Digging up the Past – Thoughts on past performance and asset allocation

Something that constantly comes up in FIRE forums on Reddit/FB etc is people asking for advice on their current or proposed portfolio.  Sometimes this will be a fairly standard mix of 50% Aussie shares and 50% Intl shares or somewhere around that at least, and other times it’s 50% US stocks, 30% tech stocks, 20% cryptocurrencies. 

So why is it that there are so many of the second type of portfolios being asked about at the moment?  And what sort of asset allocation should you have?

Quick disclaimer:  As is always the case you should not plan your finances around what some random person on the internet says. Everything which is written here is of a general nature at most and is certainly not specific professional advice for you and you should not be relying on it when making decisions. Whilst every endeavour is made to provide accurate information at the time of writing you should be talking to a licensed professional about any specific areas of your finances, taxes etc.  Also, it’s going to be really embarrassing if it all goes pear shaped and you have to explain that it did so because you read about something from a random blogger.  Moving on!

Hmm, I wonder if it’s got anything at all to do with the price of Bitcoin going up infinity percent over the last 5 years, and over the last 6 months in particular.

Or the Nasdaq, which is a reasonable proxy for tech, going like this over the last 5 years?

Just to make my point, here’s the joke/meme cryptocurrency Dogecoin.

Plus who can resist a good Drake meme?

It’s different this time!

Pretty much everyone has heard the saying that past performance is not an indicator of future performance.  And yet it seems to be human nature that a lot of us ignore that and just assume that because something has had tremendous performance in the past, that will happen in the future as well.

I’m old enough that I was working in finance during the tech boom and bust around the turn of the century.  And in the leadup to that we saw pretty much exactly the same behaviour as we are seeing again now with lots of money going into hot companies and the tech sector as a whole.

Valuations were irrelevant, every tech company was going to be next big thing, every non-tech company was talking about how it was going to pivot to become more of a tech company.  And then oops, the Nasdaq went from 5,000 down to just over 1,000 at the lows.  Australia didn’t experience this nearly as badly as the US, mostly because there wasn’t (and still isn’t) much of a tech sector here, but it still hit a lot of people’s portfolios hard.

Looking at the current market favourite FANMAG stocks (Facebook, Apple, Netflix, Microsoft, Amazon and Google, they’re all at pretty much all time high prices for their stock prices.  I think that they all have much better businesses than what we were seeing back in the early 2000s, but hey I’m also well and truly old enough to remember MySpace being bigger than Facebook. 

Speaking of the early 2000s two of the giants from that era, Yahoo and AOL, just got sold to a private equity fund for roughly 1% of their peak values.  Please note I am not saying that this will happen to any of the FANMAG stocks or any other tech stocks, just that there are plenty of former market darlings that are worth a lot less than they used to be and there are no guarantees this won’t happen to any of the current set.

American Exceptionalism

A large part of the reason so many people want to invest in the US is that it has a much larger exposure to tech stocks than most of the rest of the world, with almost all of the major software stocks being based and/or listed in the US. 

It’s had much better performance on a comparative basis since the GFC thanks to that higher tech exposure and lower cyclical exposure as shown in the chart below from JP Morgan AM.

You can also see from the chart below that IT and Consumer Discretionary have had far better returns over the last 10 years than most other sectors.  Why Consumer Discretionary you ask?  Because Amazon is in that sector rather than IT.

The below chart shows the period of US outperformance compared to the rest of the world over time, and you can see that it’s done massively better for the last 12 years or so.

And here we are

So between tech companies having a fantastic 10 years and the US having a much larger exposure to tech than most other major markets, people look at those two potential investments and decide that given they’ve had great past performance which is likely to go on into the future.

It’s possible of course that this will be the case, I have no idea what will happen to stocks, countries, sectors or anything else in the future.  I’ve been wrong about plenty of investment ideas in the past, amongst these residential property and crypto, and it’s entirely likely I will be wrong multiple times again at various times.

But there is also the possibility that investors will decide that there are limits to how much tech companies can grow their earnings, that new companies may displace them, that other sectors and regions may start seeing more growth etc.  It’s generally a pretty good idea to not have all your eggs in one basket.

You are not your portfolio

When your portfolio is made up almost exclusively of one type of asset, and in particular one specific asset, there is the risk that your identity gets caught up in that. 

I make no secret of the fact that I prefer shares to the other major asset classes, but I acknowledge that there are tradeoffs to it and I don’t kid myself that shares don’t have downsides.  I also have exposure via the various ETFs that I own to probably at least 1,500 or so different companies so I don’t really care about any one company in particular. 

I do own two individual stocks which between them make up about 3-4% of the overall portfolio (I’m including the amounts owned in ETFs/super here), but as much as I would obviously like to see them do well it doesn’t really move the needle one way or another for me.

However if you have most of your money tied up in one asset class or even moreso if it’s just one asset, well that might be a different story according to this article.

But if you have a very large percentage of your net worth invested in one particular asset class or individual asset, well it’s going to dominate your portfolio and also potentially your life.  According to this survey “About 25% of those who’ve invested 10% or less of their net worth into crypto say that they’ve seen a negative impact on their personal relationships, according to the survey, which was done with 1,033 Americans and balanced by age and gender. That number rises to 73% for those who’ve invested 10%-25% of their net worth, 94% for those who’ve invested 50%-75% of net worth -- and 100% for those who’ve invested 75% or more of their net worth.”

Well yeah, I can see that if you have a big chunk of your net worth in one asset that has fallen 20% or more 3 times in 2021 alone, it might affect your mood and thus your relationship! Particularly given that the gain in your net worth almost all came in the last 6 months, and it’s by no means certain that those gains will remain.

So what overall asset allocation should you have?

There is no one size fits all answer to this.  I know that some people at least on Reddit or the various Australian FIRE FB groups will push for an all equities portfolio which is why I’ve previously written about not having all your money in equities, and in particular Australian equities.  

It’s easy to think that you’re going to be cool calm and collected if the stockmarket drops 50% and your investments get cut in half.  And if you’re early into your FIRE journey and have $50k invested which is half your annual salary or so, there’s actually a reasonable chance you will be.  But when you get to having much larger amounts invested which are multiples of your salary and very large dollar amounts, it’s a lot harder to stay cool.

During the Coronavirus crash last year our portfolio dropped by a six figure amount which was multiples of my annual salary.  Let me tell you, that is not a fun experience!  Given the stock market experiences 20% drops every 5 to 7 years, I would expect that there will be at least a couple more of these before we reach FIRE, and then a bunch thereafter given we will hopefully be around for quite some time.  It’d be nice to think that we’ll get used to them, but I suspect that it’ll still be at least somewhat stressful each and every time. 

Realistically it’s likely that at some point in our lives the value of our portfolio will go down by a million dollars or more.  That won’t be fun, although I guess maybe it’ll be something to talk about at barbecues?  I’ve written before about what a bear market feels like, and how you think you’ll feel and how you actually feel can be two very different things.

When you look at how you want to invest, you want to be bearing those future falls in mind and how you will react to them.  Typically that means having at least some of your money in safe investments like cash or term deposits or bonds so that you know that at least part of your portfolio is going to hold steady when everything else is crashing. 

Personally I think anywhere between 10% to 30% of your portfolio should be in defensive assets, with this likely increasing in dollar terms as you get closer to retirement but probably lower in percentage terms of the overall portfolio. 

Not co-incidentally this is what has historically worked out as being optimal for a successful retirement as per my own work and that of Dan at Ordinary Dollar, and has a lot less volatility than an all equities portfolio.

What’s your asset allocation?  Has this post changed your mind?  If you enjoyed this post and would like to read more like it please subscribe!