If your eyes quickly glaze over when someone starts talking about investing, here is the quick summary.
I am a professional worrier. I spend an inordinate amount of time imagining personal and world events that could put your goals in jeopardy. Portfolios are structured to achieve your goals while avoiding unacceptable outcomes due to these risky events. This means using enhanced indexing to invest efficiently while modeling scenarios that assess the opportunities and risks of the current environment to determine the appropriate amount of portfolio risk.
For those who want a more techinical description of what that means, read on. The following is what I see as the evolution of investment strategies.
Evolution of Investment Strategies
Throughout history you find wealthy patrons evaluating and investing in businesses. Because the businesses were often small, risky and illiquid and there were few wealthy patrons, most of the power rested with the investor, who insured the deck was stacked in their favor. With the advent of securitization however, this dynamic was reversed and now investors rarely have much influence or deep knowledge of their investments.
Because of the abundance of competition and the increasing complexity of businesses, successful stock picking is incredibly difficult. Not only do you need to identify companies that the market is undervaluing, but the market must then come around to your point of view. Furthermore, it takes over 30 years to reliably label a stock picker as skilled rather than lucky. There is a reason mutual fund prospectuses all say “past performance is not necessarily indicative of future results” and that is because it’s true.
Hindsight is 20/20. It always seems obvious after the fact that bad/good things were about to happen. Unfortunately, this leads many people into believing market timing can be a reliable way to improve returns. Market timing (or as it has come to be renamed “tactical asset allocation”) typically comes in two flavors.
The first flavor exploits the momentum effect of stocks (e.g., stocks going up tend to keep going up and stocks going down tend to keep going down). The effect is real and works great until there is a sudden market dislocation which can undo all the benefits you have accrued.
The second flavor exploits the reversion to the mean of stocks (e.g., stock prices in the long run are tied to their economic fundamentals). The problem with this strategy is that stock prices can stay “irrational” for a VERY long time. In 1996, stock valuations went into bubble territory, and it wasn’t until 2008, 12 years later, that stocks dropped back to a historically normal valuation.
People who realized that stock picking and market timing are not reliable strategies looked for ways to invest that would avoid their inherent problems. Stock market returns come from the following sources:
- Dividend yield
- Real earnings growth
- Price/Earnings expansion/contraction
When looking across business cycles the first two sources are pretty reliable so indexes were developed to allow an investor to capture their share of world output (dividend yield) and economic growth (real earnings growth) for minimal cost. Short term bonds are then added to dampen the volatility to an acceptable level. And finally, regular rebalancing helps keep the volatility under control.
Looking to build a better mousetrap, researchers investigated whether there were additional sources of risk and return other than simply exposing yourself to the world equity market. They found two new risks that historically have been rewarded in the long term.
Value companies have below market average fundamentals (e.g., higher dividend yields, lower PE ratio and other value metrics). While these companies are often riskier (that is why they have below market fundamentals), they can also deliver higher returns if the anticipated risk does not materialize.
Similarly, small companies have the potential for very high levels of unexpected growth (i.e., it is much easier for a small company to double in size than for a big company). So companies that are both small and have value fundamentals are riskier (e.g., they don’t have deep pockets to ride out troubles like big companies do) but provide the opportunity of higher returns in the long run.
Enhanced indexing strategies start with a world market portfolio and then tilt (i.e., add more exposure) towards small and value companies to improve returns.
Scenario Based Risk Management
Traditionally, advisors using indexing and enhanced indexing strategies determine your portfolio’s stock/bond mix solely on your time frame and tolerance for volatility, ignoring two critical factors (and potentially others): your downside tolerance and the returns current market valuations suggest.
A 50% stocks and 50% bonds portfolio might be expected to provide $100K/year in retirement. But a more aggressive 70% stocks and 30% bonds portfolio might be expected to provide $110K/year in retirement. If you could handle the additional volatility, the more aggressive portfolio would seem to be the prudent choice.
But along with more volatility, the more aggressive portfolio also comes with greater downside potential. So while the 50%/50% portfolio might never force your spending below $90K/year even after some bad years, the 70%/30% portfolio might force your spending to $70K/year after a string of bad years. If a $70K/year spending level is unacceptable, then the 70%/30% portfolio should not be chosen. Incorporating your unacceptable outcomes into your investment decisions is critically important.
Remember those fundamentals of stock returns: dividend yield and PE expansion/contraction? When dividend yields are low and PEs are high, the market is promising lower returns going forward and is considered “highly valued”. During these times people need to save more and spend less to achieve the same goal. The downside risk is also higher during these periods which then requires longer time frames to make stock risk attractive. This can lead to the unintuitive result that for young people, having their portfolio drop in value can potentially make it easier for them to reach their goals.
In summary, scenario based risk allocation allows us to balance the current valuation based benefits of increasing risk exposure against the desire to avoid unacceptable outcomes.