Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. The more different you are from the person that defined a rule the less you should follow the rule. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.

3 things you won't find in my portfolio

“Learning to choose is hard. Learning to choose well is harder. And learning to choose well in a world of unlimited possibilities is harder still, perhaps too hard.”

― Barry Schwartz in The Paradox of Choice

We have an abundance of choice as investors. This is often characterised as a good thing. I’m not so sure.

Once the basics have been covered – and they have – choice becomes problematic for investors. When there are lots of choices it means the providers of investment products must work harder to get chosen. This means more niche products. It means more products that appeal to our base emotions.

We start to see sensible ideas like John Bogle’s championing of passive investing perverted by narrower and narrower indexes. Worst of all investor behaviour is negatively impacted by choice and the aggressive marketing that is needed to stand out. Many people bounce between different choices far too often and churn their portfolios.

Our financial outcomes are likely more a result of what we choose not to buy than what we choose to buy. With that in mind here are three types of investments you won’t find in my portfolio.

Bonds

We can start with the big categories. And bonds are a big and controversial exclusion from my portfolio. I wrote an article creatively titled ‘why I don’t invest in bonds’ which goes through my argument in detail.

There are four points that I made in my article. All of which challenge conventional wisdom.

  1. Volatility is not how most investors should think about risk over the long-term. The real risk is not earning high enough real – or after inflation – returns to meet my goal.
  2. The trade-off for getting lower volatility is meaningfully lowering long-term returns. This significantly impacts the risk of not achieving my goal.
  3. Bonds lower volatility but have significantly higher inflation risk when compared to shares. The risk of inflation destroying the purchasing power of my portfolio is one of the biggest risks that I face as an investor.
  4. While volatility is not a risk most long-term investors face it does cause most people to make more bad decisions. That impacts long-term returns. I believe my track record during bear markets and temperament lower the chances I panic.

The fact that I don’t invest in bonds does not mean all of my wealth is in the share market. I do hold defensive assets. Just not bonds. I just don’t think the trade-off is worth it with bonds.

Bonds lower volatility but they do not eliminate it. Bonds still exhibit volatility. Just less than shares. Sometimes bonds are negatively correlated to shares meaning their prices move in the opposite direction as share prices. Sometimes they are positively correlated which means they move in the same direction. It all depends on the economic environment.
But bonds still go down in price. The recent environment of increasing interest rates is illustrative of this risk.

There is one asset that has no volatility. Cash. If you put $100 in the bank it will be there when you want to get it out. And it will grow although the growth will be less than bonds. Over the past 30 years cash has delivered returns of 4.2% a year according to Vanguard. That is less than the 5.5% from Australian bonds.

Inflation also is a large risk to holding cash. Cash may not have volatility but the money you put in the bank will lose purchasing power over time. Over the last 30 years cash has delivered real returns of 1.5% a year vs 2.8% for bonds.

While inflation is a risk to achieving my goals and inflation is an outsized risk to both bonds and cash I think cash is preferrable in a period of high inflation. Higher inflation and higher interest rates cause bond prices to go down. Cash held in a savings account or term deposit does not go down in value and adjusts to the higher interest rates quicker.

I could buy shorter-term bonds either individually or in an ETF. However, in an upward slopping yield curve where longer-term bonds earn higher returns I wouldn’t get Vanguard’s long-term bond returns without them. That shrinks the difference between the returns on cash and bonds. I just don’t think the trade-off is worth it.

And the beauty of cash is that to reduce the volatility of your portfolio by the same amount as holding bonds you need less of it. That means you can hold more higher returning shares. And if you’ve decided like I have that volatility is not a risk cash may help to reduce the poor decisions you make by providing safety.

Actively managed funds and ETFs

Part of developing an investment strategy is thinking about your edge or competitive advantage over other investors. This informs the approach you take and the types of investments that you consider for your portfolio. If you don’t have an edge you should invest passively.

I personally believe that one of my sources of edge is structural. Structural edge refers to external factors that influence the way an investor acts. This is largely an issue for professional investors. There are lots of factors that influence professionals – career considerations, dealing with investor inflows and outflows and pressure to not let short-term performance dip below an index. None of these issues impact me. This allows me to focus on the long-term and my objectives.

Structural edge is something that impacts the average active manager which is one reason for high turnover. This is a generalisation. However, active managers also charge higher fees which detract from the income generated and generate poor tax outcomes when compared to passive products. This is also a generalization but it matters to me because I’m an income investor.

When combined with the fact that most active managers underperform it is enough for me to exclude active management. People may disagree with this decision. I’m ok with that as I don’t believe this decision impacts my ability to achieve my goals.

Shares that don’t pay dividends

I want to start by saying that there is nothing wrong with shares that don’t pay dividends. Nothing at all. You may ask if I’m missing out shares that will have great performance? The answer is yes. And I will go further. I assume that I will miss out on the top performing shares over the next 20 years.

I only invest in shares that pay dividends for several reasons. I’ve written about how I spend some of my income to pay for things I want to do now. That is a fine reason to pick dividend shares but it only captures a portion of my rationale.

I invest in dividend paying shares because that is the investing approach that resonates with me. That is the approach that I know I will stick with over the long run. I know that investing in dividend shares is the right approach for me because I know myself and I know the secret to investing success is time and consistency.

Investing is personal. Our experiences shape our views and to deny this is counterproductive. I started investing during the internet bubble. It was a time of hype and speculation. Most of it turned out to be complete nonsense. Since that was my formative experience, I have an aversion to anything that isn’t tangible. And what is more tangible than a dividend? Cash gets put in my bank account and I spend that cash on things I want to do.

Aesop told us about the race between the tortoise and the hare. The hare made fun of the tortoise for being slow and when the time came to race the hare jumped ahead of the tortoise. But the tortoise ‘kept plodding on, and in time reached the goal’. Find whatever investment approach allows you to keep plodding along. For me that is dividend paying shares.

Final thoughts

This is an article about me. The lesson is not to exclude all or any of these options from your portfolio. The point is to challenge your thinking about what is in your portfolio and how it helps you to achieve your goals.

Far too many investors think that diversification means owning every type of investment. That isn’t true. We diversify away single security risk. We don’t need to own everything.

Want to know more about my investing approach? The Equity Mates Bryce and Alec recently had me on their podcast. Listen here as I describe my money philosophy.

Please share any thoughts or topic suggestions with me at [email protected]  

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