Everyone has been asking how I invest my own money. Some have basically pieced it together from various mentions across the blog, but I finally got around to laying it out in detail. I’ve named it the Ginger Ale Portfolio.
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Foreword – A Brief History of My Investing Journey
I hate when recipe websites tell an unnecessary, long-winded story before getting to the recipe, so feel free to skip straight to the portfolio by clicking here.
Starting around age 18, I spun my wheels for nearly a decade stock picking and trading options on TradeKing (which Ally later acquired), usually underperforming the market. I was naive and egotistical enough to think that I could outsmart and out-analyze other traders, at least on average.
Unfortunately, a math degree with a focus in statistics strengthened my faulty conviction for a few more years before I finally converted to index investing. Thinking back on that time and the way I traded (I don’t think I can even call it investing) makes me cringe now, so these days I try to do whatever I can to help others – particularly new, young investors – avoid those same pitfalls I succumbed to. I’d be much further ahead now had I just indexed from the start.
Since I had previously only traded U.S. securities and entirely ignored international assets, when I converted to index investing, I went 100% VTI for the total U.S. stock market (U.S. companies do business overseas, right?) and wrote myself an Investment Policy Statement (IPS) to avoid stock picking as a hard rule going forward. I was also still tempted to try to time the market using macroeconomic indicators and by selectively overweighting sectors around this time before realizing that sector bets are just stock picking lite, market timing tends to be more harmful than helpful, and the broad index fund does the self-cleansing and sector rearranging for me.
Then I dug deeper into the Bogleheads philosophy and realized I was still being ignorant by avoiding international stocks (more on this below), so I decided to throw in some VXUS at about 80/20 U.S. to international. I kept reading and researching and digging and concluded that I still had way too much home country bias. The U.S. is only one country out of many around the world! So I switched to 100% VT. Global stock market, market cap weighted. Can’t go wrong. And “100% VT” would still be my elevator answer for a young investor just starting out.
Then I got further into the nuances of evidence-based investing as well as the important behavioral aspects of investing and what the research had to say about these things – Fama and French, Markowitz and MPT, efficient markets, leverage, Black and Scholes, Merton Miller, asset allocation, risk tolerance, sequence risk, factors, dividend irrelevance, asset correlations, risk management, etc.
I started realizing that, in short, 100% VT is objectively suboptimal in terms of both expected returns and portfolio risk. Emerging Markets only comprise 11% of the global market. Small cap stocks make up an even smaller fraction. And we should probably avoid small cap growth stocks. And certain funds have superior exposure to Value than others based on their underlying index’s selection methodology. And can I stomach the drawdowns that accompany a 100% cap weighted stocks position during a crash? This line of thinking led me to books and lazy portfolios from present-day advisors like William Bernstein, Larry Swedroe, Ray Dalio, Paul Merriman, and Rick Ferri, all of whom influenced my thought process and subsequent portfolio construction.
I also realized there’s an observable tradeoff between simplicity and optimization. I’m a tinkerer by nature and tend to default to the latter, probably to a fault (i.e. overfitting and data mining), which is why this blog’s name is what it is, for better or for worse. People say indexing is boring, but it doesn’t have to be. There’s still plenty of learning to be had, and subsequent research-backed improvements to be made in the pursuit of optimization if you choose to tinker.
But don’t get me wrong. Simplicity is – and probably should be – a desirable characteristic of one’s portfolio for most people. Whatever allows you to sleep at night, stay the course, and not tinker during market downturns is the best strategy for you. It can take some time (and probably a market crash) to figure out what that strategy is. The portfolio below will seem “simple” to a stock picker with 100 holdings; it may seem complex to the indexer who is 100% VT.
So below I’ve pieced together what I think is optimal for me, based on my understanding of what the research thus far has to say about expected returns, volatility, diversification, risk, cognitive biases, and reliability of outcome, all while realizing I may get it wrong and that I may want to change it in the future.
About the Ginger Ale Portfolio
I’m bad at thinking of clever names for things. When writing posts, I usually sip on a can of ginger ale, so the Ginger Ale Portfolio seemed like an appropriate name.
Aside from “lottery ticket” fun money in the Hedgefundie Adventure and my taxable account in NTSX, this portfolio is basically how my “safe” money is invested. Leverage, while perhaps useful on paper for any investor, is probably not appropriate for most investors purely because of the emotional and psychological fortitude its usage requires during market turmoil.
Thus, for a one-size-fits-most portfolio, I can’t in good conscience just recommend a leveraged fund. Moreover, whatever I put below will likely just be blindly copied by many novice investors who won’t even bother reading or understanding the details, so I have to take that fact into consideration and be at least somewhat responsible.
This portfolio is 80/20 stocks to fixed income to, again, accommodate a one-size-fits-most asset allocation for multiple time horizons and risk tolerances. I’d call it medium risk simply because it has some allocation to fixed income. It is a lazy portfolio designed to match or beat the market return with lower volatility and risk. It heavily tilts toward small cap value to diversify the portfolio’s factor exposure. It is also diversified across geographies and asset classes.
In selecting specific funds, I looked for sufficient liquidity, appreciable factor loading, low tracking error, and low fees.
Here’s what it looks like:
Ginger Ale Portfolio Allocations:
- 20% U.S. Large Cap Stocks
- 20% U.S. Small Cap Value
- 15% Developed Markets (ex-US)
- 15% Emerging Markets
- 10% International (ex-US) Small Cap Value
- 10% U.S. Long-Term Treasury Bonds
- 5% TIPS
- 5% Emerging Markets Government Bonds
Below I’ll explain the reasoning behind each asset in detail.
U.S. Large Cap Stocks – 20%
Most lazy portfolios use U.S. stocks – and specifically large-cap U.S. stocks – as a “base.” This one is no different, but they’re still only at 20%. You’ll see why later.
Not much to explain here. The U.S. stock market comprises roughly half of the global stock market and has outperformed foreign stocks historically. I don’t feel comfortable going completely small caps for the equities side so we’re keeping large caps here to diversify across cap sizes, as large stocks beat small stocks during certain periods, while small stocks beat large stocks over other periods.
This segment captures household names like Amazon, Apple, Google, Johnson & Johnson, Microsoft, etc. Specifically, we’re using the S&P 500 Index – considered a sufficient barometer for “the market” – via Vanguard’s VOO.
Why not use VTI to capture the entire U.S. stock market including some small- and mid-caps? I’ll answer that in the next section.
U.S. Small Cap Value – 20%
I don’t use VTI (total U.S. stock market) because I want to avoid those pesky small-cap growth stocks which don’t tend to pay a risk premium. Even mid-cap growth hasn’t beaten large cap blend on a risk-adjusted basis.
Specifically, small cap growth stocks are the worst-performing segment of the market and are considered a “black hole” in investing. The Size factor premium – small stocks beat large stocks – seems to only apply in small cap value. As Cliff Asness from AQR says, “Size matters, if you control your junk.” Basically, if you want to bet on small caps, you want to do so in small cap value, preferably while also screening for profitability.
By “risk premium,” I’m referring to the independent sources of risk identified by Fama and French (and others) that we colloquially call “factors.” Examples include Beta, Size, Value, Profitability, Investment, and Momentum. I delved into those details in a separate post that I won’t repeat here, but I’ll be referring to these factors and their benefits quite a few times below. Though it may sound like magic, the evidence suggests that overweighting these independent risk factors both increases expected returns over the long term and decreases portfolio risk by diversifying the specific sources of that risk, as the factors are lowly correlated to each other and thus show up at different times.
I know the exclusion of mid-caps entirely seems bizarre at first glance too. Factor premia get larger and more statistically significant as you go smaller. That is, ideally you want to factor tilt within the small cap universe. That’s exactly what we’re doing here by basically taking a barbell approach in U.S. equities: using large caps and small caps to put the risk targeting exactly where we want it while still diversifying across cap sizes and equity styles. Essentially, we’re letting large caps be our Growth exposure in the U.S. and consciously avoiding small- and mid-cap growth stocks.
In short, small cap value stocks have smoked every other segment of the market historically thanks to the Size and Value factor premiums. “Value” refers to underpriced stocks relative to their book value. Basically, cheaper, sometimes crappier, downtrodden stocks have greater expected returns. Small cap value stocks are smaller and more value-y than mid-cap value stocks. Thus, no mid-caps. (As an aside, Alpha Architect basically takes this idea to the extreme – finding the absolute smallest, cheapest stocks and concentrating in only 50 of them; talk about a wild ride.)
I don’t want it to seem like I think this is some profound, contrarian approach. Using VTI (total stock market) instead of VOO (S&P 500) would be perfectly fine, and at only 20% of the portfolio, the difference is admittedly largely negligible. The simple point is that I’ve already decided on a specific small cap allocation, and I’m choosing to get that exposure through a dedicated small cap value fund rather than through VTI.
The fund I’ve chosen for U.S. small value tracks an index that also screens for strong financials, conveniently providing some exposure to the Profitability factor as well. That fund is VIOV from Vanguard. Full disclosure, I recently replaced it with the new fund AVUV from Avantis in my own portfolio (I explained why here), but AVUV is actively managed, so I can’t make a blanket recommendation to others for that fund given that VIOV is a fine choice to capture this market segment; I wouldn’t include it if it weren’t.
Some will note that Vanguard’s VBR is cheaper and more popular. I discussed here why VIOV is demonstrably better. In short, VIOV has superior factor exposure across the board, as VBR calls itself a small value fund but is unfortunately not very small or very value-y.
Developed Markets – 15%
Developed Markets refer to developed countries outside the U.S. – Australia, Canada, Germany, the UK, France, Japan, etc.
At its global weight, the U.S. only comprises about half of the global stock market. Most U.S. investors severely overweight U.S. stocks (called home country bias) and have an irrational fear of international stocks.
No single country consistently outperforms all the others in the world. If one did, that outperformance would also lead to relative overvaluation and a subsequent reversal. Consequently, we want to diversify across geographies in stocks.
During the period 1970 to 2008, an equity portfolio of 80% U.S. stocks and 20% international stocks had higher general and risk-adjusted returns than a 100% U.S. stock portfolio. Specifically, international stocks outperformed the U.S. in the years 1986-1988, 1993, 1999, 2002-2007, 2012, and 2017.
Dalio and Bridgewater maintain that global diversification in equities is going to become increasingly important given the geopolitical climate, trade and capital dynamics, and differences in monetary policy. They suggest that it is now even less prudent to assume a preconceived bet that any single country will be the clear winner in terms of stock market returns.
In short, geographic diversification in equities has huge potential upside and little downside for investors.
Vanguard offers a low-cost fund called the Vanguard FTSE Developed Markets ETF. Its ticker is VEA.
Emerging Markets – 15%
Emerging Markets refer to developing countries – China, Hong Kong, Taiwan, India, Brazil, Thailand, etc.
Stocks in these countries have paid a significant risk premium historically, compensating investors for taking on their greater risk. Arguably more importantly, Emerging Markets offer a lower correlation to U.S. stocks compared to Developed Markets, and thus are a superior diversifier. I delved into this in a little more detail here.
Emerging Markets only comprise about 11% of the global stock market. This is why I don’t use the popular VXUS (total international stock market) – because its ratio of Developed Markets to Emerging Markets is about 3:1. Here we’re using a 1:1 ratio of Developed to Emerging Markets, as well as a 1:1 ratio of U.S. to international stocks.
Vanguard’s Emerging Markets ETF is VWO.
International Small Cap Value – 10%
We can also specifically target small cap value in ex-US stocks. It costs a bit more to do so, and some who tilt small cap value in the U.S. don’t feel the need to do so in foreign stocks, but I think it’s a prudent move considering the factor premia – in this case Size and Value – have shown up at different time periods across different geographies throughout history.
Until just about a year ago, expensive dividend funds from WisdomTree (DGS and DLS) were arguably the best way to access this narrow segment of the global market. Now, Avantis has launched a fund available to retail investors that specifically targets international small cap value – AVDV.
I know I’m being a bit hypocritical in suggesting the actively-managed AVDV here while refusing to include the actively-managed AVUV for U.S. small value above. I think this case is different because there are far fewer options for ex-US small value. Again, prior to the launch of AVDV, we were forced to use dividend funds as a suboptimal proxy for international small cap value. Now AVDV is the only fund available to the public that specifically targets Size and Value (and conveniently, Profitability) in ex-US stocks. AVDV is also roughly half the cost of the former options DGS and DLS.
U.S. Long-Term Treasury Bonds – 10%
No well-diversified portfolio is complete without bonds, even at low, zero, or negative interest rates.
By diversifying across uncorrelated assets, we mean holding different assets that will perform well at different times. For example, when stocks zig, bonds tend to zag. Those 2 assets are uncorrelated. Holding both provides a smoother ride, reducing portfolio volatility (variability of return) and risk. We used the same concept above in relation to risk factor exposure. Now we’re talking about entirely separate asset classes, but we’re also taking advantage of the two risk premia in fixed income – term and credit.
I can see the waves of comments coming in, which I see all the time on forums and Reddit threads:
- “Bonds are useless at low yields!”
- “Bonds are for old people!”
- “Long bonds are too volatile and too susceptible to interest rate risk!”
- “Corporate bonds pay more!”
- “Interest rates can only go up from here! Bonds will be toast!”
- “Bonds return less than stocks!”
So why long term treasuries? Here are my brief rebuttals to the above.
- Bond duration should be roughly matched to one’s investing horizon, over which time a bond should return its par value plus interest. Betting on “safer,” shorter-term bonds with a duration shorter than your investing horizon could be described as market timing, which we know can’t be done profitably on a consistent basis. This is also a potentially costlier bet, as yields tend to increase as we extend bond duration, and long bonds better counteract stock crashes. More on that in a second.
- Moreover, in regards to bond duration, we know market timing doesn’t work with stocks, so why would we think it works with bonds and interest rates? Bonds have returns and interest payments. A bond’s duration is the point at which price risk and reinvestment risk – the components of what we refer to as a bond’s interest rate risk – are balanced. In this sense, though it may seem counterintuitive, matching bond duration to the investing horizon reduces interest rate risk and inflation risk for the investor. An increase in interest rates and subsequent drop in a bond’s price is price risk. A decrease in interest rates means future coupons are reinvested at the lower rate; this is reinvestment risk. A bond’s duration is an estimate of the precise point at which these two risks balance each other out to zero. If you have a long investing horizon and a short bond duration, you have more reinvestment risk and less price risk. If you have a short investing horizon and a long bond duration, you have less reinvestment risk and more price risk. Purposefully using one of these mismatches in expectation of specific interest rate behavior is intrinsically betting that your prediction of the future is better than the market’s, which should strike you as unlikely.
- It is fundamentally incorrect to say that bonds must necessarily lose money in a rising rate environment. Bonds only suffer from rising interest rates when those rates are rising faster than expected. Bonds handle low and slow rate increases just fine; look at the period of rising interest rates between 1940 and about 1975, where bonds kept rolling at their par and paid that sweet, steady coupon.
- New bonds bought by a bond index fund in a rising rate environment will be bought at the higher rate, while old ones at the previous lower rate are sold off. You’re not stuck with the same yield for your entire investing horizon. The reinvested higher yield makes up for any initial drop in price over the duration of the bond.
- We know that treasury bonds are an objectively superior diversifier alongside stocks compared to corporate bonds. This is also why I don’t use the popular total bond market fund BND.
- At such a low allocation of 10%, we need and want the greater volatility of long-term bonds so that they can more effectively counteract the downward movement of stocks, which are riskier and more volatile than bonds. We’re using them to reduce the portfolio’s volatility and risk. The vast majority of the portfolio’s risk is still being contributed by stocks. Using long bonds also provides some exposure to the term fixed income risk factor.
- We’re not talking about bonds held in isolation, which would probably be a bad investment right now. We’re talking about them in the context of a diversified portfolio alongside stocks, for which they are still the usual flight-to-safety asset during stock downturns. It has been noted that this uncorrelation of treasury bonds and stocks is even amplified during times of market turmoil, which researchers referred to as crisis alpha.
- Similarly, short-term decreases in bond prices do not mean the bonds are not still doing their job of buffering stock downturns.
- Bonds still offer the lowest correlation to stocks of any asset, meaning they’re still the best diversifier to hold alongside stocks. Even if rising rates mean bonds are a comparatively worse diversifier (for stocks) in terms of expected returns during that period does not mean they are not still the best diversifier to use.
- Historically, when treasury bonds moved in the same direction as stocks, it was usually up.
- Long bonds have beaten stocks over the last 20 years. We also know there have been plenty of periods where the market risk factor premium was negative, i.e. 1-month T Bills beat the stock market – the 15 years from 1929 to 1943, the 17 years from 1966-82, and the 13 years from 2000-12. Largely irrelevant, but just some fun stats for people who for some reason think stocks always outperform bonds.
- Interest rates are likely to stay low for a while. Also, there’s no reason to expect interest rates to rise just because they are low. People have been claiming “rates can only go up” for the past 20 years or so and they haven’t. They have gradually declined for the last 700 years without reversion to the mean. Negative rates aren’t out of the question, and we’re seeing them used in some foreign countries.
- Bond convexity means their asymmetric risk/return profile favors the upside.
- I acknowledge that post-Volcker monetary policy, resulting in falling interest rates, has driven the particularly stellar returns of the raging bond bull market since 1982, but I also think the Fed and U.S. monetary policy are fundamentally different since the Volcker era, likely allowing us to altogether avoid hyperinflationary environments like the late 1970’s going forward. That said, I’ve still thrown in some TIPS.
“The purity of noncallable, long-term, default-free treasury bonds provides the most powerful diversification to investor portfolios.”
Ok, bonds rant over.
For this piece, I’m using Vanguard’s VGLT.
TIPS (Treasury Inflation-Protected Securities) – 5%
TIPS are relatively new, complex instruments with a lot of moving pieces, so their details are beyond the scope of this post, but basically they’re treasury bonds linked to inflation, so they help hedge against unexpected, rapid inflation during which nominal bonds would likely suffer.
Here we’re using the low-cost intermediate-term TIPS fund from Schwab (SCHP), as Vanguard only offers a short-term TIPS fund.
Why not gold?
Gold is not a value-producing asset, meaning it has a long-term real expected return of zero. We still want our diversifiers to have positive future expected returns, otherwise we’re not really improving the expected risk-adjusted return of the portfolio. That is, an asset like gold reduces the portfolio’s volatility and risk but likely simply drags down its long-term total return.
Secondly, gold has not been a reliable inflation hedge historically. With its small positive correlation to stocks, I think gold may offer a short-term diversification benefit, but I invest for the long term and I try not to care about the short-term noise. I maintain that gold has no place in a long-term investment portfolio unless the investor is very risk averse and simply aims to minimize volatility and risk.
Lastly, gold funds are comparatively pretty pricey, and the metal is taxed as a collectible at 28%.
Emerging Markets Government Bonds – 5%
I know this one looks weird at first glance, too, but hear me out.
Government bonds from developing countries have much greater credit risk than those of developed countries, and thus tend to compensate investors in the form of a significant risk premium, in this case called “credit” or “default.” Junk bonds (high yield corporate bonds) offer the same credit risk, but they’re inherently highly correlated to stocks. Emerging markets government debt is lowly correlated to both U.S. stocks and U.S. bonds. I don’t subscribe to the “take your risk on the equities side” idea, and just like with stocks, I like the idea of avoiding an overweighting to Developed Markets assets that are highly correlated with U.S. assets.
Until fairly recently, holding Emerging Markets government debt was difficult due to illiquidity and subsequent greater implementation costs, but USD-hedged funds like Vanguard’s VWOB have emerged (pun intended) that have largely solved these issues. And at the end of the day, at a 5% allocation, it’s not going to break anything.
You might also be wondering why there’s no dedicated allocation to REITs. Though they are treated as such, REITs technically aren’t a distinct asset class. Interestingly, in the 2018 paper Are REITs a Distinct Asset Class?, Jared Kizer and Sean Grover found that we can achieve the same factor exposure that explains REIT returns – effectively replicating them – with a 66/34 split of small-cap value stocks and lower-credit bonds.
Now this obviously isn’t their exact replication (they used long-term corporate bonds), but with a healthy amount of small cap value stocks and some lower-credit government bonds from Emerging Markets, we can arguably get some behavior that mimics what REITs would otherwise do, while avoiding the idiosyncratic risk of the real estate market. Will this provide a diversification benefit? Probably not, because it’s debatable whether REITs even do that in the first place. But the point is we don’t have to worry about any dissonance from excluding them here.
Ginger Ale Portfolio – Historical Performance
Some of these funds are pretty new, so I had to use comparable mutual funds in some cases to extend this backtest. The furthest I could get was 1998, going through February 2021:
Here are the annual returns:
Here are the rolling returns:
Keep in mind the Size and Value premia and international stocks have suffered over the past decade, otherwise I think the differences in performance metrics would have been even greater.
Ginger Ale Portfolio Pie for M1 Finance
So putting the funds together, the resulting Ginger Ale Portfolio looks like this:
- VOO – 20%
- VIOV – 20%
- VEA – 15%
- VWO – 15%
- AVDV – 10%
- VGLT – 10%
- SCHP – 5%
- VWOB – 5%
You can add this pie to your portfolio on M1 Finance by clicking this link and then clicking “Save to my account.”
Being More Aggressive with 100% Stocks
If you’re young and/or you have a very high risk tolerance, you might be itching to ditch the bonds and go 100% stocks. Again, the one I designed above is sort of a one-size-fits-most asset allocation. Here’s a more aggressive version, basically giving 5% each to VOO, VIOV, VEA, and VWO:
- VOO – 25%
- VIOV – 25%
- VEA – 20%
- VWO – 20%
- AVDV – 10%
Just note that historically this would have resulted in worse performance than the original 80/20:
Questions, comments, concerns, criticisms? Let me know in the comments.
Disclosure: I am long VOO, AVUV, VEA, VWO, AVDV, VGLT, VWOB, and SCHP.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.