We began 2015 with our Change of Seasons report describing in absurd detail, how our investment process works. Specifically, that report started with a big bold statement of our goals across all strategies where we define what we consider “Success”. As market risk is clearly on the rise and the estimates for future returns in US equities and bonds ratchets lower, we are making important and intentional asset allocation changes in order to hit our longer-term goals. I think this is a very important time for investors to avoid complacency and pay attention.
How Do We Define Success?
Success (defn.) – Generating asymmetrical results across all investment strategies: to expose ourselves to return in a way that doesn't expose us commensurately to risk, and to participate in gains when the market rises to a greater extent than we participate in losses when it falls.
The concept of asymmetrical results has always been amazing to me. Why every investor wouldn't work toward this goal is a mystery to me. In the industry, this goal is the same as generating “alpha” or effectively more return for a given amount of risk (volatility) than what would be naturally be available through an unmanaged portfolio. Why is this important? Well there are several answers to that. First, we try to control portfolio volatility so you can sleep and night and not worry if you are going to be eating cat food in retirement. A portfolio that generates high risk adjust returns is also one that can handle regular withdrawals easier while continuing to make consistent returns that effectively feed those regular withdrawals. Many of our retirees find this attractive. Finally and most importantly, when we generate asymmetric returns, we let the favorable effects of compounding work to our advantage. Remember a 50% loss requires a 100% gain just to break even. If we contain our losses to recoverable levels, we minimize our recovery periods and let positive compounding do its magic as we make all time new highs more often. As we say in our materials, we are in the business of wealth creation, not just managing money. You would be surprised how many portfolios I see with values well below the high levels of year 2000. This is the antithesis of wealth creation; this is wasting time.
Are We Successful?
Looking backwards, the answer is yes but this is not one of those “mission accomplished” things. There is never really a moment where we stand proud and proclaim victory. Rather, this goal is an ongoing pursuit across all strategies each day, week and year. If we do our jobs well and execute according to sound judgment based on solid evidence, the results should follow. Of course, some cycles have been better than others and we are not perfect, but we’re always evolving and looking for a better way to skin the kitty. As the risk/ return chart of our flagship All Season strategy shows statistically, we’re pretty good at generating asymmetrical returns. Since we began tracking our data like this in year 2000, you can see the compound Rate of Return is almost three times that of our Benchmark Stock Index (DJTSM – Dow Jones World Stock Index) with less than half of the risk. Against the Barclays Aggregate Bond index (AGG), All Season still generates a more favorable return but with higher risk. Of course, All Season is blended asset strategy made up of stocks, bonds, alternative securities, commodities, internationals and everything in between so we should expect our results to fall somewhere between these two benchmark extremes. Full details and stats on ALL SEASON
Angling Toward Success
As I said earlier, this feels like an important time for all investors. This is a time to respect market risk, to avoid chasing high-risk returns, to embrace risk management systems and to be patient! Remember, valuations are high and no longer attractive but neither are they extreme – yet. Reputable research shops like Case Shiller, GMO research and Ned Davis are all looking critically at current valuations and developing forward looking estimates for various asset class returns based on multivariable historical regression analysis. They all paint the same picture pointing to a 7-10 year compression of returns for both US equities and US bonds. See below. As we are knocking at the door of next quarter’s earnings announcements, we should all consider this possibility. In a nutshell, until we see deep corrections in both US stocks and US bonds which will lower valuations for both and create new higher estimates for returns, we need to do something different than simply sitting in stock and bond index funds and hoping it all works out (aka Modern Portfolio Theory). To me, this is like sitting on the railroad tracks as you can hear the train in the distance.
Your question is of course, “So how to do we do that?”. How do we generate Asymmetric Results? Back to the beginning. We lean on our well defined risk management process explained in our last Change of Seasonsreports, which tells us when to cut exposure (Net Exposure Analysis), which sectors are leading (Selection Criteria) and how much to put into each security (Position Sizing).
For example, tomorrow in our All Season strategy, we will formally reduce our allocation to equities by another 5%, down to 55% now from a high of almost 80% in early 2014. We are slightly cutting down on our Equity Sector exposure to 18% and reducing our Dividend Stock exposure to 12%. The extra 5% is going to our Alternative securities allocation where we continue to find more and more options to invest in things that are moving higher with little to no correlation to either stock or bond markets. These are funds with names like Managed Futures or Multi-asset Alternative funds. The chart in Red is the Guggenheim Managed Futures fund, which we have owned since late 2014 and the Green line is the benchmark Down Jones World Stock Index.
Our Alternatives allocation will now be increased to 25% of total assets with this change leaving our Income allocation the same at 20%. Cash should still be held to a minimum as it generates almost no return and an effective negative yield net of mild inflation. These types of risk reduction moves are taking place both in magnitude and timing across all strategies as conditions warrant. In the end, we hope to be in a position to continue making consistent returns without adding unnecessary risk while “market” returns for both stocks and bonds might perhaps follow the less attractive path of those estimated future returns. Remember, once we get a reset in prices lower, then we can add risk back into our strategy, recover any mild losses quickly and get on with our business of wealth accumulation.
There will be no Red Sky Report next week as I’ll be writing the quarter end Change of Seasons.