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?

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