The universal portfolio

Not to be confused with Cover’s Universal Portfolio Algorithm. Or something like The Ultimate Buy and Hold Portfolio. This is not an allocation or management strategy. Instead, it’s a model for conceptualizing, tracking, and making decisions (executing a management strategy).

Assertions:

1. Everyone has a portfolio.
2. Every portfolio has 5 categories.
3. Each category can grow and shrink in value independently.
4. Each category is based on characteristics, not the things inside.
5. Things may move between categories based on historical performance.
6. All Revenue becomes an Asset, and all Expenses start as a Liability.

The first 2 assertions are why it’s called The Universal Portfolio.

The Universal Portfolio is based on Permanent Accounts and the Net Worth Calculation. For the uninitiated, that means Assets and Liabilities and the following calculation:

Assets - Liabilities = Net Worth

Liabilities are a bit more fluid and difficult to break down. We’ll give some examples that should get you started:

• Liabilities: Things you owe or give
  1. Revolving loans:
     • real rate is lowest (usually negative) compared to other Asset and Liability categories.
     • usually have a limit and can be borrowed against repeatedly without needing more paperwork.
     • more favorable in all but deflationary-contracting environments.
  2. Terminal loans
     • real rate is low (usually negative), but not as low as Revolving loans.
     • usually have a term (hence the name), which means once it’s paid off, you are done.
     • more favorable in all but deflationary-contracting environments.

We break Assets down into 4 sub-concepts:

• Assets: Things you have or receive
  1. Short-term:
     • real rate is relatively neutral compared to other categories.
     • more favorable in deflationary environments.
  2. Growth:
     • real rate is the highest compared to other categories.
     • more favorable in growth environments (hence the name).
  3. Negative correlation:
     • lowest (usually negative) correlation with Growth.
     • more favorable in contracting environments.
  4. Low correlation:
     • low correlation with other categories. May be negative, just not as negative as the negative correlation assets, or the correlation may be positive but less than 60–80 percent.
     • more favorable in inflationary environments.

“Historical” in this context, means decades; 10, 20, 30, 40, and so on years.

We’ll intentionally inject a recency bias, giving more weight to recent time scales. We do this to avoid reversion to a mean, accommodate the complex adaptive nature of financial systems, and see paradigm shifts early.

The first round lists the categories. The second round outlines the primary characteristics of things in each category. The third round lists items that have fallen into each category historically.

We adjust all interest rates by the inflation rate. For liabilities, we use a positive number for the interest rate, add the inflation rate, and convert the sum to a negative number. For assets, we use a positive number for the interest rate and subtract the inflation rate, leaving us with the real rate.

For example:

• A utility bill is an expense. It has a 0 percent interest rate. Inflation is 3 percent, and the sum is 3, giving us a negative 3 when we’re done.
• A credit card is a liability. It has a 20 percent interest rate, inflation is 3 percent, and the sum is 23 percent, giving us a negative 23 when we’re done.
• A savings account is a short-term asset. It has a 3 percent interest rate. Inflation is 3 percent, leaving us with 0 as the real rate.

The following is a derivative of The Holy Grail of Investing. However, the result is similar. We’ll end up with 4 quadrants. The horizontal axis goes from infinite deflation (left) to infinite inflation (right); in percent. The vertical axis goes from infinite growth (top) to infinite contraction (bottom). At any given time, the market you are saving and investing in is in one of the 4 quadrants, and you are operating in a market in one of the 4 quadrants. The markets may not be the same; for example, someone operating in Venezuela while saving and investing in the United States. The 4 quadrants are as follows:

1. deflationary-growth,
2. inflationary-growth (2021, for example),
3. deflationary-contracting, and
4. inflationary-contracting (2022, for example).

A market can be at equilibrium, represented by the point where the scales cross. Historically, different types of holdings are more favorable in different environments.

On to the primary characteristics of each category.

It’s worth a couple of clarifications and examples.

Typically, in finances, we don’t think of liabilities and expenses in terms of the real rate. There are two reasons we did it in The Universal Portfolio context. First, it reduces cognitive load; if I’m thinking of every category in terms of the real rate, I don’t need to shift mentally—if this is a liability, then I don’t use the real rate. Second, using the real rate can help increase the psychological impact when looking for “high-interest debt.”

Next is that, in finances, we typically don’t think of liabilities and expenses as favorable in any given economic environment. That said, if you’re in a growing economy, chances are interest rates will be low on loans. If you’re in an inflationary economy, buying something now is “buying low” because prices are increasing. So, while these things aren’t bringing in more money in a deflationary contracting environment, they’re always going out and are costing less.

In contracting times, interest rates tend to increase. As a result, it costs more to borrow money; therefore, liabilities are less favorable.

Further, let’s say a pack of chewing gum lasts you a year. At present, the cost of a pack of chewing gum is 1 USD. The inflation rate for the last 10 years in the economy in which you are operating has been 7 percent. If the next 10 years are anything like the previous 10, that pack of gum will be 2 USD. If you have an extra 100 USD sitting around and buy 100 packs of gum, and the next 10 years are like the last 10 years, you have “bought low.” If the next 10 years are deflationary at the same rate (only negative), then a pack of gum becomes 0.50 USD. You actually “bought high”; less favorable.

The last 4 categories will be much shorter.

We’re going to focus on the “elephants in the room.” And we’re only talking about as of this writing.

1. Bills, charitable giving, and time.
2. Terminal loans (auto, mortgage, student, and so on).
3. Revolving loans (credit cards, lines of credit, and so on).

1. Your paycheck and time.
2. Cash.
3. Things with a maturity date of fewer than 10 years (certificates of deposit and share certificates, I-bonds, short-term treasuries, and so on).

The lists for the other types will get shorter because they have the biggest elephants.

United States equities.

Long-term United States Treasuries.

This one has two elephants. We’ll call them a parent and child. But, it’s one of those instances where the child is larger than the parent.

The parent is what we typically call alternatives in general, and the child is gold specifically.

With the meat and potatoes (or dessert if you remember the original presentation) out of the way, let’s talk about what this model gives us.

Why not just do it the way everyone else does?

In short, because I was reconciling the “shoulds” and “buts,” I was hearing from the various life and financial content I was consuming:

• You should have an emergency fund that covers your insurance deductibles, and it should be in cash (short-term asset); but
• you should also reduce your high-interest rate debt (liabilities) and expenses; but
• you should also build a cash reserve of at least 3 months of living expenses, and it should be in cash (short-term asset); but
• you should be in the market (growth assets) and not have cash (short-term assets) sitting on the sidelines; but
• you should consider risk by having a stock-bond portfolio (negative correlation and growth assets); but
• not all bonds are created equal (short-term, negative correlation, and low correlation);
• and on.

These are a lot of guidelines and guardrails, and it’s not even a complete list.

So I wanted a model that could accommodate all the “buts” and “shoulds” and different ways people do things with their finances—investing on margin (liability), cash-only (short-term), accumulation (short-term and growth), buy the dip (short-term and growth without negative or low correlation), and so on.

Let’s look at some other primary considerations.

The way many of us talk about finances allows us to, for lack of a better term, hide things and not say anything. Talking money in the United States is pretty taboo, and the way we usually talk about finance, in particular, allows us to say something without saying anything:

I have a net worth of 500,000 USD, and my portfolio is 100 percent in a total stock market index fund.

On the surface, we could presume all sorts of things.

This person has a total stock market fund valued at 500,000 USD, and every time they get paid, the money goes straight into it, and they cashflow their lifestyle from selling shares. Not saying it’s terrible if you do that. But I could presume that’s what’s happening.

Chances are, though, that’s not what’s happening.

Again, it’s saying something without saying anything. For the sake of closing out the example, let’s put their financial situation into The Universal Portfolio model:

1. Liabilities and expenses: They have a mortgage with a 200,000 USD balance.
2. Short-term assets and revenue: They have 100,000 USD in cash to cover deductibles and 12 months of living expenses.
3. Growth assets: They have a total stock market fund valued at 100,000 USD.
4. Negative correlation assets: None.
5. Low correlation assets: They have a house they paid 500,000 USD for.

Assets of 700,000 USD minus liabilities of 200,000 USD is a net worth of 500,000 USD. So now let’s examine the part about “my portfolio is 100 percent in a total stock market index fund.”

If by “portfolio,” they mean everything excluding cash and liabilities (the mortgage) and use assets (the house), absolutely true. But that wouldn’t be in Univeral Portfolio terms.

We have a portfolio with a total value of 900,000 USD:

1. Liabilities and expenses: Roughly 20 percent.
2. Short-term assets and revenue: Roughly 15 percent.
3. Growth assets: Roughly 15 percent.
4. Negative correlation: 0 percent.
5. Low correlation: Roughly 50 percent.

Transparent.

Traditionally we look at portfolios in terms of growth assets (stocks) and non-cash assets (bonds).

One of the “shoulds” in the financial community is that you should be all stocks during accumulation mode. Further, another “should” is that you should rebalance your portfolio regularly. Finally, you should buy low and sell high (buy the dips).

That said, there is no rebalancing if your “portfolio” only has one index fund. The Universal Portfolio changes that. Let’s use our example portfolio from above.

1. Liabilities and expenses: Roughly 20 percent.
2. Short-term assets and revenue: Roughly 15 percent.
3. Growth assets: Roughly 15 percent.
4. Negative correlation: 0 percent.
5. Low correlation: Roughly 50 percent.

Let’s say the growth assets drop by 20 percent:

1. Liabilities and expenses: 200,000 USD.
2. Short-term assets and revenue: 100,000 USD.
3. Growth assets: 80,000 USD.
4. Negative correlation: 0 USD.
5. Low correlation: 500,000 USD.

The percents change to:

1. Liabilities and expenses: Roughly 23 percent.
2. Short-term assets and revenue: Roughly 11 percent.
3. Growth assets: Roughly 9 percent.
4. Negative correlation: 0 percent.
5. Low correlation: Roughly 57 percent.

Hypothetically part of your investment policy is you want to maintain the same percentage of short-term and growth assets. Further, if growth assets drop by a certain percentage, you can do some rebalancing (rebalancing on bands).

Then, in this circumstance, you can take 1 percent of your short-term assets and buy growth assets. 1 percent of 100,000 USD is 1,000 USD. Bringing us to:

1. Liabilities and outflows: 200,000 USD.
2. Short-term assets and inflows: 90,000 USD.
3. Growth assets: 90,000 USD.
4. Negative correlation: 0 USD.
5. Low correlation: 500,000 USD.

This brings us to the following percentages:

1. Liabilities and expenses: Roughly 23 percent.
2. Short-term assets and revenue: Roughly 10 percent.
3. Growth assets: Roughly 10 percent.
4. Negative correlation: 0 percent.
5. Low correlation: Roughly 57 percent.

Let’s say growth assets have a severe spike (30 percent), and you’re still in accumulation mode:

1. Liabilities and expenses: 200,000 USD.
2. Short-term assets and revenue: 90,000 USD.
3. Growth assets: 117,000 USD (90,000 USD + 27,000 USD).
4. Negative correlation: 0 USD.
5. Low correlation: 500,000 USD.

Now the value of the portfolio is 907,000 USD and the following percentages:

1. Liabilities and expenses: Roughly 22 percent.
2. Short-term assets and revenue: Roughly 10 percent.
3. Growth assets: Roughly 13 percent.
4. Negative correlation: 0 percent.
5. Low correlation: Roughly 55 percent.

Does that mean we should sell some growth assets?

Depends on the investment policy statement. You may be in accumulation mode and have as part of your statement not to sell other assets. Okay. You could stop throwing extra money at growth assets, keep it in a savings vehicle, or pay down liabilities.

And, maybe your policy statement says go ahead and sell, but it’s only half. To illustrate using our example, we’d need to trade 1.5 percent of our growth assets (roughly 2,000 USD) to get short-term and growth assets to be equal weights in the portfolio. Our policy statement would allow us to do 0.75 percent (roughly 875 USD).

With the traditional way of looking at a “portfolio,” we compartmentalize and may not see these opportunities.

To stretch a bit, it’s like separating “work” from “life” despite both being time you spend.