A Lazy Person's Investment Strategy (updated 10/30/2020)

（An old short essay from 2015; edited and updated. Congrats to beautiful wind for becoming the moderator of  this highly informative forum.)

 

BGM Autumn Leaves:

 

 

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First, a picture is worth a 1000 words. Top panel is monthly return of SP500 ETF; Middle long term bond ETF; bottom a portfolio that longs 3 shares of TLT for each share of SPY. What patterns do you see below? 

 

1. stock (SPY) goes up and down over time;
2. bond (TLT) goes up and down over time;
3. both tend to go up over time (company makes things and earns money; bonds pay interest);
4. but they tend to move in opposite directions, especially during volatile periods; this offsetting effect was very obvious around 2008-09 global financial crisis and the 2020 March pandemic;
5. so if you combine them, you account is much less volatile. 

So if you do not want to spend too much time watching market minutes by minutes, you can just hold a well-diversified index in stocks and bonds in more or less stable proportion. Say you start with a 40%-60% portfolio in $ terms (this somewhat ad hoc ratio actually allows them to "cancel" risk, the so-called risk parity approach). You can adjust back to the benchmarkt proportion when it is too much out of the way, say at every 10% deviation from the benchmark proportion:

Say SPY went up 12% and TLT went down 8%, and now you are at about 50-50%, then you can sell some stocks and buy some bonds to get back to the benchmark ratio.

Note the third panel in both chart is simply 1 share of SPY + 3 shares of TLT, without periodic mechanical rebalancing, which will improve performance further. Also the actual return is higher as both SPY and TLT pay dividends/coupons (around 2% for SPY and 3% for TLT) annually.

During the crisis of 2008-2009, TLT helped to dampen the shock to SPY, but not completely.

Holding this type of portfolio has two disadvantages:

1. Your overall return will be lower than 100% stocks when market is in a bull trend as TLT does not yield much, and likely will lose as higher required yield leads to lower bond price. The so-called risk parity approach calls to use a little bit of leverage as the diversification improves the return-risk profile.

2. When the dominating concern in the market is tightening of monetary policy, you might lose money from both. However my observation is that those issues tend to be of second order in magnitude and few and far between. 

In the current low yield environment, the role of t-bond is less of a yield play. it is more of a panic insurance that pays a small but positive carry. You can think of it as GLD but without storage cost, and pay you a small amount of interest instead. I would not hold TLT by itself, but I would not mind holding some as part of a portfolio to protect downside in equities.

Just my 2c.