Most investors are familiar with the benefit of rebalancing. Typically this is looked at using a simple portfolio of stocks and bonds. Let’s say you decide you want a 50% stocks and 50% bonds allocation. If stocks do well for some period of time, then you end up with more money in stocks and a lower relative amount in bonds, shifting your allocation. If, for example, your allocation had drifted to 60/40, then you sell stocks and purchase bonds to bring your allocation back to your 50/50 target. The data on rebalancing are clear…..it really does add some small but meaningful increase in returns over the portfolio that is not rebalanced, and it lowers risk. This is because you are forced to sell the assets that have appreciated (i.e. sell high) and buy those that have declined or lagged (i.e. buy low).
The reason that rebalancing works is that assets tend to go up and down in cycles and each asset class behaves a bit differently than others ones depending on the degree of correlation. Mean reversion (i.e. the cyclical nature of business/credit cycles and subsequent asset returns) in particular is a very powerful force in the world of investing and history shows this is much more common than not. Assets that do well for a while tend to return less in the future and those that do poorly for a while, tend to do better in the future. I’m generally a forward-looking person that doesn’t care much for history but in investing, an understanding of history is critical because many of the future investing patterns will look surprisingly similar to those that happened in the past. Much of this is based on human emotion, and our emotional evolution appears to be pretty slow.
These general observations around the powerful force of mean reversion are true and backed by history. We know with good certainly that these patterns happen. What we can’t predict is the timing so using these observations requires a longer time horizon of at least 5 years. In addition, no one can predict the perfect time to rebalance since the degree and timing that different assets will diverge is also not predictable. However, as a long-term investor, I believe there is a way to use the knowledge of mean reversion to tactically shift asset allocations to take advantage of relative value and improve investment returns.
In this article, I want to give a personal example of how I not only rebalance, but how I recently have started shifting to extremes of allocations across different asset classes based on relative performance and valuations.
It’s important to note that this approach is not well accepted in the FIRE community or by financial advisors and many would say this entails too much risk. However I have a stubborn independent streak and a high risk tolerance combined with a conservative withdrawal rate of a little less than 2% in my plan. So I could use a very conservative investment mix to achieve my cash flow goals. But I personally would rather use this position to try for bigger gains since I enjoy investing. If my strategy goes very poorly, I will shift to a more conservative mix after sustaining losses but I will likely still be at or below the standard 4% withdrawal rate. Please don’t take what I do as a recommendation for yourself. Personal finance is exactly that…..personal. But hopefully this gives you something to think about as you create your own investing strategy.
Before I get into the details of what I am doing, let me explain why the standard rebalancing (which is proven to work) is only a starting point to me.
First, it’s usually based on an arbitrary timeline, often annually. There is nothing special about a year or other timeframe in investing. Sometimes different assets diverge over time and sometimes they do so quickly. Having rebalancing triggered by an arbitrary time makes no sense to me.
A more rational approach involves having a set point in relative asset values trigger rebalancing. For example, if stocks grow to 60% of your portfolio, and your target allocation is 50%, it would trigger a rebalancing event if you set your upper limit to 60%. This is a better approach since it allows your winners to “run” since momentum does exist in investing, often over several years. Generally this type of automated rebalancing method is the best approach for most investors, with trigger points based on a predetermined range you’re willing to let your allocation drift.
I take a different approach that is more active. Something akin to sector rotation over the business cycle that many large institutional investors perform. Or allowing a bonds/stocks allocation to shift when stocks get to very high or low valuation levels, something advocated by the great Benjamin Graham (someone Warren Buffet credits as foundational in his success) in The Intelligent Investor: The Definitive Book on Value Investing way back in 1934 when he listed a 50/50 stock/bond allocation for most time periods but allowed for a shift of up to 75/25 either way depending mainly on the level of bargain in the stock portion. For investors able to resist their emotions that tell them to do the wrong thing at the wrong time, this type of asset allocation shift strategy has been and continues to be beneficial over a straight buy and hold allocation approach.
Like many investors, I have a target asset allocation across a variety of asset classes. However, I plan to hit this target asset allocation over time, not at a particular point. At a particular point in time, I allow substantial deviations from this target allocation based on my analysis of relative value of each asset class. I use standard valuation methods to determine these relative values. For stocks, which are my main investment class, this means things like price compared to earnings (I use a smoothed value like CAPE which smooths earnings over a 10 year period) and book value as two key metrics. If the cost of an investment (price) is low, compared to the underlying assets or likely future earnings, then it’s a more attractive investment with a higher probability (but not a guarantee!) of better future returns.
Most of the time assets are correlated well enough that they don’t deviate significantly and I stick close to my target allocation, with typical rebalancing along the way. However, if relative performance differs substantially, usually over a period of many years, then I will shift my allocations more aggressively.
So what actions has this approach resulted in? I’ve done a few things over the years but my largest moves have been with my allocation among emerging markets and the US stock market. I have always had a relatively high 20% allocation to emerging markets (I use the diversified Vanguard VWO emerging markets fund due to it’s low 0.15% expense ratio). I have done this because of the long-term forecast on earnings growth in emerging markets and the fact that they represent a large portion of global GDP now. Home-country bias is strong in investing and I want to avoid that and be diversified to reduce risk. You can look to Japan’s last few decades of poor returns to make you cautious about betting on one country. At the same time, I have a relatively low 10% allocation to foreign developed markets like Europe and Japan. While you can’t predict perfectly, I think it is prudent to factor in your best prediction of the future based on long-term earnings growth expectations. With the many demographic, cultural, and political structural constraints on innovation and earnings growth in these wealthy foreign markets, I am underweight compared to many others.
I am much more positive about the US despite some of the problems we have. There are enormous systemic advantages in the US with regards to innovation (higher education system, legal protections, financial liquidity, cultural elements, work ethic, and many more) that make it very difficult for other countries to match. And innovation drives productivity gains, which drive earnings and ultimately our standard of living. Simply our belief and support of personal and business freedom is something that is hard for many other governments to accept and replicate. So my target allocation is 55-60% US stocks, 10% foreign developed, and 15-20% emerging markets. If you add these up, I generally am 80-90% invested in stocks, with the balance in real estate and a small portion in bonds and cash. I am not a big fan of bonds right now given their long-term return vs business ownership (stocks) and the current historically-low interest rates. I also do not include home equity in my investment tracking.
So this explains my target, long-term asset allocation at a high level. But recently I have made a much stronger shift to emerging markets after 5 years of underperformance (where I kept my target allocation steady, continuing to buy periodically as they declined, and then making a big shift after a 15% drop in the diversified emerging markets index in 2015. More importantly, this 2015 performance followed another 13% underperformance in 2014 and even bigger underperformance of 37% in 2013 relative to the S&P 500. After these three years of much lower performance, valuations in emerging markets became attractive enough relative to the US that starting in late 2015 and ending early 2016, I sold US stocks and bought emerging market stocks so that my US portion was cut by 2/3 and is now at 20%. Emerging markets more than doubled and represent about 45% of my investment portfolio right now.
The graph below shows the significant recent change in my investment allocations.
Astute readers will see that % total is generally around 80% but recently has gone to about 65%. This is because I have recently built up more cash and short-term bonds. However, this is for short term expense planning and to minimize sequence of returns timing risk as I consider early retirement. I will keep that out of scope for this article since it’s based on short-term personal considerations and isn’t part of my long-term investment strategy. I’m actually more comfortable being fully invested and look forward to being back at that point in the future.
So why am I confident this isn’t a “value trap” where prices are low for a reason and may stay that way for a very long time? I mentioned earlier that I love US businesses and feel that the US has a bright future. And many emerging markets have very real economic and political problems that are significant and play a key role in their overall business success. Plus, it’s important to remember than many US companies, especially the big ones in the S&P 500, already have a large portion of their earnings growth coming from emerging markets so you are already participating if you own large US stocks. Many very smart, successful investors see no need to go outside the US. Names you may have heard of like Warren Buffett and Jack Bogle. And some in the FIRE community as well like Mr. JLCollins. I’m certainly not smarter than these folks and just for the record, I believe you will do just fine if you only invest in US stocks long-term. But there is a good case to be made for what I’m doing as well.
The key reason I made this move now is because of the difference in cost of buying the businesses in these different markets that produce the same earnings. As I mentioned, the US has outperformed emerging markets significantly over the last 5 years and particularly the last 3. When this happens to the extent that it has, history teaches us that future returns are affected such that the investment that did unusually well is likely to do worse in the future and vice versa. Detailed studies indicate valuations are the best predictor we have of future returns. It’s incredibly difficult to predict future stock market returns and nearly impossible over the short-term of a few years. But valuations can directly explain about 40% of the deviation in future returns when you look over a 10+ year timeline. 40% is still not a high degree of confidence (e.g. I bet no reader is using 40% as a confidence level in his or her firecalc retirement calculations) but in investing, this is a huge factor. Many institutional investors are moving to an overweight position in emerging markets based on valuations as well. In the end it’s your money so you decide what to do with it.
Also buried in these numbers are some additional specific investment allocations within these categories. The vast majority of my investment is in large diversified and low-cost index funds/ETFs like Vanguard’s VWO. However, about 10% of my investment is country-specific in terms of emerging geographies since there is considerable differences in countries in the broad emerging markets funds. As an example, I focused on Brazil early this year after a horrendous stock market performance in 2015. Yes, there were good reasons for this. The drop in commodities like oil and sugar that are key goods for Brazil. The Petrobras corruption scandal. High inflation, decreasing earnings. All the headlines were negative. But the annual performance was amazingly bad and caught my eye. Valuations looked attractive to me and much of the bad news was actually good for the future. A young population angry with corruption is likely to lead to improvements that help long-term. And I expected commodity prices to stabilize over the next few years. There are many complex data points both for and against Brazil but that is somewhat the point. If you wait for data to become more clear, you will be too late. This is what many investors look for. You will see articles advising caution. Wait until quarterly earnings start to improve. Wait until there is less political uncertainty. But if you wait for that, stocks will have made a big portion of the move already. The stock market is a prediction market. Pricing is based on estimates of future earnings, not a valuation of current earnings. My Brazil investment is up almost 100% this year and the news has been bad the whole time. At the time of my investment they were in a very deep recession. This is when you want to invest. Not after a recovery has started. At this point, the run-up in Brazil has been so strong that I would not invest new money into it and would be more comfortable looking for value somewhere else or diversifying in a broader index fund.
As part of that value look, I more recently invested in Poland as well. I won’t go into all the details why and I didn’t invest as much because it’s not as great a bargain but it looks like a good value, again looking at long-term prospects. The investment is only up a little at this point and I can’t say whether it will go up or down over the next few years but I see little downside and a good potential upside over the next decade.
It’s important to note that my good results in emerging markets this year are pure luck. I fully expected my investment thesis to work but I also expected it would take many years and be a slower change. It’s highly likely I would have bought even more in the event that emerging markets continued to decline. I stayed fully invested in the financial crisis and invested every new saved dollar throughout the whole event, despite expecting it would take much longer than it did for investment values to recover.
Again, this is a long-term investing approach and the timing cannot be predicted. US stocks could start a major correction tomorrow, or could continue to do well for many years. I have no idea. I just know the price to buy ownership in a US business is expensive relative to those in emerging markets right now.
Beyond the current valuation argument, there are other reasons I have shifted so aggressively to emerging markets. Some of these are based on quantitive analysis and some are qualitative. In the end, I’m well aware that I’m simply making an educated guess and making a bet. I think it’s a sound bet with good upside and limited downside but it’s a bet nonetheless and it may not work. However, it’s important to remember that I’m not going to the casino with this money. I’m investing in businesses. The real risk is a long period of underperformance in emerging markets relative to US stock markets. In that case, I end up with less money than I could have had if I had remained with my target US stocks allocation. But I will still likely build wealth over time, not lose money. With current valuations though, I believe the probability of US stocks outperforming foreign stocks for the next decade to be low.
Let me list a few of the long-term advantages I observe in emerging markets:
- Profit margins at US companies is at an all-time high. They are about 50% above the norm at 9% vs a historical average of 6.5%. In emerging markets, profits are at a cyclical low, about 10% below their long-term average. Profit margins are one of the most mean-reverting time series in investing so this one is strong evidence that we are close to a cyclical high in stock prices in the US and there are much better bargains in emerging markets. After all, these are markets. High profit margins invite competitors, ultimately driving profits back to an equilibrium value. Conversely, unacceptable profit margins drive weaker players out of business and leads to consolidation, driving profit margins again back to an equilibrium value.
- In many emerging geographies, the population is relatively young (China is a notable exception). This helps drive population growth and economic growth, which in turn drives earnings growth over the long-term. This link is not as strong as many people think as it’s easy to find slower growing nations with much better stock market returns but it’s still a general positive factor for emerging markets.
- Room for improvement. As the world continues to become more global, emerging markets have a lot of room to catch up to wealthy developed economies. This covers a wide scope of items. Legal protections, financing systems, industrial know-how, a growing middle class, etc. The internet, global trade, and movement of people are all helping drive some of these changes faster than ever before. The most important aspect is productivity, which is key to earnings growth and a rising per capita income. The world’s developed economies are much, much more productive than emerging geographies. As some of the known productivity-enhancing factors in developed economies (education, infrastructure, management skills, IT resources, etc) are improved in emerging geographies the gap between developed and emerging geographies will continue to close over time, improving earnings.
- Financial transparency and protections. Emerging markets have historically run P/E ratios about 30% below those of the United States, due to structural reasons around accounting standards, corruption and investor legal protections among others. As emerging markets improve these systems, this structural gap should close and P/E ratios will expand, creating a nice tailwind for investor returns over time.
- Inflation in the US has been steadily declining and is incredibly low which has helped drive a long-term bond and stock bull market since the 80s. Historically, the current low inflation and interest rates support a maximum P/E ratio. While this is a valid argument for why P/E ratios are justifiably high right now, deviations from these super-low values are likely to compress P/E ratios based on what history tells us. This would be a significant headwind on investment returns (often even more impactful than earnings in magnitude) even if earnings continues to grow. And remember point #1 about earnings? In many emerging markets, there is still inflation and relatively high interest rates so there is room for improvement here.
- Currency. The dollar is very strong relative to other currencies right now. It’s likely to strengthen further as the fed raises rates. But long-term, it’s more likely that the dollar will weaken vs other currencies to a more equilibrium value. This is a tailwind for emerging market stock returns.
- Dividend yields. Yields in the US are about 2% and in emerging markets it averages close to 3% so this supports a ~1% higher long-term investment return in emerging markets based on the well-accepted Gordon equation as explained by William Bernstein in his book The Four Pillars of Investing: Lessons for Building a Winning Portfolio.
What about the disadvantages of emerging markets? Here I could also write a long list of very real and relevant factors. Again, the US in particular (more than other developed nations in Europe or Japan) has many strong advantages. But we’re back to the price you pay to invest. We often forget that this is a critical factor. It’s not whether the US is better than emerging markets in terms of business. On an absolute basis, the US wins hands-down which is why my long-term asset allocation is 3x more invested in the US versus emerging markets. Right now however, investing in the US costs a lot relative to emerging markets (for the same amount of predicted future cash flows). This is the reason for my extreme rebalancing. It’s nothing more than relative valuations that I feel have drifted so much that it’s worth this significant shift in my asset allocation.
In the end, via different types of valuation methods, my best guess for long-term, real (i.e removing inflation) stock returns in the US is 2.5-4.5%, factoring in investment costs and volatility. For a diversified emerging markets fund like VWO, I expect 3.5%-5.5% long term real returns, so ~1% higher. It doesn’t sound like much but it’s a 20-40% higher predicted return, which is worth the bet to me.
Again, this is a fun hobby to me and it’s unlikely I will be financially ruined if I’m wrong. I currently sit at about a 2% SWR (and am still working) so I have the freedom to be aggressive in investing. I also have a high risk tolerance. I would rather try my own path in investing and risk a much lower return but also have some nice upside. This not a choice many people would choose to make, although I would point out that many real estate investors take even more risk for a potentially higher return via leverage. I’m too risk averse for that path 🙂
In the end, it’s your choice but I wanted to write this article just to give a different investment perspective in the FIRE community. There are really only a few “rules” that you need to follow for FIRE. Namely to save a significant % of your income and invest in such a way that you can mitigate the real risk of inflation removing your wealth over time. Within those rules, there is a lot of freedom and in the FIRE community in particular, we should have some more diversity, particularly with regards to investing where there is usually less discussion. There are many paths to income, savings, and investing. Learning from others is a great way to create your own, personalized path to FI.
Feel free to throw stones at this one (it’s an easy target) in the comments or share your own investing thoughts to add to the conversation! Are there any other closet active investors who think they can beat a buy-and-hold S&P 500 index fund?