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Oct 22, 2020

“Swiss Army Knife” Portfolio Solution

by Rita Silvan
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Rita SilvanWhat can a drag queen teach us about investing? Trixie Mattel, filmmaker, writer, and a winner of RuPaul’s Drag Race All-Stars, told The New York Times, “…drag queens are like Swiss Army knives. Most come from having to take $50-a-show pay and doing their own costume, wig, music and jokes.”1.

Whether you’re an investor or a drag queen (or both, why not?), the trick is how to deploy the capital for the best return. And, while a drag queen must survive one show, an investor must navigate a range of economic conditions and cycles over a lifetime, including exogenous events like pandemics and trade wars, which require vastly different investing strategies.

As economies suddenly shut down in March, central banks stepped up with wage subsidies, loans, and corporate debt buying, as well as direct support to citizens with mortgage payment deferrals and “helicopter money” to cover basic expenses. Somehow, we made it through—and now it’s fall. What happens from here? (Hint: buckle up.)

What effect will this unprecedented spike in money printing and consequent swelling of government debt have on our investments? Many are fearful of an era of rampant inflation, in which case hedges like gold, commodities, and real estate might come in handy. Others say we should be more worried about deflation, low-to-negative interest rates and prices along with weak consumer demand. Optimists see the economic contraction as a mere pit stop on the bull market express we’ve been riding for the past 11 years, which might require leaning deeper into cyclicals to catch the upside. Wait, maybe the pandemic has only hastened the inevitable bear market that everyone cautioned was long overdue which means we ought to lighten up on equities, especially cyclicals and lower quality stocks.

In the midst of a multitude of possible outcomes, we’ll only know if we’ve made the right decision post-facto. Instead of driving yourself nuts, the solution may be a “Swiss Army knife” portfolio with a handy-dandy asset mix for almost every situation. (Except an alien invasion or a speeding asteroid.)

What Is A Swiss Army Knife Portfolio?

The Swiss Army Knife portfolio (SAK) is not a new idea. Many fine investors—from Ray Dalio at Bridgewater Associates, to author and investment analyst Harry Browne, to our very own Canadian Pension Plan Investment Board (CPPIB), employ some version of it. Basically, the SAK is a lifelong portfolio composed of a diversified asset mix that works well enough during periods of economic growth and stagnation because of the historical low or negative correlations among the constituents. When one asset class goes down, chances are the other(s) go up. The SAK will not shoot the lights out during bull markets, nor will it sink your ship during bear markets. The CPPIB calls theirs the “Steady Eddie” portfolio.2   Simply, the SAK is composed of bonds, stocks, gold, and commodities.

Rationale For Bonds:

During periods of falling interest rates and market downturns, bonds tend to perform well. Because bond prices are inversely related to interest rates, when rates drop, bond prices go up, potentially generating capital gains. When COVID-19 hit in March and the markets tanked, bonds experienced only modest losses. If a portfolio is a sailboat, then bonds are like the keel, an underwater balancing force that prevents the boat from tipping over. Equities get all the media attention but it’s instructive to remember that since 1929, bonds have outperformed stocks in 45 of those 91 years.3

Rationale For Stocks:

Equities do well during periods of strong economic growth. They’re like the sails that capture the wind and make the boat move. They drive returns due to the equity risk premium, historically around 3.5 per cent, over and above the risk-free government bond rate. Hence, over the long-term, portfolios tilted towards equities outperform. For example, one dollar invested in the S&P 500 in 1973 rose to $18 by 2020 (vs.$14 for a 60/40 portfolio, adjusted for inflation and including dividends).4 Equities also provide a hedge against inflation because business revenues should reflect the rise in consumer prices. According to a survey by Credit Suisse, since 1900, equities have returned an average of 5.2 per cent over the rate of inflation. (In the short-term, rising inflation may reduce stock prices because investors jump into risk-free bonds.)5

Rationale For Gold:

During periods of inflation, gold and commodities tend to perform well. Gold is also seen as a store of value and it shines when there is uncertainty; because, unlike a fiat currency, governments cannot make more of it. Gold pays no dividend, so it costs an investor to hold it. Physical gold must be stored which also increases costs. Gold investors must be prepared to endure long periods of underperformance. For example, prior to this year when gold rose to $2,000 an ounce, the last time gold prices peaked was early 1980 and they did not revisit those highs until 28 years later!6

Rationale For Commodities:

Commodities also do well during inflation. As the economy grows there is an increasing demand for inputs such as natural resources which drives up prices. Commodities are traded globally so even if there is slowing growth somewhere, there is likely rising growth somewhere else. Of course, there is always the possibility of a large exogenous shock, like a global pandemic, to stop growth everywhere but this is usually short-term.

Weight Watchers

For investors, the question is asset allocation. Let’s see what the experts do. (Canadian investors need to keep currency risk and tax treatment in mind and adjust accordingly.)

Ray Dalio’s All-Weather Portfolio:

  • U.S Bonds = 55%
  • U.S. Stocks =30%
  • Gold/Commodities = 15%

According to Nick Maggiuli, COO of Ritholtz Wealth Management, the All-Weather Portfolio can be easily reproduced with 5 Exchange-Traded Funds (ETFs):7

  • Long-Term U.S. Bonds (TLT) 40%
  • Intermediate Term U.S. Bonds (IEI) 15%
  • S&P 500 (SPY) 30%
  • Gold (GLD) 7.5%
  • Commodities (DBC) 7.5%

Harry Browne’s Permanent Portfolio:

Equal mix: Stocks, long-term bonds, cash (or short-term bonds), and gold. A Canadian version might look like this (courtesy of The Globe and Mail):8

  • Canadian Equities (VCE) 12.5%
  • Global Equities (VXC)12.5%
  • Long-Term CAN Bonds (XLB) 25%
  • Short-Term CAN Bonds (XSB) 25%
  • Gold (CGL) 25%

CPP “Steady Eddie” Portfolio:9

  • Public Equity 28.5%
  • Private Equity 24.7%
  • Credit 12.4%
  • Real Estate 11.3%
  • Gov’t Bonds, Cash, Absolute Return Strategies 10.9%
  • Infrastructure 8.6%
  • Other Real Assets 3.9%

(Asset mix as of March 31, 2020)

Final Thoughts

Regardless of which portfolio you prefer, rebalance annually back to your target asset allocation. Rebalancing is hardest for D.I.Y investors but working with ETFs makes this easier.

With interest rates at such historically low levels and central banks’ vows to keep them lower for longer, a high allocation to bonds (55% in the All-Weather Portfolio) seems high. Some investors view bonds as an “impaired” asset class with a high probability of underperforming in the future due to guaranteed negative real returns if held to maturity. Cash could replace some of the bond portion. Jeremy Siegel, finance professor at Wharton School, University of Pennsylvania and author of bestselling Stocks for the Long Run, recommends a higher allocation to stocks due to their even more generous risk premium over government bonds today.10 Still others suggest replacing at least some of the bond holdings with shares of stable dividend growers. Both of these equity-tilting strategies imply potentially higher gains along with higher price volatility; they are not a true replacement for bonds.

Finally, a resilient portfolio works only if you have a resilient mindset to accompany it. During periods of economic and market turbulence, being resilient means having Plans A, B, C and/or D thought out. These might include trimming unnecessary expenses, finding other sources of income, adjusting lifestyle expectations, as well as accepting that some things are outside of your direct control and just accepting what is.

Rita Silvan, CIM, is the former editor-in-chief of ELLE Canada magazine. She is a freelance financial journalist and the editor-in-chief Golden Girl Finance (www.goldengirlfinance.com), Canada’s leading digital magazine about women and financial matters. She is based in Toronto and can be reached at rita@ritasilvan.com.

 

1      https://www.nytimes.com/2018/08/29/magazine/trixie-mattel-says-drag-queens-are-like-swiss-army-knives.html

2      https://www.theglobeandmail.com/business/article-canada-pension-plan-trails-rocketing-stock-markets/

3      https://www.theglobeandmail.com/investing/markets/inside-the-market/article-low-returns-ahead-investing-strategies-when-everything-is-expensive/

4      https://ofdollarsanddata.com/ray-dalio-all-weather-portfolio/

5      https://www.economist.com/finance-and-economics/2020/05/28/what-is-the-link-between-inflation-and-equity-returns

6      https://ofdollarsanddata.com/ray-dalio-all-weather-portfolio/

7      https://ofdollarsanddata.com/ray-dalio-all-weather-portfolio/

8      https://www.theglobeandmail.com/investing/markets/etfs/article-the-profitable-etf-portfolio-built-to-survive-a-market-crash/

9      https://www.cppinvestments.com/the-fund/how-we-invest/our-investment-strategy

10   https://www.theglobeandmail.com/investing/markets/inside-the-market/article-low-returns-ahead-investing-strategies-when-everything-is-expensive/