Sigma Investing Philosophy

Summary

The Sigma Investing Philosophy is derived from learning and insights around three core areas:

1. To build wealth to protect your current lifestyle and save for retirement, you must aggressively save as early as possible to take advantage of the long term benefits of compounding interest (see The Millionaire Next Door by Stanley and Danko)

2. The best way to grow your wealth while being able to sleep easy at night is to construct a diversified market portfolio consisting of low cost, passive index funds and ETFs (see Unconventional Success by Swensen)

3. If you have personal aspirations and the risk appetite to obtain higher wealth, create a portion of your portfolio which will be focused on more concentrated positions. (see The Aspirational Investor by Chhabra)

Applying these guidelines, we can help you construct an investment portfolio to deliver security for today's needs, performance to meet your needs for retirement and potential to hit your personal financial aspirations to support key life objectives.

Mapping your portfolio to your financial objectives

Chhabra breaks down an individuals core financial needs into three categories:

1. Security - basic financial security to support your core needs

2. Market - ability to protect and maintain a good lifestyle now and through retirement

3. Aspirational - aspirational life objectives that require more wealth

Thus, it recognizes that some people might be fairly risk averse and seek market returns to maintain a lifestyle and beat inflation. However, others may have aspirations which require significantly more capital than a diversified broad market portfolio can be expected to deliver. Thus, they may want to allocate a portion of their portfolio to higher risk / higher return options like concentrated stock positions, equity from working at startups, cryptocurrency investments, or ownership of family businesses.

I found this to be a good framing and approach to investment portfolio construction. Plus, it matched the way that I was constructing my own portfolio outside of my standard low cost, index fund based portfolio.

Let’s explore these objectives and the proper financial instruments for each.

Investment Objectives

Security - Everyone should strive to have basic financial security to support your life needs - paying for basic needs (housing, food, education) and guarding against unexpected life situations like health problems or periods of unemployment. To support this objective, one portion of your portfolio should consist of protective assets like cash, short term treasuries, and annuities. You can also count other assets which you can utilize for cash if needed in an emergency like the equity in your primary residence. You should consider holding some insurance to protect against specific risks. If you have stable employment, you can also count the value of your current earnings in this portion of your portfolio.

With this portion of your portfolio, you expect to earn returns below market rates but you are selecting very safe assets. For a rule of thumb, you should save and build assets in this portfolio such that it would cover 1-2 years of your expenses. This level of assets in the security portion of your portfolio will protect your living standard through challenges that arise and give you peace of mind under normal conditions.

Market - The second portion of your portfolio should be geared towards growing invested capital at rates which match the broad market and can sustain medium term volatility since this portfolio will not be something which needs to be spent in the short term. In my mind, this portion is responsible for protecting your ability to maintain a good lifestyle now and through retirement and to ensure that inflation doesn’t erode your quality of living.

This portion of your portfolio should consist of a diversified, low cost market portfolio which is periodically rebalanced. Sigma Investing offers many tips on constructing and managing this type of portfolio. I would suggest starting with reviewing the Market Portfolio Strategy and Implementing the Market Portfolio. You can include some private equity in this portion of your portfolio if you are not overly concentrated and are using it for diversification. Overall, your expectations should be for market level returns (which will outpace inflation) and moderate volatility which will decrease as you enter into retirement through gradual changes to your asset allocation.

With this portion of your portfolio, you are mostly building to support retirement spending. Two approaches to calculate how much to save would be:

1. Determine your expected retirement spending and multiply by the number of years that you expect to live in retirement. For example, if you spend $100,000 annually in retirement and expect to live 30 years into retirement then you would target a portfolio balance of $3M at the time of retirement.

2. Another way to validate would be to divide your expected annual spend by 2.5% which would represent your annual deduction from your portfolio. I use a lower number than the standard 4% to be more conservative and to account for taxes paid. Thus, with the same $100,000 annual spend as above, dividing this by 2.5% would result in a required initial balance of $4M.

I would take the larger of these two calculations as my target. Both of these approaches are fairly conservative, so you should have sufficient capital if you manage to hit this target portfolio value.

Aspirational - The last portion of your portfolio exists to generate wealth to meet your aspirational life objectives. These types of aspirations might include buying a vacation home, donating a substantial amount to charity or leaving a nest egg to your children. This portion will be more risky but has the potential for out-sized returns. You should be fine financially if this portion of your portfolio lost 100% of its value.

Some investments which you could include in this portion would be:

• concentrated positions in individual entities, cryptocurrencies, private equity or real estate

• angel investments

• equity holdings in private companies

• family-owned businesses.

As you approach your target level, you should plan to move the assets into more stable and less volatile instruments to lock in the value.

Example Portfolio and Targets

Here’s a simple example for someone who currently spends about $100,000 per year and expects that level to persist through 40 years of retirement.

The investor should pressure test this portfolio and gauge how they would feel and react to the following situations:

• 50% market drawdown in their market portion

• 100% decline in value in their aspirational portion

• Loss of employment for 1 year

These are possible outcomes so the investor should make adjustments to their targets if they feel that these events would create real hardship. Some investors might not have a high risk appetite and might not have enough wealth to have a large aspirational portion, those can start with a much more modest target there and perhaps increase their targets in the security and market portions.