This is a long article. So get comfy, get something drinkable (wine!) and eatable (grapes!), and let's go back in time when we first stumbled on investing.
We already had some money saved, because saving sat well with us. We also had some not unfounded mistrust of our own ability to deal with bad times.
If we were going to invest, it needed to be conservative and idiot-proof.
Then we found something. At the time, it felt like one of the most well-kept secrets in the financial world. Kind of still does, actually.
Let us explain what we found.
Fortune, ever waxing and waning. We didn't trust this girl to mess too much with the money we had saved.
The Bad Scenario
What did we do?
As Seneca might recommend, let's start by considering the doomsday scenarios.
Much of this will be about feelings. It might be easy to laugh at us for being afraid of what we might do in a bad scenario. But, well, I'm not sure if we were cut out for the worst scenarios in the stock market. I'm still not sure we are.
We were also well aware that the lowest depth we knew didn't have to be the lowest depth there will be; so we already knew that a future bad scenario could be much worse than what history has presented us with so far. And over a lifetime, some really bad scenarios are likely to play out.
The last half-century, the worst year (year - not period, that's much worse) for the US total stock market, including dividends, was down 49% and it took 11 years before it had crawled back to its starting point.
We hoped to achieve some kind of basic financial independence within 5-7 years. If that suddenly turned out to be 11-15 years, that would not have felt good at all.
There's a limited number of decades to a life.
Even the classic 60/40 portfolio is quite scary too, with a 34% loss over the worst year, and it took a frightening long 11 years to come back to where the portfolio started.
Even with a bleak, but not the worst, three year run in the US, the 60/40 portfolio fares a 0.1% In other countries, it looks worse. In Switzerland for instance, it fares -8%, in Germany and France around -7% and in Australia -5% during those same bleak scenarios.
Moving 5 percent backwards every year for three years. Ouch.
This was why we were hesitant. We feared a major setback could turn into psychological depression and derail us entirely from the idea of financial freedom. We were just too scared, and the only advice seemed to be something like 'buckle-up, shut up, sit it through and get over it'.
The idea, according to all we read, was to bind oneself to the mast, put wax in the ears and promise oneself not to be upset about the portfolio valuation, in the case of a stock market meltdown - with impacts for periods up to ten years. And if course, by ignoring the bad weather, one can theoretically sail through the worst of financial storms.
Which certainly seemed to have worked for Odysseus. No listening to the Sirene's calls of selling on a bad moment there. So if you are more like Odysseus - go for it!
Greek heroes have no trouble with stock market investing.
(painting on vase, 495 BC)
As new financial sailors we didn't even know how to bind ourselves to the mast.
Something made us queasy, with both the advice to go all-in on the stock market and with the 60/40-portfolio. We had a nagging feeling that there were more stocks in the portfolio than we could swallow.
What could we do? And can one really decide on a strategy based on the worst scenario?
Our portfolio in a bad scenario
Well, we did find something. In the worst scenarios around the world, the portfolio we settled for dropped around 10-16 percent in the worst year, depending on the country, and it recovered completely within five years.
So depending on how we looked on it, it was between double to five times better than stock-heavy portfolios when a really bad storm hit.
It would still be a very rough ride, but somehow it felt like we didn’t have to hope that we were heros.
It seemed that we had found a strategy that might not entirely sink the boat if the captains were more nervous than they hoped.
The Bleak Scenario
We realized that for us, it was important to balance the objective of getting to financial independence BOTH quickly AND safely, at the same time. So one important factor was that the portfolio needed to fare decently in the short run. And the other factor would be safety.
The worst case must still be better than a complete disaster where plans need to be abandoned.
But it was not only that. Even if things didn't turn out rosey, we did not want even a bleak scenario to become a several years long setback on our journey to financial independence.
So we also needed to study bleak scenarios.
But what is a bleak scenario?
Let’s meditate. Would we be very concerned if things turned out bad in a year? No, not really, as long as things recovered within the near future. Two years moving backwards also seemed fine. But three years of going backwards, that seemed to start to nag on our journey.
So in a three year period, we would like to have something that with some significant likelihood would at least keep pace with inflation.
What’s a high likelihood? Well, if this was a board game, we would say that 85% would be pretty safe. So we guessed we could find a portfolio composition that would work decently in 85% of the 3-year periods in the last 50 years, in most countries. Then we would be on to something.
If we do the same back-tracking with the portfolio we finally settled for, it fares around 1-2 percent up compared with inflation - remember, in still a very bleak scenarios where corresponding stock-heavy portfolios would go backwards - for a whole set of countries: US, Australia, Switzerland, Sweden, Germany and France.
This was a portfolio that seemed to be able to bring us to a safe harbour without major delays, even if the three years ahead of us would turn out to be not-that-good-at-all.
The Average Scenario
We understood that we needed to pay something to give us the protection we wanted. And one thing that we needed to pay with would obviously be the average return.
And what is a decent return, anyway?
Would the average return be too low for our objective of reaching financial independence quickly and safely?
Using the same 50-year historical period and the US stock market as illustration, the historical average return - excluding inflation - was 5.9% for our portfolio, 6.1% for the 60/40 portfolio and the total stock market was on average 8%.
The averages are more similar across countries.
So on average, we were talking about 6 months to a year longer to reach independence, but with much better protection against bad scenarios.
This was the well-kept secret that allowed us to start investing for real.
Conclusions
Let's sum this up in a gigantic table. The table to rule them all. And let's colour everything that feels close to ruin and a big risk of derailing us from our journey to financial independence in red.
Summing it up for the tables-lovers out there.
Portfolio | Portfolio | US | Germany | Sweden | France | Australia |
Total Stock Market | Average | +8.3% | +7.6% | +11.9% | +8.2% | +6.3% |
Bleak 3 Year Baseline | -2.1% | -5.1% | -4.2% | -8.4% | -5.7% |
Worst 3 Year Period | -16.8% | -23.9% | -23.3% | -17.7% | -21.2% |
Worst Doomsday Year | -49% | -56% | -55% | -50% | -68% |
Time to recover | 13y | 13.5y | 11y | 15y+ | 15y+ |
Worst Time to Financial Independence | 13.5y | 14.5y | 12y | 15y | 19y |
60/40 | Average | +6.3% | +6.2% | +8.6% | +6.6% | +5.2% |
Bleak 3 Year Baseline | +0.1% | -1.8% | -2.3% | -3.6% | -0.4% |
Worst 3 Year Period | -10.7% | -11.8% | -11.7% | -9.2% | -16.7% |
Worst Doomsday Year | -34% | -31% | -31% | -34% | -53% |
Time to recover | 12y | 12y | 12y | 14y | 15y+ |
Worst Time to Financial Independence | 13y | 13y | 12y | 15y | 17y |
Our Portfolio | Average | +5.2% | +4.8% | +6.0% | +4.8% | +4.5% |
Bleak 3 Year Baseline | +1.6% | +1.8% | +0.2% | +1.1% | +1.2% |
Worst 3 Year Period | -0.4% | -3.0% | -3.9% | -3.3% | -3.8% |
Worst Doomsday Year | -14% | -9% | -12% | -13% | -16% |
Time to recover | 5y | 4y | 5y | 5y | 8y |
Worst Time to Financial Independence | 9y | 10y | 8y | 9y | 10y |
Some notes: All % are yearly CAGR without inflation. So in the worst 3 years run one would experience on average a yearly setback of around -8-10% with the 60/40 portfolio, for instance. Worst Time To Financial Independence assumes that 10y expenses are already saved, which is roughly where we started, and a 50% savings rate. And we assume that up to a 16% setback in one single year is livable.
So to sum it up. If the average return was roughly the same as 60/40, but we had found a strategy that would get through a bleak or doomsday scenario relatively unharmed - why go for something else?
Yes, we would lose out on upside opportunities. But that felt like an easy trade-off if that meant we could avoid the trapdoors that risked to set us back for many years, perhaps even as long as half a decade.
Now it felt that we were on to something. A conservative trade-off between safety and return that would bring us with an overwhelming certainty to financial independence in surprisingly few years, even in a bad scenario.
This was the hidden treasure, the reasonable balance between risk and return, that no-one had told us about.
We hope that gave you some food for thought on how to think about your own journey.
In the next article we'll dive into our thoughts on the strategy we went for.
Take care,
//antinous&lucilius
Where to go from here?
NB:
Some technical details: The numbers are without inflation, so for most market one needs to add 2-3% to get a sense of what is reported as return on an investment account. And as we said before, dividends are also assumed to be reinvested for both stocks and bonds.
We have back-tested this ourselves, and used Monte Carlo simulation (both simulators available on the net and home-built simulators). The numbers in the article stretches back to 1970 and comes from portfoliocharts.com. If you haven't been there, go there. We love it.
Why look at so many countries? Well, it increases our feeling of safety that it's not a local fluke for one country that our portfolio worked well, but only there. In the short run, there seems to be much more of a fluke with the performance of the 60/40 portfolio.
Another remark: A big, big risk with looking at historical numbers is that one adapts a portfolio that fits the history, rather than one that fits the future. But if one finds a portfolio that works decently irregardless of where in the world it's implemented, it starts to actually say something about the robustness of that portfolio.
