As markets fall, now is a good time to 'take your medicine, save more and spend less', according to the highly respected US fund manager, Meb Faber.
In other words, Faber thinks that if the expected returns from your portfolio are going to be low, you need to invest more. Faber told me this when I interviewed him before Christmas for our latest Big Call Radio Show.
Faber is a man with loads of other interesting ideas, so I thought it would be a good idea to compile some of them here. The ideas either come from the Big Call interview or from Faber's book: 'Global asset allocation - a survey of the world's top investment strategies.'
Let's start with some of his evergreen ideas that apply all of the time, and then we'll look at some of Faber's thoughts about current markets.
If you invest at an expensive valuation, poor returns are likely.
Look at this chart from Faber's book.
Ten-year CAPE ratio vs future returns 1900-2014
So if you invested in the US market when the cyclically adjusted price/earnings ratio (CAPE ratio) was under ten; on average, you'd get a real return of more than 10% a year over the following decade. That's 10% a year on top of inflation! But if you invested at a CAPE ratio above 25, you'd get a negative return over the next ten years.
Diversify by asset class - the only free lunch in investing
This chart, also from Faber's book, looks at the real returns from three portfolios over a century. The first is the US bond market, the second is US shares, and the third is a 60/40 portfolio which is comprised of 60% US equities, and 40% bonds.
US asset class real returns 1913-2013
By going for the 60/40 portfolio, you reduce the annual return from 6.59% a year (stocks) to 5.11% a year (60/40). So you could argue that the diversification away from the stock market was a mistake. But you've also reduced your volatility from 18.61% to 11.79%. In other words, the risk has come down. The 60/40 Sharpe ratio, which measures risk-free returns, is higher at 0.4.
'Maximum drawdown' means the portfolio's biggest fall from its previous all-time high. Interestingly, the 60/40 portfolio does best on this criterion.
So a simple piece of diversification was worth doing back in 1913. Right now though, a 60/40 portfolio may not be the best strategy. We'll discuss why later in the article.
Gold and other real assets can be a good diversifier
In his book, Faber also discusses a 'Marc Faber' portfolio which implements the ideas of Marc Faber, another well known investor and fan of gold. This portfolio has 25% in stocks, 25% in bonds, 25% in commercial property, and 25% in gold. (The stocks are split between US companies and overseas ones.)
Real returns including 'Marc Faber portfolio' 1973-2013
You can see that stocks do deliver a slightly better annual return than the Marc Faber portfolio, but the Faber portfolio scores better when you look at volatility, the Sharpe ratio, and maximum drawdown.
If you want to invest in gold, you could consider the ETFS Physical Gold ETC | PHGP. This isn't an ETF, it's an exchange-traded commodity, which means it has less regulatory protection than an ETF, but it is backed by gold bars in a vault.
Buy cheap assets and avoid expensive ones
This quote from The Big Call interview sums it up:
Part of the value approach is 'you're investing in the cheap stuff and that's good, and people understand that, but it's equally important avoid the expensive stuff too‚Ä¶I mentioned the US and there are a few other countries that are on the expensive side but historically, avoiding countries like Japan in the 80s and the BRICs in the mid-2000s is equally as important.'
Don't go all in
Here's another quote from The Big Call: 'The feeling of a binary outcome where you have to be all in or all out of something is one of the biggest mistakes investors make.'
So if, for example, you think that gold offers the best opportunity in current markets, don't put all your money in gold. Just tilt your portfolio in that direction.
The US is expensive but some markets are cheap
Before Christmas, Faber said that the US market was still expensive. It's down 2% since then, and I don't think that's a big enough fall for Faber to change his mind. But he was more upbeat about the rest of the world:
'The good news is most of the rest of the world is reasonably priced to cheap to downright screaming cheap.'
He cited emerging markets, and particularly emerging Europe as areas where valuations are attractive.
If you want to invest in emerging markets, read Four top emerging markets ETFs.
The UK is cheap too
Faber also thinks that UK shares have fallen too far. Read more in
60/40 isn't a great strategy currently
Although 60/40 has often worked well over the last century, it may not be such a good strategy for now. That's because both bonds and US equities look expensive, so neither asset may perform well. Their movements may be more correlated than usual in the next few years. In other words, they may both go down!
Take your medicine!
I mentioned Faber's 'take your medicine' advice at the beginning of the article. His advice to save more, and invest more is especially relevant if you're investing in an expensive market such as the US where returns are likely to be poor. If an investment isn't going to grow much, you need to save more to build a decent nest egg.
But 'take your medicine' is also good advice when it comes to cheaper markets. After all, if you can find extra cash to invest in cheaper areas such as emerging markets, that should stand you in good stead.
Just make sure you don't make one big bet and pile all your cash into emerging markets. That's a mistake for any market - above all else, you should always diversify.