Hi YXI friends,

A while back, one of our subscribers asked how we can apply the various sectors covered in YX Insights to portfolio construction.

While our research does not focus on portfolio management, I’ve taken some time to reflect on this topic. In this article, I’ll outline a basic approach to portfolio construction, incorporating considerations of relative risks and returns while utilising our cross-asset knowledge.

Many of our subscribers are far more experienced in portfolio construction. I would greatly appreciate your feedback or any corrections you may have for this piece.

Table of Contents

• 1. Using Simple Instruments Only

• 2. 60/40 vs SPY

• 3. 80/20 or 40/60 vs SPY

• 4. The Basic YXI Portfolio (“YXI Model 1”)

• 5. YXI Model Portfolio Variations

  • 1) YXI Model 2: 20% in MSFT

  • 2) YXI Model 3: 10% In AMZN Instead Of MSFT

• 6. What’s the catch?

• 7. Thinking About What’s Right For You

DISCLAIMER: This newsletter is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.

1. Using Simple Instruments Only

We keep the instruments simple in this note. The purpose is not in the technical details but a conceptual understanding of portfolio risks and returns using the different instruments we cover.

Moreover, we are deploying a static allocation method rather than a dynamic one in this article. This implies that the allocation is macro-agnostic - we are not imposing our market views on how well bonds or stocks should perform in any given year.

We will use SPY to represent “Equities”, and TLT to represent “Bonds”. For the purpose of this article, we ignore QQQ, but you can regard QQQ as a single-name stock alternative, which will make sense for section 4.

Our model start date is 3 January 2005, 20 years ago. (Where has the time gone?)

A preview of our results shows two interesting findings over a 20-year period:

1. By including some allocation of bonds (e.g. the 80/20 portfolio), we can significantly reduce the portfolio risk, measured by annualised volatility, without sacrificing too much returns, compared with owning just SPY (the “benchmark”).

2. We can also come up with a superior portfolio to SPY, measured through a higher Sharpe Ratio, by including alternative assets in the “YXI Model” portfolios. The YXI Model portfolios show comparable annualised returns with much lower annualised volatility than SPY and an 80/20 portfolio.

Finally, we could even experiment and improve the profile of the portfolio by changing certain weighting or single-name stocks. More on that in Section 5.

2. 60/40 vs SPY

A traditional portfolio consists of 60% equities and 40% bonds. It is a well known composition that favours both capital growth and stability. There is a mathematical basis for this too, which we can examine in our next article.

While investors forfeit some of the upside in a bull equity market, having bonds in their portfolios tend to provide some buffer in a raging bear market. Note this is not always true and does depend on the market context, as I will show below.

Both Benjamin Graham (The Intelligent Investor) and John Bogle (Founder of Vanguard, Little Book of Common Sense Investing) favour having a certain percentage of bond holdings in one’s portfolio for this reason.

Graham recommends equities holding not to exceed 75% or fall below 25%, while Bogle suggests one could use their age to approximate the percentage holding in bonds.

For the younger investors, it may be difficult to imagine stocks not going up forever. It is also difficult to shake off Warren Buffett’s “buy S&P and forget” mantra. But if one has gone through the Dotcom Bubble or the Great Financial Crisis, they might remember not sleeping well at night with a 55% drawdown and their employers going bankrupt.

60/40 Portfolio vs SPY 20-Year Drawdowns

In terms of losses, the 60/40 portfolio endured “only” a 30% drawdown in the Great Financial Crisis, compared with 55% in SPY. 60/40 also showed smaller drawdowns in the 2018 Q4 Volatility Spike and the COVID Crisis.

However, it did lose marginally more than SPY during the 2022 bear market. The rebound has also been slow. Why?

The inflation surge triggered the fastest Fed rate hikes in decades, which created a bear markets for both bonds and stocks. Today, the Fed cannot cuts rates too quickly as inflation proved sticky, pinning bond prices to the floor while equities climbed back.

60/40 Portfolio vs SPY 20-Year Total Performance

Since 2005, the 60/40 portfolio kept up with SPY very well until 2021, by which point both 60/40 and SPY returned about 320%. However, after the inflation surge, SPY started to lead and nearly doubled its returns to 605%. In contrast, 60/40’s 20 year returns is now way behind at +387%.

However, on a risk adjusted basis over a 20-year period, the 60/40 portfolio is actually still very favourable with a higher Sharpe Ratio.

60/40 Portfolio vs SPY 20-Year Annualised Returns and Volatilities

3. 80/20 or 40/60 vs SPY

An 80/20 portfolio allocates 80% of investments to equities and only 20% to bonds. This is more aggressive than the 60/40 portfolio.

In contrast, a 40/60 portfolio allocates just 40% of investment in equity but 60% in bonds. This is a fairly conservative or defensive approach. The Intelligent Investor disciples would lean into this when market valuations are expensive. This is why Warren Buffett continues to sell down his equity holdings in today’s market environment and stays in cash.

One might also prefer this allocation if they are nearing retirement and strongly wishes to avoid a significant drawdown in the near future.

80/20 vs SPY 20-Year Drawdowns

The drawdowns of 80/20 approach that of SPY, but still enjoys some buffer in most crises except for the 2022 inflation surge bear market.

80/20 vs SPY 20-Year Total Performance

Similarly, the returns of 80/20 matches that of SPY until the end of the 2022 bear market, after which SPY started to outperform.

40/60 vs SPY 20-Year Drawdowns

The 40/60 portfolio drew down only a maximum of 17% during the Great Financial Crisis. That’s pretty remarkable given the world looked like it was about to end.

Unfortunately, this bond heavy portfolio did get hit hard by the last inflation driven hiking cycle. The 30-year yield surged from 1.1% in 2020 to 5.2% in 2023, creating a prolonged bear market for bonds.

40/60 vs SPY 20-Year Total Performance

It should be noted that while the 40/60 portfolio is less volatile, it in fact outpaced SPY up until the end of 2020.

4. The Basic YXI Portfolio (“YXI Model 1”)

Instead of only owning SPY and TLT, I incorporate alternative assets such as Single Name Stocks, BDCs, Gold, and Bitcoin in our model as well.

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