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How To Intelligently Invest for Stable & Consistent Returns

Part 1

Equitable Divergence is a series of papers written by our Chief Investment Officer. Every quarter a new paper in the series will be released. All papers in the Equitable Divergence Series are free.

First Things First.

We all watch television, interact on social media, read blogs, and listen to the radio. It’s hard to disconnect. Everyone has an opinion or is an expert in a certain space. They speak with such vigor that their words are difficult not to believe.  Financial pundits are everywhere and they compete for the biggest audience they can find that will listen to their “expert” opinion. It’s tough to separate the wheat from the chaff. So, what do we do? Over the years we have found that there is advice that withstands the test of time. Information that can be relied upon. Information that can be acted upon. We will attempt to distill the most important financial concepts that can be relied upon throughout your investing career. Whether you have an advisor, are an advisor, or manage your own portfolio, these concepts will be helpful as you navigate the financial markets.  In investing, your worst enemy is yourself, so keep these principles close as you never know when you might need them.

Diversification

What is diversification? An easy way to think of diversification is mixing assets with uncorrelated returns. This simple idea reduces overall risk to a portfolio. In practical terms it is nearly impossible to find three mutually uncorrelated assets. Consequently, we can’t hope for a risk reduction of more than about one-quarter to one-third from diversification. In other words, as you add more asset classes to your portfolio there will be a point where the benefits of diversification may decrease .  A well diversified portfolio will see some assets zigging when other assets are zagging. It’s the nature of the beast, but also the benefit.

Effective portfolio diversification can increase return while reducing risk. Achieving maximum benefit from effective diversification requires periodic rebalancing (which we will go into detail below) of portfolio composition back to the target composition. This is difficult to do as it almost always involves moving against market sentiment. One practical example of diversification is finding assets outside the bond/stock world that combat inflation. Even though long-term returns for precious metals are highly suspect and are fairly low they may be a great hedge for inflation and will likely do well during an inflationary environment when other stocks and bonds would be adversely affected. This would would reduce overall market risk. Additionally, there are many sub-categories of fixed income and many of these categories react differently than you would expect. For instance, a Junk Bond Fund tends to outperform other bond funds when interest rates rise and would be a great counterweight in your retirement account when combating inflation. Additionally, Emerging Market Bond Funds rarely move in unison with the US Stock market, so they are one of the rare investments that are unlikely to drop just because the US stock market takes a dive. As you can see, diversification can be created in some interesting places and is imperative if you want consistent growth out of your investments.

Exhibit A below provides some concrete data points to back up the benefits of diversification. Exhibit A is a comparison of a simple 60/40 portfolio versus the S&P 500. The data goes back to 1976 and shows how important diversification really is in providing more stability in your portfolio. No one wants a repeat of the 2008 financial crises and lose 50% of their net worth. Everyone needs to mitigate losses and create downside protection. The easiest way to do that is diversification.

*Start of period coincides with inception of Barclays U.S. Aggregate Bond Index. Out of 460 total periods. Source: SPAR, FactSet Research Systems Inc.

Recouping losses always requires a larger percentage gain than the loss itself, and the difference between the two gets more dramatic as the losses get larger. For example, let’s say XYZ stock lost 50% of it’s value and it went from $10 to $5. How much does that stock have to gain before it’s back where it started? Many would say 50%, but that would be incorrect. To get back to $10 XYZ stock would have to gain 100%, twice as much as it lost in percentage terms. Even worse, what if XYZ stock lost 68% of it’s value, as some stocks did in the 2008 financial crises? How much does that stock have to gain to get back to where it started? Believe it or not, it would need to triple in value and gain 214% to make up for the loss. The name of the game is to minimize losses and mistakes. Diversification can reduce the frequency and degree of losses, which would provide an investor a quicker turnaround to get back into positive return territory. Mitigating the inherent risks associated with investing is imperative and you are ahead of most market participants when you diversify your portfolio.

Rebalancing

Rebalancing plays an important role in producing long-term consistent growth in your portfolio. It can be thought of or regarded as the only consistently effective method of market timing. Rebalancing increases long term return while reducing risk. Think of a simple diversified portfolio of stock and bonds. Many times bonds will move inversely to stocks and vice versa. Say you rebalance that portfolio once per year to move your portfolio composition back to your targets. A good result for one asset (maybe stocks move up 10% since last year) is associated with a bad result for the other (maybe bonds are down 6%). Rebalancing forces you to sell some of the successful asset (Stocks) in order to buy more of the unsuccessful asset (Bonds).

The benefit derived from rebalancing is monetary, but is also psychological. If you get into the habit by moving in the direction opposite of the market’s, the investor gains both a healthy self-reliance and distrust of market sentiment. Distrust of market sentiment and “expert opinion” is one of an investor’s most useful tools. Failure to rebalance a portfolio of stocks and bonds eventually leads to an almost all stock portfolio because historically long term stock returns are higher, which resets your risk-return combination to a higher level. Producing a habit to rebalance instills in the investor the discipline to buy low and sell high. Seems like an easy idea, but what history has shown us is that it’s very hard to put into practice. There’s no effective way to predict in advance which rebalancing period will be optimal for a given portfolio, but as a general rule, long rebalancing intervals are preferred. Why? Because of momentum. Asset class returns have a slight tendency to trend, and it’s important to take advantage of this phenomenon.

Exhibit B below is a chart that provides a glimpse into the monetary benefits of rebalancing a portfolio. As you can see the benefits are impressive when an investor has a diversified portfolio that is rebalanced annually. Regular rebalancing has historically bolstered investment returns far more than many expect. Additionally, rebalancing has also muted portfolio volatility. As you can see in Exhibit C below volatility reduction is enhanced when you regularly rebalance a diversified portfolio.

The simple act of regularly rebalancing a diversified portfolio not only provides the potential for higher long-term returns, but also mutes volatility.

Asset Allocation

Oh, the holy grail of investment success. Yes, you heard me right! Asset allocation accounts for most of the difference in performance among money managers. As a definition, asset allocation is the dividing up of one’s securities among broad asset classes.  Believe it or not, arriving at an effective asset allocation is not that hard to do, but is very important. The long-term success of your portfolio does not hinge on your individual security selection or market timing, as both are extraordinarily hard. Fortunately, those methods are nearly irrelevant to having success.

No one can predict the future. As such, it’s impossible to know what the best asset allocation will be. Your job is to find an allocation that will do reasonably well under a wide range of circumstances. The objective is to develop a long term strategy, so that you can become the casino owner, not the mark. So, how do we do that? You must stick to your target asset allocation no matter what, as this is much more important than the right asset allocation.

When building a portfolio you must keep the points below in mind.

  • Favor short to intermediate term bonds as your “risk diluting” asset rather than long term bonds.
  • The aggressiveness of your portfolio is reflected in your overall stock and bond mix, not in the kinds of equity you hold.
  • Small stocks outperform large stocks in the long run, but that comes at the cost of higher risk.
  • Value stocks tend to fall much less in price than growth stocks when earnings disappoint.
  • Value stocks tend to rise more in price than growth stocks when earnings exceed expectations.
  • During bull markets growth beats value, but during bear markets value stocks lose much less than growth stocks. Thus, the returns on value stocks may be superior to growth stocks simply because of their more benign bear-market performance.
  • When stocks get more expensive, their future returns are likely to decline, and when stocks are very cheap, future returns are likely to be more generous.
Bernstein, William. The Intelligent Asset Allocator: how to build your portfolio to maximize returns and minimize risk. New York: McGraw-Hill 2001.

In constructing a portfolio, ask yourself three questions .

1) What is the largest annual portfolio loss I am willing to tolerate in order to get the highest returns? Below is a good chart to help you on your way.

Bernstein, William. The Intelligent Asset Allocator: how to build your portfolio to maximize returns and minimize risk. New York: McGraw-Hill 2001.

2) How much complexity am I willing to tolerate? To start you’ll need at least four asset classes including US Large Stocks, US Small Stocks, Foreign Stocks, and US Short-term bonds. If you’re interested in taking on more asset classes, build around those four positions. Just keep in mind that as you add more asset classes to your portfolio there will be a point where the benefits of diversification may decrease. It will be imperative that you watch your portfolio react under different stresses of the market.

3) How much tracking error (the difference between a portfolio’s returns and the benchmark it was meant to mimic) can you tolerate? If you love comparing your portfolio to the S&P 500 you may want to consider a healthy allocation to US Large Cap Stocks. This question is very important. If you are comparing your portfolio to the S&P 500, but your portfolio is constructed in a globally diversified way, your portfolio will not track well with the S&P 500 and will fail in meeting your expectations. It goes without saying, know your investments!

HEAD OVER TO PART 2!


About The Author:

Jason C. Hilliard, J.D. is the President and Chief Investment Officer at Forecast Capital Management. Jason has been involved in the financial markets for two decades, which started at the Chicago Board of Trade in the 30-year bond pit. He was coached by some of the most successful bond traders at the time. In 2011, Jason decided to fuse his educational background as an attorney with his practical experience as a professional futures trader and investor in order to provide clients a better service and investment strategy than was currently provided in the market. Jason has been quoted in major publications and books including Bloomberg, Infusionsoft, and Wall Street Kitchen by Victor Chiu.