The Power is in the PLAN not the Prediction
FIVE THINGS YOU SHOULD KNOW
- Equity Markets – rose this week with U.S. stocks (S&P 500) up 0.78% while international equities (EAFE) gained 1.38%.
- Fixed Income Markets – also saw improvement with investment grade bonds (AGG) up 0.16% and high yield bonds (JNK) up 0.06%.
- Delta Disruptions Continue – The spread of the delta variant of the coronavirus continues to ramp up across the globe with China partially shutting down the world’s third busiest port as a result, and Japan stating the spread in Tokyo is now “out of control”. The resurgence of new cases has put a damper on future expectations, both from a sentiment and growth standpoint.
- Crypto Concerns – This week saw more clarity and details around the proposed infrastructure bill, with the plan set to include language that would allow the U.S. to have broad oversight of virtual currencies. While this will face strong opposition from the crypto community, proponents of the push for stricter oversight will point to examples of security breaches like the hacker this week that was able to steal $600 million in cryptocurrency from the exchange PolyNetwork.
- Key Insight – [VIDEO & ARTICLE] In honor Friday the 13th, we take a look at what scares many an investor “market risk and volatility.” We’ll share some hopefully new and powerful insights with you on how the oft-mentioned, but all-too often ignored, wisdom of diversification can help you with both your risk AND your returns.
INSIGHTS for INVESTORS
Intro
Let’s be honest, it feels much better to blame someone else other than ourselves when things go wrong or not as expected. The problem is such an approach rarely fixes anything.
As it relates to financial matters, it easy for many to blame the stock market and what it has (volatility) or hasn’t (expected returns) given them, or the ever-rising costs of college and housing, than to actually accept what one can control in one’s: 1) spending, 2) saving, 3) timing, 4) risk tolerance or 5) legacy – in other words, their own personalized plan.
The collective excuses for not having a well-built plan are all pretty common but generally boil down to either, I don’t have the time or the money. It’s worth noting there have been several studies which show the average American spends five or more hours on their next car purchase or vacation, but less than an hour a year on their 401k/retirement.
If it isn’t about not having time or money, and I would argue for most it’s not fair to say planning for retirement isn’t a priority, but rather the topic is seen as intimidating, defeating or simply boring.
The latter is of course a common response because our industry is notorious for using too much jargon and/or spouting meaningless cliches that many advisors themselves don’t fully understand – e.g., “you should be diversified.”
We’ve touched on general planning a number of times, so this week (in both the video above, as well as in this article) I am going to tackle WHY proper planning and DIVERSIFYING your portfolio are in fact important.
I. The Tough Reality: All Investments Entail Some Risk
The inescapable reality is every asset carries risk. And while most everyone will acknowledge this if consciously asked, all too many seem to subconsciously forget it when it comes to how they actually invest (e.g., ask a bitcoin believer about risk, or someone that holds a bunch of Apple stock, the S&P 500 for the last decade, etc.). They may acknowledge risk and give a tip of the cap to “not putting all of your eggs in one basket” but they don’t invest as if they actually believe it.
Even cash (lowest risk measurable risk on the chart below) carries some risk if one looks at not only volatility, but also inflation’s impact on one’s purchasing power or even a regime collapse.
I found the chart below, which is a fun breakdown of all kinds of assets and their perceived risk based on historical volatility. From cash with a volatility score of 1, to common stocks with a score of 74, to things like art which stretch traditional forms of risk assessment and get an NR for “not rated.”
In summary, it all has risk.
Why is RISK so important to bring up today?
While I could point to the much-written issues around crypto disciples, meme stocks or even just traditional investors who find themselves vastly overweight to US large-cap tech after their recent run versus other asset classes (all valid), I am bringing it up this week because once again we find ourselves in an abnormally long period without volatility (see chart below). Extended risk and reduced diversification combined with pending volatility is likely to cause about as productive a response to volatility when it does arise as the proverbial sun-bather that gets doused with cold water.
US equities have continued their stellar performance despite high valuations that have raised correction concerns. Following last week's performance speedbump, the S&P 500 has persisted upward. It has now been 184 trading days since the last 5% S&P 500 drawdown. This marks the 15th longest period without a meaningful pullback and is significantly above the historical average of 97 days. – Goldman Sachs
With that, let’s quickly run through some key benefits of diversification and why it’s worth another look in order to make sure your portfolio is ready to take advantage of them.
Benefit of Diversification #1: Improved Mindset – There is Always Something to Cheer as Opposed to Chase
Investing is tough business, and it’s far more emotional than most want to give it credit for. Furthermore, history, and a number of studies, have shown behavioral finance issues whether it’s investors panicking at the lows or chasing returns at the highs, have drastically undercut long-term performance (see https://www.vanguard.com/pdf/ISGQVAA.pdf).
If you glance at the chart below which looks at a variety of asset classes (each colored box), your initial confusion quickly and clearly demonstrates the near impossible mission of predicting returns. What the above article in part is referencing to are people’s habits of selling off last year’s loser to buy last year’s winner only to have things flip all too often.
If we look at the black circle (representing a diversified portfolio) you can again quickly see while you are never the top box, so too you are never the bottom. Your investment approach becomes about the proven strategies of discipline and patience. This, aided by always having some winners to either take heart from and/or use for actual needs, as opposed to trying to predict next year’s “top box” and/or having to sell at an importune time because your need arises while your portfolio sits predominately in the bottom box.
Benefit of Diversification #2 – Improved Risk to Return Dynamics
Another reason some investors avoid better diversifying their portfolios is that they believe somehow it means they’ll make less money over time. This usually comes from a few places:
- someone really hit it with a single stock or story (e.g., bitcoin) and has yet to experience the other side of the coin (pun intended),
- an abbreviated time frame under consideration (e.g., looking at the common holdings of the S&P 500 or NASDAQ only post-2008 and ignoring their relative performance over other timeframes),
- a general lack of actual investment facts/history.
The important takeaway is a diversified portfolio is likely to generate comparable performance over time relative to a riskier allocation, particularly if one considers that performance in terms of the risk one took to achieve it. Put simply, over the last 22+ years, investors would have had to endure 60% more volatility to achieve just 0.35% better return. (See chart below)
This proving true assuming one held their investments steady over the whole timeframe. What’s more likely is they had need for some of that money over those 20+ years, which makes it highly probable that they didn’t even experience as good of a return as the diversified portfolio where an investor could be more selective of what they sell to raise needed funds.
Benefit of Diversification #3 – Lower and Shorter Portfolio Drawdowns
The last benefit(s) we’ll discuss, though hardly the last in general, are the benefits to one’s emotions and planning flexibility from 1) reducing the overall size of portfolio drawdowns during market volatility, and 2) the reduction in the likely timeframe one’s portfolio would take to “get back to even” after such a period.
The first chart below, looks at the performance (including worst annual drawdown) of the S&P 500 and a sample diversified portfolio from 1999-present. Alluding to the point above, a diversified portfolio’s average intra-year drawdown was only a -8.9% vs. -15.5% for the S&P 500 alone – a reduction of over 40%!
The last chart I’ll share for this week (among admittedly many) highlights the benefits of diversification from a few other key angles that touch more on the second point above. Consider:
- Dot.com crash – a diversified portfolio experienced 30% less total drawdown and took 41 LESS months to get back to even.
- 2008 Financial Crisis – a diversified portfolio experienced almost 20% less total drawdown and recovered 2 years more quickly.
As a side note, while any timeframe is arbitrary (including this one), it is worth noting how often a diversified portfolio hasn’t just performed well on a risk/adjusted basis, but on an absolute one relative to equities as well.
Summary
The importance of diversification is generally understood and widely given lip-service, but most don’t know how to correctly quantify its true value and/or importance to things such as addressing behavioral finance challenges or “sequence of returns” risk for retirees.
It’s just something advisors learn to parrot, and investors politely nod to.
My hope is the above shows you that “planning” and “diversifying” isn’t just for reducing risk but is a path to achieving solid returns regardless of market volatility and personal needs along the way.
Remember this isn’t just a theoretical game we are playing; it intersects in some very important and practical ways with your life.
When the market is “risk-on” as it has been certainly since last March, and arguably since 2008, diversifying sounds boring and counterproductive. History suggests otherwise, especially after similar runs in market history.
As they say, the time to buy insurance isn’t after the fire starts.
If you are wondering if you are properly diversified both in general, but also specifically for your goals and personal style reach out to us anytime.
Have a wonderful weekend,
Tim and the team at TEN Capital
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