When most investors think of diversification they generally see a portfolio spread among several asset classes. Owning some small caps, large caps, international, bonds, and sector specific funds, among others is a common strategy that will tend to smooth out performance over the long term and attempts to eliminate catastrophic losses to the portfolio. The core portfolio will usually last several years and most investors will rebalance their portfolios on a quarterly or annual basis to keep an allocation steady and current. The term for this is Strategic Asset Allocation (SAA) and is probably the most common approach used by investors today. We call it “Buy and Hold with some tweaking.”
Along with the growing sophistication of the markets and investors, some newer diversification strategies have begun to emerge. These strategies take into consideration a change in the investment process itself and often involve a more active strategy than the traditional SAA. These have become more prevalent since the Bear Market of 2000-2003 wreaked havoc on many portfolios.
Tactical Asset Allocation (TAA) involves shifting the SAA when the manager feels there is an opportunity to take advantage of. This does involve some market timing and adds more decision making to the manager and the associated risks of being wrong. A situation such as overweighting the energy sector for the last several years would be a tactical strategy. At some point reverting to the core allocation would occur when the opportunity appears to have run its course.
The next approach is Dynamic Asset Allocation (DAA). DAA involves a high level of market timing in attempting to determine the short-to-intermediate term direction of the market and/or sectors of the market. This strategy involves flexibility, vigilance, and a more nimble approach. A manager using this strategy may have spent most of the previously mentioned Bear Market in bonds as they behaved well due to the flight to quality that often occurs when stocks decline. One could have also attempted to short the stock indices or own inverse funds, which is a more aggressive approach.
You may have heard the phrase before “No one can time the market.” Many pooh-pooh DAA because of this belief. In reality anytime a security is bought or sold a form of market timing occurs. Selling a stock for a profit is indicating the investor thinks the market has now fairly valued – or even possibly over valued – the stock. So the sell decision does involve second-guessing the market and that is a form of market timing.
A couple of potential pitfalls of DAA is that the process is more labor intensive than SAA or TAA, along with the possibility of being wrong and underperforming the market. The advantages of DAA are the flexibility and the potential to outperform the market whether it moves up, down, or sideways. The rigidity of SAA and to some degree TAA does not generally allow for major changes in the portfolio unless a significant change in an investor’s risk makeup (not the market environment), such as retirement, occurs. Because of that most SAA and TAA investor portfolios tend to move in the general direction of the market.
It basically boils down to Econ 101, supply and demand. When demand is in control stocks move up, when supply is in control stocks move down. We review hundreds of charts daily looking for patterns that tend to repeat themselves. We have created a list of checks and balances that attempts to reduce exposure when the market appears uncooperative and increase exposure when stocks appear constructive. A critical premise with implementing DAA is summarized in the following quote “It is okay to be wrong, but it is not okay to stay wrong. A performance sheet is available upon request.
Most current investors learned stock market investing during the Bull Market of the eighties and nineties. We believe SAA became ingrained in many investors psyche then as the strategy is relatively easy to implement and was usually successful during that period. Wall Street promoted “Buy and Hold” as a mantra to their clients. Selling long term optimism worked for their business model, as a conversation about potential market problems made it more difficult to sell financial products. Stockbrokers during that period became more of asset accumulators rather than portfolio managers or stock jockeys as they were in the seventies and eighties.
With the near 50% correction in the S&P 500 from 2000-2002 and the markets’ recent issues, diversifying your portfolio with more nimble strategies began to make more sense. I think the current fundamental backdrop for the economy and the market could lead us to experience a Secular Bear Market, which have lasted as long as a couple of decades in the past.
Below is a chart of the Dow Industrials from 1960 to present. This chart portrays the last Secular Bear and Secular Bull Markets our country has experienced. From 1966 to 1982 you can see the Dow made virtually no progress. Buy-and-hold strategies during this period were subjected to this roller coaster and returns were generally low for many stock market portfolios. We believe we may be in for another similar bout of this type of extended trading range.
With the Secular Bull Market starting in late 1982, the Buy and Hold mantra began to develop. It truly got legs in the nineties as the market accelerated and the Crash of ‘87 appeared as just a speed bump. Many pundits claimed those who held for the long term are always rewarded. What they failed to disclose is that if you had planned to retire in the late sixties and were dependent on equity growth to fund at least a portion of your retirement, you may have had to go back to work!
Hiding from the Bear in CD’s and/or other fixed income vehicles may not provide enough of an inflation hedge for your portfolio. Even in a Secular Bear Market there can be significant rallies. During the past two Secular Bear Markets the stock market experienced several significant rallies, with three of them exceeding 90%. The only catch is that each rally fell way to a correction taking back most if not all of the entire gain. “Buy and Hold” did not work during these periods and if a person was in the beginning period of their retirement, the consequences could be substantial.
The truly frustrating thing about long-term trading ranges is that – if you’re lucky – you end up back at the same place you started after experiencing years of hair raising starts and stops. To make things even worse, many individual investors find themselves selling at the bottom (when things look the worst) and buying at the top (when they appear the best). Let me ask you a straightforward question: What if we are currently in a long-term trading range now? Do you have a plan in place to help navigate through it without ending back in the same place you started (or worse)?
The S&P 500 may have started a trading range of its own starting in 1997 (chart 2) and many investors have made little progress since the highs attained in 2000. Some pundits believe we may be headed back down to the bottom of the range within the next year. With the large contingent of Baby Boomers nearing retirement another significant market correction could create many Boomers working past their planned retirement date. Generally returns from SAA/TAA portfolios reflect the trend of the stock markets. Diversifying with at least a portion of your funds allocated to a DAA strategy could help if the markets behave similar to the thirties and the seventies.
So, what if the credit markets are contracting and headed for an extended, possibly generational convalescence period? Our feeling is that the potential for a Secular Bear Market has increased significantly in the last year due to this. If it does unfold and your portfolio is built for a Bull Market, it could certainly be hazardous to your wealth. Using a form of DAA as a diversification tool could add a new dimension to your investment management and perhaps enhance the returns in the overall performance of your portfolio. Due to the market volatility this decade has endured, we believe more and more investors will seek a non-traditional approach – such as DAA – toward achieving an effective, hands-on investment strategy.
We believe one of the precautions an investor can employ to prevent from becoming a casualty of the next severe correction is to ask their financial advisor a series of questions. Conveniently these are them:
1. Have you reviewed previous Bear Markets that have occurred domestically and globally?
2. Do we have a strategy that can take advantage if a Secular Bear Market unfolds?
4. Are there investments in my portfolio that are uncorrelated to US equity market?
5. Do we have access to investments that will profit if the stock market corrects significantly?
6. What was your strategy with your clients in 2001?
7. Is there a level of pullback in the major indices that will change your current strategy?
The moral of the story is that as markets and investors have become more sophisticated over the last couple of decades, strategies that reflect those shifts should be considered. We think that diversification can be accomplished through asset classes and through using multiple or varied strategies. With the volatile markets investors have been subjected to for the last ten years, one might be advised to consider strategy diversification in managing something as important as your financial future.
Final Thought
“History may not repeat itself, but it certainly does rhyme” – Mark Twain
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