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Episode #15: The Trinity Portfolio

Guest: Episode 15 is just Meb.

Date: 8/10/16

Run-Time: 42:53

Topics: Meb tries something new in Episode 15. In “audio book” style, he walks listeners through his latest research piece: The Trinity Portfolio. “Trinity” reflects the three pillars of this investing approach: globally-diversified assets, weightings toward value and momentum investments, and active trend-following. On one hand, Trinity is broad and sturdy, rooted in respected, wealth-building investment principles. On the other hand, it’s strategic and intuitive, able to adapt to all sorts of market conditions. The result is a unified, complementary framework that can relieve investors of the handwringing and anxiety of “what’s the right strategy right now?” If you’re an investor who’s struggled to find an investing framework able to generate long-term returns that make a real difference in your wealth, Episode 15 is for you.

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Transcript of Episode 15:

Welcome Message: Welcome to Meb Faber Show where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.

Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.

Sponsor Message: This podcast is sponsored by the Soothe app. We all know how stressful investing in volatile markets can be. That’s why I use Soothe. Soothe delivers five-star certified massage therapists to your home, office or hotel in as little as an hour. They bring everything you need for a relaxing spa experience without the hassle of travelling to a spa. Podcast listeners can enjoy 30 bucks to their first Soothe massage with the promo code MEB. Just download the Soothe app and insert the code before booking. Happy relaxation.

Meb: Hey, everybody. Welcome to the show. We’re going to try something a little different today so no guest, no cohost. I’m going to try to go over a research piece and this is our most recent of about a dozen white papers called the Trinity Portfolio. I’m going to kind of read this and comment on it audio book style. Send me some feedback. If you all like this, hate it, let me know. We’ll try it and see how it goes.

Today, we’re going to talk about the Trinity Portfolio, a long-term investing framework engineered for simplicity, safety and outperformance. You can download this online either on my blog at Meb Faber as well as on the Social Science Research Network, the SSRN. Let’s get started.

I am a quant. In other words, data, numbers and verifiable results dictate my investment decisions. This makes it difficult for me to place my faith in any one investment strategy, much less advocate it to others. Yet, that’s what I’m doing in this podcast as I find myself strongly believing in the investment framework I’ll detail in the following minutes, hopefully not hours. There are a few reasons why I’m willing to stand behind this strategy. First, based on my personal research, it produces returns that historically outperform those of common benchmark portfolios.

Second, the same research suggests it does this with reduced volatility and drawdowns. However, there are many investing strategies claiming great returns and/or lower volatility, many of which I’ve written about. In fact, over the last 10 years, I’ve written 5 books, a dozen white papers and over 1500 investing articles. Why is this strategy different? The answer leads us to the third reason why I believe in the framework. It addresses a major question facing many investors today: How do I put it all together? Investors have access to more data and strategic information than any other time in history, yet from the perspective of the average investor, this huge volume of fragmented information presents a challenge. How does one actually implement it all? The third reason I’m advocating this framework is because it’s holistic. On one hand, the approach is broad and sturdy, rooted in respected wealth-building investment principles. On the other hand, it’s strategic and intuitive, being able to adapt to all sorts of market conditions. The result is a unified complementary framework that can relieve investors of the hand-wringing anxiety of “What’s the right strategy right now?” If your investors struggle with generating long-term returns that make a real difference to your wealth, I believe this strategy can help. If you want less anxiety during periods of heightened market volatility and drawdowns, I believe this portfolio can help. If you’re unsure how to balance the simplicity of buy and hold with the various benefits of an active portfolio, I think the investing framework in this podcast will help. Let’s get started.

The foundation of the Trinity Portfolio. I’ve named this portfolio you’re hearing about today the Trinity Portfolio. Actually, a blog reader suggested the name but it’s appropriate so it stuck. Trinity is a reference to three core elements of the portfolio: one, assets diversified across a global investment set; two, tilts towards investments exhibiting value and momentum traits; and three, exposure to trend following. If you find any of these terms unfamiliar, don’t worry. We’ll talk about each one in the minutes to come. At this point, it’s more of a guide post.

You see, in addition to being the foundational elements of the Trinity Portfolio, these three pieces also provide us the sequence to follow when constructing the portfolio, three chronological steps if you will. As I introduce Trinity, we’ll follow this three-step road map. We’ll analyze the effect of each step on our portfolio considering its impact on returns, volatility, as well as a few other metrics. This will enable you to see the exact engineering behind the final result so let’s get started.

Let’s say you set out to design a portfolio knowing everything we know today about investing. How would a logical evidence-based investor construct such a portfolio? First, you’d start with a little history and start out with the basics, US stocks and bonds. How has that performed historically? If you go back to 1926 through 2015, US stocks did 9.9% a year, US bonds 5.2% per year. People would say, “Why not just invest everything in stocks?” Well, stocks have much higher volatility, volatility of 19% per year, US bonds only 6% and stocks had a much larger drawdown so all-time peak-to-trough loss 80% whereas bonds are only around 16%. While stocks experience nearly double the annual return of bonds, they’re not without risk. You had that 80% drawdown in the Great Depression and the unfortunate math of these big losses, like an 80% decline, requires an investor to realize a 400% gain to get back to even so even a mild decline, like we’ve seen twice in the last decade of 50%, requires not a 50% gain to get back to even but 100% gain to get back to even. While stocks in the long run would result in a much higher ending wealth, very few investors could have sat through that bumpy ride to arrive unscathed at the finish line. Picture your portfolio right now and subtract 50%, even subtract 80%. Can you sit through that? Most cannot. However, comparing stock and bond returns is not totally fair. In order to accurately compare the returns over time, we need to include the impact of inflation. Let’s talk about real returns.

Real returns are the returns of an asset after subtracting the wealth-eroding effect of inflation. We often describe real returns as returns you can eat. After adjusting to include the effect of inflation, we see an interesting difference. The stock drawdown charts appear fairly similar but the bond drawdown charts are substantially different due to high inflationary periods in the 1950s through the 1970s. During those decades when inflation soared, the result was a long, painful drawdown for bonds. If you think about bonds, it’s more of a steady drip, a steady erosion based on inflation whereas stocks are usually much more exposed to big price declines. While stocks outperform bonds over the long run, there have been many periods of 20 – which is 1929 to 1949 – 40 years – 1969 to 2009 – where stocks underperformed bonds. If you include the 1800s, there was a 68-year period of no stock outperformance over bonds. That’s a long time because different economic environments affect stocks and bonds in different ways and since we cannot predict what the future will hold, it makes sense to allocate to both types of investments rather than just one. In other words, you diversify your portfolios.

Diversification has been called the only free lunch in investing. This free lunch, so to speak, is the benefit an investor receives from diversifying his investing capital into two assets that are not perfectly correlated. The idea is when one asset falls, the negative impact on the overall portfolio is softened and the second asset won’t fall to the same degree or may even rise since there is not perfect correlation. In essence, by investing in uncorrelated assets, one plus one equals three. If you look at the traditional 60/40 portfolio comprised of 60% US stocks and 40% US bonds, this is often what’s seen as a starting point onto which investors layer additional asset classes or strategies but we think about this as the Asset Allocation 101 portfolio.

If you look at the benefits of combining stocks and bonds, you see that you don’t get quite as high a return as US stocks did – so 8.5% versus 9.9% – but you also reduce your volatility from US stock levels of 19% all the way down to 12%. Your Sharpe ratio, which we often talk about which is a measure of risk-adjusted return… most asset classes have Sharpe ratios over time around 0.2 to 0.3. Over this period, US stocks had a 0.34 Sharpe ratio. Bonds had a 0.27. Then, the 60/40 portfolio gets you up to 0.43. It’s an improvement in risk-adjusted returns but the biggest problem in 60/40 and what a lot of people talk about with risk parity is that most of the risk, the true risk, is in the stock allocation. While stocks are only 60% of the total, in actuality, they have about 90% of the risk because their volatility dwarfs bonds. You still end up with a 60% loss in that portfolio at one point. If you look globally, there’s not a 60/40 portfolio anywhere in the world that we’ve researched that has less than a 60% loss at some point due to the large losses, mostly in stocks.

With only two assets in a 60/40 portfolio, your portfolio’s future returns are especially sensitive to each asset starting valuation. In other words, the price you pay influences your rate of return. Pay a below-average price and you can reasonably expect an above-average turn and vice versa. We talk about more about valuations for stocks and other asset classes in my book, Global Value, but what do evaluations today say about 60/40? US stocks are priced at a premium valuation right now. If you talk about Shiller CAPE ratio but also other valuation metrics, they say that stocks are overvalued. They don’t say they’re in a bubble but they say that they are expensive. Shiller CAPEs is a value of around 25. This means I expect returns to remain low. Let’s call it 4% or 5% a year which is much lower than historical, say, 8%, 9%, 10% returns and stocks. Bond returns are easy to forecast and if held to maturity, bonds should return about 1.5% which is their current yield. Many institutions agree with our analysis and a recent report by AQR pegged the forward-looking real return of US 60/40 portfolio at the lowest level they’ve seen in over 100 years. Note that these anemic returns fall woefully shy of the 8% return most pension fund and investors expect. Given this, it is clear that while the US 60/40 is a good starting point, it’s hardly where we want to end up. So, what’s the next step?

The next step is go global. As we just saw, 60/40 leaves investors exposed the underperformance and huge drawdowns that can gut a portfolio when it’s entirely allocated just to one country like the United States. Of course, this isn’t just a US problem. Any global market is susceptible to underperformance. The problem is you don’t always know which market it will be or when. If you happen to be born in the wrong country at the wrong time and limit your portfolio to domestic investments, the odds can be stacked against you. Now, if your response is you’d simply avoid this by investing in some bullish market on the other side of the globe, statistics suggest otherwise. That’s because investors commonly fall victim to a pitfall called home country bias and we’ve talked about this a lot but it’s exactly what it sounds like. We tend to put most of our money into investments from our own country. For example, Vanguard has demonstrated that US investors usually put about 70% of their stock allocation at home here in the US when it should only be about 50%. This isn’t unique to the US. It occurs everywhere. Most investors around the world invest the majority of their assets in their domestic market.

Vanguard talks a lot about this home country bias in the US but also in the UK, Australia, Canada or just about everywhere and it shouldn’t be surprising to most. After all, I’m a Denver Broncos fan but we have plenty of coworkers in our office that are Seahawks and Patriots fans. While you might believe professional money managers wouldn’t make a mistake, they’re just as prone to home country bias as individuals. If you look at a study from J.P. Morgan, it shows that US institutional investors put 75% percent of their funds in North American markets, similar number for Europe and Asia is even worse at a value of 85%.

Given our tendency to invest in our home countries and accounting for the reality that many times our home countries won’t produce adequate returns, how can we layer an added layer of safety to the 60/40 portfolio that hedges us from the wrong country at the wrong time? Simply, you expand your opportunity set to include a broader set of global investments. By diversifying away from holding just one country, we greatly increase the odds of sliding towards the average. While this may not sound appealing if we’re looking for outsized returns, it’s far more welcome when it protects us from outsized losses. Remember, concentration is a double-edged sword and investing a large part of your wealth in any one country or asset class can often be a terrible idea. Just ask an investor in Brazil, Greece, Russia or many other countries over the past few years.

We showed that expanding our portfolio to include global investments slightly reduces our returns but, in exchange, we receive lower volatility and drawdowns that results in a near-identical Sharpe ratio. If you look at the common periods… we take this back to the ’20s but if you look at the common period in the 1970s to 2015, we show it as well because that’s a common period for most asset classes including real assets we’ll look at. However, many people will look at these results and conclude that adding foreign assets is a step backward. Indeed, it was during this time period. However, that is why it’s important to study market history to ensure you’re seeing the whole picture. Consider the abysmal equity returns in the US during the Great Depression. If you just looked at the US equity returns during that one decade, would it be correct to assume that that would predict US returns the next five decades? Of course not. That’s why investors should never assume that returns of short investment periods will be repeated in longer periods.

Let’s go back to foreign asset returns. It surprises some investors; US stock performance versus international stock performance has historically been a coin flip with both out- or underperforming the other about half the time. This doesn’t mean both cannot go through stretches of outperformance. Indeed, there been two periods since 1973 when foreign stocks have outperformed US stocks for six years in a row – not six years rolling – six years in a row and this property of oscillating returns is timely right now and US stocks have outperformed foreign stocks five of the last six years. Perhaps it could be a time for foreign stock market rebound. Even though foreign asset returns are a little bit lower than US returns, remember they represent only a select narrower period.

If you look at the US 60/40, it did 9.5% since 1973 and the global 60/40 did 8.8% so a little bit lower. Volatility was almost nearly identical. Drawdown was similar although the global is actually a little bit higher but the Sharpe ratio – 0.44 for the US and 0.37 for global – is very close and remember this is highly dependent on the time period selected. Expanding into global investments even more important right now as we believe the US stock market is one of the most expensive in the world. Foreign equity markets are much cheaper than the US and emerging markets are cheaper still. We’ll link to an article we wrote at the beginning of 2016 on global stock market valuations and it looks like this is beginning to change. We wrote that the cheapest market in the world is Brazil which is up over 60 percentage points this year. Second cheapest market is Russia which is up over 20%. We’re seeing some strong returns in foreign markets and we expect that to continue in many years to come.

Pulling back to the larger picture, the important takeaway is that by going global, we’ve protected ourselves from overconcentration in any one country and that’s the home country bias. We’ve also reduced our portfolio’s volatility and drawdown numbers over time. It cost us a little bit of return but that’s fine. We’ve just been playing defense. Offense will come later. A global 60/40 portfolio protects us from this concentration risk but there’s a new problem. With only two principal asset classes, such as stocks and bonds, we’re limiting our global investment opportunity set and in a globalized world in 2016, there’s no reason to do that. We want to squeeze every bit of return out of the degree of risk we’re willing to accept. Historical data suggests we can do this by adding other non-correlated assets.

Investors can allocate to many other assets and including one we’ll add next which is an entire category described as real assets. A lot of people call these hard assets but it’s got a broad definition. We’re including commodities, real estate through REITs and gold. It’s not a new idea. In fact, people have been talking about it for 2000 years investing in land. You could also include timber and other asset classes here but we’ll just add these three.

The exact allocation we’ll be using is from our book Global Asset Allocation. If you want a free copy, you go to freebook.mebfaber.com and download one. This allocation resembles something called the global market portfolio. We call Global Asset Allocation portfolio here but, in essence, that’s simply the portfolio you would own if you were to wrap all the global investments into one composite portfolio. I’ll read it out here but don’t get too concerned with the numbers because they’re in the white paper. That’s 18% in US stocks. That’s 18% in foreign stocks of which 13.5% is foreign developed so emerging is a small chunk of that but it’ll be growing. Corporate bonds 20%, 30-year bonds 14%, foreign bonds 15%, TIPS 2% percent, commodities 5%, gold 5%, REITs 5% and I’m rounding there. You can see the exact allocation in the paper. If you look at adding these to a global 60/40, you’ll notice that return improves slightly over the US stock and global stock returns, the volatility comes down a lot so whereas the volatility was around 10% for the global 60/40, US 60/40, the Global Asset Allocation brings it down to 8%. More importantly, the Sharpe ratio shoots up to 0.56. You’ve increased return, reduced volatility and drawdowns. That’s sort of like having your cake and eating it too.

One of the big reasons is this… if you look at this chart, both nominal and then after inflation – so real returns – it was a substantial help during the tough investment periods in the ’70s and the 2000 bear market. The ’70s were a decade where almost nothing performed well so stocks, bonds, bills all did very poorly but real assets, due to the ’70s being a high inflationary environment, helped buffer the portfolio and smooth out the returns and again, in 2000 when there was the huge stock market bubble, particularly in the US, real returns helped smooth out that as well. They weren’t a big help in 2008 but each bear market has its own personality and different characteristics.

If you look at this portfolio, many investors could stop here. We often talk about portfolios all the time where we say, “Look, many portfolios are fine.” The vast majority are probably junk that pay too much in fees, that aren’t allocated correctly, we think, but this would be a fine portfolio. Is it the best that you can do? No, of course not – and we’re going to talk about that in a minute – but it’s better than what most investors already hold.

What about improving our returns? That takes us to step two. Step one was go global. Step two will be adding tilts. The two tilts we’re talking about here are tilts that have been known for over 100 years but really talked about the financial literature since the ’60s and ’70s but it’s called adding value and momentum. Here, we’re starting to borrow from academic research. We have the building blocks in place, specifically an assortment of asset classes spread out over the entire global investment step. Now, it’s time to begin refining those building blocks. In this case, we’ll be using strategies that, again, have been around for decades. If any listeners are unfamiliar with these terms, tilt simply means weighting towards a specific asset class or investing style. A value tilt means we’re investing more heavily in global stocks exhibiting traditional traits of being priced at low valuations. This could be something as simple as ranking stocks on common measures of value like [00:20:14]price-to-book or price-to-earnings ratios. A momentum tilt means we’re investing more heavily in global stocks that are enjoying more upward momentum in market price than other similar stocks. For example, a traditional momentum strategy would be buying the stocks that increased the most in the past 12 months. You might think of this as race car speeding around a track. Suddenly, one of them hits the gas and begins passing the other race cars as it pushes towards the front of the pack. This car would be said to have the best momentum.

There are, of course, many flavors of both strategies. Yet, regardless of which specific variety you choose, the performance attained by combining value and momentum comes not just from investing in what is cheap and going up but also by avoiding what is expensive and going down. What are the specific steps taken to tilt this portfolio towards value and momentum? For a value tilt, I’ll substitute our US equity exposure with the [00:20:57]head strategy from our paper Valve and Momentum and we’ll link to that in the show notes again. I encourage you to read it for all the details but, in general, it ranks stocks by value and momentum and takes the average reading across the variables. You can use these ratings to identify stocks with the best aggregate scores. In doing this, our goal is to only own cheap stocks with rising market prices. For the foreign stock exposure, we’ll use the strategy from our book Global Value. Same deal, we’ll link to it. This strategy invests in the cheapest global markets around the world.

A detailed explanation of these two strategies really isn’t the point of the paper. We just want to show it and in order to not to leave anything dangling but market cap weighting, which is simply investing in the largest companies, often allocates more heavily to overpriced assets. Therefore, if you’re an investor looking to buy at a discount, a market cap-weighted portfolio may be working against you. This is why any weighting other than market cap – it could be equal weighting, it could be fundamental weight, it could be value – often carries added benefits.

We’ll also tilt towards value in the global bond space with a methodology from a white paper we wrote called Finding Yield in a 2% World. This strategy also moves away from the market [00:22:09]cap-weighted index where 70% of the global debt, sovereign debt, comes from only five countries. Instead, this strategy invests in the highest yielding sovereign bonds around the world. For perspective as we talk about this, the top five global bond issuers yield around 50 basis points which is 0.5% including a couple that are negative yielding whereas the value strategy applied to bonds would yield closer to 6% or 7% today.

To demonstrate the effect of adding all these value and momentum tilts – what some people might call smart beta; in the paper, we just refer to it as Global Asset Allocation Plus – it basically has the effect of increasing returns. Volatility and drawdowns stay similar but you get a boost of about two percentage points per year and it’s got a positive effect on the Sharpe ratio, taking it from the Global Asset Allocation portfolio of 0.56 up to a value of 0.8. Now, the biggest challenge here, of course, is that many smart beta funds try to charge very high fees so you need to be careful and make sure you implement this with low-cost funds like ETFs or mutual funds.

Again, as before, many investors could stop here as this, too, is a perfectly fine portfolio. It would hold over 10,000 global securities and a handful of basic indices. You could rebalance this portfolio once a year in tax-exempt accounts or in taxable accounts. An investor could employ tax loss harvesting strategies using various inflows and outflows. This should take you about one hour per year to implement this portfolio. We have an ETF that implements this, the first and, to my knowledge only, ETF currently with a 0% management fee. All in, it’s around 0.3% cost to own that ETF but it owns about 30 underlying ETFs and gives you exposure similar to what we believe in this paper.

The simplicity in returns of this portfolio make it very attractive. In fact, we think, again, you could stop here. There are also many automated investing solutions, what a lot of people would call robo allocators or robo advisors that would implement it but despite the benefits of this portfolio, I think we can still do better which leads us to our final step. For review, first step, go global. Second step, add tilt, sources of value and momentum and now the third step, adding trend following. At this point, we have a buy-and-hold portfolio minus your occasional rebalancing and that’s a great starting point but many investors struggle with buy and hold. It’s difficult to do nothing while watching your portfolio drop 10%, 30%, 50% or even more and these losses lead to all sorts of bad behavior including the most damaging which is selling assets during bear markets and then never re-entering again. If this is you, think back to any “I can’t take it anymore” moments that you may have had in 2008 or 2009 or after the tech bubble in 2002, 2003 where you just simply threw up your hands and said, “That’s it.”

The alternative to buy and hold is any sort of active management. One of our favorite strategies is a trend-following approach. Many investors are confused as to the distinction between trend and momentum which is what we talked about in step two. Momentum refers to how security is performing versus other securities. Remember our early example of the race car speeding around the track. In the case of stocks, it may be something like “Is Apple outperforming Google or IBM over the past 12 months?” Trend following, on the other hand, tries to answer the question “Is it going up or down?” Is Apple going up? Is it an uptrend or is it going in a downtrend? Not a perfect analogy but you may want to think it as “Will the race car continue speeding around the track or is it about to get sidetracked for a lengthy pit stop?” You don’t want to be invested in securities that won’t be rising or stuck in a pit stop in our example.

Using a trend filter helps weed them out from our portfolio. If you look back the most famous trend-following indicators, like the 200-day simple moving average, this is nothing more than an average in an investment’s closing price over the last 200 days. It’s a way of trying to reduce the noise and find a signal. If the price is above the 200-day moving average, it would indicate a bullish trend and you would be longing that asset but if the market price fell below the 200-day moving average, it would indicate a bearish trend. You would sell the asset to avoid taking additional losses.

A quick clarification: Many investors expect basic trend strategies to magically time the market. They want something that will say, “Hey, I want to be able to buy in March 2009 and I want to sell at the peak in December of ’99.” However, a basic trend strategy is not meant to be an outperformance strategy. Let that sink in for a second. It is not meant to be an outperformance strategy. Rather, it is designed to produce similar returns as buy and hold but with much lower volatility and drawdowns.

How will we apply trend to the Trinity portfolio? Once again, we’ll borrow from the strategies we published. In this case, it was in our first white paper in 2007 called A Quantitative Approach to Tactical Asset Allocation. This paper has been downloaded almost 200,000 times. In it, we use numerous models of varying degrees of risk and granularity which I encourage you to read about in the white paper but we’ll talk about one here. The specific model we’re going to use here we’ll call global trend. It is meant to be an aggressive and concentrated strategy that combines both momentum and trend and if you’re reading the old white paper, it’s similar to the GTAA Aggressive system as published in the paper.

The way this works, the general summary is if you look at the universe of Global Asset Allocation Plus portfolio, the buy-and-hold portfolio we’re using and then you went and sorted that by momentum. You went and said, “We’re only going to take the top half of the securities in that portfolio.” Let’s say it’s a lot of real estate in emerging markets and stocks. You’re only going to take those if they’re above their long-term trend and in this in this case, in the paper, we use the 10-month simple moving average which is the monthly equivalent of the 200-day moving average. You update this once a month. Again, if you rank the top performers over the past year… I actually think in the paper we may have done 3-, 6-, 12-month performance. It really doesn’t matter, anything between 3 and 12 months. A lot of academics use 12 months. We may have used an average just because we want to blend but if the price is above the long-term trend, the asset remains in the portfolio. If the market price is below the trend, you would sell it and move to cash and T-bills.

One quick side note: Using cash or T-bills is the lower vol option Historically, had you replaced the cash component with bonds or 10-year bonds, you’d add another percentage point or more onto the returns of the portfolio but given the fact that bonds have gone from double-digit yields all the way down to a percent and a half, is there much return enhancing from that strategy in a rising-rate environment? We don’t think so. If you look at the ’70s, it didn’t hurt but, in general, we don’t expect there to be a big push. Using bonds or bills, I think either is fine but, at this point, we don’t expect a lot of outperformance from the from the bond component.

Remember, this part of the strategy of using momentum and trend means you could be 100% invested in that part of the strategy ranking the securities based on momentum but if everything is going down like 2008, 2009, that portfolio could be 100% cash and bonds. Adding trend to the portfolio has the benefit of both increasing returns and lower volatility, a double bonus. The effect is the Sharpe ratio gets up to around… I think it’s actually over 1. It’s more than double than where we started with our base US 60/40 portfolio.

There are a couple ways to approach implementing the trend allocation. The first would be to update the model every month. Takes 20 minutes. Update it. Rebalance. Place suggested trades. Astute enterprising investors with time on their hands can certainly do this. Even though that approach has worked well since I originally published the paper, it comes with two challenges. One, it forces investors to regularly update and trade it which introduces opportunities to stray from the model. A lot of us are robots, totally logical that could do this. I’m not one of them. Many can’t so many people struggle with updating something and say, “Oh man, I really don’t want to sell REITs this month. They’ve been crushing it. Maybe I’ll just wait a month,” and this start to introduce emotions into a logical, rules-based model which is what you don’t want to happen. Two, trading this all the time increases taxable events and commissions which can erode returns, especially for small investors. Trend following tends to be more tax efficient than most active strategies because consistently harvesting small losers and holding on the long-term gains but it still has the effects of bid-ask spread, commissions, etc. A second, easier way to apply a trend strategy is simply by investing in a fund or an ETF. We manage one that implements a similar model.

With superior returns to buy and hold, why don’t you just put all your money into this momentum and trend strategy? At the beginning of this podcast, I introduced trend as an alternative to buy and hold… sorry, at the beginning of the section, part three. Again, many investors will find buy and hold challenging when markets are headed south but the irony is those same investors also struggle with trend following or being too different from the world in general. The reason is because being a lone wolf investor, significantly different from the pack, can feel risky. Being different is great when your strategy is outperforming like trend did in 2008 but it’s a a supreme challenge when it’s lagging a roaring bull market in the years that followed or going through periods of underperformance which every strategy experiences at some point. Even worse, lots of other investors, particularly your neighbors and coworkers, are making a lot of money in big gains.

Because of this, many investors don’t like being that different but the challenge is that any active strategy by definition will be different than a buy-and-hold market strategy. You can look at this back and forth many investors feel when comparing active timing strategy with a passive buy-and-hold strategy and if you look at comparing Global Trend versus Global Asset Allocation Plus, there are multiple periods where one of the strategies outperforms the other by over 30 percentage points. Imagine that. Imagine underperforming the market and your buddies by 30 percentage points and how crappy that would feel.

Either strategy can go years underperforming the other, making you second guess your choice. With both buy and hold and trend following presenting their own unique challenges, what should an investor do? The answer, in my mind, points us to the final step we’ll take which will result in the completed Trinity portfolio. The simplistic solution addressing buy and hold versus trend that actually works quite well – and I apologize for the technical term here – is to go halfsies, specifically use buy and hold – so GA Plus – as your foundation with the 50% allocation and, with the other half, allocate to trend, this global trend strategy, with the other 50%. To summarize that, if you look at original US 60/40 stocks and bonds, 9.5% returns. Trinity gets you up to 13.7% so major outperformance. The GA Plus is 11.8%. Global Trend is 15%. It falls somewhere in the middle which is kind of what we want. Volatility, 60/40 is around 10%. Trinity takes you all the way down to 8% which is actually, by the way, lower than both Global Asset Allocation Plus and Global Trend so you have a little bit of a diversifying effect there. Sharpe ratio up above 1 and a drawdown of only 17%, 18% historically versus 30% for US stocks and bonds 60/40. Recall, this is going back to 1973. If you took that back to the ’20s, that 60/40 portfolio would have doubled in drawdown.

Some investors will listen to those numbers or look at the paper and scratch their heads. They’ll say, “If the Global Trend has stronger risk-adjusted returns than Trinity, why wouldn’t we just put all of our money into the superior strategy?” The reason because is the best investment strategy is the one you’ll stick with year in year out. Remember, investing 100% of your money in either buy and hold or trend means there could be years when one style outperforms the other and when that happens, our natural tendency is to jump ship, abandoning our investment approach, often at the wrong time with injurious results. That is the last thing you want.

The Trinity portfolio, with exposure to both buy and hold and trend, reduces the chances you’ll jump ship because part of your portfolio will likely be benefiting from either buy and hold or trend or both. Yes, Trinity has slightly lower returns than Global Trend does but it’s for good reason, to save us from ourselves. Look, we’ve come a long way from our initial only 60/40 portfolio. The three steps – going global, adding additional asset classes with tilts towards value and momentum and then adding the final step of Global Trend – transform this portfolio into, we believe, one of the best portfolios for individual investors.

Before we finish discussing the engineering behind Trinity, I’d like to point out one final attribute of the framework and that’s its flexibility. Despite Trinity’s balance make-up which results in low volatility, some conservative investors may prefer even less volatility. Fortunately, a Trinity portfolio is easily customizable. The simplest way to match Trinity’s volatility level to your personal investing temperament is by adjusting the bond allocation. For example, if you want a lower volatility than this portfolio’s, you simply reduce the 50/50 exposure to Global Asset Allocation and Global Trend and just add more in bonds. You put 20% in bonds and then 40/40 in the other two investments. You put 40% percent in bonds and then 30/30 in the other investments. Hell, you could put 60% in bonds and then 20/20 in the other two investments as a way of reducing your volatility. particularly if you’re an older investor who doesn’t want the exposure, you can really have a fixed-income component but, again, in general, you probably want that fixed-income component to be global because, as we know, US bond returns and what we talked about earlier, a lot of the top debt issuers have very low yields as well.

Regardless of which customized Trinity portfolio is right for you, if you’re a serious investor with a long-term perspective and self-discipline, then I’m pretty confident Trinity has the potential to provide you with significant wealth and peace of mind. So, how do you actually implement this portfolio? We have a great portfolio. We think we should outperform over time in various market conditions but you’ve got to guard from two common mistakes that trip up investors; one, paying excessive fees and two, letting your emotions lead you astray.

Let’s start with fees. Investors tend to focus excessively on returns, something which is actually mostly out of their control, while not paying enough attention to fees which is totally within their control and has a huge effect on long-term wealth. Here’s some ballpark fees for just perspective. Average mutual fund charges 1.25% per year. Average ETF charges 0.54% per year so that’s half of the average mutual fund. You can use index funds which are actually even lower than both. The average financial advisor charges about 1% a year although the most expensive quarter of advisors charge over two percentage points per year.

When you combine all of these fees, the impact can gut your long-term returns. Yet, most people have little awareness of this. One, it’s not the fun part of investing. Talking about fees, taxes and other costs is not as sexy at a cocktail party as chatter is about next hot stock whether it’s Tesla or some other cool stock. It’s seldom top of your mind. Two, fees are also skimmed off the investment so you never see them which, of course, is a brilliant move by Wall Street and kind of hiding these fees but don’t let this element of stealth mislead you. The report The Real Cost of Fees by robo-advisor Personal Capital demonstrates just how much people lose to fees over a lifetime. Assume you have a $1 million portfolio growing at 7% over 30 years. How much you think you’ll pay in fees including management and underlying fund fees? According to Personal Capital, you could pay as much as $1.4 million. That’s obviously 40% more than your original investment.

Most investors don’t understand these since fees are invisible but if you had to go to your bank… frame it this way. Instead of it getting skimmed off the top, what if you had to go to your bank, withdraw 20 grand in cash and deliver it in a briefcase to your advisor? A lot of people would think about that quite differently. By year 30, that withdrawal, by the way, is $86,000 to give to your advisor. Would you do that? Would you go get a briefcase with a lot of cash? Chances are probably not.

For another illustration of the destructive power of fees, let’s rewind to step two of the Trinity portfolio. That’s when we added the tilts of value and momentum to Global Asset Allocation. These tilts increase the returns by about two percentage points a year. Let’s tweak this now. Let’s say we’re going to apply the same tilts. The difference is we’re going to ask an advisor to do it for us, pay him and we won’t notice that the advisor fulfills our request using these expensive smart beta mutual funds at 1.25% per year. The result, the associated fees will likely raise all of the gains we generated from the tilt in the first place. If you look at a chart of these same portfolios and this time you implemented this with a 2.25% total fee, you can see it makes a huge difference.

We came to a similar conclusion in our book Global Asset Allocation. We examined where the way to protect your portfolio from fees is, first, by awareness. Be diligent about how much you pay for investment funds, the lower, the better. The good news on implementation is there are now many low-cost index mutual funds and ETFs available to purchase from any brokerage account: Fidelity, E-Trade, Schwab, Robinhood, whatever. My asset management company, Cambria, launched the first and only, to my knowledge, permanent 0% management fee ETF in the financial industry.

What about your advisor? If an advisor brings significant value to your life or financial situation, I have no problem with that. They’re worth their weight in gold but likely their value add is not in the asset allocation process but rather in behavioral coaching, meaning financial and estate planning, insurance, etc., all these things, holistic things, not really the asset allocation and I would say many advisors are worth reasonable fees of the average 1%. They can be a major defense against the second trap in which many investors fall which is succumbing to the emotions of investing, specifically letting fear and greed manipulate you into action at the wrong times. Vanguard estimates that hiring a good advisor could add up to three percentage points in annual returns and most of that value is in the behavioral coaching, keeping you from doing really dumb stuff.

The Trinity portfolio – or any portfolio utilizing buy and hold as a component, for that matter – requires a mastery over emotions that few investors exhibit on a long-term basis. For good reason, of course, it can be hard. Remaining faithful to your strategy when a portfolio is dropping 10% or 20% or more is incredibly difficult. Similarly, when our neighbors and coworkers are making big returns from the latest market darling and you’re missing out, it’s a challenge resist joining in.

How do you prevent this emotional decision from ruining your returns? That’s simply with discipline. Whether it’s losing weight, whether it’s exercising, whether it’s getting up early, whatever strategy you decide to implement, simply stick with it. Whether it’s 60/40, a Global Market portfolio or even Trinity portfolio, find something that works for you and enables you to sleep well at night. Then, stick with it. Let the rules of your strategy dictate your actions, not your emotions. If that’s too difficult for you, consider partnering with a cost-effective advisor who help you stick with your plan.

In the meantime, let’s not lose sight of the bigger picture. From George Mallory, the famous mountaineer… we put this on our blog when we first started writing almost 10 years ago and it says, “Enjoy is, after all, the end of life. We do not live to eat and make money. We eat and make money to be able to live. That is what life means and what life is for.”

Hopefully, you enjoyed this long audio book monologue from me. You can always find the show notes for the Trinity portfolio paper as well as any other episode on the podcast at mebfaber.com/podcast. We love hearing feedback from you all. You can email me at feedback@themebfabershow.com and you can subscribe to the podcast on iTunes or any other type of podcast players and we would love to have a review if you have the time. Thanks again for listening, friends, and good investing.

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