Bernstein on Bulletproof

Barron's had a fun article that looked at some ideas from William Bernstein titled The Trick To A Bullet Proof Portfolio? Invest For The Very Worst Of The Worst. I'm a sucker for this sort of article. Based on the title, it would seem to be in the neighborhood of creating an all-weather portfolio which we've looked at in several different forms over the course of my full 19 years of blogging.  

We've studied the Permanent Portfolio and 75/50 going way back to more recently the Cockroach Portfolio and the Dragon Portfolio. 75/50 seeks to capture 75% of the upside with only 50% of the downside. That is difficult to pull off but if you do the math on that it shows long term outperformance. The Permanent Portfolio equal weights equities, long bonds, cash and gold with the theory that no matter what, at least one of those four will be doing well. 

Cockroach and Dragon both seem to be heavily influenced by Permanent with the basic building blocks of asset allocation as follows;

Cockroach 20% each I believe

• Stocks
• Volatility
• Trend
• Income
• Gold/Crypto

Dragon appears to be the following

• Equity 24%
• Long volatility 21%
• Gold 19%
• Long Bonds 18%
• Trend 18%

Volatility, trend (managed futures) and gold usually have negative correlations to equities. Having that much in asset classes that are intended to not look like equities should mean that the long term result won't look anything like the stock market. A 25% allocation to equities for someone who needs equity market growth for their plan to work won't get it done. Something close to a normal allocation to equities with smaller weightings to the other asset classes these portfolios own very well could get it done. 

This is why we talk about taking bits of process from various sources. Some managed futures to help manage volatility makes sense to me but not a 20% allocation. Same with the others.

Now to weave in some of Bernstein's ideas. If you design your portfolio to survive the absolute worst, then you're going be more conservative than might be comfortable. This implies it would be emotionally difficult to watch the stock market go on a multi-year run without you. I don't think protection needs to be that extreme. The Financial Crisis reasonably could be considered the worst of the worst couldn't it? Someone who was cognizant of sequence of return risk could have, without trying to predict anything, set a couple of years worth of planned expenses aside in cash or a cash proxy so that no matter what might happen or when they wouldn't be forced sellers in size after a large decline. That is not guessing what markets will do, that is just managing asset allocation and cash needs. Remember, the peak in the S&P 500 in October, 2007 was 1565. Then it more than cut in half but is now at 4400. As bad as 2008 was, we're 3x from there.

A belief about corporate bonds that he has come to have is that their prices fall along with equities in down markets. "You want the riskless part of your portfolio to be absolutely riskless. Corporate bonds don't belong in your portfolio." Buying longer dated corporates at the wrong time can certainly take on equity beta in a big decline, we saw that last year. I mentioned seeing some portfolios in our reorg that owned bonds that were the poster child for what Bernstein is talking about. Corporates bought when yields were low that are due in the 2030's are down massively. Sitting on them means 10 or more years of below market yields and selling them probably means permanently impairing your capital. 

One of the commenters on the article pushed back that when you own a bond, you own it for the carry (the yield) and because you will get your money back, the volatility in the meantime doesn't matter. That is true except when it isn't. The mechanics of what he described are correct but sitting on a 2% carry sounds bad. Getting a 5-6% yield though for 10 years seems pretty good to me even if two years later prevailing yields are in the sevens. That's mental accounting on my part, draw your own conclusion but a normal yield for ten years is fine with me, an all time low yield for 10 years or more is not. 

He makes a good point about not relying solely on math to assess markets and portfolio construction, that the psychology of markets is important too. I'll put a non-behavioral spin on that comment to discern between how things should work versus how they actually work. Simple examples come from REITs and MLPs. They were lauded for their diversification attributes, that investors should have 20% in those segments. I  pushed back on that pretty hard way back when, along came the bear market associated with the Financial Crisis and of course they imploded just like everything else. There's a cogent argument why they should hold up better but I don't think that argument is reliable.

Bernstein thinks people over estimate their tolerance for risk and/or volatility. I agree with him. A long time ago, our firm had a client who wanted a lot of equity exposure because he could handle the volatility, 20% declines wouldn't scare him. Then of course some decline happened that very few people would even remember and he panicked out right away. It was so obvious that was going to happen, I told my colleague it would happen and it did. Going back to the above, risk and volatility become much easier to endure when you know that your cash needs for x number of months are all set and you truly understand that bear markets end and eventually there will be a new high even if that takes longer than you'd like. 

"The name of the game with investing is not to get rich, but to avoid getting poor." That will not resonate with everyone but it is valid. He says the way to get rich is to find the next Apple but the problem is they all sound like the next Apple. I've said before that I am a sucker for a good story, they all sound good. Being aware of this flaw has helped me avoid picking a lot truly bad stocks. That being said, I don't think I agree with him. I think the point he is making is about the the difficulty of picking stocks. I think from other writings, he doesn't believe in using individual stocks (please comment to correct me) and if that is the case then I do not agree. People need to draw their own conclusion on this point. 

Take the time to read the comments too. One said owning dividend stocks is the only way. Another said investors should just use index funds. There are countless valid strategies for long term stock market success. I would define success as having enough money when you need it. Dividends did very well last year and are lagging by a ton this year. Indexing got pasted last year and MCW indexing is having a great year this year. Nothing will be best for every market environment but many will get the job done.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.