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This is part of our ongoing series on investing. Part 1: Index Investing
Disclaimer: Since we’re not licensed financial advisors, we aren’t legally allowed to recommend individual assets. We are simply describing the investing strategies that got us here. Please consult a professional before implementing any of these strategies.
So we’ve discussed Index Investing (please go back and read that if you haven’t already). But Index Investing alone isn’t enough to tell you how to invest. Which indexes do I buy? And how much? We’ll answer these questions now.
But first, some background. When it comes to stocks, bonds, or ANY financial asset (even houses), the two most important factors are return and risk.
What does this mean?
- Return. Simple. This is how much an asset’s price went up over a given time frame (including reinvested dividends). Typically expressed as % per year.
- Risk. Not so simple. This is defined as asset volatility. High volatility means the asset will swing wildly, low volatility means the asset will just stay the same. This is typically expressed as an asset’s standard deviation.
Have you ever heard the term no risk, no reward? This is where it came from. High returns come from additional risk, and in the short term you’ll experience more wild market gyrations. Let’s look at an example.
For these numbers, I downloaded the price data of a US bond fund (Vanguard Total Bond Market ETF or “BND”). And for the S&P500, I used the Vanguard 500 ETF (“VOO”). I then analyzed their pricing data (including dividends) over the last 5 years, and calculated the annualized rate of return and the asset’s standard deviation. Here’s what I found.
Okay, here’s how you read the chart. Y-axis is the return. Higher is better. X-axis is volatility. The further to the right, the more volatile. I also added in a dot for a savings account, just for the Hell of it. It’s super low, meaning a low return, and also all the way to the left, meaning no volatility. It is impossible to lose money in a savings account.
But what does this actually mean? Well glad you asked, imaginary person I’m talking to. Here’s a graph of both ETF’s price history over the past 5 years.
You’ll probably notice a few things right off the bat. The S&P 500 goes much higher and is WAY more spiky. That’s volatility. The higher the standard deviation (and the volatility), the more wildly its price swings, day to day. There are 2 large drops on the right on August 2015 and January 2016. They were caused by the oil price crash you’ve read about in the news. Bonds, on the other hand didn’t drop at all. In fact, they kept going up (slowly, but up).
That’s how you gauge risk/return of financial assets. The higher the dot, the more it goes up over time. But the more “to the right” , the more spiky it is in the short term.
So which one do we want to buy, stocks or bonds? The answer is “both.”
Instead of shoving all our money at stocks or bonds, we buy some of each. This way, rather than just jumping into a hot tub and hoping not to get burned, you can ease into it at a rate that’s more comfy for you.
To show you how to do this, I’ve created some sample portfolios using these two assets:
- 60% stocks and 40% bonds (or “60/40”)
- 40% stocks and 60% bonds (or “40/60”)
Let’s see what effect this has on risk/return.
And let’s bring that up on the Risk/Reward chart…
Notice how the 60/40 and 40/60 dots are between the S&P 500/Bond dots? These portfolios are getting both the stability of the bonds plus the returns from stocks. % of assets in stocks is like a knob you can turn. So you get to decide how much return to trade off for spikiness.
How do these portfolios look on the price history chart?
Oooh colourful! The more equities you own, the higher your return, but also with more spikes. That being said, those big drops don’t look so scary on the 60/40 line, does it? And even less so on the 40/60 line.
So that’s how you build a portfolio and control volatility. Investing doesn’t seem so complicated now, does it?
Now, before we go any further, let me reiterate that I didn’t make any of this stuff up. This is a simplified explanation of Modern Portfolio Theory, created by economist Harry Markowitz. His work on this ended up winning him a Nobel Prize in economics.
But of course it wouldn’t be fair to write about Modern Portfolio Theory without discussing what’s wrong with it. Modern Portfolio Theory is a very math and statistics-based strategy. In Statistics, Expected Value is a “probability-weighted average of all possible values“. And if you go in and actually read the paper, you’ll realize that the authors are treating each stock or asset in their portfolio as a random variable with a known Expected Value, or an “Expected Return”.
In real life I don’t have a crystal ball to figure out a stock’s Expected Return, so the best I can do is look at history to calculate it. And that leads to the biggest criticism of Modern Portfolio Theory:
It assumes what happened in the past will continue to happen in the future
Why is this a problem? Because for individual stocks, this assumption isn’t true. Just because a stock appreciated 10% a year over the last 5 years does not mean it will continue to do so. Remember Blackberry? Or Palm? Or Nortel? All were, at some point hot stocks that were gaining like crazy.
That’s why it’s very important to understand that Modern Portfolio Theory only makes sense when combined with Index Investing. Remember, Index Investing is based on the idea that while individual companies may rise and fall, all companies as a whole will always make money. So for the Index, I can state with confidence that long-term past behaviour can predict future results.
And I can already hear the keyboards clamouring, pointing out low interest rate policy and globalization and China and Donald Trump blah blah blah. And you are free to disagree with me. But the S & P 500 goes all the way back to 1923, and during that time, we’ve had:
- The Great Depression
- Two world wars (WORST SEQUEL EVER)
- The Cold War
- The Cuban Missile Crisis (which, may I remind you, was a period in which nuclear apocalypse was a very real possibility)
- The rise and fall of Communism
- The Great Financial Crisis of 2008
Throughout it all, humanity as a whole remained standing, and continued to make money.
THAT is why we chose Modern Portfolio Theory combined with Index Investing as our investment strategy.
And again, I’m not trying to influence you. In no way do I gain by convincing you one way or the other. If you believe the world is about to end, then this investing strategy doesn’t make sense for you and you shouldn’t do it. Although to be fair, if you believe that, then NO investing strategy makes sense for you because Trump/Communists/Zombies will eventually kill us all. And when that happens, the one with the most shotgun shells wins.
But in the unlikely event that you’re still with me, the million dollar question is: How do I know what percentage of equities is right for me?
Great question. This is a process called Asset Allocation, and that’s what we’ll be discussing on the next article in this series.