Lots of investment advice is fine in theory but ineffective in practice.
For example, the recommendation to simply “buy and hold a balanced portfolio”, promulgated by academia from the 1960s, is flawed, because very few people can actually follow it. The potential return is therefore just a pretty chart.
When it comes to investing, fear is the enemy – fear of missing out, fear of failure, fear of loss. Fear leads to risk – not the traditional definitions of risk that quants generally use such as skew, variance, beta, tracking error etc. – but the risk that market shifts will catalyze anxiety, regret, or another emotion that leads an investor to take action that results in long-term or permanent destruction of portfolio value.
Unfortunately, traditional portfolios recommended by many advisors do little to assuage these emotions. A vanilla, static, 60/40 portfolio (i.e., 60% stocks, 40% bonds), for example, crashes too much and captures insufficient upside. It fails the fear tests miserably.
As a result, investors often abandon plans and do it alone. Based on my countless conversations, over many years, with clients, prospects, industry professionals, and friends on how and why they invest like they do, self-direction results in a myriad of quirky portfolios. From excessively large cash positions, highly concentrated bets on esoteric instruments, to overly diversified holdings, to various individual styles of stock picking, they are all understandably trying to solve for the glaring behavioral problem of traditional portfolios recommended by academics and financial advisors. Unfortunately, such solutions often increase the probability of significant losses of value or long-term underperformance. A few get lucky.
Financial academics and their practitioner followers are failing most investors by designing and selling strategies that ignore the most important determinant of how well we will respond to advice – our psychology.
I am certainly not the first person to make such statements given the rise in behavioral finance over the last several years. But I have developed a specific solution – dynamic diversification -- that gives investors the edge they need to stay invested. Investing without an edge is doomed to fail.
What’s the Obstacle to Buy and Hold?
Investors who try to hold a static portfolio over the long run will find themselves at times concerned about stocks being too expensive, bond yields being too low, international diversification not working, and unhelpful comparisons between their own returns and those of the S&P500. Along the way, investors face the paradoxical advice: advisors will say, “do nothing, stay on course”, while the financial press, numerous niche blogs, and TV shows will be showcasing the next big thing to invest in or advocating an immediate, drastic change in asset allocation.
What action are you meant to take when you see headlines like, “What's the hot investment of 2022? Discipline” or “Billionaires Dumping Stocks are Record Pace”?
We can debate the merits of risk parity vs. the endowment model vs. the 60/40 from here to eternity. But, if all of these so-called moderate risk portfolios crash in frequency and magnitude beyond what investors can tolerate, they’re not really working. Moreover, during an actual crash, nobody can guarantee where the bottom is – it’s only visible in hindsight – meaning that asking people to just hold and trust things will work out is largely unhelpful.
How Actual People and Institutions Really Invest
Actual portfolios held by real people and real institutions are much more idiosyncratic. All the investors I’ve spoken to are all trying to find a balance between the need to conserve and the desire for upside. This means allocating to higher risk, higher potential upside opportunities (venture capital, crypto, thematic ETFs, value stocks) and a lower risk allocation of higher quality assets. Depending on how effective they each are, the crash risk and FOMO (fear of missing out) still exist in varying amounts.
What’s possibly more interesting is now many industry professionals – despite being closer to the investment mantras than the general public – are significantly in cash. I would love to know how many advisors and portfolio managers truly eat their own cooking rather than just nibbling at it, but that’s for another time. (For the record, I am both the chef and the customer when it comes to my investment strategies!)
What’s the Solution?
Be dynamic, not static. It’s that simple.
Dynamic doesn’t mean you should engage in guessing which way the market is going. Such timing is another fool’s errand. Instead, we advocate a systematic, rules-based dynamic diversification solution.
Our Dynamic Balanced strategy is effectively a version of the 60/40 that understands that the concept that “moderate risk” is, itself can only be achieved in a dynamic fashion.
By using a quantitative model to determine the weightings of the asset classes, we remove the human guessing game that adds to fear and stress. Leveraging our analysis of two centuries of data and the most reliable liquid asset classes for long-run returns (90%+ of a typical static portfolio’s outcome is driven by its allocations to these common asset classes) our model forecasts risk and return for the selected asset classes. It uses divergent signals, which reduce downside fluctuations by shifting the allocation from stocks to bonds when both the stock market is declining, and volatility is rising materially. In a world where equity risk periodically devastates static portfolios, Dynamic Balanced acts as a multi-layered risk management system by applying academically researched techniques such as volatility targeting, trend-infused expected returns, interest rate grounded forecasts, monthly rebalancing and the use of long-term government bonds for diversification.
The result is a portfolio (based on back-test simulations) that would have significantly outperformed a static 60/40 portfolio in both the Great Depression and the 2008 financial crisis – the two most notorious crash episodes. Dynamic Balanced would have been down -23% during the Great Depression versus the static portfolio, which had a maximum drawdown of -63% and down only 19% versus -32% during the 2008-2009 Financial Crisis. While it might seem odd to focus on the downside, these are the times when investors sell out of the market, causing irreparable damage to their capital. While upside is more fun to talk about (and we have an alpha-focused strategy for that) protecting against the downside is also critical.
What’s left after this is buying Dynamic Balanced and holding on to it (sound familiar?). However, in this case, the model will decide what to do if it identifies indicators that suggest a bubble or a crash - the model will decide how to allocate. While experts don’t agree on what action to take, the model will ignore the noise and focus only on the signals so you can ignore the news!
The best investment approach is the one that you will not give up on
I designed this dynamic approach for myself and my family and through my own testing, it became apparent that many other people could benefit from it as well. No matter whether an investor has multiple thousands or multiple millions, this is a balanced, actually moderate risk portfolio that can help investors protect your capital against downside risk while also capturing upside.
We give investors the necessary edge to be successful. The real edge is when an investor feels prepared for market swings, whether up or down, because they know in their gut that they are okay, and won’t have to make ad hoc decisions.
At Two Centuries Investments, we focus on building and maintaining strategies that allow uncertainty and risk to coexist with an implementable, and durable plan. This helps us feel somewhat in control, and protected from having to make multiple decisions as the investment context changes. Our core capabilities are an alpha-generating, intangibles-focused, equity strategy - Focused Quality - and a risk-mitigating, multi-asset approach - Dynamic Balanced - as noted above. Both are systematic, help to mitigate impulsive behavior, and easily understandable for a wide range of investors. If you would like to learn more about our investment philosophy, our whitepaper, "The Two Centuries Approach to Investing", is available upon request.