August 23rd, 2013

Portfolio Management – Part 5: The Hidden Cost of Diversification As “Insurance”

Risk and Opportunity

 

In economics, risk is defined as volatility. Furthermore, one truth of economics is that high risk accompanies high return while low risk means lower return. Investment managers put us in a dilemma when they play on our fears by asking us to take the safe course by accepting low volatility and lower returns. They want to convince us to diversify away from the higher volatile and higher return of stocks by adding a large dose of lower volatility/lower return fixed income securities to our portfolios (the standard is a 60/40% mix). But what are the sorts of risks they warn us of? How likely are they to actually materialize?

Investor advisors essentially try to convince us that sometime in the future, they don’t know what or when, our portfolio could be significantly impaired sometime in the future if we don’t diversify to reduce its volatility, probably just when we need to liquidate some of the assets to provide funds for a specific large expenditure like tuition, a wedding, a 25th anniversary trip, extraordinary medical costs, job loss or retirement. They claim that the values of our portfolios are vulnerable to a wide range of real world risks, including:

  • Company risk from
    • financial or operating performance which, if the market perceives to be negative, adversely impacts the price of that company’s stock
    • technological risk
    • competitive risk
  • Industry risks including
    • government regulation
    • product or technological obsolescence,
    • international competition
  • Economic risk arising from
    • either governmental fiscal or monetary policy,
    • international events and
    • inflation risk
    • interest rate risk
    • exchange rate risk
  • Political risk

There’s no question that these sort of “risks” can actually happen; they happen all the time but how significant is that risk? For the time being, let’s put aside individual stock risks and focus instead on risks that influence most stocks, the economic or political risks that are characterized as “systemic” risks. No one knows what, how or when these sorts of risks will become real events but, when they do, their impacts are huge and affect nearly every single stock. As a matter of fact, in today’s global investment climate, they impact most investment vehicles both domestic and foreign stocks and bonds. There’s usually no place to hide, no safe haven. These risks often manifest themselves as stock market crashes.

For example, the recent Financial Crisis Crash significantly damaged real estate values, cut stock prices in half and even brought down international stock markets. Because of the fear of financial collapse and corporate failures, the value of all debt with the exception of US debt was also adversely impacted (until the Fed stepped in with their Quantitative Easing program that drove debt values higher and interest rates down).

Since the stock market suffered two major crashes in the past decade, investors are especially loathe to invest in stocks. Investment managers play on these fears and push such strategies as the “Ultimate Buy-and-Hold Strategy” as a panacea. But how unusual were the events of the past decade and how likely is it that they and other risks will occur over the long-run future? Should any of these risks materialize, what sort of impact might they have on the stock market and a stock price volatility? Putting individual companies risks aside for the moment and instead focusing exclusively on systemic, total market risk, we find that the probability of significant stock market declines (i.e., declines of more than 15% in a year) are actually quite rare:

Risk Dimensions

There have been 894 months over the past 75 years since 1939 when, during that period, the market suffered monthly declines 41% of the time however in 57%, or more than half, those declines were less than 2%. In fact, during any single month, almost none of those declines were more than 10%.

What happens when the holding period is extended to a year? During the 882 rolling, sequential 12-month periods, 70% ended in a gain; 12 month loss occurred in less than 30% of the cases. In fact, many of those declines were bunched together in short time periods since they occurred during extended market crashes. In the 30% of cases when there was a loss at the end of 12 months, the losses were less than 10% more than half the time. The market increased fairly regularly over the past 75 years and the increases have been substantial:

Profit Opportunities

The market closed higher in 70% of the 12-month periods since 1939 and in almost half of those instances the gains were 10% or more; in a third of those periods, the gain was 15% or more. Among the nearly 900, shorter 2-month holding periods, the market advanced 62% of the time and nearly half of those gains were 2% or more.
One way of interpreting the trade-off presented by the market In the very short-run (i.e., each and every single month):

  • hold stocks for a month for a near 60% likelihood of capital growth with a 35-40% probability that the growth would be 2% or more and
  • a 30% likelihood of a capital loss that has a 57% probability of being less than 2%.

For two months is succession, clearly enough time for someone to evaluate the market’s longer-term risk and adjust a portfolio’s exposure to that risk the market, a typical trade-off is:

  • hold stocks for two month for nearly a 62% likelihood of capital growth with a nearly 50% probability that the growth would be 2% or more and
  • a 37% likelihood of a capital loss that has a 44% probability of being less than 2%.

The past 75 years probably cover nearly every possible type of macroeconomic, technological and geopolitical event and the above statistics summarize the stock market’s reaction to them all. Could the future introduce anything more dramatic than these and could the stock market’s behavior in the future be much different? I think not. These statistics cover all sorts of market conditions including:

  • World War II, Korean, Viet Nam, Iraq and Afghanistan and the first attach on U.S. soil,
  • two secular bear markets (the 1970′s and the 2000′s), crashes (Tech Bubble of 2000-2003 and Financial Crisis of 2007-2009)
  • 17-year bull markets (post war 1949-1966 and 1962-2000)
  • technological upheavals with the beginning of space age, biotechnology, PC’s and the introduction of the Internet into everyday life
  • major geopolitical events like the fall of Soviet Union
  • global economic crisis including the 20-year Japanese economic winter, Federal budget and debt ceiling crisis and the launch and near collapse of the Euro
  • presidential assassinations, resignations and near impeachments
  • natural disasters including hurricanes, earthquakes and tsunamis
  • market flash crashes and the largest single day stock market loss of 22.6% on October 19, 1987

Even though they say they are looking out for you personally, the typical investment manager has many clients and protects you through a cookie-cutter, one size fits all approach. You don’t want your manager to be a passive manager but instead an active one continually reacting to ever changing environments.  Instead of paying your investment advisor fees to continually anticipate extreme yet relatively infrequent market declines, expect them to navigate around major declines when and if they happen. You should expect them both to protect your portfolio and to earn returns greater than could be earned by owning an index fund.

During the next parts of this series, I’ll discuss my approach that’s less costly than the “insurance premium” by intentionally foregoing profit opportunities (higher volatility); that approach is to incrementally, in part or totally, move to the sidelines when volatility increases in the wake of bear markets and crashes.

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  • http://www.prop-trading.com/ Torey Thompson

    For run-of-the-mill cookie cutter approaches,
    does one really need to hire an investment manager? As you say, a good
    investment manager would help you work around sudden and huge declines in the
    market- should such a thing happen- and keep our portfolio safe. Excellent
    post, Joe.

    • http://www.stocktipsnetwork.com/ Jamie

      Torey you are right. That is why professional fund manager are high in demand. Portfolio balancing is more of a science than art. Professional Fund Manager uses mathematical model to ensure that there is no emotional bias in the decision making process.