The “Sleep Well At Night” Investing Strategy

January 15, 2018

The “Sleep Well At Night” Investing Strategy

  • Investing is personal and should be more about sleeping well at night than returns.
  • I hope you sleep well at night because you are well prepared for what might happen and not because you don’t know the risks.
  • Unfortunately, sleeping well will always come at a short term cost but I think it’s well worth it.



Introduction

Two and a half years ago, I took out a mortgage with a fixed interest rate (3.55%) even though my friend from the Dutch National Bank was telling me to take the lower variable interest rate (2.5%) because the probability that interest rates would rise was very small and I could always change the variable rate to a fixed rate if necessary.

Taking a variable rate would have saved me about 5% of my monthly mortgage payment which isn’t much, but it’s still significant over time. (Note: the nominal difference is bigger than the actual because interest payments are tax deductible in the Netherlands.)

However, even with interest rates falling further in the last two years, I’m still happy to have a fixed mortgage because I sleep well at night. Sleeping well at night is one of the most important, if not the most important investing factor of them all. Today, we’ll discuss how to invest so you can sleep well at night.

Sleeping Well At Night

There are two ways to sleep well at night. One is to absolutely not care about what can happen, drinking your own Kool-Aid and convincing yourself that the strategy you have chosen is the best one. Given that the S&P 500 returned 20% last year and is up more than 200% in the past 8 years, many see a 100% exposure to stocks as the best investment out there with the belief that “In the long-term, stocks can only go up.”

The second way to sleep well at night is to create such a portfolio that really makes you sleep well at night because you know it will lead you to your financial goals no matter what happens in the financial environment. However, this requires a lot of studying to understand what can happen, lots of research to find the investments that fit your requirements, and patience to invest only when it is smart to do so.

I wasn’t really surprised when I read that Ray Dalio said that investors can expect 10-year returns from bonds and stocks to be around zero. This is much worse than the 4% long term returns he expected just a year ago. Well, as the market has gone up another 20% since then, there went the 4% returns that were supposed to happen over the next 5 years. So if you can expect returns of 0% over the next 10 years, which are probably not going to lead you to your investing goals, you can either take more risk or sell what you have and play it safe.

Selling Everything For Protection

If you would sell your stocks now, you would probably have done so two years ago because nothing has really changed. The long-term risks of holding stocks are still huge as you really can’t expect positive 10-year returns with a PE ratio of 26.46.

Figure 1: The S&P 500 boasts a price to earnings ratio of 26.4, 80% higher than the historical median. Source: Multpl.



The issue with selling everything is that you might miss out on further gains as the S&P 500 keeps going higher. However, you can’t time the market, and neither can anyone else. Therefore, you have to look at where you are in your financial life and answer one question: Would a market crash be good or bad for you?

You might wonder how a market crash can be good for anyone, but a market crash would be beneficial for most of those who are still investing a part of their pay check every day.  Our article about why a crash can be good for you explains the mechanics of such a situation better. So if a crash would actually do you good, stick to what you are doing as you can sleep well at night no matter what. However, if you really can’t afford a crash now because you need to retire in a few years or use that money for something else, then really think about cashing out.

What About Diversification?

One of the main stories that Wall Street sells is diversification, usually a 60% stocks and 40% bonds portfolio with the notion that when stocks fall, bonds will go higher as the FED will intervene and lower interest rates. This has worked well in the past 35 years, but the problem is that stocks and bonds have had positive long-term correlation due to declining interest rates.

Figure 2: The FED’s effective rate has been declining since 1982. Source: FRED.

From 1962 to 1982, a period with rising interest rates, stocks didn’t go anywhere while bonds were named certificates of confiscation. The Dow Jones index didn’t deliver a positive real return over 20-years even when we include dividends in the calculation.

Figure 3: The DOW and the S&P 500 from 1962 to 1982 with dividends adjusted for inflation. Source: Wall Street Journal.



How To Sleep Well, Then?

The way to sleep well is to have an all-weather portfolio where whatever happens, you will do well. However, a huge part of such a portfolio would be short term Treasuries as the risk of everything else is simply too big right now. However, you would sleep well.

The first thing you have to understand is that sleeping well comes at a cost. Your performance won’t track that of your neighbor or brother in law, but what it will probably do is lead you to your financial goals with no stress in the long term. It’s up to you.