An Interview with Your Advisor
I get a lot of questions about our investment strategy, especially in times like these when a single asset class (US stocks) has been on a tear and virtually everything else has been lagging. Here are a few of the most common questions and my responses:
Is our strategy working?
The goal of multi-asset diversification is first and foremost to avoid “the big loss” that tends to occur in any one asset class with some regularity every eight or ten years. The US stock market fell more than 30% in 2000 and about 38% in 2008. Some think we are now due. It takes a 60% gain to recover from a 30% loss. That’s just math. Most of my clients would find such a loss devastating and don’t have the time or intestinal fortitude to wait out a multi-year recovery just to get back where they started. Nor is that necessary. We can achieve market returns with bond-like risk through multi-asset diversification. Our strategy is working perfectly. We’ve had average annual returns for the past ten years of 9% across all client portfolios. The last two years have been light as money has flowed out of other asset classes and into US stocks making them now rather pricey. No one knows if this will continue, but the longer it does, the more likely pain will follow. We avoid that pain by maintaining a commitment and discipline to multi-asset diversification.
Is there a downside to multi-asset diversification?
Being diversified across the widest possible array of asset classes means that you’ll never have all of your money in the best performing asset class in any year (of course the reverse is also true!). The past two years US stocks have had a phenomenal run. At the same time, most other asset classes had modest single digit returns or were even negative. Mitigating the risk of a big drop can come at a cost of lower short term performance from time to time, but in the end multi-asset diversification produces superior long term returns over rolling ten year period without the roller coaster ride of very high highs and very low lows from year to year.
Is this what the Ivy Portfolio is about?
Yes. David Swenson in his PhD dissertation thirty years ago performed long term studies that demonstrated that multi-asset diversification with routine rebalancing always outperforms all other strategies over any rolling ten year period. His studies proved that this has remained true over time and all the way back to when records were first kept in 1880’s, both in the US markets and abroad. His results were so impressive that Yale hired him right out of school to run their multi-billion endowment. Thirty years later he is still at the helm and has become a legend in the investment world as the top performing investment manager of all time. Harvard, Stanford and lots of other Ivy League universities now adhere to the discipline of multi-asset diversification, earning the strategy the nickname of “The Ivy Portfolio”.
How has this strategy performed recently?
The past two years have been all about the US stock market. The performance of every asset class has paled in comparison. The period reminds me a lot of 1998 and 1999 when everyone and his brother was concentrating their wealth in US stocks and in US tech stocks in particular. The words “it’s different this time” ruled the day as US stocks were bid to unsustainable levels. In 2014, when newscasters announced that “the U.S. stock market hit another new high today”, consider that meant it was just getting back to its former level last reach 15 years earlier! For those who invested their money in the year 2000, it took 15 years to get back to breakeven! For those invested heavily in US stocks back in 1998 and 1999, it felt good at the time, but we all know how that ended. It takes a lot of discipline to avoid the temptation to over-emphasize any one asset class in an investment portfolio. Succumbing to the temptation to “chase performance” by doubling down on yesterday’s winners almost always ends badly. Our multi-asset investment discipline provides equity-like returns but with bond-like risk. It’s the closest thing that we have to a “free lunch” in the investment world.
What happened in the second half of 2014 after starting the year so strong?
Two unexpected and seismic events occurred in late 2014 that were temporary setbacks. First oil prices fell more than 50% after having been stable for many years. We own oil in the commodities category of our allocations and also own oil companies in the natural resource category. Second, the US dollar recorded its largest and fastest gains in recorded history against virtually every currency in the world. The Euro was at about $1.35 to the dollar and now hovers around $1.09. That was more than a 20% drop in the Euro versus the US Dollar in just a few months. The same was true of the Japanese Yen and all other currencies around the world. So what does that mean to us? Even if valuations of European and Asian companies remain unchanged in their home currencies, they fell when measured in US dollars. We own international stocks, bonds, real estate, infrastructure and other assets. As the dollar rises, the values of these assets fall when measured in US dollars. Normally currency moves are small and gradual, but the move in 2014 was largest and fastest in our lifetimes. The big drop in oil prices and the big rise in the dollar combined to erase the double digit returns recorded earlier in the year. We ended the year with a modest 1% to 2% gain. The good news is that it is unlikely that this is a continuing and forever trend. A snapback or reversion to the mean is possible in 2015 or 2016 since big moves in either direction are often overdone.
Commodities and gold have performed poorly recently. Why are they in our portfolio?
Disciplined multi-asset investing requires a meaningful commitment to non-correlated and negatively correlated asset classes, even those that are currently out of favor. Including assets that are negatively correlated with the growth assets in our portfolio protects our downside when the winds change. We have to be prepared for all scenarios. Commodities and gold are negatively correlated with stocks. As the US stock market propelled to new highs, commodities and gold moved in the opposite direction. Yet, despite several years of under-performance, gold remains the best performing asset class over the past fifteen years. From 2000 to 2010 US stocks were flat, with a return averaging less than 1% per year. Gold and some commodities recorded annual double digit returns during that same period. Gold more than tripled over this time span. None of us know when or if this will occur again. Trends only become obvious after they are firmly established… And then they can come to an abrupt end. By the time inflation starts to show up again, real assets such as real estate, commodities and gold will have already soared to new highs while equities will have rolled over. We maintain disciplined allocations to all asset classes to maximize upside opportunity and minimize downside risk. This enhances long term returns, but (by definition) it means that we won’t have everything or most everything in the top performing asset class each year. The opposite is also true. We won’t lose big when the winds shift unexpectedly as they always do given enough time, often when valuations are already stretched, making the fall quite painful.
Is inflation really a concern?
Not at the moment. In fact deflation seems to be most likely scenario, leading central banks all over the world into “currency wars” to depreciate their currency. They perform this experiment in an attempt to stimulate their economies, create inflation and gain short term advantage over others. But this is a zero sum game, with gains in exports achieved by some coming at the expense of reduced exports for others. Many fear that this one-upsmanship will end badly with rapidly rising prices as people lose faith in paper currencies. There may be a tipping point when all of this has gone too far. For that reason, we maintain a healthy 40% commitment to “real assets” that would hold their own when inflation unexpectedly returns or paper money drops in value.
Most well designed retirement plans can withstand a lower rate of return than originally projected, but very few can withstand much higher inflation. No rate of return is adequate if prices are rising exponentially. Unexpected inflation is the most serious and potentially devastating risk for retirees. We protect against that risk by maintaining a healthy commitment to real assets in your portfolio.
What are “real assets”?
Real assets include things that have intrinsic value like food, water, energy and other basic necessities of life. They include domestic and foreign real estate, global infrastructure, energy and food commodities, and traditional stores of value such as silver and gold. Some people also include inflation-protected bonds and natural resource companies under the classification of “real assets”. We have a healthy amount of all of these things in our multi-asset diversified portfolios. Unfortunately, a few of them such as oil and gas commodities, natural resource companies and precious metals have been taking it on the chin for a while. That will change at some point. Our discipline of not straying from prudent allocations will be what protects us from the sizeable losses that other investors who are more US stock-centric will experience from time to time.
What are you doing to actively manage my portfolio, add value, and enhance long term returns?
Routine rebalancing, typically once per year, has been proven over and again to add to long term returns. We sell a little of what has been going up and buy more of what has been going down. Eventually trends reverse and you are better off now owning more shares than if the volatility had never occurred. Even more importantly, I regularly perform “tax loss harvesting” to capture taxable losses by selling assets while they are down and replacing them with similar investments that will have similar gains when the rebound occurs. In the meantime we receive a “free lunch” in the form of a capital loss that reduces your taxable income. This doesn’t show up in quarterly returns, but often adds more value to your net worth you than you would ever achieve from investment returns alone.
Ultimately though, the most important way I can add value is to help you avoid “the big loss”. That comes with helping you maintain the discipline of multi-asset diversification even when the powerful human emotions of fear and greed tempt us to deviate from our well designed plan. Most investors can’t resist this temptation. They can’t help but compare themselves to their less diversified neighbors who might have a good run every now and then. They are always selling asset classes when they are down, abandoning well designed strategies when they are temporarily under-performing or changing advisors every time the wind blows in the wrong direction. This is a sure-fire way to underperform all investors as a group over the long term. Many people never learn these lessons, always thinking that they just have bad luck or a cloud hovering over them, when in fact they are the ones that seal their own fate. Trust in the logic and proven history of diversified multi-asset diversification if you want to win the game over time. Always chasing yesterday’s winners is a losing strategy and the mark of inexperience, lack of knowledge and inability to control our all too human impulses. None of us can predict the future and none of us can tell which asset class will be next in taking its turn at the top. Disciplined investing means sticking with a well-crafted plan and routinely rebalancing even when you feel like shaking things up from time to time. Patience and discipline are always rewarded in the investment world. Constantly searching for greener pastures is a losing strategy and a sure-fire way to underperform.
Sometimes a picture is worth a thousand words. Notice the unpredictability, randomness and extreme moves of individual asset classes. Relative performance of one to the other can’t be predicted, only explained in retrospect. Would you rather pick one or two and take a roller coaster ride or maintain a disciplined allocation to them all, making the ride as smooth and predictable as possible? Your portfolio is very close to the “Asset Class Blend” in white.