Episode #147: The Stay Rich Portfolio (or, How to Add 2% Yield to Your Savings Account)

Episode #147: The Stay Rich Portfolio (or, How to Add 2% Yield to Your Savings Account)

Guest: Episode #147 has no guest, It’s a Mebisode.


Date Recorded: 2/27/19     |     Run-Time: 15:07

Summary: In this episode, you’ll hear Meb discuss a critical topic to consider for investors…The portfolio that helps you get rich isn’t necessarily the portfolio that’s going to help you remain rich. In this piece, Meb explains that risk-free assets often considered “safe,” aren’t exactly that, if viewed in the proper context. He proposes that with some thought, a strategy can be engineered to offer expected drawdowns similar to T-Bills historically, while at the same time, going above and beyond by historically offering exposure to some positive performance after inflation.

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Links from the Episode:

Transcript of Episode 147:

Welcome Message: Welcome to “The 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

Meb: Welcome, friends. We have another episode of Meb Shorts where today, we’re gonna be talking about a really fun topic near and dear to my heart. It was originally the two-part concept of questions we get a lot from people, where I think the conclusions are not what most investors would expect. And I think they fly in the face of most of Wall Street wisdom, and they really come from two prongs of what people ask me a lot.

The first being, “Hey, Meb. I’ve won the game. I’m wealthy. I have whatever the number is, 100,000, 1 million, 10 million, 100 million, and I wanna stay rich. I wanna protect my wealth. How do I do it?” And the second question is, “Hey, Meb. I really wanna compound as high as I can. What is the best method to do this?” And so we’re writing a two-part series. The first one we pinned in January called the Stay Rich Portfolio, or How to Add 2% Yield to Your Savings Account. And the second one called To Get Rich Portfolio will publish at some point, hopefully, in the second quarter. But today, I wanna talk about the Stay Rich Portfolio because I think it’s a really interesting topic that not a lot of people think about. So let’s get started.

In 2012, Eike Batista had an estimated net worth more than $35 billion, the self-made billionaire. He’s Brazilian. Created an empire that stretch from mining to oil to public works. Many considered him the pride of Brazil. About two years later, he lost it all, $35 billion. He actually owed an extra billion to creditors. How does that happen? How does a $35 billion portfolio practically evaporate overnight? You could point to several poor decisions, perhaps the biggest of all was concentration risk and also Buffet’s favourite destroyer, leverage.

Batista’s wealth was overwhelmingly tied to the global commodities boom. All that investment concentration was a huge tail end in helping Batista become rich but eventually proved his downfall as well. This points to a critical takeaway every investor needs to be aware of. The portfolio that helps you get rich isn’t necessarily the portfolio that’s going to help you stay rich. Research has shown that 70% of wealthy families lose their wealth by the second generation and a whopping 90% by the third generation. Granted, some of that is due to high spending, addiction, bad luck, leverage, or just poor decisions, but a lot of it is how people invest their money.

Can you invest in a certain way to bombproof your portfolio to minimize losses? In this piece, let’s do what Battista should have done. Let’s spend a few minutes focusing on the “stay rich” part of the equation. If you’re an investor who has already amassed great wealth and won the game, what’s the right market approach that’ll help you keep and potentially even grow your wealth? So, the second part is how safe are risk-free treasury bills? When trying to engineer a Stay Rich Portfolio, it makes sense to start with the investing community refers to as the risk-free rate. Most often we find this is the rate of current treasury bills.

Many investors believe T-Bills to be safest, most conservative investment available. In fact, if you look T-Bills back to 1926, they returned 3.4% per year with zero drawdown or losses. Pretty safe, right? Not so fast. These are nominal returns. And nominal returns are an illusion because they don’t take inflation into account. All that matters to any investor is returns after inflation or what we call real returns. And if you measure the returns of T-Bills after inflation, you see a different story.

Unfortunately, that’s the story most investors haven’t seen. So I recently asked my Twitter followers the following question. If you’re not on Twitter, hop on, I’m @MebFaber. So let’s say you’re a conservative investor and you put all of your money into safe U.S. government short-term treasury bills. How big of a drawdown, which is a peak-to-trough loss, after inflation did you experience in the 20th century? And the four pole choices were 0% to 15%, 15% to 30%, 30% to 45%, and worse than 45%. So 16 people said the first answer, 27, the second, 21, the third, 36, the last.

So the good news is most people got it right of the four choices. The bad news is the vast majority of people underestimated this. So 64, almost two-thirds of people had this wrong. Now, the actual real maximum drawdown was half. You lost half your money on after-inflation basis by putting it into safe T-Bills. By the way, the people that follow me on Twitter, you can’t follow me on Twitter unless you’re a pretty much big time quant financing nerd. We don’t tweet a whole lot of fun dialogue for the rest of the 99.9% of the world.

So the point being is that this audience is already curated, probably investment professionals, to where this number in this poll, the fact that two-third got this wrong would probably be much higher for the general population, than people who don’t have a long history in financial markets. So these are very intelligent people, good-looking too, by the way, Twitter followers, podcast listeners. Far greater investing experience in most, you know, they seriously underestimated the loss of short-term bonds.

So the risk-free rate isn’t risk-free after all. And I’m ignoring, by the way, as an example, other global sovereign bond markets that have produced 100% loss on investment, whether through hyperinflation, etc., defaults. The original version of this post that I wrote actually ignored a lot of what people actually do with their money. They leave in the bank with a 0% interest rate, the modern day version of stuff, again, under the mattress. I can’t tell you how many people… By the way, if you’re listening, ask yourself, “Do I know how much interest I’m getting on my cash in the bank?” And if you don’t know the answer, the answer is zero. For some of you others, you may be getting 0.1%, 0.2%.

But do you know you can actually get well over 2% right now totally protected in a savings account? So if you’re not, you’re just being lazy. So a full third of people responded when I asked another question of what they earn on their bank account. A third of people responded they earn 0% or didn’t know. So, by the way, if you don’t invest in T-Bills, you just put your money under the mattress, or you leave it in the bank account, we’re talking Bank of America here, where you’re getting 0% return, you’ll eventually lose all of your assets. We’re talking minus 97% at a clip of about 3% per year.

So it’s a slow bleed, people don’t notice it. But over time, it really adds up. That, by the way, is why a lot of older folks listening to this episode, the old phrase, “I remember when a Coke used to cost a quarter. I remember when movies were only $1.” That’s due to inflation. So what about other asset classes? Might real returns be safer elsewhere? Remember T-Bills lost half, putting money on a mattress lost 97%. Unfortunately, not. Losses are worse when we expand our analysis of other asset classes below or following a real max drawdowns back to 1926. U.S. stocks, were talking minus 80%. Same thing for foreign stocks. U.S. bonds at 10-year lost 60%. Foreign bonds at 80%, gold, 85%. Ouch.

The naysayer who’s listening, might look at this and say, “Yeah. But these are max drawdowns that likely played out over several years.” A smart investor would have gotten out after say a one-year of bad returns. Well, with that in mind, we published a table, and I’ll read it, that highlights the worst 12-month period of real returns for each of the aforementioned asset classes. Nothing was truly safe. Again, in one-year period, gold lost 40, foreign 10-year bond, same thing, U.S. bonds, 20, foreign stocks, 60, U.S. stock, 67, cash, 17, and money on the mattress, same thing.

So it’d be reasonable to argue that people would prefer a slow erosion or bleeding of wealth to a sharp loss. And, in this case, T-Bills do indeed look safest on these metrics. However, the slow erosion of bonds might appear less painful at first glance, but consider the analogy of the frog in the boiling water. I hear this might be an urban myth, but we’ll keep with the analogy. As it goes, you throw a frog in a pot of boiling water, feel the pain and jump right out. But if you put them in a pot of cool water and slowly turn on the burner, the frog will remain until it boils. The slow erosion of wealth with T-Bills is a bit like a frog sitting in water that’s simmering towards the boil.

Let’s pause and briefly recap. At this point, it’s clear, there’s no single asset that is guaranteed to preserve your wealth. The best we’ve done is lose half of your money. What now? Is there a way to combine assets to build a minimum loss portfolio? Asset allocation strategies have long been known to reduce risk for a portfolio at large. So what’s the worst drawdown we’ve seen with the venerated 60/40 portfolio? You still lose 50%.

All right, great. What if we expanded the global 60/40? A little bit better, minus 46%, shows the benefit of diversification. We still lost almost half. How about adding real assets like gold? This allocation looks a little bit like the global market portfolio we talked a lot about and discussed in our book, “Global Asset Allocation,” which free download if you go to cambriainvestments.com. We give up a little real return, but we lower our max drawdown. So, it’s a bit of a mixed bag.

So, for example, the real return on 60/40 is 5.5%, global 60/40, 4.8%, and the global market portfolio, 4.4%. But the max drawdown decreases from minus 54% to minus 46% to minus 39%. So a little better, but again, doesn’t really get us there where we wanna go. Those all points were takeaway, which I think is vastly understated by almost every investor on the planet. Nearly every allocation or every single asset class likely declined by at least a third on a real basis and probably more in your lifetime. Let that settle in for a minute. That’s a hard pill for many to swallow. But at least you have this knowledge ahead of time, which will hopefully that you anticipate and better weather the storm if and when it does happen.

So, why does it all matter, Meb? Are T-Bills still the safest. You might have listened to this and say, “Okay, you’ve been a real ray of sunshine, Meb, in showing me that every asset class and portfolio is still susceptible to huge drawdowns.” So if it’s all bad, then I might as well start back at the beginning. T-Bills seem to offer the lowest drawdowns, that’s where I’ll park my wealth. I’m gonna propose an alternative. And a part of this has been inspired by a friend, Dan Egan at Betterment, who puts a lot of his cash and savings to work investing. So I’ll give him a little hat tip here.

And so our studies have shown that historically, an investor can combine a diversified global market portfolio with some cash to produce an outcome with similar loss levels as T-Bills but yield much greater returns. So if you go back to 1926 to 2018 and you look at the real return, we’re gonna look at mattress, T-Bills, and then putting two-thirds in global market portfolio and a third in cash as an example. The real return in cash minus three, real return on mattress strategy, so bank at 0% are under the mattress, minus 3% per year. Cash, 0.5% per year. So better, you basically tread water with inflation.

But if you invest in stocks, and bonds, and real assets, and some cash, you know, a third in cash, you’re up to 3.2% real per year. So if you frame this as a savings account rather than an investing account, you have three choices. You lose 3% a year, you make 0.5% a year, or you earn 3.2% per year. Seems to be a clear choice, particularly when you look at the max drawdown. The max drawdown on mattress is you lose all your money, so 97%. The max drawdown on cash is you lose half. The max drawdown on our global asset allocation plus cash portfolio use 37%. So not only do you have lower real return drawdown, you have 3% higher returns.

So in both instances, it’s a better savings vehicle. And this goes to a lot of the takeaways of modern investing. I think it’s a marketing problem. If people looked at their bank account and said, “No, I’m seeing my investment brokerage account. I’m gonna rebrand that in my head as savings.” You have a totally different approach the way you think about it. You’d say, “Look, it’s gonna bounce around. But hell, T-Bills are gonna bounce around and lose half. So I wanna minimize my chance of drawdown, and I wanna maximize my chance of savings yield. “

So in this scenario, investing two-thirds in the global market portfolio gets you a much better yield, well over 2% higher than cash T-Bills. So if you were to say, “Okay, I’m gonna assume that T-Bills right now will do 2.5%.” This gets you up to 5% or 6% yield. How many people would take that? Almost everyone, right? And you said it’s gonna lose less. You may have to endure a little bit more volatility. But at least, historically speaking, the losses and return numbers were very similar.

Of course, as with a lot of stuff that Meb talks about, speaking in the third-person, that I talked about, whether it’s CAPE ratio, dividends, this is a philosophical departure for many. It’s kind of, like, you gotta take the blue pill to leave what I’m saying here. Mini conservative investors will continue to keep their safe money in savings account that earns T-Bill-like returns. But is that really the safest place for it?

History would suggest that investing across a broad global portfolio with some cash has actually been safer allocation than T-Bills alone. Now, about that high-spending child and their dare-like spouse, that’s another problem. PS, You guys know I love using trend. But since that’s an active strategy, I left it out of this discussion as well as any other tilts towards value, momentum, all the things we talked about in the Trinity Portfolio white paper. However, if you add in an allocation of trend in lieu of, or in addition to cash, historically, hypothetically, it would have helped the benefit of increased returns with even lower drawdown. You can read more about that in our white paper, the Trinity Portfolio. Again, free to download online.

And for those of you who don’t care about minimizing losses, the big risk takers, daredevils out there, but rather than maximizing gains, stay tuned for our next piece and the upcoming series, The Get Rich Portfolio. You can find more in our archives friends, mebfaber.com/podcast. Please leave us a review. We love reading them. Subscribe to the show on any of our favourite apps, RadioPublic, Breaker, Overcast, Stitcher, even iTunes. Send us some feedback at feedback@themebfabershow.com. Thanks for listening, friends, and good investing.