2nd Quarter 2015 | "Best Fit"
By Sam Jones, President
The purpose of this quarterly report is to help guide our current and prospective clients specifically regarding the design, methodology, and process behind our investment strategies. We also work to offer a higher level of transparency into our investment strategies by showing unique perspectives on returns and risk profiles. Subjectively, this is a self-effacing report openly critical of areas in which we still need work and similarly patting ourselves on the back when appropriate. While we are proud of our historical returns, future risk-adjusted returns are what really matters. We believe that investment success the direct result of excellent design, solid execution and regular self-critical evaluation.
This Change of Seasons reports is focused on Best Fit in the sense of which strategies (or combinations of) offer a best fit for your various life stages. Effectively, I hope to address our value as it relates to excellent portfolio design by walking you through the design process itself. Knowing which of our strategies is right for your stage of life can be a puzzle. Consequently, we have gone to great lengths to work up prescriptive strategy mixes for different client household profiles based on typical risk tolerance, age, and stage in life. I’ll begin first by identifying our four “profiles”, including our “prescriptions” by investment category for each and finish with some individual strategy statistics to explain how certain strategies are indeed a Best Fit for their target investor. Our website is chock full of detail regarding all of the above so feel free to dive in on-line anytime.
We are seeking “Success” over a reasonable “Judgment Period” by knowing when to embrace and reject conventional wisdom regarding perceived market trends, “Risk” and opportunities. Superior, above average, results over time are only achievable through unconventional decision-making, experience, and discipline.
Risk (defn.) – The probability of unrecoverable or semi-permanent loss of capital, not to be confused with variable degrees of periodic volatility.
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.
Judgment Period (defn.) – A period of time that captures a full investing cycle including both bull and bear markets – typically any rolling 5-6 year period
To understand why a certain investment strategy is prescriptively right for you, it is important to understand the natural volatility of any investment strategy. Natural volatility can be measured by way of something called the Distribution of Returns where we can clearly see and plot the frequency of gain and loss periods. Let me provide two very different examples.
A younger investor (“Plant” or “Grow”) who is regularly adding to investment accounts and is years away from any form of withdrawals, cares mostly about accumulating wealth with less regard for regular volatility in their portfolio. In fact regular volatility provides nice clear opportunities to add new money. These investors are savers from a behavioral perspective and should be matched with higher return, stock oriented growth strategies, like any of our three Tactical Equity strategies. If we look under the hood at our Worldwide Sectors strategy for instance, we see characteristics in the Investment Allocation and the Distribution of Quarterly returns that make this strategy appropriate for a younger investor.
Worldwide Sectors Strategy since inception net of all fees.
As you can see, Worldwide Sectors is an all stock or equity strategy with a blend of stock ETFs, Sector ETFs and a 50% allocation to individual growth company stocks. These are maximum allocations for each group but all are still subject to our proprietary risk control criteria for Net Exposure, Selection and Position Size on a daily basis. On the right, you see the distribution of returns, which is broad including gain and loss cycles. But importantly, the data are skewed to the right where we see the highest number (bar) of quarterly periods with +4-5% gains. Aggressive younger investors have clear opportunities to add more money into this strategy during any of the quarterly loss periods to the left including some that are deeper than others (-10% or more).
Now, compare this strategy, which is a Best Fit for our “Plant” or “Grow” profile clients, to one that is better suited for our “Cultivate” or “Harvest” profile clients like any of our Blended Asset or Income strategies. These households are naturally older, largely without income and regularly withdrawing money from investment accounts to subsidize living expenses. Why does downside capital protection matter so much to someone in this situation? There is more to the answer than the absence of replacement income! Consider these two different portfolio balance charts.
The blue line shows the results of a fully invested (passive) stock index fund portfolio experiencing the full force of the last bear market in 2008 and 2009 and subsequent four year recovery. The red line shows the results of the same portfolio but with the subtraction of 6% in annual withdrawals. Even worse, the red line doesn’t account for the tax liability associated with distributions from an IRA. A passive index portfolio with the headwind of regular withdrawals, even as little as 6%/ year, is not likely to recover from losses like these, perhaps not in the investor’s lifetime. However, any well-designed portfolio with an appropriate focus on downside risk controls will certainly make life easier for portfolios under withdrawal pressure as portfolio recovery is always within reach.
Our flagship All Season strategy, one in our Blended Asset category, has the following Investment Allocation and Distribution of Quarterly Returns.
All Season Strategy since inception net of all fees.
What should be obvious is the broader mix of allocations to diversified asset classes as well as the tighter distribution of quarterly returns, again skewing to the positive side of zero. You do not see quarterly losses in excess of 8% because there are none in its history of nearly 18 years. In fact, there are only three years in which the strategy has lost money at all on a calendar year basis. All three were mild and quickly recovered. Such a strategy is certainly a Best Fit for those who need to make regular withdrawals and don’t have the time or means to recover from a significant portfolio loss.
Either of our Income models would also be appropriate for our Cultivate and Harvest profile households for the same reasons as returns are earned even more consistently and periodic losses are mild to non-existent.
Retirement Income Strategy since inception net of all fees.
As we like to say, the magic is in the mix when it comes to designing a complete portfolio of strategies that serves as a Best Fit for any of our client households. Our prescriptions and profiles are there to guide us but every household is a bit different with special needs, circumstances and personal biases. The relevance of this discussion to today’s market should be self-evident. While we do not believe the long-term bull market in global stocks is over yet, we do know that the risk of significant loss is on the rise with an associated bear market. This is an excellent time for all investors to revisit their portfolio design and make sure current holdings (strategies) are a Best Fit for where you are in life. We regularly do this for our clients during our reviews and would be happy to do so for any parties upon request.
That’s it for this 2nd quarter Change of Seasons report. Stay tuned to the weekly Red Sky Report for important updates on the timing of the next developing best buying opportunity.