I Know the Next Big Stock Market Crash is Coming. I Just Don’t Care, Nor Should You
The ins and outs of asset allocation. Building a resilient, low-risk globally diversified ETF investment strategy with examples
Sept. 29, 2008. I was not prepared for what was about to happen. This was the day that would change the way I invest forever. I had just turned 21 when I learned the most valuable lesson in investing.
The market doesn’t care about what you think, nor does it care about emotions. It will do what it will, no matter how hard you disagree or how angry it makes you. You can not change what happens; you can only prepare.
The Backstory
The following month was a blood bath. I had never experienced anything like that in my life. I had heard about market corrections, but I never imagined they could happen so suddenly and quickly. Day after day, I watched my hard-earned money disappear. My account was already down by about 25% from the highs, and I thought the correction should be over soon. Then the real crash started. In the next 3 months, I lost another 45%. It wasn’t long before I also lost my job. A lot of people did.
I was angry, I was depressed, and I was scared. I searched for another job, but nobody was looking to hire unskilled workers. I quickly realized that I had only one option. During the next couple of months, I slowly liquidated all of my assets as I needed cash for food and rent. For the prideful young man that I was back then, it was painful.
I clearly remember feeling good about living in Bulgaria at the time, where food and accommodation were extremely cheap. Although all of my savings were wiped out, at least I had enough cash to survive the winter. It took me years to stop blaming the world, the economy, and the rich people, accept my own mistakes and start putting money aside once again.
The next recession is coming… eventually
Many of you are probably worried about when the next recession will hit and how deep the S&P500 will go, but honestly, you don’t have to be. All you have to do is to prepare.
But how? According to most fund managers and financial-professionals, you should only invest in good strong companies, to dollar cost average; or even better — to give them your money so that they can do it for you.
Picking only a handful of well-established strong companies sounds like a good idea. Hiring a professional to do it for us sounds even better. Unfortunately, as I detailed in my article “Index Funds (ETFs) vs. Active Management,” this could not be further from the truth. Hedge fund managers will try to convince you that they can limit the potential downside during market corrections. In reality, all they will do is charge you large fees, therefore reducing your overall profitability.
Historical data shows that when you account for the compensations, active managers demand, the results that they produce often underperform the market. The relatively small amount of hedge funds that can beat the market for several years quickly become victims of their own success. As their client base grows, they have to be capable of investing increasingly larger amounts of money. Imagine hedge funds that invest billions in a single company. How will they deal with the liquidity issues should they want to quickly sell all of those shares during a substantial market crash?
If the arguments above were not enough to persuade you to stop listening to financial advisors and fund managers, take a look at what Warren Buffet himself has to say about that in his 2016 annual Berkshire-Hathaway letter.
“If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing — or, as in our bet, less than nothing — of added value.”
Having the right mindset
Hopefully, by now, we have established that investing in low-cost index funds by ourselves is the most sensible approach for most investors. But how do we protect our investments against market turbulence and volatility?
If nobody is managing our money, do we have to follow the daily financial news? Should we sell our shares as soon as we hear something bad is about to happen and then repurchase them at a lower price?
It might sound counter-intuitive at first, but the answer is no. Absolutely not.
While listening to financial news might help us stay informed about the world around us, trying to time the market is one of the worst things an investor can do. We, investors, are not day traders. We don’t gamble our money. We have a long-term outlook and earn financial freedom through the power of compounding interest. And the way we do that is by building a well-diversified portfolio across asset classes and markets.
The secret sauce — Asset allocation
When it comes to investing, the slow way is usually the fast way, and the fast way is usually the slow way.
The goal is not to go fast. It is to go at whatever speed our risk preferences allow. Knowing that our risk preferences are met should help us stick to our long-term strategy and not panic sell as soon as we see the first signs of a correction.
The Benchmark
Let’s start by looking at a theoretical portfolio that invests 100% of our equity in just one ETF — the S&P500 (ticker symbol SPY). This will be our benchmark.
Using a free backtesting tool provided by portfoliovisualizer.com, we can see that a $10,000 investment in 2007 would have appreciated by an additional 250% and gone up to $35,000 in 2021. This comes down to a 9.38% annualized return. Not bad at all. But would you have had the stomach to hold through 2008? Or the 2020 Coronavirus decline? Having just this one ETF in our portfolio would have been down 50.8% in 2008 and would have ended the year at a 36.81% loss. I think we can do better.
Asset class diversification. Bonds.
Depending on his current age and time horizon, an investor can decide to also invest in bonds. Bonds are an important asset that can provide our portfolio with stability due to their historical negative correlation with stocks. When stocks go down, bonds tend to rise.
Some of the common stock/bond allocations are 20/80, 40/60, 60/40, or 20/80. This largely depends on the investor’s preferences and risk tolerance. Even though I’m still in my 30’s, my risk tolerance is quite low, so let’s try to spread our investment between 40% stocks and 60% bonds.
I personally prefer treasury bonds as they are generally considered safe (unless one day, the U.S. government is unable to pay its debts). Long-term bonds will give us the highest sensitivity to market conditions as well as the highest yields. Keep in mind that they are also riskier than short-term bonds due to the long time-to-mature. For this example, we will pick a long-term U.S. Treasury ETF with the ticker symbol TLT.
This looks much better. Looking at our new hypothetical portfolio represented by the smooth red line on the graph, we can clearly see that it was very stable during the crash of the housing market bubble in 2008 and during the 2020 Coronavirus crash. The annualized return was almost the same — 9.26% vs. 9.38% for the 100% SPY investment, but the max drawdown decreased by over 3 times — from 50.8% down to 15.87%. We would have finished 2008 at +5.64% profit with this kind of asset allocation instead of -36.81% (loss).
We now have a good split of inversely correlated assets. When one is falling, the other one goes up and offsets for the loss. This is already much better, and many will argue it is good enough. For me, however, it is not. We’re still only exposed to the U.S. market.
The world index
So which countries should we be investing in? The short answer is — all of them. Combining U.S., International Developed, and Emerging Market stocks into an asset allocation strategy improves the risk and return characteristics relative to each of the individual parts. The U.S. equity market is a bit of an exception, as it actually looks better on its own over many historical periods. We know this in hindsight but should not bet on it going forward.
One way to add global exposure would be to include the “Vanguard FTSE All-World ex-US ETF,” ticker symbol VEU. This index itself is weighted by market capitalization and free float. It represents the combined performance of approximately 2,200 large and mid-sized public companies from 46 countries across developed and emerging markets. Companies from the US are excluded.
As you can see, splitting our 40% equity part into 20% S&P500 and 20% International stocks results in a smooth uptrend but underperforms the benchmark slightly, as the last 5 years have been solid for the U.S. stock market. But as you can see, this was not always the case. From 2008 through 2017, our portfolio would have beaten the benchmark while providing a lot less volatility.
Applying the three-factor model
According to the Fama and French three-factor model, we can further improve our returns by getting some additional exposure to small-cap and mid-cap value stocks. We can do that by adding the iShares Russell 2000 Value ETF (IWN) and the Vanguard Mid-Cap Value ETF (VOE). Although value stocks have been underperforming for the past decade, past data shows that value has beaten growth stocks in almost every 10 year period from 1926 through 2020. Those two combined will give us an over-average exposure to U.S. small and mid-cap value stocks, which should increase our long-term expected return. For this example, I will also split our 60% TLT bond investment into 40% TLT and 20% BLV to expand our bond holdings a bit more. BLV is another long-term bond ETF, but this one is provided by Vanguard instead of iShares.
Our portfolio is finally well-diversified and exposed to all the known factors that have been proven to increase profitability and decrease risk. It consists of 40% TLT and 20% BLV for our fixed income (bond) part, 20% all-world index (VEU), and our U.S. part is split into 15% SPY and 2.5% of each IWN and VOE.
As you can see, we are still underperforming the S&P500 benchmark in the last couple of years, but this is a future-proof portfolio that is barely affected by past market crashes. Half of our equity consists of companies outside of the U.S., which should keep us above water even if the U.S. enters a recession.
But that’s not all. There is one more instrument that we can use when planning our investments.
Portfolio optimization with the use of leverage
Yes, yes, I know. Leverage is risky, costly, and can wipe out my account. Not necessarily. What if I told you there is a way to use leverage without significantly increasing our risk or costs? I’m talking about leveraged ETFs.
As a young investor with a long time horizon myself, I am always looking for ways to improve my long-term profitability, even if that means going through slightly higher volatility. Using a bit of extra leverage can go a long way in increasing our future profits without adding too much extra risk. It’s all about the amount.
The way leveraged ETFs work is by promising to deliver 2x or 3x the daily return of an underlying ETF. Note the word DAILY, as we will come back to that later. Let’s look at two different ETFs — SPY and SSO. We already know that SPY represents the S&P500 index, and so does SSO. But unlike SPY, SSO multiplies the returns of the S&P500 by 2x for a given day. For example, if SPY were to move up by 2%, SSO would move up by 4%. If SPY dropped by 1%, SSO would drop by 2%.
Now, why did I say that the word DAILY was important? The index only looks at the daily moves and rebalances its holdings accordingly. I will not go too deep into it, but what that basically means is that the 2x does not necessarily apply to longer-term timeframes (than daily).
For example, if SPY dropped 35% over 2 months, this does not mean that SSO would drop by 70%. It would drop by about 54%. The same rule applies in the opposite direction.
Let’s replace our 15% SPY ETF from the diversified portfolio we just created with SSO and observe the changes.
By adding a bit of leverage to increase our exposure, we achieve comparable returns to the S&P500 at a fraction of the risks.
Comparison against the benchmark
Here is how the two diversified portfolios (with and without leverage) stack up to the benchmark in a backtest.
Annualized returns:
SPY (Benchmark): 9.71%
Diversified: 7.98%
Diversified + Leverage: 9.22%
Last words
Investing in low-cost index funds can provide a wide variety of possible asset allocations, volatility, risk tolerance, and future returns. The important bit is to find the balance between all of those factors and the courage to execute your strategy with as little emotion as possible. I hope to have inspired you to take your financial future in your own hands.
Disclaimer
This article does not constitute financial advice. The above portfolios are just examples of what could be achieved by using index funds. The actual asset allocation that I use in my broker accounts is slightly altered to fit my personal preferences.
Leverage, like anything else suggested in this article, is a choice — an option. Everyone should decide whether they want to use it or not, based on their time-horizon, risk preferences, insecurities, knowledge, and experience. Consult a financial advisor before making any changes to your finances.
