At the start of 2020, I took a fresh look at the stock market and realized that it was up about four times from 2010. Many people who had $250,000 in the markets in 2010 are now millionaires. My wife and I started working before 2000, so we had already saved up a lot in our 401ks and Roth IRAs before 2010.
I was excited by all this progress. The plan was working to perfection. I had a fear… I didn’t want to lose all these gains. However, we weren’t 45 years old, so we still had a decade or two before we started to access these retirement accounts. I wanted to stay invested, but I didn’t want to take the big risks that I did when I was 25. At that time, not only was I young, but the market had collapsed with the Dot Com bust of 2000. It was the perfect time to buy growth stocks.
In 2020, it looked like technology dominated the stock market. The world’s biggest companies were not GE, Walmart, Citibank, and Exxon like they were back in 2000. Instead, we have GAMAF: Google, Apple, Microsoft, Amazon, and Facebook. (I’m substituting Microsoft for Netflix in the popular FAANG acronym.) To reduce tech risk I replaced much of the major total market index ETF I had (VTI) with a high-dividend index ETF (HDV).
I may have lost out on some gains as the pandemic was great for tech stocks. Alternatively, many companies cut their dividends. However, vaccines came out and the boring companies that are in the high-dividend index are thriving. Those boring consumer staples and energy companies are in-demand as they are generally inflation-proof.
There was one other way that I tried to protect our money in 2020. I added more bonds. I haven’t been a big fan of bonds because historically, the best returns come from stocks. I’d rather have 60 years of 10-12% returns than 60 years of 4-6% returns. However, with stocks in a 10-year bull market, I felt it was best to move some money to bonds to diversify with a lower-risk asset. I slowly started to buy Vanguard’s major bond ETF (NASDAQ: BND).
Fast-forward to today and I was either smart or very lucky. I think maybe it was a little of both. HDV is only down about 5% from its highs. VTI is down around 20%. The tech-heavy NASDAQ index has been off of its highs by about 30%. Bonds haven’t been great as they’ve been down about 11% – but they are at least better than VTI.
One of my good friends has an Investment Policy Statement (IPS) that she loves. An IPS puts down in writing how you are going to invest in advance of any market conditions. The beauty is that once you have your philosophy in black and white you simply have to just execute it. I’ve been thinking about creating one for some time, but I’ve been living up to my Lazy Man moniker on that one.
With the market going down and possibly heading further down, I’ve started to think more seriously about what might be in my IPS. One thing I know for sure would be a valuation-based asset allocation. I know a lot of people stick to one asset allocation and change it to be more conservative as they grow older. One old rule of thumb is that you should subtract your age from 100 and have that percentage in stocks. Thus, at age 45 now, I would have 55% in stocks (100-45). I’m an aggressive investor so that rule of thumb doesn’t sound great to me. (It may work beautifully for you though.)
While I do believe that age should be important in asset allocation, I also believe that the market’s valuation should be considered. Here’s a chart of the Shiller P/E:
The Shiller P/E is an indicator of how expensive the market is. The higher the number, the higher the price you are paying for the earnings. One thing that you’ll notice is that for 125 years until the last decade, when the P/E is above 25 there’s been a crash. It can stay up there for a little while. It almost always crashes at 30 until the last ten years or so. It’s crashed down a bit from 37, but could still have some way to go.
That’s why I came up with…
Lazy Man Rule of 20
The Lazy Man Rule of 20 says that my bonds should be around the Shiller P/E minus 20. When the Shiller P/E was 37, I should have had 17% in bonds. In reality, I had around 15% of my money in bonds. (This is a new rule that I’m implementing now, but it would have been nice to have been at 17% bonds.) Now that the Shiller P/E is at 30, I should have around 10% in bonds. I have been selling off bonds and buying stocks (including the NASDAQ at 30% off), but I still have about 11.25% of my money in bonds. The next day that stocks go down, I may sell 1% of my bonds and buy stocks.
Let’s look at how this may have worked in big market bubbles and crashes in the past. I’ll start with my first year out of college in 1998:
- Bubble of 1998
At the top of the market in 1999, the Shiller PE hit about 45. Using my rule of 20, I should have 25% of my money in bonds (45-20=25). In hindsight, it should be 100%, but 25% bonds for an aggressive investor at age 25 is a lot. I may have missed the run-up in 1997 and 1998 as I sold stocks to buy that 25% in bonds.
- Crash of 2000
As the market starts to crash in 2000, I allow myself to sell the bonds to buy stocks. Bonds performed well from 2000 to 2003, but the stock market was down 9% in 2000, 12% in 2001, and 23% in 2002. By the time it recovers in 2003 the Shiller PE was 23, which means that I only 3% bonds and 97% stocks. That goes to about 7% bonds (Shiller P/E of 27) until we get to 2008.
- Crash of 2008
When the crash of 2008 hits, the Shiller P/E goes to 15%. Suddenly, I was allowed to have -5% bonds. Realistically, I can’t do that, so I get to 100% stocks while the market recovers.
- Bull Run from 2010 to 2020
During this time, I’m gradually selling stocks and buying bonds. In 2013, I only have 2% bonds. By 2014, I’m up to 5% bonds. In 2015, I’m up to 6.50% bonds. This continues… in 2017 I had 8%, in 2018, I had 13%, in 2019, I have 8%. Finally, in 2000, I’d be back up to 11%.
One of the keys to my Lazy Man Rule of 20 is that I stay invested. I’m not pulling money in and out of the market. Some people claim that you can’t time the market. Is valuation-based asset allocation timing the market? I think it depends on who you ask. I think it is, but I’m using the market itself to tell me what to do.
Make Your Own Rule
I picked my Rule of 20 out of thin air. It was based on my gut feel and I’ve acted when the stock market is up and down. It was only recently that I made the connection that I tend to have bonds that are Shiller P/E minus 20.
If you are a more conservative investor you might want to choose to keep bonds that are equal to Shiller P/E. Or maybe if you are in retirement, you want to have twice the Shiller P/E in bonds. As I get older, I may move from my Rule of 20 to go through all these valuations.
What do you think? Are you going to explore valuation-based asset allocation? If so, let me know what your rules might be in the comments.