MONEY Master the Game: 7 Simple Steps to Financial Freedom (61 page)

If you look at how the All Seasons portfolio would have performed against the market in more recent years, the difference is even greater!
From January 1, 2000, through March 31, 2014, the All Seasons portfolio destroyed the returns of the market (the S&P 500).
During this time frame, we endured all kinds of what Ray calls “surprises”: the tech crash, the credit crisis, the European debt crisis, and the largest single-year drop in gold (down 28% in 2013) in more than a decade. This time frame includes what experts call the lost decade, in which the S&P 500 was flat for ten years, from the beginning of 2000 to the end of 2009. Take a look at the difference in how his design performed:

BURN ’EM DOWN

It’s fascinating and quite sad that we live in a time where the media is salivating to take down anyone considered to be “best in class.” Culture seems to lift them onto a pedestal of perfection only to hope they come
crashing down. Whether it’s an athlete, a CEO, or a money manager, any false move or seemingly slight crack in the armor is exploited to the fullest. Stone them in the town square of television and the internet.

I found it mind boggling that with more than 30 years of stellar returns, Ray’s All Weather strategy received intense criticism when he was down approximately 4% in 2013. A whopping 4%. Not the whopping 37% hit that the S&P took just a few years earlier. Remember, based on history, the All Seasons approach will take losses, but the goal is to minimize those dramatic drops. Let’s be honest: you could buy into this portfolio and see a loss the first year. This portfolio is not meant to shoot out the lights. It’s a long-term approach for the smoothest possible ride. It would be a mistake to judge it by any single year, rather we need to evaluate its overall long-term performance—like any other investment opportunity. At the time of this writing (mid-2014), the media is back on the Dalio bandwagon, as his All Weather fund was up 11% through June.

Imagine, all this media attention over a 4% loss? Never mind that over the last five years, between 2009 and 2013, the All Weather has averaged over 11% per year, even including this single down year! But the fact he lost even a small amount when the market was up and that he received big media attention shows how his incredible performance has become expected. You are only as good as your last “at bat” when it comes to the financial media. How ridiculous. Never mind the fact that Ray’s clients have enjoyed incredible returns year after year, decade after decade, as the
New Yorker
reported in a 2011 article on Bridgewater called “Mastering the Machine”:

“In 2007, Dalio predicted that the housing-and-lending boom would end badly. Later that year, he warned the Bush Administration that many of the world’s largest banks were on the verge of insolvency. In 2008, a disastrous year for many of Bridgewater’s rivals, the firm’s flagship Pure Alpha fund rose in value by 9.5% after accounting for fees. Last year, the Pure Alpha fund rose 45%, the highest return of any big hedge fund.”

The point is, there are a number of pundits who will sit back and criticize
any
strategy you may deploy. To echo my favorite quote from Dr. David Babbel, “Let them criticize; let us sleep.”

GOOD QUESTIONS

When it comes to the All Weather approach, the biggest question from the bloggers is: What happens when interest rates go up? Won’t the government bonds go down and cause a loss to the portfolio because of the large percentage allocated to bonds?

It’s a fair question, but deserves more than a sound bite from an armchair quarterback. First, remember that by having a large allocation to bonds, it’s not a bet on bonds alone. This portfolio spreads your risk among the four potential economic seasons.

Ray showed us that the point is not to plan for a specific season or pretend to know what season is coming next. Remember, it’s the surprises that will catch most off guard.

In fact, many have been trying to proselytize and predict the next season by calling for interest rates to rise quickly. After all, we are at all-time lows. Yet Michael O’Higgins, author of the famous book
Beating the Dow,
says that people may be waiting quite some time for any significant interest rate increases, since the Fed has a history of suppressing interest rates for long periods to keep costs of borrowing low: “To the great number of investors who believe interest rates will inevitability go higher in the coming year (2014),
remember that the US Fed kept long (duration) rates below 3% for 22 years from 1934 to 1956.
”

The Fed has kept rates low since 2008, so who knows how long interest rates will remain low. Nobody can tell you with certainty. In early 2014, when everyone was expecting rates to rise, they dropped yet again and caused a spike in US bond prices. (Remember, as rates go down, prices go up.)

HOW DID THE ALL SEASONS PERFORM IN A RISING-INTEREST RATE MARKET?

A revealing exercise is to look back in history at what happened to the All Seasons portfolio during a season when interest rates rose like a hot air balloon. After interest rates declined for many decades, the 1970s brought rapid inflation.
Despite skyrocketing interest rates, the All Seasons portfolio had just a single losing year in the 1970s and had an annualized return of 9.68% during the decade.
This includes enduring the back-to-back drops of 1973 and 1974, when the S&P lost 14.31% and then another 25.90% loss, for a cumulative loss of 40.21%.

So let’s not let the talking heads persuade us to believe that they know what season is coming next. But let’s certainly prepare for all seasons and the series of surprises that lay ahead.

LET’S GET REAL

One final and crucial advantage of the All Seasons portfolio has a much more human element. Many critics will point out that if you could stomach more risk, you might have been able to beat this All Seasons approach. And they would be right. But the point of the All Seasons portfolio is to reduce volatility/risk while still maximizing gains!

If you are younger and have a longer time horizon, or you are willing to stomach more risk, you could still take advantage of the All Seasons foundation but make a small adjustment in the stocks versus bonds to, hopefully, produce a greater return. But keep in mind, by adding more stocks and decreasing your bonds, this change will increase risk/volatility and have you betting more on one season (in which you hope stocks will go up). In the past, this has worked quite well. If you visit the Stronghold website, you can see how, over time, by adding more stocks, the portfolio would have produced a greater returns but also produced greater downside in certain years. But here is what’s incredibly interesting. When compared with a standard 60%/40% balanced portfolio (60% in the S&P 500 and 40% in the Barclays Aggregate Bond index),
the All Seasons approach, with more stock exposure, outperformed handily—and you would have to have accepted nearly 80% more risk (standard deviation) with the traditional 60/40 portfolio to still achieve results that would still fall slightly short of the All Seasons with increased equity focus.

But let’s be honest with ourselves. Our stomach lining is much weaker than we let on. The research firm Dalbar revealed the truth about our appetite for risk.
For the 20-year period from December 31, 1993, to December 31, 2013, the S&P 500 returned 9.2% annually, but the average mutual fund investor averaged just over 2.5%, barely beating inflation.
¹⁴
To put this in perspective, you would have received a better return by investing in three-month US Treasuries (which is nearly a cash equivalent) and avoided the stomach-turning drops.

Why did the average investor leave so much on the table?

Dalbar president Louis Harvey says investors “move their money in and out of the market at the wrong times. They get excited or they panic, and they hurt themselves.”

One of the more startling examples is a study conducted by Fidelity on the performance of its flagship Magellan mutual fund.
The fund was run by investment legend Peter Lynch,
¹⁵
who delivered an astonishing 29% average annual return between 1977 and 1990. But Fidelity found that the average Magellan investor actually lost money!!!
How in the world? Fidelity showed that when the fund was down, people would cash in—scared of the possibility of losing more. And when the fund was up again, they would come running back like the prodigal investor.

Here is the reality: most people couldn’t stomach another 2008 without selling some or all of their investments.
It’s human nature. So when people talk about better performance, for the most part they are talking about a fictitious investor; one with nerves of steel and a drawer full of Tums. Case in point: I was reading MarketWatch recently and came across an article by Mark Hulbert. Mark’s financial publication tracks the performance of
subscription newsletters that tell investors exactly how to trade the markets. The best performing newsletter over 20 years was up 16.3% annually! Outstanding performance, to say the least. But with the ups come major downs. As Mark explains, “[T]hat high-flying performance can be stomach churning, with his performance during the downturns of the last three market cycles—since 2000—among the very worst of his peers. During the 2007–09 bear market, for example, the service’s average model portfolio lost nearly two-thirds of its value.” Two-thirds?! That’s 66%! Can you imagine investing $100,000 and now seeing only $33,000 on your monthly statement? Or $1 million of your life savings reduced to just $333,000? Would you have white knuckled it and held on?

When Mark asked the newsletter publisher about whether or not investors could actually hang on during the roller coaster ride, he provided quite the understatement by saying, in an email, that his approach isn’t for an investor who “bails out of his/her broadly diversified portfolio the first time a worry arises.”

I would call a 66% drop more than “a worry.” He makes it sound like us mere mortals are prone to overreaction, as though I jumped out of a moving car when the check engine light came on.
Remember, a 66% loss would require nearly 200% gains just to get back to even—just to recoup the portion of your nest egg that it may have taken your entire life to save!

Without exception, the “money masters” I interviewed for this book are obsessed with not losing their money. They understand that when you lose, you have to make significantly more to get back to where you started—to get back to breakeven.

The
reality
is, if we are being honest with ourselves, we all make emotional decisions about our investments. We are all emotional creatures, and even the best traders in the world are always fighting the inner fear. This All Seasons portfolio protects you not only from any potential environment but also from yourself!!! It provides “emotional scaffolding” to keep you from making poor decisions. If your worst down year in the last 75 years was 3.93%, what is the likelihood that you would have freaked out and sold everything? And in 2008, when the world was burning down but your All
Seasons portfolio was down just 3.93% while everyone else seemed to be melting down, how peaceful would have you felt?

So there you have it! The All Seasons recipe from the master chef Ray Dalio. And rather than wait until you have a $5 billion net worth, you get access here, for the few dollars you invested in this book! He has simplified it by taking out the leverage and also making it a more passive approach (not trying to beat the market by being the best picker or predictor of what’s coming next). You are welcome to implement this portfolio yourself, but if you do, let me just add a few points of caution:

• The low-cost index funds or ETFs you choose will change the performance. It’s crucial to find the most efficient and cost-effective representations for each percentage.

• The portfolio will need to be monitored continually and rebalanced annually.