Tuesday, December 22, 2020

Comparisons of Different EFT Portfolio Models

One "rule of thumb" for portfolio composition is to have the bond part of your portfolio equal to your age. For example, if you're 70 years old, then 70 percent of your portfolio should be in bonds. I don't follow this "rule." 

First, let's define portfolio for the purpose of this article. It is a collection of stocks, bonds, and other assets with the goal of sustaining a person in retirement. That is the goal of the portfolio: to supplement a retiree's income without running out of money. The amount of the portfolio depends on the needs and goals of the individual. 

There are hundreds of "rules" for portfolios. They can be simple, or complicated. Very popular currently with financial managers is Modern Portfolio Theory, which is based on mean-variance analysis, a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. Wow. What a mouthful. 

Ever since I studied finance in graduate school, which is heavily based on statistical models, I have a problem with the methods for estimating expected rate of returns. Change the model -- or the expectations -- and you'll have different results. Predicting the future is hard, or impossible. If you expect returns of 10 percent next year, you'll definitely make different decisions than if you expected a negative return of 10 percent. 

Stay fully invested. Rebalance your portfolio. Diversify. You can't time the market. These are the mantras of financial "experts," including my own stock broker. (However, there are a few who don't follow these adages: One is Ken Moraif of Retirement Planners of America, and author of Buy, Hold, and Sell.  

While there are certain principles of financial management that have held true for thousands of years, your own portfolio should be based on your own goals and financial plan. Having written goals and a written plan are two of the age-test financial principles. 

Let's get to the point of all this: constructing a portfolio that works. While there a probably a hundred ways to do this, I have selected a few portfolios to test. I think planning your portfolio rather than just investing in things that seem "hot" at the time will bring you better returns, and probably less anxiety. 

I've constructed a couple of test portfolios out of ETFs. What you invest in can be tricky. Just buying an ETF that tracks an index, such as the S&P500 might be one strategy, but different indexes have greatly different returns. Compare these sector areas with the actual returns of the major indexes, year-to-date (2020): S&P500: 14.81%; DJIA: 5.75%; NASDAQ: 42.16%; Russell 2000: 18.07%. 

So attempting to decide what to buy with an uncertain future is -- most of the time -- a guess, at best. So I propose that it's best to diversify, but not overly. For example, if we'd just invested in the DJIA, our return for the last 12 months would have been only 5.75%. But if we'd invested in the NASDAQ, our return would have been more than 42%. But how could we know in December 2019 which was best, or even that the markets would go up over 12 months. You couldn't. While you can chart general trends, and in December 2019, the trend was up, trends reverse themselves, as we saw in March 2020. 

One such remedy would be to invest in all four, in an equal-weighted portfolio. The entry date is Dec. 18, 2019 and current price is the close of Dec. 18, 2020. Total return (including dividends) is 23%. 

So it's not as good as if we'd placed all of our money in the NASDAQ, but how could we know that it would go up 40% while the Dow only went up 8%. There is no way we could have. Of course, you could have tried to re-balance at some point during the year based on performance, but that adds risk to the portfolio. 

Look, a 23% annual return is very good. It beats many mutual funds and ETFs. Many financial advisors would not like the fact there are no bonds in the mix, so let's put together some portfolios with bonds, as we are advised to do. 

This next one was designed to be moderately conservative, with 50% in fixed income. While it only returned 10.15% (including dividends), the best measure of how this portfolio performs is how did it react to the market downturn in March 2020. 

The first chart shows the value of our portfolio as of March 21, 2020. The second, as of Dec. 21, 2020. 

At market bottom: Dec. 18, 2019 - March 20, 2020

Buy and hold: Dec. 18, 2019 - Dec. 21, 2020

Let's see what happens if we use a moving average rule to avoid the market drop of almost 34% on the S&P 500 that begin on Feb. 20 and continued until late March. Our rule will be to sell if the S&P 500 closes 3% or more below its 50-day moving average. Conversely, we'll buy if the SPY is 3% above its 50-day. 

The sell signal came on Feb 25, when the S&P 500 closed at 3128. We would have sold during the day, but we'll use the closing prices. Our overall loss would have been less than 1%. The results below do not include dividends, which probably would have kept us a break-even. We keep our powder dry to fight another day. 

Dec. 18, 2019 - Feb 25, 2020

That day comes on May 18, 2020, when the S&P closes over 2,867. We buy the same portfolio, and the gains to date are shown next. 

May 18, 2020 - Dec. 21, 2020

Buy and hold results in a gain of 10.15%. Buy, hold and sell strategy results in a gain of 17.29%, dividends not included. Another alternative would have been to move everything into the BND EFT, which may have resulted in a few extra dividends for the period. Care must be taken with bonds, because they can have the same downward trend, depending on how interest rates are trending. (Higher interest rates cause lower bond prices.)

Let's do the same with a portfolio that uses 90% of its assets in high-growth ETFs (equity) and the other 10 percent in a high-yield bond ETF. 

First, the buy and hold strategy resulted in nearly 36% gain. Dec 19, 2019 - Dec. 21, 2020.

Selling at the beginning of the 2020 downturn resulted in a 1.63% gain. Dec. 19, 2019 - Feb. 25, 2020.

We buy again on May 18, 2020, as we did in the first example. This resulted in a return of just under 37%.

These charts were done in Excel, using pricing from my broker's web site. You can set these same tests up. Not shown are the columns for dividends, which are added into the gain column, for a total return including dividends. 

Conclusion. If you have the discipline to follow a set rule, such as the 3% 50-day rule, selling and reverting to cash, then buy on a renewed uptrend, creates the largest returns. Longer term outlooks can be created with either the 100-day or 200-day moving averages. However, for the less well disciplined, holding a basket of stocks and bonds long term (5+ years) can provide suitable returns for very little effort. 

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