Do keep in mind that absolute returns are not the most important factor in investing. What you should care about are risk-adjusted returns of a particular asset, and return stability of your whole portfolio.
You can always use leverage to magnify the returns of any asset class up to whatever level you want. The only limiting factor there is risk and the cost of borrowing.
Before I learned about finance I thought that the purpose of diversification was safety. And it is, in part. But as a consequence of the AM-GM inequality [1], diversification actually increases your long-term returns. A returns stream of 8% every year will have substantially more money than a returns stream with a mean of 8%, that bounces up and down. If you play around with some numbers, you'll quickly see how profoundly important this fact is.
I'd love to see a primer for leveraged diversification for people at the Bogleheads level. A lot of people are under the impression that a three-fund portfolio is the pinnacle of responsible self-investing, or a target-date retirement fund. But when I dig in I see people regularly make the point that that isn't true diversification, that asset class diversification isn't sufficient, that diversification is about measuring what investments move counter to each other in different macroeconomic environments, that leveraging is good, etc. I want to know more about how to apply all that when managing retirement funds at Fidelity or Vanguard, but I'm never going to work for a quant firm.
What you should be trying to achieve is a portfolio that earns the exact same return every single year, and you can do that in part by looking at historical covariance of the asset's time series. However, you also want to take a prospective view, and think about which asset classes may become correlated in the future.
There's no universal answer here (in the out of sample case - you can solve it in-sample), however. And another huge, huge factor is tax. Making sure your investments are tax-efficient is extremely important. Nothing will do more to ruin your compounding than taxes. So whatever you do, carefully consider the tax implications of your choices.
A lot of people focus on the tax rate. But what's actually quite a bit more important is the tax frequency. If you pay long term capital gains every two years on your whole portfolio...that's much worse than paying short term capital gains once at the very end (over a long period). What this means is that you want to choose things like passive ETFs, that are not taxed on their internal rebalancing. Even if you were to find a mutual fund that beat that ETF by 1% every year, the tax consequences of that fund would likely make it not worthwhile, before even considering the high fees it would likely charge you.
> You can always use leverage to magnify the returns of any asset class up to whatever level you want. The only limiting factor there is risk and the cost of borrowing.
This is false. In order to maintain a constant amount of leverage, you need to buy and sell securities if your leverage isn't unity. With increasing leverage, as security prices increase, you need to buy securities as your position earns a better return than the underlying. Conversely, you need to sell securities as prices fall. Together, this reduces your overall return via volatility drag.
The Kelly Criterion has the math for the absolute max return you can get via levering up assets.
> This is false. In order to maintain a constant amount of leverage, you need to buy and sell securities if your leverage isn't unity. With increasing leverage, as security prices increase, you need to buy securities as your position earns a better return than the underlying. Conversely, you need to sell securities as prices fall. Together, this reduces your overall return via volatility drag.
Ya sure that's true if you want to maintain constant leverage, there are tradeoffs there.
> The Kelly Criterion has the math for the absolute max return you can get via levering up assets.
Not exactly. The Kelly Criterion is the maximum that you should lever, over all the probability-weighted paths the portfolio will take to maximize log(wealth). However, nobody actually uses full Kelly leverage, because of estimation/fit error. One third or so of Kelly leverage is more common.
The arithmetic vs. geometric mean distinction is a good one to note. Since you mention risk-adjusted return, do you favor any particular approaches to optimization? ReSolve makes a pretty strong case for numerical optimization, summarized by this decision tree based on prior beliefs:
I generally prefer using something like scipy.minimize to maximize the expected sharpe ratio with returns de-magnified, which causes the optimization to be closer to a minimum variance portfolio.
> A returns stream of 8% every year will have substantially more money than a returns stream with a mean of 8%, that bounces up and down.
Also why the US is so rich growing at ~2.5% every year without failure vs. e.g. $emerging_economy which can grow at 8.0% on average but with significant volatility
(I'm on mobile so the exact numbers above may vary but the point stands)
That discounts businesses that collapse entirely, or under-preform enough to exit the index market. Indexes are misleading because they have a strong survivor bias. Stocks that slipped out of the S&P 500 entirely no longer register, but the money you had in them sure does.
That would be the massive amount of QE & money injected into the system. I doubt next recession it will be so simple to sell the bonds we need to to run a massive QU campaign again
Keep in mind that these are cherry-picked, they only include American returns. The 20th century was an exceptional one for the United States. The 21st century may also be, but you should definitely be diversifying globally.
The worst case return definitely isn't on this list, it's the returns from 1914 Germany, which didn't break even until 2014...
Definitely. Having said that very few countries have an advanced financial system. Probably a handful of cities globally, and even then some like Singapore or HK werent a thing 100 years ago.
But about that whole Germany thing, they did kinda, sorta, really screwed the pooch on that one by starting 2 world wars. Maybe they kinda, sorta, you know...had it coming.
Now the fun part. Pick any 30 year period, and you will beat inflation with stocks. Even if you get in at a peak, 30 years later, you will be well ahead.
Real estate is tricky because you're usually gambling with someone else's money (ie a mortgage) and your access to that is dependent on many factors like provable income and credit rating.
I recommend you download the spreadsheet, it can be really helpful in doing the 'null' hypothesis in financial analysis. I always like to compare my choices in investments versus the 'stick it into SPX500 ETFs' as the alternative. To do that you need to collect all this data, which is doable, but hey here they have it all in a nice package.
I'm curious -- what does HN think of factor investing [0]? It has been shown over long periods of time to outperform the total market, and has seen many new ETFs available. Does anyone here tilt towards small cap value? Do you think those effects will last, now that they're more widely known, or are the last 15 years evidence of them weakening? I've been looking into investing but I'm probably going with a total world stock market. Part of the reason I find those ETFs less attractive are the higher associated fees as well as the more "active" look. I have trouble believing anyone who claims there is a way to consistently outperform the market while charging me for it.
Readit News
You can always use leverage to magnify the returns of any asset class up to whatever level you want. The only limiting factor there is risk and the cost of borrowing.
Before I learned about finance I thought that the purpose of diversification was safety. And it is, in part. But as a consequence of the AM-GM inequality [1], diversification actually increases your long-term returns. A returns stream of 8% every year will have substantially more money than a returns stream with a mean of 8%, that bounces up and down. If you play around with some numbers, you'll quickly see how profoundly important this fact is.
1. https://en.wikipedia.org/wiki/Inequality_of_arithmetic_and_g...
https://github.com/robertmartin8/PyPortfolioOpt
What you should be trying to achieve is a portfolio that earns the exact same return every single year, and you can do that in part by looking at historical covariance of the asset's time series. However, you also want to take a prospective view, and think about which asset classes may become correlated in the future.
There's no universal answer here (in the out of sample case - you can solve it in-sample), however. And another huge, huge factor is tax. Making sure your investments are tax-efficient is extremely important. Nothing will do more to ruin your compounding than taxes. So whatever you do, carefully consider the tax implications of your choices.
A lot of people focus on the tax rate. But what's actually quite a bit more important is the tax frequency. If you pay long term capital gains every two years on your whole portfolio...that's much worse than paying short term capital gains once at the very end (over a long period). What this means is that you want to choose things like passive ETFs, that are not taxed on their internal rebalancing. Even if you were to find a mutual fund that beat that ETF by 1% every year, the tax consequences of that fund would likely make it not worthwhile, before even considering the high fees it would likely charge you.
This is false. In order to maintain a constant amount of leverage, you need to buy and sell securities if your leverage isn't unity. With increasing leverage, as security prices increase, you need to buy securities as your position earns a better return than the underlying. Conversely, you need to sell securities as prices fall. Together, this reduces your overall return via volatility drag.
The Kelly Criterion has the math for the absolute max return you can get via levering up assets.
Ya sure that's true if you want to maintain constant leverage, there are tradeoffs there.
> The Kelly Criterion has the math for the absolute max return you can get via levering up assets.
Not exactly. The Kelly Criterion is the maximum that you should lever, over all the probability-weighted paths the portfolio will take to maximize log(wealth). However, nobody actually uses full Kelly leverage, because of estimation/fit error. One third or so of Kelly leverage is more common.
Low transaction fees being an obvious example. If moving from one asset category to another involved paying high taxes, it’s very rarely worth it.
https://twitter.com/gestaltu/status/1044977487556595714
Also why the US is so rich growing at ~2.5% every year without failure vs. e.g. $emerging_economy which can grow at 8.0% on average but with significant volatility
(I'm on mobile so the exact numbers above may vary but the point stands)
Even for the crash of the early 1930's, after 8 years you were back to where you were.
https://seekingalpha.com/article/207935-is-there-survivorshi...
I'd like to see the S&P performance of then current index stocks over the same time period, im guessing it would be significantly worse.
The worst case return definitely isn't on this list, it's the returns from 1914 Germany, which didn't break even until 2014...
But about that whole Germany thing, they did kinda, sorta, really screwed the pooch on that one by starting 2 world wars. Maybe they kinda, sorta, you know...had it coming.
Accounting for inflation reduces the ROI by an order of magnitude, but the result is still impressive! (36,560.12% return)
https://www.in2013dollars.com/us/stocks/s-p-500/1928
[0] https://www.investopedia.com/terms/f/factor-investing.asp