This post provides investment advice for people who are only willing to devote a few hours per year to managing their assets. I will assume that you have a brokerage account in the U.S., but people in other countries ought to be able to follow the advice with modest changes.
Table of Contents
- Recommended Portfolio
- Isn’t the market perfectly efficient?
- Fundamental Weighting
- Low volatility
- Small Cap
- Low corruption
- Alternatives to stocks
- Concluding Remarks
Here are my suggested investments (all are etfs):
|Developed markets low volatility
|SmallCap Low Volatility (US)
|Emerging markets low volatility
|Developed Markets ex-U.S. Small-Mid Portfolio Fundamentals Weighted
|PowerShares FTSE RAFI Emerging Markets Fundamentals Weighted
|FTSE RAFI US 1500 Small-Mid Portfolio Fundamentals Weighted
I recommend that before setting out to beat the market, you worry about whether you’ll be able to do as well as the market. The typical investor does worse than the market averages, usually due to buying more when the market is high than when it is low. Take a few minutes to imagine that you will be influenced by the mood of other investors to be pessimistic when the market has been doing poorly, and optimistic when the market has been doing well. Also imagine that you will have more money available to invest when the market is high than when it is low. If you’re confident that you can avoid these problems, please stop reading this post – you’re either good enough to not need my advice, or deluded enough that you ought to start somewhere else.
Isn’t the market perfectly efficient?
The efficient market hypothesis is an approximation that is good enough for many purposes, such as telling you that you shouldn’t be confident that you can beat the market by much unless you’ve got a really good track record .
Many people infer from this that any effort to beat the market will be wasteful. Why do I disagree?
The simplest answer is that if there were no inefficiencies in the market, the people who are making the market efficient wouldn’t have incentives to continue doing so.
But that tells us little about how large and hard to find the inefficiencies are.
The cost of short-selling is one measurable obstacle to efficient markets. The average fee charged (to institutional investors) for shorting stocks seems to be around 0.5% to 1% per year. Stock market inefficiencies seem to be highly concentrated in stocks for which the fees are much higher than average . These are clear symptoms of bubble-like behavior in some stocks, which rational investors won’t fully correct. (There also seems to be undiversifiable risk associated with shorting those stocks, which limits the market efficiency further).  appears to suggest that simply avoiding stocks with high shorting fees would have increased returns to index fund investing by over 5% per year. I don’t currently see a practical way for typical investors to directly exploit that specific evidence , but my recommendations should enable you to buy fewer of those overpriced stocks.
The causes of those bubble-like overpricings seem fairly stable over time. There’s lots more money being invested by unsophisticated investors than by investors with the skill to make the markets more efficient. There is some tendency for the best investors to get control over more money, but that is limited by the difficulty of recognizing expertise and by diminishing returns to larger investments.
Note that most fund managers are experts at something. But that something is typically some form of “doing what the customer asks”, not beating the market. Amateur investors who try to pay experts to beat the market usually fail by mistaking luck for skill.
Note that my advice is almost entirely about avoiding bad investments. Finding underpriced stocks is more time-consuming and easier to get wrong.
Diversifying across countries reduces some hard-to-measure risks. One of the most thoughtless mistakes investors make is to invest mostly in stocks of their own country, when it makes more sense to underweight the country whose economy their other income is most correlated with. Betting on one country might make some sense if you have good reason to think it will do better, but you’re more likely to do it for signaling purposes or due to availability bias.
A standard index fund holds stocks in proportion to the market capitalization, which means that when a stock is in a bubble it is overweighted within that fund.
Weighting holdings by fundamental information is one way around that problem. Value stocks (those with low price/book value, low price/earnings, high dividend yield, etc) have outperformed by 2 – 4 percentage points .
There are a bunch of funds which implement this somewhat well. Book value and dividends are solid choices to use. Investors pay enough attention to price/earnings ratios that I expect those to be less valuable. Price to cash flow (or free cash flow) ratios provide evidence similar to price/earnings ratios; with fewer investors using them to reduce market inefficiencies, I expect them to work better. I don’t recommend using revenues as an indicator .
I have more confidence that fundamental weighting will outperform the market over long time periods than I do for other strategies. But I expect an investor with some risk tolerance should aim for higher returns, and use a diversified set of strategies that are slightly riskier but more promising.
Low volatility stocks have outperformed high volatility stocks by 5-10 percentage points .
I expect low volatility stocks to continue outperforming the highest volatility stocks. One factor that keeps investors in high volatility stocks is that they care about relative performance more than absolute gains. People are bothered at least as much by underperforming when the market is at its best (which is when low volatility stocks underperform, and also when people are most actively talking to peers about their performance) as they are by losses in a bear market. Also, stocks that are in a bubble have high volatility. Finally, people have some bias toward investing in stocks that make good conversation topics at parties, and low volatility stocks are harder to turn into interesting conversation.
Small-cap stocks have outperformed large-cap stocks by 3 percentage points .
Maybe that is due to the tendency of bubble to move the stocks they affect into larger capitalization categories. Maybe it’s due to neglect by large investors, who avoid them because it’s hard to buy large enough stakes to be worth their attention (e.g. Warren Buffett has most of his wealth in chunks of stock worth over $1 billion). Maybe it’s due to the popularity of S&P500 index funds. I’m less confident about these forces remaining important than I am for the previous two ideas, but even if they eventually diminish they’re still important today.
Companies spun off from a parent company have outperformed by about 15 percentage points in their first year. Unfortunately, the etf that invests in spin-offs doesn’t buy them until 6 months after the spin-off, and holds them for about two years, which suggests it should outperform by more like 5 percentage points if spin-offs continue to do as well as before this pattern was publicized .
I don’t think many investors are paying much attention to the spinoff performance gap yet. Some factors that might maintain the inefficiency are that etf’s, mutual funds and trust funds are reluctant to change their investments at irregular times, so they end up delaying purchases of spinoffs for months after the spinoff happens. Anyone who invests based purely on quantifiable fundamental and/or technical data about an individual stock will often delay buying spinoffs due to lack of data.
That’s it for my official list of recommendations. But I’ll mention some other ideas that you should consider if you have enough time and wealth to justify a more complex portfolio.
I invest a modest amount of my money in low corruption countries. This approaches is only supported by my intuition. Historical data for the 6 best countries for which etf’s were created in 1996 doesn’t confirm the value of this idea. I suspect that if risks of political harm to markets were to increase, this strategy would be valuable, without causing much harm in other conditions.
I don’t see signs that investors have much awareness of which countries are less corrupt than the U.S., much less a desire to shift investment toward those countries. If markets are pricing them efficiently, it’s likely due to something indirect such as investors in those countries having more confidence in equities.
I view the low corruption strategy as more of a risk-reduction strategy than a high expected value strategy.
- EWCS (Canada Small cap)
- EWAS (Australia small cap)
- EWSS (Singapore small cap)
- EWL (Switzerland)
- EWN (Netherlands)
- EWD (Sweden)
- ENZL (New Zealand)
- EDEN (Denmark)
- EFNL (Finland)
- NORW (Norway)
I have typically used leverage of somewhat more than 1.5x, but I currently have essentially no leverage. That’s partly because stocks are less cheap than average, and partly because I’ve become more risk averse as my wealth increases and my ability to get a job doing something else decreases.
Using leverage (typically by buying on margin) is often valuable, but I’m reluctant to advise people to use it. One concern is that people are most likely to start using margin near market peaks, and ignore advice to use margin when it’s most valuable.
I’d like to recommend buying on margin when stocks are not overpriced based on a simple measure such as the Cyclically Adjusted PE Ratio (which should indicate buying on margin is safe when it’s below about 20), or the market capitalization to gdp ratio. I’m unsure whether this ought to be measured for the world as a whole or for each region corresponding to individual etf’s.
However, due to some combination of stock prices being high and the data not meaning quite the same thing as it used to, it seems unlikely that any rule I suggest will justify using margin in the next year or two, so I’m not going to suggest any rule now.
If you buy on margin, beware that margin rates vary a lot between brokers (and maybe from customer to customer at each broker – brokers with high rates are reportedly willing to negotiate).
Interactive Brokers has low margin rates. But their system is designed for experienced traders, and most investors will find it confusing and hard to use (e.g. their warnings about margin calls only provide a few hours notice, as opposed to 3 days with most brokers, and it takes fairly detailed knowledge of margin regulations to figure out how to avoid forced sales).
I don’t know much about etf’s that implement leverage. I have little interest in them because I haven’t seen any of those that implement strategies such as low volatility or fundamental weighting.
Brian Tomasik has written more on this subject than I’ve been willing to read. See also Paul Christiano’s comments on risk aversion.
Alternatives to stocks
Bonds have some value as a way to diversify. They do well at times when stocks are doing poorly, which means they reduce your risk while also providing profits at times when investing those profits in stocks is most valuable. But you’ll probably won’t rebalance your bond profits into stocks when stocks are unusually low. Also, bonds are probably overpriced today because recency bias causes us to overestimate the benefits of declining inflation and underestimate the risks that bonds will do terribly when inflation rises. Inflation is currently low enough that there’s no way for the benefits of further declines in inflation to balance the risks that bonds will suffer from high inflation. Bonds have underperformed stocks by several percentage points over the past century, so even if this was as good a time as is typical to buy bonds, risk-tolerant investors won’t invest much in bonds.
Real estate is a popular alternative to stocks. Directly investing in it has the disadvantages of illiquidity and (unless you’re very rich) requiring you to bet on one location. So it seems better to invest in stocks of companies that own real estate. I have no opinion on whether it is wise to weight real estate stocks more heavily than do the etf’s that I recommend. WPS (iShares International Developed Property etf) looks worth considering.
Digital money-like entities such as Bitcoin and Ripple XRPs are a reasonable place to put small fractions of your wealth, provided you can protect them against theft. I currently have less than 0.1% of my wealth in Bitcoin and XRP. The most popular ones will have some tendency to outperform the obscure one. Beyond that I have little insight to offer.
You should hold some cash or money market funds for emergency use and routine spending. It makes little sense to hold more than that unless you are wise enough to identify a stock market bubble.
A mutual fund that tracks an index is almost as good as an etf, but mutual funds tend to have higher costs and hidden problems due to only using end-of-day pricing. I haven’t done a careful comparison of the mutual funds that are most similar to the etf’s I recommend.
Some of these etf’s are less heavily traded than well-known investments, so they have less liquidity. When you place buy orders for them, use limit orders, not market orders, and set the limit price a little bit above the midpoint of the bid and ask prices.
The only ongoing changes I suggest making is to rebalance your holdings about once a year to bring them back in line with the suggested weighting. That will create a small tendency to move money away from investments that are experiencing bubbles and into neglected investments.
All of the approaches I’ve mentioned are likely to outperform by less than history suggests, due to the increased amount of investment attempting to exploit them. That increased investment over the past decade or two doesn’t look large compared to the magnitude of the inefficiencies, but if trading volume on these etf’s becomes comparable to that of leading etf’s, I’d expect the benefits of these etf’s to go to zero.
My expectation is that these investments will outperform the market over the next decade or so by something like 3% per year. That should offset your tendency to buy when the market is high, and enable you to at least match market returns.
Disclaimer: I currently hold positions in these symbols: XSLV, CSD, EWSS, EWD, and ENZL.
 You should also doubt your ability to evaluate your track record. It is quite normal for a bad strategy to produce what looks like a good track record for a year or two.
 Although an experienced investor could come close with an account at Interactive Brokers and a good deal of work.
 For example, revenues give a distorted comparison between Google and Amazon because Amazon because most of the value of Amazon’s revenues comes from whoever made the products that Amazon sells; Google creates a much higher fraction of the value of it’s revenues.
 Excluding Luxembourg, which doesn’t seem to have an etf.