Memoirs of a Money Manager: The Rip Van Winkle Portfolio Five Times Over (1)

Rip Van Winkle reportedly fell asleep for about 20 years after drinking moonshine outside his village in the Catskill Mountains in New York State. The story, an all-time favorite fairy tale in American literature, was written by Washington Irving and published in 1819. Here is a description of what he found when he awoke:

He awakes to discover shocking changes. His musket is rotting and rusty, his beard is a foot long, and his dog is nowhere to be found. Van Winkle returns to his village where he recognizes no one. He discovers that his wife has died and that his close friends have fallen in a war or moved away. He gets into trouble when he proclaims himself a loyal subject of King George III, not aware that the American Revolution has taken place. King George's portrait in the inn has been replaced with one of George Washington. Rip Van Winkle is also disturbed to find another man called Rip Van Winkle. It is his son, now grown up. (2)

Think now over the last 20 years of your life, the changes in the world and the incredible changes in the financial markets. Who would have predicted the two equity bear markets, the low inflation rate and the nearly zero interest rates? The only constant we can count on in life is change itself. Whatever it is today, it most likely will be different tomorrow. Many years ago, in reading the story of Rip Van Winkle to my son, I thought about how difficult the prediction/forecasting business is. If Rip Van Winkle had an investment portfolio when he went to sleep would he have been pleased with the result when he woke up? Had he known that the Revolutionary War was coming, would he have invested differently?

Suppose now that you had to invest for the next 100 years (think of five Rip Van Winkle naps combined). The portfolio I am asking you to create is very special because once the rules are in place, you are going to take a nap for 100 years and wake up to see the results. This approach presents lots of problems. Who is to carry out your wishes? How do you make sure that your wishes are followed? What legal entity will hold the portfolio: a trust, corporation, foundation? In what jurisdiction will this entity be domiciled? Who will be the custodian(s) of the assets? How can you be sure that upon your return from your long nap you will have legal access to the portfolio? How do you protect yourself from taxes, confiscation and outright embezzlement or theft? Notice that these complications arise now, while you are awake and present. But once you start your 100-year nap you lose control except through the instructions, legal and institutional arrangements you left behind. I have almost concluded these difficulties are insurmountable, but let’s wave a wand and say they can be solved. How will you invest the money?

Investing the money poses a real dilemma. You cannot easily say, “I would like hedge funds,” for example, because their selection is so manifestly difficult and they must be constantly monitored; in fact, selecting any investment is problematic. I first had this scenario described to me in the early 1960s during a speech by a finance professor who once employed me. During the question and answer period a woman asked:

“Professor, if you’re so smart, why aren’t you rich?”

He promptly replied, “Well, Ma’am, I am.”

The lady persisted.

“Professor, May I ask how you became rich?”

“Certainly, Ma’am. In 1949, I knew the U.S. stock market was selling at very cheap valuations but I had no idea what to buy. So I purchased one share of every stock on the New York Stock Exchange.”

“Professor,” the lady continued, “when did you sell?”

“I never sold,” he replied, “for I do not know what to sell any more than I knew what to purchase.” [I have paraphrased the conversation since I only have a recollection of the discussion but quite obviously not the detailed specific words]

The audience was stunned, as was I. Here was a full professor of finance at a large university effectively admitting that he was unable to decide what to buy or sell in his own portfolio. This admission came after he had spoken on the various approaches to common stock valuation. I thought of asking him if that was really true, but I knew it probably was. He was brilliant enough to find that solution and humble enough to know that he could not do better. So instead I remarked:

“…it seems to me what you really did was to create a price-weighted index of the whole NYSE when you could have approximated the same effect by buying the Dow Jones 30 Index.”

“No, not at all,” he commented. “I purposely bought the exchange because I wanted to own the low-priced shares which I thought would appreciate by a greater percentage amount.”

Many years later I realized the brilliance of his investing this way; it was a form of index fund investing made under complete uncertainty with respect to what to purchase, but near complete certainty that the market was historically cheap at that time. Today’s index funds are mostly capitalization-weighted funds, although there is a growing list of funds weighted by factors other than capitalization, typically fundamental factors of value, growth, income, etc. The Dow Jones 30 Index continues to be price-weighted.

I have never forgotten this incident that occurred so very long ago; every time passive index fund investing is discussed my mind flashes to that evening. I concluded that low expense, low turnover, capitalization-weighted index fund investing is the most reasonable solution to investing Rip Van Winkle’s portfolio and even more suitable for the 100-year portfolio. But what index? In my view, the perfect index for the 100-year portfolio would be a blend of world or global equities and possibly fixed income, all in unhedged local currencies. Here are the reasons why it is a good choice:

5. Finally, I do not wish to make light of index fund management; I know enough about it to know it is not as easy as it sounds and rules must be developed to permit low cost trading and minimize slippage; also the custodian(s) of the assets in a global context is not a trivial decision.

What should be the stock/bond proportions? The normal rules go out the window. Retirement? What retirement? I am just taking a 100-year nap! Cash withdrawal needs? None except to pay fees. Inflation likely? Of course; all governments like to purchase popular support through easy money of some kind. Deflation possible? Most certainly; easy money causes booms and bubbles and these are followed by financial and economic collapse, deflation and depression. Confiscation of property? Absolutely! Think Russia and China. Regulation? Of course; even America is slowly being regulated to death. Confiscatory taxation? Most certainly; while tax rates fluctuate with the political flavor of the day, taxation and regulation together are a form of property theft. Wars? When have people not been killing each other? We should assume there will be wars, genocide, slavery, starvation, mass migration and displacement of people. Some countries will be absorbed into others and disappear while others will acquire territory. We can assume some existing diseases will be cured while new ones will cause much human pain, suffering and death. Thus, while there is a good argument for fixed income in portfolios where the individual or organization needs a reserve in case of adversity during the 100 years, if nothing can be done until the 100 years is up, I would argue for 100% equity.

Are you ready to drink the Kool-Aid?

Good, let’s get started. The time is January 1, 1900; your nap will be over on December 31, 2000. In 1900 the equity portfolio you will create and then own for your 101-year nap will be invested in 16 countries and dominated by stocks in the United Kingdom, United States, France, Germany, Italy, Japan, Spain, South Africa and Belgium. Because of problems with the availability data and biases that creep in when data are collected, you will not be invested in every security in every country, but you will have a very good sample.

I bet I know what you are thinking right now. You are thinking about owning stock in Germany during WWI, the post-WWI hyperinflation and WWII. The portfolio is also invested in the rest of Europe that suffered during both world wars and in Japan, which was attacked with the atomic bomb in two cities. You will own all the tragedy. Your portfolio will experience the 1907 panic, the booming 1920s, the 1930s depression and the post-WWII economic prosperity, the Korean War and the Vietnam War. But that is not all: The portfolio will experience massive shifts in industry and sector weights as consumer needs change and technology rapidly responds to these shifts in demand. Do you really think you could have hired an investment firm or firms that could have maneuvered through those hundred years deftly? Consider the changes in the last 30 years of these companies: Polaroid, Kodak, Wang, Digital Equipment, Motorola, TWA, Blackberry, Nokia. Who anticipated the rise of Amazon and the disappearance of the local bookstore? The sharing economy is crushing many business models. Competition in a capitalist society is fierce; even the socialist economies are impacted. Here are a few sector weightings in 1899 and 2000 (3) to indicate how brilliant your active money manager(s) would have to have been:

While one must marvel at the speed with which some sectors/industries became inconsequential over the 100-year period, the truly incredible discovery is the huge increase in the proportion of sectors that were small or non-existent in 1899 and yet grew to nearly 50% in the U.K. and over 60% in the U.S. by 2000. It is beyond belief that any active investment manager(s) you might have selected in 1900 could have, or would have, anticipated these changes and the dynamic growth of new sectors, industries and businesses any more than today’s managers dreamed in 1990 about Google, Amazon or the other disruptive technologies that have become everyday experiences in 2015. These data make a joke of those economists and politicians that advocate central planning.

Now that you are fully awake from your long nap, we are pleased to report that the investment results are available for your portfolio. The year is 2002 and it has taken some time to calculate approximately how much your portfolio earned, including reinvested income, over the period from January 1900 to December 2000. This period is actually 101 years, but should suffice for your purposes. It is fortunate for you that, because of the thoughtful and diligent work by three professors at the London Business School, we know approximately how much your portfolio earned. The professors, Elroy Dimson, Paul Marsh and Mike Staunton, published these investment returns in a book entitled Triumph of the Optimists, 101 years of Global Investment Returns. (4)

Bottom line is that with a capitalization-weighted world 100% equity portfolio, in real inflation-adjusted U.S. dollars, compounded at the geometric mean rate of 5.8% per annum over the 101 years, you wake up rich! Your USD $100,000 in 1900 has become $29,720,249. Oh, you thought you would be a billionaire? Take another nap; in 100 years you will be worth $8,348,706,884! If nothing else, this exercise should give you respect for Mr. Buffett.

Two additional points should be made. First, an analysis of the equity return data from the U.S. and the world over the two halves of the twentieth century confirms that owning international equities resulted in risk reduction; the world equity index has a smaller standard deviation than the U.S. equity market. Second is the matter of holding fixed income securities. The professors found that the equity returns, over the whole period, exceeded bond returns in every single country.

My conclusion after nearly 50 years of pondering this 100-year investment problem is that if you really wish to live forever, can handle the volatility and are able to keep all expenses and withdrawals to 1.5% per annum or less (of the trailing ten-year average portfolio value), then an all-equity world/global portfolio is a very reasonable strategy. The portfolio would be all indexed, capitalization-weighted in every country in the world. No fixed income. The real problem I now believe is not the investment of the assets but rather the protection of the assets from fraudulent behavior of individuals and institutions and from the confiscatory taxation and outright confiscation of assets by cities, states and nation-states. There are no perfect solutions to these problems.

(1) Although I have been thinking about the problem of how to manage a portfolio “beyond the grave” and for clients interested in dynasty trusts for decades, this is the first time I have written anything using the Rip Van Winkle idea. Just as I was about to post this blog an article appeared in The Journal of Portfolio Management entitled “Rip Van Winkle Indexing,” by Robert Arnott, Noah Beck and Vitali Kalesnik. Volume 41 Number 4, Summer 2015. Their article is very interesting from the standpoint of cap-weighted indexing, which is what we are proposing in this blog, and their demonstration that if “…Rip Van Winkle settled in for a 20-year nap and, upon awakening, invested in the surviving companies in his 20-year-old cap-weighted index in proportion to their stale weights from 20 years ago, he would have enjoyed average historical outperformance of 180 basis points or more…” The article is very interesting, but I think the application of their ideas under the conditions I specify in my blog make it quite difficult to implement beyond the grave and for 100 years.

	United Kingdom		United States
Sectors	1899	2000	1899	2000
Railroads	49.2%	0.3%	62.8%	0.2%
Banks and Finance	15.4%	16.8%	6.7%	12.9%
Mining	6.7%	2.0%	0.0%	0.0%
Textiles	5.0%	0.0%	0.7%	0.2%
Iron, Coal and Steel	4.5%	0.1%	5.2%	0.3%
Telegraph and Telephone	2.5%	14.0%	3.9%	5.6%
Sectors that were small in 1899	3.4%	46.9%	4.8%	62.4%