This is a continuation of last week’s post. Read it first or this won’t make much sense. One clarification from last week that several people pointed out is that my definition of Beta was too simple and a better definition is that Beta is the reward you get for taking risk. The end result is the same, though: diversify your risks to receive a somewhat steady reward while having the risks counteract each other as much as possible.
I also realized that I probably should have waited for this post before inviting comments, because several people pointed out why you wouldn’t want to lever up in the current climate, which I address here.
I was starting to understand the blueprint for managing finances. You want the most balanced portfolio possible, so that you can that add leverage to maximize the return for any given risk tolerance. As I delved into these portfolios and saw their historic performance, the graphs looked a lot more palatable than the index fund graphs that had previously turned me off.
My new goal was to create the perfect balanced portfolio, figure out how to leverage it, and then figure out how to borrow against it. That would allow me to safely “double dip” with my money, investing once in the market and once in one of my normal investments (minus some margin of safety, of course, as you can’t borrow 100% of your portfolio value).
As I was figuring this out, I happened to have a conversation with a good friend of mine who is a real estate developer in New Orleans. I’ve invested in dozens of his projects down there and gotten excellent returns. I’ve always known that he was sharp with money, but I didn’t realize just how experienced he was. When I started to tell him about my plan he interrupted, “You know I managed a multi-family office before I did real estate, right?”
It turns out he’s the one person I know who was actually in the business of managing the money of the ultra-wealthy. Not only did he validate everything I had discovered, but he added a lot to my knowledge and wants to mirror my portfolio. Very encouraging!
One of the most interesting things he told me was this: “Rich people don’t try to make money in the stock market. They don’t even think about it. All they want to do is preserve their wealth, slowly grow it, and borrow against it.” The more research I did, the more I realized that was true.
This, of course, is the opposite of how many people invest. They’re trying to pick the next hot stock to make a lot of money.
The Current Financial Climate
We live in a very unusual time and are entering into a new era, which will probably fundamentally change what a good portfolio looks like.
The Fed’s primary lever on the economy is adjusting the interest rate up and down. This has big effects on the economy and can be useful to keep us out of a recession and also to try to avoid bubbles. The problem is that for the first time in decades that rate is almost zero. While it is possible that we could have a negative interest rate, the Fed has very limited ability to use this lever to adjust the economy. Instead they are printing money and injecting it into the economy. This will have profound effects for a portfolio.
The biggest component of most balanced portfolios is bonds, because bonds are very uncorrelated with stocks, and tend to go up when stocks go down. The primary mechanism by which bonds go up is the federal interest rate. If it goes down, your bond goes up (because it has locked in a higher interest rate), and vice versa. Now that the Fed can no longer adjust the interest rate downwards, it appears that the risk/reward for bonds no longer makes sense. If stocks do crash, bonds probably cannot do much to dampen it.
(If you do not think this is true, please contact me. I have looked everywhere for counterpoints to this but haven’t found anything)
I have also been researching the effects of all of this extra money in the economy and it seems that only two things, or a combination of both, will happen. The first is that inflation will increase. This is an obvious effect of more money being printed. The other is that some companies will be able to use this excess liquidity to their advantage and will benefit from it, thus increasing productivity and stock prices.
So while it is always possible that equities could drop, it is not a foregone conclusion. However, it is likely that returns going forward will not be as good as they have been in recent years/decades.
BIG CAVEAT: I am just a guy on the internet and not a financial advisor. My hope is that my research will serve as a starting point for you to do your own research. Even if I am 100% right (which I’m probably not), my goals may not match your goals, so my portfolio may be wrong for you. I am sharing it here to explain my thinking and also have some accountability to see how I performed down the road.
My #1 goal is to create a portfolio that is very unlikely to lose big, and which should protect me against inflation and be able to capture some upside if things go well. I may tweak it, but I am trying to design it to be a “set and forget” portfolio until the interest rate goes back up, at which point I will be a bit more aggressive. I have no way to actually know, but my best guess is that this portfolio will return something like 6%. I don’t consider backtesting to be very useful, except to discover correlations, because I believe we are in a new financial era.
I am not trying to predict what will go up. I am trying to be in good shape no matter what happens. In other words, I am assuming all of these ETFs are priced accurately now, some will go up, some will go down, and the net effect will be a gain over the long run.
I had originally planned on doing a very leveraged portfolio (2-3X), but without being able to use bonds I don’t feel that it makes sense. After consuming hours of writing and videos by Ray Dalio and other investment experts, here are the things I am investing in, with reasoning.
Short term TIPS – TIPS are short term inflation protected bonds. Long term bonds expose you more to the rate change of bonds, while short terms expose you to less. I have these just to buffer the account and to protect against inflation.
Gold – Gold is another reasonable protection against inflation and is very uncorrelated with the general market.
The Whole US Market – I waffled between just doing the S&P 500 (or some other large cap slice) and the whole market, and ended up on the whole market. It has better returns usually and more risk. I’m young enough to tolerate some risk and figure that any publicly traded company has a good shot at being able to use liquidity to its advantage.
Utilities – Utilities are a segment of the market that tend to do well in inflationary times and are not all that correlated with the market as a whole
Europe – Dalio says that the three relevant financial spheres are US, China, and Europe, so this is to cover the Europe base. The idea is that one of these spheres could become dominant, so you want to have a piece of it.
Emerging Markets – This is to cover China. You could also go with a China-only fund but I chose to go with Emerging because it’s heavy in China anyway, and is a bit more diversified.
Emerging Government Bonds – This is the one I’m least convinced on, but the idea is that emerging markets have higher interest rates, so they still have room to lower them and create gains.
Real Estate – Real estate can also do well in inflationary times and adds some more uncorrelation (or… removes correlation)
There’s a method (pioneered by Ray Dalio) called risk parity. What it means is that you size positions not by dollar value, but by risk value. For example, If you have 50% of your cash in bonds and 50% in stocks, stocks will contribute way more volatility. If your stocks dropped by 10%, bonds may only go up by 3%. So to really balance a portfolio, you’d want to be around 80% bonds, 20% stocks. Bonds tend to underperform stocks, so your returns would go way down, but the graph would be really smooth, so you could apply leverage.
I started with full risk parity, and then adjusted my TIPS and foreign bonds down because I am willing to take a bit more risk for better returns. Risk parity would dictate, for example, that 50% of my portfolio should be TIPS, but I am doing only 30%. The rest I nudged up and down for a variety of reasons, but they generally track the ratios dictated by risk parity. I am still waiting for money/positions to transfer to my new broker, so my percentages or ETF choices may change.
In choosing ETFs I have generally chosen the ones with lowest management fees. I also looked through Ray Dalio’s SEC filings to see what he chose and favored those ones.
Here’s my current plan:
Here is a visual look at the portfolio. You may note that it doesn’t backtest particularly well, which I see as a feature. It’s easy to make a portfolio that backtests well, but based on what I’ve learned I think that going forward the safest portfolios will look very different.
I may have saved the best for last here. There are two brokers that I discovered that are in a league of their own, primarily because they offer really cheap margin loans.
M1 Finance (affiliate link- we each get $10 if you sign up) is like WealthFront for people who want more control. You can make a “pie” of your stocks (here’s one of the stocks I’m buying), and can automatically invest in it. You click one button to rebalance, and it will apply deposits to underallocated portions automatically as well as sell assets according to tax benefit. Very smart.
If you pay for M1 Plus ($125, but the first year is $25), you can borrow up to 35% against your portfolio at 2%. They also have an integrated checking account that pays 1% and gives you 1% cash back on your debit card. If you don’t want to go too crazy with the next brokerage I’ll recommend, I think there’s a strong argument to made for moving all/most of your banking and investing to M1. That was my plan before I discovered the next brokerage.
I actually had an Interactive Brokers (not an affiliate link) account in 2000 when I tried to start a hedge fund (we lost all of our friends’ money within a few months because we weren’t nearly as smart as we thought we were). Even back then it was considered the best option, but now it is just amazing.
The big draw here is that you can borrow at a 1.6% rate! You can also borrow a much higher percentage of your balance. You can borrow at least 50%, but if you have over 100k you can borrow using Portfolio Margin. It gets better as you have more money: if you had $1MM in there, you could probably withdraw around 800k safely and pay less than 1%.
Both brokerages offer debit cards and ACH payments.
How I Will Put it All Together
I am in the process of moving all possible assets to Interactive Brokers. I will invest all available cash into the portfolio I outlined in these posts. I will then borrow heavily, keeping a reasonable buffer, against that amount for other very safe investments I have access to (for example, I earn a guaranteed 8% investing in a friend’s real estate business, I could buy USDC stable coins and get 8.6% on BlockFi, etc). That gives me an extra 7% very safe return on a portion of my money that I’m already earning on.
I will only invest in EXTREMELY safe things, and will make sure that at least 50% of them are liquid. My goal is to add a very safe extra return to compensate for my conservative portfolio, not to leverage up and speculate.
In my case I already have some money in very safe things, so rather than liquidate them, put them in the portfolio, buy stock, borrow, and then rebuy, I will just buy more of the portfolio on margin.
I will set up all of my credit cards to be automatically paid from my Interactive Brokers account. Usually I keep a buffer of cash in a checking account just in case my income deposit dates aren’t in sync with credit card payment dates, but now I will allow the margin to buffer that so that I can keep all of my money at work.
I will also keep ~$1000 in a Schwab checking account so that I can take money out of an ATM anywhere in the world with no fees. The interactive Brokers Debit card does not reimburse ATM fees and charges an extra $0.50.
The benefits of this system are that it keeps all of my money working for me at all times, provides me with a lot of liquidity, and that it automates a ton of my finances. I will, of course, write software that connects with the Interactive Brokers API to rebalance my portfolio, tax loss harvest, and notify me if I have too much or too little margin utilization.
Should You Do This?
I think for most people it makes sense to have some safe portfolio at some brokerage where you can borrow on margin. If you already have a portfolio I think it’s a total no-brainer to move it and have access to that super cheap credit line. If you’re a gambler, prone to debt, or not very disciplined with money, I would probably stay away from all of this entirely.
While I’m excited about potential returns and double-dipping, one of the biggest draws for me is the big pool of liquidity. I hate having cash sitting around idle, so I always try to have it all invested, but then that sometimes puts me in a situation where I have to wait for the return of one investment before I can move into the other one. Now I can keep all of my money invested at all times but I can still react quickly without having to reshuffle everything. If I don’t have great opportunities to invest money I can just return it to reduce my margin and not feel like it’s sitting there eroding against inflation.
At the very least, think about all of these tools and puzzle pieces, and see if there’s a more logical way in which to arrange your finances. I’ll post an update in 6 months letting everyone know how it’s working out, and will post all portfolio updates to my Patreon inner circle members.
Photo is sunset on Lake Mead. Can you tell that I pretty much only go one place outside the house?
Huge thanks to everyone supporting my Patreon so far!