Portfolio Patience

We have a lot of fun here building portfolios that although in practice I would not suggest do help with understanding how to manage volatility, correlation and other attributes to help navigate through an entire stock market cycle with the hopeful result of capturing a decent amount of the upside while trying to avoid the full brunt of the downside. The converse of this would be just buying a broad based equity index fund and holding on no matter what. You'd get the upside and feel the full brunt of the downside. 

Here is another one to explore. 

Portfolio 1 is 70% allocated to a low vol equity proxy and 30% to an alternative strategy that is intended to look like a horizontal line that tilts upward. The alt used does not take interest rate risk. Portfolio 2 is 100% Vanguard Balanced Index Fund (VBAIX) which is a proxy for a 60/40 portfolio and Portfolio 3 is the SPDR S&P 500 (SPY). 

Portfolio 1's standard deviation is dramatically lower than the S&P 500 and noticeably lower than VBAIX and the CAGR is compelling relative to the other two. This only goes back to 2020 because that is when the alt fund as it is now managed came to be but a lot has happened in that time that makes the study worthwhile. You look at the 43 months and yeah, over the entire period Portfolio 1 is interesting, it is reasonable to conclude it's done well. 

Fine but there have been some periods where it lagged by a lot and you can tell just by looking at the chart it dropped step for step with the SPX during the Pandemic Crash of 2020.  Here's the year by year.

In 2020 it lagged VBAIX and SPY by a lot. In 2021 it lagged the S&P 500 by a lot but was better than VBAIX, 2022 it was up which is where a lot of the positive stats come from and this year through July 31 it is lagging both by a lot. This year, Portfolio 1 is up 8.47%, again it is lagging. 

An interesting thought exercise about that 8.47% YTD. On January 1, I think most people would have been thrilled if they knew they'd be up 8% on July 31st. But now, here were are with that 8% but it is far behind 60/40 and straight equity exposure. Introspection time, if you "signed up" for lower volatility would lagging like Portfolio 1 is in 2023 cause you to capitulate and go after something else? 

Any portfolio you could possibly construct will at times be challenging to stick with, that is the nature of it. I would say the most important steps here are understanding what you need your portfolio to do, make sure what you've constructed has a reasonable shot of doing what you need it to do, understand the type of environments that will challenge you emotionally (I am saying impatience is an emotion) and then be able to stick with it during a relatively bad patch.

One point to close out on is something I said in the first sentence. Portfolio 1 has two funds in it. Putting it all into one or two funds is not going to be ideal in too many circumstances. Both the funds in Portfolio 1 are in my ownership universe. I believe they will both do what they are "supposed" to do the vast majority of the time but cannot ensure they will do what they are "supposed" to do 100% of the time. 

Arguably, in 2022 bonds with any sort of duration didn't do what they were "supposed" to do but duration was an obvious accident waiting to happen. Investors with a 60/40 portfolio with the 40 in individual bonds maturing in 10, 15, 20 years are sitting on some very depressed assets and will be for many years. Talk about portfolio patience (the title of this post), that's a tough spot.

I can't envision the scenario where the alt I used in Portfolio 1 would drop by 30% the way some bonds have but I don't need to worry about it. That fund has a mid to low single digit weighting not the 30% I used to build the portfolio for this post. Diversify your diversifiers and as we learned last year, that applies to maturities too. 

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.