Investment Strategy: The Terminator

"That Terminator is out there! It can't be bargained with. It can't be reasoned with. It doesn't feel pity, or remorse, or fear. And it absolutely will not stop, ever, until you are dead."

This nearly effortless strategy will by far give you the best 'bang for your buck' in terms of time and effort required for its implementation and the portfolio return you get. Most people shun this approach though as it is seen as boring and to be honest just too easy.

I personally use this approach for a significant part of my investments such as pensions and children's savings. I use other strategies also which I will go into at a later date.

If you haven't already guessed it's a diverse portfolio of index funds held and rebalanced over the long term. No doubt some of you are already thinking about leaving this webpage, disappointed I haven't revealed a new and exciting strategy that will help you multiply your money over the next few months.

You may be surprised to hear though that this approach will crush the far majority of private investors in the long term. Why? History has shown us they (unsuccessfully) try to time the market, jump in at the top, run away when prices get cheaper, spend too much on commissions and chase after the latest hot tip with high hopes for the future.

Past performance also shows us that you will also beat most fund managers, especially after fees are taken into account. Of course, just matching an index and getting an 'average' return is not appealing to investors and doesn't feel a worthy goal for investing.

The big irony however is achieving an index return over the long term would put you in the high performing category of investors as most fail to match that simple benchmark. Check out the graphs below, shocking isn't it?!

Investor returns are a mere half of S&P 500 index, even less when it comes to bonds! Simply focusing on reducing that behaviour gap will give you huge returns over the long run.

To close this gap the investor must switch off their emotions, any thoughts on what the market will do next and pretty much just do one thing, relentlessly keep on buying and rebalancing. (Sounds simple doesn't it, but it's fraught with dangers as the human mind will want to tinker and want to predict - see pitfalls below).

It requires absolute discipline. Whatever the market sentiment, up or down, bull or bear, new highs, new lows, with no emotion you keep on moving forward, saving month after month, accumulating more and more index funds/ETFs for your portfolio. Overtime it will grow and grow and you won't have to think twice about what the market will do next.

Follow these steps to set up your 'Terminator Portfolio'

1. Asset allocation: First step is to choose the mix of bonds and equities. This depends on your age, risk/volatility tolerance and time frame. The younger you are, the more risk you are willing to take and further out in time you plan to use the money the greater the % of stocks. A very general guideline is your age in bonds, so for example someone who is 30 would have 30% of portfolio in bonds. This can of course be adjusted plus/minus 10%, I prefer a higher amount in equities.

2. Costs are key to higher longterm returns, the cheaper the better so choose low cost index funds  and ETFs; keep that obey for yourself and your investments. will smaller portfolios it is better to focus of funds rather than ETFs so as to keep commision charges low.

3. Diversify the asset classes over different indices.
Bonds: Sovereign bonds, High quality corporate bonds,  Low quality 'junk' bonds
Stocks: US, Europe, Asia, Emerging Markets, Small Cap and Value.

For example (there are many ways of doing this; the simplest example being a mix of Total world equity index/Total international bond index)

20% Sovereign bonds
5% Corporate bonds
20% US equities
20% European Equities
20% Asia
15% Emerging markets

3. Re-balance periodically. There is no hard or fast rule when and how to do this. One approach is to do it on an annual basis, another is to wait until there is more than a 10% deviation in the set allocation. For example emerging markets may be set at 20%, but has fallen by 2% to 18%. Sell those funds that are above their set allocation and use the money to buy more emerging market stocks.
This approach exploits the fact that asset class performances revert to the mean so rebalancing forces the investor to sell high and buy low.

Some pitfalls to avoid:

1. Timing the market, such as equity indices are now at new highs so reduce their allocation in prediction of a pullback. You will most likely fail.

2. Failing to rebalance. US equities performed really well in 2013. It may be tempting to keep any growing allocating as you want to capture any future outperformance. You will miss the next reversion to the mean of the underperforming assets.

3. Overconfidence. Believing you can tweak the strategy to improve the returns with adhoc decisions making e.g. timing, predicting the next turn, watching the news; or even outperform it by buying individual securities. I'm not saying it definetly can't be done but you will now be swimming with the sharks, one of them being your own behaviours and biases! Prove you can do it first before changing the whole portfolio.

4. Pulling you money out at the market bottom during the next bear market, the worst and hardest of all. Seeing your portfolio cut in half is most likely going to freak you out, especially if there aren't many years left to retiring. Unless you really need the money do not start selling your funds/ETFs. Keep rebalancing, some assets will perform better (or less worse!) that others. Even better you should still be putting in your monthly savings. You will actually now be buying more stocks/bonds for the same amount of money. You should get handsomely rewarded for this in the future.

Well that's about it, a simp mechanical portfolio that will terminate most of your peers and even some professionals!

A simple two fund portfolio

Before I get into the original purpose of this blog entry I would firstly like to highly recommend this article by Fidelity  It describes the importance of diversification and how the addition non-correlating assets can lower the overall risk of a portfolio.

Some important messages include:

1. A simple diversified portfolio of stocks and bonds would have had a smaller draw down than that of just stocks during the financial crisis of 2008.
2. The recovery of the diversified portfolio from 2009 to 2013 is slightly lower but its overall performance is still superior to the 100% stock portfolio.
3. Correlations between assets classes did increase during the financial crisis but importantly they didn't become fully correlated. Diversification still worked!
4. To be able to fully benefit from diversification investors would have had to stick to the asset allocation throughout the bear market instead of being tempted to shift to lower risk assets and then missing the subsequent recovery in stocks.

The following is a suggestion for a very simple diversified portfolio, one fund in bonds and another in stocks. The primary goal is to maximise diversification for minimum cost. We ideally want global exposure, get it as cheap as possible, and exploit the low correlation between binds and stocks.

Starting with stocks we can find:

SPP Aktiefond global, 0.3% fee

AMF Aktiefond global, 0.4% fee

Both hold hundreds of shares from around the role predominantly in the USA, Europe and Japan. If there is any weakness it's that the emerging markets and Asia get a bit less than 10% exposure. Performances over the past 5 years are about the same at roughly 50%.

The only difference is the SPP fund does not invest in companies considered to be unethical such as those involved with weapons and tobacco. So it's up to the investor if this is important to: them or not when choosing between the two.

The next part is the bond component:

Öhman obligationsfond, 0.15% fee

AMF Räntefond Mix, 0.3% fee

Öhmans fund is the cheapest bond fund which invests in Swedish sovereign debt. However, I like the look of AMF's fund which invests in government bonds from not only Sweden but also the rest of Europe and USA. For a slightly higher fee one gets far more diversification. 

The allocation of the two funds depends on ones tolerance to risk; typically more bonds means less volatility and smaller drawdowns. This also means with age the older you are more a higher bond allocation is recommended to lock in gains and reduce any potential loses as retirement approaches.

It will be interesting to see how this type of strategy will work in the future as we are currently in a very low interest rate environment, bonds prices are very high and we have just come through a 30 year bond bull market. The expectation going forward is rising interest rates and big losses for those with investments in bonds.

However, for the moment, the standard portfolio is a 60/40 stock & bond mix but I'm a more of a stock fan so prefer more of a 70/30 allocation.  So here it is

70% AMF Global stock fund

30% AMF Mix bond fund

A simple two fund portfolio that achieves global diversification across two asset class at a relatively low fee of 0.37%. Both allow very small monthly investments, as low as 50 SEK, and being funds no trading fees would be incurred, such as with ETF's.

A possible 50% crash: What should I do?

Business insider recently released an article arguing the the case for the increasing likelihood of a crash, a big one in the range of 40%-55%. To be fair the article is quite balanced in that the author doesn't scream 'sell! sell!' and clearly states he is still invested in stocks but it did get me thinking.

I first became really interested in investing strategies soon after the financial crisis, which pretty much means I've only really experienced as a 'conscious investor' the wave of a bull market and never the white knuckle ride of seeing my investments cut in half by the panic of a possible world wide depression.

What has been fascinating though is during this time is the constant flow of end of the word predictions, end of the dollar, end of the euro, end of sovereign debt, end of USA, end of the european union, buy gold, buy silver, only to see the stock market just keep on going up, up, up!

It can be completely convincing and in fact compelling to read an article with deep analysis and flourishes of descriptive narration on how exactly the modern economy and its fiat currency will come to and end. The problem is all these predictions, despite their seemingly logical arguments have proven to be wrong!

The problem is with enough predictions going around combined with enough time someone somewhere will eventually look like a master predictor! As the staying goes 'even a broken clock is correct twice a day', although I prefer 'even a blind chicken finds a kernel of corn every once in a while'. Bear markets come and go, keep on predicting one long enough and you will eventually be proven correct.

Does it mean it will never happen, no of course not. It just means any prediction, bullish or bearish, is taken by my good self with a huge lorry load of salt! I read them, understand them, but then just file them in the 'could happen' category. I do not under any circumstance keep changes my investment strategies based on what I read. 

So back to this prediction that is currently taking hold especially with those with a bearish bent. Apparently valuations have only ever been this high twice before in history. That's right, twice, thats barely a correlation let alone a causation of severe bear markets.

Yes, there could be a 50% pull back from here, history shows they are rare but do happen. Should I though really care? When I care I mean, should I pull out all my money, change tactics, panic buy gold etc. Well I'm certainly not going to pull all my money out. Going to cash could easily mean I end up watching the market go to new highs whilst I sit on the sidelines waiting for Mr Market to deliver the big pull back that had been predicted.

(At this point it is important to say I have the benefit of not retiring in the next couple of years. For near retirees an upcoming bear market that could half your pension would be very worrying indeed).

Fact is bear market or not I will continue every month to add to my diversified portfolio of stocks and bonds in different countries across the globe. That will not change. On top of that with a 50% drop I will actually be scooping up twice as many shares for my future pension. 

Two years ago I was still adding to my European stocks when it looked like Greece would default and the whole union would fall apart. I was still adding to my emerging market stocks earlier this year when the supposed FED taper caused a pull back and the chatter was then about the end of the emerging market bubble.

This is the magic of passive index investing. Set up the monthly payments on automatic and let it run year after year, slowly accumulating stocks, ignoring the ups and downs of what might happen next.

Investors can even add a simple in/out trigger based on the 200-day moving average of each of the indices they are following in their portfolio. Simple. This way when the bears start shouting 'I told you so, look, look!' you can remain calm and simply sell and go to cash when prices fall though the moving average, then get back when prices move higher again above the moving average.

The markets are a complex ecosystem of many factors that do not always produce the same events and outcomes. Step away from the predictions, focus on putting together a sound investment plan and hold the mindset that no one really knows what will happen from here on.