Get Comfortable with Being Uncomfortable, Part 2:
Maximum Diversification

This is the second of a three-part series we’re affectionately calling “How to Get Comfortable with Being Uncomfortable.” The series covers the tremendous headwinds investors in traditional portfolios are likely to over the next decade or more, and the steps required to turn a bad situation into a great opportunity.  These steps – set realistic expectations, diversify as much as you can handle, and take advantage of others’ mistakes with factor investing – are designed to help investors through whatever the future holds.


Reminder: Valuations are a Problem

In How to Get Comfortable with Being Uncomfortable: Part 1, we addressed how valuations on stocks and bonds remain extremely lofty. As a result, it is unrealistic to expect the portfolios that investors have grown comfortable with over the past few decades to produce the returns investors need to achieve financial independence.  In fact, after adjusting for inflation and fees, we estimate that investors will be hard-pressed to earn more than 2% per year on traditional portfolios of domestically focused stocks and bonds over the next decade.

Investors who are entrenched in the current investment model face the uncomfortable choice of working longer, saving more, or lowering expectations about their retirement lifestyle.

But investors have other choices if they are willing to think more broadly about their investment options. These choices are no panacea. While they may substantially reduce investors’ savings burden, and provide long-term returns that will support a more substantial retirement lifestyle, they inflict a different type of discomfort.

Global Risk Party and Maximum Diversification

One way investors can make their portfolio more resilient to an uncertain future is to consider more comprehensive diversification strategies. Many investors would be surprised to learn that typical “balanced” portfolios composed of 60% stocks and 40% bonds actually derive over 90% of their risk from equities. This is because equities are so much more volatile than stocks. Even worse, equities only produce positive returns during periods of persistent positive growth shocks, benign inflation and abundant liquidity. While these conditions have prevailed in most years over the past few decades, there have been notable exceptions. In addition to the acute crisis periods like 2000-2002 and 2008, which many investors lived through personally, both equity and bond markets suffered through a 16-year period of low growth and high inflation from 1966 through 1982.

Figure 1 puts the idea of extreme diversification in context, by illustrating how various global asset classes would be expected to react to the economic effects of growth and inflation. Investors who do not feel qualified to forecast future economic environments might be well served by allocating to all of these asset classes so that they have the opportunity to profit however the future evolves. Of course, the asset classes in Figure 1 have very different risks, and complex relationships with one another.

The portfolio that maximizes the opportunity for diversification across these diverse assets is called the Global Risk Parity portfolio.

Figure 1. Asset class responses to the four major economic environments.

Source: ReSolve Asset Management

One way to introduce the prospect of higher future returns is to introduce frontier asset classes, such as emerging-market stocks and bonds. By many measures, emerging-market stocks, currencies and bond markets represent substantially better value – and commensurately higher prospective returns – than the developed markets with which investors are typically comfortable. For example, global firm Research Affiliates expects emerging market stock and bond markets, and commodities, to produce 7%, 3.4% and 1.9% real annualized returns over the next decade (See Figure 2). While these returns may appear unexciting, they compare quite favorably to expectations for US stocks and bonds, which range from 0.7% to -0.7%.  By construction, global risk parity strategies allocate a significantly larger portion of capital away from U.S. equities, and provide greater allocation to markets that may offer higher expected returns.

Figure 2. Global Asset Classes: 10-Year Expected Real Returns

Source: Research Affiliates

If your Emotions Can’t Handle Extreme Diversification, Here is a Solution

When investors become acquainted with the arguments in favor of extreme diversification, they are often convinced that global risk-parity should form a meaningful portion of their portfolio. While I wouldn’t argue with this sentiment, diversification is not always an easy path to follow. Concentrated equity portfolios typically deliver very exciting returns during periods of strong growth and low inflation. Diversified investors will experience this excitement, but to a lesser extent. This breeds feelings of regret, especially when investors’ domestic equity market is leading the charge.

In practice, we advise clients to hold a portion of portfolios in their home equity market, and in other markets that they watch. This will attenuate feelings of regret, which often cause investors to make unwise choices under extreme emotion.

Capitalize on the Market’s “Willing Losers”

While a certain core of financial academics continues to cling to an outdated model of efficient markets, open-minded academics, and most experienced market practitioners, now acknowledge that investors make errors. Some of these errors are truly random and are offset by equally random errors in the opposite direction. But there are some types of errors that investors make over and over again in the same way. Some of these errors are actually not errors at all. Rather, they reflect the fact that investors have a variety of preferences in markets other than a pure focus on wealth maximization. I call these investors “willing losers” because they have decided to forego wealth maximization to pursue alternative objectives.

Minimizing the mistakes in your own portfolio while capitalizing on the mistakes of others are two sides of the same coin.  Both require identifying errors – both irrational and rational – and systematically implementing methods to address them.  In part 3, we will explore these promising methods, known collectively as “factor investing.”

Click here to learn more about Global Risk Parity.

Disclaimer

Confidential and proprietary information. The contents hereof may not be reproduced or disseminated without the express written permission of ReSolve Asset Management Inc. (“ReSolve”). ReSolve is registered as an investment fund manager in Ontario and Newfoundland and Labrador, and as a portfolio manager and exempt market dealer in Ontario, Alberta, British Columbia and Newfoundland and Labrador.
These materials do not purport to be exhaustive and although the particulars contained herein were obtained from sources ReSolve believes are reliable, ReSolve does not guarantee their accuracy or completeness. The contents hereof does not constitute an offer to sell or a solicitation of interest to purchase any securities or investment advisory services in any jurisdiction in which such offer or solicitation is not authorized.

Forward-Looking Information. The contents hereof may contain “forward-looking information” within the meaning of the Securities Act (Ontario) and equivalent legislation in other provinces and territories. Because such forward-looking information involves risks and uncertainties, actual performance results may differ materially from any expectations, projections or predictions made or implicated in such forward-looking information. Prospective investors are therefore cautioned not to place undue reliance on such forward-looking statements. In addition, in considering any prior performance information contained herein, prospective investors should bear in mind that past results are not necessarily indicative of future results, and there can be no assurance that results comparable to those discussed herein will be achieved. The contents hereof speaks as of the date hereof and neither ReSolve nor any affiliate or representative thereof assumes any obligation to provide subsequent revisions or updates to any historical or forward-looking information contained herein to reflect the occurrence of events and/or changes in circumstances after the date hereof.

General information regarding returns. Performance data prior to August, 2015 reflects the performance of accounts managed by Dundee Securities Ltd., which used the same investment decision makers, processes, objectives and strategies as ReSolve has used since it became registered and commenced operations in August, 2015. Records that document and support this past performance are available upon request. Performance is expressed in CAD, net of applicable management fees. Indicated returns of one year or more are annualized. Past performance is not indicative of future performance.

General information regarding the use of benchmarks. The indices listed have been selected for purposes of comparing performance with widely-known, broad-based benchmarks. Performance may or may not correlate to any of these indices and should not be considered as a proxy for any of these indices. The S&P/TSX Composite Index (Net TR) (“S&P TSX TR”) is the headline index and the principal broad market measure for the Canadian equity markets. The Standard & Poor’s 500 Composite Stock Price Index (“S&P 500”) is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy.

General information regarding hypothetical performance and simulated results. These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account or fund managed by ReSolve will or is likely to achieve profits or losses similar to those being shown. The results do not include other costs of managing a portfolio (such as custodial fees, legal, auditing, administrative or other professional fees). The contents hereof has not been reviewed or audited by an independent accountant or other independent testing firm. More detailed information regarding the manner in which the charts were calculated is available on request. Any actual fund or account that ReSolve manages will invest in different economic conditions, during periods with different volatility and in different securities than those incorporated in the hypothetical performance charts shown. There is no representation that any fund or account will perform as the hypothetical or other performance charts indicate.

General information regarding the simulation process. The systematic model used historical price data from Exchange Traded Funds (“ETFs”) representing the underlying asset classes in which it trades. Where ETF data was not available in earlier years, direct market data was used to create the trading signals. The hypothetical results shown are based on extensive models and calculations that are available for any potential investor to review before making a decision to invest.