Only when the tide goes out do you discover who’s been swimming naked.”
Warren Buffett
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Warren Buffett is known for offering his investors these words of wisdom on more than one occasion. He intended to remind investors that everyone can look like a genius in a bull market, but undisciplined investing can leave you vulnerable during market downturns. Understanding and managing your risk is our number one job. Protecting against changing regimes and worst-case scenarios while providing exposure to growth is quite the balancing act. Still, financial science has proven that we can do it.
Fortunately, financial science has evolved to assist with diminishing risk. Still, not all financial advisors know the tools or do not use them due to their business model. Independent fee-only advisors have the freedom to lean on science, but if they are not CFAs or Ph. D.s in investments are often unaware of recent portfolio theory development or how to apply it. While the investment profession continues to argue whether the 60/40 portfolio – a mix of 60% stocks and 40% bonds, is dead, financial science has long passed this archaic asset allocation mix.
While no one is happy to see their portfolios lose value, our All-Weather strategy designed with cutting-edge statistical tools takes full advantage of risk diversification. It is a risk-balanced asset class portfolio that provides equity-like returns with far less risk and stabilizes returns throughout changing market environments. This is not a new strategy, as some people have suggested.
We have been using financial science to create robust portfolios that can weather any market condition with our average model reflecting a 33/33/33 split for at least twenty years. While our portfolios still hold stocks and bonds, they also have asset classes that negatively or negatively correlate with stocks and bonds. Many call these asset classes alternatives; we prefer to call them enhancers since their presence results in more efficient portfolios – less risk with any given level of return. The following is an example of an actual client portfolio. In this case, we held some cash for a particular cash need.
In the traditional 60/40 model, the purpose was to diversify across stocks and bonds and minimize overall portfolio risk. Many traditional models limit the holdings to Large Cap Domestic Stock and Corporate Bond Funds, missing out on adequate diversification within the growth and stability categories. Yet, more importantly, this strategy does not include alternative assets (always publicly traded, please) which hold unique sources of risk that are less or negatively correlated with stocks and bonds, creating a more substantial diversifying effect. It is all about diversification, extending into how we invest in “Growth” assets, specifically, Large-Cap stock. One way to get diversification is to select equally weighted (or revenue-weighted) ETFs over the standard market-cap-weighted SPY ETF. Since stock’s representation in a market-cap-weighted index is according to their size, larger companies disproportionately influence the asset class’s performance. Capital weighting (or cap weighting) uses a company’s market price and the number of outstanding shares to determine the percentage weighting of the company’s inclusion in the index. The larger the components, the more significant the company will be weighted (allocated) in the portfolio. The index tracks the stock market more closely, but it is overweighed by the largest mega-companies, especially Microsoft, Apple, Amazon, Alphabet, Tesla, Nvidia, Netflix, and Meta Platforms. These companies alone have contributed to half of the decline in the S&P. Instead, equal weighting distributes the same pro-rated investment amount into each company stock. Regardless of their capital size, all companies will thus be represented equally in the index.
Below is an example of index weighting (market-cap and equal-weighted) used to create an index that is comprised of four companies:
Professionals should create portfolios to meet each investor’s unique goals. Many have relied on outdated 60/40 allocation models and simplistic ideas around indexing that are insufficient in protecting downside risk. Investors who understand financial science and how to protect their portfolios will profit by not losing as much in down markets.
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