Upgrading Your Asset Allocation In 2007(ZT)

"A complacent satisfaction with present knowledge is the chief bar to the pursuit of knowledge"

B.H. Liddell Hart (1895-1970)

As mentioned in last week's article, False Diversification May Prove Costly In 2007, long bull markets often cause us forget about the benefits of true asset class diversification. To illustrate the concept of false diversification, we studied a hypothetical portfolio made up of 12 different mutual funds and ETFs, which declined by 42.49% during the last bear market in U.S. stocks (2000-2002). Considering the S&P 500 declined by 46.34% in the same period, our hypothetical growth investor did not have a truly diversified portfolio due to positive investment and asset class correlations. This article will attempt to take the first step towards building a portfolio and an ongoing management strategy tp provide a realistic opportunity to be profitable during both bull and bear markets in U.S. stocks.

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Building A Truly Diversified Portfolio
Understanding Asset Class Correlations

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If one of your primary objectives is to produce positive investment returns while having a low probability of incurring losses in a reasonable time frame, you must first understand how different asset classes behave in different economic and financial market environments. For the purpose of this writing, the terms economic contraction, economic slowdown, recession, and bear market are used to describe periods of economic weakness, which have resulted in prolonged periods of declining stock prices. The terms economic expansion and bull market refer to periods where the economy is healthy and stock prices are moving higher.

The portfolio management strategy described here attempts to minimize exposure to investment portfolio losses during bear markets in U.S. stocks. Figure 13 below illustrates how different asset classes performed during the last bear market in U.S. stocks. The S&P 500 began a period of significant declines in late August of 2000. As the U.S. stock market began to anticipate an economic recovery, the S&P bottomed on October 7, 2002. The asset classes in Figure 13 are shown in their order of performance during the period. Gold stocks were the biggest winners and U.S. small cap stocks had the worst performance during the period. The data in Figure 13 is taken from the actual performance of specific investments within each asset class. For example, the returns for gold stocks below are those of a widely held gold stock mutual fund. Figure 13 shows returns with dividends being reinvested. Dividend reinvestment explains why the Vanguard 500 Index Fund slightly outperformed the S&P 500 Index. Using the data below, we know that it may be prudent to reduce exposure to holdings in emerging market stocks and small cap stocks when the economy is entering what may be a prolonged period of slowing economic growth.

Figure 13

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Identifying All Weather Investments

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Since we are attempting to build portfolios that can be profitable in both bull and bear markets, it makes sense to identify asset classes that were able to produce positive returns in both environments. These all weather investments can serve as the core of any well-diversified investment portfolio, which seeks to minimize the probability of investment losses. Within the context of the studied portfolio management strategy, the all weather investments are used as core building blocks to create a model economic contraction portfolio and a model economic expansion portfolio. Every asset class (represented by a single proxy investment) in Figure 14 below was able to produce positive returns during the entire full market cycle, but more importantly, they were able to produce positive returns from August of 2000 to October of 2002 when the S&P 500 (shown in red) was in a serious bear market.

Figure 14

Investors can use ETFs, such as GSG, IEF, TLT, DVY, GLD, and SLV to gain access to a variety of asset classes.

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Historical Performance vs. The Real World

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Obviously, the next bear market and subsequent bull market in U.S. stocks will be different from the most recent cycles. The strategy we are building was developed with a respect for Mark Twain's way of looking at history: he stated,

"The past does not repeat itself, but it rhymes."

The future will not be exactly the same as the past, but there will be meaningful similarities. This strategy is based primarily on how asset classes, not individual stocks, performed under different economic and market conditions. This should make the results more relevant than if we studied how Microsoft's stock performed under the same conditions since individual stocks can be influenced by company specific outcomes (earnings disappointments, fraud, credit ratings, analyst recommendations, etc).

A common criticism of any study of historical asset class correlations is to point out that none of us know which asset classes will be the winners in the future. While that criticism does hold water, many of the asset class correlations presented here should remain relevant in future economic cycles. For example, the odds are extremely high that bonds will be more desirable in an environment where the Federal Reserve is lowering interest rates (the Federal Funds Rate). Conversely, in the future, the odds are good that bonds will be less attractive under conditions where the Federal Reserve is raising interest rates. The odds are also reasonable that commodities will be more attractive in periods of economic expansion and they will be less attractive in periods of economic contraction.

A multiple asset class approach to investing is an excellent way to prepare for the fact that none of us know which asset classes will be the winners in the future. By having exposure to low or negatively correlated asset classes, an investor will, in theory, always have some winners in their portfolio. A prudent investor can then decide if he or she wants to increase their exposure to the winning asset class in the early stages of a bull run. If we use gold as an example, an investor who had a small exposure to gold (even as low as 1%) would have been one of the first to notice and profit from the gains in early 2001. As a result, they could have made small incremental increases in the position as it continued to be profitable. On the other hand, a one or two asset class investor, using primarily stocks and bonds, may not even have heard about gold's big move until it had already gone from under $300 to over $500. Having multiple asset classes in your portfolio, even in small amounts, enables you to be early to many of the investment parties. It also helps you keep an open mind about where to allocate your assets. It is human nature to defend the asset classes that are in your portfolio and dismiss the ones that are not. How many people told themselves "gold is not a good investment" as it moved higher while they remained on the sidelines. For those of you that did not have gold on your radar, the trailing five-year average annual return for precious metals funds is 35.08%. That sounds like a pretty good investment to me when the objective is to make money.

The beauty of this strategy is that it can also help you cut back weakening positions. As a multiple asset class investor, I am happy to peel off some profits in profitable assets classes during periods of weakness, like gold in May of 2006, and redeploy the money to an asset class that may be more attractive. Using this approach, I don't really care which asset classes are making money. My goal is to ride the long-term winners and cut back on the long-term losers based on all the fundamental and technical information that is available. Imagine the results if you had used this approach to help you slowly shift away from technology stocks in 2000 towards a larger position in commodities. In over simplified terms, you would have slowly decreased your exposure to tech stocks because they were going down and slowly increased your exposure to commodities because they were going up.

A multiple asset class investor must also be open to adding new asset classes to the portfolio from time-to-time based on changing market conditions and trends. For example, gold might not have been in a multiple asset class portfolio in the late 1990s due to its poor performance from 1988 to 2001. A student of the markets would have seen gold moving up in the asset class rankings in 2001 and 2002. Under this strategy, gold would have been at least considered and monitored as a possible new addition to a multiple asset class portfolio. Similarly, technology stocks would have been in the mix in the 1990s. As prices of tech stocks fell and the fundamental outlook was less than encouraging, an investor may have dropped them from the portfolio. Flexibility and an open mind are important elements to successful implementation of any investment strategy.

Is multiple asset class investing the cure for all your investment worries? We all know that no such cure exists. However, research shows that there may be a better way to build a portfolio of investments that offers real diversification and an opportunity for improved returns. In an effort to better prepare for 2007 and beyond, I recently conducted some extensive research on the potential benefits of investing in a wide array of asset classes, including some with low or negative correlations to U.S. stocks. Since the study, Protecting Your Wealth From Inflation And Investment Losses, is rather lengthy, I will continue to summarize what the historical numbers tell us in future articles. While there are several ways to successfully approach the investment markets, I feel we can all gain some advantage from reviewing how different asset classes performed in both bull and bear markets. As time permits, I will continue to expand on these topics in the coming weeks.