Portfolio Strategy & Considerations
Asset allocation is the strategy we use to diversify your money across a mix of assets. The rationale in this approach is that each asset serves a distinct purpose within your plan. Your asset mix is then determined by how much return you need to meet your goals without taking unnecessary risk. Risk, in these sense, is broadly defined as running out of money when needed. Which also means that time is an important risk management consideration. Lastly, strategy is designed to minimize your overall investment cost as well as to defer and minimize taxes so more of your money can work for your goals.
Diversified strategies have proven over time to lessen variation within a portfolio and deliver better returns after accounting for risk. This is because different assets respond to economic factors differently. To give you a simplified example: stocks rise with economic confidence and corporate profits; bonds respond better when interest rates are trending lower and economic uncertainty is rising. Stocks are more volatile; bonds more stable. Combining assets in a portfolio allows us to balance growth, income, and stability to better meet your goals.
Asset Class Review
- Stocks: The US continued its 5 year outperformance on a rising tide of low interest rates, an improving economy, and record high corporate profit margins. Europe and Japan are fighting deflation and recessionary pressures. Russia’s annexation of Crimea added geopolitical risk and precipitated a decline in Europe and emerging markets. China’s economy is slowing and other emerging markets are following suit. Currency issues also hampered international markets anticipating a rise in US interest rates.
- REITs: Outperformed all asset classes by a wide margin. Declining interest rates sent money chasing yields.
- Commodities: Supply and demand drive commodity prices. Oil prices in particular, have fallen dramatically. China demand has declined while US shale production has increased supply; OPEC members are determined to keep market share against shale producers. Deflationary forces are driving many commodity prices lower.
- Bonds: Bond prices rise when yields decline. The US 10-year bond yield declined from 2.8% to 2.1% during 2014, despite a slew of forecasts predicting that rates would rise to 3-4%. Consequently, US bonds did well.
Diversification by Asset Class
Financial investments are total return vehicles that consist of price return, income return, or both. Generally, stocks get most of their return from price movement; REITs get a more even mix between price and income; commodities rely most on price return (though we use some investments that generate income); bonds rely most on income return. To further explain why we diversify consider the purposes for owning the following assets:
- Stocks: are long-term growth assets (10 years or more) and have provided investors with the highest rates of return of all asset classes, allowing people who own them to maintain their living standards into retirement years. If money is needed in the short-term (0-5 years), then can be very risky due to volatility.
- REITs: are long-term growth and income assets. They offer high levels of current income which helps to reduce some of the return risk, since almost half of the total return is paid out quarterly.
- Commodities: natural resources and precious metals offer inflation protection. Commodity price movements also tend to move counter to stocks; therefore, combining these assets helps to reduce portfolio risk.
- Bonds: generate current income and price stability which helps to reduce portfolio risk. However, bonds can be risky and lose value when inflation and interest rates are rising because they are “fixed income.”
Diversification by Geography
We also diversify across different geographies despite the fact that investors across the world tend to exhibit a home-country bias with their investments. Long-term studies show that international diversification reduces risk when compared to domestic only portfolios without sacrificing long-term returns. We divide the world by US, International Developed, and International Emerging markets. The table below shows that for the past 45 years no regional stock market consistently outperformed another. A defining feature of markets is that trends reverse. When the reversal might occur is a guessing game that no one can predict with any certainty or consistency.
Why Diversify – The Concept
If stocks provide the best long-term return, why diversify? Answer: look out below! Psychologically, a diversified mix helps you sleep during painful stock market declines. Practically, if you need money during these declines, it’s preferable to draw from the stable or rising portion of your portfolio while the depressed portion has time to recuperate. This will let your money last longer. To reiterate: time is an important risk consideration.
Why Diversify – The Practicality
To illustrate the concept, the table below shows a 7.56% average return over a 30 year period. The only difference in A, B, and C is the return in year 1 and year 30. Yet this difference determines drastically different results:
A. Would run out of money in 22 years
B. Would have $98,000 left in 30 years
C. Would have $1,543,000 left in 30 years
As you can see, the sequence of returns has huge implications for how long your money can last. If markets are down and there isn’t a stable reserve to draw from, you may run out of money…..or you may be forced to radically change your lifestyle with spending cuts. We don’t know the direction of markets on a yearly basis, so it’s prudent to guard against the unknowable. Diversification is not a guarantee against loss, though history shows that it reduces the risk that volatile markets may force you to consume capital when assets prices are depressed.
Some More Practicality – Keep the Odds in Your Favor
Risk and return are tightly connected: you can’t have more return without taking on more risk. Everyone has a different tolerance for risk. This is neither good nor bad; however, the table above shows that one’s personality shouldn’t preside over practical consideration! Over the past 100 years stock owners have had almost a 30% chance of losing money in any given year; over 5 years the odds of losing lessen to 14%; over 15 years they go to 0%. Time has tended to lower risk. By understanding portfolio risk and return in the context of your time horizon and goals, we can better target a return that minimizes risk to your lifestyle and spending considerations.
Why It Matters for Your Money
Consistent execution of a well-defined strategy is important to building and preserving your wealth. Targeting the best return that can meet your goals with the least amount of risk is central to our approach. Strategy implies a long-term perspective. We don’t attempt to tactically time the ups and downs of various markets because the odds of beating markets over time is a losing game. Studies by Vanguard, Standard & Poors, and other unbiased sources show a 70%-90% of losing when trying to beat market indexes. Eliminating excess costs (taxes, trading and sales commissions, or other extraneous fees that erode your value), enables more of your money to work for you, thereby further increasing your odds of achieving your goals.
The US stock market has outperformed other stock markets for the last 5 years, and today are looking expensive. Valuations play a large role in determining future return potential of an asset. If an asset is overpriced today, it likely means that its future appreciation potential is limited. The table below shows the US market sells at a Price/Earnings ratio (P/E ratio) of 18.7, and is almost 20% more expensive than its historical average and 20%-38% more than other developed economies. Removing the top 3 companies in the S&P 500, the P/E is at 20. Yet another measure called the cyclically-adjusted P/E ratio (CAPE) shows the US market overvalued by 25-30%.
Another point to consider is that US profit margins are some 20%-28% higher than their historical average, both on a percentage basis and as a percent of GDP (the overall economy). Unless competition has disappeared, profit margins are very likely to revert to their long-term average. This further implies that US markets are more overvalued than P/E measures indicate. Low bond rates do tend to support higher P/E ratios in the stock market, but that isn’t a sustainable investment premise. Even so, rates are lower across the globe. It may be sensible to pay a premium for investing in the relative safety of the US economy, though valuation ultimately matters.
International markets are less expensive and pay out higher levels of current income. From a pure valuation perspective they offer more return potential. However, economic, political, and demographic issues are creating a headwind for appreciation in these markets. We don’t know when the cycle will turn in these markets, but we think it’s prudent to maintain exposures.
Bonds – Where Has All the Yield Gone?
Strong economic performance usually is accompanied by rising interest rates. Yet rates in the US declined by 25% in 2014. The current yield on the US 10 year bond is less than 2.0% vs. a long-term average of about 5.0%. Long-term rates have declined, even as the Federal Reserve has spoken about raising short-term rates. Why such strange behavior for an improving economy? Many hypotheses abound: secular stagnation, aging demographics, technology, global indebtedness, lack of fiscal stimulus, global labor supply, low yields in other nations is creating demand for US debt, thereby pushing our rates lower etc. Savers continue to be punished by a low interest rate environment and government policies that encourage indebtedness over investment.
Summary & Conclusion
We point out some of these technical, political, and valuation issues because it leads us back to the simple, sophisticated reasoning in our strategy. Trying to outwit market movements is a proven way to put the odds against your money; you can burn a lot of investment calories (dollars) trying. Periods of outperformance and underperformance recur across asset classes and geography. In diversifying these asset exposures, history shows we can receive the benefit of each assets performance while lowering overall portfolio risk through economic cycles.
Our strategies are not designed to beat any particular market; they are designed to deliver a total return that can meet your goals without over exposing you to risks that can jeopardize the successful achievement of your goals.
PLEASE NOTE: You can’t invest directly in an index. Past performance does not guarantee future performance. All investments are subject to risk, including possible loss of the money you invest. Diversification does not guarantee profit or protect against a loss. Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. For details please see Disclosure.
Appendices: These charts support the diversified, long-term perspective that guides our strategy.
Appendix A: Why The Long-Term View
Appendix B: Why Timing Markets is Ill-Advised
Appendix C: Why Asset Mix Helps Provide Downside Protection
 Elroy Dimson, et al, “Triumph of the Optimists: 101 Years of Global Investment Returns.” Princeton University Press, 2002.  St. Louis Federal Reserve, 2014