 146
Re: Guest Post: Investing In One Lesson

From the article:

This is the unfortunate result of markets where governments and central banks try to truncate risk and algos determine marginal prices based on short-term patterns.  In the real economy, price signals have become distorted, thus causing capital to be inefficiently allocated.  In the financial economy, the environment has become riskier than ever.  The farther prices are pushed away from their true underlying value, the greater the adjustment will be.  And one thing the algos don’t do  - adjust slowly.

http://www.zerohedge.com/article/guest-post-implied-correlations-approach-100-energy-healthcare-technology-rat%E2%80%99s-ass-etc

yobob1's picture
yobob1
Status: Silver Member (Offline)
Joined: Apr 20 2009
Posts: 132
Re: Guest Post: Investing In One Lesson

Excellent MH - you couldn't buy this analysis from any money mangler.  I do however have similar questions as Chris.  At this stage of the game, the only era we have for comparison is the 1930s - the only other time in relatively modern history that has witnessed a severe credit contraction. That era too was fraught with massive interventions from all quarters - to no avail as the credit bubble then was no more immune to total deflation from the gaping hole and insufficient additions demanded by the Ponzi-esque nature of fractional reserve lending.

We as mere mortals cannot know the true extent of the contraction as we are not privy to an honest analysis of holdings of our fine upstanding financial institutions.  We can only get glimpses of some of it such as this piece from a WSJ blog

http://blogs.wsj.com/economics/2010/09/18/number-of-the-week-defaults-ac....

In short almost all of the debt reduction by consumers over the last 2 years (including mortgages) has been by default. And how many times was debt leveraged and releveraged?  We do not know but the size of the derivatives tower in comparison to total global debt is a pretty good clue.

I doubt there's too much we can project into the future based on the past - unless we look way back and skip right over about 70 or 80 years.  Even that may be of little value since the monetary system back then at least gave lip service to a species backed money and frankly too much time has past.  Those who might have served as guides are dead and much has been lost to history or suffered "revision".

This game may turn out not answering the question of who made the most, but who lost the least.  The average 401K holder with his $40,000 invested and $225,000 mortgage on a house now worth $150,000 is already road kill. 

jpitre's picture
jpitre
Status: Gold Member (Offline)
Joined: Mar 3 2009
Posts: 366
Re: Guest Post: Investing In One Lesson

This thread and much of this site talks/argues about so-called "investments". I submit that somewhere along the way in the last 30 years are so, nearly all investments within the mainstream meaning have become speculative gambles. Markets are so manipulated that pricing has become so removed from true value, that typical investors are no longer tied to actual wealth and the means of creating it --  rather to the current scam of the day perpetrated by the Corporatocracy colluding with the banksters and big government,

Chris has been careful to describe the source of all wealth as coming from basic resources coupled with human effort & ingenuity including manufacturing. We have now moved into a virtual world where derivatives with unknown value form the majority of our wealth. Paper shufflers who pretend to create wealth but create none --  do the manipulation by means of false markets and our debt based monetary system. Most of us have come to accept that Wall Street somehow is an indicator of real wealth when in fact nothing could be farther from the truth. We make major decisions based on the Dow and/or some index and where we guess the speculators will push them. 

Difficult if not impossible to survive without a seat at the table with those who call the shots when their only aim is selfish control with no regard to our country, our people or any moral guideline.

Jim

taxed2death's picture
taxed2death
Status: Member (Offline)
Joined: Jan 24 2010
Posts: 22
Re: Guest Post: Investing In One Lesson

I don't understand most of the derivatives and forecasting and soforth.More than one great investor has warned not to invest in something that you do not understand.I am in my late 20's,self employed,blue collar as they come.All my long term stocks are in DRIPS.I think the idea is great,I invest my "excess human energy"(money)into a company I believe in and if they make even more excess human energy from it then I get a portion which I can send straight back to them for even more profits.

The poison in the kool-aid for me is this:In the last couple of years I have learned about fiat currencies and us gov money policies.

I worked damned hard for some paper which could be devalued because my representatives are less responsible than me?A single,high taxation of my hard earned money always pissed me off,but when I realized they will tax it multiple times without a vote by quantitative easing(isn't that one of the complaints in the declaration of independance?) I stopped buying Stocks and started holding gold and silver.

I have often thought about a bank that only loaned gold or silver(to be repaid in only gold and silver).Is it legal?

JAG's picture
JAG
Status: Diamond Member (Offline)
Joined: Oct 26 2008
Posts: 2490
Re: Guest Post: Investing In One Lesson

cmartenson wrote:

The question, then, is what happens to the 5MM model if/(when) the correlations revert to the mean?  

Dr. M,

Perhaps I have misunderstood your query here, but what I think your saying is that all asset classes are tightly correlated and diversification is not possible in this market. If this is the case, how is owning gold any different from owning (or renting) any other asset? Many here believe that owning gold effectively takes them "out of the game" and is therefore a safe investment relative to stocks and bonds. As you know, I think idea that gold is a market safe haven is very short-sighted. Its price is not derived from the average Joe exchanging bullion with his dealer, its derived from the same market as every other asset.

But the mean reversion that we should really be concerned about is not in the stock, bond, real estate, or commodity markets: its in the credit market. Without the explosion in credit over the last decade, none of these assets would have appreciated to the degree that they have, gold included. And without that credit these assets are going to depreciate in purchasing power.

The only asset that is not correlated to the markets is physical cash. When the demand for cash rises, all other assets depreciate in value. And with a mean-reversion in available (private) credit taking place, the demand for cash will only increase in our future. Besides, its the ultimate contrarian play, after all, what fool would hold (or desire) physical cash in the face of unprecedented "printing" by the Fed? The "fool" that needs to feed his family would. 

Best....Jeff

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

cmartenson wrote:

machinehead wrote:

In setting out a long-term portfolio, one needs to take advantage of uncorrelated markets

Said more simply, the above chart suggests that reversion to the mean (a return of correlation) is a distinct possibility and that a period of 'devolution' from high correlation to low(er) correlation might, possibly, maybe, blow a model or two out of the water. 

The question, then, is what happens to the 5MM model if/(when) the correlations revert to the mean?  Is the 5MM a helpful place to be or the opposite?  Do returns increase or decrease?

About 8 of the 10.67 years of data used in the 5MM featured relatively uncorrelated markets, which are the preferred condition for a multi-market model -- otherwise market diversification doesn't offer as much protection as it should. 

The 5MM model performed just fine during the highly correlated markets of 2009 and 2010. But it's really the uncorrelated markets that it is designed for.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

yobob1 wrote:

At this stage of the game, the only era we have for comparison is the 1930s - the only other time in relatively modern history that has witnessed a severe credit contraction. 

That comparison doesn't bother me. REITs didn't exist in the 1930s -- although Joseph Kennedy reportedly made a fortune buying Chicago's Merchandise Mart at the low point in 1933, with huge overcapacity in commercial real estate overhanging the market.

But common stocks enjoyed a monster rally from 1932-1937, while gold stocks (e.g. Homestake) rallied for the whole decade, and T-bonds and oil companies held their own. 

Under any given economic conditions, some asset class either will be doing well, or will be cheap enough to constitute the 'buy of a lifetime.' I fantasized about buying Zimbabwean assets during the hyperinflation. The hyperinflation burnt out, and both stocks and real estate doubtless have bounced back strongly with the return of monetary stability.

Markets are always changing, but they still rhyme with the past. We can't allow ourselves to be immobilized by the notion that there are no guideposts to steer by.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

Although the source of this chart was not identified in the Zerohedge article, it has the look of a Ned Davis chart:

The construction of this chart is a little odd. One would expect that when gold, oil and the CRB are rising, the two-year and ten-year yields would rise too. On the other hand, all of these factors normally would be bad for the dollar. So the inclusion of the dollar index in this group strikes an off note. The dollar index ought to be included as an inverse factor.

When deflation fears rule, naturally stocks (the S&P 500) correlate with material prices and yields. Bullish economic prospects make them all rise together, and vice versa. 

When Ben Bernanke finally defeats deflation, this tight correlation will evaporate like a morning mist. In the long run, rising materials prices and interest rates cannot be good for stock prices. This temporary strong correlation is exactly what the chart identifies it as -- a rare statistical outlier.

rwitty's picture
rwitty
Status: Member (Offline)
Joined: Dec 12 2009
Posts: 4
Re: Guest Post: Investing In One Lesson

In all of the analysis presented, I'm surprised that returns are not adjusted for inflation.

For example, the bond market returned 15% when inflation was 9%. The current nominal return is not as skewed as the gross returns presented.

It doesn't necessarily render conclusions invalid, so much as indeterminate. Rather than get educated, I got fogged, and I am familiar with this stuff.

Debt is more of a class issue than is being articulated here.

Debt is a relationship between a debtor and a creditor. Without question, being in debt, and in net debt is the absence of freedom, even in absence of freedom to fulfill one's social responsibilities to use one's net equity well.

The increase in debt, and interest, in the world, is a relationship of transfer of net wealth (or net social permission to rights) from working classes to owning classes.

The relationship of geometrical debt returns to lesser geometrical productivity returns, or arithmetic solar income or personal savings, is a transfer between classes.

When creditors receive 3% return on their net equity, and productivity increases by 1.5% and over an extended period of time, that is a transfer of wealth, that drives the prospect of economic collapse.

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Guest Post: Investing In One Lesson

rwitty wrote:

In all of the analysis presented, I'm surprised that returns are not adjusted for inflation.

For example, the bond market returned 15% when inflation was 9%. The current nominal return is not as skewed as the gross returns presented.

It doesn't necessarily render conclusions invalid, so much as indeterminate. Rather than get educated, I got fogged, and I am familiar with this stuff.

Expressing rates of return in nominal terms is the industry standard for reporting stock and mutual fund performance. 

Inflation has run at 2.5% compounded over the past 10 years. Nominal compounded annual returns for this period can be converted to real returns by subtracting 2.5%.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Login or Register to post comments