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Thoughts On The Mess We Are In

An article providing Mr. Foley\'s thoughts on portfolio construction in today\'s volatile market environment.

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Thoughts On The Mess We Are In

  1. 1. Thoughts on the Mess We Are In Portfolio Construction in a High Risk Environment Patrick M. Foley, CFP®, QPFC December 2012Our Chief Investment Strategist Bruce Bittles’ primary theme has long been the problem of systemicdebt. In that context, the turmoil in Europe and the volatile markets and our nearly 9%unemployment rate should come as no surprise.Since our National debt is not going away anytime soon (and demographic and market trends arenot helping), we expect conditions will remain challenging for the foreseeable future. With that inmind, I would like to discuss strategies for investing in difficult markets.In the good ol’ days of the great bull market of 1982-2000 constructing portfolios was relativelyeasy. You used a mixture of stocks and bonds, with some of the stocks being in the then almostexotic category of “international”. How much of each? That was simply a matter of your personaltolerance for risk. If you could stomach ups and downs you used a lot of stock, and you got higherreturns. Likewise it was presumed that stock ownership should correlate with age: more stock foryounger investors, less as you got older.It was a beautifully straightforward system… if you wanted higher returns you simply dialed in a bitmore risk and that’s generally what you got. Actually, that is a fundamentally sound concept in someways, except that it does not always work.The chart below illustrates the concept of secular (long-term) bull and bear markets. There is noquestion that we have been in a secular bear market; the only question is how much longer it willlast. 1
  2. 2. Most of today’s investors, and the modern investment industry for that matter, learned how toinvest during the greatest secular bull market of all time. As a result, there are some investmenttheories imbedded in our collective psyche that might not be all that effective at the moment. It isnot necessarily a case of “this time is different”, but rather that this cycle is not like the last.Looking at the period between the 2000 market peak and now, it seems that increasing one’sallocation to stocks would not have been a path to superior returns. In a secular bear market, theremay be a temporary disruption in the traditional relationship between risk and reward, at least interms of stock allocations. It is as if we are sitting on such a mountain of risk that any additional riskfails to be rewarded in the usual way. I believe this calls into question the investment industry’sreliance on “risk tolerance questionnaires” as a primary tool of portfolio allocation.Another point about risk tolerance in secular bear markets is that we have been seeing less variancebetween younger people and older people, or between more adventurous investors and conservativeinvestors. In times like this, most people seem to want the same thing… to have their money growwithout getting crushed in the process.This collective desire for asset protection has helped create another complication: interest rates arenear zero, so traditional safe havens such as CDs and government bonds provide little to no return.This is partly a function of government actions (keeping rates low in an effort to spur growth), andpartly a function of a “crowded trade” (the mutual desperation for safe harbors drives down ratesbecause people are willing to accept low returns to achieve low risk). 2
  3. 3. So, high debt has helped to create an environment of high risk, slow growth, and low interest rates.Now what?There are a number of ways to approach the problem, each with certain drawbacks. Actually, theyall share the same drawback, but more on that later.One popular approach is to simply sit this mess out. There is an obvious appeal to staying out ofmarkets that are short on returns and high on volatility. Your money will not grow, but at least it isnot exposed to huge drops. The problem with this approach is that it accepts the likelihood of lossin the form of inflation. If inflation were visible, if you could see the way it eats away at yourmoney, people would be more wary of its effects. Inflation is relentless, and its impact thoughsubtle is just as real as drops in value that occur in the market. At the moment the rate of inflation isrelatively low, although in certain areas - healthcare and education in particular - it remainsdangerously high.Another way to attempt to deal with risk is through active trading. Get out when the market isdropping; get back in when it is heading higher. This approach has obvious appeal, but practicallimitations. The problem simply put is that the market does not announce its intentions in advance.It is easy to look back at 2008 in retrospect and think how great it would have been to avoid thewhole mess, but retrospect is never available when we need it most: now! Sometimes the marketexperiences its biggest surges when imminent doom seems unavoidable. This is often referred to as“climbing a wall of worry”, and we can see a couple of notable examples from the post-2008 periodin the chart below:Sourced from most people the three low points indicated on the chart did not “feel” like times to buy. In fact,they were times when headlines, market conditions, and gut instinct were all arguing in favor ofpanic! 3
  4. 4. The way many people think about trading is that if the market starts plunging and things look reallybad they will get out, and when the coast looks clear they will get back in. The problem is that I justdescribed “sell low / buy high”. And the reality is that most investors who attempt to time themarket end up with subpar results1.The flip side of that would be to sell when the market rises and buy when things look ugly. Thisidea would seem to have more logical and statistical merit, but it can cause problems duringparticularly bad plunges such as 2008, when “buying the dips” led to some very ugly results(particularly with regard to financial stocks).A more methodical approach would be to apply specific limits, such as selling when your positionsdrop 10%, in an attempt to prevent steep losses. But what if the market drops 10% and then headsback up, leaving you to have to buy back in higher? In a particularly volatile market this approachcan lead to a lot of expensive and tax-inefficient trading activity, with no assurance of positiveresults.Aside from staying out of the market entirely or trying to time it, there are a number of other tacticsthat attempt to provide returns that deviate from the stock market or mitigate its risk. There arestrategies that focus on mergers and acquisitions, and those that buy assets from companies indefault. Investors can trade or hold international bonds, currencies, oil, metals, agriculture, oralmost anything else you can imagine. There are “long-short” strategies that bet for and againststocks or other securities. These various “alternative investments” are a very hot subject these daysas people seek out ways to make money in difficult times.In addition to various asset classes and trading approaches, investors can access a variety ofinvestments that carry bank or insurance company backing (subject to the credit worthiness of thebacker!). There are variable annuities, market-linked CDs, structured notes, and other vehicles thatattempt provide upside potential with some measure of principal protection.The problem with each tactic I have referenced is that they come with certain tradeoffs ordownsides. Some are essentially market timing / trading strategies that face the same limitations asthe trading of stocks. The ones that offer guarantees come at a price in the form of fees or limitedupside. I mentioned earlier that all of the various methods of dealing with the current environmenthave the same drawback. That drawback is a tendency to provide somewhat modest returns, at leastin the conditions we face now.Whether by virtue of limits inherent to active trading, or because of the costs of guarantees, or thedrag of low interest rates, it seems that none of the strategies I referenced can be expected to createthe sort of 10-12% annual returns we became accustomed to during the great bull market. No onestrategy appears to be a magic bullet.So which strategies do we recommend? All of them! Or at least a broad selection. Casting a widenet is one of our core methodologies as we believe that extra measures of diversification arewarranted in dealing with heightened uncertainty.1 “Quantitative Analysis of Investor Behavior” Report, 2010, Dalbar, Inc. (January 1990– December 2009) 4
  5. 5. Below is a picture of my four year-old. It was taken this October, and the weatherman was certainlynot calling for snow. But… she was PREPARED!More fun than a chart.Also, note the diversity of colors in the suit. And the helmet is not highly correlated with the rest ofthe outfit. Preparation, diversification, and lack of correlation!That sums up our themes for investing in a secular bear market: diversify among asset classes andinvestment methods, seek non-correlation, and prepare for market downturns in advance. Finally,and maybe we should do this with my daughter in terms of the forecast for snow, we think investorsmust temper their expectations. The relationship between risk and return is not truly broken, and ifwe are to mitigate risk we must expect to forgo some measure of return. With that in mind, our goalin building most portfolios these days is to achieve a positive return above inflation. Despite thechallenging conditions, we think that is attainable over intermediate to long time frames.Ask yourself if 2008 happens again (or worse), would you be comfortable holding your currentportfolio until the storm blows over? Is there enough variety, are you invested in quality companies,do you hold debt investments that are unlikely to default, do you have enough guarantees in place? 5
  6. 6. The time to ask these questions is before things go bad. To use another weather analogy, you do notwant to be out in the yard trying to nail boards to the windows when the hurricane has alreadyarrived. On the other hand, if we do not revisit the abyss, are you positioned to benefit? Does yourportfolio have upside potential as well as downside protections?Remember that we began this discussion by talking about cycles. I believe that someday I will writea market letter about how to invest in a secular BULL market. Maybe I will call it “Revenge of theRisk Tolerance Questionnaire!” In the meantime though, we advise you to be wary, to useprotective strategies, to be hyper-diversified… to be prepared. ____________ The Foley GroupMichael C. Foley Janet G. Kelly Patrick M. Foley, CFP®, QPFCSenior Vice President Assistant Vice President First Vice President(610)239-2627 (610)239-2629 (610)239-2628 Visit the Foley Group website: Important DisclosuresPast performance does not guarantee future results. Diversification does not ensure against loss. Any transaction that mayinvolve the products, services and strategies referred to in this presentation will involve risks, and you could lose your entireinvestment or incur substantial loss. The products, services and strategies referred to herein may not be suitable for all investors.While further diversifying a portfolio with alternative investments can help to reduce risk, this asset class can include higher fees,greater volatility, higher credit risk, can be more complicated, less transparent, less liquid, less tax friendly, may disappoint instrong up markets and may not diversify risk in extreme down markets. You should consult with your Financial Advisor prior toengaging in any transaction described in this communication.Robert W. Baird & Co. Incorporated, member SIPC 6