October 4, 2016
The Top 10 Reasons Investors Need Active Management
The Investment View from Prescott, Arizona
A few years ago my friend Jerry Wagner founded a magazine called the ProActive Adviser. A recent article featured there by Linda Ferentchak cited the Top 10 Reasons Investors Need Active Management in Retirement.
1. The traditional age-adjusted portfolio isn’t working
Traditional asset allocation maintains that as individuals age and approach retirement, their investment portfolios need to reduce exposure to high-risk assets and focus on capital preservation through investments such as more conservative bonds. A typical portfolio recommendation for an investor over the age of 65 might look like this:
Based on the Barclays U.S. Aggregate Bond Index, this pegs the majority of the portfolio at approximately a 2.2% annual yield. Reduce these yields for taxes and the erosion of purchasing power caused by inflation, and bonds are actually slipping in value. The equity and real estate portions of the portfolio have to provide unrealistic outperformance to offset the weakness of such a bond-heavy portfolio.
2. Bond risk is greatly underestimated
There can be no guarantee that a high bond allocation will preserve the value of the portfolio. Bonds face many of the same risks as equity investments, including the financial health of the issuer—default risk—and substantial market risk as interest rates rise from historic lows.
3. Traditional age-adjusted portfolios lack an inflation hedge
Inflation has been remarkably mild in recent years, but there is no guarantee it will continue at its current 1% rate. The U.S. money supply has increased dramatically since the 2008 credit crisis, far outpacing economic growth. By increasing the money supply, the Federal Reserve is trying to increase inflation. At some point they will get their wish and the bond portion of a portfolio will get hammered as inflation goes up and bond prices go down.
4. Correlations break down in severe market declines
Traditional diversification is based upon the premise that bond values and stock prices are uncorrelated—they move in opposing directions. When stocks decline, bonds should increase in value, stabilizing the overall value of a diversified portfolio. Studies have shown that in recent times of market uncertainty, these relationships tend to break down with higher-risk bonds most vulnerable to losses. In the 2007–2009 market decline, almost all asset classes moved down together. This means that traditional diversification just had investors losing money in more categories.
5. Retirees need equities for higher returns, but may not have time to recover from a severe bear market
Buy-and-hold investment approaches rely on the market’s long-term upward bias to recover from a bear market. But the recovery is neither guaranteed nor predictable. A new bear market begins every 5.5 years, on average, and it takes close to five years for most major market indexes to recover to prior highs. If you need income within 5 years you may be forced into selling low, the opposite of what the great American investment creed suggests doing.
6. Active management offers more effective risk management than a bond-centric approach
Passive portfolio management is an investment strategy that works great in rising markets, but it can be a disaster in falling markets. A key tenet of active management is the use of more than one investment strategy. Adjusting portfolios to various market conditions by diversifying among investment strategies reduces risk just as diversifying among individual investments does, adding a third dimension of diversification. Investors wanting to reduce risk can do it with active management.
7. Active management doesn’t have to be perfect to work
The common criticism of active management is the statement that no one has ever been able to perfectly predict market movements. But most active managers don’t predict, they simply react to what is, and in doing so reduce the risk of being on the wrong side of a market trend for very long. And, active management doesn’t have to be perfect to work. The reason is the mathematics of gains and losses. It doesn’t take a 37% gain to recover from a 37% loss. It takes a 59% gain. Reduce the size of the loss and an investor can more easily make gains.
8. There’s more than one way to actively manage a portfolio
Active management encompasses a wide spectrum of investment strategies and approaches. The right approach is the one that makes the investor the most comfortable while their money is at work. Often that means a diverse blend of strategies and asset classes.
9. Active management accommodates behavioral finance biases
In weak markets or strong ones, people tend to approach investing in predictable—although not necessarily logical—ways. These reactions tend to be counterproductive to long-term portfolio growth, and it is well-documented how individual investors have historically underperformed broad market indexes when left to their own emotion-driven decisions. Active management adds discipline through professional money management, resulting in the increased peace of mind so important to retirees
10. Market bubbles are inevitable
Exploiting their opportunity and limiting their damage requires active management. When it comes to pursuing exceptional portfolio gains, there’s nothing better than a good market bubble for making big gains. But what goes up inevitably comes down and wise investors are prepared for that eventuality. One of the best quotes on that topic comes from Warren Buffet, who said “It’s when the tide goes out that you can see who has been swimming naked.” Active management is a tool for participating in a “bubble” while always keeping one eye on the exit.
Conclusion
Combining capital preservation with the opportunity for capital appreciation is what most investors really want. While no investor or investment management style can predict the future, flexibility to respond to opportunity may be the most valuable part of an investment plan. Active management can provide that opportunity.
What the Markets Are doing
World stock markets, including the US markets, surged in late June and early July after the “Brexit” vote when Britain decided to leave the European Union. Just like it’s hard for a sprinter to run another race right after they have just completed one, it’s hard for a market to mount a new up leg right on top of an old one. And that is exactly what we saw in the markets during the quarter ending September 30th.
Market exhaustion post-Brexit, combined with seasonal weakness had most markets flat for the quarter.
The Vanguard Total Market Bond Fund (VBMFX) gained a measly .2% during the quarter. Gold dropped .66%. 7-10 Year Treasuries (IEF) dropped .53%. The S&P 500 Index**, after the post Brexit sigh of relief, is down .2% since July 20th.
Even the stock market volatility during September, a key bell-weather of trouble coming in the markets, was pretty minor, probably thanks to European and Japanese central banks pouring money into the world economies like our Fed did a couple of years ago.
All in all the markets made for a rather boring 3rd quarter, but given September’s reputation for declines, boring is good.
However, October has often provided nasty market declines in the past, so this is still not a time for investors to be complacent.
The End of an Era
For the past few years my son, Matt, has been playing drums with the Wes Williams Band, a group that seemed to be going places. A couple of times a month I would go to watch him play at places like the State Fair, Frontier Days Street Dance, PV Days, etc. It was great fun and with his degree in performance art, watching my son practicing his craft brought me a sense of pride.
I was briefly disappointed when he told me he had decided to quit the band because he was tired of touring. The July tour was 12 days through Texas, Louisiana, Oklahoma and New Mexico, but several weekends a month they would be in Utah or California, Flag or Phoenix.
Matt now has two children, Mal age 5 and Caleb age 2, and he wants to be here with them rather than being on the road all the time. Although I am disappointed that I won’t get to hear him play, I now have another source of pride for my son – that he made a really grown-up choice.
There will always be another band, but only one time that his kids are growing up. And life moves on . . .
College Classes Coming
Managing an Inheritance: Planning It, Getting It, and Keeping It
October 19th, 1:00 – 3:00 pm
If you plan to be on either the giving or receiving end of an inheritance from a parent or other loved one, planning is crucial if you hope to preserve the gift, save on taxes and avoid family squabbles. This two-hour discussion will guide you through the heart of complex issues, both emotional and financial, that families face during the three phases of inheriting: planning an inheritance, receiving it, and making your life better because of it. Topics include: documents you may need, dealing with disability, the use of trusts, basic estate planning principals and protecting your assets. Call Yavapai College at 717-7755 to enroll in course # FA16-142. Tuition is $45.
What’s Going on in Your Portfolio?
Just as the markets were relatively flat in the 3rd quarter, there were no big moves in our model portfolios.
Shock Absorber Growth portfolios were down a little over 1% for the quarter and Flexible Income portfolios were up 2.2% for the same period. Adaptive Growth and Adaptive Balance portfolios, being a blend of Shock Absorber Growth and Flexible Income were flat for the quarter, as was our Municipal Income portfolio.
Mental Floss
What do you see here?
Do you see the word ‘LIFT’?
Or, a bunch of black splotches ?
What We Were Saying Back Then
More on China
I recently saw a report on strong growth in Chinese industrial production, which ought to be good news since weakness in the Chinese economy had been holding the world back over the past couple of years.
In this instance, the good news may be bad news. The gains were in steel, concrete, coal, and electricity, all factors of production for infrastructure. It appears that the Chinese are still encouraging local governments to erect buildings and other projects to keep the boom going. China already has batches of empty neighborhoods and even “see through” cities and certainly doesn’t need any more.
Increased bond offerings by local Chinese governments support this theory, as provinces borrow to fund these projects. They’re borrowing what they can’t repay to build what they don’t need. This won’t end well.
But at least it keeps the populace working.
Ready for A Review?
I try to not bug you about matters that you have asked me to take care of, but it is important that we occasionally review your circumstances and investment portfolio to ensure that you understand what I am doing for you, that you are comfortable with my work, and the strategies I am employing on your behalf are still appropriate for your life circumstances.
If you would like to see the details on a strategy or review anything else about your portfolio, please call the office to arrange a time to talk, either in person or on the phone. The number is 928.778.4000
Our Spotlight Strategy – Flexible Income
With our Flexible Income Strategy we strive to provide high total return consistent with Capital Preservation.
Your money will be invested in bond mutual funds and exchange traded funds (ETFs), including inverse and leveraged funds, currency funds, including precious metals that may be used as currencies, and equity-income investments whose price trend is up. If the price cycles down, holdings are replaced with new investments that are going up, repeating as needed. Growth stocks are not used.
Click here to read more about Flexible Income.
