Date: Feb 23,2023

Financial Independence is the ultimate goal of a sound and productive economic life. If you are not thinking about it, you are either okay depending on a company or the government to support you. It has been said that the secret of becoming wealthy and financial independent is not to make money, but to keep it. Some people think that saving is the only way to keep it, and that might be partially true.

We are human beings that like to live. We like to travel, eat in nice restaurants, build experiences with our loved ones. All of that requires resources, so it is impossible to save every single penny.

The only way is to save as much as possible and learn the secret of the rich. The rich do not work for money. Money works for the rich.

Now, must of us in the US save money through our 401k. Some people hire a broker to manage their money for them. But the truth of the matter is that recessions happen and will continually happen. In a recession the broker does not make its commission, but does not run any risk with you. You run all of the risks and pay a broker a commission. It is a well known fact that over 96% of brokers do not beat the market consistently. One of they keys to make money in the stock market is to minimize the amount of commission you pay to brokers. You might be able to do this if you have millions of dollars, but if you don’t, you won’t.

If you ever want to become financially independent, you have to learn to manage your own business. And this is what this is all about.

About Exchange Trade Funds (ETFs)

An exchange-traded fund (ETF) is a type of security that involves a collection of securities—such as stocks—that often tracks an underlying index, although they can invest in any number of industry sectors or use various strategies.

The secret is to select a diverse selection of classes of assets (ETFs) that allow you to participate in dynamic industries - Technology, Real Estate, US corporate, International corporate, Emerging Markets - and mix it with ETFs desgined to protect you during downturns - Corporate Bonds, Treasuries, Inflation-Protected Securities, Municipal Bonds. If the right mix is selected and you rebalance your portfolio every 5 weeks you will never pay a single dime on commision to a broker.

ETFs used for this analysis and how they contribute to the portfolio

These ETFs are used for this analysis: 1. IVV - Core S&P 500 (US Large Stocks) 2. IEFA - Europe Far East Asia (Core MSCI EAFE, international stocks in developed world) 3. EEM - Emerging Markets (Stocks in emerging markets) 4. SOCL - Social Media ETF 5 BRK-B - Berkshire Hathaway 6. TIP - Tips Bond Barclay 7. FREL - Fidelity Real Estate 8. FTEC - Fidelity MSCI Information Technology 9. AGG - Corporate US Aggregate Bond 10. SCHD - Schwab US Dividend Equity ETF 11. VUG - Vanguard High Growth Fund (Apple, Google, Amazon, Microsoft, Facebook, Tesla, NVIDIA)

What do these ETFs offer?

  1. IVV - Capital growth, long-run inflation protection, tax efficient
  2. IEFA - Capital growth, long-run inflation protection, tax efficient
  3. EEM - Capital growth, long-run inflation protection, tax efficient
  4. SOCL - Capital growth, long-run inflation protection, diversification, tax efficient
  5. TIP - Income, low historical volatility, diversification, inflation protection
  6. FREL - Income, diversification, inflation protection, tax efficient
  7. FTEC - Income, diversification, tax efficient
  8. AGG - Income, low historical volatility, diversification
  9. SCHD - Capital growth, high-dividend yield, inflation protection
  10. VUG - High Growth - US Tech Firms
  11. BRK-B - Warren Buffett wisdom

Where do we get our data for analysis?

Companies like Google and Yahoo have FREE financial information published in their sites and updated daily. They get their data from market data vendors or the exchanges themselves.

What Percentages to Use?

First of all, let’s recognize that the goal is not only to maximize returns, but also to minimize risk. Therefore, any portfolio mix should consider these two goals. There’s a theory to do just that that won the Noble prize for its inventors - Modern Portfolio Theory.

Modern Porfolio Theory

Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. According to the theory, it’s possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper “Portfolio Selection,” published in 1952 by the Journal of Finance. He was later awarded a Nobel prize for developing the MPT.

Efficient Frontier for the Portfolio Selected

We did the calculations for you, here’s the efficient frontier plotted for you using the latest published data…

Sharpe Ratio

Another key concept to help understand the return of an investment compared to its risk. The ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return allows an investor to better isolate the profits associated with risk-taking activities. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.

In other words, Sharpe is a ration of returns under risk, means under standard deviation. You select the higher value and note down the percentages. That’s an optimized portfolio.

Plotted would look like this…

The next step to optimize a portfolio is to examine the efficient frontier and the Sharpe ratio for portfolios with different constraints

Establishing constraints is done depending on how you think the economy is doing, the cycle of the stock market, how averse you are to risk, etc.

The Constraints for this analysis are: a. In the final model none of the ETFs (IVV, IEFA, SOCL, TLT, TIP, FREL, FTEC, AGG) should exceed a weight of 35% of the total.
b. In the final model, the ETFs, IVV, IEFA, SOCL, TLT, FREL, FTEC, AGG should have at least 2% minimum in the portfolio c. TIP should have a minimum of 2% of the portfolio d. The addition of the total portfolio should be 100% e. No Shorts are allowed, which means that all the money will be invested and not more.

New Efficient Frontier with constraints

This is the new plot…

Optimized Portfolio

This is the optimized portfolio. Balance your portfolio using this percentages.

Portfolio Average Return: 0.86%
Portfolio Standard Deviation: 313.21%
Portfolio Sharpe Ratio: 0.27%