Search Results for: Buying Stocks

There seems to be a lot of angst about the stock market these days. It’s been going up, up, up. Is it too high? Will there be a crash? Accordingly, I just caught up on the most recent Howard Marks memos – There They Go Again… Again [pdf] and the follow-up Yet Again?. Everyone from Warren Buffett on down reads these memos to Oaktree Capital clients.

The first memo contains mostly cautionary advice about how asset prices are high, prospective returns are low, and high-risk behavior is commonplace. We are in the midst of high uncertainty in terms of central banks, politics, technology, future jobs, and more. Yet stocks are at historically high-valuations and risky bonds (junk corporate, emerging markets) are priced at historically-tiny premiums to Treasury bonds.

A common explanation for these thing is that interest rates are low, so the prices of stocks and bonds are justifiable. Therefore, I found this quote interesting:

The bottom line is that while the prices and prospective returns on many things are justifiable today relative to other things, you can’t eat (or spend) relative returns.

In other words, just because you can justify it doesn’t mean you should buy it.

The second memo tries to respond to criticisms and also provide additional guidance. It’s easy to point out flaws. It’s harder to lay out clear and actionable advice. Investing in low-cost index funds is not perfect and has many drawbacks. But what is better?

What should an investor actually DO with high asset values everywhere? Marks offers the following choices:

1. Invest as you always have and expect your historic returns.
2. Invest as you always have and settle for today’s low returns.
3. Reduce risk to prepare for a correction and accept still-lower returns.
4. Go to cash at a near-zero return and wait for a better environment.
5. Increase risk in pursuit of higher returns.
6. Put more into special niches and special investment managers.

For the most part, he dismisses #1, #4, and #5. This leaves:

For me the answer lies in a combination of numbers 2, 3 and 6.

After digesting these Howard Marks memos, here are my personal takeaways and opinions:

• Adjust your future return expectations to be lower than historical averages.
• Make sure your portfolio is stress-tested. If a 50% drop in your stocks would freak you out, then reduce your risk slightly by selling a bit of stocks and buying a bit of short-term, high-quality bonds (or cash). Don’t go 100% cash, but do take some risk off the table if necessary.
• You might simply keep your portfolio the same. I’m sticking with 2/3rd stocks (globally-diversified) and 1/3rd bonds (on the shorter-term, higher-quality side).
• If you are Howard Marks, you might look for “special niches and special investment managers”. If you are not Howard Marks, ignore this option because you’re most likely to do harm than good. If anything take 5% of your portfolio, manage it however you like, and compare your return honestly with your index funds.

Here’s a good quote from a 2007 memo as to the consequences of being cautious:

If you refuse to fall into line in carefree markets like today’s, it’s likely that, for a while, you’ll (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs. In my experience, times of laxness have always been followed eventually by corrections in which penalties are imposed. It may not happen this time, but I’ll take that risk. In the meantime, Oaktree and its people will continue to apply the standards that have served us so well over the last [thirty] years.

Risk-taking in the capital markets is becoming widely accepted again. Therefore, the contrarian thing is to not increase your risk right now. You may have to give up some possible return, but it is wiser to be prepared. Marks is not a “perma-bear” that always call for an impending crash. If you read the Barron’s cover above it quotes Marks as saying “stocks are cheap” back in March 2013 (paywalled article). Not a bad call in hindsight. Bookmark this article for another hindsight check in 2021/2022.

You can read previous Howard Marks Memos online for free, or as a book with extra commentary in The Most Important Thing.

In early October 2007, the S&P 500 index hit just over 1,500 – an all-time high. You might have been concerned, or you might not have even noticed. Less than 2 years later, the financial crisis occurred and the S&P 500 dropped 50% down to 750 (March 2009). If you were a lump-sum investor, October 2007 would have been the worse month to invest in a rather long time. However, consider this chart via Bloomberg article:

If you held on through the panic, you broke back even some time in mid-2012 if you include dividends (total return). Four years after hitting bottom, you were again hitting an all-time high. After that, basically all of 2013 was spent reaching new “all-time highs” over and over again. You might have gotten nervous again. Is it time for another drop?

Yet, if you continued to hold on until now (October 2017), even if you had the worst possible timing an pushed all your chips in on October 2007, you would have doubled your money. Over the last 10 years, even after both pushing your chips in at an all-time high and experiencing a 50% drop, you would still have earned over a 7% compounded return.

You could interpret this as pro-stocks, but my takeaway is instead that all-time highs don’t mean much. The price could drop by 50%. The price could go up 100%. We’ve seen that, and thus should be prepared for both. Instead of worrying, try considering either possibility and make a plan.

If stocks keep going up from here, I will ______. If stocks drop 50% from here, I will _______.

In my case, my portfolio could be described roughly as 67% stocks and 33% bonds. If all my stocks dropped 50% and my bonds held steady, then I would end up at 50% stocks and 50% bonds. After a 50% haircut, I would be shaken but hopefully remind myself that stock valuations would look a lot better as well. If I can get up the courage, then I will rebalance back to 67/33. If I turn out to be a scaredy-pants, simply staying at 50/50 should still keep me adequately exposed to any recovery.

A reader asked me to expand on the thought process behind my asset allocation choices. I don’t have a highly scientific answer, but here’s how I would explain it to a friend over drinks. Prepare yourself for some rambling…

I know that I could run simulations and backtest return data to figure out exactly which mix of assets have produced the best risk/return characteristics historically. I’ve also looked at various model portfolios based on such analyses. However, perfection can only be seen in retrospect and it is constantly changing. I just try to take away the big nuggets.

The overall goal is to hold asset classes that will provide long-term returns above inflation, distribute income via dividends and interest, and finally offer some historical tendencies to balance each other out.

Stocks Breakdown (Benchmark Ticker)

• 38% US Total Market (VTI)
• 7% US Small-Cap Value (VBR)
• 38% International Total Market (VXUS)
• 7% Emerging Markets (VWO)
• 10% US Real Estate (VNQ)

To put it briefly, I am taking the total markets and increasing the portion of one additional asset class which I think has the highest diversification benefits. For example, Small Value is a subset of Total US market, and Emerging Markets is a subset of the Total International market.

38% US Total Market. Instead of “stocks” or “equities”, I prefer to call it “owning businesses”. It’s not just a ticker blip going up and down. I am buying a diversified mix of real businesses that are a critical part of a huge economy. A single company or even a handful of big companies might go bankrupt, but as a whole they are not going anywhere.

The Vanguard Total Stock Market ETF (VTI) holds 3,600 stocks to represent the entire US publicly-listed market from Apple ($770,000 million) to Bridgford Foods Corp. ($100 million). It is market-cap weighted, which means that the amount of each stock held is directly proportional to the total market value of the company. See my VTI review for details.

7% US Small-Cap Value. Historically, small-cap value stocks have produced a higher risk-adjusted return than the entire market. You could also argue that small companies a more representative of the private business market. Therefore, I choose to hold a little more of this asset class via the Vanguard Small-Cap Value ETF (VBR).

You probably haven’t heard of 99% of the stocks in the Small Value index, which is kind of the point. Someone who invests in individual small cap stocks must be wary of that company going bankrupt (or effectively bankrupt). But by owning 828 of these stocks at the same time, I don’t have to worry about VBR ever going to zero (although it can be relatively volatile). Will VBR outperform VTI by a huge margin? Maybe, maybe not, but it probably won’t lag the overall market greatly either.

VTI can be roughly broken down into 85% Large-Cap companies, 10% Mid-Cap companies, and 5% Small-Cap companies. My blend of 85% VTI and 15% VBR is still roughly 72% Large-Cap and 19% Small-Cap. I have “tilted” the amounts, but it’s still predominantly composed of huge businesses like ExxonMobil, Google, and Johnson & Johnson.

International Total Market. The United States is not the only place where businesses create value. Many brands that you deal with every day are listed in foreign countries – Nestle, Shell, Samsung, Toyota, GlaxoSmithKline, Anheuser-Busch InBev. (Bud Light is a foreign company!) The Vanguard Total International Stock ETF (VXUS) holds over 6,000 stocks from around the world according to market-cap weight. See my VXUS review for details.

I also keep to close to the world market-cap split with 50/50 US/non-US. If you want to go 70/30 or 60/40, that’s perfectly fine with me. Again it’s more important that you stick with it than any specific ratio.

Emerging Markets. Within the foreign markets, I choose to put extra money towards Emerging Markets – countries that currently include China, Taiwan, India, Brazil, South Africa, Mexico, Russia, Thailand, and Malaysia. Again, this asset class is more volatile but also has higher historical returns. The Vanguard FTSE Emerging Markets ETF (VWO) allows me to track this asset class in an efficient and low-cost manner. If there were better options for International Small Value stocks, I would have been open to that.

VXUS is 43% Developed Europe, 30% Developed Pacific, 19% Emerging Markets, and 7% Canada. My blend of 85% VXUS and 15% VWO is 37% Developed Europe, 26% Developed Asia, 31% Emerging Markets, and 6% Canada. Again, it’s not a huge tilt.

(Exit option: If something happened to me and my wife wanted to simultaneously simplify the portfolio, reduce the overall risk level, and generate cash, she could simply sell off my US Small Value and Emerging Markets positions that make up ~10% of the entire portfolio. The resulting portfolio would still be diversified.)

Real Estate. The Vanguard REIT ETF (VNQ) holds publicly-traded real estate investment trusts (REITs) which hold things like office buildings, hotels, apartment complexes, nursing homes, self-storage units, and shopping malls. I choose not to be active in residential real estate other than owning my own home, so I like the diversification and income that this asset class provides.

I am sticking with domestic REITs for both simplicity and lower costs. REITS only make up about 7% of my overall portfolio. I might include foreign REITS if it was a larger holding, but I’m going to bother splitting up 7%.

Bonds Breakdown

• 50% High-quality, Intermediate-Term Bonds
• 50% US Treasury Inflation-Protected Bonds

I keep roughly 30% of my portfolio in bonds. This is meant to be the stable ballast of my portfolio, but it should also generate some level of interest income. Bonds are debt, so I only lend money to the places that I think will pay me back most reliably:

• US government, which can both tax residents and print the world’s reserve currency. This includes US Treasuries, FDIC-insured bank accounts, and US Savings bonds. Treasury Inflation-Protected bonds also offer an interest rate that adjusts with inflation.
• Local municipalities, which can tax residents. If you don’t pay your property taxes, they take your house. “Muni bonds” currently offer the best tax-effective yield for my situation. I hold them through low-cost, actively-managed funds like Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX). See, I’m not only about index funds!

I exclude investment-grade corporate bonds because I don’t see enough benefit in taking on extra risk in this manner. I’d rather get 3% dividend yield through stock ownership (which includes unlimited upside potential) than get paid 3% interest (with no upside potential). Corporate bonds don’t have the company interests aligned with you – they want to appear stable and pay as little interest as possible. I’m not overly trusting of bond rating agencies in general.

I also exclude international bonds because what’s the point of diversifying to get a significantly lower interest rate? Vanguard US Total US Bond Market ETF (BND) has a current SEC yield of 2.43%. Vanguard Total International Bond ETF (BNDX) has a current SEC yield of 0.74%. Blech!

Recap. At a basic level, I own baskets of US businesses, international businesses, real estate, and high-quality debt. I plan to eventually spend the dividends from the businesses, rent from the real estate, and interest from the loans. I expect the stock dividends and rent to increase faster than inflation. I expect that the bond interest will at least keep up with inflation. This mix makes sense to me and I believe I can hold it through the ups and downs. It is not perfect but it is good enough.

I recently read (and re-read) a post at Philosophical Economics titled Diversification, Adaptation, and Stock Market Valuation, which serves both as an educational resource and an interesting argument for a new shift in stock investing. It’s rather lengthy and not written for novices, but it doesn’t require a finance or math degree either. I recommend reading it in full, but here are my notes.

#1 Diversification is good. Buying a single stock exposes you to the risk of your investment going to zero. Lots of companies have gone to zero. For a long-time, most people either bought individual stocks or bought funds that owned a limited number of individuals stocks. High risk leads to lower valuations and thus higher expected returns.

Buying a diversified basket of stocks provides good returns with greatly minimized risk of permanent capital loss. Here’s the dividend history of the S&P 500 from 1926-2016, adjusted for inflation:

#2 People are realizing that diversification is good. When Jack Bogle published Bogle on Mutual Funds in 1993, Vanguard was considered a big success after reaching $100 billion in assets. (I recently bought a first edition for my collection.) Today, Vanguard manages over $4 trillion in assets. Yes, 40 times as much.

In 2000, under 10% of asset were in index funds. Today, roughly 25% of the US stock market is now held in index funds with no signs of retreat. Nearly everyone has the ability to buy a basket of 500 to 3,000 stocks for just $5 a year per $10,000 invested.

#3 We are also seeing higher average equity valuations. Correlation or causation? If everyone starts to agree that low-cost index funds (and “closet” index funds) makes investing less risky, then shouldn’t lower expected risk lead to higher valuations, and thus lower future expected returns? It won’t be a straight line, but it could be a powerful overall trend.

A couple of excerpts:

My argument here is that the ability to broadly diversify equity exposure in a cost-effective manner reduces the excess return that equities need to offer in order to be competitive with safer asset classes. In markets where such diversification is a ready option–for example, through low-cost indexing–valuations deserve to go higher. But that doesn’t mean that they actually will go higher.

To summarize: over time, markets have developed an improved understanding of the nature of long-term equity returns. They’ve evolved increasingly efficient mechanisms and methodologies through which to manage the inherent risks in equities. These improvements provide a basis for average equity valuations to increase, which is something that has clearly been happening.

Definitely food for thought.

When I think about it, I am impressed with how different 2017 feels compared to when I started seriously learning about investing in 2003. Instead of only reading about it in few books mostly read by finance nerds, nowadays nearly every robo-advisor out there uses a globally-diversified mix of low-cost ETFs to build their portfolios. What used to be a relatively quiet alternative to buying 4-star active funds is now becoming the default choice.

We’ve seen from the Callan Investment Returns Table that the best-performing asset classes constantly change from year to year. In a industry magazine called Investments & Wealth Monitor, there was an article titled Why Global Asset Allocation Still Makes Sense by Anthony Davidow. (Found via AllAboutAlpha.)

Here’s an illustration of how a globally-diversified portfolio has outperformed. Below is a graphic from the article comparing a 100% S&P 500 portfolio, and 60/40 S&P 500/US Agg Bond portfolio, and a “globally diversified portfolio” using historical data from January 1, 2001 to December 31, 2016. Index values are used directly as opposed to actual ETFs or funds. The portfolio are rebalanced annually back to target asset allocation.

Their “diversified portfolio” had a rather finely-diced list of asset class ingredients:

• 18% S&P 500 (US Large-Cap)
• 10% Russell 2000 (US Small-Cap)
• 3% S&P US REIT
• 12% MSCI EAFE (International Developed)
• 8% MSCI EAFE Small Cap
• 8% MSCI Emerging Markets
• 2% S&P Global Ex US REIT
• 1% Barclays US Treasury
• 1% Barclays Agency
• 6% Barclays Securitized
• 2% Barclays US Credit
• 4% Barclays Global Agg EX USD
• 9% Barclays VLI High Yield
• 6% Barclays EM
• 2% S&P GSCI Precious Metals
• 1% S&P GSCI Energy
• 1% S&P GSCI Industrial Metals
• 1% S&P GSCI Agricultural
• 5% Barclays US Treasury 3–7 Year

I do wish this portfolio was a bit more simple and easy to replicate. However, if you take a step back, you could simplify this asset allocation into the following:

• 56% Global Stocks (50% US/50% Non-US)
• 5% Global REIT (60% US/40% Non-US)
• 34% Global Bonds (70% US/30% Non-US)
• 5% Commodities

Now, we can’t necessarily expect a global portfolio to always outperform. One thing is usually doing better than another thing you own. Most recently, US stocks have outperformed International stocks quite significantly. Here’s an explanation from the article about the “free lunch” of diversification:

Diversification strategies do not guarantee capture of profits or protection against losses in any market environment, but they have been shown over time to provide a smoother ride. Rather than bearing the brunt of the 2000 Tech Wreck and the 2008 Great Recession, the diversified portfolio provided cushioning under the large market drop and was able recoup losses and grow over time.

At the bottom of the Berkshire Hathaway 2016 Annual Report, you may not have noticed that Warren Buffett republished a previous article from the 2005 annual report titled “How to Minimize Investment Returns”. A version become the first chapter (find it here) of The Little Book of Common Sense Investing by Jack Bogle. I am jumping on the bandwagon and republishing this 2007 blog post below as well. 🙂

It’s both a highly recommended parable and it comes at the perfect price of free. Read it if you haven’t already.

Original post:

I just watched the Will Smith movie The Pursuit of Happyness this weekend. I found it ironic that he really didn’t change job types when he joined Dean Witter. Mr. Gardner started out a salesman, and ended up a salesman. But by managing to change his product to financial services, he turned his tenacity and people skills into millions of dollars.

Why is financial services such a lucrative field? This reminded of an excerpt that I had saved from Warren Buffett’s 2005 Letter to the shareholders of Berkshire Hathaway. Although a tad on the long side, I think it provides an excellent “big picture” view of investing the the stock market.

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