Do you need stocks in your portfolio?

rollercoasterMost financial professionals would tell investors not to focus on matching or beating market indices, but rather on making sure that they stay on track to meet their financial goals.

Some investors push back against this advice, perhaps thinking that it is an excuse advisors have for not being able to beat the market. Yet, the advice is sound. While some investors need full exposure to equities, others do not need to take that much risk and some would be much better off having no exposure to stocks at all.

How much risk one takes depends on personal circumstances. Unfortunately, investors are bombarded with 24/7 stock recommendations, and they become more receptive to them when the market has been strong and steady as it has been in the last few years. While bull markets make people feel more confident taking on risk, relying on your level of confidence to decide how much risk to take is the wrong way to pursue your financial objectives. The risk inherent in the stock market is high, and it should be handled with care.

Consider a 75-yr old widow (i.e. without a significant other, for simplicity) who wants to make sure that her $2.2mm in savings will be enough to pay for $100,000 of yearly expenses for the rest of her life. As that rate, she will spend $2mm by the time she reaches 95, leaving $200,000 to spare. Probably her best bet is to invest those savings in short-term, high-quality fixed income products to protect them against inflation. This ultra-low-risk strategy would be aligned with her goal, which is to minimize the chance of running out of money. It would have the important benefit of being highly predictable and likely devoid of unpleasant surprises.

What about a 75-year old single man who has the same expenditures but $1.5mm in the bank? Spending $100,000 per year will deplete his savings in 15 years, or sooner if he spends more due to inflation. Because there is 100% certainty that he will run out of money way before he reaches 95, he needs the extra return of stocks to make his portfolio last.

How much stock exposure does the less-wealthy investor need?

One way of answering that question is by simulating sequences of stock market returns and examining how his portfolio would fare under each sequence. This can give a sense of how his situation can be improved.

Without stocks, his portfolio will inexorably shrink by $100,000 per year. Because stocks are volatile, adding them to the portfolio will make it less predictable. The higher the proportion of stocks, the more it will depart from that steady declining path. To illustrate this, we ran a few possible ways his portfolio can depart from the no-stock scenario (see first graph).

portfolio paths 50% stocks

Adding stocks clearly makes it possible for this retiree to stretch his portfolio past year 20. But it can also make his portfolio run out of money sooner than 15 years, or subject it to a terrible start such as a 25% decline in the very first year.

How would he react to a bad start? If his tolerance for risk is low, he may close out his positions right away, book a loss, and end up worse off than before. Every investor should consider his or her risk tolerance carefully with the help of a professional.

Things can go very wrong when the volatility of stocks is not properly understood. Imagine that the widow in the first example, even though she has plenty of savings and little need to invest, becomes convinced that she is “leaving money on the table” by not keeping up with a rising stock market. She decides (or is encouraged) to deploy all her portfolio in an S&P 500 index fund.

portfolio paths 100% stocks

While her final portfolio could potentially be much bigger than without any exposure to stocks, she now has a small but very real chance that she could run out of money – a scenario that, before switching to stocks, she was virtually assured not to face (see second graph). In exchange for the chance of having more money at the end of her life (when it is least useful) she introduced the risk of being wiped out sooner, or experiencing distressing early losses that could prompt her to close out positions in a panic and lock her out of her goal.

It is tempting to invest in stocks when they seem to carry little risk. Investors should not rely on forecasts; instead, they should examine their own situations, understand their tolerance for risk, and develop an appreciation for what could go wrong with their investment strategies.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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Limit Stock Market Losses to Improve Long-term Returns

men putting out fireInvesting in stocks can be brutal. According to research, the S&P 500 lost at least 10% from a previous high every two-and-a-half years on average, and at least 20% every six. A 30% loss happened every 13. It has fallen 50% from a peak three times since 1954. None of these declines were, or could have been, anticipated with any kind of precision, and they certainly do not come at regular intervals. And, remarkably, losses of this magnitude contradict the models we use to describe market behavior.

For example, the largest S&P 500 one-day loss was 20.5% in October 19 1987. According to a widely used model of stock market returns (which assumes that they form a bell curve around an average) the likelihood of the 1987 loss is similar to picking the right card in a deck containing as many cards as there are atoms in the known universe. In other words, the chance that such drop could happen is essentially zero.

Clearly the problem is not that impossible events happen but that our models are inadequate. A lot of analysts have tried to come up with better ones, but so far this quest has proven fruitless. We still can’t predict markets with any meaningful accuracy. This is why markets are not so much like the weather, as they are often compared, but rather like earthquakes, which scientists now admit are unpredictable.

But here is the good news: we cannot predict earthquakes, but we know how to build earthquake-resistant structures. Likewise, we cannot predict markets but we have techniques that can help us limit losses when markets tank.

There are some very basic reasons why limiting losses is more important than producing strong returns.

A well-known example goes like this: If you lose 50% of $100 you need a 100% return on the remaining $50 to break even. This means that a large percentage loss requires a very large percentage gain for full recovery.

But a far more important example is this: If you only lose 20% of $100, you will need just 25% to bring the remaining $80 back to $100. So a small loss requires much less effort to come out from it.

This is even more important for retirees who use savings to pay for living expenses.
For example, taking $10 after a portfolio falls from $100 to $50 leaves the saver with only $40. A subsequent 100% return only takes the portfolio back to $80. That means that the $10 withdrawal turned into $20 because of its bad timing.

But when $100 only falls to $80 and $10 are taken, a subsequent 25% recovery on the remaining $70 brings the value up to $87.50. This means that the $10 withdrawal turned into $12.50—a much smaller penalty for taking money out at the worst possible time.

The moral is clear: limiting losses is an essential element in portfolio management.
Limiting losses requires some basic processes in place. The best known is diversification, or investing in a mix of assets that tend to move in different directions. But a mix that looks diversified today may not be diversified tomorrow, especially when markets take a turn for the worse. This is because in down markets investors sell everything and correlations go up sharply. Therefore, a mix that does not take into account how the market cycle changes is prone to go through periods where diversification goes away just when investors need it most.

Adapting portfolios to market conditions requires dedication, patience, and a well-designed set of rules. This is, or should be, the professional portfolio manager’s job. Some investors insist that the portfolio manager’s job is simply to beat the market by picking a high proportion of winning assets. Accordingly, they are willing to pay a premium for those managers who seem to have the hot hands. This is a bad approach, commonly known as “chasing past returns.”

Many studies show that virtually no active fund can consistently beat its benchmark, and not because of fees. According to Standard & Poor, which publishes a regular analysis of fund performance, most funds underperform their benchmarks both before and after fees.

The simple explanation is that poorly diversified funds can only outperform their benchmarks through superior forecasting. But, just like for earthquakes, forecasting the market accurately is impossible. As one academic put it:

Going back to basics, the idea “to invest successfully in the stock market, you need to know whether the market is going to go up or go down” is just wrong. (Professor David Aldous, UC Berkeley – The Kelly criterion for favorable games)

While limiting downside exposure is crucial in portfolio management, having this protection in place at all times can be frustrating. If the market keeps on rallying, the “insurance” against declines appears to be an unnecessary drag on returns, just as going through the expense of building a house that is earthquake-resistant may seem like a waste as long as there are no earthquakes.

We all have complained about paying for insurance that we don’t seem to need. This is understandable as long as disaster does not strike. But the temptation to cancel insurance can be dangerous. If you are not yet convinced this is so, please reread the first paragraph to see why having a systematic process to protect investments from losses is a good idea.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours.

We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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Why trying to beat the market is a very bad idea

path-1The usual investor experience is a recurring cycle of euphoria and disappointment. Fortunately, there is a better alternative that can put an end to the emotional and financial rollercoaster that is all too common in traditional investing. This alternative requires a serious examination of what are the right priorities that should drive the portfolio management process.

One of the most dangerous goals individual investors have embraced is trying to “beat the market.” This objective can cause tremendous damage to their portfolios.
Here is why: Beating the market (i.e. “getting a better return than the index”) does not accomplish much when the market goes down in a big way. A portfolio that declines by 30% when the index goes down 40% beats the market handily, but it hardly qualifies as “success.” This issue became clear during the market crash of 2008-2009.

Another reason is that for a portfolio to beat the return of an average basket of stocks, it has to be more aggressive than the basket itself. If the market goes up, a portfolio heavy on conservative assets is unlikely to show higher returns than the market. That means that it needs to be over-exposed to aggressive stocks, which magnifies losses when the market sooner or later takes a turn for the worse. This is what happened to investors who loaded up on dot-com stocks during the late 90s, only to see them crash back to earth after the internet bubble burst.

Another issue is that “beating the market” is a pointless goal by itself. An elderly individual with many millions of dollars in the bank, modest expenses, and no legacy goals is much better off with hyper-conservative investments to protect his or her savings rather than with a stock portfolio. Equity exposure is inherently risky, and potential returns would offer no marginal benefit to a portfolio that has already achieved the investor’s goal of paying all living expenses many times over.

These three reasons – limiting the downside, determining the risk/return portfolio profile, aligning risk to goals – have a common thread: managing risk is more important than targeting returns. As a bonus, concentrating on risk rather than returns may actually lead to stronger portfolio performance.

Chasing returns often leads to this kind of unsatisfying experience:
path-2In the last twenty years alone, investors have been badly bruised by several legs of bull and bear markets that leave them disappointed with their investment results. This is one of the reasons why the current bull market, although one of the strongest ever, has been called “the most hated rally in history.” Many investors are still stuck on the “I should have bought earlier”/“I still don’t trust it” phase, or have finally entered in the last 18 months, only to witness a market largely trapped in a range.

Ironically, this dispiriting cycle reinforces the idea that beating the market is a do-or-die goal. As the thinking goes, eking a market-beating return while the market goes up may well be the only way to cushion the downside when the cycle inevitably turns. Compounding this mistake, most investors think they will be able to identify the early stages of a bear market and exit early enough to prevent a big loss.

A much better approach is to focus on managing risk using a systematic, disciplined approach. This can result in a much more satisfying pattern that may require investors to accept lower returns than the market during a bull run in exchange for a considerably gentler experience during times of crisis.

path-3At Path Financial we specialize in designing portfolios intended to provide such smoother experience. It requires a dynamic management of positions to ensure that the level of targeted protection is consistent with the market cycle. Most importantly, it focuses on risk management over return targeting as a source of investment performance.

As an example, we tested how a hypothetical portfolio of mutual funds would perform under some of our process rules. We chose mutual funds that have been around for a long time in order to cover many market cycles of boom and bust, and selected a group representing a broad array of domestic and foreign equity, bond, and commodity baskets.

path-4As the graph shows, this hypothetical portfolio managed according to our risk-based approach could provide a much smoother long-term ride than the stock market, or than a more typical 60% stocks/ 40% bonds mix. It captures a positive return when the market goes up, and drastically cuts the downside in times of crisis. The process focuses on controlling risk over producing high returns, and yet it delivers a comparable performance than a much riskier all-equity exposure over the long term.

To achieve these results investors must take a long-term view and turn their focus away from trying to find market-beating positions, which is a largely impossible task other than by luck. Once they embrace the idea that risk management alone can produce much more stable long-term returns, they will be in a far better position to leave behind the frustrating cycle of euphoria and disappointment they often experience.

What now?
We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return. We implement this process for our clients and we tailor it for their specific circumstances. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of our most recent whitepaper describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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