What’s the biggest challenge for investors these days? Macroeconomic risk? The threat of war in the Middle East? Slow economic growth? A collapsing euro? One can argue that the explosion of information and advice (much of contradictory) is the number-one hazard for thinking clearly and designing a portfolio that will succeed over the medium- and long-term horizons. What’s the antidote to the noise that permeates our digital world? It starts by considering the major asset classes and a benchmark of these betas, such as the Global Markets Index that’s routinely updated on these pages.
The main question in money management is deciding how to reweight and rebalance assets. If you allow yourself to be pulled into the vortex of the media circus, it’s easy to become confused. In fact, you can count on it. The constant din of markets gurus predicting that, warning about this, and so on, is about as clarifying as filing paperwork in a hurricane.
One story published last week, for instance, outlines a guru’s case for seeing a new U.S. recession in the near future, followed by surging inflation. The recession, we’re told, may be triggered by higher taxes or a decline in government spending. Meanwhile, higher government debt will soon unleash an inflationary storm. The article goes through the pros and cons of holding various assets for dealing with this expected future, including gold, inflation-protected Treasuries, REITs, emerging markets stocks, and junk bonds. Some of these may do well, or not. And the potential for another recession could easily render some of the otherwise high-confidence advice null and void, we’re told. By the end of the story, it’s easy to feel whipsawed.
That’s not unusual. The financial media’s agenda isn’t necessarily aligned with the best interests of investors. That’s old news, of course, and it’s not particularly shocking either. High-quality investment advice doesn’t lend itself to daily (or hourly) reinvention and a steady stream of new and dramatic headlines.
How to cut through the noise? Minds will differ, although there’s a strong case for considering everything as an opening bid and then deciding how to reweight and rebalance. This basic advice doesn’t change, which is why it gets old if you’re if you’re trying to make a splash in the financial publishing game. But in the pursuit of earning decent returns through time, and keeping risk to a minimum, thinking holistically has several compelling attributes.
Unfortunately, too many investors (including a number of pros who should know better) ignore or dismiss a broadly defined list of market betas for designing and managing asset allocation. I’m amazed at some of the reasons I hear for this oversight. Some critics say that looking to a broad array of asset classes ensures dismal returns. At the other end of the spectrum are those who say that a broad mix of assets, a la the major asset classes, is redundant vs. a lesser list. But both of these complaints are wrong, and demonstrably so.
It’s clear that if you monitor an expansive list of betas (including their representative ETFs), you’ll find a fair amount of volatility and moderately low or even negative correlations between the components. That’s a sign that even simple rebalancing can yield productive, perhaps even stellar results. To cut to the chase, you can do a lot with a long list of betas—a lot more, in fact, than is generally recognized, and at a lower risk level compared with most of what passes as “professionally managed” portfolios.
What’s the catch? First, you have to be looking. Monitoring a broad list of betas, and becoming comfortable with each and every one of them, is far from standard practice. Second, you have to be prepared to act as a contrarian—buy low, sell high, basically—in order to reap the rewards of rebalancing. Third, you must hold a portfolio with a sufficiently broad mix of betas in order to exploit the volatility and correlation factors. There’s a risk of slicing and dicing betas too narrowly, but there’s also the headwind of owning too narrow a mix. By my definition, there’s a dozen or so “major” asset classes, although this isn’t written in stone. You could easily double that list by dividing the components into smaller pieces. Suffice to say, if your asset allocation is comprised of, say, five asset classes, you’re probably making your job harder than it has to be, in which case you may pay a price in lower performance, higher risk, or both.
Yes, you can do a lot more beyond diversifying across asset classes and rebalancing the portfolio, and to some extent you should. For instance, you can dive into a more granular review of trailing and expected risk premiums for each asset class (as I did here last month). You can also do some basic modeling to evaluate how a multi-asset class benchmark fares through time (see my analysis here, for instance).
None of this would mean much if the real-world results were lackluster. Yet history tells us that a mindless benchmark of owning everything (and one that’s easily and inexpensively replicated with ETFs) earns competitive (to say the least) results vs. a broad set of actively managed multi-asset class mutual funds over the past 10 years. That’s hardly a definitive historical analysis, but the past decade was a pretty good stress test.
It all adds up to a strong case for thinking that diversifying across a wide array of asset classes and rebalancing the mix periodically is the foundation of a successful investment strategy. It’s also a foundation that should be customized to a degree to fit your specific financial situation and investment goals. The building blocks are available at a low cost via ETFs (and/or index mutual funds), and so the basic strategy for how to proceed is clear. It may not make for exciting articles in the press, but the first rule of success in the money game is distinguishing between dramatic prose and prudent financial advice.