Asset Allocation

One of the most pervasive – and in our view dangerous – misconceptions about risk is that investors should allocate significant amounts of portfolio capital to non-equity holdings, such as bonds and gold. Traditional asset allocation strategies of the kind favored by most investment professionals may create a sense of comfort, but feeling safe comes at a very high price; holding lots of bonds, cash, gold, and other non-equity assets is nearly certain to cause serious damage to returns over time while doing little to reduce long-term risk.

The bottom line is that, over long periods of time, stocks have outperformed every other asset class, and history has demonstrated conclusively that it is unwise to reduce stocks except in the most extreme (and infrequent) situations. Unless one wishes to substitute pure conjecture for the hard data of market returns over the past century, the conclusion is inescapable: among all asset classes, stocks are by far the best choice for investors seeking to maximize long-term, after-inflation returns.

This does not, however, mean that an investor should simply buy and hold index funds. Index funds and exchange trade funds (ETFs) are terrific tools, and we certainly favor an approach that uses these low-cost, well-diversified equity funds rather than picking individual stocks - an exceedingly difficult and time-consuming task for even the most experienced investors… and also one of the least important when it comes to long-term returns. But portfolio tools are not a substitute for portfolio strategy – as with any tool, serious damage can occur if used improperly.

For starters, one the best features of index funds and ETFs – the ability to buy a diversified basket of stocks with just a few clicks of the mouse – is also one of their worst features: they are far too easy to sell. This is a problem because the overwhelming majority of self-described long-term investors are in reality closet market timers; they misuse index funds by shoveling larger and larger amounts of cash into them near market tops, only to hit the sell button in frustration near market bottoms. Our most important job at Financia Capital is to help our clients resist these perfectly understandable behavioral impulses and do everything we can to keep them on the right side of the market.

Another problem is that index funds are less diversified than people think – funds that track the S&P 500, for example, are in reality “big-cap growth” funds, and the sectors that have been hottest the longest (and are thus most likely to revert to the mean) will tend to make up a larger percentage of the fund over time due to past relative strength. There is a time in every market cycle to own lots of big-cap growth, but there is also a time to favor other styles, and that is where Financia Capital’s portfolio strategy adds real value.

Finally, a passive approach to investing cannot protect against the devastating impact of big declines. One bear market is all it takes to wipe out as much as half of a portfolio’s long-term gains, and the math of losses is perverse – e.g., a 50% decline requires a gain of 100% just to get back to break-even, something that can take a decade (or more) to accomplish. Those unlucky enough to see such a loss early in their retirement years may never recover, and an important part of our portfolio strategy is protecting our clients’ hard-earned money during severe bear markets.

Avoiding the worst losses in a bear market is crucial to preserving long-term gains, but it is not necessary – nor desirable – to try to get the timing perfect. The most damage almost always occurs in the second half of the decline, and, after the bear ends, the strongest gains are concentrated in the first half of the new bull market. Hence, the best strategy is to adopt a defensive stance a few months after a bear market has started (it is almost impossible to distinguish a real long-term top from a short correction without analyzing investor behavior and price action following the initial decline) and to get back in a few weeks before it ends (so as not to risk missing the very strong gains of the young bull market). Our goal is not to make money in every market environment, but rather to avoid losing capital in a calendar year in which stocks decline.

Specific tactics used by Financia Capital during a bear market may include writing covered calls (an options strategy that acts like an insurance policy for existing holdings), switching into inverse index funds and inverse ETFs (instruments that rise when the market falls, and vice-versa), buying selected fixed-income investments (such as Treasury notes and bills, GNMAs, and CDs), or even just holding cash until there is sufficient evidence that the bear market is bottoming out.

For clients who are approaching retirement or are already living off of investment income, Financia Capital will combine our core equity holdings with selected fixed income securities to create an income-generating balanced portfolio. However, as we have already mentioned, holding lots of bonds and other non-equity assets creates a false sense of security and is nearly certain to cause serious damage to long-term returns. And unlike retirees of generations past, most individuals in their 50s and 60s today can expect to live another twenty or thirty years… or more! Given such a long retirement time frame, the biggest risk a retiree faces is outliving his or her money, something that is much more likely to happen with a bond portfolio than with a stock portfolio. For this reason, we encourage even our retired clients to maximize equity exposure and hold just enough fixed-income investments to provide adequate cash-flow visibility for peace of mind.

Contact us today to set up a free review of your current portfolio holdings and to discuss how we can work with you to reach your investment objectives.