The Trinity Portfolio: A Long-Term Investing Framework Engineered For Simplicity, Safety, And Outperformance by Meb Faber, Cambria Investment Management
I am a quant.
In other words, data, numbers, and verifiable results dictate my investment decisions. This makes it difficult for me to place my faith in any one investment strategy – much less advocate it to others. Yet that’s what I’m doing in this paper, as I find myself strongly believing in the investing framework I’ll detail in the following pages.
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There are a few reasons why I’m willing to stand behind this strategy. First, based on my personal research, it produces returns that historically outperform those of common benchmark portfolios. Second, the same research suggests it does this with reduced volatility and drawdowns.
However, there are abundant investing strategies claiming great returns and/or lower volatility, many of which I’ve written about. In fact, over the last ten years, I’ve written five books, ten white papers, and over fifteen-hundred investing articles. Why is this portfolio different?
The answer leads us to the third reason why I believe in this framework: It addresses a major question facing many investors today — “how do I put it all together?” Investors today have access to more market data and strategic information than at any other time in history. Yet from the perspective of the average investor, this huge volume of fragmented information presents a challenge — how should one actually implement everything?
So the third reason I’m advocating this framework is because it’s holistic. On one hand, the approach is broad and sturdy, rooted in respected, wealth-building investment principles. On the other hand, it’s strategic and intuitive, able to adapt to all sorts of market conditions. The result is a unified, complementary framework that can relieve investors of the handwringing and anxiety of “what’s the right strategy right now?”
If you’re an investor who’s struggled with generating long-term returns that make a real difference in your wealth, I believe this portfolio can help. If you want less anxiety during periods of heightened market volatility and drawdowns, I believe this portfolio can help. And if you’re unsure how to balance the simplicity of buy-and-hold with the various benefits of an active portfolio, I think the investing framework in this paper can help.
If that sounds like your type of investing, I hope you’ll read on.
The Foundation Of The Trinity Portfolio
I’ve named the portfolio you’re reading about today “The Trinity Portfolio.” Actually, a creative reader of my blog suggested the name, but as it’s appropriate, it stuck.
“Trinity” is a reference to the three core elements of the portfolio: 1) assets diversified across a global investment set, 2) tilts toward investments exhibiting value and momentum traits, and 3) exposure to trend following.
If you find any of these terms unfamiliar, don’t worry. We’ll detail each in the pages to come. At this point, I present them more as a set of guideposts.
You see, in addition to being the foundational elements of the Trinity Portfolio, these three pieces also provide us the sequence to follow when constructing the portfolio. Three chronological “steps,” if you will. So as I introduce Trinity, we’ll follow this three-step roadmap. We’ll analyze the effect of each step on our portfolio, considering its impact on returns, volatility, as well as a few other metrics. This will enable you to see the exact engineering behind our final result.
Let’s dive in.
STEP 1-A: Assets Diversified Across a Global Investment Set
Let’s say you set out to design a portfolio, knowing everything we know today about investing. How would a logical, evidence-based investor construct such a portfolio?
First, you would start out with the basics: U.S. stocks and U.S. bonds. How has that performed historically? Below is a data table followed by a chart depicting their returns back to 1926. It demonstrates the true dominance of stocks over the last century.
(If you’re unfamiliar with any of the included metrics, please refer to the appendix for their definitions.)
But while stocks experienced nearly double the annual returns of bonds, they were not without risk. As you’ll see in the chart below, stocks suffered numerous declines of “only” 40-50%, on top of the massive drawdown of over 80% during the Great Depression. The unfortunate mathematics of an 80% decline requires an investor to realize a 400% gain just to get back to even!
While “stocks for the long run” would have resulted in much higher ending wealth, very few investors could have sat through that bumpy ride to arrive unscathed at the finish. Picture your portfolio right now, and subtract 80% — could you sit through that?
However, comparing stock and bond returns is not totally fair. In order to accurately compare returns over time we need to include the impact of inflation on a portfolio.
Below are real returns of stocks and bonds (real returns are the returns of an asset after subtracting the wealth-eroding effect of inflation). We often describe real returns as “returns you can eat.”
After adjusting to include the effect of inflation, we see an interesting difference. Notice that whereas the stock drawdown charts appear fairly similar, the bond drawdown charts are substantially different due to the high inflationary periods of the 1950s through the 1970s. During those decades when inflation soared, the result was a long, painful drawdown for bonds.
This points toward an important difference between stock and bond investing: While stocks often suffer from sharp price declines, bonds usually suffer from the slower erosion of inflation. And while stocks outperform bonds over the long term, there have been periods of 20 (1929 – 1949), even 40 years (1969 – 2009) where stocks underperformed bonds. (And if you include the 1800s, there was a 68-year period of zero stock outperformance!)
Because different economic environments affect stocks and bonds in various ways, and since we cannot predict what the future will hold, it makes sense to allocate to both types of investments rather than just one. In other words, we diversify our portfolios.
Diversification has been called “the only free lunch in investing.” The free lunch, so to speak, is the benefit an investor receives from diversifying his investing capital into two assets that are not perfectly correlated. The idea is when one asset falls, the negative impact on the overall portfolio is softened as the second asset won’t fall to the same degree (or may even rise) since there is not perfect correlation. In essence, by investing in uncorrelated assets, 1 + 1 = 3.
With this in mind, let’s look at the traditional 60/40 portfolio comprised of 60% U.S. stocks and 40% U.S. bonds.
This portfolio is often seen as the starting point onto which investors layer additional asset classes and/or strategies. Given that, we might think of the 60/40 portfolio as our “Asset Allocation 101” portfolio.
Notice the benefits of combining U.S. stocks and bonds. The Sharpe ratio increases substantially. And while volatility tamps down significantly from “just stock” levels, an investor doesn’t lose much in terms of returns. But the U.S. 60/40 portfolio is not without its drawbacks.
A portfolio consisting of just U.S. stocks and U.S. bonds leaves investors exposed to an obvious problem: What if one of those two assets underperforms? What if both assets do poorly? Despite lower volatility than just stocks alone, the 60/40 portfolio still had a whopping 60% drawdown.
Plus, with just two assets in the 60/40 portfolio, your portfolio’s future returns are especially sensitive to each asset’s starting valuation. In other words, the price you pay influences your rate of return. Pay a below average price and you can reasonably expect an above average return, and vice versa. (For those unfamiliar with valuation methods for stocks, I discuss this in detail in my book Global Value.)
What are valuations today telling us about U.S. 60/40 returns going forward for the next decade?
As I have demonstrated in my Global Value book, U.S. stocks are priced at a premium Shiller CAPE ratio of around 25. This means I expect returns to remain low, around 4% a year. Bond yields are easy to forecast, and if held to maturity should return their 1.6% current yield.
Many institutions agree with our analysis, and a recent report by AQR Capital Management pegged the forward-looking real return of the U.S. 60/40 portfolio at the lowest level in over 100 years! Note that these anemic returns fall woefully shy of the 8% returns most pension funds and investors expect. Given this, it’s clear that while the U.S. 60/40 portfolio is a fine starting point, it’s hardly where we want to end up. So what’s our next step?
Simple — go global.
See full PDF below.