Advisor Blog

"Did your portfolio return 117% over the past 10 years?  Ours did..."  That's the subject line in the email that was sent to investors by Morningstar.  It's obviously designed to grab your attention and if you have even a vague idea of the return that the S&P 500 generated over that time period, it probably worked.

According to Morningstar, "The past 10 years have been, well, complicated (to say the least).  From a long, brutal recession and fitful recovery to markets driven by fear and uncertainty, it has been a real test of any investor's mettle... which makes the simplicity and success of our strategy all the sweeter... for our flagship newsletter, Morningstar StockInvestor." 

Morningstar goes on to explain that their "tortoise portfolio" returned 123.2% and their "hare portfolio" returned 109.7% for a combined 116.5% as compared to 42.8% for the S&P 500 over the time period of 6/18/2001 through 4/1/2012.  That's actually closer to 11 years than 10 years, but I suppose that wouldn't sound as good.  If we advertised our performance in this manner, we would be in violation of SEC rules.  But, since Morningstar isn't a Registered Investment Advisor, they aren't held to the same standards.  Ignoring this, though, the performance sounds impressive - particularly when compared to the S&P 500.  But, how much risk did the portfolio take to generate this return?  We don't know because there isn't a shred of data about risk included in the advertising - no measure of beta or standard deviation anywhere.  No information about risk-adjusted return (Sharpe ratio, Treynor ratio, etc) to be found.  To call this incomplete would be a charitable description.

OK, ignoring risk (like Morningstar did), what about the return?  The numbers certainly sound good.  So, let's compare it to something we know like, oh, say - the Talis 100 portfolio, our globally diversified equity portfolio built with DFA funds.  We can't quite match the odd time period that Morningstar chose (starting 6/18/2001), but we can look at both 6/1/2001 and 7/1/2001 through 4/1/2012 - close enough.  And those numbers (adjusted for the fund expense ratios and the highest advisory fee that we charge and subject to important disclosures found here) are 145.2% and 144.4%, respectively.  I think it's fair to say that's a significantly better result.  So, how much risk did we take to get there?  Unlike Morningstar, you can visit our website and compare the standard deviation of any of our portfolio models to appropriate benchmarks.

We frequently explain to clients that all investment portfolio designs are based on a set of tradeoffs.  Brad Steiman, Vice President at DFA, in his Northern Exposure article series does very good job of explaining one of the considerations in portfolio design in the following article.

Many aspects of life require careful consideration and balancing of the tradeoffs that arise from competing demands. For example, a common lifestyle tradeoff is working longer hours versus spending more time with your family. The competing demands within this decision are the income necessary to provide a suitable quality of life for your family versus the immeasurable benefits of quality time with your family. There is no right answer, but most people understand the tradeoff and attempt to find the balance that is right for them.

Successful investing and financial planning also require balancing tradeoffs. For example, a common investment tradeoff is that of risk and return. One of the competing demands is preservation of capital versus preservation of purchasing power. The former may allow for a better night's sleep during periods of heightened uncertainty and corresponding volatility, but the latter helps ensure you'll have a comfortable bed in the future when accounting for rising prices from inflation. Once again, there is no right answer, no "optimal" solution. Understanding the tradeoffs between preserving capital and preserving purchasing power will help investors find the balance that is right for them. This balance will depend on their definition of risk and attitude towards it.

According to a research report published by Vanguard, recent stock market volatility is not unexpected when compared to previous time periods of significant macroeconomic events.

"Although the stock market volatility... appears extraordinary relative to the calm of the last year, [data] demonstrates that the levels of market variations today are, in fact, "ordinary" relative to the volatility of other periods characterized by major gobal macro events." state authors Francis M. Kinniry Jr., CFA, Todd Schlanger and Christopher B. Philips, CFA.

From July 1992 to August 2011, the S&P 500 Index moved an average of 0.7% per day.  The daily volatility spiked - or doubled - to 1.46% when significant global events occurred.  "As a result, we would argue that... volatility in equities, although high and painful to many investors, was not unexpected, given the market environment and the widespread repricing of risk.  Thus, in Vanguard's view, to cast the current environment as a 'new paradigm' of volatility is misleading."

The Vanguard report found that from August 5 (the day that S&P downgraded US Treasury debt, kicking off this period of volatility) to August 30, the S&P 500 Index moved an average of 2.5% per day.  We examined the September and October time period and found that the average daily volatility was 1.6% and 1.5% respectively.  It is not unusual for volatility to spike and slowly decay (statistically, it is serially autocorrelated). 

In 2008, we saw 23 days when the S&P 500 moved more than 4%.  This level of volatility occurred for seven days in 2009, no days in 2010, and has occurred six times, so far, in 2011.  Movement of 1% happened on 129 days in 2008, 108 days in 2009, 67 days in 2010, and 59 days in 2011 to date.

The Vanguard report looked at the volatility of two hypothetical balanced stock/bond portfolios - an 80% S&P 500/20% Barclays Aggregate Bond and a 40% S&P 500/60% Barclays Aggregate Bond.  As expected, in 2008 and 2011, the S&P 500 experienced "markedly more volatility than the two more conservative portfolios." and concluded that investors with balanced, diversified portfolios have faced much less aggregate volatility than the headlines would suggest.  We concur.

Finally, the authors note that "realized volatility is a critical factor in the equity risk premium (ERP), or the extra return demanded by investors for investing in stocks instead of less risky assets such as bonds or cash" and that "periods of heightened volatility or risk can actually increase the forward ERP."  This is, of course, consistent with the message that risk and return in capital markets are inevitably related.

The book entitled “The Quest For Alpha” by Larry E. Swedroe presents comprehensive evidence documenting the futility of active portfolio management by examining the quest for money managers that are capable of delivering alpha¹.  Swedroe references academic studies on mutual funds, pension plans, hedge funds, private equity/venture capital, individual investors, and behavioral finance.  He demonstrates that markets are indeed highly efficient and makes the ultimate conclusion that the only winning move is not to play the game.  Girolamo Cardana who was a sixteenth-century physician, mathematician, and quintessential Renaissance man made the same conclusion for gambling (which is quite similar to active management) when he said “The greatest advantage from gambling comes from not playing at all.”

Referenced in the book, Philip E. Tetlock, a professor of psychology, business and political science at the University of California (Berkeley) found that the so-called experts who make prediction their business – appearing as experts on television and talk radio, being quoted in the press, etc. – are no better than the proverbial chimps throwing darts.  His research indicates that it makes no difference whether forecasters are PhDs, economists, political scientists, journalists, or historians; whether they had policy experience or access to classified information; or whether they had logged many or few years of experience in their chosen line of work.  The only predictor of accuracy was fame, which was negatively correlated with accuracy.  The most famous made the worst forecasts.  All of these so-called experts seem to fall victim to hindsight and/or confirmation bias.

I strongly encourage you to read the book for the deeper discussions and supporting research that examines the dismal results of active management in its multiple forms.

1. If an asset's return is even higher than the risk adjusted return, that asset is said to have "positive alpha" or "abnormal returns". Investors are constantly seeking investments that have higher alpha.

Our portfolio model performance has been updated through June 30, 2011.  To view it, click here, read the disclosure, scroll to the bottom of the page, and click on the accept button.  The update shows model performance net of fund expenses and advisory fees for 1, 5, 10, and 20 year periods and for annual time periods.  It also shows 20 year standard deviation results for each portfolio.  Standard deviation is a common measure of portfolio risk as measured by the variability of portfolio return.

As a comparison, we show the results of benchmark indices, including the S&P 500, MSCI World ex-US, MSCI World Small Cap, MSCI World Value, Intermediate Bond, and 3 month US Treasury Bills.

The recent spate of bad economic news seems to have caused a sudden reversal in the average investor's appetite for risk.  Fund flows into bond mutual funds have returned to the same levels that we saw last year.  According to The Economist, "in the week ending on May 18th bond funds collectively recorded their largest inflows since late October 2010".

A couple of months ago, I was constantly hearing from people that were worried about their bond portfolios and the effect of rising interest rates, usually in response to something that they had heard on CNBC or read in the financial media.  Two things are pretty clear.  First, most investors don't really understand the relationship between bond prices and yields or what makes a bond portfolio more or less sensitive to interest rate changes.  Second, most investors don't understand the right way to use bonds in constructing a portfolio.

Bond prices and bond fund share values decline as interest rates rise.  This inverse relationship is easy to understand.  Think of it this way.  If you own a bond that pays an interest rate of x and there is a new bond issued with similar credit and term characteristics that pays an interest rate of more than x, then who would pay the same price for the bond you own that pays a lower interest rate?  The price of the bond has to be discounted to a point that the buyer would realize the same return as the newly issued bond.  Thus, the price of existing bonds falls as interest rates rise.  But, by how much?  The sensitivity of the existing bonds, or bond portfolio, to interest rates is determined by the duration (technically, the "modified duration") of the bond or portfolio.  Duration is a calculated number and it is based on many factors, but the most important is the remaining time (number of coupon payments) until maturity.  Lower duration bond or bond funds are less sensitive to interest rate changes.

As duration increases, so does the volatility of a fixed income position or portfolio.  At some point, it approaches the same level of volatility that we observe in equity portfolios.  But, and this is an important point, without the same rate of return.  So, chasing yield in the bond allocation of a balanced portfolio does two bad things - it increases risk and increases correlation with equities.  There is a good chart on page 27 of the Talis Investment Philosophy presentation that illustrates this concept. 

Credit quality also matters.  During the equity market meltdown in 2008, we saw many portfolios designed by competitors that contained allocations to high yield (aka "junk") bonds that had suffered almost as much as equities.  All the while, our fixed income portfolio was delivering positive returns, offsetting losses in equities exactly as it was designed to do. 

So, the lesson is pretty simple.  Short-term and high credit quality fixed income does a good job of dampening the volatility of a portfolio and allowing risk to be taken in asset classes with more efficient return characteristics.  How much risk is appropriate in the fixed income allocation and how it's managed are subjects for a future article.  And, what about the "bond bubble" that now seems to be forgotten with the recent round of lackluster economic news?  No doubt, most investors will be worrying about it again at some point in the future. 

It is axiomatic in the world of financial economics that, in capital markets, risk and return are always related.  In fact, you will often hear that in order to create a portfolio with a higher expected rate of return, one must take additional risk.  One of my friends, who is also a client, recently told me that this seemingly obvious statement is very confusing to a lot of people.  He asked me how this could be true when a comparing a poorly diversified portfolio with a well diversified one.  And, he has a point.

The statement assumes that idiosyncratic risk in the portfolio has already been diversified away.  After that, adding to expected return requires taking more market risk.  Understanding the difference between indiosyncratic (or non-systematic) risk and market (or systematic) risk is critical to understanding this concept.  And, unless you've taken some finance courses or you're a portfolio manager (not a product salesman at a brokerage firm), you may not fully understand this.

Idiosycnratic, or non-systematic risk is risk that can be diversified away in a portfolio.  This is risk associated with individual assets.  An example would be company risk associated with an individual stock position (think Enron, for example).  If you hold just a few stocks in your portfolio, this is very signficant.  If you hold a few thousand stocks, it is so insignificant that it's close to zero.  It has been "diversified away".  The Capital Asset Pricing Model (CAPM) for which Sharpe won the Nobel Prize tells us that investors are not compensated for taking diversifiable (idiosyncratic or non-systematic) risk.  In other words, investors are only compensated for bearing market risk.

Market risk is risk that cannot be diversified away.  Rational investors eliminate all diversifiable risk for which they should not expect to be compensated.  Now, we can examine the statement that higher expected returns require taking additional risk.  The assumption is that diversifiable risk has been taken out of the equation.  Thus, tilting a portfolio toward riskier asset classes like small cap or value stocks increases the expected rate of return.  Likewise, adding less risky assets such as bonds, to the portfolio will reduce the expected rate of return.  Of course, this also reduces the overall risk in the portfolio and is used to adjust the level of portfolio risk to a level that is suitable for a client's risk tolerance, capacity, and time horizon.

The concept is better explained by the statement that, in a properly diversified portfolio, additional expected return can only be achieved by taking additional market risk.