Portfolio construction assumptions

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konik
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Portfolio construction assumptions

Post by konik »

I have recently found a good article overviewing some assumptions we make during the portfolio construction.

https://drive.google.com/file/d/1JlqpkV ... sp=sharing

While we often say "nobody knows nothing" classic 60/40 portfolio includes some expectations. The paper also classifies other possible choices.
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nedsaid
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Re: Portfolio construction assumptions

Post by nedsaid »

I will contribute to this discussion by mentioning the assumptions behind the simpler Boglehead portfolios.

First, is the Equity Risk Premium, the assumption that over time that Stocks will outperform risk free treasury bonds albeit with lots of volatility.

Second, is the assumption that there are three main asset classes: Stocks, Bonds, Cash.

Third, to keep portfolio volatility tolerable, an investor invests in a mix of Stocks, Bonds, and Cash. The younger an investor is, the more stock heavy portfolios should be, as an investor ages that he or she should increase allocation to Bonds and Cash.

Which leads me to a fourth assumption that human capital, or future earnings potential from work, decreases with age. So you balance the risk of Volatility in the Stock Market against declining human capital over time. In other words, as you age the present value of future earnings decreases and thus your ability to take risk in the Stock Market declines over time. Hence the need for an increasing allocation to safer and less volatile asset classes as one ages. This is also known as a glidepath.

Fifth, Bogleheads believe that the markets are efficient, though not perfectly so, thus there are limits to what efforts to optimize a portfolio can do. For the most part, assets are fairly priced in the markets. Hence, the standard advice to focus on the allocation of the basic three assets within a portfolio: Stocks, Bonds, and Cash. If you want to increase returns, you need to increase allocation to Stocks keeping in mind a portfolio will have increased volatility when you do that.

A corollary to point five is that if markets are efficient then the best way to invest is in Market Cap Weighted Indexes. In other words, markets know best about the valuation of securities as prices reflect the collective wisdom of all of the market participants. One is not captive to a particular point of view as he or she can rely on the collective wisdom of the market itself.

A sixth assumption is that over long periods of time that Stocks, Bonds, and Cash all beat inflation: Cash by a little bit, Bonds by let's say 1-3%, and stocks by 7% a year.

John Bogle made the statement that Bonds are for investment and Cash is for shorter term savings. Thus, Boglehead portfolios are pretty light in cash.

So a while a Boglehead approach is not particularly sophisticated, there are certain assumptions behind this philosophy. Because of skepticism regarding Factors, Bogleheads tend not to be big believers in Portfolio Optimization. I may have missed a point or two here but this is largely the Boglehead philosophy of Portfolio Construction.
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nedsaid
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Re: Portfolio construction assumptions

Post by nedsaid »

I think a big reason that people don't put too much faith in portfolio optimization is that the economy and the markets are dynamic. In other words the world changes.

I like the word that Nisiprius coined around here is the word "slipperiness." It is the idea that such things as comparability of data, correlations between asset classes, volatility, and even definitions of certain phenomenon we observe in the markets are not 100% constant, everything seems to shift around a bit. We try to make an Art into a Science and we try to make what is inexact in nature to be exact. So half of the battle here is realizing that we live in an imprecise world. We cannot even define exactly what risk is, the best we can do is describe the different types of risk that we can observe.

The most commonly recognized type of risk is market volatility. The second most recognized risk is the potential loss of buying power over time due to inflation. The former is what Bill Bernstein calls "shallow risk", and the latter type of risk is "deep risk." In other words, what we really care about over time is what we can buy with our portfolio in order to support ourselves when we are older and not so much about short term fluctuations in price.

I also like to talk about pricing risk or perhaps speculative risk. In other words, investors might show their favorite investments too much love and price them beyond what fundamentals can support over longer periods of time. Too much investor enthusiasm can turn a great company into a poor investment.

This leads me to what I would call fundamental risk. Things like Price/Earnings, Price/Cash Flow, and Price/Sales. In other words, are investors paying too much for a future stream of earnings? Are Sales/Cash Flow/Earnings growing over time or shrinking? If growing, is the earnings growth volatile or more consistent? We would also look at the Balance Sheet, how much debt does the company have? Can the company meet its debt obligations in the future? How vulnerable is the company to changing economic conditions? Stuff like that.

There is also the single company risk. Thus the more securities that you hold within the portfolio, the less exposed you are to the idiosyncratic risks of a particular company. On the other hand, not all companies are equal in terms of their unique risks. You would not want a portfolio of 100% speculative mining stocks or 100% in speculative technology stocks. Safety in numbers isn't truly safety unless you have a concentration of companies with fewer unique risks. In other words, you get more safety in 1,000 companies with solid balance sheets and consistent earnings than a portfolio of 1,000 companies with weak balance sheets and volatile earnings, if they have earnings at all.

In portfolio construction, we also have to weigh that market returns are both economic return and speculative return. Over very long periods of time, the economic return from investing in the stock of a company should be equal to the market return. Of course, there is the element of investor emotion, either enthusiasm for a stock and/or for the market in general or lack of enthusiasm. These swings of emotion can greatly affect prices, in shorter time periods driving the market price of a security below its actual economic value in times of excessive pessimism or driving the price of a security above its actual economic value during times of market euphoria. This volatility in prices caused by human emotion is called speculative return.

Of course, this affects the efficiency of markets as you wonder how efficient markets are during times of panic or during times of extreme euphoria. In other words, human emotion can drive asset prices above or below intrinsic value during times of extremes in market sentiment. During the Go-Go 1960's, some of the Nifty Fifty Blue Chip stocks had price earnings ratios of 50 or more. These were "one decision" stocks where you bought and never sold, sort of set it and forget it. During the 1973-74 Bear Market, price earnings ratios for the market got to be about 8. I would argue that neither a 50 P/E or an 8 P/E represented true economic value but were a reflection of market moods. Of course, there were economic factors that drove these extremes but stock prices were both higher and lower than they probably should have been.

This also leads to the discussion of how the economy and such things as interest rates and energy prices can effect the economy as they did in the 1970's.

So when we discuss the "slipperiness" of the investment discipline and then the risks that effect security prices, you can see this gets complex in a hurry. You can see why folks don't want to bother with portfolio optimization as they are skeptical that this can be achieved in real life. My own belief it that it is worth a try but don't get too fancy or complex.
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Re: Portfolio construction assumptions

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nedsaid wrote: Sun Aug 14, 2022 1:11 pmA sixth assumption is that over long periods of time that Stocks, Bonds, and Cash all beat inflation: Cash by a little bit, Bonds by let's say 1-3%, and stocks by 7% a year.
Bonds when on the gold standard (pre WW1), when money was gold, broadly 0% inflation, and the 4% average yield was like a real rate of return. With fiat currency, typically with targeted 2% inflation, bonds transitioned to being more 0% real, sometimes borrowers win, sometimes lenders win.

US tax changes in the 1980's incited more of earnings being retained (lower dividends paid out). In the UK without such bias broadly share prices have paced inflation, but in a very volatile manner. Similarly gold prices might generally pace inflation but again in a very volatile manner. In addition to share prices broadly pacing inflation stocks pay dividends, on average around 4% dividend yield historically. Firms actually do better than that, the average yield is what investors priced share prices to, typically twice book value.

The US was a 20th century right tail, good/great case outcome, in having become a more 'developed' market and expecting that relative out-performance and cash 0%, bonds 1-3%, stocks 7% rear view tinted mirror is optimistic in forward time IMO.

Also, with many more having surplus capital than a century ago, I wouldn't be surprised if 7% real was bid-downward, perhaps to 4%, maybe even less.

If your assumptions were

Hard cash -2% (in reflection of 2% targeted inflation rate)
Cash deposits/T-Bills/bonds/gold 0%
Stock prices 0% + dividends of 3%

then as a consistent 1.33% real secures a 4% 30 year SWR, then that's suggestive of around 45% stock along with some cash deposits and/or bond and/or gold, whichever might help smooth down overall portfolio volatility. Subject to choice of stock, The Larry Portfolio for instance holds higher volatility stocks which assuming compensated for that higher risk might facilitate stock being reduced to 30-33%.

Maybe in 30 year time rather than seeing many cases of ending 30 years of 4% SWR with still substantial amounts of capital remaining, we might see more cases of capital exhaustion. Historic investors have had the benefit of declining yields since the 1980's along with share prices in general being bid up (many more with surplus capital looking to invest).
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nedsaid
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Re: Portfolio construction assumptions

Post by nedsaid »

seajay wrote: Sun Aug 14, 2022 5:11 pm
nedsaid wrote: Sun Aug 14, 2022 1:11 pmA sixth assumption is that over long periods of time that Stocks, Bonds, and Cash all beat inflation: Cash by a little bit, Bonds by let's say 1-3%, and stocks by 7% a year.
Bonds when on the gold standard (pre WW1), when money was gold, broadly 0% inflation, and the 4% average yield was like a real rate of return. With fiat currency, typically with targeted 2% inflation, bonds transitioned to being more 0% real, sometimes borrowers win, sometimes lenders win.

US tax changes in the 1980's incited more of earnings being retained (lower dividends paid out). In the UK without such bias broadly share prices have paced inflation, but in a very volatile manner. Similarly gold prices might generally pace inflation but again in a very volatile manner. In addition to share prices broadly pacing inflation stocks pay dividends, on average around 4% dividend yield historically. Firms actually do better than that, the average yield is what investors priced share prices to, typically twice book value.

The US was a 20th century right tail, good/great case outcome, in having become a more 'developed' market and expecting that relative out-performance and cash 0%, bonds 1-3%, stocks 7% rear view tinted mirror is optimistic in forward time IMO.

Also, with many more having surplus capital than a century ago, I wouldn't be surprised if 7% real was bid-downward, perhaps to 4%, maybe even less.

If your assumptions were

Hard cash -2% (in reflection of 2% targeted inflation rate)
Cash deposits/T-Bills/bonds/gold 0%
Stock prices 0% + dividends of 3%

then as a consistent 1.33% real secures a 4% 30 year SWR, then that's suggestive of around 45% stock along with some cash deposits and/or bond and/or gold, whichever might help smooth down overall portfolio volatility. Subject to choice of stock, The Larry Portfolio for instance holds higher volatility stocks which assuming compensated for that higher risk might facilitate stock being reduced to 30-33%.

Maybe in 30 year time rather than seeing many cases of ending 30 years of 4% SWR with still substantial amounts of capital remaining, we might see more cases of capital exhaustion. Historic investors have had the benefit of declining yields since the 1980's along with share prices in general being bid up (many more with surplus capital looking to invest).
Sounds like you live on the other side of the pond. Wherever you live, that was a very good post.

There are inflection points in financial history. Getting currencies off of the Gold standard and going to a Fiat Currency and allowing currency valuations to float against each other. Consulting Professor Google, I see that the U.K. abandoned the Gold Standard in 1931, the U.S. in 1933, and the U.S. abandoned what remained of the system in 1972. You might say that the Great Depression was one point where the direction of monetary policy changed and the end of Bretton Woods in 1972 was another. I wonder if the Great Recession of 2008-2009 and the unprecedented levels of Central Bank intervention was yet another.

Since the Great Recession and the Financial Crisis, it has been difficult to get any kind of decent yield from bonds. Another thing was the Great Bond Bull Market of 1982-2020 and now we are in a Bond Bear Market, hard to say how long this Bear will last. In any case, Bonds have a negative real yield except for TIPS and I am wondering if this is a replay of the aftermath of World War II. We could be in for an extended period of negative real yields in Bonds, that is where the inflation rate exceeds Bond yields.

The point here is that the economic landscape really affects the assumptions and the rules that we invest by. Bogleheads were spoiled by the tailwinds of declining interest rates and disinflation, we saw twin bull markets for Stocks and Bonds. It might be that the assumptions that Bogleheads have built their portfolios upon might no longer hold true and that perhaps we should rethink some things. Certainly the world before and after the Gold Standard was much different. You have also said that assumptions about investment returns should also be reconsidered.
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Re: Portfolio construction assumptions

Post by seajay »

nedsaid wrote: Sun Aug 14, 2022 7:13 pm
seajay wrote: Sun Aug 14, 2022 5:11 pm
nedsaid wrote: Sun Aug 14, 2022 1:11 pmA sixth assumption is that over long periods of time that Stocks, Bonds, and Cash all beat inflation: Cash by a little bit, Bonds by let's say 1-3%, and stocks by 7% a year.
Bonds when on the gold standard (pre WW1), when money was gold, broadly 0% inflation, and the 4% average yield was like a real rate of return. With fiat currency, typically with targeted 2% inflation, bonds transitioned to being more 0% real, sometimes borrowers win, sometimes lenders win.

US tax changes in the 1980's incited more of earnings being retained (lower dividends paid out). In the UK without such bias broadly share prices have paced inflation, but in a very volatile manner. Similarly gold prices might generally pace inflation but again in a very volatile manner. In addition to share prices broadly pacing inflation stocks pay dividends, on average around 4% dividend yield historically. Firms actually do better than that, the average yield is what investors priced share prices to, typically twice book value.

The US was a 20th century right tail, good/great case outcome, in having become a more 'developed' market and expecting that relative out-performance and cash 0%, bonds 1-3%, stocks 7% rear view tinted mirror is optimistic in forward time IMO.

Also, with many more having surplus capital than a century ago, I wouldn't be surprised if 7% real was bid-downward, perhaps to 4%, maybe even less.

If your assumptions were

Hard cash -2% (in reflection of 2% targeted inflation rate)
Cash deposits/T-Bills/bonds/gold 0%
Stock prices 0% + dividends of 3%

then as a consistent 1.33% real secures a 4% 30 year SWR, then that's suggestive of around 45% stock along with some cash deposits and/or bond and/or gold, whichever might help smooth down overall portfolio volatility. Subject to choice of stock, The Larry Portfolio for instance holds higher volatility stocks which assuming compensated for that higher risk might facilitate stock being reduced to 30-33%.

Maybe in 30 year time rather than seeing many cases of ending 30 years of 4% SWR with still substantial amounts of capital remaining, we might see more cases of capital exhaustion. Historic investors have had the benefit of declining yields since the 1980's along with share prices in general being bid up (many more with surplus capital looking to invest).
Sounds like you live on the other side of the pond. Wherever you live, that was a very good post.

There are inflection points in financial history. Getting currencies off of the Gold standard and going to a Fiat Currency and allowing currency valuations to float against each other. Consulting Professor Google, I see that the U.K. abandoned the Gold Standard in 1931, the U.S. in 1933, and the U.S. abandoned what remained of the system in 1972. You might say that the Great Depression was one point where the direction of monetary policy changed and the end of Bretton Woods in 1972 was another. I wonder if the Great Recession of 2008-2009 and the unprecedented levels of Central Bank intervention was yet another.

Since the Great Recession and the Financial Crisis, it has been difficult to get any kind of decent yield from bonds. Another thing was the Great Bond Bull Market of 1982-2020 and now we are in a Bond Bear Market, hard to say how long this Bear will last. In any case, Bonds have a negative real yield except for TIPS and I am wondering if this is a replay of the aftermath of World War II. We could be in for an extended period of negative real yields in Bonds, that is where the inflation rate exceeds Bond yields.

The point here is that the economic landscape really affects the assumptions and the rules that we invest by. Bogleheads were spoiled by the tailwinds of declining interest rates and disinflation, we saw twin bull markets for Stocks and Bonds. It might be that the assumptions that Bogleheads have built their portfolios upon might no longer hold true and that perhaps we should rethink some things. Certainly the world before and after the Gold Standard was much different. You have also said that assumptions about investment returns should also be reconsidered.
Thanks. Great thread.

The UK ended gold convertibility in 1931 as circumstances attracted large scale conversions of money (Pounds) into gold and then removing gold from the country. Gold reserves were running out due to that 'gold run' and the Bank of England had no other choice other than to pull the convertibility plug. The Chancellor at the time had a nervous breakdown, opining that it was financial armageddon to end the backing of money with gold, and others made the necessary choice to end convertibility whilst he was recuperating abroad. The US followed that lead a couple of years later fearful of also seeing large-scale outflows of gold. Fundamentally it all started back in 1914 WW1, where for years massive resources/expenditure on warfare bankrupted all of Europe (ended the British Empire) that upon cessation still lingered resulting in a the ending of gold=money and the subsequent WW2 resumption of warfare.

Under fiat currency 0% (real) expectancy for share prices, gold, bonds ... is a fair assumption IMO, in the broad sense, but with volatility/deviations that can extend decade(s), and with elements of opposing correlations and/or degrees/magnitudes. Diversification helps smooth that down. Additionally stocks are productive, like buying a farm and tending to see the land value rise with inflation over time, but where the land is worked to generate dividends. Factor that diversity might yield 0%, add on dividends and a 3% dividend yield with 33% weighting = 1% real. Which is close to supporting a 30 year 4% SWR - but leaving little if any left at the end of the 30 years. Scale up 33% stock (alongside 67% 0% real) and so that has the tendency to leave more at the end of the 30 years, but induces greater risk of volatility - the particular circumstances/events that occur during your individual 30 year period.

One choice I quite like is to start with thirds each stock/gold/T-Bills and increase stock each year by reducing T-Bills, so ends at 67/33 stock/gold, time averages 50% overall stock exposure (33 at start, 66 at end). Compared to 50/33/17 stock/gold/T-Bills constant weighted (yearly rebalanced) and historically much the same overall outcome SWR and final value wise, but where the former was more a form of half lumped in, half averaged in approach that had the additional optionality to go all-in with all of cash and gold reserves at a time when opportunities might present (after large declines) and in so doing tend to lead to more towards a above average/great overall outcome. Sometimes DCA wins, sometimes lump wins, diversifying equally across both is a reasonable choice. Lower stock in earlier years also helps reduce early years sequence of returns risk to near insignificantly low levels. Whilst gold provides portfolio insurance such that if/when stocks do dive deeply and gold rises, so that gold might facilitate scaling up the number of stock shares held by multiples. Leave you sitting comfortable when others are tearful.

The way I look at assumptions it to assume that someone in the future is inclined to pay a inflation adjusted amount for something I originally bought for whatever reasons during years when I had surplus capital being set aside to be spent later, at the time when I come to sell that asset and they are looking to buy for similar reasons. Be that a house, art, stock, gold ...etc. Accepting that that is not a consistent/reliable metric, where some assets may be favored over others, however where diversity of assets is inclined to smooth down the collective portfolio of assets. If a asset consistently increased in real terms it would eventually become too expensive, similarly if a asset consistently decreased in real terms it would eventually become valueless. For enduring assets that is unlikely to occur.

I don't see bonds as being a lender broadly wins asset, rather overall equalization of sometimes lenders sometimes borrowers win, 0% overall whether you're a lender (long bonds) or a borrower (short bonds). But again subject to time periods that can span decades. I'd guess that after 1980 to recent very high to very low bond yield transition that has benefited lenders, that there either could be a extended period where borrowers win, or a short sharp spike in yields back up again inducing fast/large losses and a repeated subsequent progressive decline back down again. Of those two I suspect its more inclined to be a case of the latter. Bonds and stocks mid to longer term correlate, short term inversely correlate. Such that what might drive bond yields high (seeing large capital value declines), so also might stock values decline, but from those lower prices become good/great investments again in forward time. Gold can spike during such yield spikes especially if driven by high inflation and negative real yields. The go to asset when other assets look unappealing or when financial stability fears are high. And with comparable to bonds broad 0% real reward expectancy/assumption.
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Charles Joseph
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Re: Portfolio construction assumptions

Post by Charles Joseph »

This is excellent. Thank you.
nedsaid wrote: Sun Aug 14, 2022 1:11 pm I will contribute to this discussion by mentioning the assumptions behind the simpler Boglehead portfolios.

First, is the Equity Risk Premium, the assumption that over time that Stocks will outperform risk free treasury bonds albeit with lots of volatility.

Second, is the assumption that there are three main asset classes: Stocks, Bonds, Cash.

Third, to keep portfolio volatility tolerable, an investor invests in a mix of Stocks, Bonds, and Cash. The younger an investor is, the more stock heavy portfolios should be, as an investor ages that he or she should increase allocation to Bonds and Cash.

Which leads me to a fourth assumption that human capital, or future earnings potential from work, decreases with age. So you balance the risk of Volatility in the Stock Market against declining human capital over time. In other words, as you age the present value of future earnings decreases and thus your ability to take risk in the Stock Market declines over time. Hence the need for an increasing allocation to safer and less volatile asset classes as one ages. This is also known as a glidepath.

Fifth, Bogleheads believe that the markets are efficient, though not perfectly so, thus there are limits to what efforts to optimize a portfolio can do. For the most part, assets are fairly priced in the markets. Hence, the standard advice to focus on the allocation of the basic three assets within a portfolio: Stocks, Bonds, and Cash. If you want to increase returns, you need to increase allocation to Stocks keeping in mind a portfolio will have increased volatility when you do that.

A corollary to point five is that if markets are efficient then the best way to invest is in Market Cap Weighted Indexes. In other words, markets know best about the valuation of securities as prices reflect the collective wisdom of all of the market participants. One is not captive to a particular point of view as he or she can rely on the collective wisdom of the market itself.

A sixth assumption is that over long periods of time that Stocks, Bonds, and Cash all beat inflation: Cash by a little bit, Bonds by let's say 1-3%, and stocks by 7% a year.

John Bogle made the statement that Bonds are for investment and Cash is for shorter term savings. Thus, Boglehead portfolios are pretty light in cash.

So a while a Boglehead approach is not particularly sophisticated, there are certain assumptions behind this philosophy. Because of skepticism regarding Factors, Bogleheads tend not to be big believers in Portfolio Optimization. I may have missed a point or two here but this is largely the Boglehead philosophy of Portfolio Construction.
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Re: Portfolio construction assumptions

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Getting back to the article that the original post referred to, the article seems to say that simpler methodologies behind portfolio construction are "naive" and puts out the weaknesses of naive methods such as weighting your investments according to your conviction, by market cap, or equal weighting your securities. The article talks about more sophisticated ways of building portfolios, discusses a decision tree, makes some good points, but never provides evidence to why more complex portfolio construction is superior to more "naive" methods. It seems to be a philosophical discussion but I don't see data to support their points. I suppose the article is a good starting point, perhaps a follow-up would be to provide real life examples of asset managers who are practicing what the authors are endorsing. In defense of the authors, these seems to be the first article in a series and this article is laying the foundation for future articles.

It would be cool if someone would read further down this series of articles and provide a summary of the points the authors are making. I suppose looking at the ReSolve Asset Management website would provide clues where the follow-up papers might reside.
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Re: Portfolio construction assumptions

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Here is the website for ReSolve Asset Management. I might study what is on the website and report back to see exactly what these folks advocate for. Hint: They are advocates of Tactical Asset Allocation which is frowned upon here at the Bogleheads. The theory is great but it has been harder to get the desired results in real life.

https://investresolve.com/

That being said, I am okay with such a dynamic strategy around the edges. I have suspected that such strategies will have more success at reducing risk rather than enhancing investment returns. The skeptic in me wonders if this fails on both counts: failing at reducing risk and failing at increasing returns. I know that I have tried. Just like everything else, even if you think this is the greatest thing since sliced bread, don't overdo it. For example, I believe in Factors and the Academic Research but in my own portfolio my tilts are actually pretty mild. I just know from experience that I could be wrong.

The central problem to all of this is that one cannot be sure what the other market participants will do. So you can be in all of the correct investments and strategies to provide diversification benefits only to see all of this crash hard in a crisis. My best guess is that the best of risk mitigation techniques work maybe 2/3 of the time and some of these techniques work more often than not. That comes from personal experience and my own research. We all want that magic diversifier that does well when everything else crashes but too often you wind up disappointed. Asset classes do not have to act in accordance with our expectations, particularly in a crisis.

They also seem to be believers in Momentum strategies.
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Re: Portfolio construction assumptions

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Seajay has said that in the future that capital gains from Stocks will keep up with inflation and that the excess return over inflation will come from dividends. Perhaps in the UK, dividend yield on Stocks is 3% but here it is more like 1.5% to 2%. I know with the individual Stocks that I own, I target a yield of about 3%. The implication is modest expectations of investment returns and more of a focus on dividends than what is discussed here on the forum. In fact, Bogleheads are mostly a "Dividends Don't Matter" crowd. I have fought the dividend wars, read all of the arguments that dividends don't matter, but yet still have a preference for Dividend Stocks. I do think yield is important particularly to older investors but you aren't really allowed to say that here. Even the Boglemeister himself was interested in yield from Stocks and Bonds, he was fine with reaching a bit for yield but not overdoing it.
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Re: Portfolio construction assumptions

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nedsaid wrote: Tue Aug 16, 2022 8:15 am Seajay has said that in the future that capital gains from Stocks will keep up with inflation and that the excess return over inflation will come from dividends. Perhaps in the UK, dividend yield on Stocks is 3% but here it is more like 1.5% to 2%. I know with the individual Stocks that I own, I target a yield of about 3%. The implication is modest expectations of investment returns and more of a focus on dividends than what is discussed here on the forum. In fact, Bogleheads are mostly a "Dividends Don't Matter" crowd. I have fought the dividend wars, read all of the arguments that dividends don't matter, but yet still have a preference for Dividend Stocks. I do think yield is important particularly to older investors but you aren't really allowed to say that here. Even the Boglemeister himself was interested in yield from Stocks and Bonds, he was fine with reaching a bit for yield but not overdoing it.
Somewhat oddly, over on the UK TMF a popular threat was a style (called High Yied Portfolio (HYP)) where the crowd considered "Capital doesn't matter", 4% British average dividends, they target buying at modestly above average stock selections (not over-stretching, more like 5%, as a indicator of 'value', diversifying across a broad range of sectors) and looking to see dividends grow with/ahead of inflation. Presented originally as a alternative option to annuities where the money is 'spent' anyway, but that had the option of access to capital for heirs or if otherwise needed.

When UK TMF postings ended that survived over into a follow-up board and where the most recent posting for that is here (HYP is 21 (years)). From that you get a feel for how dividends can see quite high levels of volatility. Dips, but tending to relatively quickly recover. Separate to that others prefer what are called Investment Trusts that list on the London market, stocks whose primary activity is stocks and where some boast long (50+ years) of increasing dividends. They have the flexibility to leverage/de-leverage and/or retain cash - where those that target rising dividends tend to build up cash reserves in good times to supplement dividends during bad times - to seemingly good effect. Takes the load of individual investors that might otherwise attempt to do similar. One of the oldest is FCIT, previously known as "Foreign and Colonial" but renamed in more recent years for obvious reasons, that dates back to 1865. In effect a global stock index fund with similar overall total return/rewards to more modern day 'world tracker' ETF's. The flexibility in its management typically means that the costs are matched by the alpha (leverage/deleverage/flexibility of holdings etc.). Generally leverage is relatively mild, might be +10% or -10% type ranges, more often much less. Prices used to vary quite considerably around net asset value, maybe at times seeing prices 20% below net asset value, in more recent times however the funds themselves tend to play that, buy back shares when -5% below for instance, that has resulted in prices tending to more closely match net asset values. Some look to combine such Investment Trusts into baskets/groups for specific purposes, for example.

Forming ones own dividends out of total return is subject to not taking too little or too much. Having other professionals doing that leg work for you is preferred by some. Each to their own. I guess that if you never intend to sell shares then "capital doesn't matter" is just a valid call as "dividends don't matter" is for others. Pointless arguments, just indicative of personal preferences/styles.

The original version was based on straight buy and hold, no changes being made, yet others do make changes such as looking to keep holdings more equally capital weighted such as reducing when a holding had risen to being 1.5 times the median individual stock value, topping up the laggards. And/or rotations, selling those where the dividend yield had fallen below the market average to be replaced by another with above average yield - as a form of value rotation. Again however I broadly see little overall differences in broad outcomes/results, the main one being that the non-rebalanced is inclined/destined to hold relatively high weightings in a number of the holdings (increased idiosyncratic risk), so I guess not the best risk-adjusted reward choice.

As ever with momentum/value/whatever its a play that does well if the choice did well, or otherwise induces lag. Momentum for instance can work for extended periods until it doesn't (such as zigzag repeatedly to have to you repeatedly buy high/sell low). The boglehead philosophy is to put that all aside and just buy the market, but even that is somewhat based on mechanical methods (or even include elements of selectivity). The "market average" as measured by index methodology is just a guideline of the average if you were in the better choice of historic index methodology, where that best method can be changed over time, but unknown in advance, and where that is then often used as a indicator of historic 'averages', but where many might not have actually followed that particular method/index. For years in the UK the FT30 index was the followed average, until replaced by a 'better' choice (FT100) - that has subsequently relatively lagged other choices. If yet another index/method takes over from that, then backtesting against that replacement version as a suggestion of historic actual averages would be simply wrong as most investors would have lagged that 'average'.
KneeReplacementTutor
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Re: Portfolio construction assumptions

Post by KneeReplacementTutor »

nedsaid wrote: Sun Aug 14, 2022 1:51 pm We cannot even define exactly what risk is...
Amen.
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nedsaid
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Re: Portfolio construction assumptions

Post by nedsaid »

Seajay, this discussion of a Dividend focus is very interesting. Good to learn what folks are thinking across the pond in the U.K. I have interacted with Valuethinker, who has lived both in U.K. and Canada, and I think he resides in U.K. now. I know there are a couple of other notable U.K. posters that I have interacted with and it is always quite interesting. There has been a lot of talk regarding home country bias by US investors, particularly when US Stocks have been outperforming International Stocks since 2009. A lot of this is a strong US Dollar, or as I like to put it, that the US is the least dirty shirt in the laundry hamper. I was interested to learn that home country bias is strong in the UK as well, there was a time when UK Stocks were doing even better than US Stocks, don't know how the numbers compare years later.

One principle that I have followed for a long time with my own portfolios is the concept of International Diversification. Many of the world's best companies are headquartered outside of the United States. I also know that such things as interest rates and economic growth rates vary from country to country. It is also a way of getting currency diversification and participating in the global economy. Something like 28% of my Stocks and over 10% of my Bonds are outside of the United States.

As far as a Dividends vs. Capital Gains debate, my portfolio probably won't be large enough to live off of dividends and interest, I will need to harvest capital gains as well. So in reality, I am a Total Return investor.

I hope this thread gets people thinking about proper portfolio construction and the concepts behind it. If an investor has a good theoretical grasp of the concepts behind investing, has a grasp of market history, and has strong conviction regarding his or her investments; the better of a chance that people will stick with a plan when markets turn tough. In other words, it is not only important to know how to do certain things but also why you are doing them. There is a lot of power in why.
A fool and his money are good for business.
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