Play Your CARDs Right
Rebalancing Reduces Risk
If you play your cards right, things are going to happen in the long run. In the short run, it is anybody’s guess.
An investment in knowledge pays the best interest.
– Benjamin Franklin
Rachel Kaplan, created what we refer to as the Periodic Table of Asset Classes. Rachel analyzed performance returns for seventeen different asset class indices and created a chart that ranked each sectors’ performance for each year for the 20 year period from 1991 through 2010. Besides creating something that looks very familiar to anyone who ever had a high school science class, she did a great job visually depicting the power of diversification. The random pattern of the colors in the chart graphically illustrates what investment gurus have been telling us for decades: Don’t bet too heavily on yesterday’s winners, and don’t completely discount yesterday’s losers.
Rachel’s research got us thinking about the power that diversification and rebalancing provide, when used together, to reduce risk and to increase returns. When combined with Equitas’ research on correlation, asset classes and risk, their power to affect a desired outcome on a portfolio is even greater. We coined the term CARD, (Correlation, Asset Allocation, Rebalancing/Reducing Risk and Diversification) to better capture the flavor of each of these inputs in portfolio engineering.
In the world of finance, correlation is a statistical measure of how two securities move in relation to each other. We do extensive correlation research as we think about risk and returns in clients’ portfolios.
Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.
A well balanced portfolio will have multiple asset classes that have low correlation to one another. When done correctly, the art and science of blending a variety of low correlated asset classes allows a portfolio the opportunity for a smoother ride than otherwise possible with a more concentrated blend of asset classes. If a portfolio is diversified among asset classes that are all perfectly correlated (+1), there is no benefit to the diversification. Correlation is the power behind diversification.
Goodness is the only investment that never fails.
– Henry David Thoreau
An asset class is a group of securities that exhibit similar characteristics, that behave similarly in the marketplace, and that are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments), however when Equitas researches and constructs a portfolio, we include as many as sixteen different classes. They may include international securities, MLPs, real estate, and commodities among others.
The terms asset classes and asset class categories are often incorrectly used interchangeably. In other words, describing large-cap stocks or short-term bonds as asset classes is incorrect. These investment vehicles are asset class categories, and are used to increase diversification.
Each asset class is expected to reflect different risk and return investment characteristics, and will perform differently in any given market environment. Using multiple asset classes in portfolio construction helps achieve a lower risk, less correlated portfolio, and it is the first step in diversification. Our return attribution analysis indicates that proper asset allocation is the most powerful tool in portfolio construction.
The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell.
– Sir John Templeton
Rebalancing Reduces Risk – The Three “Rs”
To rebalance is to bring a portfolio back to its original asset allocation mix. Though it may feel counterintuitive, rebalancing entails selling winners and buying underperformers. This is necessary because over time, allocations to asset classes and individual managers become out of alignment with investment policy guidelines. Some asset classes will grow faster than others. Rebalancing ensures that a portfolio is not over or under weighted in relation to guidelines. By selling outperformers and reinvesting in laggards, a portfolio locks in its gains, and re-invests in underperforming sectors while they are “on sale”. As long as the initial investment thesis still rings true, and there is no fundamental change in a manager that may require putting them on a “watch” list, buying on dips is a great way to reposition a portfolio for increased alpha.
There are three different methods to rebalance a portfolio:
- Periodic: Pick a period, such as annually, and sell investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories.
- Event Driven: Whenever an asset class falls out of the acceptable range noted in the Investment Policy, rebalance the portfolio back to the Policy’s Target allocation.
- Cash Flow: Use new contributions and withdrawals to rebalance the portfolio. Purchase new investments from cash flows with-in the portfolio to buy under-weighted asset classes, and make the sales from the appreciated, over-weighted asset classes.
The Cash Flow method is the smoothest for money managers. Event Driven has the greatest impact on performance. We use all three methods at Equitas. Regardless of how it is achieved, a portfolio should be rebalanced on a regular basis in order to optimize returns. Equitas monitors clients’ portfolios continually to seize rebalancing opportunities.
Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.
– Warren Buffett
A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. In other words, investors need to be compensated for taking on additional risk.
For example, a U.S. Treasury bond is considered to be one of the safest (risk-free) investments and, when compared to a high yield bond, provides a lower rate of return. A corporation that can only borrow in the “junk” market is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a junk bond is higher, investors expect a higher rate of return.
A well-constructed portfolio consists of multiple asset classes that are positioned on various spots on the risk return spectrum. When done correctly, this lowers overall portfolio risk while optimizing returns. The whole portfolio becomes safer than the sum of the parts.
Money is like manure. You have to spread it around or it smells.
– J. Paul Getty
Diversification is a risk management technique that mixes a wide variety of asset classes within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the asset classes and managers in the portfolio are not perfectly correlated.
Our asset allocation studies have shown that maintaining a well-diversified portfolio of asset classes and managers yields the most cost-effective level of risk reduction. We strive to provide the lowest possible level of volatility that still allows a portfolio achieve its return targets.
Diversification benefits are gained by investing in asset classes that have low correlation to one another. For example, an economic downturn in the U.S. economy may not affect Japan’s economy in the same way; therefore, having Japanese investments would allow an investor to have a cushion of protection against losses due to an American economic downturn. This happened very effectively in the decade of the 1970s.
Most investors wait for investments to go up and then they buy after the investments have appreciated. Investors tend to buy what they wished they had bought. Conversely, they sell after the investment has gone down. Correlation, Asset Classes, Rebalancing, and Diversification are tools to help avoid these problems. Playing your CARDs right can keep you from falling into these traps and yield a more prosperous investment experience. Equitas Capital Advisors is proud to serve as your investment management consultant. We appreciate your business, and value the trust and confidence that you place in us. We look forward to continuing to engineer and deliver investment solutions to you for years to come.
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.
Disclosures and Disclaimers:
Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.
Equitas Capital Advisors, LLC is registered as an investment advisor with the U.S. Securities and Exchange Commission (“SEC”) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.
Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.
Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
All investment strategies have the potential for profit or loss. There can be no assurances that an investor’s portfolio will match or outperform any particular benchmark. Past performance does not guarantee future investment success.