In times of economic turmoil and financial market upheaval, it’s a good idea to take a deep breath and reflect on this question. Understanding what you own and why you own it is the first step toward building confidence and conviction. Confidence and conviction are always tested during periods of market volatility. The more you understand about the design of your portfolio, the better you’ll sleep at night when the world around us appears to be coming unglued.
Before we look inside your portfolio, let’s first review a few principles. It is important that you first have this foundation to fully understand what you own and the role it serves in your portfolio:
Principle #1: None of us can accurately predict the future. This might come across as common sense, but deep down none of us really believe it. We are all human beings who tend to follow our “gut”. That in turn is heavily influenced by media reports, crowd psychology and an unfortunate human tendency to extrapolate recent trends well into the future. If one of our investments drops unexpectedly, fear sets in and we emotionally project that it will go to zero. When another investment rises to new highs, greed takes over and our gut tells us it will keep going to the moon. The truth is that nobody can reliably and consistently predict the future, but that never stops us from trying!
Principle #2: Human emotions always trump logic when they are at their most extreme. Our gut feelings offer a false confidence that is heavily driven by consensus opinions that were likely formed by reading, listening and watching what the masses are saying. It’s hard to go against the consensus. Even if the consensus proves to be right, any advantage you might gain by following it was lost as the markets have long since re-priced to reflect consensus. The expected result is already baked in. Going against consensus, when you are right, can be quite rewarding.
Principle #3: Attempting to ‘Beat the Market’ is a Fools Game. The market is by definition the sum of all investors, each of which has multiple votes based upon the size of their financial commitment. The sum of all investors set a price for each investment based on all the known information about that investment and all other known environmental factors. The price is determined and constantly fluctuates in a tug of war between those who are bullish and those who are bearish, with the big players who have the greatest knowledge and resources dominating the game. The rest of us are just casual observers. It is foolish for any of us to think we can correctly guess the winner, not just once or twice, but time and time again.
Principle #4: Diversified Portfolios = Safety. If none of us can consistently and accurately predict the future, and if the prices of all investments already reflect all the known information that is available, the ONLY reasonable strategy is to spread our money around and not make any big bets. Putting all of your eggs in one basket is a get rich quick strategy that rarely works other than for a very lucky few, most of whom later lose it all in the next round. Diversification is known in investment circles as the only true “free lunch”. It is a strategy to mitigate risk and to slowly and steadily move forward one step at a time, with only a few steps back every now and then. It’s a strategy that avoids big losses and improves your likelihood of reasonable gains over the longer term.
Principle #5: Over time, the law of averages prevails. Investors who stick with managers, allocation strategies and a rebalancing plan achieve better risk-adjusted returns and will end up richer. Putting all your eggs in the stock market is great when it’s on a tear, but don’t be fooled by short-term results. It’s the old fable of the tortoise and the hare. Steady, disciplined and consistent always win over time.
Principle #6: Don’t obsess over the losers. Diversification means that some of your investments will do very well and others may do less well or even poorly. That is by design. It’s impossible to know the outcomes in advance. Expect this to happen and don’t obsess over the losers. And whatever you do, don’t dump those that go down! They are likely tomorrows winners as they are now out of favor and bargain-priced. It’s a peculiarity of human nature that we feel better buying things that are now expensive and dumping things that are now cheap!
Principle #7: The smartest guys in the room build disciplined models and follow them religiously. Two of thesmartest in the universe are David Swenson who manages the $27 billion Yale endowment fund and Jack Meyer who does the same for Harvard’s $36 billion fund. Their strategies are quite similar, so much so that many investors now refer to what they do as “The Ivy Portfolio”. The Ivy Portfolio is famous for its simplicity and discipline. It equally weights a large number of asset classes and regularly rebalances back to those equal weights. Each asset class is chosen due to its lack of correlation to the other asset classes, not to the investment manager’s predictions for how well that asset class will do in the future. In less formal terms, some are likely to zig while others are likely to zag. Each asset class will respond differently to changing economic conditions, government policies and investor psychology. Equal weighting is designed to combat our human tendency to tell ourselves stories about why one will do better than the other (predicting the future). Equal weighting allows the markets to set prices based on all the known information. Equal weighting acknowledges that to favor one asset class over another is another way of saying that you know better than the markets. We do not.
Principle #8: Volatility is our new best friend. Following a disciplined process reduces our reliance on emotion and prevents us from making bad decisions in periods characterized by the emotional extremes of greed and fear. In fact, the volatility that brings out these emotions becomes our best friend. Big drops in any one asset class require us to accumulate more while it’s temporarily cheap. Big increases in any one asset class force us to take some of our chips off the table before it comes back down to earth.
Principle #9: Learn from how the smart guys on the block manage their money. Our current model portfolios embrace the Yale and Harvard methodology. All of our model portfolios embrace diversification and require disciplined rebalancing back to the target percentages. However, the design of the old models did occasionally make bigger bets in one direction or another (inflation versus deflation, dollar strength versus dollar weakness, etc.). Sometimes that worked to our advantage, sometimes not. Our newer models equally weight twenty different asset classes as the base case, with modest deviation from those targets based only on individual investor considerations. The portfolio is highly diversified across asset classes (breadth) and highly diversified within each asset class (depth). The strategy relies on a disciplined rebalancing process to maintain our weightings over time. We sell what goes up and buy more of what went down. We let the markets set the appropriate price without second guessing our equal weightings. We let rebalancing do the work for us and make our buy sell decisions. It is the opposite of a “predict the future” strategy. We don’t have to constantly guess if the markets have it right or have it wrong.
10 Twenty – Diversified Investment Portfolios with a Plan.
Ten model portfolios are available for my diverse set of clients, each of which includes twenty distinct asset classes. A chart comparing the models is attached as the last page. Each asset class was chosen with an eye toward reducing correlation to the other asset classes. The goal was to have some asset classes in the mix that would respond favorably to almost any potential future scenario. The default model is called “Balanced” and requires an equal 5% weighting to each asset class. The other models are more or less conservative or aggressive and make adjustments to account for individual investor risk tolerance, need for return, and other circumstances. Rebalancing is performed primarily in tax deferred retirement accounts when possible. We also look to harvest losses in the taxable portfolio to offset other positions that have taxable gains.
The asset classes are divided into the categories of equities, fixed income and real assets with all asset classes assigned to one or the other.
Equities – aka the “Engines”
Equities do especially well in periods of better than anticipated economic growth. They do poorly when growth falls short of expectations. Notice that it is the difference between the expectation of growth and the actual growth that drives the price of equities. Equities can do poorly in periods of strong growth when their prices had already discounted strong expected growth. Likewise they can perform well in periods of weak growth and when the economy is doing poorly as long as they perform somewhat better than the lowered expectations. There are 8 asset classes in our model that fall under the category of equities:
1. Large U.S. companies (5%): U.S. large capitalization stocks have been the best performing asset class in the world in recent years after coming off a decade of flat performance that generated a measly 2% average return per year during the period from 2000 to 2010. The strong recent performance is largely due to flight capital from Europe and Asia looking for greater safety in the U.S. dollar and our historically more stable economic and political systems. By some accounts, this rally is long in the tooth as U.S. stocks (like Johnson & Johnson and Exxon for example) are at least 30% more expensive than their European counterparts (like Bayer and Royal Dutch Shell). This defies logic since these companies have relatively equal prospects given that they sell similar products to the same customers all around the world. The U.S. companies that make up the S&P 500 are trading at a price that equates to a 2% dividend yield, whereas the 500 largest European companies trade at a price that produces a dividend closer to 3%. Overemphasizing this asset class while its trading at premium valuations relative to others is making a big bet that U.S. companies will continually and consistently grow faster than the markets already lofty expectations. That seemingly ignores the headwind of a higher U.S. dollar that will make U.S. exports more expensive to the rest of the world. Meanwhile, international companies in similar business will see their exports to the U.S. surge as their prices become more competitive compared to their U.S. counterparts. The allocation decision isn’t about patriotism; it’s about the laws of economics. Rubber bands stretched too far tend to snap back, as do valuations of any one asset class when pushed to extremes.
2. Small and Medium size U.S. companies (5%): Smaller companies tend to outperform larger companies over time, and value-oriented small stocks tend to outperform growth-oriented small stocks over time. Those are well established truisms that have been accepted for decades. We include small and medium sized companies in our portfolio to take advantage of these probabilities. We also follow a value tilt when portfolio size justifies a larger number of separate investment assets in the mix.
3. International developed market companies (5%): Currently priced at a 30% discount compared to their U.S. competitors, this asset class looks to be a better bet relative to U.S. equities at current prices.
4. Emerging market companies (5%): Despite greater instability and volatility, it is important to have some exposure to the portions of the world that are growing. And some are on fire. Literally and figuratively! Latin America has added more citizens to its middle class in just over two years than Texas has residents. Mexico, despite all its bad press, is a rising manufacturing power. Frontier markets like the Philippines, Indonesia and Africa may well be the next big boom. But right up front I will say we shouldn’t toss around the phrase “BRIC” – Brazil, Russia, India and China – as an investable class. The acronym should stand for “bloody ridiculous investment concept”. Those four countries couldn’t be more different in terms of education, history, natural resources, economic policies, work culture, respect for rule of law, demographic, or market outlook. Russia and Brazil thrive on high energy costs; India and China suffer from them. If treating that small group as homogeneous is silly; treating the other 150 or so developing and frontier markets as a unit is downright absurd. The various countries of the world will follow their own unpredictable paths. We will focus on the more stable “global blue chips” that know their markets better than any U.S. company could. We also favor ETFs that focus on companies that closely tied to emerging market consumers. Young populations of upwardly mobile consumers are part of the demographic trends that favor growth for these consumer-focused companies.
Natural Resource Companies. Heavily leveraged banks and insurance companies come and go. Software and other tech companies are only as good as their continued ability to innovate. Retailing and the fashion industry is littered with winners and losers. Natural resource companies, by comparison, are unique for their mundane, predictable and relatively stable businesses and strong stable and growing dividends. They also provide a degree of inflation protection that most other equities do not. These unique characteristics set them apart. For these reasons, we carve them out from the universe of broad-based equities and give them a category of their own.
5. Energy companies (5%): Developed economies need energy to transport goods, feed people and provide all the benefits of modern lifestyles. It takes ten times more energy to produce a meat diet than a diet based on rice alone. Producing and delivering energy is a stable business that generates strong and growing dividends over time. There is a reason that Exxon has grown to become one of the largest companies in the world. Unlike other industries, the original players are all still around in one form or another. We can’t say that about almost any other industry.
6. Food and Farmland companies (5%): The big argument for it is easy to guess: the demand for food will continue to skyrocket as frontier and developing economies progress, and as rising middle classes of China, Africa and the Middle East demand better and more reliable sources of protein. By one measure, if every person in China ate two extra eggs a week, it would require all the grain Canada currently produces just to feed the chickens! And, food aside, farmland is also in demand for biofuel production. Annual returns from farmland have been very strong in recent years, somewhere in the mid-teens when you include cash rents, profit-sharing income, and appreciation. The inflation benefits are obvious, for both the annual income stream and, more importantly the residual value. That leads some people to call farmland “gold with a coupon.” The bad news is that there has already been a big move in prices, especially for the best located: prime Iowa acreage may be in a bubble, with prices reaching as high as $20,000 acre earlier this year. On the other hand, the worldwide ratio of arable land per person keeps dropping, from almost three acres per person in 1960 to about one now, while developing demand for its output is nearly certain to rise.
7. Timber Companies (5%): Timber companies provide strong income streams along with inflation protection. The headline here is simple: Harvard has a $3 billion dollar allocation to timber, an enormous 10% of its endowment. After tremendous success in the US woodlands market, buying from paper mills that needed cash and then selling out to other endowments and pension plans that awakened to the value, Harvard headed to Romania and New Zealand and reloaded. It’s now stomping around the forests of Brazil looking for even more. Timber is special. It is perhaps the only asset class that can do four distinct jobs: It’s an outstanding hedge against inflation. It throws off a steady income stream with only modest effort. It is a fundamental way to play the expansion of the world’s economies. Finally, it’s a surprising play on green technologies as new and unexpected markets for wood products are continually developed. Somewhat counter-intuitively, “green” regulations are creating a push toward timber as a “renewable energy resource.
8. Water and Environment Companies (5%):
Water: All evidence seems to indicate that people really do enjoy water. Too bad, because only about 1% of it on the entire planet is potable. You already know that the supply is under incredible and growing pressure from increasing populations. The exact reason that’s true, however, is a bit surprising. It’s not so much that people drink more water, or even use it for other purposes like bathing. It’s that as the demand for protein food sources increases, the need for fresh water to create it explodes: from this point of view, in fact, eating a hamburger is the same as taking a 12 hour shower. Given exponential growth needs, water may the ultimate liquid investment!
Environmental Services: More people on the planet living a middle-class lifestyle means more waste and more pollution, pure and simple. Companies that clean up the planet will be in demand for eons to come.
Fixed Income – aka the “Brakes”
Fixed income in the form of cash and bonds adds stability to portfolios. They also provide much needed liquidity in times of market turmoil, becoming the fuel that we need to purchase other assets when they happen to be down.
9. Cash (5%): Cash is the first fuel we use when rebalancing. It also provides liquidity for distributions for those who are retired from the workforce. It grows naturally from accumulated dividends.
10. U.S. bonds (5%): U.S. bonds offer deflation protection, but can be hurt significantly in periods of rising interest rates and increased inflation expectations. For that reason, we have shortened the maturity (known as duration) of our bond holdings in general. We also emphasize short and medium-term inflation protected bonds over nominal bonds that lack inflation protection.
11. International developed market bonds (5%): International bonds currently offer higher yields than their U.S. counterparts. We limit our portfolio primarily to foreign government bonds and inflation-protected foreign bonds to mitigate default risk and inflation risk. Foreign bonds also offer diversification away from the U.S. dollar which can at times be a plus and at other times a minus. For that reason, we favor a mix of 50% currency hedged and 50% non-currency hedged international bonds.
12. Emerging Market bonds (5%): There are many reasons that emerging market debt instruments bear so much higher rates of interest than U.S. obligations. Partly it’s the perceived safety of U.S. instruments, and partly, it’s fear of inflation in the issuing country. And then there’s the currency risk that you’re taking on in those foreign jurisdictions. But it’s very hard to ignore four or five extra percentage points of interest these days. Besides, these are not your father’s emerging markets. Emerging market countries are actually in much better shape financially than their developed country counterparts. Most are creditors, not debtors. Additionally they have younger populations and fewer retirees to support, which should enhance their growth prospects when compared to the west. We favor 50% dollar denominated emerging market bonds and 50% in local currencies.
Real Assets – the “Diversifiers”
Real assets are physical, as opposed to financial. Even in periods of modest inflation, currencies (and the financial assets measured by them) lose value, real assets hold theirs.
Real Estate and Infrastructure:
13. U.S. Real Estate (5%): REITs are tax advantaged pass-through vehicles that collect rent and mortgage payments from every part of the real estate world including residential and commercial, with subcategories like health care, luxury resorts, shopping malls and even self-storage. REIT dividend rates are higher than bond yields, which makes them susceptible to rising interest rates.
14. International Real Estate (5%): International REITs operate exactly like US REITs except that they own property outside the U.S. They are currently paying significantly higher dividend yields than U.S. REITs due to the perception of greater safety in the U.S. than in European and Asian markets.
15. Global Infrastructure (5%): In many parts of the world, infrastructure such as bridges, power plants and even airports are owned by public companies. These generate returns over long periods of time from user fees, royalties, rents, and shares of government tax income. The good news, and the bad, is that you usually have a governmental partner: That can provide monopoly power, but also some uncertainty… politicians have been known to change their mind on occasion. Outside the U.S., many smart folks believe infrastructure is the very best way to profit from the developing economies of Asia, Latin America, Eastern Europe and Africa. Immature economies will suffer from fits and starts as they adjust to capitalism and therefore can be a roller coaster. Long-term infrastructure projects might be safer, with water and energy infrastructure the surer bet.
16. U.S. Oil and Gas MLPs (5%): Master Limited Partnerships or MLPs are a unique and very underappreciated asset class. Congress created special vehicles back in the ‘80s to spur energy infrastructure construction, and could almost say that they went overboard bestowing investor incentives to kick-start that effort. MLPs trade publicly, do not pay entity-level tax, pay out nearly all of their net income directly to unit holders, and can actively manage energy businesses to grow distributions. The most interesting sort of MLP for most investors are those active in the “midstream” sector. These companies provide pipelines, storage facilities, and other plumbing to move energy products around the country. That should keep revenue growth cooking and help this group maintain its long history off increasing distributions by something like 5% to 10% per year. The yields they generate for investors are tax-favored since they are treated as a “return of capital”. A 6% yield suddenly looks more like 8% or 9% after considering this tax benefit. The annoying thing is that it’s harder to figure out how to buy each MLP. Pure MLPs generate a K-1 and can be a little messy around tax time. MLPs in the form of ETFs are much simpler to work with but do lose part of their tax advantage.
Commodities and Alternative Strategies
17. Precious Metals (5%): Is gold a good investment? I don’t know: Is insurance? In both cases you’re spending dollars to protect against something you very much hope doesn’t happen. Obviously, the one great and undeniable advantage of gold is that, over many centuries and indeed throughout human history, it has generally retained its value against the vagaries of paper currencies. There is quite an active little argument about whether gold “is money”. It certainly has some fantastic characteristics that make it a natural candidate for that role; it’s difficult to produce, there are limits on the supply, it is incredibly durable (98% of all gold ever found in civilization is still kicking around), its fungible, easily divisible, measurable, and transportable. But it has also proven time and time again to be quite volatile. So gold is insurance in our portfolio, nothing more. Whether it qualifies as an investment, or merely a smart thing to do, is just semantics. But do remember that nobody would recommend paying lavish insurance premiums without something to insure. Same with gold. It protects your financial assets from confiscation through devaluation at a time when many central banks are experimenting with unprecedented money printing on a scale never before seen. Gold has risen by as much as 100% per year, and has fallen by as much as 25% per year, in just the few years that we’ve owned it. I’ve come to believe that 5% in gold and other precious metals is enough insurance for most portfolios as too much can make for a bumpy ride.
18. Commodities (5%): Physical commodities tend to behave differently than stocks and bonds, which is a good thing when you’re looking for diversification. There have been many times in history when stocks and bonds were both declining in value, while commodities did the reverse. Energy commodities were terrific performers during the 1970’s and early 1980’s even while world economies were stagnant. Over time, energy should become more and more expensive as demand will increase with a growing middle class and the costs of extraction continue to rise. There may still be plenty of oil and gas left in the ground, but it’s getting harder to find and more expensive to extract over time. That suggests that energy prices should rise over time at something more than the rate of inflation.
Commodities in general are a great diversifier. They exhibit a low correlation to almost every other asset class. That alone is enough of a reason to include them in our portfolio. Increasing demand for agricultural and other food products, not to mention potential currency depreciation, add to their allure. This category is also where we park other alternative strategies that may be appropriate from time to time including private equity, long short funds, merger arbitrage, and other hedging strategies.
19. Thematic Strategies: We are entering a decade when technological innovation and powerful demographic trends are likely to significantly impact our world. Companies are struggling to adapt to these new realities. Some will be successful and others not. Traditional investing focuses primarily on geography (US vs International) and company size (large, medium and small cap) as differentiators of performance. A thematic approach shifts the focus to investments that stand to benefit from rapidly evolving demographic and technological changes. We are heading toward a future that includes self-driving electric vehicles, genomic alteration that will extend life expectancy, robots that more efficiently and accurately perform functions than their human counterparts, and artificial intelligence that offers implications beyond our imagination. Think of how Uber, Amazon and Facebook have already changed our lives. There is much more to come. Thematic strategies focus on identifying disruptive innovators with the potential to create exponential growth and profitability. Such companies demand at least a modest allocation in any diversified portfolio.
20. Hedge Strategies: For years, hedge fund managers have engineered financial strategies to protect portfolios from the bear markets that occur from time to time. These strategies come in a variety of flavors, but their common element is a goal of providing positive returns that are uncorrelated with stocks and bonds. Common hedge strategies include
a. “long-short” equity strategies that take long positions in stock that are expected to appreciate and short positions that are expected to decline.
b. merger arbitrage strategies, also known as risk arbitrage, seek to profitably speculate on the successful completion of announced mergers by taking advantage of inefficiencies in the market prior to closing a transaction.
c. relative strength/momentum investment strategies focus on buying stocks that are rapidly appreciating and quickly exiting the moment that they stop rising in value.
d. private equity seeks to invest in privately held companies before they go public, hoping to cash in on their rapid growth before it is fully priced in the public markets.
Historically these highly engineered growth enhancing and risk mitigation strategies were only available to ultra-high net worth investors who often paid their hedge fund managers “2 and 20” (2% annual fee plus 20% of profits). That has changed with the introduction of a low cost, high quality ETFs that replicate many of these strategies. Our modest allocation to hedge strategies offer investment returns that are uncorrelated with public equity markets and can therefore enhance returns and reduce overall portfolio risk over time.
Considerable thought has gone into the creation of our ten portfolio models. The principles under which they were constructed are based on strong academic research that provides sound empirical evidence of a tendency toward superior performance and risk reduction in the real world. If you’d like to read more about the research that underlies our strategy, I can suggest the following resources:
The Investors Manifesto by Dr. William J. Bernstein
The Ivy Portfolio by Mebane T. Faber, CAIA, CMT and Dr. Eric W. Richardson
7 Twelve – A Diversified Portfolio with a Plan by Dr. Craig L. Israelson
The Alternative Answer by Bob Rice, Bloomberg TV’s Alternative Investment Editor
Unconventional Success by David Swenson, Chief Investment Officer, Yale University
The Age of Deleveraging – Investment Strategies for a Decade of Slow Growth and Deflation – Dr. A. Gary Shilling
The Crash Course – The Unsustainable Future of Our Economy, Energy and Environment by Chris Martenson, PhD.