My portfolio is based on the work of Harry Browne. In 1973, Harry realized that there are only four liquid investments one can invest their money in; Stocks, Bonds, Commodities, and Cash. He also realized that these four asset classes are non-correlated which means they move for different reasons. Stocks do well in times of prosperity, Bonds do well during deflation, Gold does well in times of inflation and Cash does well in both inflation & deflation.
His concept was to invest 25% in each of the above four asset classes and only rebalance when one of the asset classes moved up or down by 40%. Over time this has been a wonderful investing plan. The key is that all of the asset classes returned between 7-9% over 40 years, so that is what you made. Furthermore, since the four asset classes are non-correlated, he eliminated a lot of the volatility. In times of high volatility, non-correlated asset classes move opposite, dampening the volatility. In 2008 when stocks lost approximately 35%, Treasury Bonds gained approximately 35%.
For the Stock Component, he chose the S&P 500. He realized individual stock picking is just legalized gambling. When you own the S&P 500 you actually own a piece of the 500 largest stocks and receive all the dividends. You own the popular stocks of the day such as Apple, Google, and Facebook, etc. along with the more stable stocks such as Home Depot, Verizon, and Walmart, etc. More than 60% of the profits from the companies in the S&P 500 come from overseas, so you also have worldwide exposure.
For the Commodity component, he chose Gold as it is primarily financial with limited industrial uses. It is actually considered the world’s second currency behind the US Dollar.
For the Bond component, he chose the 30 Year Treasury as it is the Bond that moves the most dramatically due to interest changes with no credit risk.
For the cash component we invest in short-term U.S. Treasury bills that have no credit risk and high yielding structured notes. This allocation is designed to provide liquidity and consistent income.
I do not attempt to predict the future. I also do not listen to any of the pundits on CNBC who claim to know everything when in reality they know nothing. No one can predict what is going to happen with the stock market or the economy. Even if they could, they could never predict how people will react to that news. When North Korea detonated nuclear bombs, conventional wisdom would have been to sell stocks and buy bonds. Yet stocks rose. This is further proof that even if you can predict the future, you cannot predict how people will react.
That is why I follow what is called; “rules-based investing”. In rules-based investing, you define a clear set of rules that comprises an investment strategy. You stick to that strategy month after month regardless of your own emotions.
Developed through years of evolution, our basic human instincts are necessary for our survival. Keeping with the laws of the jungle, these instincts push us to run when in danger and charge when we see opportunity. The stock market, much like a casino, is built to take advantage of these instincts. Investors, if left to their primitive fear/greed instincts, tend to buy high and sell low.
These instincts harm their investing decisions. They make a naive person wait for a stock to double, triple, or even quadruple until every single person he knows claims to have made huge profits. Then he decides to buy, only to see the stock crash! What happens next to our hypothetical investor is that he looks at a -10% loss and hopes it will rebound. When the loss grows to -20% he starts getting worried. At -27% he thinks of selling, but hey, this may be the bottom, since he wants to sell, right? When his loss hits -40%, he goes into shock and stops looking at the stock. When his loss reaches -60% he gives up and stops checking his account. He feels he has been cheated and exits the markets. It may take years for him to return, if at all. Most likely, he will never recover his losses.
Strong opinions, like the ego, may also hinder an investor. Take the ordinary investor. This is especially true as we get older and feel wiser. A perfectly logical opinion goes like this. It is 2011 and interest rates are almost at zero. The average investor determines interest rates will rise in the future (What else can they do?). So, the investor shorts the Treasuries. Eight years later long-term interest rates have barely moved, and our ordinary investor has once again lost money following his opinion.
Following rules prevent this process by eliminating ego and opinions. The investment strategy is programmed when to buy and sell. It will buy 30-year US Treasuries in 2011 even when everyone believes interest rates will rise. If Gold trends downward for years the strategy may be to buy it, whether you believe in Gold or not. However, there are still biases at play, even when following a strategy. How smart is my strategy? How smart am I for picking this strategy? But these are easy to deal with. This is minimized by back testing and past performance. At the end of the day, the question should not be how smart I am, but rather how disciplined am I when the investment strategy dictates a buy and when it triggers a sell.
History shows that if you stay invested in the same strategy, you will probably make money. The challenge is to stick around. The more you get involved emotionally in the market, the quicker you will tire and give up. By following a rules-based strategy, you can spend less time watching the markets, reading news and analyses and spend more time doing things you enjoy. In the process, you will also improve your health. Because in investing, as in life, your most valued asset is time. The more you have the better your chances are.