Investor Education - Video Series
The Five Secrets
of
High Performance Investing
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High Performance Investing Secret #5
In the last video we discussed the important contribution that stocks add to your investment portfolio’s potential return as well as the high levels of risk they introduce. We learned the higher the risk of your portfolio the lower the certainty you will have in achieving your investment objectives. We also learned that once you have selected the appropriate allocation your portfolio should have to stocks, designing a portfolio around that allocation to limit the risk as much as possible is key to producing higher long-term compounded returns and increasing the probability you will achieve your desired returns and therefore your investment objectives. That brings us to the fifth and final investing secret we are going to share in this video series. The secret is that Traditional diversified portfolios, which are the only portfolios broadly available to individual investors and small institutional investors, are poorly diversified and much riskier than you may think. We are going to share with you both why traditional diversified portfolios are more risky than you may think as well as two risk management techniques you can use in the design of your modern investment portfolio to help reduce your portfolio risk to levels not possible using just traditional diversification. Reducing portfolio risk is so important because as we have explained in this video series, by reducing the risk of any given asset allocation, you gain the opportunity to earn higher compounded returns. Investors with traditionally diversified portfolios learned the hard way during the financial crisis that their diversified portfolio was much riskier than they thought, as they failed to minimize large losses. A traditionally diversified portfolio with 60 percent in stocks and 40 percent in bonds suffered losses of around 35 percent during the financial crisis between October 9th of 2007 and March 9th of 2009. This is a loss that many would find intolerable, pushing them to make possibly unwise changes to their portfolio in the middle of a recession. Compared to the S&P 500 which lost about 50 percent at the lowest point during the financial crisis, the traditional diversified portfolio did lighten the losses, but considering the traditional diversified portfolio only had 60 percent in stocks, investors still captured around 70 percent of the S&P 500 losses. This magnitude of losses in a diversified portfolio will likely result in a permanent reduction in total wealth an investor will accumulate over their investing time horizon. We have already covered the disproportional impact that large losses have on a portfolio, as you recall from the second video in this series, if you want to maximize the wealth you accumulate over time from investing, it is very important prevent the size of losses that traditional diversified portfolios experienced in 2009. This hypothetical chart shows the difference in wealth accumulation between a low-risk modern portfolio that uses the risk management techniques we are going to show you (in dark blue) versus a traditionally diversified 60-40 portfolio which would be similar to the investment portfolios most common in the industry (the Grey dotted line). Both portfolios have 60 percent of the portfolio invested in stocks. The chart shows how the value of a 100 dollar investment in both portfolios would have changed between March of 2005 and August of 2019. The low-risk modern portfolio was significantly less risky because of additional risk management techniques used to structure the portfolio, the lower level of risk turned the initial 100 dollar investment into 258 dollars over the time period versus just 188 dollars for the traditional diversified portfolio. The chart demonstrates that because the low-risk portfolio restricted the loss in 2009 to about 21 percent versus about 35 percent for the traditional portfolio, a gap in wealth between the investors was created that may be permanent. The reason traditionally diversified portfolios are so much riskier than investors believe is because 90 percent of the total portfolio risk comes from the 60 percent stock allocation. When 90 percent of a portfolios risk is concentrated in stocks, despite only having 60 percent of the portfolio in stocks, when stocks are generating large losses so is the investment portfolio. The reason stocks account for 90 percent of the total portfolio risk in a portfolio with 60 percent in stocks, is because stocks are much riskier than bonds, meaning the gains and losses stocks generate far exceed those of bonds. There is a huge risk mismatch between stocks and bonds, making bonds a relatively poor diversifier. This chart shows the returns of bonds in dark blue and the returns of stocks in light blue between November of 2007 and February of 2009. The chart visually demonstrates the risk mismatch between stocks and bonds. The S&P 500 lost 41 percent during this time period, while bonds gained just 4.5 percent as represented by the Barclays US Aggregate bond index. When 60 percent of your portfolio experiences declines of around 41 percent, while at the same time the other 40 percent of your portfolio gains around 4 percent, that is a drop in the proverbial bucket. The 4 percent returns that bonds contributed to the portfolio, cannot offset the 41 percent loss the stocks contributed. The primary diversification benefit of the bond allocation within the portfolio comes from the fact that bonds are not stocks, so having less in stocks is the only material risk protection. So now lets examine the risk management techniques that you can use to reduce the risk that your stock allocation has on your portfolio. We will start by looking at the components of traditional diversification that make up the risk management for traditional investment portfolios. There are three, what we call dimensions of diversification in a traditional investment portfolio. The first is security diversification, meaning the portfolio holds dozens but usually hundred of individual stocks through ETF’s or Mutual Funds. Security diversification lowers the risk of being impacted by a potential financial collapse of just one or a handful of companies. By adding more stocks you become more diversified across not only different companies and business models, but also sectors that the different companies operate within. The second dimension of diversification in a traditional diversified portfolio is asset class diversification. This means you do not have just exposure to stocks but also other asset classes like bonds, real estate, commodities and cash. Asset class diversification helps lower the risk of a portfolio by making you less dependent on the performance of any one asset class. Also, asset classes often perform differently in different market conditions helping the portfolio perform more consistently. The third dimension of diversification is global diversification. Instead of being invested only in U.S. securities including stocks and bonds, the portfolio also invests in international securities. While global economies have a fairly high correlation to each other, there is still benefit to diversifying internationally, because each economy has it’s own economic cycle, central banking and political systems, which provides a diversification benefit. Also, more than 50 percent of the investment opportunities are outside the united states so there is a potential opportunity cost to not investing internationally. At 3Summit, we lower investment portfolios dependence and risk associated with the stock allocation by adding two additional dimensions of diversification, making it possible to significantly lower risk. The two additional dimensions of diversification not found in traditional diversified portfolios is economic and strategy diversification. Let’s go through these additional dimensions of diversification one at a time. Economic diversification acts to spread a portfolios risk more evenly across the four phases of the economic cycle. For those of you who do not remember or have never known the phases of the economic cycle do not fear, here is a diagram. The grey squiggly line represents the growth of an economy in terms of Gross Domestic Product the economy produces. There are four phases in The economic cycle. The first phase starts right after recession and it’s called return to growth. During this phase one or more sectors have begun to experience growth. Commodities, and emerging markets debt are the asset classes that tend to perform the best. Because traditional diversified portfolios have minimal to no exposure to these asset classes the portfolio returns are driven by the generally mixed returns in stocks during this phase. The second phase is expansion, which is usually the longest phase, during this phase, economic growth is accelerating and broadening across all or most sectors of the economy. This phase is when stocks do the best. Because a traditional portfolio has 90 percent of its risk in this phase, and depends on this phase to produce the vast majority of returns, this is the only phase the portfolio is designed to perform during. The third phase is contraction, during this phase GDP growth slows but is not negative. Treasury bonds usually perform the best. Much of the bond allocation in traditional portfolios is corporate bonds, which offer little diversification benefit because like stocks the bonds perform best during expansion. At 3Summit we do not include corporate bonds in the portfolios we design for this reason and focus on government bonds as they add the most diversification benefit. The final phase of the economic cycle is recession. During this phase GDP is shrinking and the economy experiences negative growth. Treasury Inflation Protected Securities (or TIPS) which are U.S. treasury obligations that adjust for inflation, usually perform the best. Most portfolios little to no exposure to TIPS so they have nothing to offset the beating stocks take during a recession. The percentages at the bottom of the chart, in light blue, show the risk within a traditional diversified portfolio that is concentrated in the asset classes that do the best during each phase of the economic cycle. As you can see the traditional diversified portfolio has most of the risk concentrated in the expansion phase and no exposure to either recession or return to growth. This is why the portfolio experiences sharper declines in value in any other economic phase aside from expansion. There are no offsetting investments to compensate for stock value losses. Conversely, at the top of the chart, the dark blue percentages show that the low-risk modern portfolio spreads the risk more evenly across the phases of the economic cycle, by including exposure to assets that perform in the different phases. More evenly spreading risk concentration to all the phases of the economic cycle, significantly lowers the risk of the low-risk modern portfolio. In a perfect world the risk of every portfolio would be spread perfectly even across all phases of the economic cycle, but to have a perfectly balanced portfolio can take years to implement. For example, it is currently not a good time to buy 30 year maturity bonds, which you are needed to further balance the risk. We do adjust the portfolios we manage when opportunities present themselves to move portfolios closer to perfect balance. The important point to understand about economic diversification, is that it allows a portfolio to perform more evenly regardless of the phase the economy is in. The second dimension of diversification, not found in traditional diversified portfolios, is Strategy diversification. The best way to understand strategy diversification is to think about a business. A stable business has many sources of revenue, meaning they do not depend on just a few clients for the vast majority of their revenue, but instead have many clients, each making up just a small portion of their business. Ideally, the clients also operate in different industries making the business even more resistant to changes in the business cycle. Strategy diversification works in the same way. Traditional diversified portfolios count on one and at most two sources of returns from their stock allocation. The most common is stock selection, which is the strategy of buying mutual funds or individual stocks believing you or a professional manager in the case of mutual funds, can pick stocks that perform better than the market. All statistical evidence points to the fact that stock picking is a very poor strategy. First, it is more risky then even investing in index funds and second, managers rarely outperform the market they seek to beat. We will not get into the specifics but we have written about stock picking in our investing insights and I will include the link below this video if you are interested. The second source of returns is to buy indexes which represent the returns of the market as a whole. Markets are quite risky, and by investing in the entire market you are capturing 100 percent of the upside but also 100 percent of the downside. This is not an efficient way to accumulate wealth because of the outsize impact losses have on a portfolio. Strategy diversification is the process of investing in quantitative investment strategies that target specific sources of returns from stock markets that arise from market inefficiencies as a result of investor behavior. Again, quantitative investing goes beyond the scope of this video series but we have written extensively on quantitative investing and the benefits of quantitative investment strategies within a portfolio. We will include links below to the papers we have written, as well as the podcasts we have produced on the topic. The important point here is that each quantitative strategy seeks to benefit from a unique and specific source of returns within stock markets. A low-risk modern portfolio is then designed to invest in three to more than six individual stock strategies, each of which performs differently during different market conditions. Because the strategies perform differently as market conditions changes, by adding many unique strategies, with low correlations to each other, within a single portfolio, the strategies work together to balance each other out and generate more consistent returns. When one strategy has a tendency to under perform, another in the portfolio may be outperforming, therefore they counter balance each other over time. As this slide visually shows, a quantitative investment strategy that targets momentum has historically performed well at different times than a quantitative strategy that targets value stocks. By including both the strategies in the portfolio the investment strategies compliment each other and provide a counterweight to the portfolio. A traditional portfolio generally has only one strategy, most commonly stock picking. Not only are most stock picking strategies more risky than the market as a whole they tend to produce sub-par performance compared to the market which adds a performance drag on an already risky portfolio. Stock picking strategies do not do well in declining markets, which is why the stock allocation of a traditional portfolio is so risky. Because stocks provide 90 percent of the risk to the portfolio, when stocks are not doing well the traditional diversified portfolio can generate large losses quickly. We have covered a lot of information, lets quickly recap. Traditional diversification is not a very effective risk management strategy, because the total risk of the traditional diversified portfolio is highly concentrated in stocks, which only perform well during one of the three phases of the economic cycle. Furthermore, the risk within the stock portfolio is high because the portfolio usually counts on a single risky investment strategy, stock picking or indexing , to generate the returns. You can dramatically lower your total portfolio risk by adding economic diversification and spreading the concentrated stock risk across more assets that perform better in each phase of the economic cycle. You can also diversify your sources of stock returns by investing in many complementary quantitative investment strategies ,that each target a unique sources of returns within the market and therefore tend to have a low correlation to each other. The key point we want you to take away from this video is that traditional diversification is riskier and less diversified than you may think, leaving your portfolio vulnerable to larger losses than you may have thought possible, therefore reducing the long-term wealth you will accumulate from investing. You can further limit risk in your portfolio while maintaining the same allocation to stocks your traditional diversified portfolio holds, by adding the two additional dimensions of diversification we discussed, including economic diversification and strategy diversification.
