Is This The Perfect Portfolio?

April 30, 2018

Is This The Perfect Portfolio?

  • We’ll discuss how Robert Shiller predicted the stock market bubble in the 1990s and how it resembles the current situation.
  • We’ll also discuss the perfect portfolio.



Introduction

I recently listened to an interview with Nobel Prize winner Robert J. Shiller on the topic of finding the perfect portfolio. It’s a very interesting subject, so I’ll summarize the interview and discuss the key concepts.

Before we dig deeper, let me first describe a few interesting interview intros. Shiller didn’t get the Nobel Prize for nothing as he correctly identified that stocks were in a bubble in the 1990s, and that real estate was in a bubble in the 2000s.

It’s interesting how, when testifying before the Federal Reserve Board in 1996, Shiller said the market was in a bubble, especially the tech part of it. He was only 4 years early, and saw the market double again in those 4 years only to be proven right later. But this is one of the most difficult things to understand when investing, risk-reward.

Shiller and his co-author, Campbell, told the FED how markets were irrationally exuberant and two days later, Alan Greenspan made his famous irrational exuberance speech. It’s interesting how they came to the conclusion that the markets were in a bubble.

These were the two criteria they looked at:

#1: Watch the crowd not the game.

When everybody is talking about the stock market, you know that things are getting irrational. Last year, we saw what happened to cryptocurrencies and who knows if this mania surrounding stocks will end anytime soon.

I googled the phrase “stocks to buy,” and we can see how interest has been rising over the past 5 years right alongside rising stock prices.

Figure 1: Google trends for the phrase “stocks to buy.” Source: Google.



As you can see, bull market interest for the stock market and for buying stocks has been going up constantly which usually indicates that euphoria is here and a bubble might be too.

#2: CAPE ratio – Cyclically Adjusted Price to Earnings ratio.

The second indicator Shiller and Campbell used is the CAPE ratio, which uses 10-year average earnings to get the common valuation metric so as to smooth out cyclical influences.

Figure 2: CAPE ratio over time. Source: Multpl.

In 1996, the CAPE ratio was 24.76 which means that either earnings had to go up for investors to reach significant returns or prices had to go down. Historically, the case has been that prices go down and that is what happened in the 2000 to 2002 period even though the CAPE ratio skyrocketed to 43 in 2000.

Further, Shiller tells us—but also anyone who studies history will tell you—that good economic times are usually followed by bad economic times and that has been the case in the past 5,000 years and will probably be the case in the next 5,000. However, the run-up in stocks between 1996 to 2000, and from 2009 to today, makes history seem irrelevant.

From my perspective, we should take advantage of the market’s irrationality but also know when to say enough is enough, leave the greed aside, and take our gains and switch to protection.

Another bubble that is mentioned is the real estate bubble which I will dedicate a special article to as things are getting similar to how things were in 2007. In this environment, here’s what Shiller would say is a perfect portfolio.



The Perfect Portfolio

Shiller describes the perfect portfolio as one with high levels of diversification which includes investing abroad and across various asset classes, and it has to be related to your own personal vulnerabilities. For example, if you work in the automotive industry and your salary depends on it, you should be short automotive stocks to be well diversified.

Also, Shiller advocates bonds linked to GDP as governments would be less leveraged as tax revenues would correspond to their obligations. GDP is much bigger than corporate profits and would be a much better diversification. There are no GDP-linked bonds, but perhaps there will be in the future. An interesting thought for financial innovation.

Conclusion

I know that financial innovation is scary, but when it’s well diversified, all you need to do is rebalance across various asset classes in relation to the risk and reward. You don’t even have to think much, just do it once a year and you will do extremely well over time.