One of the most frustrating investment markets is a flat market like the one we are in currently. The news cycle is full of both bears and bulls and everybody is espousing strategies and predictions with the confidence only a fool can muster. One week it sounds like Europe is falling apart and the next we are talking about the surprising strength of American employment. Returns are paltry or negative and the instinct to do something begins to creep in. However, this is the moment to stick to your long-term investment principles in order to avoid missing out on future returns.
Diversified, Strategic, and Cautious
Goldman Sachs recently came out with an article on their three portfolio construction principles that I have borrowed from and will expand on in this article. Those three principles are as follows:
One of the key tenants to modern portfolio construction is that of diversification. This is not a strategy that suggests that we should give up and spread our investments around because we don’t know any better. Instead, this is a research-intensive analysis of how asset classes work together to optimize a portfolio that matches your goals and investment horizon. Correlation, volatility and return expectations play a crucial role in determining the balance of asset classes that you should invest in. Too often investors find themselves overweighting what has done well lately. Many investors have abandoned emerging and international stocks and replaced them with only US large cap exposure lately. US large caps have only been in the top five asset classes twice in the last 15 years (’13 and ’14) and have actually been in the bottom five performers six times over the same time period (see Exhibit 1 below).
Take a look at the chart below and follow any asset class. The pattern is pretty much random and on average 3 or 4 asset classes are negative per year. Trying to guess which asset class is going to outperform is incredibly difficult. About a third were negative over any given ten year period over the last 15 years. What is important to remember is that even though we went through two painful recessions during this time period, not a single asset class was negative over the full 15 years. The only way to have negative returns is to move around and mistime the cycles.
What is striking from this chart is how extreme the divergence of returns are every single year. The average performance gap between the highest and lowest performing asset class is 53% per year. The gap has been as large as 80% and never smaller than 30%. In over half of the periods (8 of 15), an asset class has produced double-digit losses. This gives credence to extreme caution in deviating from your planned asset allocation. Remember that losses are much more powerful in investing than gains. If your portfolio loses 20% it will take a 25% increase to just break even. If your portfolio loses 50% it will take a 100% gain to break even. The steeper the drop, the more difficult the recovery especially if you are drawing on the portfolio.
Ultimately investing can be an extreme test of patience and willpower. All investors feel the tug of overreacting to an extended time period of low returns and it will only get worse if the markets turn sharply negative. The truly great investors have shown a dogged patience when it comes to managing their portfolios. Pursuing the greatest value within each of the different asset classes is one of the few time-tested strategies that has led to outsized returns over any long-term cycle.
(click to enlarge)
"The Benefits of Asset Allocation." Goldman Sachs Asset Management. 2015. Retrieved from: https://assetmanagement.gs.com/content/dam/gsam/pdfs/us/en/investor-resources/general-education/benefits-of-allocation.pdf.