Psychological challenge of sticking with a volatile portfolio

[thrifty++]

I thnik you absolutely must stop looking at it at all. I have been through this experience recently as well and just completely stopped checking. And do not do any net worth tallys at all for at least 6 months to maybe a year. Staring at it is a little bit like staring at a huge plate full of cakes and pastries all day and expecting not to eat them.

I have found after time it gets easy to not check any more. The habit changes.

Plus yoou are at 3% SWR that is friggin awesome! You have a massive margin of safety.

Also, it might help to focus on generating cash (consulting or employment or side hustle or whatever) and doing a cash stockpile to give you some comfort and stop starting and thinking about reducing NW so much. Maybe your NW will increase with the savings of cash - once you check it 6 months later!!! And maybe doing this only until such time s you are comfrotable with the situation again. And maybe hankering down on the frugality more to help with stockpiling cash.

[plantingtheseed]

Backtesting my strategy shows very low drawdown. Volatility isn't crazy high but in the past I've been very diversified and conservative so it will take some getting used to.

"There is a danger of expecting the results of the future to be predicted from the past.” John Maynard Keynes

"At bottom the ability to buy securities -particularly common stocks - successfully is the ability to look ahead accurately. Looking backward, however carefully, will not suffice, and may do more harm than good." Benjamin Graham

"The biggest mistake investors make is looking backward at performance and thinking it’ll recur in the future." John Bogle

“You can’t see the future through a rearview mirror.” Peter Lynch

“You don’t get paid for what’s already happened. You only get paid for what’s going to happen in the future. The past is only useful to you in the extent to which it gives you insights into the future, and sometimes the past doesn’t give you any insights into the future.” Warren Buffett

“The worst thing one can do, especially late in a paradigm, is to build one’s portfolio based on what would have worked well over the prior 10 years, yet that’s typical.” Ray Dalio

Sorry, couldn't resist

So you're flying down the freeway at 80 miles an hour and all of sudden you hit this massive downpour. It is pouring so badly that you can barely make out what in front of the car. So what do you do?

[Lucky C]

I rely on a historically very reliable storm warning system. The warning is always early so I wait a safe amount of time and then slow down to about 40 mph or under. When I actually do hit the storm, I exit the freeway until it passes.

This is much safer than the average driver who might be going a safer 70 mph vs. my 80 mph when there is no risk of a storm, but who hits the storm at 70 mph vs. my 40 mph and might try to power through it still at 60-70 mph after I have reduced my risk to nearly zero.

If the early warning system fails to alert me, I still end up in a safer position than the average person because again I am able to get off the freeway while most power through it. If the early warning system gives a false positive signal, I don't miss out much on going down to 40 mph before accelerating back to 80 mph when a set amount of time has passed with no sign of the storm.


Dalio is right and I am indeed avoiding what has worked well in the past (buy & hold index funds, 60/40 portfolio, etc.).

[classical_Liberal]

@plantingtheseed
Your argument is copying previously historical portfolios will not work. It's data mining, the future will not mirror the past, those economic exploits are now known and have been taken advantage of already, etc. These are the main arguments folks use to push against @tyler9000's work.

In contrast, I believe the most important part of historical backtesting is that it provides one with the ability to see interactions, not just ROI's or previously successful portfolios. Once interactions are noted, a deeper understanding of "why" these interactions seem to recur can be ascertained. Then one can attempt to model the future based on current trends, using these underlying previously observed mechanisms.

I'm not saying it's perfect, but it certainly lies on a level of understanding much beyond "past performance is no guarantee of future results".

[Jason]

Inevitable.

https://www.marketwatch.com/story/finan ... 2020-06-14

[nomadscientist]

All-US stock/bond rebalancing mechanical trading "passive" scheme is known and the argument for it is... backtesting.

There must be a lot of low-hanging fruit in 30 year buy and hold portfolios.

There is no innovation in this market because no one is trying.

Almost no one who wants to invest this way trusts active management, and on the flip side of the coin active management sells its product on evidence of short time scale returns. So active management just isn't interested. But coming up with a better automatic trading scheme than all-US stock/bond rebalancing is "active management."

"Passive" managers like Vanguard cannot change their strategy because they "are" the market. They are too big to move. If they diverge too much from market capitalisation weighting they move the market, causing non-linearities that require more active management. Individuals have much more freedom, because they can do all sorts of stuff with only linear effect. Cap-weighting is what allows "passive" investing but it leaves plenty of known facts ignored. CAPE ratio for instance. Cap-weighting is necessary to make Vanguard's business, not necessary for the individual, who does not move the market.

BTW, why does Vanguard say 80% equities, 20% bonds, rather than cap-weighting equities and bonds? Bond market is about 10x larger than equity market. What could be the effect of American society, as a whole, diverging from cap-weighting for investing in equities? Could it... move the market?

[Lucky C]

I believe Shiller had a paper a few years back where he showed what the market would be like if valuation was pretty much constant and so stock prices only moved based on changes in earnings (probably based on CAPE so just one quarter's big earnings change wouldn't move the price much), a hypothetical efficient market of all value investors. The low volatility made the path of the stock market look more like bonds but of course with the same returns as equities in the long run.

Of course instead of efficient value investors (who don't buy or sell very often) we have fear, greed, and indexing dominating the vast majority of trades / price discovery. Buying into an index puts more dollars into the large caps than the smaller caps and selling does the reverse, so if a lot of people are indexers, momentum is amplified both going up and coming down.

It could be argued that buying into an index is thus not a bet on an efficient market but a bet on positive momentum, along with a bet that people won't be moving away from indexing. It's probably safe to say indexing isn't going to go away any time soon, but momentum is a different story. With more indexers now than ever, it is no surprise we saw a historically sharp decline in Feb-March when momentum flipped.

Buy and hold indexing is easy psychologically since it is popular and there is no thought required, but you are at the mercy of the market's momentum, whether good or bad. Diversification smooths out the bumps but often by taking a bite out of ROI (for example adding low yielding bonds).

The alternative is to do what's hard psychologically. Invest differently from the crowd, be very smart about it / work very hard at it, and eschew diversification in favor of sticking with the highest expected returns (without doing anything silly like using a dangerous amount of leverage). This alternative may be value investing or it may be some other strategy.

I believe that anything that is easy and popular is not a good way to make a lot of money in the long run - though it may work well in the short run, especially if you are ahead of the crowd. Doing what most people can't do or don't want to do maximizes earnings. This is true for most careers as well as investing.

[nomadscientist]

According to orthodox portfolio theory, you can set return to whatever you want (using leverage) so diversification by offering a higher volatility-adjusted return is a free lunch.

I think indexing is sort of fine, in principle, in some pure market, but in reality the dumb money gets targeted with scams, even if it isn't acting dumb, just like how (intrinsically very secure) Windows gets targeted most by viruses just because most people use it.

Before WWII and especially before WWI financially independent people (which used to be called "the middle class") lived off government bonds in the UK. They were expropriated by inflation, which was presented as an unrelated phenomenon, but which noticeably vanished soon after. Funny that.

And any big strategy lets smaller and more active players scurry between its feet and eat the crumbs which may nonetheless be very large for those smaller players.

The problem with this is is that most smart, hardworking investors underperform index and it's hard to tell if you are one of them before the wheels fall off.

[plantingtheseed]

Remember that risk as defined in MPT (index, asset allocation et. al.) is not applicable under uncertainty, where the probability is not quantifiable.

IMO back-testing, for the purposes of MPT, would better suited for observing the degree of correlation between assets classes. But there's the rub again, past is just that, past. (i.e. stocks and bonds are becoming more and more correlated under the MPT definition, as bonds are becoming more "risky")

Not saying it is not worthwhile playing mean variance games with estimates of mean return but it must fit the situation. And even if it did fit the situation, I would still take the results with a grain of salt.

Key thing is diversity and sticking with it if the future outlook of the US economy will remain exceptional is to believed, as the average will move higher.

[Lucky C]

...(using leverage) so diversification by offering a higher volatility-adjusted return is a free lunch.

Not so free after margin fees and additional taxes, so I would be avoiding leverage unless conditions are very favorable (not at this time)!

risk as defined in MPT

One of the psychological hurdles to get over is to accept/ignore more risk as defined by MPT (= volatility based on asset correlations) while limiting Buffett's definition of risk (don't lose money = drawdown). So my portfolio has nothing to do with historical asset correlations and the Efficient Frontier since I am not trying to optimize for volatility and adjust leverage to my risk appetite.

I am however considering adding a non-correlated or negatively-correlated strategy to this main strategy, but I don't think there is a way to backtest this second strategy I have in mind, at least not over a long period of time. Maybe that's a good thing - one strategy that's been rigidly defined and tested using decades of data, and another that's only based on experience, but without risk of data-mining, and more adaptable to change.

[plantingtheseed]

In the end, it will result in the weighted average, especially for a static portfolio. Future is not yet written. No amount of back testing will account for all of the possible outcomes.*

Consider, Buffett's method is also forward looking (looks to the future) but does not define risk and rather accepts that risk exists and accounts for it.

I believe this may be the key that you are looking for.


*One of the reasons why I would not base my retirement on firecalc results alone, even though I admire and appreciate the insight firecalc provides.

[shemp]

My approach is to regard stocks as income producing assets. As a rough guide, expected income is E/P less about 2% to account for economic depreciation being higher than GAAP depreciation (for example, newly created buggy whip factory suffers 100% economic depreciation when buggies replaced by horseless carriages, goodwill of brands often need constant investment to stay fresh, etc) and management theft (distorting earnings upwards to justify big pay, then skipping out before sh@t hits fan and company reports extraordinary "one time" writeoff). P/E of 20 means E/P of 5%, which implies 3% income by my formula.

Because stocks are real assets, income is inflation adjusted. Formula is intended for broadly diversified ETFs, not individual stocks. Income would typically be a mix of dividends and growth of dividends (from retained earnings, either share buybacks, reduction in debt, accumulation of cash, reinvestment in business).

If you buy at a P/E level that implies a good income return, it doesn't matter what happens to the price. A lower price simply means the next buyer gets a higher income return than you agreed on, but it doesn't negate your return. A higher price also doesn't affect your return on your original investment, but it does give you the option to take a capital gains profit and then invest elsewhere for income, if you so choose.

I have always been comfortable at 99% equities. I was 70% international equities at start of this year because I sold my USA equities several years ago when they became expensive. I went 99% stocks on March 23, after United Kingdom Public Health removed covid-19 from list of high consequence infectious diseases because of low fatality rate. That plus the gibbering of panicky fools on the internet (including in this forum) convinced me that we were at the point of capitulation. Unfortunately, I once again overloaded on international stocks so didn't get full benefit from the run-up from the bottom, plus I de-risked after massive first week run-upin hopes of taking advantage of a double dip which never occurred, so I missed part of the run-up before going 99% again. Oh well. I'm still up 1% overall for the year as of yesterday.

Buying at the bottom has always been easy for me, since I'm a natural contrarian and am happiest doing the opposite of everyone else, plus I have a good sense of when markets are near capitulation. My problem is that I have difficulty selling at the top, but without selling at the top, no way to buy at the bottom.

I'm 99% stocks now (30% USA value stocks, the rest international) with no desire to sell. So I won't be able to take advantage of any dips. But I am confident I wont panic even if a bear market goes on for 40 years. My stocks should return at least 3% real, and that is all that matters.

[classical_Liberal]

My stocks should return at least 3% real, and that is all that matters.

As long as that's income return, and it's relatively consistent. Being forced to sell ownership of income producing assets, if/when they are significantly devalued to maintain the 3% cash flow, is the definition of sequence of return risk. This is why if someone chooses a volatile portfolio, cash flow is king, IMO.

[nomadscientist]

@shemp: focusing on value at purchase time rather than retirement time is a concept I have been shifting towards over the last few months.

Typical FIRE mentality is to only care about portfolio size judged by mark to market at the moment of retirement, and then apply fixed rules to judge its value (e.g. withdrawal rate). This grossly overvalues portfolios with high P/Es at moment of retirement due to recent unsustainable run-up. At the same time, the fixed rules like 3% are way too pessimistic if you exclude the worst retirement date P/Es.

Seems like one conceptual error is corrected by making another.

[classical_Liberal]

Seems like one conceptual error is corrected by making another.

Right. This is why a noncorrelation strategy is so appealing. Knowing you want to "end" or RE with a specific range allocation of noncorrelators, you are free to purchase those that offer the most value while accumulating. From a psychological standpoint it's very appealing because I always feel like I'm getting the most value out of my earnings, even if that something is cash. In RE it's appealing because real returns matter less than volatility when considering a maxed withdrawal rate and no income. I get to sell the most overvalued asset to produce income.

[shemp]

As long as that's income return, and it's relatively consistent. Being forced to sell ownership of income producing assets, if/when they are significantly devalued to maintain the 3% cash flow, is the definition of sequence of return risk. This is why if someone chooses a volatile portfolio, cash flow is king, IMO.

In my crude "income = E/P - 2%"' formula, income is NOT pure dividends. However, 3% is a pessimistic estimate, since average P/E of stocks I own is about 16. For example, VEU (all world ex-US) has 16 P/E as does VTV (US large cap value stocks). 16 P/E means E/P of 6.25%. Subtract 2% and result is 4.25%. Plus even that 2% factor is probably pessimistic.

Anyway, I am not planning to spend down my wealth to any great extent. This is also psychological. I get pleasure from possessing wealth, independent of the pleasure of spending income from that wealth, so I over accumulated when younger. In other words, I have miser/hoarder tendencies. I would have never been comfortable with lean FIRE nor would I be comfortable planning to die broke. Excess wealth means excess income most of the time, so sequence of returns risk disappears.

Even if I were cutting things closer, so that sequence of returns risk was an issue, I have no difficulty temporarily cutting expenses. More psychology. For me at least, pain of spending too much principal would exceed pain of temporarily reduced standard of living, even drastically reduced like to near homelessness. (I'm camped in the forest at this very minute, BTW.). With that mentality, sequence of returns risk is greatly diminished.

In general, I strongly tend towards pessimism, planning for worst case, conservatism, etc. Know your own personal psychology and work with it, not against it. By working with my conservatism, I was able to become comfortable at 99% stocks. Warren Buffett has a similar mentality to mine. A born cautious conservative miser who works with his personality, not against it.

[Mister Imperceptible]

If the market capitalization of the US stock market is at 150% of GDP, then to expect the principal value of your stocks to return 0% real, the market capitalization of the US stock market must remain near 150% of GDP in the future.

[classical_Liberal]

@MI
This is more of a question than a comment, so pick it apart.

Wouldn't lower leverage rates, lower corporate tax rates, and decreased nonUS based production costs increase profits without increasing GDP? As a matter of fact, since non government interest income is part of GDP, lower leverage rates could theoretically be a drag on GDP. In addition couldn't more offshore production do the same thing?

So in an environment in which one or all three of these things happen (like now), wouldn't the market cap:GDP tend to skew higher from historical points in which this wasn't happening? Hence provide a legit reason for what we are seeing here.

Second question to you, I know you're a pessimist and contrarian in investing, but I haven't seen a post where you directly address the Fed buying corporate bonds now. What do you think the macroeconomic impact will be of this specific policy? I mean it seems an obvious tactic to keep zombie companies alive. In a way it's backhanded Fed based socialism. Fed owning means of production, not really, just a bunch of leverage that the means of production needs to remain solvent.

[classical_Liberal]

@shemp
Yes I know you're nowhere near a 3% withdrawal rate. So this discussion is probably not a big deal to you. I agree expense reduction is the other side of the coin. Earned income would qualify as a solution too, if one were so inclined.

But to address the question of WR directly through invest style only, without other material behavior changes, SOR is very high for anyone running in the >3% WR at the moment with a volatile portfolio of mostly equities.

I also see you're a fan of International due to its apparent value nature in today's markets. @seppia agrees with you, and I used to. Presently only about 15% of my assets are in international (nonUS) equity because they have underperformed for a very long time. I have begun to give up, in that I think much of developed nonUS equity space is a no growth value trap.

The other thing you and @seppia have in common is that you both spend all or most of your time in nonUS countries, which may give you both insight I can not see. Other than prices and PE's, is there a fundamental reason you think international will turn it around? I'm talking culture and growth potential here... Thanks in advance.

[nomadscientist]

The other thing you and @seppia have in common is that you both spend all or most of your time in nonUS countries, which may give you both insight I can not see. Other than prices and PE's, is there a fundamental reason you think international will turn it around? I'm talking culture and growth potential here... Thanks in advance.

To flip question on its head:

If the US stock market had underperformed for the past ten years, would you invest overwhelmingly in the US anyway because of your assessment of its superior* culture and growth potential?

Is it sensible to base investment decisions in equities on backtesting with time horizon of ten years? If we take one hundred year data, can we find instances where this would have given wrong answer?


*superior to countries you seem to be saying you don't have much info about