Third Quarter Commentary, Part I

I continue to be surprised by how attracted clients are to a 60% / 40% asset allocation, or some variation thereof.  That is a static process which assumes asset risk is constant over time.  The concepts within Modern Portfolio Theory—from which “optimal” allocation percentages are derived—are, at best, a starting point for investment strategy.  MPT is by no means a panacea.

Risk is not constant over time.  While there are many different types of Risk, I think the following most adequately defines Risk for a portfolio:  the chance that the portfolio’s actual return will be different than expected.  By this definition, not only is there a risk of underperforming, but there is also a risk of outperforming.  I assume most investors do not consider outperforming expectations to be a Risk.  If that is the case, there is, of course, a very simple solution to greatly reduce investment risk:  lower your expectations.

But unfortunately Risk is often substituted for the more pressing, more quantifiable concept that investors are actually concerned with:  Capital Loss.  Ironically, we (industry professional and investors alike) defer to Risk when talking about portfolios because future Capital Loss is unknowable and not built into expectations.  Think about it, if you expected to lose money, you wouldn’t make the investment.  In fact, you expect to make lots of money (relatively speaking).  Seriously.  By allocating money to a portfolio of equities and bonds and commodities and so on, you’ve decided to pass up:

  • the 0.32% opportunity in a 1-Year CD
  • the 1.10% (annualized) opportunity in a 5-Year CD
  • the 1.61% (annualized) opportunity in a 10-Year Treasury Note
  • the 2.69% (annualized) opportunity in a 30-Year Treasury Bond

I’m not certain what your expectations are about your portfolio’s future return, but I would hazard a guess between 5% and 10%—and likely toward the upper end of that range.  I’ve stated before, and I’ll restate here again:  a return of 5% annually over the course of the next four years will be a good return.  Consistency also adds value in that scenario.  However, let’s use 7.5% as a baseline.  With a 7.5% return expectation on your portfolio, you expect to make:

  • 2.79 times that of a 30-Year Treasury Bond
  • 4.66 times that of a 10-Year Treasury Note
  • 6.82 times that of a 5-Year CD
  • And 23.44 times that of a 1-Year CD

Back to the point:  we ironically discuss Risk as if we can quantify it with certainty.  We cannot; refer to the story of JP Morgan and the London Whale.  Expected return is ever-changing and predicting the chance associated with not meeting those expectations is frequently ineffective.

When designing a portfolio, you need to incorporate dynamism:

  • Use history is a guide, not a map
  • Risk changes and, therefore, certain opportunities are better than others
  • Because opportunities vary, timing is critical

Timing is critical and understanding this will take your investment strategy one step further than Modern Portfolio Theory.

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