2017

January 1, 2018

My SmallTrades Portfolio holds stocks and broad-market index ETFs (chart 1).

chart 1. SmallTrades Portfolio in 2017.

Chart 2 shows the diversification of ETFs as measured by percentages of year-end market values among ETF classes.

chart 2. Diversification of ETFs in 2017.

Chart 3 shows the diversification of stocks among 8 market sectors as measured by percentages of year-end market value for each stock sector and the ETFs.

Chart 3. Distribution of stocks and ETFs by market sectors.

Chart 4 shows the distribution of stocks according to market capitalization.

Chart 4. Combined market capitalizations.

Performance

My investment goal is to outperform the “Benchmark” Standard & Poors 500 Total Return Index, yet my portfolio has never outperformed the Benchmark (chart 5).

Chart 5. Portfolio performance.

Chart 5 shows growth trends for the benchmark (blue dashed line) and portfolio (solid blue line) since 2007 [the benchmark represents a passively managed, buy-and-hold investment; my portfolio is an actively managed investment].  On the Y axis, a unit value of $1.00 was assigned to both the total market value of the Portfolio and the Benchmark on December 31, 2007. Ratios of subsequent market- and benchmark values to the 2007 baseline are displayed line plots on the chart.

In 2014, my investment policy was modified to buy stocks of good companies and hold them for the long term. Chart 6 shows the result of my stock investments (red line) compared to the Benchmark Index (blue line) and ETF investments (red dashed line). The unit value of $1.00 was calculated on December 31, 2013. Since then, the stock group clearly outperformed the Benchmark and ETFs.

Chart 6. Stock and ETF performances.

Risk Management of ETFs

Broad-market index ETFs are primarily protected against stock losses by the passive management of investment portfolios which mimic the composition and performace of reputable market indices.

ETFs are secondarily protected by rebalancing significant allocation errors as described in the SmallTrades Portfolio’s strategies for risk management. In theory, a significant drift of asset classes occurs when one asset class surpasses a 24-28% allocation error. My preferred allocation of ETF market values is 30% stocks, 30% REITs, 20% bonds, and 20% gold bullion.

A perfect allocation of ETFs would result in 0% allocation error.  Furthermore, allocation errors would reflect disproportional gains or losses of market value.  Chart 7 shows the year-end allocation errors (blue bars) and error limits (red dashed lines) of my ETFs. There was growth of the Global Stocks ETF and decline of the remaining ETFs. Any allocation error that exceeds an error limit (red dashed line) should trigger trades that rebalance the ETFs to the preferred allocation.  My ETFs were not rebalanced in 2017.

Chart 7. ETF allocation errors in 2017.

Risk management of Stocks

My stocks are primarily protected against risks of steep loss by diversification of the market sectors, as illustrated in the preceding chart 3. The second line of defense is stop-loss orders.  In keeping with the investment goal of holding good stocks for the long run, I set ‘stops’ at a wide margin to prevent recent market fluctuations from triggering an unwanted sale.

Plan

The SmallTades Portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. In 2017, I failed to sell large cap stocks in order to buy good small cap and mid cap stocks. Consequently, 60% of the total market capitalization of my stock portfolio was in the Large Cap category.  In 2018, I would like to reduce the Large Cap category to 40% total market capitalization and boost the market capitalization of small- and mid cap stocks issued by good companies with potential growth of earnings.

Portfolio history

  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in a Roth account.
  2. During 2007-2010 the actively managed mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’.  Four mistakes led to a big loss:
  3. mistake #1: after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of the company’s large debt and lost $45,000 during Lehman’s decline to bankruptcy.
  4. mistake #2: substantial long term profits from good companies were lost by selling holdings for short term profits. My strategy was to earn a quick 30% in the first year and re-invest in the next winners. It was too difficult to identify the next winners.
  5. mistake #3: day-trading was a game of chance that I played and managed to break even; meanwhile, good stocks grew in value.
  6. mistake #4: a trial of investing in leveraged ETFs resulted in losses due to negative compounding.
  7. I abandoned the goal of a 30% annual return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad-market index ETFs and 20% stocks for the long term. ‘Good’ companies attract and retain investors for many years. I will search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, partiicipating in an investment club, using stock screeners, and attending investor conferences. Then I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  8. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since my retirement income didn’t depend on making withdrawals from the SmallTrades Portfolio, I increased my ETF exposures to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

Warren Buffett’s advice to nonprofessional investors

April 1, 2014

Warren Buffett’s advice (1) to nonprofessional investors is to “own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.” Warren also advises nonprofessional investors to accumulate shares of the index fund over a long time period, never sell them when share prices are low, and minimize the costs of investing. There is no need to hire a professional investment advisor.

1.  Warren E. Buffett, Chairman of the Board. Letter to the shareholders of Berkshire Hathaway, Inc., 2013. Pages 19-20, 2/28/2014. http://www.berkshirehathaway.com/letters/letters.html


Investment strategy of the SmallTrades ETF Portfolio

February 14, 2014

An index ETF is designed to capture the investment returns from a financial market.  The SmallTrades ETF Portfolio (“Portfolio”) uses index ETFs to invest in several financial markets.  The goal of the Portfolio is to earn returns at a faster rate than possible by investing in risk-free bonds or the broad market of U.S. stocks, thereby ensuring that the accumulation of returns outpaces the inflation of prices in the American economy.  Success is measured by the following benchmark indices:

Investment strategy

The Portfolio is a high-risk, high-return investment in ETFs that duplicate well-established market indices for global stocks, U.S. bonds, U.S. real estate investment trusts, and gold bullion.  Twenty five percent of the portfolio’s market value is allocated to each index.  The ETFs generate at least 99% of the portfolio’s value and any remaining value is stored in a money market fund.  The ETFs will be held indefinitely except when faced with the advantage of replacing one with a more suitable ETF for the same index.

Table of holdings

ETF trading symbol Market Allocation
 AGG   U.S. bonds 25%
 GLD   Gold bullion 12.5%
 SGOL     Gold bullion 12.5%
 VNQ     U.S. real estate investment trusts 25%
 VT  Global stocks 25%

Expected return

Unfortunately there is no 50-100 year history of ETF performance that enables the forecast of an expected return.  To compensate for this limitation, two models were used to test the allocation plan shown in the table of holdings.  In one model of the 15-year recovery from the 1997 Asian Financial Crisis, the allocation plan outperformed the U.S. stock market.  In the other model of the 5-year recovery from the 2008 Global Financial Crisis, the allocation plan underperformed the U.S. stock market.  Among both time periods, the lowest return of the model portfolio was 8.5%.

  • MARKETS portfolio of financial-market returns from 1997 to 2011: The global-stocks market was simulated by a mixture of 75% U.S. large capitalization stocks and 25% emerging markets stocks.  Trading and management fees were excluded from the model.  The annualized return of the portfolio was 8.5% in comparison to the 5.7% annualized return of U.S. large capitalization stocks.
  • ETF portfolio of historical prices from 2008-2013: Trading fees, but not management fees, were included in the calculations (– management fees are charged in the primary market before ETFs are listed in the stock market).  The annualized return of the portfolio was 10.9% in comparison to the 17.8% annualized return of SPY, an ETF that tracks the Standard & Poor’s 500 Total Return.

Risk management

The holding period will be at least 5 years.  Fluctuation in market prices is the main risk of investing in index ETFs.  The likelihood of incurring a loss from a declining market decreases as the length of the holding period increases (– e.g., the risk of loss from stocks and bonds declines by 50% as the length of the holding period increases from 1 to 5 years; and, the risk declines by 80% when the holding period is extended to 10 years (1)).

The Portfolio will be rebalanced as needed to maintain the allocation plan within an acceptable limit of 28% error.  The Portfolio is concentrated in 4 markets and losses may occur when one or several markets decline.  The 25% allocation plan assigns equal weightings to each financial market in order to smooth the effect of market declines.  After accounting for trading fees, the strategy of rebalancing a large allocation error is more cost-effective than using a rebalancing schedule.

The Portfolio holdings are investable, have established reputations, charge low management fees, and are safely structured.  Although there’s no guarantee that the index ETFs will sustain their historical performance, the stock market, bond market, and real estate market ETFs provide diversified investments in underlying assets.  The risk of investing in these ETFs is lower than the risk of investing in an underlying asset.  Gold bullion ETFs are non-diversified investments in the volatile gold market.  Gold bullion is theoretically susceptible to physical damage by theft or fire.  This risk is diminished by investing in two funds, GLD and SGOL, that store the bullion in separate vaults located in London and Lucerne.

The investor’s tax burden can be reduced by holding these index ETFs in a tax-deferred retirement account.

Copyright © 2013 Douglas R. Knight

References

1.           James B. Cloonan, A lifetime strategy for investing.  American Association of Individual Investors, Chicago, 201


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