100% equity portfolio: advantages and risks

We begin our exploration of portfolios with the most basic allocation possible, based on a single asset class: stocks. This strategy may seem foolhardy to some. However, we will see that it is not as foolhardy as it seems.

A 100% stock investment portfolio can offer attractive growth opportunities, but it also carries significant risks. In this article, we'll review the pros and cons of an all-stock portfolio, as well as strategies for effectively managing this type of investment.

Benefits of a 100% stock portfolio

Investors who choose a 100% equity portfolio typically do so in the hope of achieving higher returns than those offered by other types of investments. Historically, stocks have shown superior long-term profitability compared to other asset classes. This is supported by a large body of research, including that of J. Siegel which we have already discussed in our previous articles.

Additionally, many companies regularly pay out a portion of their profits as dividends to their shareholders. These dividends can provide a regular income stream for investors, in addition to potential capital gains.

Risks associated with a 100% equity portfolio

However, a 100% stock portfolio also carries higher risks. Stock prices can be volatile and subject to significant fluctuations in the short to medium term. This volatility can result in significant losses for investors, especially if they need to withdraw their money at a time when the market is down. People who have reached the stage of financial independence and have started to withdraw their capital are particularly exposed to this risk.

Investment horizon and equity portfolio

This brings us to the question of the investment horizon, or the length of time an investor plans to hold their securities. The shorter it is, the greater the risk of losing money with stocks. The most difficult duration is under 10 years. I had the bitter experience of this myself when I started investing in 2000. I struggled until 2010. It is true that in terms of timing it was difficult to do worse.

On the other hand, for investors with a longer investment horizon, a 100% equity portfolio may be appropriate. In the long term, in fact, the volatility of stocks decreases. It even becomes lower than that of Treasury bonds from an investment horizon of 20 years. This has also been demonstrated by J. Siegel.

Diversification in a 100% stock portfolio

In addition to time, the other aspect to consider is diversification. Limiting yourself to a single asset class does not prevent you from diversifying within it. This consists of spreading your investments across:

• different companies (obviously)
• different company sizes (large, mid and small capitalizations)
• different economic sectors
• different countries.

There are several ways to do this. The first is to buy a broad ETF (like VT) that covers all of these categories. The second is to invest in multiple ETFs to mix different asset subclasses. The last is to mix ETFs and stocks, or even to focus only on stocks.

It has already been mentioned, in our previous article, these different approaches. We have also seen the characteristics, advantages and disadvantages of ETFs that rely on sectoral, geographic or market capitalization sub-indices. Let's now see what happens when we put them together.

I would like to point out that all the backtest results below are given with the CHF as the reference currency. In dollars or in most other currencies, they would therefore be even better, given the historical strength of the Swiss franc. We will talk about the monetary aspect again below.

Capitalizations vs US Market

We saw in the last article in this series that ETFs have a significant bias towards large caps. We also discussed the fact that small caps tend to post excess returns relative to the market. If you decide to invest via a single broad ETF, even if it includes small companies, you are partially depriving yourself of the potential associated with small caps. In addition, you are concentrating your position on a single fund, which can be risky. Conversely, using several "Cap" type ETFs allows you to dilute this risk, while theoretically allowing you to obtain higher profitability. To be sure, let's see what this gives.

Let's take the VTI ETF, which represents almost the entire US market, all company sizes combined. Since it is weighted by capitalization, large companies have a strong influence on the performance of the fund. For more information on this ETF, refer to our last post.

On the other hand, let's use four ETFs to dissect the market into equal parts:

• Large Caps: SPY
• Mid-Cap: IWR
• Small caps: IJR
• Micro capitalizations: IWC

Each ETF is adjusted once a year to match 1/4 of the portfolio value.

By giving more representation to smaller companies, this strategy should, as has been said, show a better performance than the market as a whole (ETF VTI). However, the result is disappointing:

In truth, this is hardly surprising. In our last article, we had already noted that the further down the market capitalization scale we went, the less ETFs tended to reflect the excess returns that are likely to be achieved with small companies. IWC is particularly affected by this phenomenon, with an average annual return of less than 5% over this period, associated with a much higher volatility than other ETFs. We had gotten around this problem by directly selecting Micro Cap stocks, rather than trading IWC. To do this, we will use the qualitative filter already used in our last post.

The results are much more convincing:

Why not focus only on quality Micro Caps? This is indeed a possibility, since we thus obtain a nice CAGR of 13.4%. In addition, despite a higher volatility, the Sharpe ratio is at 0.62, even higher than above. But there is still better to do.

If we look at the four asset subclasses used to break down the market, we see that the first three are highly correlated. Conversely, Quality Micro Caps and the S&P 500 are the least correlated.

This means that paradoxically one can obtain better diversification by using fewer instruments. By focusing on SPY and Quality Micro Caps one further improves the CAGR and the Sharpe ratio compared to the version with IWR and IJR.

The CAGR is certainly slightly lower than that of Quality Micro Caps alone (13.4%), but the Sharpe ratio is significantly better. In other words, at equal risk, the profitability of this approach is the best. To do this, the sub-indices must be allocated in equal parts, i.e. 50% for SPY and 50% for Quality Micro Caps.

Compared to VTI, there is no comparison. We obtain an excess return greater than 3%, for a much better Sharpe ratio. With this approach, we correct the bias of ETFs in favor of large caps, which improves the results both from the point of view of profitability and risk management.

Economic sectors vs US market

We talked in our last post than certain sector ETFs:

• show a relatively low correlation with the market and especially with each other
• show convincing results in terms of profitability and risk

This is particularly the case for QQQ (Nasdaq 100), VDC (Consumer Staples) and XLV (Health Care). The sectors concerned do not come out of nowhere. I have already backtested them as part of the PP 2.0 (an upgrade of the Permanent Portfolio). Their mix makes sense and works because it combines defensive positions with growth stocks. Unlike PP 2.0, which also uses Treasury bonds and gold, we will focus here on stocks, via the three ETFs mentioned above. We will return to the Permanent Portfolio and PP 2.0 in our next articles.

For the US market reference we will take this time SPY rather than VTI. Indeed QQQ and XLV are based on very large companies. VDC is a little larger but remains quite high in terms of capitalization.

The results are quite astonishing:

The three sector ETFs, equally distributed and rebalanced once a year, allow us to obtain not only a better return than the market, but also a higher Sharpe ratio. The growth provided by QQQ and the defense provided by VDC and XLV work wonders when combined.

The CAGR is worse than that of the SPY & Quality Micro Caps strategy that we saw above, but the Sharpe ratio is better. In other words, at equal risk, this approach performs better. Conversely, the CAGR is better than that of the PP 2.0, but the Sharpe ratio is less good. This is normal, given that we only have one asset class here, with shares.

With only three ETFs, this approach obtains very convincing results compared to the market, both from the point of view of performance and risk. In addition, it allows you to diversify your portfolio over three positions, instead of just one (SPY).

International diversification

Geographic diversification is another aspect to consider. By investing in companies from different countries and regions, one can theoretically benefit from global economic growth and reduce dependence on a single economy. However, as we already discussed in our previous article on ETFs, the situation is not that simple in reality.

Emerging markets, as well as some developed countries, have posted rather disappointing results over the long term. We cannot only talk about cyclical factors here. There is a real structural problem that has been weighing on the economies concerned for years. Various causes can be mentioned. For emerging markets, we have already talked about excessive investor expectations. Siegel has shown that there is paradoxically a negative correlation between GDP growth and stock market returns. We can also add corruption, fraud and the illiberal, unstable or downright hostile policies of many governments. For developed countries, this is often linked to excessive state interventionism, as in France. Unsurprisingly, the most liberal countries are also very often those whose stocks perform the best, as we will see later.

Exchange rate risk

A doctor prescribes a drug only if he is certain that its benefits outweigh its side effects. This is a wise approach that can also be applied to investing. When you are trying to manage a risk, you have to be sure that you are not creating a bigger one. The saver who refuses to invest in the stock market because of short-term risks is thus certain to lose money in the long term because of inflation.

Equity investors understand this well. Yet many of them manage currency risk the way average investors manage equity risk: by avoiding it. In doing so, they create another problem. Focusing on domestic stocks creates a diversification gap, which translates directly into risk and performance.

A country can experience economic events that affect it more than others. The second half of 2024 is an excellent example for Switzerland, which has been hit hard by the collapse in Chinese demand in the watchmaking sector.

There is an even more insidious danger for those with a home bias: structural failure, as discussed above. A country can perform poorly for several years, or even decades. Many European countries find themselves in this situation. For example, a French or Belgian investor who limits himself to domestic stocks has been at a considerable disadvantage compared to his compatriots who have adopted a globally diversified investment strategy. The same observation applies to a Swiss investor with a home bias, although his situation is slightly better thanks to the Swiss market’s strong international exposure.

From March 1996 to December 2024, the national indices progressed as follows (Total Return in CHF):

• USA: 1032%
• Canada: 601%
• Sweden 517%
• Australia: 488%
• Spain: 400%
• Switzerland: 397%
• France: 340%
• Netherlands: 338%
• Germany: 260%
• Belgium: 200%
• Austria: 196%
• Italy: 194%

Imagine for a moment the frustration of the Italian, Austrian or Belgian investor who, for fear of currency fluctuations, has not dared to place his funds abroad.

In the short term, the exchange rate risk is very real and can weigh on the performance of a portfolio. In the longer term, however, it is minimal when investing in assets such as stocks,real estate and gold. J. Siegel (him again) explains this phenomenon by the fact that assets have an intrinsic value which compensates for currency fluctuations in the medium to long term.

As can be seen above, and as will also be seen later, this is also valid for Swiss investors. Despite the weakness of other currencies against the Swiss franc, the exchange rate risk when investing in foreign securities is minimal in the long term. It is even riskier not to do so.

Investing broadly in the global market

A simplistic global approach, via a single ETF (such as Vanguard's VT), is not optimal. The results are not there, both from a profitability and risk point of view, as I detailed in the article dedicated to ETFs. We will therefore explore other possible configurations below in order to determine the one that offers us the greatest chance of success. We will mainly use the American market as a frame of reference, since it is the one that has historically performed the best.

Domestic Market vs US Market

Let us now compare the results of a strictly national strategy (here Switzerland, with the EWL ETF) against the American market (SPY). I specify once again that I use the CHF as the reference currency.

Cumulatively, between 1996 and 2024, as we saw above, this represents, over 28 years, nearly 400% for the Swiss market, compared to more than 1,000% for the American market. The difference is enormous. Especially since the Sharpe ratio is higher for the US market, meaning that for equal risk it has performed even better than the Swiss market.

Domestic & International Market vs US Market

To overcome this problem, many investors resort to a mixture of national and international shares. The 50/50 is a great classic, but we come across all possible mixes, depending on national preference,risk aversion and the country of residence. For the backtest, we limit ourselves to three configurations, which give us an order of magnitude for all the possibilities:

• 75% domestic stocks / 25% international stocks
• 50% domestic stocks / 50% international stocks
• 25% domestic stocks / 75% international stocks

The portfolio is rebalanced once a year to align it with the planned allocations.

For domestic stocks, I used EWL (MSCI Switzerland). Since Swiss stocks are at the top of the basket of non-US stocks (see list above), a French or Belgian investor would have obtained slightly lower results. Conversely, a Canadian investor would have been slightly advantaged.

For international stocks, I used VT (Total World Stock). It is not perfect because there is a small overlap with Swiss stocks (2% of the ETF). Unfortunately, there is no ETF of international stocks outside Switzerland. The impact on the results remains marginal, however. Since the history of VT only goes back to 2008, the backtest does not go back further, but it already covers a nice period.

For the benchmark, we keep the American market, this time using VTI rather than SPY. Indeed, the capitalization of EWL and VT securities is more related to VTI than to SPY.

Regardless of the allocation chosen, the results are, however, quite disappointing:

Of course, for the CAGR, it was to be expected. Two relatively poor-performing ETFs do not become better when combined. We saw that the Swiss index lagged behind the US market. We also mentioned the fact that VT was heavily penalized by emerging markets and some developed countries. However, we could have expected a better effect on risk management. However, the Sharpe ratio is significantly lower, regardless of the chosen allocation, than that of the US market.

US & Domestic Market vs. Global Market

If we cannot achieve better results by combining the domestic market with the global market, why not simply combine it with the US market?

Over the same period as above, and still rebalancing the portfolio once a year, we obtain the following results:

Findings:

• The results are significantly better with VTI (instead of VT), both in terms of CAGR and Sharpe ratio.
• The addition of EWL to VTI in the portfolio fails to improve the CAGR, which was expected given its relatively weak performance.
• The addition of EWL to VTI, even in small doses, also fails to improve the Sharpe ratio, which is a little more surprising. One could have imagined that the defensive nature of Swiss securities could have positively influenced this ratio.

Should we therefore focus solely on the USA? Not necessarily. Firstly, because as we always say, "Past performance is no guarantee of future performance" (even if it often tends to repeat itself). Then, as we saw above, economic events can weaken any country, even the USA. Diversification, again and again, is therefore essential.

The problem with national indices outside the US is that they are based on a very small number of companies. The MSCI Switzerland for example (ETF EWL) has about forty stocks. Since they are weighted by capitalization, the largest positions have a huge influence on the price of the index and therefore of the ETF. In the case of EWL for example, the first ten positions represent 2/3 of the index. Just the first two (Nestlé and Novartis) account for 1/4 of the index. Obviously, in this situation, we understand that diversification with such an ETF is not optimal.

It is therefore hardly surprising that one cannot improve a portfolio by including these ETFs based on national indices outside the US. This happens even with those that have performed best in the past, such as Canada, Sweden, Spain or Australia. In fact, it is with Switzerland that one obtains the best Sharpe ratio, thanks to its defensive virtues. But as we have seen above, VTI alone performs even better.

We had a similar situation with Micro Caps, in the previous post. ETFs in this sub-asset class were failing to replicate their excess returns. The problem was worked around by selecting stocks directly. Let's see what happens if we apply the same principle.

For the selection of Swiss stocks I applied qualitative filters (margin, asset turnover, interest coverage, and Piotroski score) to the companies that make up the MSCI Switzerland. I retained, in equal parts, the five that ranked best according to these criteria. Each position is set at 5% of the portfolio value, to represent a total of 25%, the remainder being allocated to the American market, via the VTI ETF.

The results of international diversification are this time much more convincing:

CAGR clearly outperforms VTI alone, with a much better Sharpe ratio. Again, as with Micro Caps, direct stock picking pays off.

Capitalization, sectors and countries

Let's summarize the lessons so far:

• From a capitalization point of view, the best PF, on the US market, is made up of 50% of SPY and 50% of quality Micro Caps.
• From a sector perspective, the best PF in the US market is made up of equal parts QQQ, VDC and XLV.
• From a country perspective, the best PF is made up of 75% of VTI and 25% of quality Swiss Big & Mid Caps

Compiling all this data, we obtain the following portfolio:

• 75% for the US market
  • 37.5% from Big Caps
    • 12.5% QQQ
    • 12.5% VDC
    • 12.5% XLV
  • 37.5% Quality Micro Caps
• 25% Swiss Quality Big & Mid Caps

As a frame of reference I will take the three ETFs that we used above: VTI for capitalization, SPY for sectors and VT for countries. The retroactive test between 2008 and 2023 gives us very nice results:

All three benchmarks are comfortably beaten, both in terms of CAGR and Sharpe ratio. Of course, this portfolio is more complicated to implement because of the direct stock selection. An investor who does not want to take the hassle can therefore be satisfied with the one relating to sectors (QQQ+VDC+XLV) which also gives very good results for an easy-to-follow approach.

Conclusion

A portfolio composed solely of stocks can still be diversified and relatively low risk for this type of asset. To do this, you have to play with the capitalization, the sector of activity and the geographical area. A sector strategy, based on a few ETFs that are relatively uncorrelated, offers good results, better than the market, while remaining easy to access. If you are prepared to select direct stocks in addition, you can obtain very convincing figures, both from the point of view of profitability and risk.

Stock-only strategies are very profitable over the long term, but they may not be suitable for all investors. Inexperienced investors or those without a high risk tolerance will benefit from starting with more conservative portfolios. We will see a number of these in our upcoming backtests.