January 4, 2021: Our Investment Philosophy For 2021 And Beyond

Jan 5, 2021 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

 

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Monday February 1, 2021. 

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Our Investment Philosophy For 2021 And Beyond

Happy New Year! For most people, 2020 is a year that couldn’t be forgotten faster. Fortunately, it’s now over and we are in the brand new 2021. 

In this newsletter, we outline our investment philosophy for the coming years. Our philosophy has been always the same but we believe it’s useful to outline it more clearly and emphasize some important points in the current environment. We believe this can be useful for subscribers to understand clearly what we offer. 

Basic principles

The most essential and fundamental belief in our investment philosophy is that one has to stick to a well defined investment strategy for a long period of time. By strategy, we mean it’s based on a set of clearly defined rules that react to the prevailing and current economic and financial market conditions. Our favorite quote is that ‘a strategy is not a strategy if its rules keep changing’. 

The following are the basic principles we follow to choose our investment strategies: 

  1. Return goal: achieve inflation beating reasonable returns with acceptable risk. Inflation beating reasonable returns help to preserve and hopefully even grow one’s wealth over time. In general, we are content to deliver returns that are comparable or better than stocks’ long term returns (something around 10% annually). 
  2. Risk goal: acceptable risk means we would like to achieve such returns with risk (volatility or fluctuation) of a portfolio’s value to a level we can psychologically accept. We expect this should be half of or lower than that of a stock market index. Two ways to tame down volatility: diversification and tactical/dynamic allocation. The are reflected in our two principal strategies: Asset Allocation Composite (AAC)  and  Strategic Asset Allocation (SAA) .
  3. Diversification through asset allocation: our investments should be diversified over major assets such as stocks and bonds to reduce risk while still being able to achieve our return goal. 
  4. Low cost index funds and a few of excellent bond funds are all we need to construct a good portfolio. We don’t want to deal with individual stocks or bonds as they carry additional specific risk such as a company’s specific market or financial problems. Furthermore, we believe, for stocks assets, ultra low cost index funds are much safer and highly effective for our purpose (most of actively managed stock funds can’t outperform a low cost index fund in a long period of time). There is only an exception in fixed income (bond) investments: some excellent total return bond mutual funds have managed to outperform bond index funds more consistently. We thus also offer some fixed income portfolios using these bond mutual funds as candidate funds (so called total return bond fund portfolios, see, for example, those on the fixed income page). 
  5. Long term commitment: Regardless how a strategy behaves (buy and hold or tactical or dynamic), to completely realize a strategy’s long term returns requires to follow the strategy for a long period of time. Financial markets (and their underlying economy) are inherently random and thus it requires a reasonably large sample of time intervals (such as days or months) in order to converge to a strategy’s expected return (or average). In general, one should be prepared to stick to a strategy for 10 years or longer for this purpose. 

We have written hundreds of articles that explain the above principles. We encourage readers to browse our newsletter archive and a guide to understand these. 

Our main investment strategies are Asset Allocation Composite (AAC) , Strategic Asset Allocation (SAA)  and Tactical Asset Allocation(TAA). Please refer to our investment methodology page for more details. 

An investment framework

As we have stated numerous times, we advocate a cash flow or bucket style overall capital allocation: an investor should divide his/her capital as follows: 

  • Immediate cash needed within a few months such as up to 3 or 4 months to pay living and other expenses. This portion should be placed in a money market fund or a saving/checking account. 
  • Ultra short term capital needed within a year or so. This portion should be invested in an ultra short term fixed income portfolio or just simply in a money market fund. We will discuss and reveal some ultra short term fixed income portfolios in a future newsletter. 
  • Short term investments (for capital needed up to 7 to 10 years): this portion should be in a fixed income bond portfolio such as the one on our Fixed Income page. 
  • Long term investments (for capital needed beyond 10 years): this portion should be put into a portfolio that can yield long term inflation beating returns. They are usually risk assets such as stocks. 

For the long term portion, we further advocate the following: 

A simple rule of thumb example is that for a retiree who relies on 4% annual withdrawal from an investment portfolio, that would mean it needs at least 4%*10=40% in a fixed income portfolio (or portion) and the rest 60% in a AAC all stock portfolio. This would result in a 60% stocks and 40% fixed income AAC portfolio (a moderate portfolio). Or in the strategic portfolio case, it would need 15 years allocated in fixed income, thus 4%*15=60% in fixed income and the remaining 40% in a strategic buy and hold all stock SAA portfolio. This would result in a 40% stocks and 60% bonds moderately conservative SAA portfolio. 

Tactical or strategic for the coming years

Given one of the most over extended and over valued stock market in history, we now advocate a full tactical investment portfolio in the coming years. Here are the rationale behind this decision: 

  • Extreme valuation in stocks: based on several well known stock valuation metrics, US stocks are now at a valuation that can rival 1929 and 2000. Stocks are now probably in one of the most overvalued level in history. Based on these metrics, stocks will probably return ranging from 0% (or negative) to 4% annually in the coming decade. We recommend further readings from this, this and this. The current extreme stock valuation makes it highly likely that stocks will experience a steep correction or slump (as much as like 50% to 60%). This is the period where a strategic buy and hold (or so called passive) portfolio will not be likely to perform well. 
  • Ultra low interest rates: the current stock bull market is sustained by the extremely loose and likely unprecedented monetary policies as well as fiscal policies worldwide. These policies have driven down interest rates to a level unseen before (see the following chart). There is a possibility that these loose policies might eventually result in inflation that can wreak havoc stocks. 

  • Finally, we are more and more confident that our improved tactical strategies (both Asset Allocation Composite (AAC) and Tactical Asset Allocation(TAA)) will be able to deliver better returns with lower risk than an SAA or buy and hold popular portfolio in the coming years. Our composite market indicator incorporates both macro economic indicators and market indicators to guide general risk asset allocation. The indicator is more relaxed than the risk asset allocation decision in our previous TAA strategy so that it’s not too sensitive or too quick to reduce risk asset exposure because of the relative strength in ‘safe’ bond asset. We believe such an indicator will cope well in the current environment while still managing to reduce big loss in a distressed environment. 

To summarize, given the current long over-stretched, extremely over valued stock level, we no longer have a confidence that a strategic buy and hold stock portfolio will be able to withstand large drawdown (or interim loss) and achieve a reasonable return in the coming decade. Our AAC or TAA based portfolios, on the other hand, will be able to reduce interim loss or drawdown and take advantage of opportunities to achieve better returns. In the situations where stocks never experience large losses in the coming decade, we believe that a tactical or dynamic portfolio like our AAC will still reasonably maintain as a buy and hold portfolio and thus derive comparable returns. In a word, the AAC or TAA strategies don’t rely on an imminent large stock loss (and we have no any insight into when such a large loss will happen) to achieve comparable returns in some extreme situations but the odds of large interim losses are high enough to warrant us to rely on these strategies going forward. 

Finally, there are still several situations that might still warrant strategic portfolios. One example is if you have already accumulated a large taxable capital gain for your stocks and you don’t want to incur too much tax at the moment. The other example is that you are still very young and you just need to have some core extremely long term (like 30 or 40 years) stock holdings in your overall investments. There are just too many individual situations that might still demand a buy and hold portfolio. 

Market overview

The covid-19 pandemic continues its rampage across the US and the world. Meanwhile the slow rollout of vaccination in the US only exacerbates the situation (only about 2 million people were vaccinated so far compared with the original goal of 20 million). Investors are somewhat conditioned to these scenarios and financial markets are hardly affected in the holiday period just passed. For now, some possible factors that might affect the markets include a continuing election tussle in the US. 

It’s encouraging to see that now small, mid and large cap stocks finally align together in a more uniform uptrend: 

So it’s almost universal that stocks, large or small, are trending high. However, remember a crisis usually comes at an unexpected time. So we again call for the following practice: 

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation now reached another high. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.  

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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