We live interesting times. 10 years after the 07-08 financial crisis and the stock market is by any metric overvalued.
Let’s take the Shiller PE ratio, also known as the CAPE ratio (Cyclically adjusted price to earnings ratio). This popular metric measures the price of the overall US stock market compared to its average past 10-year real earnings per share.
This is used to predict future equity returns and at the moment is looking extremely worrying to me. The current value, as of March 2018 is 33.25, which is double the average 16.83!
Is there another recession coming? Are the future returns really halved?
In his annual shareholder letter, Buffet just recently told investors that they struggle to make acquisitions due to the high prices all businesses cost nowadays.
If everything is expensive, predicted returns are lower and interest rates are going up, what shall we, plain investors, do? If you had your money in the market – or bought a London property for that matter – in the past 10 years you’re probably way ahead.
But how do we move forward? What about those people that just received a big lump sum or keep piling up more cash? Passive investing has pushed prices even higher but sitting on cash is not a wise idea either. Increasing inflation is our worse enemy and we know our cash purchasing power is certainly dropping.
I am simply talking out loud here. I know that I am building my wealth in my 30s and the time to invest and have a high savings ratio is in the next 10 years. A portfolio I can count on in both expensive, as well as in cheap markets, is all I need.
Sleeping well at night is also important to me. I’ve read many investing books and keep reading. I’ve listed my favourite financial independence resources for those interested. Ok, enough talking. Showtime!
Imagine we live in a world where humans have conquered 10 different planets. But there is a limitation. Humans cannot communicate with humans living on different planets! News cannot spread and each planet runs its own economy.
In a fantasy world like this, I would invest all of my hard-earned cash only in stocks across all planets. I would spread it according to the GDP portion of each planet and would capture the stocks returns without worrying much about time horizons, risk etc.
Stocks are the best-performing asset out there, in the long-term. The problem, usually, is the second part of the sentence. Long-term means that you’ll have to wait 10 or even 20 years before your average stock returns outperform the neighbour’s wine cellar.
A stock ride is a bumpy one. You see, the problem is that a market crash in the US affects the UK, the emerging markets as well as my peer-to-peer loans.
Highly correlated assets tend to fall together. This is why we need to diversify and try to capture returns that behave differently to stocks. We lower our returns a bit but smooth out the short-term ride.
World equities are the best performing asset. Anything invested in bonds or gold hurt my long-term gains.
That’s not to say that other asset classes don’t have their place in someone’s portfolio. They make you sleep well at night and lower your risk.
Foxy Monkey Investment Strategy
A Foxy Monkey wants a rock-solid investment strategy. One that will work well in all seasons and that is well understood.
Criteria for a rock-solid investment strategy
- low fees
- low maintenance (no stock picking research, no frequent rebalancing)
- globally diversified to avoid country risks
- passive index investing
- good risk/reward ratio
It is obvious that to achieve a low maintenance low fee strategy you need to sit back and let the market do the talking. Index investing, aka passive investing, is the way forward here as it takes decisions out of the way. But there are so many markets!
We don’t want surprises, either good or bad! I want my investments to be as boring as they can be. To a more practical approach now, let’s see what the available tools are to construct a Foxy Monkey portfolio.
Assets in my toolbox
The best company to do that is Vanguard. The culture of the company is to help investors save on fees and capture the market returns through passive investing. Thank you, Mr Bogle!
Equities (developed markets): Moderate to high risk, and the core of Foxy Monkey’s portfolio. Equities have performed well in the past and businesses are here to stay. This will be the main profits driver in our portfolio.
Expected annual return after inflation: 5%.
Equities (emerging market): Investing in developing countries such as China, Brazil, India and Mexico comes with a higher risk than investing in the UK!
As a result, investors need to be compensated for the extra risk. Volatility is also higher. A quick look at the recent emerging markets history shows a -15% decline during 2013-14 followed by +14%, -15% and +44% in 2016-17!
Almost like a crypto-rollercoaster, only in years not weeks! Emerging markets have a 0.7 correlation with their developed counterparts.
Expected annual return after inflation: 7%
Bonds: Fixed-income to smooth out the returns and make me sleep well when the market decides to crash. With bonds, you know how much you’re expected to receive. You get into a contract with the bond issuer and you receive the coupon fixed-rate payments until your bond expires. Upon maturity, you receive your principal back.
The correlation between stocks and bonds is low, meaning that we want bonds to perform well when equities perform poorly and vice versa. Short-term bonds (up to 5 years) are low risk.
Long-term bonds though should be taken with caution. The longer the duration the more sensitive the bond is to interest-rate changes if you want to sell it earlier. Your 3% bond will look a poor cousin to the 5% new fancy bond if interest-rates go up and you’ll only sell it cheaper should you wish to sell it earlier than its maturity.
This is why it’s important to only use short-term bonds. I buy bonds because I want stability plus protection against deflation. Therefore’ I’ll stick to high-rated bonds (minimum AA) up to 5-years. Did I mention I want my bonds to avoid currency risk? So I’ll either buy in local (GBP) currency or global bonds hedged back to GBP.
Expected annual return after inflation: 1%
Real estate (in the form of REITs): I can already hear angry people hands typing that UK buy-to-lets should be at least 40% of everyone’s investments. London properties double every 10 years after all 🙂
Despite my very long research into property investments I have yet to take the plunge. Maybe I’m afraid of the boiler night calls. Maybe I don’t want to get into agency talks. I don’t know. But I won’t leave global commercial real estate out of the equation since it’s a great diversifier.
Stocks and property are moderately correlated making my portfolio more robust.
Expected annual return after inflation: 4%
Peer-to-peer lending: Probably one that looks low risk but is indeed high. Although I am sceptical about this new alternative investment, I have given it a shot and allocated a small percentage of my portfolio to it. I enjoyed the ride so far. I treat it as a high-yield bond.
The million dollar question is this: What happens to peer-to-peer loans during a stock market crash?
In other words, is the correlation to stocks high? So far, only one UK provider (my Zopa review) has gone through a recession and stayed quite healthy. But one provider is not a representative sample, compared to the 100 years+ of stock market history.
Expected annual return after inflation: 4%
Overall, the Foxy Monkey asset allocation consists of the following:
- 50% Developed markets (market cap weighted)
- 15% Emerging markets
- 10% Global Commercial Property (REITs)
- 20% Short-term global bonds
- 5% Peer-to-peer lending
And in funds:
Although not a developed-only markets equity fund, Vanguard Lifestrategy 100% fund keeps a good balance between all stock markets according to their GDP. It has a UK home bias of 20% but on the other hand, this protects me from currency risk. 50% is in the US which has a quite high CAPE ratio. American companies, however, are international (think of Coca-Cola) and therefore it reflects a more global approach.
Vanguard Lifestrategy includes 8% of emerging markets in its assets. To boost the emerging markets to 15% of my asset allocation I provided another 10% of the same fund (Vanguard Emerging Markets Stock Index) as a separate investment.
As for bonds, 20% is a good hedge. One could argue that a higher bond allocation is needed but we have other diversifiers too.
Speaking of which, BlackRock’s iShare Global Property Security Index makes 10% of the portfolio. It’s moderately correlated with stocks and I can say I own a commercial mall somewhere in Hong Kong.
I like Ratesetter better than any peer-to-peer lending provider simply because you can set your own rate. The loans are up to 5 years and you know that the interest received is not variable. In the past 2 years, I have received 6% returns before inflation.
They have also set up a Provision Fund to cover any defaults. Everyone pays into the fund and no investor has lost a penny (yet?).
What about small-cap or value companies?
Small-cap and value companies can also boost returns with extra risk. But since the portfolio is a low maintenance one, I don’t want to add any more funds to it. In fact, some of the small and value companies are already included as part of the global equities market tracker.
What about gold?
I always wanted to own gold! I won’t lie. But gold is a precious metal that does not contribute anything (apart from hedging) to my portfolio. It’s like buying an insurance. In some cases, an insurance is a tax for those who are bad at maths and buying gold is one of those cases IMO.
What about cryptos?
Why this stock-bond ratio?
Bonds, unlike stocks, have a guaranteed return (coupons). You know that each month you will get your little profit back and what that actual profit is going to be.
With stocks, you also get a coupon but it doesn’t have a written number on it. You actually own a small part of a business and businesses return 10% on average. Some businesses operate better, returning higher than that. Some other businesses fail miserably and this is why we buy ALL businesses by using an index fund. Ths way we get the average which is great.
When bond returns are low, like in today’s environment, people tend to buy more stocks pushing the prices up. There is a big difference between a 2% bond return and a 10% nominal stock return.
However, back in 1983, interest rates were very high. Long-term bonds returned 15%! Why take the risk of owning a business that may return 15% when I can have a guaranteed return by buying a government bond? High bond returns make stocks look a lot less attractive, hence driving their prices down.
In today’s environment, interest rates are low and my horizon is quite long (20 years +). In fact, I can argue my horizon is forever since I want my portfolio to work hard so I don’t. If I want high returns and don’t care about 5-year price fluctuations, I tend to allocate more in stocks.
Stocks are not for everyone, and maybe you shouldn’t hold any if you’re worried about price fluctuations. Also, you shouldn’t hold any if you need the money short-term (< 5 years minimum). The stock market doesn’t have to open tomorrow! Stocks can also crash 40% in a year and it’s certainly a bumpy ride! But the longer you hold those stocks the less risky they become. Whereas the longer you hold bonds the riskier they become!
Whether you own stocks or not, it’s wise to shelter your income from tax, by using an ISA. Not sure which? Read the best Stocks & Shares ISA provider post.
We saw how a Foxy Monkey invests in this overvalued stock market. This investment strategy aims to maximize the reward for the risk I am taking. The risk is high.
If you want a more conservative approach then put more money into your defensive assets (bonds) and decrease your aggressive assets (stocks!). Invest less in emerging markets and as always, do your own research.
There are certain books which helped me understand the stock market history and economics. I highly recommend you read them. These are:
- Smarter Investing by Time Hale
- Four Pillars of Investing by William Bernstein
- Irrational Exuberance by Robert Shiller
- Financial Independence Resources
Disclaimer: This is not investment advice. This is purely my own view on the markets. I am not responsible for any of your losses. As always, do your own research!