Simple Path to Wealth 2 – Risks and Asset Allocation

Today’s post is our second visit to The Simple Path To Wealth, by JL Collins.

Diversification

Chapter 6 begins with Jim dissecting a money magazine interview with a “famous economist and finance professor at an equally famous and prestigious university”.

• I think Jim’s interpretation of some of the terminology is a little self-serving, but there’s some good stuff in there.

The professor is advocating against buy and hold (in a single market) because human psychology induces investors to sell low and buy high.

• Instead, he suggests diversifying across asset classes and geographies.

Obviously, I’m with the professor, so why isn’t Jim?

Before we look at what Jim says, let’s think about why Jim might support buy and hold in a single market:

1. his home market is the US, the “best” (most dynamic, innovative and liquid) market in the world
2. his investing career from 19756 to 2015 covers a period when that market did well
3. over the past 20 years in particular, the US market has been “special” due to it being the home of the tech firms which have established global dominance

And most importantly, Jim knows (from hindsight) that he stuck to his buy and hold guns and didn’t sell low, buy high (survivorship bias).

So Jim’s strategy has worked for him.

• But none of those things apply to someone starting out on their investment journey today.

There may be new reasons for the US market to dominate over the next 20 years, but they won’t be the same as the old ones.

• And there might be no reasons at all, and perhaps another region will come out on top.

What we need is a general solution, not a “Jim in 1975” solution.

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Now what does Jim say?

• He doesn’t like diversification:

To do this properly would require a ton of work. You would need to understand all the various asset classes, decide what percentage to hold of each and choose how to own them. Once you did that you’d need to track them, re-balancing as necessary.

The result of all of this effort is to guarantee sub-par performance over time while offering the slim hope of increased security.

He’s wrong about pretty much all of this.

1. The level of complexity needed to improve significantly on Jim’s one-fund approach is up to each investor.
2. You can get buy with maybe eight funds, and only the largest portfolios will need more than say 15 fund.
3. ETFs are easy to research online these days, and you can crib from model allocations and many websites, including quality blogs like my own.
4. Re-balancing is a requirement for all portfolios other than Jim’s, and has many benefits.
5. It’s as impossible to guarantee sub-par performance as it is to guarantee out-performance.

What you will get from the correctly diversified portfolio is performance close to the maximum expected return, but with lower volatility (and therefore a higher Sharpe ratio).

• Which makes it more likely that you will avoid the behavioural traps of selling low and buying high.

Jim’s solution is to “toughen up” and ride out the inevitable crashes.

• Which will also work, but for far fewer people.

And you have to assume that you’ve picked the right market to begin with.

The market always goes up

Chapter 7 tells the story of the one time that Jim did sell low, during the 1987 crash.

• He bought back in a year later, at a higher valuation.

I just wasn’t tough enough. But I am now. My mistake of ’87 taught me exactly how to weather all the future storms.

The chapter also introduces Jim’s favourite fund – VTSAX, the Vanguard (US) Total Stock Market fund, which holds around 3,700 companies.

• Note that this is slightly misleading, since like all market cap index funds, it is dominated by its largest holdings.

Market cap indexing is dumb (it over weights expensive things), but it’s easy to implement, and has become the industry standard, so it looks like we are stuck with it.

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Jim describes the way in which the index his fund tracks is “self-cleansing”:

Picture all 3,700 of these companies along a classic bell curve graph that describes their annual stock performance. What is the worst possible performance a bad stock can deliver? It can lose 100%.

What is the best performance a stock can deliver? 200%, 300%, 1,000%, 10,000% or more. There is no upside limit. The net result is a powerful upward bias.

This is true, but in practice firms will join an index (be bought) when they are doing well, and leave an index (be sold) when they are doing badly.

• This is a powerful downward bias, though admittedly less powerful on a huge index like the one Jim’s fund tracks.
• Most popular indices track a hundred stocks or fewer.

The real issue is that within a market-cap index, the more expensive a stock becomes, the more the tracker has to buy it (which in turn makes it more expensive).

• It’s just not sensible to have buying rules based on price appreciation without a selling rule to get you out when the tide turns (there are no stop-losses in an index fund).

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In the last part of the chapter, Jim explains that the market always goes up because of the creative destruction inherent in capitalism.

• Better firms kill weaker ones.

Why most people lose money

In Chapter 8, Jim runs through the reasons why most people lose money in the stock market.

• Up first is market timing, which I think we did to death last time.

Second is stock picking – I’m on the fence here:

• I use stock screens to improve my chances
• But I don’t believe in portfolio concentration (I have 30 stocks minimum)
• And hand-picked stocks account for only around 5% of my net worth.
• Bottom-line – stock-picking is hard (a lot of work), not suited to all personalities, and won’t work under all market conditions.

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Third is picking winning fund managers – this is a similar problem to picking stocks or factors.

• There have clearly been winning fund managers.
• But times change, and few stay at the top for 30 years.
• And the hardest part is identifying them in advance.

The worst kind of story is the Woodford-type event, where a good manager stops doing what he was good at and picks something new that he isn’t good at.

• But there are plenty of examples of the opposite – mangers sticking with what used to work, long after it’s stopped working.

Jim quotes the data on most active funds under-performing index funds, but that’s just maths.

• The market is all funds added together, so of course a bunch of expensive funds will under-perform a bunch of cheap funds.

Buying all the active funds would just be an expensive way of tracking the index quite badly.

• The key to using active funds is to choose the ones that don’t do anything like track the index.
• These funds help to reduce your overall portfolio volatility.

Jim also points out that fund market cheats by choosing flattering time periods for analysis, and by leaving out closed funds that did badly.

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Reason number four is that we focus on the foam (the daily noise of gyrating stock prices) rather than the beer (the underlying operating businesses).

• Remember to cut out the noise.

Deflation and hyperinflation

In Chapter 9, Jim shows that we needn’t be frightened of a repeat of the biggest market crash ever, in the 1930s.

Over a two year period, stocks plunged from 391 to 41, losing 90% of their value.

Jim’s first point is that you would have had to have bought everything in 1929 to suffer the full penalty.

Suppose instead you had invested in 1926-27. 10 years later, [you’d] be back in positive territory. Suppose you’d bought at the earlier peak in 1920. From the collapse in ’29 you’d be back even by 1936. Seven years.

• He also notes that those starting their careers in 1929 had the chance to pick up stocks on the cheap (if they were brave enough).

Jim’s third point is that deflation in the 1930s meant that your remaining money after the crash would have gone a bit further.

• He also points out that there has been only one Depression in 115 years of US stock market history, and that present-day controls mean that it can’t happen again (Fed reactions in 2008 and 2020 would tend to support this).

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The other possible big ugly event is hyperinflation.

• This was last seen in the US in 1776, but episodes in Germany, Hungary and more recently Zimbabwe show that it can happen.

Deflation defers purchases in the hope of lower prices tomorrow.

• With hyperinflation, money is worth less tomorrow, and people want to get rid of it.

Deflation creates a deadly spiral of falling prices.

• Hyperinflation ends with barter, as money becomes worthless.

Jim notes that stocks are a decent inflation hedge.

• They don’t do well under deflation, however.

Keep it simple

The more complex an investment is, the less likely it is to be profitable.

I’m not sure where Jim gets this from.

• I think he’s extrapolating from the idea that expensive active funds under-perform low-cost index funds.

Sweeping rules like this are often over-simplifications.

• Everybody’s circumstances are different, and investors need to develop the skills to evaluate the options in front of them.

That said, if you have two options with equal outcomes, simpler is better.

Jim has three inputs to his analysis:

1. are you in Accumulation or Decumulation (he calls it Wealth Preservation)?
2. what is your risk tolerance?
3. what is your investment time horizon?

These are linked, since risk tolerance and time horizon typically decrease with age, and Accumulation comes before Decumulation.

But don’t follow simple rules like “age in bonds”.

• An investor who is 60 has another 25 years to go, and needs more than 40% in stocks.

Jim notes that risk cannot be avoided.

• The best that you can do is choose which type of risk you take on.

To Jim’s inputs, I would add current portfolio size, whether you own the property you live in, and your plans for bequests to your descendants.

• All of these will impact your portfolio’s design and implementation.

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Jim uses just three assets:

1. VTSAX for US stocks
2. VBTLX for US bonds, and
3. Cash (this used to be a money market fund, but low interest rates mean that bank interest is usually higher)

Index funds

Chapter 11 is the sales pitch for index funds.

I’m sold – I use mostly index funds (ETFs, actually) in my core portfolio.

• Where Jim and I differ is in asset allocation / portfolio construction.

I’ve noticed that even those folks seeking to compliment me sometimes frame my position on Vanguard and index funds as sound advice, but only for average people who don’t want to work very hard at investing.

The idea being that with a little more effort and smarts in the selection of individual stocks and/or actively managed funds, more diligent folks can do better.

I’m afraid I’m one of those folks.

• You can definitely do better, though for most people, it won’t be worth the effort.

And again, my idea of “better” is based largely around a more sophisticated implementation of index funds (ETFs).

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Jim repeats his claim that no-one can beat the market, roping in the late Jack Bogle (founder of Vanguard) to confirm that he hasn’t met anyone who can.

This is nonsense.

• There are hundreds of millionaires and billionaires who made their money from beating the market.

That doesn’t mean its easy, or the right path for everyone.

• And Jim and others are right to stress the importance of low costs, and to warn against the seductive marketing of the fund industry.

But this insistence on index funds as the “one true path” is cultish.

Bonds

Chapter 12 explains bonds.

I’m going to assume that you’ve come across them before.

• If not, I have more on them here.

Bonds are effectively loans you make to governments or companies.

• They pay you regular interest for a while, and then they re-pay your capital.
• The longer you have to wait to get your money back, the riskier the bond and the higher the interest rate (in general).

The pattern of interest rates through the duration of bonds (from 1 year to 30 years) is known as the yield curve.

• It normally curves up to the right then plateaus, but sometimes it goes the other way (known as an inverted yield curve, this indicate future low inflation or even deflation).

Since a bond’s interest payment is fixed, when interest rates rise, the price of the bond falls to keep the effective yield constant.

• Falling interest rates over the last 35 years have created the longest-ever bull market in bonds.

Bonds can also default (go bust) – so they have credit ratings.

• Holding a bond fund like VBTLX can mitigate this risk (not all 8,00 bonds will go bust at once).

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Here are Jim’s key points:

1. Bonds are a deflation hedge – the constant income is worth more in real terms
   • Over my investing lifetime, deflation has been a non-existent risk, but it’s close now.
   • The corollary of this is that bonds do badly during inflation.
2. Bonds provide income
   • I’m not in favour of investing specifically for income, as it is a distraction from the true goal of total return.
3. Bonds are less volatile than stocks
   • This is actually a disadvantage, since it means that they are less effective at diversifying stocks.
   • But they are poorly correlated with stocks (note – not always negatively correlated with stocks), so they do offer reasonable diversification
4. Bonds have some tax advantages in the US
   • Here in the UK, at a stretch you could say that Premium Bonds are tax-advantaged, but that’s about it.
5. Watch out for callable (redeemable) bonds, credit downgrades and illiquid bonds (no trades in the secondary market).

I used to like bonds when their yields were higher than my target portfolio return (around 3% after inflation).

• Luckily I have DB and state pension entitlements that I can use as substitutes for my bond allocation.
• For the rest, I use cash, which gives me optionality.

Asset Allocation

Chapter 13 looks at some example portfolios.

The Accumulation portfolio is 100% stocks (VTSAX).

The Wealth Preservation portfolio is 75% stocks, 20% bonds (VBTLX) and 5% cash.

• Apart from the lack of geographical diversification (a failing common to all “lazy” portfolios with few funds), this is not such a bad portfolio.

Chapter 14 looks at how to choose your own asset allocation but doesn’t add anything to the discussion so far.

• Which is not too shocking, since the entire debate in the book is around whether, when and how much you should add bonds to your stocks.

There’s some discussion of (US) tax-sheltered accounts, but we’ll save that for later.

International funds

Chapter 15 explains why Jim doesn’t bother with international funds.

His first reason is that he doesn’t want currency risk.

• This is a strange answer and one you are only likely to get from an American.

Your currency risk stems largely from your own currency, and international diversification helps with this.

• When your home currency falls, your international investments will rise in value.

Jim also thinks that foreign accounting standards are worse (they probably are) and therefore foreign firms are riskier (they probably are).

• But this doesn’t matter – the attraction of international stocks is that they are likely to be driven by different factors from those driving your home country stocks, and so will be imperfectly correlated.

Jim also says that international funds are more expensive.

• In the era of low-cost ETFs, we can ignore that one.

The most diversified multi-asset portfolio will come out at a weighted average cost of around 0.3% pa.

• Which is the same as the cheapest US mid-cap and small-cap funds I can access (the S&P 500 is much cheaper, at 0.05%).

He also makes the argument that large US firms have internationally diversified sources of income.

• There’s some truth to this, as there is in the UK.
• But despite what some people will say, you can’t have too much diversification (assuming it has no extra costs).

If you do want international funds, Jim plugs the Vanguard ex-US options (VFWAX and VTIAX).

Conclusions

We covered another interesting set of chapters again today.

• Once again, there was a lot of useful information, and just enough that I disagree with to keep me on my toes.

We’re half-way through the book now, so there will be two more articles in this series, plus a summary.

• Until next time.