Happy Independence Day

Perhaps you’ve heard…  The first six months of 2022 was the worst yearly start for the US stock and bond markets for any period since 1970.  Most investors are down more than 20%.  Investors with concentrations in high-flying tech stocks are down 50% or more. 

You are not “most investors”. 

To the contrary…  We built your portfolio for times like this.  That foresight and wisdom is now paying off. 

Even after the recent sharp declines in stocks and bonds, your overall investment portfolio is still up nearly 20% over the past two years.  We are only off about 10% from our absolute all-time highs.  How is this possible?

Vindication for commodities

For years we resisted the temptation to exit commodities.  They were seemingly always a perpetual drag on our investment returns.  We didn’t give up on commodities because we knew the day would come when inflation would return.  Academics have long known that commodities have historically saved investment portfolios when both stock and bonds prices falter.  

Commodities more than fulfilled that promise by surging 117% over the past two years.  The commodities and other “real assets” in your portfolio (as compared to “financial assets” like stocks and bonds) are doing their job and doing it very well.  They are providing a strong buffer to financial assets that have been consistently dropping in value amid unexpectedly high inflation, rising interest rates and the war in Ukraine.

Commodities were assisted in the heavy lifting by our other related investments in energy infrastructure, food & farmland, water resources, raw materials and timberland.  Most investors don’t include separate allocations for “real assets” in their investment portfolios.  Consequently, they lack protection from unanticipated inflation, rising interest rates, wars, famines and other economic risks.  The recent massive gains in these asset classes largely offset the poor performance of traditional financial assets like stocks and bonds over the past year.  The majority of that benefit comes from owning these asset classes before inflation occurs and before the risk is generally understood and widely embraced.  That’s similar to the idea that it’s too late to buy insurance on your home when a fire has already started.  Or too late to shut the stable door after the horse is out of the barn.

Our Top 10 performing asset classes over the last 2 years (annual average): 

• Commodities +58% per year (i.e., up +117% over 2 years combined)
• Energy & materials companies up +34% per year
• US energy infrastructure up +31% per year
• Food & farmland companies up +23% per year
• Timber companies up +19% per year
• Water & environmental services companies up +16% per year
• Global infrastructure up +15% per year
• US real estate up +13% per year
• Large-cap US companies up +12% per year (down -20% over the past 6 months)
• Small-cap US companies up +10% per year (down -25% over the past 6 months)

Our Bottom 10 performing asset classes over the last 2 years (annual average):

• Hedges & Macro Trends up +5% per year
• International developed market companies up +4% per year
• Innovation up +4% per year (includes the FAANGs and disruptive tech)
• International real estate up +3% per year
• International emerging market companies up +2% per year
• Cash up +1% per year
• Gold & gold mining companies up +0% per year
• International developed market bonds down -3% per year
• International emerging market bonds down -4% per year
• US bonds down -5% per year

Not to belabor the point, but the past six months to two years have been one of our strongest periods of relative outperformance versus other investors in my firm’s 20-year history.  Nonetheless, it’s hard to celebrate that fact when prices are down from our last report.  Our commitment to real assets like commodities, infrastructure, food & farmland, water resources, energy & materials, timber and real estate is what sets us apart. We are down roughly 10% from our all-time highs while others are down by twice that percentage or more.  We are also up nearly 20% over the past two years while most investors are flat over the same period.  I use a 60/40 US stock/bond portfolio as the benchmark and a proxy for “most investors”.  In fact, we have consistently outperformed a typical 60/40 investment portfolio and the vast majority of investment managers over the past 5 years.  We achieved that result while taking on less risk.  That’s because we are extremely diversified over a wider variety of asset classes than most.  That gives us greater downside protection in a bear market and superior risk-adjusted returns. 

Our Recipe for Success (my analogy to food) 

A superior investment portfolio begins with sound portfolio construction and maintaining an active rebalancing discipline.  Jae tells me that building a great investment portfolio is a lot like making a great salsa (something I know little about).  Both start by adding high-quality ingredients that are then mixed together in roughly equal parts.  It’s a bit risky to make a meal of garlic alone, but when combined with other widely dissimilar ingredients, the addition of garlic makes for a better whole.

(Photo by Jae)

Like making great salsa, a great investment portfolio begins by adding high-quality ingredients in roughly equal parts.

(Photo by Bill)

Commodities and other real assets are the garlic, onions and cilantro in the salsa recipe.  You’d never eat them by themselves, but together they play an important role.  You can make a reasonably decent portfolio without commodities, but a great portfolio includes them too.  They enhance stability, reduce risk and add to long term returns. They add downside protection not only during periods of unexpectedly high inflation, but also gradually over long periods of time. 

Commodities stand alone against the ravages of inflation when stocks and bonds both falter.  Below is a chart of comparing the basic ingredients of our “7Twenty” investment model (7 primary assets with 20 different sub-asset classes).  The performance is measured over 50 years (from 1970 through 2020).  Each asset class beats to its own drummer from time to time.  Depending on the economic and political environment, some zig, while others zag.  However, you’ll notice that when combined together in equal proportion, magic happens.  The whole produces a better result than any of the top performing asset classes alone.  Commodities (often a perennial underperformer) is included due to its unique ability to bail out the other 6 from time to time.  

Notice that mixing all seven ingredients together in equal parts has produced an average annual return over the past 50 years that is roughly equal any of the top performing asset classes alone over that same period of time.  But also notice the equally-weighted blend had only 6 negative 3-year periods, while other individual asset classes had more.  Most importantly, note that the single worst 3-year return for the equally weighted 7-asset portfolio was -13.32%.  Compare that with the negative 3-year return periods between -37.61% and -55.60% for several of the individual asset classes that had similar average annualized returns. 

It's not really magic.  It’s just math. 

Mixing uncorrelated and negatively correlated assets in an investment portfolio reduces risk and improves returns.  The lack of correlation of one to the other smooths out the ride.  When combined, the downturns are shallower and recovery is quicker.  Minimizing the magnitude of market downturns is a critical element in building strong long-term performance. 

So… just like when you make a great salsa, adding these 7 ingredients together in an investment portfolio in roughly equal parts produces a better whole.  The resulting mix provides… 

• Higher average investment returns over time
• Less volatility (i.e., lower standard deviation)
• Fewer negative years
• Less downside during market downturns (i.e., “worst 3-year cumulative returns”)

The “magic” doesn’t stop there. 

There is another secret in the sauce – tax loss harvesting.  In keeping with the food analogy, I often refer to tax loss harvesting as a proverbial “free lunch”.

Tax-tax loss harvesting is a tax-optimization strategy for taxable investment accounts that adds value on top of periodic rebalancing.  Tax-loss harvesting involves selling positions that are currently valued at less than their original cost and replacing them with new positions that are expected to perform similarly to the asset sold. Losses are recognized for tax savings, but the overall asset class distribution and performance expectations do not change.  Harvested losses accumulate as “tax loss carryforwards” on your income tax returns.  They can be used to offset future taxable capital gains.  Current tax law also allows taxpayers to write off $3,000 per year of accumulated capital losses against ordinary income each year.

Most investment managers do not actively manage client portfolios for tax saving opportunities.  Our routine rebalancing and tax loss harvesting activities are relatively unique.  Most advisors see these time-consuming activities as outside of the scope of their responsibilities.  That’s a shame, as academic studies have consistently found that effective rebalancing and periodic tax loss harvesting add significant value to an investor’s net worth over time.  The recent market volatility is presenting us with the first significant tax loss harvesting opportunity since 2008.  It takes a lot of manual work, but I’ll be busy rebalancing accounts and harvesting losses in individual securities the remainder of this year. 

Summary

A great recipe is a great recipe whether it starts in Jae’s kitchen with a well-made salsa or starts in Bill’s office with a well-made pie. 

You have a very well-constructed and carefully managed investment portfolio that has historically generated average annual returns of 10% with lower volatility and less risk than any other alternative structure. 

Your investment performance has been outstanding relative to others in the current bear market.  We are significantly outperforming the market during this bear market downturn.  Our multi-asset structure and mathematically sound process provides considerably stronger downside protection than most.  I’ve discussed this before using historical charts and sound economic principles to demonstrate the logic.  Now you can see it in action with the actual performance of your own portfolio in real time. 

Our 7Twenty portfolio is fulfilling its promise that an equally-weighted, multi-asset portfolio of low-cost, tax-efficient ETFs provides better returns with less downside risk than other strategies that rely on the manager’s purported stock picking prowess or ability to time markets.  This same principle has been proven over and over by numerous academic studies.  Yet sadly, most of the industry (including the financial media) offer smoke and mirrors, and the illusion that any human being (or even a supercomputer for that matter) can effectively beat the markets over time.  The true magic comes from the mathematically sound principles of broad diversification over multiple asset classes, keeping costs low by utilizing index funds and ETFs, routine rebalancing and effective tax loss harvesting.  But that doesn’t sell magazines, doesn’t sell ads on CNBC, and doesn’t justify the salaries and bonuses of highly paid bankers who reside in in high-priced office space with private dining rooms in downtown Manhattan.  They offer little more than an empty promise that they have a better crystal ball than a similar firm across the street.

The current market volatility offers us a unique opportunity to harvest losses in individual investments without giving up any future performance potential on the rebound.  The tax savings can be even more significant over time than the investment earnings alone.    

Your portfolio is optimized for consistency of returns, lower risk, low cost and tax efficiency.  Tax loss harvesting opportunities also provide tangible dollar savings to build your net worth outside of the portfolio returns.

Your quarterly investment reports can be found by logging into your client portal at www.ComprehensiveMoney.com.

Be Smart.  Be Well.  Be Kind.

Bill