The purpose of our year end update is to help guide our current and prospective clients specifically regarding the design, methodology, and process behind our investment strategies. Subjectively, it’s probably more important as an investor to understand a well-defined process than it is to make judgments on past performance. While we are proud of our historical returns, the future is what really matters. We believe that returns are the residue of excellent design and execution so please take the time to educate yourself about what we are doing with your money.
How Do We Match Investment Strategies to a Specific Client?
Generally, we rely on information gathered from our clients regarding personal data, objectives, financial status, risk tolerance, return appetite, tax situation, etc. After nearly 25 years of working with various households through all stages of life, we have developed four specific client profiles that offer guidelines in this process. Each profile has a prescribed weighting among our various investment categories described above but ultimately a client’s individual situation is the most important directive. These are our four primary profiles. Which one are you?
When Do We Change Investment Strategies For a Client?
After a portfolio of accounts is allocated among a mix of appropriate investment strategies using the profiles above as a guide, we tend to leave the mix alone unless a client has a significant life changing event (death, divorce, retirement, new windfall, selling a business, etc). Of course aging is a factor and a valid reason to make slow adjustments to the strategy mix as well. However, the desire to affect portfolio results by changing strategies based on future perceptions of potential market risk or return are NOT valid justifications for changing the prescribed mix of strategies. Fear and greed are part of the human investing experience, and in all of our firm’s history, we have never seen a client improve their results by acting on either emotion. Remember, under the hood, each one of our strategies adapts to current market conditions within it’s own domain relieving our clients of the need to game the strategy mix itself.
We believe there are only three primary variables that can truly affect an investor’s ability to achieve Success (defined above). These three variables are overlapping, complimentary and self-reinforcing to each other giving us redundant confirmation when action is needed (buy or sell). They are as follows:
Net Exposure – Dynamic Asset Allocation based on:
Overbought/ Oversold Asset class analysis
Fundamentals – Economy, valuations, monetary policy in place
Technicals - Primary trend analysis, Breadth, Leadership, Volume
Relative value, risk and opportunity analysis
Relative strength to cash*
Time frame – Intermediate term (3-6 months)
Selection – Choosing the right securities within asset class allocations
One month risk and return rankings
Relative value and strength analysis
Growth and income prospects
Technical price patterns
Time frame – Short term (1-3 months)
Position Sizing - Focusing capital on highest conviction positions
Reducing position size if fundamental or technical evidence is not supportive and vice-versa.
Guidelines for maximum position sizes based on inherent volatility of individual securities.
Time frame – Short term (weekly)
*Cash or money markets are considered a viable “investment” within a portfolio but only employed during protracted market declines or when cash is outperforming on a monthly basis (rarely).
Secondary variables are tax strategies or tax based decisions, transaction costs and desired frequency of trading. We've seen too many examples of investors who experience significant wealth destruction in the name of avoiding taxes, taking a small loss or incurring a small transaction fee. Make sure you check with us before taking any investment advice from a CPA or tax preparer.
An Example of Our Investment Process –
The All Season Strategy (as of 1/2015)
Net Exposure – Slightly reduced standard allocation to equities again by 5%-down to 60% from 75% in mid 2014. Increasing our allocations to liquid alternatives again by 5%, up to 20% seeking up-trending securities with low correlation to US stock market. Maintaining allocations to high-income securities (20%). Cash held to a minimum if possible.
Selection – Shifting equity exposure slowly from overbought US stock market to select oversold international and developing country funds. Index exposure favors large and mid caps over small caps, growth over value and dividend payers over non-dividend payers. Equity Sector selection favors a blend defensive groups and cyclical groups, especially those benefiting from a strong US dollar and low energy prices. Alternatives favor managed futures and Real estate funds. High Income allocation favors preferred securities funds, municipal bonds, investment grade corporate bonds and emerging market debt funds.
Position Sizing – New entry level (small) positions in Emerging markets, India, Asia – Pacific, Transportation, High yield corporate and emerging market bonds. Planning to reduce larger positions in utilities, consumer staples and healthcare with large unrealized gains from 2014 once technical patterns become less attractive.
Summary With Confirmation Across our Process
There is increasing evidence that the US financial markets are approaching the final stages of long bull markets for both Treasury bonds and Stocks. Economic fundamentals are still healthy but valuations and technical indicators are not as constructive so our Net Exposure screen dictates a less “exposed” allocation. Instead of carrying more cash, we are actively moving assets to become less correlated with the US stock and bond markets now. When markets approach the final stages of a bull market, there are fewer and fewer sectors making new highs. We are seeing this happen now. Therefore, proper security Selection is going to highly dictate relative performance in 2015 at least for the first half of the year. Our only overweight positions now based on favorable risk adjusted returns are real estate and healthcare. All other Position Sizes are normal as real value with strong price trends, is becoming harder to find. Net Exposure, Selection and Position Size results are all confirming the same story. If the story changes, our allocations will adjust as needed.
What if the Market Turns Sharply Lower?
First, you must know and believe that protracted bear markets do not show up without warnings, often months in advance. Investors who choose to ignore these warnings often pay the price. We are keenly aware and watchful for such warnings and yes we are seeing them begin to appear now. However, warning type evidence can go away as they have several times since 2012 yielding higher prices. Warnings are to be given due respect and set a standard for our willingness to cut risk once prices confirm to the downside. If the market turns sharply lower after months of evidence (Net Exposure, Selection and Position Size confirming) suggesting this outcome, then our risk management system kicks in across all strategies often driving our portfolios to carry higher cash positions, bonds or positions with negative correlation to the financial markets.
Second, each position in every investment strategy has a hard and fast rule that is simple and easy to follow dictating the condition under which we continue to hold or sell. The rule is as follows; we cannot hold a position that is in a confirmed intermediate term (3-6 month) downtrend. When “the market” turns sharply lower, it often drags all sectors and asset classes lower in sync. Subsequently, many of our individual positions will also reverse course and begin downtrends as well forcing us to follow our rule and sell to cash. Some positions buck the market trend and continue higher allowing us to continue holding. Honestly, we don’t really care if the Dow is down 500 points or not, we really care about the impact it may have our individual positions. Also, we do not have hard any rules for portfolio downside loss limits (selling everything if the strategy is down 5% for instance). Systems that attempt this type of risk control find themselves selling everything at the bottom of each short term correction within a longer term bull market. It simply doesn't work.
Finally, it is important to understand the difference between RISK and VOLATILITY. By definition, risk represents significant or semi-permanent loss of capital that requires many years to recover. Volatility is something we must all put up with periodically as investors as the markets simply do not move up in a straight line during long bull markets. We do not want to sell our investments each day they experience a drop in price. We do want to stick with our investments as long as they are in long term uptrends. Our job is to determine the point at which normal volatility becomes real portfolio risk.
Our process is well defined and well tested through the most volatile markets we have seen in the last century. If we can continue to execute our process, we will add to our impressive 15 years of real performance using real client money. I will close by reiterating the final sentence of our explicit investing creed. Superior, above average, results over time are only achievable through unconventional decision-making, conviction, and discipline. Thank you.
President and Chief Investment Officer
All Season Financial Advisors, Inc.