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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You May Not Be As Diversified As You Think

onionsDiversification is the key element when managing a portfolio. If you want to smooth the ups and downs of individual assets, combine them in a basket. The less correlated those assets are, the steadier the basket’s performance.

Implementing this simple concept effectively, however, is not easy. One major reason is that asset correlations change over time, both in magnitude and direction. For example, when interest rates fall, bond prices go up but stocks can go up or down, depending on whether investors think that lower rates as a stimulus for the economy, or that they are a sign that the economy is slowing down. Because the relationship between stocks and bonds changes over time, the “optimal” proportion of both in a portfolio changes as well.

It is very difficult to forecast changes in correlations. That’s why a common approach is to assume that they will remain constant – which is where the advice that a portfolio must contain a 60% stocks/40% bonds comes from. The assumption is that such pre-set allocation will be good enough to smooth volatility and produce positive results, even if at times it is not the “best” mix for achieving the sometimes opposite goals of maximizing returns and minimizing volatility.

Is it possible to obtain better results by actively managing a mix of assets instead of fixing it at some arbitrary level?

This question is sometimes dismissed out of hand because it sounds like asking whether it is a good idea to “time the market”, an activity that is generally thought to reduce portfolio returns. Indeed, many studies show that portfolio results tend to decline when trading activity increases. The reason behind this is not clear. Some studies blame transaction costs associated with more frequent buying and selling, while others blame behavioral biases – chasing winners; holding on to losers far too long; fear and greed, etc. that are absent when a portfolio is left alone. Regardless, it is not difficult to show how simple active strategies can outperform a passive approach.

For example, it is possible to improve returns over a simple 70% stock/30% bond strategy with the following rebalancing rule: if stocks outperform bonds in any six-month period, change the mix to 90% stocks/10% bonds for the following six months. Otherwise, change it to 50%/50%. In other words, give an extra 20% to the asset class that did better in the prior six months. This “momentum” rule clearly outperforms the “passive” allocation for any base mix of stocks and bonds –70%/30%, 20%/80%, or any other.

image 1Notably, the rule only improves results starting in the early 1990s, making little difference over the “base” allocation before then. This is because there was a substantial change in the correlation between interest rates and stock returns that started around that time. This phenomenon became clear in hindsight, and many of the papers that describe it were published many years after the fact. An investor dedicated to building portfolios on the basis of responding dynamically to shorter-term correlation changes could have achieved higher returns much sooner.

It seems plausible that looking at diversification in more dynamic terms can yield better results, and in fact dynamic techniques have spread widely in the last few years. This approach has been at the center of our practice since we started managing clients’ portfolios, and we focus on developing, improving, and implementing these techniques for individual investors.

While simple strategies like the one described can be effective over the very long term, their benefits over much shorter periods may be less apparent. This is important, because the usual life of an individual’s investment portfolio is often measured in years, not decades. One consequence of this is that for retirement portfolios controlling volatility becomes more important than maximizing returns. This is because pursuing higher returns exposes a portfolio to more risk, which can get in the way of protecting a savings portfolio so it can fund future living expenses. While a static allocation designed to reduce risk must reduce its expected returns, a dynamic allocation tries to find a way to capture more of the upside while keeping risk low..

The main goal of managing diversification dynamically is to provide a better trade-off between higher returns (more risk) and lower volatility (less risk) than a static portfolio mix. This is best achieved over the long term, since fixed allocations can, and do, outperform dynamic management over shorter periods. The process used to improve this trade-off is often a differentiating factor among portfolio managers who pursue the same goal.

What now?

We believe that our portfolio management process, focused on measuring risk, can be very effective at managing the trade-off between risk and returns. We implement this process for our clients, tailored for their specific circumstances, and 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 a whitepaper describing our investment process, 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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