October 26, 2018

Not the kind of words that most would happily accept coming out of the mouth of their financial advisor, but in my opinion, a reasonably honest assessment of what it takes to create an investment strategy. The last several weeks have seen major stock indices in the U.S. suffer double digit or near double digit losses across the board, finally catching up to the disappointing performance of many international indices year to date. As unpleasant as October 2018 has felt, thus far, I think this is a good opportunity to take some personal inventory and evaluate (or re-evaluate) your investment and financial plans. When it comes to investment strategies, there really is no free lunch, no painless path. The ultimate goal is to choose one that combines the best potential outcome for you with an amount of pain that you can tolerate at the worst times – pick your poison.

When it comes to portfolio management, the myriad ways you can manage a portfolio are far too numerous to go over in a several paragraph blog post (I just lost some of you). There are strategic asset allocation portfolios, tactical allocations, active and passive, growth, value, momentum and any combination of the aforementioned. No matter which you pick, there will always be the potential that a certain market environment will cause you pain regardless of the strategy. Asset allocation portfolios are typically geared towards an investor’s risk tolerance – choosing a mix of stocks and bonds, but also diversifying in a way that humbly attempts to reflect our inability to predict an unknowable future. Tactical management comes in all shapes and sizes, but in our office this type of management can increase or decrease risk in the portfolio in response to changing conditions with the ultimate goal of reducing the probability of large losses. Some take the humility inherent in strategic allocation and just passively allocate to a diversified portfolio, not making changes other than rebalancing to maintain such an allocation over time. None of these choices is better or worse, only different.

So if none of these is better or worse, why, you silently ask, do you bother utilizing all or so many of them? Wow, that’s a great question and just what I was hoping you’d ask. None of them are better or worse, but we feel that some fit individual clients better than others. An aggressive tactical portfolio that remains 100% invested in stocks at all times, but attempts to over or under-allocate to certain sectors and/or securities might be a great fit for a younger person or a speculator with no aversion to losses and a lengthy time frame, but it’s probably not good for grandma, so we have to have different options (apologies to all the gambling grandmas out there). Same is true for a tactical portfolio that attempts to mitigate losses – might be a really good fit for a retiree using their portfolio to generate income and with an extreme loss aversion, but disappointing to those who want to generate returns that generally follow or beat the market.

It goes beyond fit, though, because no matter how well-suited an investment strategy might be for a given client, they all have pain points and it’s the knowledge of when and how these may occur and what they look like that can help you to persevere when things don’t feel good. Take a passive allocation that diligently diversifies between stocks for an aggressive investor. Assuming you diversify based on market capitalization (oversimplified: how big a company is) and internationally (you own some US stocks and some stocks of overseas companies) there are a couple of things that will feel less than perfect. The first is obvious and that’s major market corrections that are accompanied by recessions and, at least in recent years, some of those have resulted losses in excess of 50%. That’s not all, though, it’s also more common than not that you’ll have part of your portfolio performing well and part of it lagging behind. In recent years that’s been the US outperforming international markets, but there are plenty of times in the past when the reverse has been true. If you invest this way, it’s important to understand that this is not unusual, we just don’t know when or how it may happen. If you can’t accept that reality, consider a different path.

For a tactical allocation, one that attempts to mitigate large losses, the pain point is usually that, in an attempt to mitigate risk, you’re frequently less fully invested during large market advances. Maybe the market is up 20% and you’re up 10%, or even 5%. That’s not unusual and while it is unpleasant, it’s a fact that you must accept if you want to live through the flip side, which is some semblance of loss mitigation during difficult markets. In recent years, this has proven even more difficult as the US stock market had been on what seemed like a never-ending march forward until the past few weeks. Most people like these types of strategies in theory, but you shouldn’t overestimate your will power – most humans will question the merits of such strategies when they see the market go up year after year while they trail those types of returns. We get a lot of questions about underperformance in up markets and when markets turn south, which they have always done eventually, we rarely get the reverse call when a client says, ‘we sure seem to be holding up pretty well, what’s going on’?

You could write these paragraphs forever, and I won’t, but the point is, every strategy has a pain point and if you don’t know what yours is, you’re unlikely to handle it well when it happens. Like the great philosopher Mike Tyson once said, ‘Everybody has a plan until they get punched in the mouth,’ and his wisdom rings as true in investing as it does in boxing. Furthermore, if your plan is to go to an advisor and say, I don’t want much, I just want to make about 10% per year and get out before the market crashes, prepare to be disappointed. While you’re at it, go to your boss and tell her, ‘I’m not asking for much, just a salary in the deep six figure range and a modest 26 weeks of vacation.’ Let me know how it goes.

One of the most common reasons that I see plans failing and clients moving from one advisor to the next or deciding to go it alone is that there’s a chasm that exists between expectations and reality. Sometimes this falls on the advisor for failing to prepare clients and sometimes it’s a reflection of unrealistic expectations on the part of the client, but I believe it’s all preventable. Whether you consider yourself a novice investor or relatively well-heeled, you should have an earnest conversation with your advisor about what type of investment strategy may work for you and what you should expect when things are going well or poorly, mostly when they’re going poorly. It’s a rare bird that questions a strategy that is outperforming expectations and a 99 percenter that loses faith in the opposite scenario. The truth isn’t always pleasant, but a painless/riskless investment strategy doesn't exist and if it did, would also probably be a returnless (that’s not a real word) one. Demand honesty from your advisor and then demand it from yourself when things get tough.

This is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.  Past performance does not guarantee future results.  Using diversification/asset allocation as part of your investment strategy does not guarantee a profit or protect against a loss.  Investing involves risk, including the potential for loss of principal. 10/18