I was never interested in finance when I was younger, I had no desire to make a lot of money or spend my time doing anything other than mathematics.

Financial mathematics was a passing curiosity, I read a couple of books on stochastic calculus and pricing options, but I never considered putting that knowledge into practise.

I was drawn to the theorems, not the idea of making a profit.

But I always saved money consistently, I even had a share ISA set up that gave me exposure to the stock market.

When 2008 hit and people were queuing up to withdraw cash from their banks, I found that I had less money in that ISA than when I started.

That soured me on the stock market and I didn't think about it again for a long time.

After working for years building my own businesses and accumulating savings, I returned to the idea of investing and spent a lot of time trying to understand it.

Before you read any further, remember that nothing here constitutes investment advice. I'm distilling some of my own research into an accessible form as a starting point for you to carry out your own investigations.

With that understood, let's continue.

Understanding Passive Investing

When most people think about investing they think about buying shares of individual companies like Apple or Tesla.

It's possible to make money that way, but typically picking stocks, actively trading, and using complex financial products like options is a losing proposition.

You probably shouldn't devote your time to becoming a day trader when you could refine and monetise your existing skillset through a traditional career or business. Not only that, but unless you have a serious amount of starting capital, you will probably not be able to make a living from trading.

Focusing on what you do best and generating cashflow to deploy in a passive strategy is almost always better than spending time and effort researching stocks, learning how to construct a portfolio around them, and managing all your trades.

Investing in exchange-traded funds (ETFs) allows you to track the performance of major stock market indicies, like the S&P 500 or FTSE 100. For example, if large-cap US companies perform well, an S&P 500 index tracking ETF will perform well too. You don't need to guess which component companies will contribute to that performance.

Buying shares of an ETF is like buying a big basket of stocks. For example, if Apple represents 5% of the index then for every $100 you invest in the ETF, $5 goes towards buying Apple shares.

But stocks aren't the only way to invest.

Exploring Other Assets

The universe of things you can invest in can be divided into asset classes, I typically look at:

  • Stocks
  • Bonds
  • Gold
  • Cash (or cash equivalents)

There are others, including real estate, commodities (like oil), and cryptocurrency (like Bitcoin). You don't need exposure to all of them, you only need a mix of assets which are not highly correlated with each other.

Correlation is a statistical property, but in simple terms if two assets are correlated it means they tend to go up and down with each other.

Bond ETFs hold a basket of bonds, which represent debt issued by a government or corporation. They have a fixed duration and provide a yield, which you can think of as compensation to the bond holder for taking the risk of lending to the bond issuer.

Stock can ETFs also generate a yield, which is the cashflow returned to you by companies in the form of dividends.

Gold ETFs typically purchase gold in physical form, held via a custodian such as a bullion bank. Gold doesn't provide any kind of yield like a stock, bond, or real estate (if you generate rental income), but is typically held as protection against inflation (when the cost of consumer goods and services go up) and as a form of liquidity.

If you own property, you're already exposed to real estate. If you have a mortgage then you have leveraged exposure to real estate. But in any case there are real estate ETFs too, they track the performance of investable real estate.

Cryptocurrencies like Bitcoin aren't readily available in exchange-traded form (but there is one Euro-denominated product by VanEck which tracks the price of Bitcoin).

The classic "60/40" portfolio allocates 60% to stocks and 40% to bonds. The idea is that stocks are more volatile than bonds, essentially they move up and down in price more, and since bonds aren't perfectly correlated with stocks a mix of the two provides a more stable return than either one on it's own.

In recent history this kind of portfolio has performed well, you can explore the returns here.

But that mix may not continue to perform like that in the future, which is why other strategies attempt to protect against scenarios where both stocks and bonds would suffer.

Ray Dalio's Bridgewater Associates, one of the largest hedge funds in the world, introduced the "All Weather" fund based on a concept called risk parity.

You don't need to know the details of risk parity, except that it tries to balance assets according to how volatile they are.

Ray Dalio presented a simplified version of this strategy that you can implement.

Example: The 'All Weather' Portfolio

The All Weather portfolio is built on the assumption that you can't know what kind of market regime will occur in the future, but you can allocate to assets that will perform well under each different regime.

It looks like this:

  • 40% long-term bonds
  • 30% stocks
  • 15% intermediate-term bonds
  • 7.5% gold
  • 7.5% commodities

Each component is selected on it's ability to weather one of the possible economic seasons:

  • Rising economic growth
  • Declining economic growth
  • Higher inflation
  • Lower inflation (or deflation)

Assets with lower volatility get a higher weighting in the portfolio. Bonds were the best performing asset over the last few decades and remarkably had the lowest volatility, so they get the highest weighting.

Historical returns and ETFs that allow you to recplicate the All Weather strategy can be found here.

Make a note of the relatively mild drawdowns, this is an especially important feature if you're trying to preserve or grow wealth over longer time horizons: a loss of 10% and subsequent gain of 10%, leave you down 1% from where you started.

Here's how you would put it into practise.

Implementing Your Strategy

Follow these steps:

  1. Set up a brokerage account (I use Interactive Brokers, but there are many platforms) and provide a source of funds (typically bank transfer).
  2. Decide on your strategy (e.g. "60/40" or "All Weather").
  3. Pick the ETFs that express your positions with the lowest management fees (TBC).
  4. Take your starting capital and allocate, buying shares of each ETF in the proportion they appear in your strategy.
  5. Reinvest dividends and provide additional funds according to a schedule based on your income and expenses.
  6. Rebalance periodically.

That last part is surprisingly important and it's worth explaining why in more detail.

Understanding The Rebalancing Premium

When your portfolio drifts away from your target allocation, in this case fixed percentages, you eventually have to rebalance.

Let's say you're following the All Weather strategy and equities have been performing really well, now making up 50% of your portfolio. You need to sell some to get back down to 30%. Likewise if gold has been underperforming and is now 5% of your portfolio, you need to buy a little bit more to get back to 7.5%.

Most articles on passive investing advise that you should rebalance yearly, but this is an error. If you only rebalance once a year, you're missing out on a rebalancing premium that can be harvested.

The rebalancing premium is also referred to as Shannon's demon (like Maxwell's demon from thermodynamics), named after mathematician Claude Shannon. He is best known as the father of information theory and coined the term "bit" to describe a unit of digital information.

His idea was simple, but not intuitive: if you have a diverse collection of volatile assets which are not correlated with one another, you can profit from selling assets with gains to purchase assets with losses.

In other words if they move independently and don't all go up and down together, rebalancing will generate a positive return regardless of how the individual assets perform.

Let's imagine an asset which stays essentially the same, but moves up and down slightly over time. If you hold a portfolio with 50% in that asset and 50% in cash, rebalancing daily, your portfolio actually grows over time.

There's research to suggest that rebalancing between three uncorrelated assets can produce a positive return from rebalancing alone. That means without any growth in the assets you're holding, you could achieve compound growth by rebalancing between them. You can read more about that research if you're interested in the context.

That doesn't mean you should try to balance your portfolio daily, like with Shannon's demon, but monthly or even quarterly rebalancing would be superior to yearly.

With that concept fixed in your mind, let's finally look at cryptocurrency.

Adding Bitcoin to the Mix

It turns out that if you take a standard 60/40 portfolio and allocate 1-5% to Bitcoin, with quarterly rebalancing, you outperform a vanilla 60/40 portfolio without Bitcoin.

In other words, if you had taken 95% of your portfolio and allocated 60% of that to stocks and 40% to bonds, putting the remaining 5% in Bitcoin and rebalancing every quarter, you would've grown your portfolio more than by just holding stocks and bonds over the last few years.

That's because cryptocurrencies like Bitcoin provide a source of volatility and therefore rebalancing premium. Since Bitcoin has historically been both uncorrelated with stocks and bonds, it works on the same principle as Shannon's demon.

Although there are many cryptocurrencies, Bitcoin and to a lesser extent Ethereum are the only serious candidates for investment. If you have to pick one, go with Bitcoin because it has the largest market cap, the widest adoption, and the most attention from serious allocators of capital (like pension funds, hedge funds, and family offices).

Past vs. Future

It's important to caveat that everything written above about possible returns and correlations is predicated on what happened in the past. Correlations may change, volatility may increase or decrease, and portfolios that produced great returns may lose money. Don't take my word for it, go and do your own research before you invest your own money in anything I've mentioned here.

Further Reading

I highly recommend exploring the ideas presented here on rebalancing and portfolio construction if you want to go down the rabbit hole.

If you have any questions about finance or investing, you can always reach me on Twitter @BenTormey.