As Main Street investors, we want a simple portfolio that is inexpensive and minimizes drawdown risk, and we need to be able to manage it on the road in real life. Fortunately, we have the tools to do just that, and Wall Street has provided us with products that will allow us to meet our goals—products that are both inexpensive and good.
As you may have surmised by now, you will need two types of investments in your portfolio: stocks and bonds. Think of these as the two main wheels on your vehicle; much like a motorcycle, they should get you where you are headed.
Motorcycles are typically much faster than regular cars, but they also are more unsteady. A four-wheel car can handle conditions that a motorcycle can’t, and it is steadier and more comfortable along the way. Fortunately, we can continue using the driving analogy, as we will be adding two more components to our portfolio: gold as an active holding and cash as a placeholder. These four wheels—stocks, bonds, gold, and cash—will drive our portfolio forward.
Want Less Risk, Accept Lower Returns
How do these pieces fit together? To put it simply, we are going to try to move out of the market when risk levels look high. To use our driving metaphor again, when ice starts building up, visibility is down, and driving becomes scarier, we are simply going to pull over and wait until conditions improve by selling out and sitting in cash.
This is, to put it mildly, not common practice in the investment world. Many would point out, correctly, that this would lower returns in bull markets. You can find statistics about how much lower your returns would have been had you missed the 10 best days in the market. The conventional argument is that it is simply not possible to predict crashes, and, therefore, it makes no sense to try to avoid them.
These arguments are sound—but they are beside the point. Let’s take a step back and look at what we are trying to do here, which is lower risk, just as adding seat belts to a car does. No one today would argue against seat belts, but imagine what a car manufacturer in the 1950s, before seat belts were mandatory, might have said:
“We can never predict when a car will be in a crash, and it is simply impossible to end all crashes; therefore, the idea of installing these new ‘seat belts’ is simply silly. Besides, if we add seat belts, the extra weight will slow down the car. Even then, in a severe enough accident, passengers would be injured regardless. No, driving is simply a risky business, and anyone in a car has to accept those risks.”
The car manufacturer has some good points. We can’t eliminate all auto accidents; this is true. It is also true that in some number of accidents, they will be bad enough that people will be injured or killed. It is even true that seat belts and other safety features add weight and cost to the car and do in fact slow it down a bit. Yet none of these facts takes into consideration that seat belts save thousands of lives every year. I would argue that investment portfolio safety precautions can have similar benefits.
Let’s look at it from another perspective: it’s impossible to predict the weather more than about a week ahead of time and nearly impossible to predict the path of, say, a hurricane even a couple of days ahead. Does that make weather predictions or hurricane warnings useless? Certainly not. When the potential damage is high enough, some kind of early warning and protective measures may well be worth it, even though there will be some cost involved. Overall, you may regret the times you put up hurricane shutters if the storm does not show, but when it does, your precautions will pay for all the times the storm passed you by.