I hope everyone had a chance to enjoy the holidays and spend time with family! I wish you a pleasant and prosperous new year.

I was preparing for my typical review of forecasts for the coming year and read an interesting discussion about allocation strategies on the MFO Discussion Board and redirected my efforts. The discussions centered around investment and withdrawal strategies. In this article, I will create three base cases compared to the S&P500 using Portfolio Visualizer in response to the comments. I add context using secular and business cycles for the last ninety-five years. I look briefly at life expectancies. I reviewed my own investment system for setting allocations and closed with a review of trending Lipper Categories using the Mutual Fund Observer MultiScreen Tool.

This article is divided into the following sections:

• • Section 1, Summary of Comments on MFO Discussion Board
  • Section 2, Life Expectancy
  • Section 3, Creating Three Base Cases for the Past 37 Years
  • Section 4, Review of 95 Years of Stock and Bond Performance
  • Section 5, Current Market Conditions and 2024 Outlook
  • Section 6, My Allocation Strategy
  • Section 7, Trending Lipper Categories and Funds

SUMMARY OF COMMENTS ON MFO DISCUSSION BOARD

The discussion on the MFO Discussion Board about allocation strategies mostly in retirement is New Report: All Stock Portfolio Beats Stock and Bond Mix Over Time. I summarize some of the concepts that were in the Discussion by Category and ranked by my preference:

• ALLOCATION TO STOCKS
  • Glide path of owning more stocks in the accumulation stage and being more balanced in the retirement stage.
  • Guaranteed income (Pensions, Social Security) allows one to take more investment risk.
  • Yields are high for allocations to bonds should be higher.
  • Equity valuations are high so allocations should be tilted to bonds.
  • Warren Buffet’s allocation of 90% stock (for the wealthy).
  • Investors may be better off investing in half domestic and half international stocks than in a 60/40 stock-to-bond portfolio.
• WITHDRAWAL STRATEGY
  • Starting withdrawals conservatively and then ramping up later.
  • Basing withdrawal on spending needs.
  • Having higher allocations to stocks and a higher withdrawal rate.
• MANAGING RISK
  • Having enough saved for retirement and basing risk on savings.
  • Sequence of return risk.
    • Using buffer assets like cash, a reverse mortgage or whole life policy with cash value.
    • Spend conservatively.
    • Be flexible with spending during market fluctuations.
    • Glide path of being conservative initially in retirement and increasing allocations later in retirement.
  • Annuitizing part of a portfolio to create guaranteed income.
  • The risk of being too conservative.

LIFE EXPECTANCY

Key Point: Data showing returns for the past century or more is irrelevant when our investing time horizon is only a fraction of that. We should prepare for maximum life expectancy rather than average life expectancy.

The life expectancy for women at birth is about 79 years. Figure #3 shows how life expectancy changes with age. There is roughly a 32% chance that a 60 year-old-woman will live to age 90. A woman who has lived to age 80 has roughly 45% of living to age 90. We should prepare for maximum life expectancy rather than average life expectancy in order to not outlive our savings.

Figure #3: Life Expectancy at Ages 60, 70, 80, and 90 (Labels = Age)

Source: Author

CREATING THREE BASE CASES FOR THE PAST 37 YEARS

Key Point: Manage Risk First – Always maintain several years of living expenses in safe investments. This along with guaranteed income, amount of savings, risk tolerance, and long-term market outlook are the main inputs into setting an allocation strategy in retirement. I use a Financial Planner and advocate most people should start using one early in the accumulation stage.

All-Equity Portfolio Beats Bonds In Retirement Plans, New Research Finds describes a study that found across a sample of three dozen countries over 130 years was that a mix of half domestic, half international equities actually beat blended portfolios in both money made and capital preserved. My investing horizon is significantly less than 130 years during which two world wars occurred so I don’t put any relevance into these studies, valid as they may be.

Portfolio Visualizer can be used to find the best-performing strategies from 1985 to 2023. I created three strategies for comparison with the S&P 500. The link to the Portfolio Visualizer Backtest is here. The strategies are 1) 100% US stock (VFINX), 2) 50% US stock (VFINX) and 50% International Stock (VTRIX), 2) 70% US Stock (VFINX) and 30% Bonds (VBMFX), and 3) 50% US stock (VFINX), 25% International Stock (VTRIX), and 25% Bonds (VBMFX). I assumed a 6% annual withdrawal rate.

The results for the thirty-seven-year period are that investing 100% in the S&P 500 had the highest return, but also a maximum drawdown of 68% including a 6% withdrawal rate. The second-best performing strategy is the 70% US Stock (VFINX) and 30% Bonds (VBMFX) portfolio which also had the highest Sortino Ratio or risk-adjusted return. The portfolios are rebalanced annually.

Table #1: Base Cases for Past 37 Years Using Portfolio Visualizer

Source: Author Using Portfolio Visualizer

Figure #1 shows the strategies adjusted for inflation. All four strategies held up well against inflation but only the 100% SP500 strategy beat inflation while 70% stock/30% bond portfolio came close.

Figure #1: Base Cases Portfolio Growth for Past 37 Years Using Portfolio Visualizer

Source: Author Using Portfolio Visualizer

Figure #2 shows annual withdrawals on a nominal basis without inflation adjustments. Overall, the withdrawals would have kept up with inflation, but withdrawals in 2008 would not have kept up a steady stream of inflation-adjusted returns. One alternative withdrawal strategy would be to withdraw less in the years with high returns and reinvest the excess returns. A second approach could be a bucket approach where you withdraw from safer investments in the bad times instead of rebalancing annually.

Figure #2: Nominal Annual Withdrawal for Past 37 Years Using Portfolio Visualizer

Source: Author Using Portfolio Visualizer

While a strategy of withdrawing 6% during the past 37 years would have worked comfortably, the past decade has experienced unprecedented monetary stimulus which has inflated many assets. Valuations and inflation are major factors in determining future returns. The maximum withdrawal rate may depend upon spending needs and desires to pass along an inheritance, but the time-tested 4% withdrawal rate is a fairly safe assumption for historical market conditions.

REVIEW OF 95 YEARS OF STOCK AND BOND PERFORMANCE

Key Point: Secular markets can suppress returns for decades. Stocks and bonds usually move in opposite directions reducing sequence of return risk.

For this section, I rely on data provided by Aswath Damodaran at the Stern School of Business at New York University. Since 1928, stocks have returned 9.6% compared to a respectable 6.7% for corporate bonds. Stocks have returned 10.5% since 1987 used in the Portfolio Visualizer example above.

Table #2: Historical Returns Source: Aswath Damodaran at the Stern School of Business at New York University

Source: Aswath Damodaran at the Stern School of Business at New York University

Table #3 shows secular returns. The time period from 1928 to 1962 covered the Depression, World War II, and end of the war over which time stocks returned 8.7%. The next time period, 1962 – 1982 was defined by stagflation with slow growth and high inflation from which stocks only returned 2.1% on an inflation-adjusted basis. The Great Moderation was from 1983 to the mid-2000s, and stocks grew at 12.6% with relatively low inflation. During three of the time periods, on average stocks would have supported a 6% withdrawal rate, however, within each of these periods, a sustained drawdown of more than forty percent posed serious risks.

Table #3: Historical Returns by Secular Markets

Source: Author Using Data from Aswath Damodaran at the Stern School of Business at New York University; Inflation Adjusted Data from DQYDJ; Drawdown from James Picerno at Seeking Alpha

Table #4 contains a more detailed breakdown of time periods. It shows that there are three time periods in which stocks do not outperform bonds and one in which they are about the same. One of the important characteristics of bonds is that their value typically moves in the opposite direction of stocks. One can withdraw from stocks when they outperform and draw from bonds when they outperform.

Table #4: Historical Returns by Notable Market Conditions

Source: Author Using Portfolio Visualizer

To illustrate the benefits of having a balanced portfolio, from 1999 until 2020, the conservative Vanguard Wellesley (VWINX) and moderate Vanguard Wellington (VWELX) have beaten the S&P 500. This illustrates the importance of starting and ending points – sequence of return risk. A high allocation of stocks in 1999 could have impacted savings for the remainder of retirement.

Figure #4: Example 1998 – 2022 Vanguard Wellesley, Wellington, S&P 500

Source: Author Using Portfolio Visualizer

The coming decade is likely to have stock returns below historical trends. Valuations are currently moderately high as I described last month. Nearly 40% of revenues of the S&P 500 come from other countries, and trends of deglobalization will negatively impact some industries and tend to increase inflation. Population growth is slowing which suggests slower economic growth. High debts and deficits suggest interest rates will remain higher for longer. Unwinding Quantitative Easing will probably dampen asset prices. I favor a balanced portfolio that is diversified globally and tilted toward quality bonds.

CURRENT MARKET CONDITIONS AND 2024 OUTLOOK

Talk of a soft landing is still wishful thinking with the yield curve still inverted. Few investors recognized that extreme valuations were wishful thinking prior to the bursting of the technology bubble in 1999 or recognized the danger of “safe” tranches of subprime loans prior to the bursting of the housing bubble. Still, I like to review respectable outlooks for the coming year but put more emphasis on my own nowcast in the next section.

Vanguard released its Economic And Market Outlook For 2024, “Vanguard anticipates that the United States and other developed markets will grapple with mild recessions in coming quarters and that central banks will cut interest rates, likely in the second half of 2024, amid growth challenges and inflation falling toward the banks’ targets.” They also expect higher real interest rates for longer.

Wells Fargo’s December 2023 Outlook includes a mild recession. “…the specifics on whether or not we actually pull off the soft landing or have a mild recession is sort of less important than the fact that it’s just kind of going to be a crummy year.” Senior Economist Tim Quinlan adds that the consumer is holding up the economy but conditions are not as supportive.

Fidelity’s 2024 Outlook is that we have been in a late-cycle business expansion which is supported by a stronger consumer, improving corporate earnings, and easing inflation. They are seeing signs of moderating growth and may see slowly rising delinquencies for auto loans and credit card payments. The Fidelity fixed income managed account team has a base case that we may experience some type of mild recession, or at least a slowdown in growth, over the coming year. The corporate bond market is not pricing in a recession. They believe longer-term fixed income may be an option worth considering.

From my perspective of the economy, USA Facts is an interesting source of unbiased information. In 2021, the average middle-class family earned $59,600 and paid $18,800 in taxes. I think it is important to look at median statistics more so than just averages. The median wage in 2022 was $46,367, down 7% from 2021 when accounting for inflation. Poverty increased to 11.6% of the population in 2021. Over half of US renters and 22% of homeowners spent more than 30% of their income on housing in 2021. Food insecurity affected 1 in 10 households, and 41 million people received SNAP benefits each month of 2022, with an average benefit of $230.39 per recipient. To which, I add that pandemic-era stimulus is expiring.

According to the Associated Press, “The United States experienced a dramatic 12% increase in homelessness to its highest reported level as soaring rents and a decline in coronavirus pandemic assistance combined to put housing out of reach for more Americans.” The number 7 top article from USAFacts’ 10 most-read articles of 2023 is “How many homeless people are in the US? What does the data miss?” The Department of Housing and Urban Development (HUD) counted around 582,000 Americans experiencing homelessness in 2022.

MY ALLOCATION STRATEGY

I built my Investment Model based upon the principles discussed in the following books: Nowcasting the Business Cycle by James Picerno, Conquering the Divide by Cornehlsen and Carr, Investing with the Trend by Gregory L. Morris, Ahead of the Curve by Joseph H. Ellis, Probable Outcomes by Ed Easterling, The Era of Uncertainty by Francois Trahan and Katerine Krantz, The Research Driven Investor by Timothy Hayes, Beating the Market 3 Months at a Time by Gerald Appel and Marvin Appel and Morris, and Business Statistics for Competitive Advantage with Excel, (2019) by Cynthia Fraser, among others. I used over a hundred indicators most of which can be downloaded from the Federal Reserve Bank of St. Louis FRED Database that have a high correlation to the stock market six months into the future. I added other indicators that look for secular trends such as valuations and monetary policy.

I built my Investment Model shown in Figure #5 to optimize returns by varying allocations to reflect economic, financial, and market conditions. The model is intended to adjust slowly to market conditions and not to be used for frequent market timing. It works most efficiently with tax advantaged accounts. Minimum and Maximum allocations to stock are variables. Using a minimum allocation to stock of 35% and a maximum of 65% results in an average annual return of 9.0% with an average allocation to stock of 58%. It beat the S&P 500 until 2020 when massive stimulus inflated asset values.

Figure #5: Author’s Investment Model, Stock Allocation >= 35% <=65%

Source: Author

Increasing the minimum allocation to stock to 65% and maximum allocation to 80% does not improve returns significantly because it does not allow sufficient switching between asset classes to reduce allocations to stocks when recession risk is high and to fixed income when yields are high.

Figure #6: Author’s Investment Model, Stock Allocation >= 65% <=85%

Source: Author

Following the guidelines of Warren Buffet’s mentor, Benjamin Graham, of never investing less than 25% to stocks nor more than 75% increases returns to the same as an all-stock portfolio for the past 37 years.

Figure #7: Author’s Investment Model, Stock Allocation >= 25% <=75%

Source: Author

I built the core of the investment model during 2015 to 2017. I was overly conservative during COVID because I did not know how well the model would perform. In hindsight, I would have been better off following it. I use a narrower allocation to stocks than Benjamin Graham’s to take into account the psychological impact of the unknowns.

TRENDING LIPPER CATEGORIES AND FUNDS

Table #5 contains the top-performing Lipper Categories for the 635 funds that I currently track. I built a rating system based on momentum and money flow to measure what Lipper Categories and funds are trending with investor support. The first group of funds is short-term, quality fixed income. The Ulcer Index measures the depth and duration of drawdowns over the past two years, while the Martin Ratio measures the risk-adjusted performance over the past two years. The second group is the one that interests me the most and consists mostly of fixed-income funds with intermediate durations. Notice that Global and International funds are included.

Table #5: Trending Lipper Categories – Ulcer & Martin Stats – Two Years

Source: Author Using Mutual Fund Observer

CLOSING THOUGHTS

With the evolution of tax laws and savings incentives, like many investors, I own traditional and Roth IRAs and tax-managed accounts for a two-income household. Pensions and Social Security Benefits largely insulate us from market downturns. We follow the bucket approach with two to three years of living expenses in Bucket #1 (tax-efficient municipal money markets and bonds). I believe in both the Vanguard long-term strategy and the Fidelity Business Cycle strategies to investing and use both to manage accounts in Bucket #3 (more risk in Roth IRAs where taxes have been paid) for long-term investments. I use Bucket #2 to adjust to my view of the investment environment. My current allocation is just over 40% to domestic and international stocks and over 40% to intermediate bond funds and ladders. The rest is mostly in ladders of short-term fixed-income and money markets. As these mature, I will decide whether I want to increase my allocation to stocks or bonds with a preference for diversifying internationally.

With regard to the Discussion in the first section, in my opinion, there are three groups that benefit from higher allocations to stocks: 1) those in the accumulation stage with a long-time horizon; 2) those with guaranteed income to cover expenses; and 3) the wealthy with enough in short-term savings that they can withstand more volatility. For the majority of people, the bucket approach, controlling spending, and variable withdrawal rates are appropriate.

For most investors, I advise consulting with a Financial Planner. In the MFO June 2023 newsletter, Helping a Friend Get Started with Financial Planning, I described helping a friend select a Financial Planner. She interviewed one from both Fidelity and Vanguard and is finalizing her selection. I assisted her in setting up a self-directed low-risk, tax-efficient brokerage account investing mostly in municipal bond funds of varying durations. She has benefited well from falling rates.

James Mackintosh, who has always been adamantly skeptical of ESG/SRI/green investing (though less loudly opposed to anti-woke/red investing, perhaps because it’s so marginal), offered a nice analysis (“Green Investors Were Crushed. Now It’s Time to Make Money,” WSJ.com, 12/5/2023) of the declining popularity of ESG investing in 2023 and the challenges facing certain green energy firms.

“Invest according to your political views,” he begins, “and you’re unlikely to make money.”

“[T]he real world is tougher than advocates of ESG—environmental, social and governance—investing claimed,” he huffed.

It’s “The Big Green Misery Machine,” they warn.

(sigh)

One might point out that ESG investing isn’t merely a political gesture. The “G” in ESG, measuring effective corporate governance, especially, is predictive of corporate performance, but he’s never been interested in nuance.

His case highlights the stock price declines of four small “green energy” firms:

One might point out that “green energy firms” are not the core of an ESG-screened portfolio, though they might indeed be included in it. The largest holdings in the ESG-screened version of the S&P 500: Microsoft, Apple, Amazon, Invidia, Alphabet, Tesla, UnitedHealth Group, JPMorgan Chase, and Eli Lily.

Here are two more important things to point out.

2024 will be better for ESG funds than was 2023

The point that makes me less irked with him is “investors who bought green stocks probably didn’t think they were making a leveraged bet on Treasuries, but that is what they ended up with.” He argues that rising interest rates impact renewable energy stocks (for which he uses the synonym “green stocks”) in two ways. First, renewable energy projects are 80% debt-funded, and debt is increasingly expensive and hard to acquire. Second, consumers making personal investments in “green” products – heat pumps, solar, electric cars – also use debt, whether credit cards, HELOCs, or second mortgages, to finance them. Higher borrowing costs led to lower demand for those products.

High costs shift people’s attention from the long-term – the need for renewables and global heating – to the short term – the need to cover the bill.

He also argues that much, though not all, of the “greenium” has been squeezed out of the market. Valuations on renewables are way down if not deeply discounted. That makes them more economically rational purchases now than they were two years ago.

In addition, interest rates are likelier to fall than to rise in 2024. Those skilled at examining the Fed’s entrails anticipate three rate cuts of some magnitude, likely starting around mid-year. That’s complemented by a potentially game-changing Treasury Department ruling: profitable green firms can now sell tax credits that they’ve received to other corporations to raise money. The first such sale was just closed by First Solar:

In what both sides are calling the first significant credit transfer of its kind in the solar manufacturing industry, First Solar announced that it entered into two separate Tax Credit Transfer Agreements (TCTAs) in late December to sell $500 million and up to $200 million, respectively, of 2023 Inflation Reduction Act (IRA) Advanced Manufacturing Production tax credits to Fiserv, a financial services company.

The Treasury proposed regulations intending to incentivize the production of eligible components within the United States. Qualifying materials include solar and wind energy components, inverters, some battery parts, and applicable critical minerals.

“This is the IRA delivering on its intent, which is to incentivize high-value domestic manufacturing by providing manufacturers with the liquidity they need to reinvest in growth and innovation,” said Mark Widmar, CEO of First Solar. “This agreement establishes an important precedent for the solar industry, confirming the marketability and value of Advanced Manufacturing Production tax credits.” (Renewable Energy World, 1/5/2024)

The short version is that these credits give the manufacturers of solar, wind, inverters, batteries, and critical materials access to a new source of capital that is independent of traditional credit markets and not constrained by prevailing interest rates.

ESG-screened funds did better in 2023 than their non-ESG counterparts.

While investors (and several Red state governments) fled, ESG versions of the S&P 500 and the equal-weight S&P 500 continued their dominance over the non-screened siblings.

S&P Global themselves published this performance comparison, for the period ending 11/30/2023:

And it’s not just the S&P500. MFO Premium tracks 722 ESG sorts of funds and ETFs. In 2023, 370 of them outperformed their peer groups. More than half of ESG funds outperformed their peers even when conditions turned against them.

Thirty-six ESG funds and ETFs posted returns of 30% or more in 2023, including the two Shariah-screened ETF index funds.

Let’s be clear here: in the worst of times, ESG investing makes investment sense. ESG funds make serious money.

Bottom line

If Mr. Mackintosh is right, the future for ESG investing is far brighter than its recent past. Well-managed ESG funds that use screens intelligently, as a tool for eliminating financial disasters and not just for marketing purposes, are worthwhile additions to any portfolio.

That does not free individual investors from the responsibility of researching their funds carefully. Three years ago every damned marketer in the industry started running around with stickers reading “green” and “responsible” on every failed fund in the company. As it turns out, rotten funds with green stickers remain rotten funds and are dying off. At the same time, there are funds with serious, thoughtful strategies that have a long-term track record of using ESG screens to enhance performance (and, just maybe, doing a tiny bit of good in the process).

My sole green holding, which I’ve discussed in each of my annual portfolio disclosures, is Brown Advisory Sustainable Growth. It gained 38.8% in 2023 and has eked out 16% APR since I first bought it. Really, that does not feel like a “misery machine.” Which is to say, I’m not sure that Mr. Mackintosh’s analysis of ESG investing is quite so clear and profound as might be warranted by inclusion in the world’s premier business paper.

A winter walk around the Central Park Reservoir

My friend “W” and I have gotten into a good habit of taking an hour-long walk around the Central Park Reservoir every few months. An hour’s walk is a perfect amount of time when two people speak the same language, are willing to not pretend or live in a fantasy world, are willing to engage in a two-way honest communication, and then want to return to their lives.

W is one of the sharpest minds on Wall Street. For more than twenty years, he has been applying macroeconomic data and central bank policy to asset markets to triangulate the best tactical medium-term investment opportunities. 

Given everything we know, have lived, and learnt in the financial markets, our mutual quest is simple – how to become better investors of our own portfolios.

Everything is up for discussion. Active or Passive. Domestic or International. Index or Single Stocks. Stocks or Bonds. Short-dated bonds or long bonds. Options trading or no options.

Our most recent walk was in the middle of December, just a few weeks ago. Central Park can get crowded near the southern edge or near Bethesda Fountain. But in the north, especially around the bridle path surrounding the reservoir, tourists leave the locals alone on weekday mornings. The runners, walkers, and dogs are left to their own devices to enjoy the leafless Yoshino and Kwanzan cherry blossom trees which in due time will beautifully announce the arrival of spring.

Winter keeps us honest. With honesty in mind, we switch our talk to markets.

Taking stock of market returns for 2023 (and 2022): Tougher than it appears.

“You must be in a delightful mood with the recent rallies in stocks and bonds,” suggested W.

“I won’t lie,” I admit. “2023 is the kind of year where professionals have been burnt but those who had faith in asset markets, in diversification, and in keeping it simple, benefitted. I would not have predicted the stock market to bounce back as hard as it did, or the bond market to turn around the way it did. I didn’t make great calls. Passive investing worked in a way I hadn’t expected it to.”

I always try to outsmart markets, but with each year that goes by, I feel less smart. Having the discipline to be invested in assets through thick and thin has been the best self-help.

I add, “But it’s important to be honest. Any returns from 2023 must be seen in combination with 2022.”

I quote the numbers to the 3^rd week of December. An investor with $1,000 in a 60/40 portfolio, where 60 is the US Total Stock Market and 40 is the US Total Bond Market is up 17% this year. Sounds great until one looks at the combined 2-year return. The investor would have a net of $972.50 assuming quarterly rebalancing. That is, the investor is still not back to par.

A 40 Stocks / 60 Bonds portfolio, which would traditionally be seen as lower market risk, fared worse. $1000 in the beginning of 2022 would be $952.70 now, or down a cumulative 4.7% for the two years.

A portfolio that included more diversification, featuring international developed markets and emerging markets had the worst of the three portfolio results. An endowment-type model portfolio invested in public passive ETFs is down more than 10% for the two years combined. $1000 would be $897.

“It’s humbling. In the euphoria of 2023, we seem to have forgotten that most academic book corner portfolios are DOWN over a 2-year period,” I submit. I understand that most people are not religious about the percentage and mixes, but these are common numbers to use as a starting point.

“And that is before including any effects of inflation on money erosion,” adds W. “The 10% increase in the general level of prices in the 2-year period makes portfolio values that much worse.”

“No one wants to adjust their wealth for inflation,” I protest. “It’s just not done. Do you want me to lose all sense of self-respect as an investor?”

To this humility, we add one more factor – the impact of withdrawals. Assuming a 4% withdrawal rate per year, the nominal values of the $1000 portfolio for a 2-year period would be $906, $888, and $837 respectively.

The last 90 days feel like a vindication for the diversified, passive investor. But the two-year combined reality adjusting for nominal returns, inflation, and withdrawals reminds me of a proverb my grandma often used: Five notes of twenties don’t make a hundred. That is, just because you earned a hundred dollars doesn’t mean that you’ve got a hundred dollars of money to play with: groceries, taxes, mortgages, utilities, and doe-eyed children who’ve really got to have a new outfit for the school dance all eat away at it.

Digression: 40 years of investment wisdom from “MO”

A quick digression: It’s easy to rain on the parade of poor investment returns. I asked my friend MO, who has been retired for 40 years if the last two years have changed his mind. The answer was NO.

MO texted back, “Was just telling my grandson this morning that sticking to the same basic guidelines makes average investors like me look good: start as young as possible, stick to a certain asset allocation, have broad diversification, tax efficiencies, and low commissions (all of which you get with the S&P Total Market). Then sit back and enjoy the effects of compounding in an extraordinary 40-year bull market for stocks, bonds, and residential real estate. The previous 40 years were not as good as the last 40, so there is an element of luck involved.”

MO continued, “Big problem – young people have perhaps less wind on their back and this passive style of investing is boring, boring, boring, especially to young people.”

Warren Buffett might also weigh in here, as he did in his 2020 Shareholder Letter to Berkshire-Hathaway investors: “Despite some severe interruptions, our country’s economic progress has been breathtaking. Our unwavering conclusion: Never bet against America.”  Nothing I write can beat their guidance for long-term, faithful, investors. If we can digest the boredom and enjoy the years ahead, the work is done. No better fund or finding the next trade is needed.

For those who prefer more heartburn, continue reading ahead.

Bond investing: Hopes for sanity?

“Tell me, W, what are good reasons to continue being a diversified long-only investor,” I ask provocatively. “By October of this year, both stocks and bonds were looking ugly. Had the year ended in October, would we be calling the death of diversified portfolios.”

W takes me through the case for sanity. The last two years were different. COVID-related money printing or supply-side shocks created behaviors in employment and inflation which surprised the Federal Reserve (the Fed), which was behind the curve for a large part of the last two years. It had to catch up by getting ahead of the markets. And in doing so, it had to show hawkish credentials. This hurt bonds badly. When stocks tanked, bonds could not provide their traditional help and a 60/40 portfolio looked bad.

W continued, “But now, this Fed vol (a phrase to describe the volatility created by the actions of the Federal Reserve itself) should be in the past tense. Going forward, bonds can once again start reacting to economic growth and recession risks, as opposed to Fed mistakes. In such a case, if earnings decline and stocks go down, bonds can be helpful to the portfolio. Asset allocation and portfolio diversification benefits, which had temporarily been halted, have a greater chance of working.”

We stop to admire a London Planetree stripped to its bare bones and are glad to be spectators to the beauty of this giant at this time of the year. The tree is faultless in its structure. I still have many questions about US bonds, which don’t look as faultless to me.

I rebutted, “All year long we heard warnings from demonstrably smart guys. Howard Marks wrote Sea Change (December 2022) and Further Thoughts on Sea Change (October 2023), which holds that the good times in fixed income are done. Ray Dalio noted that the USA is getting to an “inflection point” (November 2023) where we become derailed because we are borrowing just to pay for our borrowed money; that is, fund interest payments on a quickly rising national debt. Robert Rubin argued in a Goldman Sachs exchange (October 2023) that the greatest risk is the lack of political will in Washington DC; that is, there aren’t enough adults left to do the hard, grown-up things we need. Jim Grant of the Grant’s Interest Rate Observer, in a Fortune interview (December 2023, with a paywall) that higher inflation is permanent and fumbling attempts to control it are compounded by lags and variable and uncertain impacts. Should we forget about all these warnings now and line up to buy bonds again?”

W is a balanced mind and less incendiary than me.

“If you have Biden, and he doesn’t do anything stupid, the propensity of the markets to digest US debt will be higher. But if you get a Trump comeback, there could be a problem. Also, there is an argument that the bond market from time to time gets too excited about the Fed cutting interest rates and the end of 2023 seems to be one of those moments with bonds being overly optimistic once again.”

W asks me if I have still been holding my 30-year TIPS. I share that I had to eat some humble pie.

“Most of 2022, I was in T-bills. That helped when US Treasuries went down last year. In the spring of 2023, I bought some NY Municipal bonds, which are no home run.”

Municipal bonds don’t make bond investors money. They provide tax-free income to those who care for such things. Residents in high state-tax jurisdictions might benefit from munis but one needs to pick them carefully with the help of a good bond broker.

“In December 2022, I purchased some long-dated TIPS when they were aggressively being sold. I was early and had some quick wins. But as the year progressed, the selloff in TIPS was greater than I was willing to digest. I rebalanced out of TIPS into three assets – short-term T-Bills, short duration high yield credit funds, and US Equities.

I didn’t expect the bond market to be as volatile and lost for anchors. When “portfolio hedges” trade this poorly, I realize I stretched myself too far. I am okay with nominal losses on stocks but don’t have the same sympathy for bonds. It’s something I need to think about more and fine-tune my expectations for the future.”

I pointed out that while we don’t know if Berkshire Hathaway bought bonds in the fourth quarter of 2023, we do know that he had $160 Billion of Treasury Bills at the end of September. Maybe if it’s good enough for Mr. Buffett, it’s good enough for me to be in short maturity fixed income instruments.

W’s two tools for asset allocators: Patience and Anchors

At this point, W reminds me of the two important tools that a long-only asset allocator must recognize and sometimes use to their advantage.

“First, as you have learnt,” points out W, “Long only investing means living through volatility because you never know when or where the positive returns are going to come. We only know the portfolio works over long periods. The smartest people fight over the short-term movements and their track records year to year are highly questionable.”

“Second, it’s important to have anchors. That is, we need to know when an asset class is irrationally cheap and when it is irrationally expensive. One percent yields on 30-year US government bonds in 2020-2021 was wrong. You were not supposed to hold bonds then. The journey from 1% to 5% might not be trivial, which was the challenge this time around. You need to use those anchors to shape allocations.

It’s not clear that most passive, long-only investors have these anchors. If you know you are not good with anchors, then you must live through the volatility. There is no other answer.”

In some ways, we have solved our way back to MO’s 40 years of investing wisdom. Live with the volatility.  

International equity weights and performance deficits

W himself has experienced a different kind of investment challenge. While he avoided bonds all through the turmoil and was thoughtfully invested in stocks and T-bills, increasing his stock allocations in early October, he has been over-invested in international and emerging markets. Not having enough US equity exposure cost him a performance return in 2023.

I’ve now spent enough time with Charles B’s MFO Premium fund engine and talked to suave international fund managers like Andrew Foster, Lewis Kaufman, Amit Wadhwaney, and Rakesh Bordia to know that the Original Sin lies in believing what works in the US (with passive equity ETFs) works abroad. It does not.

“International and EM investing is done much better through active managers,” I propose, with great conviction. “Trillions of dollars are mistakenly invested in passive indices abroad.”

The passive indices internationally were built for liquidity, not performance. One big reason why international passive does not work is because there are fewer ways to hold corporate management accountable the way active investors do in the US.

The morass that most of Europe seems to be unable to get out of weighs down heavily on developed international. China has weighed down on EM. Skilled managers can traverse these lanes better than passive funds can.

There is a big behavioral finance dilemma here. After decades of trying to pick stock and find market-beating active managers in the US, investors realized it could not be done. The S&P 500 (or the US Total Stock Market) was beating almost all the managers. Investors learnt their lesson, withdrew money from active, and plowed into passive. They did this in the US and international markets. However, the data never supported that passive investing worked outside the US. Solid active fund managers are beating the passive benchmarks outside the US, and doing this year after year, leaving passive investors abroad with a performance deficit.

As we cross the tennis courts and approach Central Park West, we have about half a mile remaining. The last half mile is about the US equity markets. This is supposed to be the happy part of the walk, where we share how thankful we are for being US equity investors. We are both beneficiaries of having investible savings, knowing how to invest, investing those proceeds in US equities, and watching the tree grow. The idea that the bond market might turn the page and be more benign going forward adds to the scent of pinecones on the ground.  

Nervous concerns about the state of the markets

But I have concerns and I must share them with a sympathetic friend.

I worry that we have reached an era where the financial investor swings too violently from narrative to narrative, that common sense as a weapon alone is too blunt for today’s markets, and while the VIX is at the ground floor level, the level of volatility of asset portfolios has increased tremendously from year to year.

“Think about crypto. We know it lives on faith alone. And I am bewildered to find so many smart people running crypto schemes. Why? Think about the greenwashing, where ESG became so important that everyone needed to be a friend of ESG. And then when ESG went out of fashion, they couldn’t wait to un-friend ESG. How is humanity moving so quickly, and so greatly in magnitude from one narrative to the opposite of that narrative? Why do I need to adjust myself to that narrative each time? And if I don’t, am I dumb? Or am I dumb if I follow every side of every narrative?”

I realize I am venting. But I need to be honest that this is not easy. I cannot always stretch my imagination to fit whatever narrative is being flung at me.

“The easiest answer,” suggests W, “is what we already know. Stick to the passive index ETFs and live with the boring. You don’t need to have more than 8-10% portfolio returns a year unless you want to fly to Mars or buy a social media company.”

My solution: Increase Berkshire Hathaway holdings

I offer my humble solution to the puzzle.

Indexing is fine, but with every day that goes by, I find myself increasing my portfolio weights in Berkshire Hathaway. Knowing my tendencies, I am probably too early. In any case, Berkshire offers a world-class portfolio of public and private businesses, common sense investing, low leverage, confidence to ignore the bullshit market trends of the season, a ton of cash that might be helpful in a stock-market crash, no fees, no dividends, no distributions, largest shareholder’s equity of any American company, and a bench of managers and Board Directors that are invested in keeping Berkshire working for its shareholders. At close to 1.35x the estimated Price to the Book Value of the company, this does not seem like a very expensive price to pay for common sense.

In a world that on some days feels like it has gone nuts, I like the warmth of the Berkshire Hathaway blanket. I don’t need to become wealthy fast. I need to know my money is in good hands.

In Conclusion

As the year has officially ended, W and I have had a chance to look at and compare our portfolio returns for the year. We have simultaneously realized that long-term, passive investing, is not a natural forte of Wall Streeters with professional training in tactical investments. We are better at protecting our investments in down markets, avoiding the tail risk. We are not as good at the blind faith demanded by asset allocation. My mother used to tell me, “The day starts when the eyes open.”

We have come a long way on this path to becoming better personal investors and maybe one day our eyes will be fully open to seeing the magic and beauty in “boring, boring, boring”.