The Sleep Easy Portfolio: How to Sleep Easy in Any Market Environment With Just Four ETFs

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Investing 100% of your portfolio in US stocks has been a winning trade for more than a decade now. Holding the popular ETF SPY (a popular stand-in for the S&P 500 index) over the past ten years would have netted you an excellent annual return of just under 14%. Investors who picked their own stocks, and held winners such as Microsoft, Amazon and Facebook may have done even better. Many investors look at the returns of other asset classes and aggressively shake their heads: International stocks? No, thank you. Bonds? I’ll pass. Commodities? GTFO!

Yet recent market events, where a coronavirus outbreak in China has led to a global growth scare, may have shaken this 100% US stock confidence just a little bit. In fact, a quick visit to Reddit’s investing and stocks forums shows that many investors are questioning “if now is a good time to get out.” There were similar messages on these boards at the end of 2018, when a 20% market correction had many investors wondering if the party was well and truly over. With hindsight, we now see that moment as an epic dip buying opportunity on the way to a 31% annual gain for the markets in 2019. This has further fueled the argument of many young investors that “stocks only go up” and “it’s always a good time to buy the dip.”

SPY’s 5-year chart as of February 2020. Source: Yahoo! Finance

When Dip Buying Doesn’t Work: Bill Miller & The Big Short

Always buying the dip has been a winning tactical strategy for more than a decade. It’s hard to doubt it. But what happens when buying the dip doesn’t work? The results can be disastrous.

Consider Bill Miller, one of the most successful mutual fund managers in history. After putting together an unbeatable ten year performance record at Legg Mason, Miller “bought the dip” in 2008, including some of the riskiest financial names at the time, such as AIG and Bear Stearns (a character based on Miller appears in “The Big Short” movie opposite Steve Carell’s protagonist–Steve Eisman IRL–during an investment conference where they argue the merits of Bear’s plunging stock towards the end of the film).

The results? Pretty ugly. It turns out the dip in this case was a falling knife called The Great Recession. Miller’s previously sterling fund lost more than 58% in 2008. Perhaps the most upsetting thing for Miller and his long-term investors was what this one error in judgment that took place over just a few months did to the fund’s long-term performance: it decimated it. As The Wall Street Journal described in an article at the time:

“These losses have wiped away Value Trust’s (Miller’s fund) years of market-beating performance. The fund is now among the worst-performing in its class for the last one-, three-, five- and 10-year periods, according to Morningstar.”

Think about that. One mistake, misjudging the severity of a market decline, wiped away ten years of excellent investing work. To gauge this loss emotionally, consider the time spent building up a portfolio to $100,000 over the course of a decade, only to see the value decline to $42,000 in less than a year.

Bill Miller’s story should serve as a cautionary tale for the “always buy the dip” crowd. Life won’t always be “lambos” and butterflies. But as the December 2018 example shows, cashing out at the first sign of danger is equally problematic. Missing out entirely on a 31% market gain is also disastrous for long-term wealth building.

How can investors avoid a Miller-like “all-in” disaster while also ensuring they don’t miss the great gains that this bull market has provided (and may continue to do so)? The key lies in understanding a concept called asset allocation.

Quick Introduction to Asset Allocation

Asset allocation is an investment jargon term that describes how your money is divided up between different types of investments, or asset classes.

Some of the most common asset classes include:

  • US Blue Chip stocks
  • Small-cap stocks
  • Emerging markets stocks and bonds
  • Corporate Bonds
  • Municipal Bonds
  • Real estate
  • Treasuries
  • Currencies
  • Commodities (Oil, natural gas, corn, etc.)
  • Precious metals (Gold, silver, palladium etc.)
  • Cash

Each one of these asset classes have their own risk and reward profiles as well as performance characteristics. Asset classes can typically be divided into risk and non-risk assets. Stocks are classified as a risk asset, meaning that when the economy is doing well, stocks will typically benefit with rising share prices as investors welcome risk (and expected gains) into their portfolio. US treasury bonds are an example of a non-risk or “safe haven” asset class; when investors are worried about the future they will sell stocks and add to positions like treasuries, where the government provides a guarantee of safety. This doesn’t mean that safe haven assets will not lose you money, however; when times are good investors will sell safe haven assets to add to stocks. Treasuries, gold and the Japanese yen (the safe haven currency) all experience serious losses from time to time.

Some asset classes are more volatile than others, meaning their movement up and down is more pronounced. Stocks, for example, are much more volatile than cash, the latter of which tends to be extremely stable, at least in the United States.

Diversification Myths

One of the fundamental mistakes novice investors make is thinking that their portfolios are “diversified” by holding a stock index fund which may contain 500 or more stocks. This approach only diversifies you in regards to risks specific to stocks. By holding many stocks you are diversified against “single stock risk,” in addition to sector risk; no one stock that fails or a sector that underperforms will devastate your portfolio.

While these are important risks to diversify, holding even the entire universe of publicly traded stocks doesn’t diversify you from a major “risk-off” move in the markets. This is because most stocks move together based on market sentiment. On big “risk-off” days, your stock portfolio will still be down 2% or more, because most stocks will fall with the market. During bear markets, this happens over a longer period of time, where the majority of stocks will decline over a period of months or even years. Bear markets tend to negatively impact even the best companies because investors exhibit herding behavior and may indiscriminately sell even healthy companies over fears about the broader economy.

In order to achieve true diversification, you need to have multiple asset classes in your portfolio that will perform in uncorrelated ways from one another. This means you need a mix of both risk and non-risk asset classes.

The Sleep Easy Portfolio: Core Positions (SPY, TLT)

The Sleep Easy Portfolio is my attempt to overcome my own bad instincts when it came to jumping in and out of the stock market. I wanted a portfolio that I could be 100% invested in at all times. I wanted to participate in the stock market’s gains, while also having downside protection and not having to worry about how my portfolio would look on those really bad “risk-off” days.

I landed on two core positions: SPY and TLT (US long-term treasury bond ETF). These two funds when used in concert together provide an excellent basis for an “all-weather portfolio,” because of their near-negative correlation with one another. As an example, take 2008: when stocks (SPY) declined 37%, TLT was up nearly 34%, almost mirroring the performance of the former.

I wondered how a 50/50 portfolio split of the two performed over the long term and turned to Portfolio Visualizer to find out. The results were very interesting: Going back to 1978, a 50/50 split between SPY and TLT never lost double digits in a given calendar year, including 2008. The mix produced double digit annual returns, with much lower volatility than either a 100% allocation to either fund alone.

The worst year for The Sleep Easy Portfolio (portfolio 3) was -7.26%, while still producing double digit annualized returns going back to 1978. The all stock portfolio (portfolio 1) lost more than 37% in 2008, while the all treasury portfolio (portfolio 2) produced weak returns overall.

For investors who are looking for a “lazy portfolio” that will allow them to capture most of the market’s gains while also protecting on the downside, a 50/50 mix of these two funds can be a good choice. You just have to understand that this downside protection comes at a price: this portfolio underperforms a 100% stock mix by about 1% annually. As you can see in the graphic above, that’s not insignificant over the course of many decades of investing your 401k, and can equate to hundreds of thousand of dollars in lost return. However, many investors simply don’t have the stomach for a 100% stock allocation. This leads them to jumping in and out of the market at the wrong times and missing big moves up as their cash earns them nothing.

The blue line represents an all stock portfolio, the red line represents the 50/50 Sleep Easy portfolio. You can see the highs are higher with all stocks, but the lows are much lower and more frequent.

For investors who worry about their “intestinal fortitude” to stick with stocks during major declines, the 50/50 SPY and TLT portfolio can be a good alternative. It takes market timing out of the equation and generally ensures your portfolio will participate in other the big risk on moves of bull markets as well as the “flights to safety” when investors get scared, which typically bid up the prices of the bonds in TLT.

The Sleep Easy Portfolio: Satellite Positions (GLD, DGS)

Even though a 50/50 split between SPY and TLT produces solid returns with low volatility, I wanted to add some more asset classes to my portfolio for a few different reasons.

  • Backtesting doesn’t guarantee future results: Just because the 50/50 portfolio has performed so well over the past three decades plus, it doesn’t mean that this asset allocation mix is guaranteed to do so in the future.
  • International stocks could make a comeback: The US market has trounced international stocks of all kinds during this bull market run. I suspect however, that this won’t always be the case, and there have been periods where emerging market stocks in particular go on major bull runs. I want to participate in those runs at least to a small degree when they happen.
  • US government debt could impact treasuries “safe haven” status in the future: The treasuries that make up TLT are the classic “safe haven” asset. That’s because most market participants still trust the guarantee of the US government to keep their money safe in such instruments. However, with US government debt projected to climb to nearly all of the GDP within ten years, we could see some future turbulence as major treasury buyers such as the Chinese government look to diversify away from this asset class.
  • Sometimes SPY and TLT will decline together: While relatively rare, there are periods where both SPY and TLT declined over a short-term period together. Part of my goal with this portfolio is to limit as much as possible a correlated move to the downside, so adding additional asset classes that move differently potentially gives me a better chance to achieve this.

So what does this mean for my Sleep Easy portfolio? I kept SPY and TLT as “core” positions, but simply reduced their allocations to 40% each.

For the additional 10% of my “safe-haven” half of the portfolio, I added GLD, the most popular gold ETF. The merits of gold elicit strong reactions on both sides of the investment community aisle. Some view it as a worthless metal favored by libertarian kooks, while others point to it as an alternative currency and store of value. I don’t actually have a strong opinion on gold, either way—I only view it as an asset class that tends to perform differently from both stocks and bonds, and tends to rise during extreme market panics. Since the coronavirus headlines have hit markets, GLD has risen by about 4.5%, and typically produces a positive return when stocks have a bad day.

As for my “risk on” portfolio, I allocated my remaining 10% to the WisdomTree Emerging Markets Small Cap Dividend ETF (DGS). I chose this particular fund because emerging markets tend to have slightly less correlation to US stocks compared to European or Japanese shares, and by going small-cap, I’m getting more exposure to companies that are focused on the domestic customer base of these markets, adding in another small diversification benefit. The dividend aspect is just another layer of protection in markets that are not well-known for their accounting standards. Companies that are total frauds tend to have a hard time producing dividends on a consistent, quarterly schedule.

In contrast to DGS, the largest emerging markets ETF, EEM, has companies such as Samsung and Taiwan Semiconductor, global behemoths that are more connected to the US economy. Remember, diversification is the name of the game here. I only add funds to my portfolio that bring something different to the table.

Performance

So how has my Sleep Easy Portfolio performed since I created it in the New Year? Pretty boringly, actually, and that’s the point. I rarely have days where my account gains more than 0.5%, but also have yet to lose more than 0.4% in any given day of trading. During last Friday’s market sell off when major stock indices were down around 2%, my portfolio lost only 0.25%. Quite often I will have two funds in the green and two funds in the red, and very rarely all four green or red. That is the sign that diversification is working.

At the end of the day, investing is about numbers. But it’s also about emotions and how those emotions drive our behaviors. Research shows that investors tend to jettison funds and asset classes at the worst possible times, selling when they have registered big losses at the bottom and then buying back in at the top. By investing in a number of different asset classes that are not correlated to one another, some part of your portfolio will win on both good days and bad, and reinforce your commitment to staying fully invested over the long-term, which is one of the keys to long-term wealth creation.

So forget being “all in” or “all out” of the market. Develop an asset allocation that works well for you and sleep easy in any market environment.

The two influences that inspired The Sleep Easy Portfolio are Harry Browne and Ray Dalio. Browne invented a concept known as the Permanent Portfolio, which has a higher allocation to gold than my Sleep Easy portfolio and as a result has suffered longer stretches of underperformance, especially during this recent bull market for stocks. Ray Dalio, the founder of hedge fund firm Bridgewater Associates, runs an “all-weather strategy” that similarly seeks to balance returns through investing in a wide range of uncorrelated asset classes.

Read more about the Permanent Portfolio here.

Read more about Ray Dalio here.

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