I am sure that it goes without saying, but I will say it anyway: On so many fronts these are challenging times that we live in. But I would quickly add that they are also quite exciting, teeming with possibilities.
At the time of this writing (mid-August 2022), I just read that public pension funds and college endowments (some of the largest portfolios in the world) had their biggest losses since the financial crisis of ’08-’09. If your 401k is invested in what has been labeled a traditional portfolio (and most are), there is a good chance that it is in the tank as well. Key word here is traditional. You might have heard the same mantra from your broker over and over again: “Simply invest in a broadly diversified portfolio of various asset classes, i.e., stocks, bonds, and some alternative, occasionally rebalance to the chosen allocation, hang on for the long term, and you will be fine.” And you will be . . . until you aren’t. We have not seen market conditions like this one for more than 40 years. But they aren’t totally unprecedented.
I think it is unfortunate that over the past two and half decades, traditional asset allocation has become normative to most investors. It is an outgrowth of what is known as Modern Portfolio Theory and the Efficient Market Hypothesis. It is fine as far as it goes. I have often said it is not wrong, just incomplete. In other words, it is too simple for those of us who seek superior results. It is predicated on the principal that an investor should hold investment assets that are negatively correlated to each other, meaning that some will be going up while others are dropping. But what happens when the major asset classes all fall at the same time? That is what happened this spring to stocks and bonds. Those who thought they were protected by holding a higher percentage of bonds were surprised. We heard more than one person say, “But I thought bonds were safe.” Remember, as interest rates go up, bond values come down.
Some of us can remember 1981 when interest rates were 22%. That was the Paul Volcker era at the Fed. I doubt seriously that we will see rates that high ever again, but I’ve also learned never to say “never.” The big story about our present-day milieu has been the easy money policy of the Fed. We believe that while it may continue to raise short term rates, the Fed will remain biased toward stimulus, i.e., easy money. They do this in concert with the U.S. Treasury’s eager deficit-spend ing. The Fed works by adjusting rates and buying bonds. Economic stimulus results in lower rates and economic tightening in higher rates. Typically, the Fed’s mission has been met by simply controlling short-term rates. Over the years, I have often remarked that sooner or later everyone (including the Fed) will be reminded that it is the bond market that is truly in charge. I have had to reconsider that statement in the recent past as the Fed has become a major player in the bond market driving down interest rates on even the longest of long-term bonds and keeping them there for a protracted time frame.
Easy money results in more debt at almost all levels of borrowing. Worldwide debt to GDP has increased dramatically in the past few years. Just when we will reach a tipping point is anybody’s guess. But if/when we get there, rest assured it won’t be pretty.
So, what’s an investor to do? Let me explain where we have been and what we are doing now as we reach for excellence for all our clients.
Before Jerry Zimmerer and I merged our two practices in 2000, each of us pursued a quite traditional approach that embodied asset allocation. He added value by using a momentum style of investing, and there was a bias toward broad diversification using mutual funds invested in bonds, stocks (large and small, foreign and domestic), and real estate or precious metals but maintaining the allocation in an effort to control risk. We knew then, as we know now, that if two investors get the same average return but with different volatilities the one with less volatility will have more money at the end of the period. Asset allocation helped smooth the ride.
In the late ‘80s I subscribed to ChartBooks in my attempt to add value for our clients. Those were thick books of point-and-figure charts (one company’s stock per page) that were updated every month. I became what is known as a technical analyst. Only when a favorable price pattern was discovered by reviewing the charts, did I dig into the company to find what it did and what its financial statements could tell me. The charts can be instructive, but not ultimately determinative, in my opinion. Thankfully, the computer replaced the books, but I still get a kick out of reading the charts and finding value.
Fast forward to late 2007. I returned from a conference where I had heard Dr. Woody Brock tell us that we don’t have to be right in this investments business, but we must be “less wrong” than the crowd. He was introducing us to an entirely different way of thinking about and making investment decisions. It was predicated on the research of Dr. Mordecai Kurz at Stanford. From that work, our wealth preservation strategy was born in time to avoid the ’08 — ’09 market downturn. It combined the best elements of technical analysis, and its objective is to achieve a real rate of return above inflation that would enable an individual a better chance to achieve his or her goals.
The two strategies have worked independently through the years. Clients were steered into one strategy or the other depending on their goals, risk tolerance, risk capacity, and return need.
Recently, we made the discovery that the two strategies, momentum growth and wealth preservation, can work together to produce risk-adjusted returns that would not be achievable using either one alone. The allocation is not targeting a blend of asset classes as in traditional asset allocation, but it is a combination of the two strategies in measured proportions. More conservative investors get a bigger slice of wealth preservation and more aggressive types get more momentum growth. Of course, as always, the accomplishment of particular investment goals is dependent upon getting the risk posture set correctly, developing a sound portfolio, establishing a discipline, and rolling with the punches that the market inevitably throws at you.
Scott Neal is the president of D. Scott Neal, Inc., a fee-only fiduciary advisor with offices in Lexington and Louisville. Comments and questions can be emailed to scott@dsneal.com or call him at 1-800-344-9098.