Investment Basics to the Rescue

To be accomplished at anything involves mastering the basics. When I was a young boy, I whined enough until my parents finally relinquished and allowed me to quit piano lessons after four years of practice.

I was laying a good foundation of theory, working on the basics and all, but the two-octave scales in different keys just killed me. Playing ball outside…or doing anything outside…or doing most anything else...was lots more fun than doing scales.

What’s this got to do with investing? Just that the basics are important, but the basics aren’t necessarily fun. Speaking broadly, we learn financial basics from reading financial textbooks; the fun stuff sells on the financial media shows and tabloids.

The basics require discipline and are designed to achieve long-term goals. Buying a hot stock that is "on the verge of skyrocketing" is certainly more exciting. The basics delay gratification, but also intensify it in the long run. Speculating on prospects of immediate and massive gratification is fun now, but usually not so fun a decade later.

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Be sure to read to the end of this article where I urge you to review your current portfolio risk, especially if you are in or nearing retirement. Or if you have experienced tremendous growth in your portfolio recently, now is not the time to be complacent. 

I’ve seen too many speculators (those who view investing as gambling--as a get-rich-quick plan) cripple themselves financially. Granted, some hit the lottery. Oh, and you hear a lot more from them than the losers who never make a peep to anyone. But I’ve never witnessed an investor who competently practiced these three principles fail.

There are setbacks, but the setbacks, though not specifically predicted, are generally anticipated. That’s what informed investing does: it looks back at history and counts on similar (but never exactly the same) crises to happen in the future. By having contingencies within their investment plan, wise investors can weather storms much better—and often avoid them if they know ahead of time that they can’t afford to weather them.    

Diversification Reduces Volatility

Speculators concentrate their money into single or a few investments, industries, or asset classes. This approach can deliver great returns if they get it right, but it also entails significant risk. Unlike a diversified portfolio, the price for an individual investment, like a single stock, can fall to zero. However, by owning several companies in different industries, you can greatly reduce portfolio risk. If one company fails, the others hold up the portfolio. This diversification can protect a bond portfolio too. Diversification can greatly mitigate unsystematic risks such as a particular company failing.

In a more macro view, Harry Markowitz, winner of the Nobel Prize in Economics in 1990, showed that effective diversification is achieved by combining assets whose prices do not move together. The effectively diversified portfolio provides stability and a larger long-term return.

It's counter-intuitive, but by adding a more volatile asset which is not highly correlated to the existing assets, the portfolio itself can actually gain more stability. For example, it has been shown that adding 24% stocks (S&P 500) to an all-bond (20-year government) portfolio on average reduces the volatility of the portfolio over the long term and increases the rate of return. The reason is that stocks and bonds are not highly correlated. Many periods, when bond prices are moving down, stock prices are moving up, and vice versa. The long-term average portfolio performance is thus more stable.

By diversifying your stock allocation by company size, industry, and geography, you can maximize your investment return for the risk you are willing to take. The object of diversification is to achieve the best risk-adjusted return for the portfolio, based on the volatility you are willing to endure. Another way of viewing it is that by diversifying, you can minimize your risk to achieve your target rate of return.

Asset Allocation is the Key Factor for Returns

Asset allocation, in its simplest form, means determining how assets will be divided and invested among equities (stocks), fixed income, real estate, commodities, and cash investments to maximize the growth of a portfolio for each unit of risk taken. This is a form of diversification and is the most important determinate of long-term performance.

In general, the higher the weighting in stocks, the higher the potential return and volatility of the portfolio. The lower the weighting in stocks, the lower the growth potential and volatility of the portfolio.

As people get older and have less time to make up market losses, they will usually desire a less volatile portfolio, made up of more bonds and less stocks. See Why Invest in Bonds. However, caution here is warranted. Longer life expectancies require that retirees as old as 60 years of age plan for at least 30 years of income, to insure not running out of money. Without any stock weighting, many portfolios would not be able to do that adequately. The choices would be to prematurely run out of money or be forced to withdraw less income during retirement. See Why Simple Savers Lose in the End.

The investor needs to construct a well-diversified portfolio composed of asset classes based on their goals, time horizon, and risk tolerance. This asset allocation would normally consist of equities, fixed income, and cash to give the maximum return to meet the investor’s goals and needs while managing risk and volatility concurrently.

Some of the most common asset classes are large cap value stocks, large cap growth stocks, mid cap stocks, small cap value stocks, small cap growth stocks, developed foreign stocks, emerging market stocks, short term bonds, intermediate term bonds, long term bonds, real estate, precious metals and cash equivalents.

For 87 years, which is a large sample size, from 1/1/1928 through 12/31/2014, the compound annual returns for six asset classes are as follows:

https://www.ifa.com/12steps/step9/history_characterizes_risk_and_return#ChartFlashID351 

Each of the asset classes have their own set of risks. For example, a diversified stock mutual fund still has systematic (i.e., market) risk. Bonds can have credit and duration risk. CDs can have inflation and reinvestment risk. By combining these investments, the risks can be properly balanced to achieve certain goals.

There are several combinations of asset classes that fall along the line which is called the “efficient frontier”. This means the portfolio maximizes the return for a given risk level. Many more possible combinations fall below the efficient frontier, meaning an investor is not getting the most return for the risk taken. Modern Portfolio Theory (MPT) recommends portfolios be optimized by combining asset classes in a way that positions the portfolio somewhere on the efficient frontier, based on the investor’s goals and risk tolerance.

Periodic Rebalancing takes Advantage of Reversion to the Mean

MIT finance professor Jonathan Lewellen has given much credibility to the theory of mean (i.e., average) reversion. According to Lewellen's findings, up to 40% of the market's annual returns are temporary, and will usually reverse within the next 18 months. He also found that stocks’ 3 and 5-year trailing returns are negatively correlated to the subsequent 12 to 18-month period. In other words, tomorrow's stock prices will often move in the opposite direction of yesterday's prices.

This pattern is not a new discovery. Dr. Jeremy Siegel is the professor at The Wharton School of the University of Pennsylvania and author of classic investment works such as Stocks for the Long Run and The Future for Investors. Professor Siegel documents that stocks have consistently gravitated toward their long-term moving average since 1802.

Investing in a concentrated portfolio of individual stocks per the mean reversion theory could be disastrous. Individual stocks can get in financial trouble and prices decline for years, or sink to zero. There is no principle of reversion for a single stock. However, the mean reversion theory can be applied effectively to asset classes where there are a statistically significant number of stocks representing that asset class.

The basic stock asset classes have all had their strong and weak periods of performance. But they cycle. (They all have their 'days in the sun' which have resulted in strong long-term average returns. Typically that is because their highs are greater than their lows and their up days are more frequent than their down days. That is why they are attractive to long-term investors.) The stock asset classes which are depressed now often have the greatest potential for growth in the future. The asset classes which have had strong performance above their mean for an extended period have the greatest potential for larger declines.

One of the best examples was the tech bubble of the late 1990s. The large-company US technology stocks in the cap-weighted S&P 500 index were affected. Some P/E ratios were many multiples of the historical average for the asset class. In March 2000, the declines began and didn’t end until March 2003, when the market again began to surge. Had investors underweighted or avoided these unsustainably high-priced technology stocks, and stayed with more moderately priced asset classes such as U.S. small-cap value stocks at the time, they would have weathered the bear market without significant volatility.

Decision-making surrounding mean reversion is the art of portfolio management. The conclusion is that it may not be best always to weight the asset allocation along the efficient frontier with asset classes that have extremely high price-to-earnings multiples above their historic mean.

Investor behavior (fear and greed) can result in a bandwagon effect, which can set investors up for a sharp or extended reversal. Ex-Federal Reserve Chairman Alan Greenspan referred to the late 1990s technology stock run-up as “irrational exuberance”. Remembering mean reversion can help an investor underweight, or avoid altogether, assets which have had an extended period of excessive over-performance.

Mean reversion should be remembered in the initial design of a portfolio and in the ongoing maintenance and rebalancing process. This approach is conducive toward accomplishing the goal of every investor, which is to buy low and sell high. To forget this principle and “chase returns” as many do, results in buying high and selling low.  

How often to rebalance is the subject of many technical studies. ‘How often’ however is perhaps not as important as ‘how out of balance’ the portfolio is. If a person’s target stock/bond allocation is 50/50, and if stocks outperform bonds for a period, resulting in a drift to a 55/45 allocation, rebalancing is needed back to the 50/50 target, regardless of how long it took the portfolio to become that way. And full dynamic rebalancing would suggest a lower weighting in stocks during periods when valuations are expensive from a historical perspective and higher stock weightings when prices are historically low.  For more details  on rebalancing, see How to Build an Optimized Retirement Portfolio.       

Investment Basics to the Rescue

How might this knowledge be put to use in today's stock market climate? If you have a large portion of your investments in large-cap U.S. stocks, take a look at this chart below.