engineered portfolio

We have all been beaten over the head about portfolio diversification and its benefits.  Don’t put all your eggs in one basket is probably the most widely known and respected colloquialism of the investing public.  Like the vast majority of people I fully buy into the benefits afforded by the diversification commandment.  However, as an engineer I don’t just accept things blindly, especially in the face of data.

With all of the great work my partner Steve has been doing around different investment strategies and unique portfolio construction I’ve found myself in an interesting predicament.  Which of these approaches and strategies do I embrace?  I’ve always had a rock solid resolve with my investments.  Every book I’ve read and advice I’ve been given has been to pick an approach and stick with it.  I have had a diversified portfolio of different asset classes that is age and risk appropriate for me, I use low cost index funds, I rebalance regularly and I hold through thick and thin.  Prudent.  Most would say I’m a pretty damn smart person for investing like that.

Heresy Time

I’m starting to wonder if my prudence is still prudent.  Has group think set in to the point where all of our individual baskets are inside of one massive basket?  By the nature of logic it will be impossible for the sound investment approach stated above to continue to outperform as well as it has in the past.  Think about it, when Jack Bogle first released index funds to the world in the 1970’s the cost of investing via other means was very expensive.  Anyone that embraced index funds early on saw a large out performance.  However, once we all herd into the index fund basket it literally becomes impossible to out outperform…..because we all have the same performance.  Similar with diversification and rebalancing, if we are all doing the same thing it is impossible to outperform.  Now you might accurately argue that someone may not outperform, but that does not mean you will perform poorly.  A good point!  At the end of the day Mr. Bogle’s biggest gift to the world was to pry away money from the professional investment community and put it in your pocket instead, thanks Jack!  I think it is very likely that following a traditional/prudent investment strategy will lead to positive results…just not out performance like it did in the past.

Here at engineeredportfolio.com we look for ways to outperform.  That has led us to create some unique portfolios (South African and Sweden stocks!!) and to investigate interesting investment strategies such as accelerating dual momentum  (ADM).  In addition to the work we have done there are endless other approaches to choose from: robo advisors, target date funds, global equities momentum (GEM), all weather, absolute return, cypto, alpha this, beta that….you get the idea.  On top of all of this there are tax considerations.  Some of these strategies are much better suited to tax advantaged accounts like 401(k)’s and IRA’s.  And lastly there are behavioral issues to consider, will the investment strategy you choose “agree” with you or will you constantly be changing or constantly stressed by how it performs?

Which One to Choose?

The obvious answer of which investment strategy to choose is simple.  Choose the one that will outperform all others!  Even though we embrace our naivete (a little is needed for innovation sometimes) here at engineeeredportfolio.com we are not so full of ourselves to think that we KNOW our strategies will outperform in the future.  However, we also know that if we want to outperform we can’t just be a lemming.  We have to do something different if there is to even  be a chance of out performance.  The ying to that yang is that we also want to be prudent investors and both grow AND protect our capital.  And finally we have arrived at the crux of the matter…strategy diversification.

Goals and Requirements

My goal is to outperform a simple risk appropriate re-balanced diversified portfolio of stocks and bonds, aka a low cost target date fund.  Side note:  If you are already falling asleep reading this and you have little to no interest in investing there is absolutely nothing wrong with going with a LOW COST target date INDEX fund and calling it day.  It is simple and easy.  At the moment I would recommend Schwab’s target date INDEX funds (make sure you get the INDEX ones, they have actively managed ones that are much more expensive).  Vanguard’s target date funds are also good.

The requirements for my strategy diversification will be to minimize taxes, minimize fees, have at least three strategies, have no more than 50% of my total balance in one strategy at a given time, leverage my behavioral strengths, manage my behavioral weaknesses, require less than two hours a month to manage and be spread across different financial institutions with SIPC insurance to best protect my capital.

The Strategies

After a lot of careful thought and reflection on the requirements, specifically the behavioral elements, I decided on the following four strategies:  accelerating dual momentum  (ADM), Ray Dalio and Bridgewater’s All Weather, buy and hold life cycle fund and a mad money component.  The mad money component effectively says I can do whatever I want, individual stocks, crypto, alternative assets, etc.  I’ll also keep a cash position to systematically deploy for opportunistic buying opportunities.  I feel comfortable with all of these strategies and would be able and willing to have 100% of my assets invested in any of them…ok maybe not 100% in the mad money one!  That being said I’m not certain which will outperform (though I have my opinion!) and I like that all four compliment each other well.  ADM will periodically but systematically adjusting to the market momentum, scratching my behavioral itch to “do something” when the tide is turning.  All weather is effectively a buy and hold portfolio but with some uncorrelated asset classes, such as gold and commodities, that are not present in the other strategies.  I like that it should perform reasonably well in any economic environment and will help me sleep at night.  Buy and hold with life cycle funds will adjust to safer assets as I age, slowly shifting my overall portfolio to a lower risk profile over time.  Again, helping me sleep!  And lastly the mad money portion will allow me 100% flexibility with a small portion of my assets to both scratch the “do something” itch and give me some real time control and influence over my investments.  I find investing challenging and fun, so it provides me the opportunity to enjoy investing a bit while also protecting my other strategies from feeling the wrath of my “need to do something” tendencies.

The Mix – Strategy Allocation

To be clear I went with 100% gut on the allocation to each of these strategies.  I wish I could tell you I spent hours and hours pouring over data and back testing this…..but I did not.  I built this on how I thought I would behaviorally react to various market conditions and came up with the following allocation:

I think the allowable ranges are key to strategy diversification because it allows for a specific strategy to run for a while before you would be forced to trim it.  It also supports my requirement of spending less than two hours a month managing my investments.  If the ranges were too tight there would be a lot of adjusting, which could also have tax implications (more on that later).

It’s important to point out that what I’ve shown above is MY strategy allocation that I designed for my personal situation and preferences.  We all have different needs and behavioral tendencies.  You’ll need to figure out what is the right balance for you.  The only thing I might suggest that should be universal is that you not put more than 50% of your assets in a single strategy.  Yep, I’ll say it….don’t put too many eggs in one basket!

Release the Cash

The cash portion of the portfolio serves a few purposes.  First, it forces a mechanism to “take a little off the top” when one or more of the strategies are performing well.  No one ever got hurt taking a profit!  Second, it provides firepower to take advantage of a significant market downturn that hurt one or more of the strategies.  I personally find from the behavioral side that I’m much more relaxed, even excited about market volatility knowing I have cash ready to deploy.  Lastly, in the event something comes up in life where I have a major expense it provides a resource that would not require selling my investments, which may have some bad tax consequences.

I have a pretty simple rule based plan for deploying my cash which you can see below.

Basically when the market as measured by the S&P 500 is down 30% I’m all in with no cash remaining.  A good question you may ask is which strategy would I deploy the cash to?  That leads us to the next part of the plan which is using a “buy to rebalance” approach.

Buy to Rebalance

Rebalancing your overall portfolio when one strategy drops below or exceeds your target range is a good idea.  It provides a rule based mechanism to sell high and buy low.  However, depending on the account you are using to hold the investments you are selling this can lead to some negative tax consequences.  For this reason my preferred method of rebalancing is to BUY to rebalance.  This is a pretty simple concept.  In the cash deployment scenario above you would simply use that cash to buy the strategy that was under performing relative to the others, or spread around the cash to get all strategies to their target allocation.  For those that are still working and earning and income hopefully you are consistently socking away some of your income into savings.  Buying to rebalance just means putting that money into the strategy that is currently under performing relative to your target allocation.  In this way you are constantly working towards your target allocations without having to ever sell investments and creating a taxable event.

Taxes

As noted above, the first step in managing taxes is to not sell your investments.  Using the “buy to rebalance” approach can help with this, but sometimes selling is unavoidable.  The ADM strategy in particular requires selling of investments in order for it to work.  For strategies that require selling, my recommendation is to run those strategies in tax advantaged accounts like 401k’s and IRA’s.  For strategies that are sedentary, like the buy and hold index fund strategy, you can have those in taxable accounts as you will only get a tax bill for the small dividend they pay.  I actually struggled with this quite a bit when I started.  I was actively “trading” in my retirement accounts and my taxable accounts were boring life cycle funds.  But that is what makes the most sense from a tax perspective so that is what I do.  For me at the moment all of my ADM is in my 401k account and I use my 401k and IRA’s for my mad money accounts.  I have the all weather and buy and hold strategies in taxable accounts.  That seems like a lot of accounts you might say….which leads us to the next part.

Account Diversification

There is a couple of reasons to have various accounts with different institutions.  First, for most investing firms the US government provides up to $500,000 of protection per account.  This is called SIPC insurance and acts similar to FDIC insurance for a bank account.  By spreading out your investments across different accounts you can increase your effective insurance.  You also spread out any risk you might have with a single financial institution running into trouble or getting hacked, etc.  Second, I find it much easier and cleaner to manage and monitor when having one strategy (sometimes two in the case of my 401k) per account.  I use and recommend Personal Capital for monitoring my investments and having one strategy per account makes it very simple to see how things are doing.

In Conclusion

If you want to outperform (its ok if you don’t) you need to do something different than the crowd.  There are a host of investment strategies out in the world to choose from.  If you try to outperform using some different strategies we recommend you practice strategy diversification in order to…wait for it…..not put too many eggs in one basket!