Sharing My Investment Returns

I'm writing a shorter post this week as I am on vacation enjoying beautiful springtime coastal British Columbia with my family.

I've received some requests to clarify my investment portfolio returns distinct from my contributions. Since 2014, my net worth has gone nearly straight up from $120,000 to $750,000—a compounded growth of 45 percent annually. This is the product of aggressive saving and aggressive investing.

There are outstanding risk/reward benefits of investing very aggressively when young with a small portfolio and high savings rate. In fact, if I had to do it all over again with my current understanding of risk, I would have invested even more aggressively at the start.

However, over time, as savings shrink in relation to net worth, it is generally wise to shift focus from high absolute returns to greater risk control (the Bernoulli rule). This is true in my own portfolio. Even when I'm contributing $60,000 a year towards my investment accounts, it is difficult to come back from a massive drawdown on $750,000 portfolio without a little nervous sweat.

As stated, our savings rate is quite high. This is thanks to careful spending. My wife and I both work full-time in professional careers. Our salaries are healthy, but far from enormous and actually look quite slim after the many mandatory deductions on our paycheques: income tax, pension contributions, extended health plans, life and disability insurance, CPP, EI, etc.

For the past few years, our income could roughly be broken down as follows: we spend around C$50,000 per year, we pay around C$50,000 in taxes, and we save the rest either in our directly controlled investment accounts or via our workplace pension plans.

I do not include our pensions in the net worth calculation as they are difficult to value with great accuracy. For some perspective on our pensions, we both have DB plans which are split between employee and employer contributions. We contribute over 12 percent of base salary and our employers put in around 13 percent.

Although DB pensions are envied by many and have much ado made about them in the media, based on my calculations our pensions are likely to provide the returns of a short-term bond fund if we wait until they mature.

My Investment Returns

I started investing in 2008, but I pulled nearly all my money out of my account to buy a house in 2011. I didn't get back to investing seriously again until 2014 as we put a lot of money into home renovations for a few years to try "build equity".  We eventually sold our house and made a pitiful profit. I can confidently say we would be much wealthier if we rented from the start, but it was a valuable lesson.

To share my actual investment returns net of contributions and without pension estimates, I completed a chart which shows my portfolio returns since 2014. I will keep this chart updated each month and post it on my About Daren page starting next week.

Adjusted monthly for contributions. Does not include all taxes.

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Risk Mitigation with a Barbell Portfolio

It is extremely common for investors today, even those with professional financial advisers, to follow a version of buy-and-hold indexing portfolios with standard ETF or mutual fund products.

Invest 60 percent (or more) of your money in diversified equities and 40 percent (or less) in bonds to achieve a target return with a reasonable amount of risk. Re-balance annually. Hold for life. These types of portfolios have provided investors with 8-10 percent annual returns averaged over the past decades.

Many investors use period backtesting to justify further spins on this basic model. Go all U.S. stocks, allocate an outsized portion to small-cap value stocks or emerging market stocks. Use equal weight indices instead of cap-weighted indices. Or pursue other niche equity factors to try eek out small extra returns.

With most of the focus on the equity side, bonds are often overlooked. Generally investors will choose a broad bond fund, which includes Treasury bonds and investment grade corporate bonds. Others choose just Treasury bonds. Again, there are minor adjustments to this standard: adding international bonds, tilting to long-duration Treasury bonds, and so on.

Much of this standard, run-of-the-mill advice is based on lengthy backtests. While investors quote long-term returns of 8-10 percent annually, very few years actually would have seen those return figures.

The chart below shows what investors believe the returns look like in this type of investing model. An (almost) straight line up and to the right—nothing wrong with that.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

The danger of looking at long-term logarithmic charts is that the true experience of the investor is cloaked by the big picture view. Hindsight returns over long periods of time are great, but real investors live in the moment. They panic when their portfolios lose money and get overconfident when things are going well.

Instead of steadily higher returns as the long-term chart above suggests, investors experience many drawdowns in the 5-10 percent range and several that are much deeper still. Being an investor, including a buy-and-hold indexer means being in some level of drawdown much of the time.

Here is the same 60/40 portfolio plotting the drawdowns during this time period.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

The drawdowns of a 60/40 portfolio are severe enough to shake the confidence of most investors. The intensity only increases when investors slide up to 80 or 90 percent equities for better returns.

The Danger of Overlooking Bonds

Many investors have a profound misunderstanding of bonds in their portfolio. Quality bonds are easily dismissed as a drag on returns, a portfolio afterthought, or even old fashioned. (I admit I had some of the same reservations about bonds for a time.)

However, I've come to view bonds differently in the past few years. The way I see it, money invested in bonds is the money you have; money invested in stocks is the money you are willing to lose in order to obtain potentially large returns.

With this logic, bonds should be the core of a portfolio for most investors, not an afterthought. The more bonds an investor has in their portfolio the better they will sleep, the more stable their portfolio will be, and the more cash access they have available for daily spending without sacrificing the return drivers in their portfolio. Further, it is reckless to risk potentially catastrophic losses with high percentages of your money.

We quickly see that the standard 60/40 (or more aggressive) portfolio falls short of adequate stability. With a small portfolio allocation in bonds, it can be difficult to take money out of the bond side for daily expenses without adding too much risk into the portfolio. If we take money from the stock side, we are effectively cutting down the money tree.

For example, lets say an investor has a $1 million portfolio and needs $50,000 to buy a new car. If they only hold 10 percent bonds, they are effectively taking away half of their safe stuff. With 20 percent bonds, it would be a quarter. That could significantly reduce the stable portfolios of the portfolio and the ability to re-balance into stocks.

Bonds are likely to provide a moderate return over inflation over time. No one gets rich investing in quality bonds. Stocks can return 50 percent or more in a single year, but we know that even diversified stocks are prone to frequent drawdowns of 30 percent or higher. Major markets around the world, including the United States, have seen drawdowns exceeding 80 percent in equities.

To achieve a safe, stable portfolio that supports larger withdrawals, we need a lot of bonds. To achieve wealth building returns we need stocks.

The solution to this problem is a Leveraged Barbell Portfolio. With this approach, an investor can allocate the vast majority of their portfolio to quality bonds. A comparatively small amount of money can be allocated to highly leveraged stocks to achieve high overall portfolio returns.

Building a Barbell Portfolio Around Bonds

For the large bond holding, I believe the best option is to use short-term bonds. Shorter duration bond products are the least likely to lose value due to inflation or interest rate increases. Remember, the bond portion of the portfolio is for stability and moderate income.

There are a number of ways to properly access leveraged exposure to stocks for this style of portfolio. For most investors, the easy option is by purchasing highly liquid leveraged ETFs. There are a number of triple leveraged ETFs listed on U.S. exchanges. Some popular options are UPRO and SPXL (Large Caps), TNA and URTY (Small Caps), TQQQ (NASDAQ), and EDC (Emerging Markets).

Another option is buying deep in-the-money call options on the largest standard ETFs. To get the necessary exposure with call options, an investor could choose LEAPS options on SPY (Large Caps), IWM (Small Caps), EFA (International Developed), EEM (Emerging Markets), or QQQ (NASDAQ).

It is important to only use leveraged ETFs or call options to utilize leverage for this strategy. With both of these instruments it is impossible to lose more money than you allocate to equities. A call option might become worthless and a leveraged ETF might become worth nearly nothing, but they won't go into negative value. You can only lose what you put into the instrument.

This is unlike using margin to buy ETFs or buying indices with futures contracts. With margin and futures you can lose more than you allocate to the equities because your bond allocation will be used to secure the margin. A stop-loss would help, but will not have the same effect or ease of management.

Comparing Returns to a Bond-Based Portfolio

The chart above showed the returns of a standard 60/40 portfolio since 1950. (For data purposes I used T-bills instead of bonds in all charts.) An investor using triple leveraged ETFs would only need to have 12.5 percent of their portfolio in leveraged stocks to achieve similar annual returns to a 60/40 portfolio over the past seven decades.

Here's the comparison chart.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

On the surface, both charts look very similar. Two nice lines traveling steadily up and to the right. However, with a tiny 12.5 percent allocation to risky assets, the leveraged barbell portfolio has a much different characteristic in drawdowns.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

In nearly all of the drawdown periods, the Leveraged Barbell Portfolio experienced drawdowns that are approximately half the severity of the standard 60/40 portfolio. Many were less than half.

Only in the 1987 crash, which saw a massive one-day fall that most affects a daily leveraged product, did the Leveraged Barbell Portfolio experience a drawdown that is comparable to the standard 60/40 portfolio. Still, the portfolio never lost more than the amount of risk assets it held at the peak before the crash.

A Leveraged Barbell Portfolio can provide superior risk-adjusted returns. With more than 80 percent of the portfolio in quality bonds at any given time, the portfolio spins off interest income and provides easy access to large amounts of cash without distorting the risk profile or taking away from potential returns.

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.