The majority of popular investment advice follows a predictable recipe: adopt a diversified portfolio of low-cost index funds and determine your asset allocations. Buy and hold the funds, and regularly add to your savings. Rebalance your portfolio at the end of each year, and repeat until you’re 65. Retire happily.
This advice is often accompanied by long-term charts that show the impressive returns of stocks and bonds over many decades. Looks great, right? But unfortunately for many investors, it doesn’t actually work out this way, for a variety of reasons.
One major problem is that even a well-diversified buy-and-hold portfolio can lose 50% during a bear market (and did exactly that in 2008-2009). And too many investors do not successfully weather such large market downturns. Some can’t bear the stress and pain caused by significant portfolio losses; others don’t have a sufficiently long enough time frame to recover from them. Too often, investors’ actions are influenced by behavioral biases and emotions (e.g., greed and fear). This leads them to make poor investment decisions (e.g., buy highs and sell lows).
Active risk management
If investors could just eliminate their larger losses, the good results would take care of themselves. —Charles D. Ellis, Yale University Endowment 2005 Annual Report
Preserving capital during bear markets is just as important as growing capital during bull markets. If investors focused more on controlling their risk rather than chasing performance, their portfolios would probably do a lot better. For many of us, active risk management is a necessary component of a successful, practical, investment strategy. As the CEO of PIMCO and former investment manager of the Harvard University endowment said during the global financial crisis:
Diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well. —Mohamed El-Erian
Our mission is to provide do-it-yourself investors with tools and insights into that “something more.” Systematic volatility management is one of the cornerstones of our Adaptive Portfolios.
Dynamic asset allocation
Portfolio diversification is a good thing, but is by itself not enough. Not only do bear markets cause substantial losses, specific asset classes can also be out of favor for a very long time. For example Japanese stock investors have endured 26+ years of ZERO returns. Or how about U.S. bonds? We've enjoyed a spectacular bond bull market since the 1980s. But what many don't realize is that between 1900-1980, U.S. government bonds provided an annualized real (after inflation) return of only 0.2%. That’s right, 0.2% per year for 80 years. Clearly, sometimes "waiting it out" is just not a practical investment option.
Rather than adopting a static asset allocation, there are benefits to constructing a portfolio that dynamically chooses from a broad basket of investments based on prevailing market conditions. This is commonly referred to as tactical or dynamic asset allocation. Proven, well-documented return factors such as momentum can be used to construct portfolios that invest in those particular asset classes that are trending up, and divest from those that are out of favor.
By combining volatility management, dynamic asset allocation, and other portfolio construction techniques, we have the potential to improve risk-adjusted returns, to risk less and prosper.