In the past decade we have had unusual market stability, artificially induced by the FED and the regime of stress testing of banks. In my opinion we narrowly avoided a depression in 2008. We are off the gold standard since largely since the great depression and that allows the government to print money. Also the FED bought toxic debt and returned treasuries which allowed banks to not go out of business. The problem is if the debt had been called in 2008, banks would have imploded. By moving the toxic debt to the FED balance sheet, it was allowed to mature and as it matured it became at least somewhat profitable. Like healing a wound add protein vitamin C, zinc, and time. By forcing bond returns low people moved out the risk curve and bought stocks, a lot of stocks. The forced stability of the FED on the market gave the illusion of safety. The economy is strong enough for the FED to unwind it’s balance sheet. Both bonds and stocks have have moved far off their historic mean trend lines. With the termination of FED interference both stocks and bonds will tend toward the mean, and the name of that game is increased volatility. Bonds are starting to yield enough return that their inherent safety plus a little dab of yield starts to look attractive in the face of turmoil. Stocks are inherently risky. You think something like SPY is pretty safe but did you know SPY tracks only a little over 300 stocks not 500 and it has a large cap tilt. VTI is even worse. It’s not 3000+ stocks but about 1500.
I always wondered what would happen in a crash. If you own SPY and they are forced to sell, SPY would likely no longer track the S&P because the momentum of the selling pressure on the 300 SPY stocks would overshooting would overwhelm the tracking of the instrument. So your 15% volatility might be greater and increased vol means bigger losses compared to the real S&P or total market index. Who knows? A LOT of people own SPY and VTI and a huge heard of sellers is an enormous pressure on price.
Controlling volatility is important in a portfolio, as important as return IMHO. High return is your friend in expansion but low vol is your friend in a crash. Lets say you own SPY. It’s projected return is 9.23% and it’s risk is 14.8%. Lets say you own a million bucks worth. Let’s say the market drops in half and my concern about increased vol doesn’t happen. So your 1M turns into 500K, a 50% loss. This means to recover to zero you need to make 100% before you reach your pre-loss level. When you reach your pre-loss level you start compounding again and making money. Till then you’re merely recovering. That recoup can take a long time.
Here is a chart of SPY you can see the local max was on 10/8/2007. It closed at $155.85 That number was not seen again till 3/11/2013. That means for almost 6 years your money was sitting there under water. After 3/11 you started accumulating and compounding again. It’s Halloween, you want even scarier?
This is the same SPY dating back to 8/28/2000. Notice it takes till 2007 to recover from 2000 and almost immediately another crash. This means nearly 13 years of living under water. If you’re going to make your million bucks with this sequence you’re going to have a tough time.
This is what you made over those 13 years with a SPY account, 2.246%/yr and that was from reinvested dividends. Say you retired in Dec 1999, with the intention of living off the dividend. Your net growth/yr over the first 13 years of your retirement is 0.343%/yr. Freaky eh!
Imagine you had some bonds say 60/40 SPY VBMFX. Your return is 7.41% and your risk is 8.93%. Lets say SPY drops in half. since your not 14.8% risked but only 8.93% risked (60% of SPY’s risk) your S&P will go down only 30% (1/2 of 60%) instead of 50%. Your 1M would only drop to 700K not 500k. That means you only have to get 60% back not 100% as in the first example. You would get your 60% back about 2 years sooner and start compounding again, while portfolio #1 is still under water. If you did that twice say in the 2000-2013 case that would be an extra 4 years of compounding portfolio #1 misses out on. For sure once portfolio #1 starts to grow again it will grow faster but the return rate on #1 is 9.23% while the return on #2 is 7.41% only 1.8% more. Eventually #1 will overtake unless there is a bad SOR as in the 2000-2013 sequence. What happens if yet another crash?. The sequence repeats.
Let’s look at the 40/60 case. 40/60 has an expected return of 6.53% and a risk of 6.24% (only 42% of SPY’s risk). Now when SPY goes down 50% 40/60 goes down only 21% (1/2 of 42%). Your million becomes 790K. Your recovery to compounding again only needs to go up 42% as opposed to 100%. This portfolio has the shortest recovery time of all. Your portfolio is still compounding at 6.53% only 2.7% less return than the riskier portfolio.
Just because you pulled some asset allocation out of thin air does not mean you are wedded to that forever. It’s not all or none. You don’t have to go completely flat, you merely have to reduce your risk for a while by using a less aggressive allocation. You can turn down the volume a bit, you don’t have to shut things off. In addition you can use that 60% bond money when stocks are cheap to buy a passel and be “loaded for bull” on the way back up. Investing is like playing poker. The house is slated to win by 8% but by playing correctly you can reduce those odds to almost parity to -0.2%(aka change asset allocation in a down turn). You can further change the odds by buying low so you can sell high and let compounding work its magic. How to know when to hold em and when to fold em is problematic. I use a financial adviser and quant analysis and I’m happy to pay for that. That’s my strategy. If the guy gives me an extra 5 years of compounding during accumulation… you do the math.
This article is an outline of a concept, a different way of looking at a portfolio from a perspective of capital preservation. It is not a plan. I do have a specific plan for my situation, but it’s more involved than this article would pretend. If our interested it gives you a starting vantage point to begin your study. The bogglehead approach is to simply stand there and take it with the refrain “I’m young I can recover!!” Problem is the young get old and the time to recover vanishes into the mist of mistakes made. Compounding takes time. If it’s a good sequence it pays off. But another way to look at compounding is mistakes take just as much time to compound into failure.
This also points out a problem with FIRE. Compounding relies on time. You can wet start your portfolio by over funding. HUH? Over funding? It means you save half for 10 years instead of say 15% for 20 years. Nothing wrong with that right? What about mistake compounding? That mistake is merrily compounding but is overshadowed by your exuberant saving profile. It will manifest in it’s allotted 30 year time frame because it may take a long time for a mistake to become significant, (Example national debt. We ignore it continues to grow). Let’s say you overfund save a lot of money but make a mistake (say running a portolio at 90/10 AA) that mistake manifests in 30 years but you retire in 15 years. It means 15 years into retirement an over exuberant asset allocation takes its toll.