As we have previously concluded markets will continue to grow long term, however at a slower pace. However, which markets will grow and what is the optimal investment strategy? United States and emerging markets seem to be better bets given presence of both technology and population growth. Developed markets could see slower growth in the medium to long term as they are already facing population decline.
Thus, I propose a a long term equity portfolio of 45% US, 30% Emerging Markets (EM) and 25% Developed Markets (DM excl. US). This proportion is overall aligned with the size of the economies and stock market but is overweight in Emerging Market stocks vs. a current distribution of a global stock index (e.g. Vanguard total stock index).
The proportion of portfolio in bonds will depend on how close one is to retirement and current interest rates. In case of major market downturn, investors close to retirement could be forced to sell equities at lower prices; instead selling bonds would be more prudent while waiting until equities recover. Also, low interest rates today mean there is really no upside to the bonds value. If in the future rates do go up, and later, there is a potential for another downward rates spiral (e.g. rates 5% to 1%), bond values will rise. So when rates peak, bonds should be added to one’s portfolio.
Flexible Asset Allocation
The weights of the 45% US (we prefer to invest in SP500), 30% EM and 25% DM portfolio should also have a degree of flexibility depending on how a specific asset class is valued. This can be assessed through something as simple as the Price-Earning (PE) ratio. (why complicate things) I like to set a threshold in PE ratios. If a certain market reaches the threshold, I start to decrease its weight and automatically increase the weight of assets that are still competitively priced. If all of the 3 assets classes start to look significantly overpriced, I sell into cash and bond equivalents. Of course, there is a degree of judgement when setting a threshold and starting to decrease weights. PE ratios can sometimes be misleading, especially in times of significant downturns when profits are really low – this was the case during the 2008/09 subprime crisis when SP500 PE was at 123.73!
However, let’s take an example of SP500 in 2020/2021 and a perception of it being overpriced. PE ratio reached 39.26 on Dec 1st 2020 and continued to be in mid 30s until March of 2021. In comparison, PE ratios of Developed and Emerging markets were at high teens / low 20s. At that point, I have rebalanced my portfolio to being underweight in US stocks. This of course proved a bit premature as SP500 continued to rally through 2021. Closer to the end of 2021, beginning of 2022, SP500 PE ratio has declined to about 25, which I consider in line with a fairly priced given the low interest rate environment, and I have started to rebalancing the portfolio closer to the model figures. Should the interest rates increase, the PE ratio threshold may be adjusted downwards. I am yet to create a formula to derive PE threshold depending on the current interest rates.
So, I have shown the logic behind my model portfolio allocations and how to deal with proportions based on how expensive the various asset classes get. You may use this logic to create your own portfolio with your asset allocations depending on risk appetite, objectives and level of comfort with a given market class.
Market Timing
Now, to the question of market timing.
It is virtually impossible to predict local peaks – we have tried and mostly failed over the years as the market continued booming. We do think that the adjustments in market allocations based on price-earnings ratios shown above are able to counter the risk of major losses if the market gets overheated. However, recognizing that the market always goes up in the long term, we consider strategy of market selling a losing strategy over time.
Instead we can focus on when to buy equities, putting an emphasis on local bottoms. That is not say that we should not be buying in the normal course of market performance. Indeed, regular contributions to your portfolio should be maintained regardless of the market conditions.
However, any significant decreases in market indexes present a great, almost guaranteed way of increasing your wealth. When markets tank 20, 30, 40 and 50%, it is a great time to get into the market. Our plan is to use leverage next time the market significantly drops and continue buying, and borrowing as long as market continues to decline. With markets at historic heights, we know for a fact, that we’ve always recovered, no matter the extent of the downturn. Sometimes, it takes years to fully recover, however that growth still significantly exceeds any alternative investments and borrowing costs. For example, if it takes 5 years to return back to the previous peak from a 50% drop, you have still made 100% on your investment if you’ve purchased at the bottom over a 5 year period, or 15% per year.
When market is dropping, it is best to maintain discipline and build an investment strategy ahead of time. For example, you think that market has a potential for a 40% drop and that you are willing to invest $60,000. You can invest the 1st $20,000 when the market enters the bear territory and declines by 20%. The 2nd $20,000 can be invested if a market declines by 30%, the last $20,000 if market declines by 40%. This strategy ensures you are disciplined, don’t over invest too early, or be too greedy, e.g. still make money if market only drops 20%.
Optimal strategy summary
- Invest into a diversified portfolio of global stocks with weights you find appropriate but relying on key market drivers of technology, population growth and money supply growth. Consider investing into bonds, cash or alternative investments if closer to retirement.
- Be flexible in your allocation depending on relevant valuation of the asset class; adjust if PE ratios of a given asset class imply overvaluation. However, be mindful that PE ratios are imperfect
- Don’t try to time the peaks. However, have a strategy to enter the market during times of turmoil and significant market declines. Consider using leverage.
Disclaimer: This article is for general education purposes and cannot be relied upon as individual investment advice. This is our optimal investment strategy, however it may not be suitable for your unique circumstences.