Bucket Portfolio Stress Test

September 4, 2013

I’ve long been a fan of portfolio buckets or sleeves, for two reasons.  The first reason is that it facilitates good diversification, which I define as diversification by volatility, by asset class, and by strategy.  (We happen to like relative strength as one of these primary strategies, but there are several offsetting strategies that might make sense.)  A bucket portfolio makes this kind of diversification easy to implement.

The second benefit is largely psychological—but not to be underestimated.  Investors with bucket portfolios had better performance in real life during the financial crisis because they didn’t panic.  While the lack of panic is a psychological benefit, the performance benefit was very real.

Another champion of bucketed portfolios is Christine Benz at Morningstar.  She recently wrote a series of article in which she stress-tested bucketed portfolios, first through the 2007-2012 period (one big bear market) and then through the 2000-2012 period (two bear markets).  She describes her methodology for rebalancing and the results.

If you have any interest in portfolio construction for actual living, breathing human beings who are prone to all kinds of cognitive biases and emotional volatility, these articles are mandatory reading.  Better yet for fans of portfolio sleeves, the results kept clients afloat.  I’ve included the links below.  (Some may require a free Morningstar registration to read.)

Article:  A Bucket Portfolio Stress Test  http://news.morningstar.com/articlenet/article.aspx?id=605387&part=1

Article:  We Put the Bucket System Through Additional Stress Tests  http://news.morningstar.com/articlenet/article.aspx?id=607086

Article:  We Put the Bucket System Through a Longer Stress Test  http://news.morningstar.com/articlenet/article.aspx?id=608619

 

 

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Correlation and Expected Returns

July 31, 2013

Modern portfolio theory imagines that you can construct an optimal portfolio, especially if you can find investments that are uncorrelated.  There’s a problem from the correlation standpoint, though.  As James Picerno of The Capital Spectator points out, correlations are rising:

A new study from the Bank of International Settlements (BIS) raises doubts about the value of commodities as a tool for enhancing portfolio diversification. The paper’s smoking gun, so to speak, is that “the correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis.”

Correlations are a key factor in the design and management of asset allocation, but they’re not the only factor. And even if we can find assets and strategies with reliably low/negative correlations with, say, equities, that alone isn’t enough, as I discussed last week. You also need to consider other factors, starting with expected return. It may be tempting to focus on one pair of assets and consider how the trailing correlation stacks up today. But that’s hardly the last word on making intelligent decisions on how to build a diversified portfolio.

As more investors pile into commodities, REITs, hedge funds, and other formerly obscure corners, the historical diversification benefits will likely fade. Granted, the outlook for expected diversification benefits fluctuates through time, and so what looks unattractive today may look considerably more compelling tomorrow (and vice versa). But as a general proposition, it’s reasonable to assume that correlations generally will inch closer to 1.0. That doesn’t mean that diversifying across asset classes is destined to become worthless, but the expected payoff is likely to dim with the passage of time.

Mathematically, any two items that are not 100% correlated will reduce volatility when combined.  But that doesn’t necessarily mean it’s a good addition to your portfolio—or that modern portfolio theory is a very good way to construct a portfolio.  (We will set aside for now the MPT idea that volatility is necessarily a bad thing.)  The article includes a nice graphic, reproduced below, that shows how highly correlated many asset classes are with the US market, especially if you keep in mind that these are 36-month rolling correlations.  Many asset classes may not reduce portfolio volatility much at all.

Source: The Capital Spectator  (click on image to enlarge)

As Mr. Picerno points out, optimal allocations are far more sensitive to returns than to correlations or volatility.  So even if you find a wonderfully uncorrelated investment, if it has a lousy return it may not help the overall portfolio much.  It would reduce volatility, but quite possibly at a big cost to overall returns.  The biggest determinant of your returns, of course, is what assets you actually hold and when.  The author puts this a slightly different way:

Your investment results also rely heavily on how and when you rebalance the mix.

Indeed they do.  If you hold equities when they are doing well and switch to other assets when equities tail off, your returns will be quite different than an investor holding a static mix.  And your returns will be way different than a scared investor that holds cash when stocks or other assets are doing well.

In other words, the return of your asset mix is what impacts your performance, not correlations or volatility.  This seems obvious, but in the fog of equations about optimal portfolio construction, this simple fact is often overlooked.  Since momentum (relative strength) is generally one of the best-performing and most reliable return factors, that’s what we use to drive our global tactical allocation process.  The idea is to own asset classes as long as they are strong—and to replace them with a stronger asset class when they begin to weaken.  In this context, diversification can be useful for reducing volatility, if you are comfortable with the potential reduction in return that it might entail.  (We  generally advocate diversifying by volatility, by asset class, and by strategy, although the specific portfolio mix might change with the preference of the individual investor.)  If volatility is well-tolerated, maybe the only issue is trying to generate the strongest returns.

Portfolio construction can’t really be reduced to some “optimal” set of tradeoffs.  It’s complicated because correlations change over time, and because investor preferences between return and volatility are in constant flux.  There is nothing stable about the portfolio construction process because none of the variables can be definitively known; it’s always an educated approximation.  Every investor gets to decide—on an ongoing basis—what is truly important: returns (real money you can spend) or volatility (potential emotional turmoil).  I always figure I can afford Maalox with the extra returns, but you can easily see why portfolio management is overwhelming to so many individual investors.  It can be torture.

Portfolio reality, with all of its messy approximations, bears little resemblance to the seeming exactitude of Modern Portfolio Theory.

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401k Abuse

January 18, 2013

With the elimination of traditional pensions in many workplaces, Americans are left to their own devices with their 401k plan.  For many of them, it’s not going so well.  Beyond the often-poor investment decisions that are made, many investors are also raiding the retirement kittyBusiness Insider explains:

Dipping into your 401(k) plan is tantamount to journeying into the future, mugging your 65-year-old self, and then booking it back to present day life.

And still, it turns out one in four workers resorts to taking out 401(k)  loans each year, according to a new report by HelloWallet –– to the tune of $70 billion, nationally.

To put that in perspective, consider how much workers contribute to retirement plans on average: $175 billion per year. That means people put money in only to take out nearly half that contribution later.

That’s not good.  Saving for retirement is hard enough without stealing your own retirement money.  Congress made you an investor whether you like it or not—now you need to figure out how to make the best of it.

Here are a couple of simple guidelines:

  • save 15% of your income for your entire working career.
  • if you can max out your 401k, do it.
  • diversify your portfolio intelligently, by volatility, asset class, and strategy.
  • resist all of the temptations to mess with your perfectly reasonable plan.
  • if you can’t discipline yourself, for heaven’s sake get help.

I know—easier said than done.  But still, if you can manage it, you’ll have a big headstart on a good retirement.  Your 401k is too important to abuse.

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Durable Portfolio Construction

November 14, 2012

Durable portfolio construction comes from diversification, but diversification can mean a lot of different things.  Most investors, unfortunately, give portfolio construction very little thought.  As a result, their portfolios are not durable.  In fact, they tend to come unglued during every downturn.  Why does that happen?

I think there are a couple of inter-related problems.

  • Volatility tends to increase during downturns
  • Certain correlations tend to increase during declines

Volatility is an artifact of uncertainty.  Once a downturn starts, no one is sure where the bottom is.  That uncertainty often creates selling, which may cause the market to decline, which in turn may create more selling.  We’ve all seen this happen.  Eventually there is capitulation and the market bottoms, but it can be quite frightening in the middle of the move when no one knows where the bottom will be.

Research Affiliates had a recent article on diversification, and included in it was a table that showed the change in volatility that accompanied recessions.  The bump is typically pretty large.

Source: Research Affiliates, via RealClearMarkets  (click to enlarge image)

In general, riskier assets had the biggest jumps in volatility when the economy was under pressure.  Thus, it makes perfect sense how a relatively sedate portfolio under typical conditions becomes much more volatile when conditions are tough.

Correlations are also observed to rise during declines.  “Risk on” assets, especially, often have rising correlations among themselves as risk is shunned.  Similarly, “risk off” assets may see their internal correlations rise.  However, it may be the case that correlations between dissimilar asset classes don’t change nearly as much.  In other words, risk-on and risk-off assets might not have rising correlations during a period of market stress.  In fact, it wouldn’t be surprising to see those correlations actually fall.  So, one way to make portfolios more durable is to diversify by volatility.

There are probably multiple ways to do this.  You could use volatility buckets for low-volatility assets like bonds and high-volatility assets like stocks.  Or, you could just make sure that your portfolios have exposure to a broad range of asset classes, including asset classes with different responses to market stress.

Within an individual asset class, you are likely to see rising correlations between members of your investment universe.  For example, during a sharp market decline, you’re likely to see increasing correlations among stocks.  However, it’s possible to think about diversifying by return factor within an asset class.

AQR and others have shown, for example, that the excess returns of value and relative strength stocks are uncorrelated.  That means that years where relative strength outperforms the market are likely to be years when value lags, and vice versa.  Both types of stocks might go up in a rising market or fall in a declining market, but they will likely have different performance profiles.  Diversifying by using complementary strategies is another way to make portfolios more durable.

As Research Affiliates points out, simple diversification is not a panacea.  As their table shows, almost every asset class (possible exception: short-term bonds) has higher volatility in a bad economy.

Durable portfolio construction, then, might consist of multiple forms of diversification:

  • diversification by volatility
  • diversification by asset class
  • diversification by strategy

While there might be rising correlations between some types of assets, you are also likely to see falling correlations between others.  Although the entire portfolio might have an elevated level of volatility, an absence of surging cross-correlations might make tail events a little more manageable.  Good portfolio construction obviously won’t eliminate market risk, but it might make regular market volatility a little more palatable for a broad range of investors.

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Net Wealth Shock and Portfolio Diversification

October 19, 2012

Professor Amir Sufi (University of Chicago Booth School of Business) is an interesting researcher.  He recently tweeted a picture of what he called “net wealth shock” to show how the recession had affected various families.  It’s reproduced below, but in effect, it shows that low and median net worth families have had a large negative impact from the recession while high net worth families have been impacted much less.  I think portfolio diversification has everything to do with it.

The Effect of Buying One Stock on Margin

Source: Amir Sufi    (click on image to enlarge)

For clues to why this happened, consider an earlier paper that Dr. Sufi co-wrote on household balance sheets.  I’ve linked to the entire paper here (you should read it for insight into very clever experimental design), but here’s the front end of the abstract:

The large accumulation of household debt prior to the recession in combination with the decline in house prices has been the primary explanation for the onset, severity, and length of the subsequent consumption collapse.

Later in the paper, he reiterates that it is the combination of these two things that is deadly.

The household balance sheet shock in high leverage counties came from two sources: high ex ante debt levels and a large decline in house prices. One natural question to ask is: could the decline in house prices alone explain the collapse in consumption in these areas?

Our answer to this question is a definitive no–it was the combination of house price declines and high debt levels that drove the consumption decline.

And he and his co-authors, through clever data analysis, proceed to explain why they believe that to be the case.

Now consider what this is saying from a portfolio management point of view: why was the impact of falling home prices so devastating to low and median net worth households?

The negative impact came primarily from lack of diversification.  Low and median net worth households had essentially one stock on margin.  I know people don’t think they are buying their house on margin, but the net effect of a home loan—magnifying gains and losses—is the same.  When that stock (their house) went south, their net worth went right along with it.

High net worth households were simply better diversified.  It’s not that their houses didn’t decline in value also; it’s just that their house was not their only asset.  In addition, they were less leveraged.

There are probably a couple of things to take away from this.

  • Diversify broadly.  It’s no fun to have everything in one asset when things go wrong, whether it’s your house or Enron stock in your pension plan.
  • Debt kills.  Having a single asset that nosedives is bad, but having it on margin is disastrous.  There’s no room for error with leverage—and no way to wait things out.

Perhaps high net worth families are more diversified simply because they have greater wealth.  Maybe they took the same path as everyone else and just got lucky not to have a recession in the middle of their journey.  However, I think it’s also worth contemplating the converse: maybe those families achieved greater wealth because they diversified more broadly and opted to use less leverage.

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Complementary Strategies: One Key to Diversification

October 18, 2012

We use relative strength (known as “momentum” to academics) in our investment process.  We’ve written extensively how complementary strategies like low volatility and value can be used alongside relative strength in a portfolio.  S&P is now on board the train, as they show in this research paper how alternative beta strategies are often negatively correlated.  In fact, here’s the correlation matrix from the paper:

Source: Standard & Poors  (click to enlarge image)

You can see that relative strength/momentum is negatively correlated with both value and low volatility.  This is why we prefer diversification through complementary strategies.

They conclude:

…combining alternative beta strategies that are driven by distinct sets of risk factors may help to reduce the active risk and improve the information ratio.

Diversification is important for portfolios, but it’s not easily achieved.  For example, if you decide to segment the market by style box rather than by return factors, you will find that the style boxes are all fairly correlated.  Although it’s a mathematical truism that anything that isn’t 100% correlated will help diversification, diversification is far more efficient when correlations are low or negative.

We think using factor returns to identify complementary strategies is one of the more effective keys to diversification.

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Reaching for Yield

October 5, 2012

More money has been lost reaching for yield than at the point of a gun—Raymond Devoe

According to a recent article in the Wall Street Journal, desperate investors are reaching for yield, this time in the high-yield bond market.  The less-polite name for these securities is junk bonds.  Why do investors love them so?  Well, they pay out fat yields—but, of course, they come with commensurate risks.  And there are already warning signs in the market.

So much money has flooded into the junk-bond market from yield-hungry investors that weaker and weaker companies are able to sell bonds [they say]. Credit ratings of many borrowers are lower and debt levels are higher, making defaults more likely. And with yields near record lows, they add, investors aren’t being compensated for that risk.

Also worrying money managers is that some new sales have similar hallmarks to those that preceded the financial crisis in 2008. Petco Animal Supplies Inc. and Emergency Medical Services Corp. recently offered to sell bonds that let them pay interest in the form of more bonds, instead of cash, a common provision before the crisis.

Skeptics note that now weaker companies are the ones borrowing. The portion of new bonds sold by high-yield companies with credit ratings of double-B and above shrank last month to 20% from an average of 30% for the year.

After three years of financial improvement, high-yield companies are now weakening by some measures. Total debt for all high-yield companies rose 7.2% in the 12 months through June—the largest rise since 2008—while cash on their balance sheet fell 2.3%, according to research by Morgan Stanley. S&P downgraded 45% more companies than it upgraded in 2012, reversing the trend of 2010 and 2011. And companies are offering investors fewer protections than usual.

Now, this is just supply and demand at work.  Investors want yield and companies are happy to oblige them, especially if they are willing to buy really junky securities.

The problem is that, from time to time, investors forget that investing is about total return, not just yield.  An 8% yield with a 20% capital loss still puts you in the hole.  Likewise, buying a stock that appreciates 20% but that does not pay a dividend still puts you way ahead of the game.  When you go to the store to buy groceries, the store owner does not care if the money comes from labor, dividends, interest, or capital gains.

Money is money, however you make it.  You’re probably better off—and safer—with a healthy total return from a well-diversified portfolio than you are reaching for yield.

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Target-Date Fund-mageddon

September 26, 2012

Markets are rarely tractable, which is one reason why significant flexibility is required over an investment lifespan.  Flexibility is something that target-date funds don’t have much of.  In fact, target-date funds have a glidepath toward a fixed allocation at a specified time.  I’ve written about the problems with target-date funds extensively—and why I think balanced funds are a much better QDIA (Qualified Default Investment Alternative).  It appears that my concerns were justified, now that Rob Arnott at Research Affiliates has put some numbers to it.  According to an article in Smart Money on target-date funds:

A target-date fund is a one-decision mutual fund that you can invest in over the course of your entire career.

Each fund is designed for those aiming to retire at a certain date. The fund starts with a lot of “risky” stocks, and over time it moves to “safer” bonds. The fundamental idea is that at any given moment between age 21 and age 65 you should be invested in a particular balance of assets — more stocks when you are younger, and more bonds when you are older.

The track to retirement, according to the industry jargon, is a “glidepath.”

Billions of dollars are invested in these target-date funds. They are today the default investment option in many 401(k) plans. Now comes Rob Arnott, the chairman of Research Affiliates and one of the handful of serious money managers in the country. In a new research paper he published yesterday, “The Glidepath Illusion,” he has blown this idea full of holes. “Shockingly,” he says, “the basic premise upon which these billions [of dollars] are invested is flawed.”

When Mr. Arnott investigated the results of such target-date funds, he found them to be incredibly variable—and possibly upside-down.  (I put the fun part in bold.)

Arnott has mined data from the stock and bond markets going back to 1871 and then run simulations to see how these target-date portfolios would have worked in practice. He considered a fund that started out with 80% stocks and 20% bonds, and then adjusted gradually over an investing life of 41 years so that it ended up 80% bonds and 20% stocks. He considered an investor who invested $1,000 a year, adjusted for inflation, from the day she started work at age 22 to when she retired at 63.

Bottom line? This investor could have done very well — or very badly. Far from enjoying a smooth “glidepath” to a secure retirement, she could have retired with as little as $50,000 in savings or as much as $211,000. She could have ended up with a retirement annuity of $2,400 a year — or $13,100 a year. There was no way of knowing in advance.

That wasn’t all. Arnott found that in most eras, investors would have actually been better off if they had stood this target-date strategy on its head — in other words, if they had started out with 80% bonds, and then took on more risk as they got older, so that they ended up with 80% stocks.

No kidding. Really.

The median person following the target date strategy ended up with $120,000 in savings. The median person who did the opposite, Arnott’s team found, ended up with $148,000. The minimum outcome from doing the opposite was better. The maximum outcome of doing the opposite was also better.

Amazing.  Even the minimum outcome from going opposite the glidepath was better!  Using even a static 50/50 balanced fund was also better.  Perhaps this will dissuade a client or two from piling into bonds only because they are older.  No doubt path dependence had something to do with the way returns laid out, but it’s clear that age-based asset allocation is a cropper.

Asset allocation, diversification, and strategy selection are important.  Decision of this magnitude need to be made consciously, not put on autopilot.

[You can read Mr. Arnott’s full article here.  Given that most 401k investors are unfortunately using target-date funds instead of balanced funds, this is a must read.  I would modestly suggest the Arrow DWA Balanced Fund as a possible alternative!]

Click here to visit ArrowFunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

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More on the Value of a Financial Advisor

September 5, 2012

I noticed an article the other day in Financial Advisor magazine that discussed a study that was completed by Schwab Retirement Plan Services.  The main thrust of the study was how more employers were encouraging 401k plan participation.  More employers are providing matching funds, for example, and many employers have instituted automatic enrollment and automatic savings increases.  These are all important, as we’ve discussed chronic under-saving here for a long time.  All of these things together can go a long way toward a client’s successful retirement.

What really jumped out at me, though, was the following nugget buried in the text:

Schwab data also indicates that employees who use independent professional advice services inside their 401(k) plan have tended to save twice as much, were better diversified and stuck to their long-term plan, even in the most volatile market environments.

Wow!  That really speaks to the value of a good professional advisor!  It hits all of the bases for retirement success.

  • boost your savings rate,
  • construct a portfolio that is appropriately diversified by asset class and strategy, and
  • stay the course.

If investors were easily able to do this on their own, there wouldn’t be any difference between self-directed accounts and accounts associated with a professional advisor.  But there is a big difference—and it points out what a positive impact a good advisor can have on clients’ financial outcomes.

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The Risks of the “Pay-Day” Approach to Retirement Planning

August 30, 2012

One of the primary reasons that we hold small business owners in such high regard in this country is our admiration for their courage.  It takes real courage to strike out on your own and to invest in yourself and your own idea.  I saw this numerous times with my father while I was growing up.  He succeeded as a small business owner of Chevron gas stations and of a community bank.  He has no shortage of confidence in his ability to succeed by working harder and smarter than the competition.  Investing in himself has paid off nicely over time.

However, this inclination to invest in yourself runs some risks.  As detailed in the WSJ article “The Economy Stole My Retirement,” many small business owners have spent decades reinvesting their profits in their businesses—some entirely at the expense of diversifying into other investments.  The plan was to sell their business for a big pay day as they approached retirement.  Then came the Great Recession.

Baby boomers, in many cases, were blindsided by the recession and its effect on their retirement plans, says George Vozikis, director of the Institute for Family Business at California State University in Fresno.

“Boomer entrepreneurs grew up believing in the American dream that you could start a business and eventually sell it for a good return or pass it onto your kids,” adds Aaron Chatterji, associate professor at Duke University’s Fuqua School of Business in Durham, N.C. “Because of the financial crisis and subsequent recession, that is more difficult today.”

Many small business owners are insulted and shocked to find that they can sell their businesses for just a fraction of what they could have prior to the economic malaise of recent years.  Their options are fairly limited at this point; they can keep working and wait it out or they can sell at the discounted prices and adjust to the realities of a more modest retirement.

One piece of advice that my father followed throughout his life, and he instilled in me from an early age, is to save 15% of every dollar you ever earn.  The result of this practice is accumulating sizable financial assets in addition to ownership of the small business.  Following that advice increases the odds of an enjoyable retirement and reduces the stress surrounding the one-time pay day approach to retirement planning.

Source: CNN Money

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The Purpose of Financial Advice

June 13, 2012

This little piece from The Economist takes the position that it is silly to pay for financial advice, as even experts cannot predict what the markets will do.  While the article is completely right about the forecasting abilities of experts, skipping financial advice is crazy.

The true function of financial advice is not based on guessing what the market will do over the next month, quarter, or year.

Several studies show that investors with advisors do better than investors without—and it’s not because they have advisors who can predict the market.  What good can an advisor do?  Here is a partial list of important benefits to having a good financial advisor.

  • Behavior modification.  Most investing problems are, in truth, caused by investor behavior.  Switching and/or abandoning strategies when they are temporarily out of favor tops the list of no-no’s.  There is voluminous research showing that clients are terrible at managing their own behavior.  Any advisor than can improve a client’s staying power is worth the fee.  An advisor that can persuade a client to add money when a strategy is out of favor, when returns have been poor, or when markets have been exceptionally volatile should get an award.  Maybe even be knighted.  Behavior modification is really difficult, but it can have an enormous positive impact on returns.  An advisor who has worse behavior than the client should be flogged with a wet noodle.
  • Portfolio construction.  Asset allocation is an important first step, but a skillful advisor will move right along to combining strategies or return factors that have low correlations.  A great advisor will do a great job creating real diversification in a portfolio.
  • Accountability.  You know how you are more likely to go to your exercise session if you have a trainer or a buddy?  It’s not just because you’ve paid for it or because you’ve put it on your calendar—it’s because you are accountable to another person.  A good financial advisor makes you accountable for all of those things that you would otherwise procrastinate about, like that IRA beneficiary paperwork or that account contribution you’ve been meaning to send in.  We all have good intentions, but it’s pretty easy to blow things off if there is no one to hold us accountable.  A good advisor helps you do the things you know you need to do.

It goes without saying that an advisor that is not doing any of these things is not adding a lot of value.  If all you’re getting is a generic pie chart allocation and a few good jokes, well, it might be time to look around again.

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Pre-Determined Plans For Drawdowns

June 7, 2012

Fact: The S&P 500 has had an annualized return of 9.41% since 1928*.

Fact: That didn’t come without a few bumps (and some serious crashes) along the way…as illustrated by the following data showing maximum S&P 500 intra-year declines.

Among the many observations that can be made from this data is that drawdowns are part of the game.  Drawdowns are best handled when there is a pre-determined plan for how they are going to be managed.  Some may choose to take no action and just ride them out. Others will choose to take certain defensive action when drawdowns reach a specified magnitude. Others will seek to address these drawdowns in the context of a broadly diversified portfolio.  There are a number of ways that will ultimately work.   However, what probably won’t work is to haphazardly react based on your gut feelings—those that do will likely find that they would have just been better off to stick to CDs (5-year CDs currently yielding 1.47%**).

Data shown with permission from The Leuthold Group. *12/31/1927 – 5/31/2012 **Source: Bankrate.com

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From the Archives: Inflation Rears Its Ugly Head

May 25, 2012

Howard Marks is chairman of Oaktree Capital, a large and well-known institutional alternative fixed income manager.  Mr. Marks’s memos are always thoughtful and worth reading.  This go round he has a discussion of all of the things that could go wrong with the world economy—essentially a list of all of the things that could go wrong.  One of the things that could go wrong is inflation.

He believes rates are more likely to go higher than lower, and that inflation, long forgotten as a risk factor, might return.  In addition, he has a list of suggestions on how to deal with inflation including TIPs, floating rate debt, gold, real assets like commodities, oil, and real estate, and foreign currencies.  His catalog of alternatives is even longer, but you get the idea.  (If you want to read the whole memo, you can find it here.)

That’s quite a list, but the first thing that I noticed about it is that not one of these items is generally considered as an investment option by retail investors.  Most investors are mentally stuck in the domestic stocks/domestic bonds arena.  Diversification consists of hitting more than one Morningstar style box.  If inflation does come back, that’s not going to cut it.  In fact, Mr. Marks asks investors, “How much of your portfolio are you willing to devote to protect against these macro forces?”  He says if the answer is 5%, or 10%, or 15% that those levels are pretty close to doing nothing.  He thinks a portfolio will need to devote at least 30-40% of assets toward inflation protection if it recurs.

Investment flexibility and risk diversification were the primary reasons that we launched the Systematic RS Global Macro account as a retail product last year.  Many of the inflation hedges in Mr. Marks’ list are asset classes that are available in the Global Macro portfolio, including TIPs, gold, commodities, oil, real estate, and foreign currencies.  Given our basket rotation strategy and our adherence to relative strength, the Global Macro portfolio could easily have 40% of its assets, or more, in inflation hedges if inflation were to recur.  I think the jury is still out about how the world economy will respond to decreased levels of fiscal stimulus, but it’s good to know that you have options.

—-this article originally appeared 1/25/2010.  We have not seen runaway inflation so far, but the point Howard Marks makes is valid.  If/when inflation does occur, you might need to devote a lot of your portfolio to inflation protection.  Is your investment process up for the challenge?

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