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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.
| Asset | Return | Standard Deviation |
|---|---|---|
| Bonds | 4.3% | 3.31% |
| S&P500 | 12.6% | 15.52% |
| Savings Account | 1% | 0% |
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.
| Asset | Return | Standard Deviation |
|---|---|---|
| Bonds | 4.3% | 3.31% |
| S&P500 | 12.6% | 15.52% |
| 60/40 | 10% | 10.9% |
| 40/60 | 8.3% | 7.95% |
| Savings Account | 1% | 0% |
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
- 9/11
- 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.
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Looking forward to the next post. Very curious to read your thoughts on asset allocation and if they match Garth’s completely. 🙂
Our philosophies about asset allocation are the same, but I can’t post his actual model portfolio. Because I’m not a licensed advisor, I’m not allowed to legally and he’d probably sic Bandit on me.
Really loving the articles! Thanks for putting them out there 🙂
Thanks for that! And thanks for reading!
Great article! Thanks for writing and sharing. My family follows a similar strategy using Justin Bender’s model portfolio setup. We struggle with what the best % allocation to bonds is. As non-resident Canadians we don’t pay any capital gains, but we do have to pay 25% on the bond distributions and on dividends. We currently have about 35% in VAB (intermediate term bond ETF) and it’s done okay, but I still worry about the bond allocation and think it may not be worth the lower volatility and the lowish gains. A lot of early retirement sites and forum posts tend to suggest going minimal with bonds, so your article provides an interesting counterpoint to those.
We’re enjoying all of the posts!
Glad you’re enjoying them!
And yes, I have heard the same advice from other early retirees as well. Mr. Money Mustache I think wrote up a post saying “Dump it all into VTSMX (a total-stock index fund)!”
The reason for this I think is that your tolerance to volatility goes up the more educated you get about investment. When we first retired we thought that safety only came with a high fixed-income allocation so we could live off the yield, but after a year of retirement and actually seeing our money go up and down, we realized that it’s possible to use a cash cushion to “smooth out” your year-to-year expenses, and can actually tolerate a much higher equity weighting (we’re 60% right now, but we calculated we can go 70% or even 80%). This is a complex topic, so we’ll write a future post about this, but that’s why.
I think people who are relatively new to investing should maintain a conservative equity weighting, and when they ride through a few downturns and realize it’s not so bad, their tolerance to volatility will naturally rise like ours did.
Thanks!
Basic…Question about asset allocation in registered vs non registered accounts…where would binds go and where would equities go.
For example where would a global ETF go…which includes 50% US and the remainder of other international assets.
Bonds are the highest taxed securities, so they go into the RRSP. Equities go into TFSA, except for US-listed US equities which go into the RRSP to avoid the US withholding tax. So for a global ETF, which is a mix of US and international, that would go into the TFSA.
We will be writing a detailed tax minimization post later this week.
XUS and XUU are both listed on the TSX, so they’re not US listed. You can tell by going to Google Finance and typing in the ticker symbols:
XUS: https://www.google.ca/finance?q=xus&hl=en&gl=ca&ei=TW6bV7CQH8XMjAGdm4bACA
XUU: https://www.google.ca/finance?q=xuu&hl=en&gl=ca&ei=Hm6bV9mwAsegjAGFx4uYBw
If you look at the top, it says “TSE:XUS”, “TSE:XUU”. This means it’s listed on the Toronto Stock Exchange. Whereas for a company like Apple, it’ll say “NASDAQ:AAPL”, which means it’s listed on the NASDAQ.
So to answer your question, XUS and XUU, from looking at Google Finance, are NOT US listed US equities, so they can go into the TFSA.
Hi, I am really enjoying your site and all the info you have to offer. Even though i’m starting late(40 🙁 ) i would like to make some portfolio changes similar to yours. I understand the index funds(Stocks) and bonds. Right now i have my money in mutual funds. Yikes, i know. When i go in to ask for the changes, i can probably sell my mutual funds to buy the index funds, but how do i buy the bonds? Thanks so much.
Can ETF index be bought in RESP account?
Yes.
I am in my middle 50s with noting. Late bloomer and late starter. Family values and culture – get married and husband will take care of you. It did not happen.
I am learning so much – thank you, thank you so much!
By the way, I am in the USA! Any suggestions?
Diem
Why not use the total stock market index fund but rather the S&P 500 index? The former truly is the total equity market while the latter is a proxy. Is the correlation between the two close enough? Can’t the S&P 500 companies change periodically like the Dow? Is S&P 500 index recommendation partly because Warren Buffet had mentioned it in his letter to shareholders?
Both are indexes and both work just fine. Fellow FI-er and Godfather J.L. Collins swears by the VTSAX (he’d name his kid that if he could). I like the S&P500 but one’s performance isn’t going to be too different than the other.
Great. Sounds like that MSCI EAFE Index is recommended? What percentage of equity is used for international exposure? I see JL Collins did not recommend that in his book (great recommendation!)
For the 4% withdrawal, is it accurate to say it is from the ordinary (not tax advantaged accounts)? Goal being first use / withdrawal from ordinary accounts until time / age allows use / withdrawal from tax advantaged accounts? If that is the case, all future dollars / income are invested in ordinary accounts / tax advantaged, or both?
Okay, one MAJOR problem with this.
If zombies rise and take over, a shotgun is not your best primary weapon. You need to be able to score one shot kills at mid-range as well as effectively carry as much ammo as possible. A shotgun is far from a marksman’s weapon and more suited to short range, at which point you should be using melee weapons. Plus, the shells are too heavy to effectively carry enough, meaning you’re taking less ammo with you.
Your primary weapon should be something with light rounds for effective carrying, with the ability to make single shot kills at mid-range with no possibility of you wasting ammo. A WWII era M1 Garand or M1 Carbine should do the trick, with a pistol as a sidearm. Silencers and scope attachments for each are also recommended as you want to avoid combat at all costs with the undead.
How are you guys going to give investment advice if you don’t know this stuff? Did you even read “The Zombie Survival Guide”? Sounds like you didn’t.
Let me know if you have any other questions.
Sincerely,
ARB–Angry Retail Banker
OK fine I get that shotgun shells may not have the best weight-per-round characteristics, but an M1 Garand chambered to .30-06 rounds? Have you ever held a clip of those? They are NOT light. Besides I prefer guns that don’t announce to the world that I’m out of ammo. PING!
But that’s besides the point. With any rifle, I’m going to have to nail a headshot to take out the damned thing, and if it takes me 3 or 4 tries to hit it, then I’m not really getting the savings from the decreased weight, am I? But with a shotgun I can just point in its general direction and let er rip. I may not technically kill it, but it won’t have a torso left over either, so…everybody wins?
I like your idea on melee weapons though. I always fancied myself a samurai sword kind of gal, but now that Michonne from Walking Dead owns that shit, I’ll have to come up with something else. Like a machete maybe? I could be a machete girl.
I really truly love this blog more because of this post…lol
I second Bill’s opinion, we have absolutely no idea where which way markets will turn, but we can see from history, what they have done, and where they are today, right now. Balance is a very important concept in finances as well as in life, so please tell me, why are there some that still push the 100% equities concept?
Sorry, not for me, and even comments such as ” I wish I had some cash at the bottom of 2008 to invest” make me think, Hey.. a duh, what do you think a balanced portfolio allows you to do…. buy low sell high…
This is blowing my mind. I think your blog is about to change my life. May I ask who you invest with? I am at investors group and not sure where to proceed with this information I am learning.
This can be done self-directed, feel free to follow our step-by-step free investment workshop to build a portfolio like ours:
https://www.millennial-revolution.com/investworkshop/
We also have a financial advisor, Garth Turner, whom you can reach out to. He only takes Canadian clients and requires a 150K+ portfolio to be taken on as a client.
Reading this in 2018! I have very little to invest at this time but things are about to change quickly by next year. I am currently a medicine resident (overworked and underpaid) but the end is near! I want to be ready when the money starts coming to be able to make the smart decisions ,and that is how I found this blog. I am grateful for all the free information, I have a lot of questions. Can you give advice on how to approach debt burden while investing (school loans up to 600k is what I am talking about ?)?
Hi guys
I have been following your blogs since more than 1 year. Great advice.
Just wondering what are you holding in your portfolio and what are you buying right now in this volatile market ?
I would appreciate if you can share please.