How Big is Your Stock Allocation

No marathon post today. Also, I am not planning to maintain my schedule of bi-weekly posts until the end of August. Vacation and family time will be taking priority!

For the last pre-vacation post, I thought I would toss out a question that I often think about.

If we Canadians were not living next door to the most successful and most free economy of the 20th century, would we be infected with buy-and-hold investment philosophy?

Contributors to the Prevailing Wisdom

Passive investing, particularly of the stock index and bond index variety, is a recent American phenomenon. It has only existed since the 1970s and was popularized in the past 20 years. Although the origins are a bit more nuanced than this, it is essentially a combination of Modern Portfolio Theory (academically published in the 1950s) and passive index funds (started in the early 1970s).

These were both great innovations! Modern Portfolio Theory provided a mathematical model for benefits of diversification and passive index funds were the answer to a long problem: managed mutual funds consistently underperformed the broad stock indices.

Index funds also blew a hole in the whole fee structure of global investments. Trailing management fees have come down massively, fund load fees have all but vanished, and financial adviser fees changed to transparent direct fees instead of opaque commissions.

All of this translated to less trading and lower costs for investors. Something many great investors figured out long before.

Even in the 1910s era, the great speculator Jesse Livermore observed that frequent trading killed profits: "Money is made by sitting, not trading".

Thanks to these innovations, if you are paying any load fees on mutual funds in your personal portfolio, or if you are paying a portfolio averaged trailing fee of more than 0.5% on funds, or if you are paying an investment advisor more than 1%, you need to move on.

Risks of Stock Heavy Portfolios

All of the innovations that I mentioned above are great for investors. Lower fees and a reluctance towards heavy trading being huge!

But I do believe there is a hidden danger in the current prevailing wisdom of "stocks for the long run".

Many self-directed investors are way too comfortable with a passive stock index dominated portfolio. This is something I was guilty of myself!

Looking at simple backtests, it appears obvious that an investor who can withstand a few hiccups here and there should be at least 80% invested in stocks with maybe a small amount of bonds for "fresh powder" in downturns. Even 100% stocks for the long run looks nice on paper.

However, this philosophy assumes that stocks inevitably climb over the medium term and long term. That ignores a significant number of real world examples where this did not happen.

Living next door to the country that came roaring into the 20th century, usurped Britain as the financial market capital, effectively took the wealth of Britain and France (war is not cheap), became the risk-free bond issuer and dominant world fiat currency, and is the largest industrial and innovation powerhouse the world has ever seen can be a bit numbing.

The Dow Jones and the S&P 500 have killed it since their inceptions! Annual returns of approximately 10% gross (6% inflation-adjusted) make for massive returns with a heavy dose of time.

But we conveniently ignore the trauma investors in other markets experienced during the same time period.

The complete collapses of the German, Russian and Argentine financial markets. Germany was a manufacturing and innovation leader with a strong economy just a few years earlier. Russia and Argentina were promising markets and resources powerhouses.

We also ignore the more recent, devastating collapse of the Japanese market. The Japanese stock market is a highly diversified market that compares well with the U.S. by sector diversification.

It has been nearly 30 years since the market peak of the Nikkei 225 and we are no where near a new market high (still down over 40%). I would be surprised if we see a new high at 40 years following the collapse. In fact, it's entirely realistic to believe that it would take 50 years—half a century—to see a new high in Japanese stocks. Thanks to dividends, an investor would be a little under break-even now.

Despite the market turmoil, Japan is still a powerful economic nation that has maintained a free market capitalist economy. Their currency has held up strongly, saving many investors from completely catastrophic loss. Companies are innovating, producing new goods and services, and creating wealth for Japanese people. Entrepreneurship is alive and well!

Dealing With Risk

My point is simple. Stocks do not always go up over time. Even broad and passive stock portfolios can experience total collapses.

We have seen a diversified, free market stock index fall 80% or more and take a lot longer to recover than you think.

Questions that come to mind:

Should you really be comfortable with the vast majority of your wealth in stocks?

What would happen to your portfolio if your stock allocation fell 80%?

What would happen to your financial dreams if it took 30 years to recover? What if it took 50 years to recover?

What are some ways you can cope with a massive and broad stock decline?

How can you protect your portfolio better?

Is it enough to diversify across countries, or through a global passive stock index?

If it is the current prevailing wisdom that a smart investor puts their money in a passive, stock dominated portfolio, should you bet along with that prevailing wisdom?

Comments & Questions

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Dual Momentum: Analyzing the Drawdowns

As a self-directed investor choosing their own investment strategy, it can be way to easy to get caught looking only at the upside. The compounded annual returns.

But before adopting any investment strategy, it is even more important to look at the drawdowns. If you can't handle the drawdowns of your chosen strategy, you won't stick to your strategy.

Worse, you are likely to abandon the strategy at the worst possible times.

If you understand the characteristics of the drawdowns in your chosen investment strategy, you have a huge advantage over other self-directed investors (who demonstrably have horrible long-term returns). Discover the frequency of the drawdowns, the process is behind them, the severity, and the recoveries. Then expect your real world results to be at least 25% worse than the past at some point in the future.

What are Drawdowns?

As an investor, it is important to know what drawdowns are because your portfolio is actually in some form of drawdown the vast majority of the time.

A drawdown is any time that your portfolio is not at a new high value. It could be down from the peak value by 0.001% or by 100%. Thankfully most drawdowns are barely noticeable, and that's a good thing!

To get a better grasp on understanding portfolio drawdowns, you need to grasp the importance of variations on timing periods.

If you look at your portfolio every minute, you will find your investment account to be in a drawdown like 99.9% of the time.

If you are a bit more trusting of the process and can restrict your portfolio peeks to just once a week, you will probably be in drawdown around 80% of the time or more.

However, once you stretch that out to looking just once a month, you are actually going to be at a new high a whopping 30% of the time! (That's using US Total Stock Market data going back to 1993.)

It's hard to believe, but even if you are completely apathetic to your investment portfolio and look at your portfolio once a year only, if you are a buy-and-hold index (60/40) investor you will likely see your portfolio in a drawdown at year-end almost one-quarter of the time.

Being in a drawdown is not the same as having a negative return for a specific period. If there is a large negative return in one period, you could find yourself in a drawdown for a long time, despite multiple periods of positive returns within that drawdown.

Dual Momentum Drawdowns

First, it is important to understand that Dual Momentum is far from Drawdown-Free.

On a monthly basis, since 1970, an investor in Averaged 6 & 12 Month Dual Momentum would have been in a drawdown 57% of the time.

On an annual basis in the same time period, an Averaged 6 & 12 Month Dual Momentum would have been in a drawdown almost 20% of the time looking at year-end results only.

Let's take a look at every portfolio correction (drawdown exceeding 10%) that an investor in this Dual Momentum program would have experienced since 1970.

Source: TheRichMoose.com

1. May 1971 - January 1972

Peak to Trough Length:  6 months
Max Drawdown:  -12.04%
Recovery Time:  2 months
Total Drawdown Period:  8 months

2. April 1973 - December 1976

Peak to Trough Length:  30 months
Max Drawdown:  -22.46%
Recovery Length:  14 months
Total Drawdown Period:  44 months

3. April 1984 - October 1984

Peak to Trough Length:  2 months
Max Drawdown:  -11.59%
Recovery Length:  5 months
Total Drawdown Period:  7 months

4. September 1987 - March 1988

Peak to Trough Length:  2 months
Max Drawdown:  -15.33%
Recovery Length:  5 months
Total Drawdown Period:  7 months

5. July 1998 - January 1999

Peak to Trough Length:  2 months
Max Drawdown:  -14.74%
Recovery Length:  5 months
Total Drawdown Period:  7 months

6. April 2000 - September 2001

Peak to Trough Length:  6 months
Max Drawdown:  -11.47%
Recovery Length:  12 months
Total Drawdown Period:  18 months

7. November 2001 - December 2002

Peak to Trough Length:  6 months
Max Drawdown:  -10.26%
Recovery Length:  8 months
Total Drawdown Period:  14 months

8. November 2007 - March 2010

Peak to Trough Length:  7 months
Max Drawdown:  -18.59%
Recovery Length:  22 months
Total Drawdown Period:  29 months

9. April 2010 - October 2010

Peak to Trough Length:  3 months
Max Drawdown:  -13.66%
Recovery Length:  4 months
Total Drawdown Period:  7 months

10. May 2011 - January 2013

Peak to Trough Length:  7 months
Max Drawdown:  -16.75%
Recovery Length:  14 months
Total Drawdown Period:  21 months

Drawdown Summary

In the past nearly 50 years, Dual Momentum experienced a portfolio correction approximately twice each decade.

Half of the corrections were relatively quick and painless (less than one year in duration and/or less than six months for recovery from the bottom) considering the sometimes extremely nasty broader investing world.

Interestingly, many of the correction periods came in bunches. The July 1998 to September 2002 and November 2007 to January 2013 periods could test the patience of the best investors.

Before pursuing any investment strategy, take a deep dive into the negative periods! Dual Momentum is pronounced a failed strategy every few years without fail. But a steadfast Dual Momentum investor who understood the reasons behind the periods of poor performance and the outcomes following those performance periods would have significantly outperformed the quick-to-criticize buy-and-hold indexing crowd.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.