2021 Portfolio Thoughts (Part 3 – Key Questions)

The reason I started writing this blog was to make sure that I can record my thinking and then learn from it in the future depending on how the outcomes evolve. In the previous blog, I have outlined an asset allocation for 2021. However, by no means is it perfect – I have tons of doubts in my asset allocation and so I have introspected on a few questions to make sure that my dogfood is worth consuming. These questions are outlined below.

Why not passive indexing vs. this asset allocation?

Most obvious question that anyone can ask is – why do you need to really build a portfolio with all these assets when you can invest in a passive index? Why agonize about asset allocation when everyone from Jeremy Seigel to Warren Buffet has told is that we are not going to be able to outperform the index S&P – no one has consistently been able to.

My response would be the following:

  1. I am still materially exposed to the passive investing bucket through broader exposure to index
  2. Probability of getting stress based ulcer is much higher in passive investing – this is because the drawdowns are deeper, and it may take long time to recover
  3. Given the recent run-up in stocks,  Passive investing may have lower expected returns – so it is unclear if passive investing will still outperform
  4. Passive investing (in S&P500) for example is not exposed to international markets

I will explain #2 in a bit more detail. Mike Greene has described the process that the boom busts in the index market can be drastic. So has Mandelbrot through this fractal theory. Basically, in normal parlance if we put the money in index fund we can expect to lose a big amount of money through the journey. Overall, if we are invested for a long time we should be able to recover and be higher, but the swings can be wild and it can take many years to build that back up.

Do we have opportunity for aggressive growth in the portfolio? In other words, can you become rich using this portfolio?

The way to become rich through investment is to have concentrated positions. The way to become poor through investments is also having concentrated positions.

However, the objective of this portfolio is to preserve wealth and grow steadily.  There are potentially some 3-5 baggers – but they have small allocations. None of this is going to get you too aggressive growth over time.

Is there a strong downside protection? How have we considered other macros trends such as long volatility?

I think that is a big gap in the current portfolio. Overall, there is no direct long volatility position in the portfolio. I do have a lot of “fear” emotion – the volatility of S&P (which hit all time high and also dropped 35% in the same year), the volatility of Bitcoin, the volatility of oil, the volatility of commodities are all very painful reminders that everything can go haywire. There needs to be a strong “long volatility” position.

Unfortunately, I think the portfolio that I suggested in my previous blog just doesn’t have a strong downside protection. I do think some protective puts might be good – but I am just getting up to speed on all the greeks to really engineer something that might be helpful. I do think that the asset classes do not have strong correlation with each other. While in March we saw everything pretty much go down at the same time, in time we did see some of the defensive asset classes start to show the expected differences.

Is it better to stick to the “all-weather” or “Golden Butterfly” portfolios?

An “All Weather” portfolio suggested by Ray Dalio to Tony Robbins in the book Money has garnered some attention. It performed quite well in the March downturn.

Golden Butterfly is another portfolio that is similar in theme.

However, I prefer my portfolio in the current situation due to a few reasons.

  1. A large bond position in both the portfolios, which may not have the expected returns
  2. Lack of commodity exposure
  3. Overweight on USD – lack of international exposure

On #1 – I am personally starting to lose sleep on long bond positions (especially longer duration bonds). There is a strong possibility that US can start to see negative rates. In UK it has happened for the first time in 300 years (so have I heard). There is about 17T of debt yielding negative. As a result there is some possibility that the yields can go down further (both in the short and the long end). However, everything considered, Bonds just have a lower upside potential. The bond year bull market is as old as I am and appears to be in the last innings. I have not seen the backtesting of “All Weather” before 1970s -and I am not sure whether it will work in the rate environment going forward. The yields are super low, and the coupons are low as well. Additionally, USD continues to see pressure. So while I am going to keep some portion in bonds (to address the possibility of yields reducing further), It may be useful to allocate the portion of the bond allocations to energy, commodities and international asset classes.

On #2, Lack of commodity exposure is a problem more in the Golden Butterfly portfolio rather than the “all weather portfolio”. Gold may replace some function of commodities, but it not a good inflation hedge. Energy and commodities would be a much stronger inflation hedge. Positioning portfolio against inflation requires us to invest a little bit in commodities – and that is what I have done (which is by the way very close to the commodity allocation in “all weather” portfolio).

On #3, overall the two portfolios are basically all US focused. Given the USD pressures, it may make sense to have some portfolio diversification into the international assets with non-USD exposure. Of course, it is unclear if USD will deflate relative to other currency given the other monetary regimes can also take efforts to devalue their currency, but it may make sense to remain exposed to emerging markets, China and Europe.

Do we have a lot of cash allocation in the portfolio?

Presumably yes. But I think we need to be positioned for any big market shocks – both to manage the draw down and also to be positioned for opportunities. I understand Ray Dalio’s argument around “Cash is Trash” in the current scenario – but having some buffer is important for the reasons described.

At the end, I wanted to make a list of other topics that I want to address in my blog in the future (whenever time permits):

  1. Scenario analysis of key Macro drivers – thought experiment
  2. Is there a prior historical time when these conditions were in place and how would this portfolio fare at that time?
  3. Investing in Oil – Current dynamics and key hypothesis
  4. Introspecting on big errors in my investing lifetime
  5. What can be a good risk management approaches for individual investors?
  6. How should a person new to financial investing start to dip their toes in the market and when?

If the readers have any questions, or are interested in any topics – please let me know below in the comment box and I can attempt to address it.

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