This Python Jupyter notebook explores investment portfolios that have decent return (approximately 8 percent on average over the last ten years) and lower risk than the overall stock market.
If you are fortunate to have some cash available for investment you have to decide how to invest this cash (not making an explicit investment decision is a decision).
The US stock market, over the long term, has yielded good returns. Unfortunately it is an inescapable fact that risk and return are related. The returns provided by the stock market come with the risk of losses in your investment portfolio, at least in the short to medium term. At the time this notebook was written (November 2021) the stock market had dramatic returns after a COVID-19 inspired market crash. In such a time it is important to remember that there have been many periods where "the market" has had substantial downturns and low returns.
As any good financial adviser will tell you, your investment strategy should depend on your stage in life. Is retirement decades away, close or are you retired?
If your retirement is decades away, one of the simplest ways to achieve good investment returns is "dollar cost averaging" where you invest a certain amount every month in one or more low fee market index funds or ETFs.
When there is a market downturn your share purchase cost will be lower resulting in gains when the market recovers. Many people take advantage of dollar cost averaging by allocating a fraction of their salary for investment in their employer's 401K retirement plan.
If you are at or near retirement age then the inevitable market downturns are much less acceptable since you will not be able to take advantage of market cycles that could last for years.
This notebook explores conservative investment portfolios that have lower risk and lower correlation with the stock market (a.k.a., lower market beta). These are portfolios that may be appropriate for people who are retired or near retirement.
The portfolio that originally inspired this notebook is based on the Bridgewater Associates "All Weather" portfolio proposed by Bridgewater founder Ray Dalio. This portfolio is discussed in a Bridgewater promotional white paper The All Weather Story From the white paper:
What the average person needs is a good, reliable asset allocation they can hold for the long-run. Bridgewater’s answer is All Weather, the result of three decades of learning how to invest in the face of uncertainty.
The results in this notebook show that, in the last ten years (from 2021) the performance a portfolio that is similar to the Bridgewater "all weather" portfolio is no better than a simple 40 percent stock, 60 percent bond portfolio that is often recommended for those at or near retirement. This notebook shows a portfolio consisting of just two ETFs VTI (40%) and SCHP (60%) has less volatility than the "all weather" portfolio with returns that are only slightly lower.
The 40% market/60% bond mix is difficult to beat when it comes to risk and return. A number of dividend assets are examined in this notebook in an attempt to find a portfolio with higher return at a similar risk level. This search was not successful.
The classic conservative investment portfolio often consists of approximately 40 percent stocks (perhaps a mix of stock ETFs) and 60 percent bonds (perhaps a US Treasury bond ETF). This type of portfolio is discussed in the All Weather Portfolio notebook.
The portfolios investigated in the All Weather Portfolio notebook have an annual return, on average, of approximately nine percent. These returns are highly volatile from year to year.
In an era of low interest rates (December 2021), with a possible interest rate increases in the future, an investment portfolio that consists mostly of bonds has interest rate risk.
When interest rates rise, the value of current bond holdings decrease as the bonds are discounted for the higher prevailing interest rate. The return paid by ETF bond funds at the time this was written were around 3 percent. This level of return does not compensate for the interest rate risk carried by a significant position in bonds.
Considering the interest rate risk of a 40 percent stock/60 percent bond portfolio, such portfolio is not, in fact, a conservative investment.
With the 2008 financial crisis and the COVID-19 pandemic, governments in the United States, Europe and Japan have embarked on fiscal policies that are referred to as "quantitative easing". This has resulted in interest rates that have been near zero. This has made many bond investments unattractive, causing huge investment flows into stock market.
The result is a stock market with high valuations and less room for growth, especially if interest rates rise.
The P/E ratio is a classic measure of any security's value, indicating how many years of profits (at the current rate) it takes to recoup an investment in the stock. The current S&P500 10-year P/E Ratio is 37.5. This is 89% above the modern-era market average of 19.6, putting the current P/E 2.3 standard deviations above the modern-era average. This suggests that the market is Strongly Overvalued.
https://www.currentmarketvaluation.com/models/price-earnings.php
An alternative to the classic 40/60 stock/bond portfolio is a portfolio of dividend assets. A diversified portfolio that returns approximately 7% from dividends should have lower volatility, compared to a 40/60 stock/bond portfolio. The focus of a dividend portfolio is not capital appreciate of the assets (as would be the case with a stock portfolio), but dividend yield.
A dividend portfolio does have stock market risk, since all of the assets are either stocks, ETFs are closed-end funds. A market crash or downturn will have an effect on the face vaue of the portfolio. The face value of the portfolio is only an issue if the assets are sold. If the dividend portfolio continues to provide an attractive yield, it would be held in the long term. The face value of the portfolio could be expected to recover over time from a downturn.