The Near-Perfect Portfolio: Sleep Well During Turbulent Times

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The Near-Perfect Portfolio: Sleep Well During Turbulent Times

seekingalpha2022-03-19

Piotrekswat/iStock via Getty Images Investing in broad market indexes at regular intervals can be a reasonable long-term strategy for younger investors who have many years before they would need ...

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·2022-03-22
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In fact, if you are investing in auto-pilot with every paycheck or any other interval, you are buying high as well as low, using the benefits of dollar-cost-average. However, there is no escape from a roller-coaster ride with the extreme ups and downs of the market. The main problem with the above strategy is that so many folks cannot tolerate the deep drawdowns and resort to panic selling exactly at the wrong time in the hopes of getting back later. On the other hand, income investors, including retirees who live off that income, have an additional problem. Since they need to withdraw income on a regular basis, they may be forced to sell when the prices are low. Even if they do not withdraw income, more than likely, they are not adding any fresh money to take advantage of low prices. Retirees can also face the problem of sequential risk if the market happens to go into a deep correction for multiple years in the early phase of retirement. If you are an income investor and don't like the roller-coaster ride of the stock market and rather sleep well even during the depth of a correction, the NPP strategy described in this article is for you. If you are a retiree or near-retiree and want to avoid the sequential risk of the stock market, in our opinion, the NPP strategy can be very helpful. If you are nearing 50 or already 50-plus and believe that low volatility leads to higher returns in the long term (and vice versa), then again, the NPP strategy may be the right fit for you. That said, everyone's situation is different, and one size does not fit all, so it is always a good idea to analyze if a strategy would suit your specific needs and goals. Since early 2020, we have been writing about a portfolio strategy that we like to call NPP (Near-Perfect Portfolio) strategy. Since nothing is perfect, especially so in the investment world, hence the name Near-Perfect Portfolio. We admit the name still may appear to be a bit over the top, but the underlying premise and goals fit the name. Generally, we're looking for a strategy that performs reasonably well during the bull markets, preserves capital when the market throws a fit or performs poorly, and provides a decent enough income stream on a consistent basis. This is the basis of the Near-Perfect Portfolio. We follow the NPP strategy in our Marketplace service \"High-Income DIY Portfolios,\" but from time to time, we provide updates and progress of the NPP portfolio here on SA public platform. As usual, we will provide an overview of the performance and broad comparison of our NPP strategy vis-à-vis the S&P 500 (based on back-tested data as well as our live performance since January 2020). In the end, we will provide a sample NPP 3-bucket portfolio. The past 27 months have seen an incredible roller-coaster ride for the broader market. We started the year 2020 with a strong booming economy, low unemployment, and a stock market that was breaking new records. Then came the pandemic that resulted in worldwide economic shutdowns. At the peak of the panic, the S&P 500 lost nearly 30%, while Dow Jones Industrials had fared even worse. Even though the market recovered very quickly from the pandemic-induced crash, at the same time, it reminded folks of the importance of knowing their risk tolerance. Folks who panicked near the bottom and sold their stock positions probably never got a chance to get back in. Now, two years later, and with nearly 100% gains from the bottom, the market is trading at much higher levels. However, recently, it has faced some headwinds, and many of the high-flying stocks of the pandemic era are down 50% or more, though the broader indexes like S&P 500 are just about 10% below their all-time highs. After many decades of low inflation, we are seeing high inflation that shows no signs of slowing down. The current geopolitical situation is only likely to make it worse. Inflation is the biggest threat to retirees and folks who are on a fixed income and their stock portfolios. With all that said, it boils down to one simple question. Do we really want to constantly go through these ups and downs of the stock market and worry about the value of our portfolio on a daily or weekly basis? Or is there a better alternative, where a conservative investor or a retiree could have low volatility, minimal drawdowns, consistent income but still could enjoy the fruits of a rising market if that continues? This is exactly the objective of this comparative analysis of the NPP portfolio and the broader market indexes like the S&P 500. What's a Near-Perfect Portfolio? It's not possible for anyone to predict what the markets are going to do tomorrow, next month, or six months down the line. So, we do not believe in chasing the market. Rather, we look for strategies that produce low volatility, preserve capital, provide a decent income and reasonable total returns over the long term. In our view, these are the goals that most retirees and other conservative investors would want as well. Retirees, in particular, cannot afford large or deep drawdowns in their portfolios because they do not have the luxury of time. Also, most retirees need their portfolios to provide a consistent stream of reliable income. The S&P 500 provides a lowly 1.4% yield today, so index investing would not be an ideal option for most income investors. In addition, the extraordinary streak of high performance of the S&P 500 during the past 13 years is unlikely to continue in the next decade. So, what should a retiree or anyone 50 years of age or older do? What's the best way to manage a stock portfolio and still sleep well at night? How can you preserve your capital, earn roughly 5% income (if you need to withdraw), and at the same time grow your investments to get a long-term total return of roughly 10% or better? Sounds like a tall target? We believe it's possible to achieve all of these three goals by adopting what we like to call a Near-Perfect Portfolio strategy. To summarize, we expect our Near-Perfect Portfolio to achieve these three objectives: • Preserve capital by limiting the drawdowns to less than 20%. • Provide a consistent income of roughly 5% to those who need to withdraw. • Grow the capital for the long term at an annualized rate of 10% or better (including the income). We must caution that these strategies need some work on an ongoing basis and may not suit highly passive investors. In addition, they require patience. NPP: A Combination of Divergent Strategies: The importance of the need to diversify cannot be overstated, especially for older investors. Sure, you can always find some investors who have done pretty well with highly concentrated portfolios. But for the vast majority of folks, that's not the recipe for success. So, the question is how to diversify and how much to invest in various types of assets or strategies. It's rather a complex topic. First, we need to diversify our stock holdings among different sectors or industry segments of the economy. But that alone may not be enough if you want to avoid volatility since the stock market is inherently volatile. High volatility brings in all kinds of emotions and issues, including fear, selling at the wrong time, fear of missing out, and above all, overall low performance. So, as a second step, we recommend diversifying in terms of types of investment strategies. We try to combine strategies that are likely to perform in divergent ways under different market conditions. This helps bring down the portfolio volatility and improve overall performance. The NPP portfolio combines monthly rotational strategies with some buy-and-hold DGI (dividend growth investing) and high-income strategies to perform well in different market conditions. Performance Behavior of NPP Strategy During Bull & Bear Markets Before we go any further, it may be beneficial to discuss how our rotational and buy-and-hold portfolios would have performed since the year 2008. Moreover, this will demonstrate how rotational portfolios can act as a counterbalance to buy-and-hold portfolios during times of crisis. We run and manage many such rotational portfolios and three buy-and-hold portfolios inside our Marketplace service. Note: All the tables and charts included in this article are sourced from Author's work unless specified otherwise underneath the image. The stock market data, wherever used, is sourced from public websites like Yahoo Finance, Google Finance, Morningstar, etc. Know Your Tolerance of Drawdowns: Let's talk about drawdowns a little bit. During the good times (bull runs), it is natural that most folks do not think much about drawdowns. However, for retirees and older investors, it is of paramount importance to know their risk-tolerance and have an idea about how much of a drawdown would be tolerable to them. In addition to the level of tolerance to drawdowns, there is always the inherent risk of negative sequential returns during the early years of retirement. So, if you think that in a worst-case scenario, you could only tolerate a 20-25% drawdown, then you should not be invested in broad market indexes. Broad market indexes like S&P 500 had a drawdown (loss from top to bottom) of over 45%, 50%, and 30% respectively during the dotcom crash (2000-2002), financial crisis (2008-2009), and Covid crash (Jan–March 2020). So, it may not be very frequent, but it does happen once or twice a decade. Sometimes a downturn can end quickly, as we experienced during the Covid crash, but at other times it can be long, slow, and painful, for example, the like of what we had from 2000-2002. So, let's compare the drawdown performance of our NPP portfolio and the S&P 500 during some of the worst times during the last 14 years (based on backtesting). We are not in a position to go beyond 2008 due to a lack of reliable data, but at least it would cover the financial crisis and a few other deep correction periods. List of drawdown timeframes: • Jan-2008 to Mar-2009 (Financial and Housing crash) • Oct-2018 to Dec-2018 (Crash of 2018) • Jan-2020 to Mar-2020 (Pandemic crash) • Jan-2022 to Mar 14, 2022 (the current period) Table-1: Author As you can see above, the drawdown of the NPP portfolio was less than one-third of S&P 500 during an extreme downturn and less than half at other times. The current period is still an ongoing affair, and so it is not the complete picture as yet. Combined Portfolio [NPP] Performance: Below is the combined NPP portfolio performance (based on back-testing results since 2008). We will then provide more details on the three components of the NPP portfolio. Table-2:     CAGR**   CAGR of DGI bucket since 2008: 14.09%   CAGR of CEF-High-Income bucket since 2008: 10.72%   CAGR of ROTATION bucket since 2008: 16.16%   CAGR of Combined NPP portfolio since 2008:  14.74%   CAGR of S&P 500 since 2008: 9.70%   ** CAGR – Compound Annual Growth Rate Chart-1: The Combined NPP portfolio vs. S&P 500 Since 2008 Author Below is the chart from the \"live performance\" of the NPP Portfolio since Jan. 2020. (Since this comes from our Marketplace service, it takes into account 6 Rotational portfolios and 3 Buy-and-hold portfolios). In practice, an investor would just need two buy-and-hold buckets and one (or maybe two) rotational buckets. In the chart below, you will notice that at the market bottom in March 2020, S&P 500 and Dow Jones were down nearly 30% and 35%, respectively; however, NPP was down only about 15%. Chart-2:   Author 3-Bucket NPP Portfolio (An Example Portfolio) In this section, we will provide an overview of each of the three buckets and their individual performances vis-à-vis the S&P 500. Bucket 1: Rotational Bucket (45% of the asset) Bucket 2: DGI Bucket (40% of the assets) Bucket 3: CEF High-Income Bucket (15% of the assets). Bucket-1: Rotational Bucket So, what's a Rotation strategy, and why invest in it? First, this is our insurance bucket (or hedging bucket), which should preserve our capital in times of crisis or panic. In addition, it would reduce volatility, provide a decent return, and some of them could provide a good income as well. Along with the DGI portfolio, these strategies are an essential part of our overall portfolio. Investment in stocks is inherently risky, and the Rotational strategies provide the necessary hedge against the risk. They bring the overall volatility of the portfolio down and limit the drawdowns in a panic or a major correction scenario. The biggest advantage is that they let the investor sleep well at night. They bring a level of assurance that helps the investor to maintain calm and stay invested in good times and bad. However, we must caution that this strategy requires some regular work on a monthly basis. One can start with one rotation strategy, but as one gains more experience and confidence, one could diversify in multiple strategies. We provide eight such strategies in our Marketplace service, but for most folks, two or three such strategies should be more than enough. Note: A word of caution for new investors - just because we're allocating 45% of the portfolio to this strategy, we are not recommending that you change to this strategy overnight with large sums of money. Rather, it should be done gradually over time in smaller steps, and one should preferably use more than one such strategy. A Rotation Strategy for the Bull as well as Bear markets: In the Rotational bucket, we normally rotate between a fixed set of securities on a periodic basis (usually a month), based on the relative performance of each security during the previous period of defined length. This portfolio is designed in such a way that it aims to preserve capital with minimal drawdowns during corrections and panic situations while providing excellent returns during the bull periods. Due to much lower volatility, this portfolio is likely to outperform the S&P 500 over long periods of time. However, it may underperform to some extent during the bull runs. The strategy is based on seven diverse securities but will hold any two of them at any given time, based on relative positive momentum over the previous three months. Basically, we will select the two top-performing funds. The rotation will be on a monthly basis. The seven securities are: • Vanguard High Dividend Yield Pacer Swan SOS Fund of Funds ETF|ETF (VYM) • Vanguard Dividend Appreciation ETF (VIG) • iShares MSCI EAFE Value ETF (EFV) • iShares MSCI EAFE Growth ETF (EFG) • Cohen & Steers Quality Income Realty Fund (RQI) • iShares 20+ Year Treasury Bond ETF (TLT) • iShares 1-3 Year Treasury Bond ETF (SHY) Chart-3: Author Bucket-2: DGI-Core We believe that a diversified DGI (Dividend Growth Investing) portfolio should hold roughly 15-25 stocks. We like to invest in individual stocks, and that's what we are going to focus on here. However, more passive investors could make this portfolio entirely of some select dividend ETFs (Exchange Traded Funds). For our sample portfolio presented below, we will look for companies that are large-cap, relatively safe, and have solid dividend records. Most of them will likely provide a high level of resistance to downward pressure in an outright panic situation. We will present 15 such stocks based on our past research, current dividend payouts, and a high level of dividend safety. The goals of the DGI Bucket are: • Long-term investments 3%-4% dividend income • Long-term total return in line with the broader market • Drawdowns to be about 70% (or less) of the broader market This is our long-term buy-and-hold bucket. It will be our core investments in solid, blue-chip dividend stocks. It's relatively easy to structure and form this bucket. However, we must put emphasis on diversifying among various sectors and industry segments of the economy. A selection of roughly 15-25 stocks could provide more than enough diversification. For this part of the portfolio, our focus is to select stocks that tend to do well in both good times and during recessions/corrections. This is especially important if you are a retiree. Please note that this is just a list for demonstration purposes, and there can be many other stocks that could be equally qualified. Stocks selected: AbbVie Inc. (ABBV), Amgen (AMGN), Clorox (CLX), Digital Realty (DLR), Enbridge (ENB), Fastenal (FAST), Home Depot (HD), Johnson & Johnson (JNJ), Kimberly-Clark (KMB), Lockheed Martin (LMT), McDonald's (MCD), Altria (MO), NextEra Energy (NEE), Texas Instruments (TXN), and Verizon (VZ). Table-3: Author The average yield from this group of 15 stocks is reasonable at 3.56% compared to 1.4% from S&P 500. If you still have some years before retirement, reinvesting the dividends for a few years would take the yield on cost up to 4% easily. Chart-4: Author Note: For performance analysis, ABBV was replaced with its parent co. ABT, prior to the year 2013 (prior to spinoff). Bucket-3: CEF High Income Bucket Earning a high enough income while preserving the capital and getting a decent total return has been a challenge for much of the last decade. Anything high yield tends to be high risk. Interest rates have been low since 2008, and even though the Fed is slated to increase over the next two years, rates are still likely to remain low in comparison to the historical norms. In fact, the fear is that Fed is behind the curve, and they might overshoot and cause a recession. For high income, one has to essentially look at investment vehicles like REITs (Real Estate Investment Trusts), mREITs, BDCs (Business Development Companies), MLPs (Master Limited Partnerships), and CEFs (Closed-End Funds). Investors should recognize that this is a relatively high-risk bucket. Some of these securities use leverage to generate high income. Leverage works both ways, and in times of panic or recessions, these securities tend to lose more than the broader market. So, we will caution not to over-invest in them. We recommend up to 25% exposure to this bucket. For this income bucket, we need to be highly selective and choose the best of the best funds in each of the respective asset classes. Also, one should consider this part of the portfolio as a sort of \"annuity\" subset of the overall portfolio. However, we believe they are much better in many aspects compared to annuities. We present here a set of 11 high-income investment funds; most of them are CEFs. However, one of them is an individual stock (Enterprise Products Partners (EPD)), being a partnership. Please be aware that a partnership usually issues a K-1 form (partnership income) at tax time instead of dividend income. Below are some of the best funds within each asset class. The average yield of the portfolio presented below is roughly 8.5%. The funds/securities that we would consider in a long-term portfolio would be: (CHI), (UTF), (UTG), (PDI), (BBN), (FFC), (BST), (THW), (EPD), (USA), and (RQI). Table-4: Author Chart-5: Note: For performance analysis, a couple of funds did not have a history prior to 2013, so they were suitably replaced for the prior period. Concluding Thoughts The market is obviously going through an uncertain period. No one can be sure if the current bout of correction is just a brief hurdle in the path of the continued bull-run or if we are on the cusp of the next bear market. Both camps (bull or bear) can provide very convincing arguments in support of their convictions. However, as long-term investors, we have a different approach to facing uncertainties in the market. We have presented above a diverse investing approach with three baskets, which would provide lower volatility, an extra layer of safety, and diversification. Above all, the combined portfolio should generate a very decent income of 5% and provide protection from bigger drawdowns. We may like to caution that the approach outlined above may not be appropriate for everyone. These strategies require a long-term investment horizon, discipline, some time, and effort on a monthly basis, especially in managing the Rotational part of the portfolio. Also, the Rotational strategies work best within a tax-deferred account. The main idea of this series of articles is to get the readers to think and explore a multi-basket investment approach. However, we strongly believe that the extra work is worth the time and effort if we could sleep well at night with an assurance that our portfolio would match or exceed the broader market over the long term, with low volatility and minimal drawdowns that are tolerable.","kind":"news","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[{"id":9034733174,"gmtCreate":1647961204226,"gmtModify":1676534285483,"author":{"id":"4090381790893340","authorId":"4090381790893340","name":"StarGalaxy","avatar":"https://static.tigerbbs.com/49916fa198da24e2605abf24a28d23d2","vip":1,"crmLevel":3,"crmLevelSwitch":0,"idStr":"4090381790893340","authorIdStr":"4090381790893340"},"htmlText":"Ok","listText":"Ok","text":"Ok","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":0,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9034733174","repostId":2220709798,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"},{"id":9035725748,"gmtCreate":1647697254590,"gmtModify":1676534259064,"author":{"id":"3581842076108699","authorId":"3581842076108699","name":"小小只样","avatar":"https://static.tigerbbs.com/c7f90d0dc72cf5dbd2ac5c13542c4c87","vip":1,"crmLevel":2,"crmLevelSwitch":0,"idStr":"3581842076108699","authorIdStr":"3581842076108699"},"htmlText":"[Miser]&nbsp;","listText":"[Miser]&nbsp;","text":"[Miser]","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":2,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9035725748","repostId":2220709798,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"}],"hasMoreComments":true,"newsSizeData":{"likeSize":8,"commentSize":2,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false}}