What is the best way to invest your money?

This is definitely a challenging question that depends on the individual’s risk tolerance.  For me personally, I am a big wimp.  I can’t stand to open up my brokerage account and see red arrows.  But at the same time I don’t want the paltry returns currently associated with bonds.  As of today (08/23/17) a 30 year US Treasury bond is returning 2.77% a year.  That’s not very exciting.  But when I look across the aisle to the stock market, and all the wild fluctuations associated with it, I start to feel a little queasy.  

So what is an average retail investor to do?  There is a lot of things you can do actually.  The obvious advice that is passed around is for you to diversify your portfolio, but with what?  If you pick individual stocks, who is to say that you don’t have horrible skill in this arena and you pick the next Enron or Sears.  Enron doesn’t exist anymore and if you invested $10,000 in Sears stock in April 2007 it would be worth approximately $445.47 today.  I am no expert, but I am pretty sure that’s the opposite of what you want to do when investing.  So how do you prevent yourself from getting the proverbial kick in the groin with your investment choices?  Take Warren Buffett’s advice.

Warren Buffett has been quoted as saying that the best thing the average investor could do is to regularly buy low cost S&P 500 index funds on a perpetual basis.  In fancy terms this is called “dollar cost averaging”.  This tactic gives you a fighting chance for a positive return and reduces the volatility that owning a single stock will give you.  It also guarantees that you will capture the market return in any given year which over time averages out to about 9-10%.  This is a much better performance than you would get if you were to own just bonds, and it reduces the volatile nature associated with individual stocks.  But, can we do better?

Even if you simply buy index funds, such as SPY (SPDR S&P 500 ETF), there will still be wild fluctuations in the value of said shares.  Every stock market expert will tell you that you need to be prepared to watch the value of the market go down by 50% at least once in your lifetime.  At the absolute bottom in March of 2009, the S&P 500 fell 57% from previous highs.  If watching the value of your money go up and down like a game of whack-a-mole makes you feel like you might need Pepto Bismol, then you might want to check out a risk parity portfolio.

What a risk parity portfolio aims to do is even out the volatility in a given stock portfolio by diversifying the money across different asset classes.  A very basic example of this would be to own 50% stocks and 50% bonds.  If you owned a 50/50 portfolio of stocks and bonds in 2009, your return would have been -15.99%.  This is much better the -37.02% the stock market as a whole turned in that year.  But we can do better than just the 50/50 stocks and bonds portfolio.

If you spread your money across multiple classes of assets the volatility goes down dramatically.  What is even better is if you pick assets that are negatively correlated to stocks, your portfolio can go up when the market is getting taken to the woodshed, and still manage a decent return when the market is doing fine.  In fact, hedge fund manager Ray Dalio has a fund called the all weather fund, which as the name implies tries to have positive returns no matter the economic climate.  He has actually alluded how to assemble this portfolio for yourself in interviews recently.

Essentially what you need to do is have 4 assets classes in your portfolio in order to achieve the kind of risk parity enjoyed by the mega wealthy and pension funds.  The 4 asset classes you need are stocks, bonds, commodities, and gold.  The trick is to allot the proper percentages to the classes based on the inherent risk associated with each of them.  By doing this you achieve true risk parity and can sleep at night knowing that your hard earned money will be a solid as a rock.  The percentages to allocated are as follows: 30% stock (ticker: SPY), 40% long term government bonds (ticker: TLT), 15% intermediate government bonds (ticker: IEF), 7.5% commodities (ticker: VAW), and 7.5% gold (ticker: GLD).  Please note that VAW is a index fund for companies that mine or source commodities, these companies do well when commodity prices go up. So that index fund serves as a good proxy for the commodities market.

This portfolio has mimicked market returns with a fraction of the volatility.  In fact this portfolio was up 2.10% in 2008 when the market was down 37%.  This is the power of having your money allocated based on volatility and spread across classes of assets that are not correlated.  The average returns since 2005 is 8.08% with the largest loss in that period being -1.68%.  This is versus an average return of 7.94% in the S&P 500 during the same period.  Don’t just take my word for it go to portfoliovisualizer.com and back test the numbers for yourself.  You will see the return is nearly the same as the market with nowhere near the volatility.

Blue line is the risk parity portfolio, red line is the S&P 500. Portfolio matches return with much less volatility.
This shows the annual returns for the portfolio. Notice that risk parity gives you a less volatile return.

This helps me sleep at night, and I like to to sleep a lot! I really hope you enjoyed reading this as much as I enjoyed writing it for you.  If you have any questions or comments feel free to contact me via the email address provided.  Also If you would like to have more money savings tips like the one you just read be sure to join my mailing list by clicking here. Thanks for reading!

(Full disclosure: I own the index funds mentioned above.)