Author: Joshua Mosshart

Although it is usually not desirable to eliminate risk, there are strategies that may help to manage the volatility of your portfolio. A diversified investment mix, a focus on large cap growth stocks, and exposure to active portfolio managers may all help you deal with greater market volatility.

The Return of Diversification

We believe that effective diversification becomes more important in an environment of rising volatility. We expect the interrelationship of stocks and bonds to provide more diversification benefits than in past cycles as real interest rates become the driver of relative performance.

Correlation measures the degree to which asset returns move together or in opposite directions. Over time, the correlation between two asset classes can change. For instance, the relationship between the total returns of stocks and the total returns of bonds has varied over the past 75 years. During much of the 1980s and 1990s, stock and bond prices generally moved together, as reflected in the +0.5 correlation between them over the period.1 In the 1990s, diversification offered little value to investors - stocks and bonds generally moved in the same direction. In contrast, the correlation between stocks and bonds in recent years - just as in the 1950s - has reversed, reaching -0.5. Diversification is of more value in managing volatility now than at any time in the past 40-50 years!

The recent decline in the stock market was mirrored in a decline in yields (and rise in bond prices) as market participants’ expectations for economic growth were tempered. Indeed, since the peak in the S&P 500 on July 19, the intermediate term government bonds have gained about 5% while stocks have fallen about 5%.2

We expect the correlation between stocks and bonds to remain below the levels seen in the 1980s and 1990s. In an era of a low, stable pace of inflation relative to historical levels, the volatility of interest rates may be driven more by expectations for the real rate of economic growth than by inflation expectations. In general, rising inflation tends to be a negative for both stocks and bonds. In contrast, rising real growth is a plus for stocks but a negative for bonds, because bond yields generally rise and prices fall. A similar period of negative correlation between stock and bond prices resulting from low and stable inflation occurred in the 1950s and 1960s.

A benefit of the changing correlation between stocks and bonds is that as price volatility remains elevated in the years ahead, a lower-than-average correlation between stocks and bonds should produce more benefits from diversification, which should serve to moderate overall portfolio volatility.

Go for Growth

In recent years, it was easy for investors who didn’t periodically rebalance their portfolios to become over-weighted in value stocks - dominated by the financial sector, which is at the hub of the current market turmoil. With the exception of the aftermath of the technology bubble in the early 2000s, value stocks have tended to be more cyclical than growth stocks - meaning they display greater volatility when economic growth slows. As volatility has returned to the financial markets growth stocks have displayed less volatility than their value peers.

We expect better performance by growth stocks in the years ahead. In contrast to the 1990s, the excesses that have built up during the 2000s business cycle can be found in value rather than growth stocks. For example, the energy sector has soared along with energy prices and is vulnerable to a pullback in prices from record highs and the financial sector is exposed to the aftermath of the bubble in subprime debt. The large cap growth asset class is more attractively priced than any time in the last 10 years and earnings growth is likely to remain robust.

Get Active

Active managers benefit in an environment of rising volatility. The percentage of active managers beating their index tends to rise and fall with the trend in market volatility. During the second half of the 1990s economic cycle, volatility steadily rose - as did the percentage of large cap managers beating the market. The percentage of large cap managers beating the index rose steadily along with volatility from 11% at the end of 1995 to 68% by the end of the first quarter of 2001.3 As volatility remains elevated relative to recent years, we may look forward to stronger relative performance by managers relative to their indexes.

While the return of volatility may be unwelcome by some market participants - it may actually be good news. The turnaround in volatility has historically been followed by years of additional gains before the end of the business cycle.

A focus on diversification, large cap growth stocks, and active management can help to effectively manage portfolio volatility. In addition, we believe that rising volatility presents opportunities to potentially enhance return and manage risk through tactical asset allocation shifts. Rather than ignore volatility and adhere to a rigid allocation, we seek to capitalize on market volatility and make full use of the flexibility of our asset allocation framework.

1 S&P 500 and the Ibbotson Intermediate Term Government bond index

2 Ibbotson Intermediate Term Government bond index

3 Chicago Board Options Exchange Volatility Index; large cap core managers in Lipper database.

Author: J.S. Kim

The Investment Myth Surrounding the Determinants of Portfolio Performance

Almost every single person that has ever been managed by a large global investment firm has seen the chart of “Determinants of Portfolio Performance” where 92% of portfolio returns are attributed to asset allocation and NOT the selection of individual stocks or specific global markets. Financial consultants tell you that studies too numerous to count have been performed that prove the above “facts”. My question is, Who performed these studies that yielded such ridiculous results? Stasticians hired by investment firms to produce results favorable to their selling campaigns? I’m not really sure who has performed these studies and I really don’t care because I know they’re wrong and that’s all I need to know. Just like tobacco firms hired doctors to tell us that cigarettes weren’t responsible for giving you lung cancer years ago, investment firms will continue telling you certain ridiculous things that are not true as well.

In the end it’s really up to you to decide whether or not to believe all the theories they propagate and mass disseminate. I’ve stopped believing almost all their theories a long time, and ever since then, my investment returns have tripled and quadrupled. In any event, financial consultants use those aforementioned statistics to convince you that little time is necessary to spend deciding how your hard earned money is invested.

Before I started my own companies, I once heard a very successful financial consultants tell me that once I had convinced the client to turnover his or her money to me, that I should not “waste” time deciding how to invest it. Paraphrasing him, he told me to turn over the money to an outside money manager and move on to the next sale. It was a “Get ‘em in, get ‘em invested, and move on” motto. If clients knew that this type of mentality is predominant among financial consultants, I wonder if they would so quickly turn over their money to them.

What’s wrong with the pie chart that tells you 92% of portfolio returns are solely attributable to asset allocation you might ask?

The Actual Determinants of Portfolio Performance

The pie chart that is used by so many financial consultants all over the world claims that only 4.6% of portfolio performance is attributable to stock picking, 1.8% is attributable to timing, 2.1% is attributable to other (I’m not sure what is in the “other” category, maybe planet alignment and sun flares), and that 91.5% of your portfolio returns are determined by asset class allocation only. If this were true, then of course it would not make sense to demand that your financial advisor spend more than thirty minutes deciding how to allocate the USD $1,000,000 you just gave him. If this were true, then once a financial consultant had decided what asset classes to allocate one client in, then every subsequent new client, whether he or she had $500,000 or $10,000,000, could conceivably be invested in exactly the same asset classes at least for the next six months. And this is exactly what the overwhelming majority of financial consultants do.

However, from a strictly logical perspective, does this theory make even the slightest sense to you? Do you really think that if you owned the five companies with the best management in the industry, that their share performance would be comparable to the five companies with the worst, bumbling, shortsighted management teams, merely because they were in the same asset class? If a business has forward sold contracts at the wrong time or if a business has not hedged against foreign currency exchange risk, this could be the difference between a profitable company and a losing one. Yet financial advisors always claim that it doesn’t really matter what individual stocks you own as long as you own the right asset classes. What if technology is tanking in the United States but booming in India? Well the above pie chart tells you it doesn’t matter regionally where you are invested as long as you are invested in the proper asset classes.

People whose portfolios have been overweighted in Asia for the past five years and that have returns 100% to 200% higher than those concentrated in the U.S. will tell you that being invested in the correct regional markets creates substantial differences in results.

Performance in stock investing is 100% about investing in the right companies at the right time in the right countries. No ifs, ands or buts. Don’t ever be misled again by the crazy notion that timing is irrelevant, regions are irrelevant, and individual companies are irrelevant.

In my mind, the only reason that the most cited “determinants of portfolio performance” pie chart holds so much credibility is because it has been cited so often without any credible discussion regarding its deep flaws. As any war historian will tell you, tens, if not hundreds of millions of people believe erroneous “facts” about wars because they have been taught wrong information in schools that has been reinforced numerous times over many years. Ask people about critical factors surrounding WWI, WWII, the Vietnam War, and in contemporary times, even the Iraqi War, and most people will get some facts twisted because they had read an erroneous report somewhere. Just because millions of people believe something does not make it true.

Instead of being called “Determinants of Portfolio Performance”, the chart most widely known by investors should be renamed “Determinants of Asset Gathering”

The lesson to take away from this is as follows: To build wealth through investing, seek someone that is a (1) a superior stock picker; (2) is very knowledgeable about global markets and is knowledgeable about regional trends; and (3) is knowledgeable about enough technical indicators to utilize market timing to your advantage. Again, I will always contend that this “someone” should be the person that stares back at you every morning when you look at a mirror.