Investing with ETFs like a PRO— Part 2
Disclaimer: these are my ideas how to make money on the stock market. I am not a registered investment advisor or broker-dealer and do not purport to tell or suggest which securities potential readers of this article should buy or sell for themselves. I may hold positions in the stocks discussed within this article. The reader understands and acknowledges that there is a very high degree of risk involved in trading securities. With respect to stocks trading, there is considerable exposure to risk, including but not limited to, leverage, creditworthiness, limited regulatory protection and market volatility that may substantially affect the price, or liquidity of a stock. I assume no responsibility for liability for the reader trading and investment results.
In Part 1, I have discussed ETFs and introduced among many others, one of the most interesting trading strategies: the diversification.
Diversification is an equivalent to say “don’t put all of your eggs into one basket”.
In this article, I will describe how a person like me (see my disclaimer above and check my linkedin profile), can create easily an ETF portfolio and also I show the role of diversification.
Before we start, let’s define some strongholds:
- #1 volatility(risk) is shorthand for standard deviation of returns
- #2 diversification lower the volatility
- #3 a PRO investor always sets realistic expectations
Different from traders, investors are interested in the medium/long term market cycle: medium/long term means 5 to 10 years.
No one has a crystal-ball and there are many scam websites or shrewd sellers that promise things like a regular income, living on an exotic island, etc.. If you look at the table below, you can see how the “world” performed in the last few years: just +26.67%. If you had invested $10,000 three years ago in the MSCI World index, you would have a profit of $2,600. Obviously it is not enough to quit your full-time job or buy a yacht. Setting realistic expectations is a mandatory task and the PRO investor does it!
Someone, especially in Italy, could argue that there are safer solutions for small investors: postal savings bonds.
For example, 1,000€ invested on 01/08/2020 after 6 (six) years will be: 1,015.87€ or 1.57% in 6 years
What? 15.87€ in 6 years? No thanks, I can do much better than that.
We will see later that in reality it is possible to achieve a higher return without being a banker or having PhD in finance.
What about the risk or volatility?
Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.
Investing, in general, comes with risks, but thoughtful investment selections that meet our goals manage risk at an acceptable level. However, we have no control over some risks which are inherent in investing.
Investing in selected ETFs is based on rules given in the Part 1. This approach makes really low the risk of losing all of the original investment. However, the risk that the returns are not in line with expectations, does exists. The PRO investor knows this risk and acts accordingly: diversification. We have already learned that single ETF invests in a basket of stocks. By investing in different kind of ETFs, we are able to create a portfolio with the highest degree of diversification and different risk profiles (low, medium, high) (#2 of our strongholds).
We all want to get as much out of our money as possible, but it’s important that the expectations are realistic. Returns are deeply connected to the risk: the bigger the risk, the bigger is the potential return (but also the loss).
Reality shows that many investors are anticipating returns far higher than what the average investment can expect to generate. It’s an overestimated approach that could put plans at risk.
What kind of returns may I expect on average? Below I show some examples of famous “lazy ETF portfolios”.
A PRO investor sets reasonable goals. Higher returns are possible with different and extremely risky instruments or more often they are scams
Picture below shows a list of ETF portfolios sorted by returns (also the risk associated with the portfolio is shown on the left side of picture).
Interesting, eh?
Let’s see how an average person, not working in the financial industry, is able to create his/her portfolio very easily and effectively.
It is actually easier than you might expect: open your browser and type “lazy etf portfolio” using any search engine. One of the first results is www.lazyportfolioetf.com. The pic above is taken from there. Lazy ETF portfolio offers a list of “famous” portfolios.
We can choose the one that matches our return expectations and risk level (Low, Medium, High, Very High). Personally I dislike portfolio with very high risk.
For the sake of discussion, I selected a medium risk portfolio (Paul Boyer Permanent Portfolio) simulating the allocation of $10,000 on 3 asset themes:
- Stocks
- Fixed Income
- Commodities
When we select a target portfolio, the Lazy ETF portfolio website provides:
- the number of ETFs required
- names of major US ETFs
- the investment type
- allocation percentages
Having all this information provides straightforward way to replicate the investment allocation using ETFs offered by your broker.
Let’s start “allocating” our initial funds by buying the following instruments:
- $2,500 of GLD (25%)
- $2,500 of SHY (25%)
- $2,500 of TLT (25%)
- $1,250 of EEM (12.5%)
- $1,250 of IJR (12.5%)
Assuming an inexpensive broker, these five operations will cost around $20. After this initial setup, we hold positions according to our investment time frame.
Every 1st of January of each year, we will adjust “rebalance” our portfolio. If the value of any instrument is greater than dollar-value of initial allocation, we sell the part in excess of, otherwise if the value is lower, we have to buy additional stocks.
Sounds easy, isn’t it?
Before jumping into real investment, let simulate (backtest) our lazy portfolio.
Using an awesome tool freely offered by www.etfreplay.com, we can backtest it in only 5 minutes against a benchmark. I am brave and I want to compare against one of the best performers over the last years: SPY.
Once the instruments and the weights are typed, click on “Test Portfolio” and let see how the portfolio behaves in the last 36 months.
As expected, the returns of SPY are almost twice that of our LAZY portfolio, but look at the volatility (risk): SPY is almost 3 times riskier than our portfolio. The diversification significantly lowers the risk.
Another interesting aspect of the above portfolio is the generated equity line: our lazy portfolio generated a smoother equity line than the SPY, the behavior is also confirmed by “Summary Statistics — Max Drawdown”. If it comes to observed volatility, the drawdown of SPY is 3 times bigger than the portfolio.
A few words about commissions: the rebalance happens only once a year, so the impact of commissions is negligible.
Conclusions
Creating an investment plan is not rocket science. I have used 2 wonderful tools available on the internet for free and is accomplished a lot. At the end of the selected timeframe, the backtest shows a return of more than 40%. If you thought that the difficult part is creating a portfolio, now you probably understand that the hardest part is to follow the plan (tune the portfolio once a year and respect the allocation percentages). In the next part, we will reviw how to improve the static rebalancing (once a year) by utilizing a more “dynamic” approach; unfortunately it will be tricky.
