Why staying the course no longer works

Mainstream investment philosophy directs us to invest assets in the financial markets while mitigating risk through prudent diversification. Inherent in this approach is the belief that the best-performing asset class will vary from year to year and cannot be predicted.

But what did we learn in 2008, a year when nearly all asset classes showed tremendous correlation on the downside? That this approach does not work. Moreover, clients are tired of the roller coaster ride of investing and are demanding an active approach that better protects their wealth. Telling clients to “stay the course” isn’t a solution.

Many studies have proved the importance of asset allocation decisions in meeting investors’ financial objectives. A well-known study by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, “Determinants of Portfolio Performance,” (The Financial Analysts Journal, July/August 1986) analyzed asset allocation decisions and returns of 91 large pension funds.

The authors concluded that asset allocation decisions accounted for greater than 90% of the investment return and that active choices were less important, if needed at all. Many investment professionals continue to point to this study to prove that asset allocation is the most important investment decision and to support their buy-and-hold approach.

After the past decade of bubbles, followed by corrections, in technology, commodities, real estate and most recently banking, investors are questioning the traditional buy-and-hold approach.

Investment professionals today realize that the nature of investing has changed dramatically over the past 10 to 20 years — but what is the real difference? Technological advances such as rapid-trading programs, quantitative investment management, short selling and the growth of the short-term-focused hedge fund business have all contributed to the challenges facing the long-term asset allocation mind-set by permanently increasing volatility, cyclicality and trading volume.

WHAT’S THE SOLUTION?

Rapid-trading programs are not the answer, as these are difficult to implement in an individual client portfolio and they tend to be extremely tax-inefficient.

However, tactical investment strategies that utilize active management are a more attractive option. In fact, a new style box is rapidly emerging in tactical exchange-traded-fund strategies. Tactical strategies seek to allocate the portfolio to the asset classes that are most attractive at a given time, and tactical, short-term adjustments are made to take advantage of market trends. Cash is a viable investment option in many of these investment strategies, facilitating wealth preservation and downside risk mitigation.

Many advisers have been slow to adapt to this tactical-investing approach because they have been trained to believe that market timing doesn’t work. To change this mindset, advisers need to view these tactical investment strategies not as market timing but as active and systematic buy-and-sell disciplines made possible due to the major technological advancements over the past 20 years.

Active investment strategies that allocate assets tactically to areas of the markets that are trending well (including cash), while avoiding those areas that are declining, are a sophisticated, quantitative investment solution.

Advisers can consider active tactical investing a permanent component of a well-diversified total portfolio. A shrewd decision would be to segregate 20% to 30% of a client’s portfolio to invest in tactical strategies available from separate account managers or through pooled vehicles.

Advisers need to do due diligence and seek managers with real long-term track records, proven tactical formulas, strong reputations and competitive fees. Advisers should be careful when reviewing a manager’s hypothetical back-tested results and should instead seek historical figures compliant with global investment performance standards.

Investment strategies that can employ a high level of cash add true differentiation, downside protection and wealth preservation. Clients will appreciate the proactive nature of tactical management, especially in downtrending markets. The next time there is a large market decline and your client’s portfolio holds a large defensive cash position, you will have something positive to say beyond just, “Stay the course.”

David J. D’Amico is president of Braver Wealth Management LLC.

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Related Topics: Investment Strategies