The purpose of this paper is to provide an overview of our strategic framework, how it is put together, and how various tactics are used in its execution. Investment discipline begins with understanding the best asset mix that will help you to achieve your objectives. A personalized risk assessment is required to select the mix that will keep the portfolio in your comfort zone. That is, how to minimize risk and meet your required return. No strategy is perfect. All assets have risk; portfolio risk exposure will vary depending on your objectives. A good adviser can add the most value by helping you understand these risks, candidly assessing their potential downside, and choosing the best asset mix that will serve your goals. In order for a strategy to achieve its intended purpose, a consistently executed discipline is required to maintain risk and return exposures.
Asset Allocation and Diversification
This process of selecting an asset mix is referred to as asset allocation. The purpose of asset allocation is two-fold: 1) to diversify your investments; 2) to weight assets in order to achieve the return you desire, with the level of risk you are willing to assume. A portfolio will then be constructed to include several asset classes. The table below illustrates that asset classes have different risk-return characteristics. Small stocks have the highest risk and the highest return over time; treasury bills have the lowest risk and lowest return. Between these two extremes we look to select a mix that can generate the best return with the lowest risk.
Diversification of asset classes provides a portfolio exposure to different economic risk and return factors. For example, stocks are subject to market risk and large price declines, but they offer better long-term appreciation and protection against inflation; bonds can experience small price declines, but are subject to inflation, interest rate, and reinvestment risk. However, because stocks and bonds respond to different economic forces they do not move in the same direction at the same time (they do not ‘correlate’ in industry jargon). The chart below shows that if you combine them in the asset mix, you can achieve a lower risk portfolio with similar investment return. Capital markets do not offer free lunches, but this is as close as you will get. The 50-50 stock/bond mix in the example below provides a similar return as 100% stock, without as much up and down price movement.
Beware of the Boilerplate Solution
Understanding your total asset mix – including assets held away from our management – is very important to keep risk levels in alignment. For example, if you owned a real estate development company, holding REITs (Real Estate Investment Trusts) in the portfolio would likely overexpose you to the cyclical factors of the real estate industry. An intelligent diversification plan would adjust the allocation and minimize or eliminate REITs from the investment portfolio. This highlights the fact that a well designed portfolio needs to consider more than assets under management.
Historically, diversification has served portfolios very well. Still, it is important to note that diversification is not bullet proof. In the financial crisis of 2008-09, every asset class except gold and US Treasuries suffered losses beyond their historical range. This was an unprecedented event in capital markets because diversification mostly failed; perhaps an historic anomaly driven by record high systemic leverage which created a lot of forced asset sales. Another factor to consider is that as international markets are more integrated and information flows instantly across the globe, diversification of non-correlated assets becomes more difficult to achieve. Assets by region and asset class are more tightly correlated than they were 15 years ago. In any case, diversifying is still a useful way to structure a portfolio, though important to recognize that it is not a guarantee.
Each asset class has multiple investment options to choose from to gain a particular exposure. We look for the best quality at the lowest cost. Quality is defined by combination of liquidity and low tracking error to the asset’s index. We keep out middlemen, so we can pass on the savings to you. We never pay loads or sales commissions and we look to minimize expense ratios wherever possible. Valuation can also play a role in asset selection. When we know an asset or asset class is well above its normalized level, we may minimize or not purchase the asset until it reverts within its historical range.
‘Buy and Hold’ Is Not the Same as ‘Buy and Forget’
Overreaction and short-term thinking can take the strategy off track. There are plenty of studies that quantify the ill effects of market timing. Wall Street loves market timing activity and heavily promotes it because it helps to generate sales and trading commissions. Investors’ trying to time the markets ups and down are fighting an uphill battle as well as one that is very tax inefficient. The wisdom of “don’t just do something, stand there,” is illustrated in the chart below. Still, portfolio discipline needs to be exercised to keep your risk exposure in line. “Buy and forget” will create distortions in your portfolio mix and can expose you to excessive risk.
Risk Reduction – Rebalancing and Patience
“Buy and Hold” needs to have an oversight mechanism to avoid over exposure to risk that can occur in a “buy and forget” portfolio referenced above. This mechanism is called “rebalancing.” Periodic rebalancing of your portfolio to target weights keeps the risk level aligned with your objectives. This part of the discipline imposes the buy low, sell high mantra. Asset classes grow at different rates of return and are sensitive to different economic events, so it is necessary to periodically rebalance a portfolio to maintain the target asset mix and maintain the desired risk exposure. The chart below shows that the return differential is minimal, but that risk reduction varies between 2.5% to 4.3% in the time periods below.
Tax Efficiency – Deferral Benefits
Any complete discussion of portfolio returns needs to include the tax impact. By combining tax loss harvesting, placing assets in accounts that will receive maximum deferral benefit, and being tax efficient in the rebalancing process, in sum, can add 1% or more when compounded over the life of a portfolio. The longer taxes are deferred the more benefit they add to your account. This is another reason that “buy and hold” is an advantage to growth or momentum investing as one normally sells at preferred long-term capital gains rates, whereas momentum investing often sells much of its portfolio at short-term ordinary income rates. As any student of Finance 101 will tell you: the after-tax cash flow is what matters most.
A strategy is only as good its implementation. Diversifying assets intelligently to account for your total assets, selecting quality assets, minimizing costs, consistent re-balancing, and exercising tax efficiency where practical are all fundamental to disciplined portfolio management, and keeps the strategy aligned with your goals.
Jerry Matecun – Founder, President
Expert guidance to plan your future, preserve your lifestyle, and retire with confidence. For a confidential consult, contact me at firstname.lastname@example.org or 949-273-4200.
PLEASE NOTE: Nothing herein constitutes investment, legal, or tax advice. For details please see Disclosure.