We live in an uncertain world. Events that impact companies and markets—and the course of our very own lives—unfold in unpredictable ways. Never losing sight of this basic fact of life, my guiding principle in constructing these Model Portfolios is to maximize the probability of successful outcomes.
My approach to doing so is to identify and put you in a position to systematically manage those things in investing over which you can exercise greater control. This includes attempting to capture every return premium financial markets make available, doing so in a manner consistent with your time frame and temperament, exercising common sense in achieving the aims of diversification and managing investment costs as efficiently as possible.
The table below summarizes the funds (by asset class) and their percentage mix in each of the Constancy Model Portfolios. Again, I name each Model Portfolio based on its percentage allocation to stocks, as I believe this is the most intuitive indicator of risk/return level. An exception is for the portfolios specifically designed for short-term interim goals.
Based on observations of market data over long periods of time, there are several reliable sources of higher returns made available by financial markets. As you want to compound your hard-earned savings at the highest possible return over time, I have designed the Constancy Model Portfolios to capture these return “premiums” wherever possible, within the risk framework suitable to your circumstances.
- First, owners of companies—companies providing the goods and services we all rely on and enjoy each and every day—participate in the fruits of the companies’ success. Stocks, as we also observed however, have exhibited higher price volatility. Given this, quite sensibly, stocks (ownership of publicly-traded companies) have delivered the highest returns over the long-term, as illustrated in Taking Advantage of Time Frame. This stock market premium drives the core allocation to stocks in our portfolios, as allocations to stocks must fit the time frame you have to work with for each of your goals.
- Second, the graphs in Taking Advantage of Time Frame also clearly show that stocks of smaller companies have delivered higher returns than larger companies over the long term. Given this size premium, we include an important allocation to small capitalization stocks in the stock component of our portfolios. As the size premium shows up sporadically over the years (in a manner impossible to predict), the stock component of our portfolio nevertheless remains well diversified with respect to size.
- Third, and most importantly, as I discussed in A Sensible Approach, the chief downfall to successful investing is overpaying in the first place. Benjamin Graham’s margin of safety mantra provides a buffer against this risk, which can be put into practice with a discipline of sticking with stocks trading at low valuation multiples. As I’ve discussed, from a quantitative/statistical perspective, historical studies have consistently shown a valuation premium—that is, higher returns for portfolios of low multiple stocks, again over the long term. As I explain further in the Stock Funds section to follow, it makes sense to think about valuation relative to fundamental company characteristics like inherent stability and profitability. Academic studies likewise support a quality or profitability premium relative to valuation. As the valuation and profitability premiums do not require taking on additional volatility, every stock fund we use in the Constancy Model Portfolios adheres to the valuation and profitability discipline. Returns for portfolios with exposure to the valuation and profitability factors will vary in the short-term from the S&P 500, the benchmark people most equate to the U.S. stock market. So, I dial back weightings in these strategies as time frames shorten.
- Finally, I would note that the bond funds I suggest also adhere to a valuation discipline. As I discuss further in the Bond Funds section to follow, the bond funds vary the risk they take on with respect to maturity and credit based on the size of the return premiums on offer for doing so.
Time Frame and Temperament
I believe in the merits of goals-based investing. Asset allocation—expressed in the Constancy Model Portfolios—should be specific to each of your goals. In evaluating the asset allocation (risk/reward profile) most likely to maximize the likelihood of successfully meeting any financial goal, the time frame you have to work with is the most critical objective input. Because each of your goals has its own time frame, each has an asset allocation consistent with this time frame. This allows you to see very clearly how you are progressing toward each goal. Moreover, as the risk (volatility) taken on in the portfolio for each goal corresponds to its time frame, you will feel more comfortable about the funding status for each goal. As an example, while a retirement fund may be significantly impacted by a stock market rout, there is 20 years to recover these declines; on the other hand, the funds for a child’s college or a down payment for a house required in a few years are little impacted, as they are invested in low volatility assets in keeping with this short time frame. In both cases, you’re okay! In short, this approach helps manage the chance for bad timing—of market declines coinciding with the arrival of a major expenditure goal.
In the Learn section of our website, I repeatedly used the metaphor of a roller coaster (as opposed to a railroad) in discussing the volatility in an investment journey, the stock component of your investment portfolio in particular. It’s a good metaphor in another way. The ride is hair-raising, but on a well-engineered and well-maintained roller coaster, you are extremely likely to step off it at the end safe and sound. We would not ride them—almost no one would ride them—if this was not the case. The same holds true with financial markets, including the stock market. With a well-designed plan (consistent with a goal’s time frame) and discipline in sticking with it, you are very likely to arrive safely at your financial goals. Like the roller coaster, however, things get truly dangerous if you panic and try scrambling out of your seat at a scary time. This is why I authored the Investor Temperament Questionnaire, which anyone who wants to can complete. I hope this helps you arrive at a good understanding of your emotional make-up with respect to investing. You can take this into account in choosing those Model Portfolios that best suit your needs. The portfolios, first and foremost, are meant to allow you to optimize the time frame you have to work for each goal. But if the volatility of these portfolios may take you out of your emotional comfort zone during the periods of market decline which will surely come, you dial it back and select lower volatility options. I want to help you stay in your seat.
Common Sense Diversification
At any level of risk (volatility) you take on, a goal is to generate the highest possible return at that risk level. In addition to selecting underlying funds that capture available return premiums and are themselves well-diversified, the way I mix these funds together in a model portfolio can also help advance this goal. This is the central idea in “modern portfolio theory” (also known as “Markowitz portfolio theory”). To “optimally” trade off volatility for expected return, MPT uses a calculation based on (1) historical volatility, (2) co-variances (how the prices of each of the different recommended funds historically have moved relative to one another) and (3) an estimate of expected return—for each fund that we could mix in. I base annual expected returns on the longest-term historical average returns available for each asset class (type of fund), adjusted for the current short-term interest rate. It is important to note that the math is the math, but there is, as always, an art to this model. Volatility and estimates of expected returns, both based on historical experience, may be off from what actually comes to pass, and probably will be. As a result, I use this framework only for broad guidance on the percentage of each fund to include in model portfolios at different risk levels, which I weigh against other common sense diversification principles.
Below, I provide two tables with key return and risk parameters for each of these Constancy Model Portfolios. I want to be very up-front and explicit in helping you think about the potential risk-return trade-offs in our model portfolios. Most pointedly, I use a very visceral measure of risk—the total decline a model portfolio would have experienced during the Financial Crisis/Great Recession, from the peak price of the S&P 500 on October 12, 2007 to its trough price on March 6, 2009. This is a hair-raising figure, which is likely why most investment service providers shy away from it. This is as stark a methodology as one can use, and this was an extraordinary period. I don’t expect to see another like it any time soon and certainly hope not to. But such declines can happen and, quite recently, did happen! Investors no doubt looked at what their portfolios were worth in October 2007 and what they were worth in March 2009 and had to deal with this stress. I want to help you understand the periods of losses you may experience, so as to be emotionally prepared in order to stay the course.
Because it pays to do so. Two years after the March 2009 bottom, the S&P 500 was nearly back to its October 2007 peak. Through the end of 2016, the S&P 500 returned nearly 80% (or 6.5% per year) from the October 2007 peak and nearly 260% (17.7% per year) from the March 2009 trough. To enjoy these returns, investors did not have to be willing and able to REALIZE the entire peak-to-trough “loss” but they did have to be willing and able to EXPERIENCE the entire peak-to-trough “loss.”
|Table 2a: Constancy Model Portfolios: Risk/Return Parameters|
|100% Stocks||90% stocks||80% Stocks||70% Stocks||60% Stocks||50% Stocks||40% Stocks||30% Stocks||20% Stocks|
|Avg Annual Expected Return||9.3%||8.7%||8.0%||7.3%||6.6%||6.0%||5.3%||4.7%||4.2%|
|Stress Test: 10/12/07-3/6/09||-63.3%||-57.1%||-50.9%||-44.6%||-37.8%||-31.2%||-24.9%||-18.6%||-12.5%|
|20-Yr Growth of $100k||$595||$529||$470||$412||$359||$318||$282||$252||$226|
|Wtd-Avg Net Expense Ratio||0.47%||0.45%||0.44%||0.41%||0.38%||0.36%||0.35%||0.33%||0.33%|
|Table 2b: Constancy Model Portfolios: Risk/Return Parameters|
|5 Yr Goal||4 Yr Goal||3 Yr Goal||2 Yr Goal||1 Yr Goal|
|Avg Annual Expected Return||4.2%||3.2%||2.2%||1.4%||0.4%|
|Stress Test: 10/12/07-3/6/09||-12.5%||-6.2%||0.4%||1.5%||5.2%|
|20-Yr Growth of $100k||$226||$188||$156||$132||$107|
|Wtd-Avg Net Expense Ratio||0.33%||0.28%||0.25%||0.18%||0.17%|
Note that the peak to trough decline for portfolios with higher volatility can grow meaningfully for model portfolios that offer seemingly modest increases in annual returns. For example, roughly a 1% increase in expected annual returns equates to having had to experience -10% incremental peak-to-trough declines over the Financial Crisis/Great Recession period. But as I showed in The Power of Compounding section of the website, over long periods (like those we often have for retirement) these small differences in annual returns result in big differences in dollars. This is why I also show you the growth of $100,000 over 20 years at the expected rate of return for each portfolio. It compounds to real money!
Finally, in an uncertain world, investment cost is one of the more controllable variables. So, a final parameter I include in the table above is what the weighted average net expense ratio for each of the Constancy Model Portfolios could be, based on the underlying funds and their weight in each portfolio. We refer to net expense ratio, which includes both management fees and administrative costs, simply as fund costs. Note that fund costs are not explicitly billed to all the fund holders, but rather paid out of the fund itself; so these fund costs effectively come out of the fund’s returns. The annual savings from lower fund costs directly benefit your returns.
For this example, I use mostly funds from Dimensional Fund Advisors (DFA), as they are some of the lowest cost funds available that pursue systematic value and profitability strategies. Note that DFA funds are only available through advisers. The cost of the model portfolios, the higher return/risk (longer time frame) portfolios in particular, are higher than those composed entirely of index funds, which currently average about 0.14%. But based on historical market data, I believe the return premiums captured by the funds will over time offset this cost differential by a considerable margin. For example, from 1928 through 2015, DFA’s Large Cap Value Index and Small Cap Value Index had annual return premiums over the S&P 500 of 1.1% and 3.3%, respectively.
Note that investment advisers charge a fee for their services, either a fixed annual or percentage of assets under management. In either case, such fees typically start at about 1% of assets, declining with asset size. There is one final category of costs which an investor faces, whether or not he uses a professional investment advisor. These are for the safe-keeping of assets and execution of trades (including individual stocks and bonds or mutual funds and ETFs), performed by a custodian and/or broker-dealer.
As a client-first firm, we believe in and strive for transparency, as it significantly helps align interests. Thus, the pricing structure we have adopted. Some advisors will charge a fee that includes fund costs and/or brokerage/custodial costs. Unfortunately, this gives rise to an incentive to look for the lowest cost funds (regardless of expected returns) or avoid economically sensible transactions (for rebalancing or tax optimization, for example) in order to keep as much of the “all-inclusive” fee. With our approach, you see exactly what you pay each service provider and why: Constancy for financial planning and investment advice and management; DFA for fund management; a third-party brokerage firm of your choosing for account custody and transactions.