Our Process of Investing
Everyone has a different idea about how you should invest your money. Without getting into those discussions, this paper deals only with what we call Our Process of Investing.
In the past 15 years, the Investment Process has moved from radical fringe to mainstream. With that shift comes a host of challenges and opportunities. An awareness of the strengths and limitations of investment techniques will be an increasingly important part of investment management in the years ahead. We need a clear understanding of what investment methods are and what differentiates them from other methods. The distinction is not as obvious as it seems.
The Many Dimensions of Asset Allocation
It is often said that asset allocation is the most important decisions that an investment manager or fund sponsor faces. It is the conventional wisdom, and is demonstrated in academic journals, that asset allocation has more influence on aggregate portfolio returns than any other single decision. Yet, like the blind men disagreeing on the nature of an elephant, different people use the term “asset allocation” for different purposes. It is interesting to note that many of the most costly and flagrant errors in institutional asset management are made at the asset allocation level, either by investors who are ill-positioned for a turbulent market or by clients chasing the most successful recent strategies.
If asset allocation for a portfolio is not managed as a deliberate strategy, then it is presumably drifting on autopilot, driven by the whims of the markets. This is an often-overlooked fact of portfolio management: If we don’t consciously manage assets on a disciplined basis, the capital markets will do it for us. The markets will assure that we overexposed to an asset class at market highs and underexposed at market lows. This same problem afflicts smaller asset management decisions such as stock selection.
There is no element in investment management that has a greater impact on long-term portfolio returns than asset allocation policy decision. This decision must be made with all of the skill and wisdom that we can assemble. History suggests that, with courage and patience, active asset allocation may offer opportunities to add measurably to portfolio returns. To do so, the active shifts in asset mix must be handles in a contrarian fashion. Those who lack the courage, discipline, patience, or will required to stay the course with the tactical asset allocation process are probably better served by adopting a rigorous discipline of rebalancing and equitizing of cash reserves.
For each element of the asset allocation decision, there is no “right answer” that is applicable for everyone. Some investors should bear the risk of an aggressive asset mix policy, coupled with a tactical asset allocation discipline. Others may find that they lack the courage to “stay the course” when such a discipline produces disappointing short-term results. Our discussion provides only a set of issues and consideration that may be useful for investors to choose their own “right answer.”
Policy Asset Allocation
Many organizations invest significant time and expense to evaluate and select an appropriate long-term cost to the investor, consistent with the investor’s tolerance for risk. This deliberate long-term normal asset mix is often called the “policy asset allocation.” After this asset mix has been established, the portfolio is typically allowed to drift with the movements of the capital markets. This sort of drifting mix is a costly problem: It moves the portfolio away from the intended policy mix, and it tends to erode long-term investment returns, as we shall demonstrate.
While one might assume that this kind of drifting results in less time-consuming than engaging in a deliberate process for the rebalancing the asset allocations, it ultimately imposes a significant drain on the time of investment officer and the investment committee of the board. This is because a drifting mix must eventually be corrected; correcting the asset allocation after it has drifted far from the intended policy requires a careful decision as to changes in the allocation of assets among asset classes and managers.
The investment and markets that offer the best prospects for long-term returns typically tend to be inherently risky, while those that offer the greatest safety tend to offer only modest return prospects. Policy asset allocation, the central decision of portfolio management, is a balancing act, weighing this quest for improved returns against the avoidance risk.
Even within this simple definition of policy asset allocation, there are many nuances an investor must consider. To be sure, policy asset allocation is the balancing of risk and reward in choosing a normal asset mix for the long term. But which risks should be avoided, and how do we quantify this risk-reward trade-off? Suppose a corporation has a “downsizing” program, with large lump-sum payoffs expected over the coming year. For this investor, with a relatively short investment horizon and a need to avoid volatility that could deplete fund reserves, the relevant definition of risk is very different from a long-horizon investor, with prospective obligations that stretch over the next century (as is the case for many endowments and foundations). The same holds true for an endowment at a University that has chosen to embark on a major building program. It is not unusual that the lowest-risk strategy for a short-horizon investor may be very different from that of a long-horizon investor.
Does this suitable policy mix shift with changed investor circumstances, or as the duration or maturity of the obligations served by the portfolio changes? Of course. These are the kind of questions that can and must be addressed in assessing the policy asset allocation decision.
One of the most important rules in asset management is to always operate within the risk tolerance of the client. If we abide by this rule, then our clients will show due patience when, as inevitably must occur, our investment strategies are temporarily out of step. If we exceed the risk tolerance of our clients, then the clients’ patience will expire before a normal dry spell runs its course.
Of course, this rule does not apply only to the asset managers who have explicit client relationships. It is a true for the client as it is for the asset manager. Indeed, even if the “client” is ourselves, investing our own money, the same rule applies. If investors invest in a fashion that exceeds their own risk tolerance, so that when things go awry (as they inevitably will from time to time) they must abandon their strategy, they have done themselves a disserves by engaging in the strategy in the first place.
If we seek not to exceed the risk tolerance of our clients, than we must understand their risk tolerance. This is a multifaceted puzzle. As we shall see, there is no single measure of risk. In essence, risk might be defined as vulnerability to any unpleasant consequence of our investment process. It probably includes any failure to educate the client or ourselves as to the patterns of risk and reward associated with our chosen strategies.
The most important part of educating and knowing the client is a recognition of which consequences are truly unpleasant, because these are the consequences that may force a change in strategy. Such consequences may be objective if, for example, they force a change in long-term spending plans. Or they may be subjective if, for example, they result in a loss of wealth or pension surplus that exceeds the clients’ tolerance for loss. Education can be an important part of the process in helping the client to understand which risks do not have objective consequences and therefore should be tolerated by the patient investor.
Risk can certainly also include the consequences of accepting too little risk. The long - term business consequences of pursuing an overly conservative strategy that moderates portfolio volatility can sharply reduce long- term rewards. For the individual, this can mean portfolio income that fails to keep pace with ordinary inflation; for the corporation, this can mean increased long-term pension cost.
One risk that is difficult to quantify, but that is far more important than most investors realize is “maverick risk” – the risk of staying too far from the actions of our peers. Whether we like it or not, we are in a horse race. If our investment strategies lead to results that lag those of other investors, our judgment is naturally called into question- even if only by ourselves! This can happen even when portfolio volatility works to our benefit, delivering good returns, and surplus volatility similarly accrues to our client’s benefit. For the corporate investor (such as a pension portfolio), maverick risk matters for a very important business reason: If our results fall short of those of the competition, we lose clients. Their cost of doing business will rise relative to their competititors; their cost of doing business will rise relative to their competition. This means that, in the short run, their competitive position is damaged.
If clients are willing to bear “maverick risk,” they create an opportunity to outstrip the investment results of their competitors; this improves their own competitive position by reducing their cost of doing business. A willingness to bear surplus volatility might give a client an opportunity to choose higher-returning asset classes, which will boost long-term returns and lower long-term business costs (e.g., pension costs). The same naturally, holds true for a tolerance for portfolio volatility. The two-edged sword can also cut us. A willingness to bear risk that can deliver higher returns also introduces a risk of lower returns.
Accordingly, the quest for investment portfolio returns should be as important to most institutional investors as the quest for operating profits or reduced operating expense. For the individual investor, an increase in the income that a portfolio generates is a valuable as a salary raise or a cut in living expenses. Few investors, however, behave as if investment gains are as important as other gains
Managing the Policy Mix
The asset allocation decision cannot be avoided. If investors choose not to make a conscious asset allocation decision, the capital markets will do it for them. Unfortunately, the market will assure that the investor is overexposed at market highs and underinvested at market lows. Most institutional investors follow a policy of permitting asset allocation to drift with the whims of the capital markets, sometimes within well established but relatively broad bands. Others will consciously choose to reassess the asset mix after markets have made a major move. Neither approach is particularly defensible for the long- term investor.
For those who favor the view that markets are efficient, a simple process of rebalancing to a static asset mix can reverse the damage done by a drifting mix or by ad hoc committee decisions. A simple mechanistic rebalancing strategy actually solves two problems at once. First, it means that the effort invested in choosing the appropriate long-term normal policy mix has not gone to waste. It does so by assuring that the normal mix is maintained in a disciplined fashion. Second, history suggests that rebalancing can add modest value. To be sure, a simple mechanistic rebalancing strategy will not add value in every year or even in every market cycle. Over the long run, however, it appears to add measurably to risk adjusted returns. With compounding, even modest incremental returns can translate into significant increases in wealth.
Suppose we believe that the markets are not efficient. This implies that we can add value with a careful and deliberate choice of the “best” available investment market. Here, once again, a drifting mix or ad hoc committee decisions make more sense. A willingness to engage in active management of asset allocation should necessarily mean moving money into the markets that are priced to offer the best prospective rates of return. Because prospective returns fall with a risking market, or rise with a falling market (in much the same way that prospective bond yields fall with rising bond prices and rise with falling prices), this sort of strategy should, over time, tend to put more investment capital into the recently unsuccessful markets rather than chasing the recently successful markets. This is an uncomfortable process, yet it is one that might reasonably be expected to improve investment performance.
Therefore the following set of investment rules which we call the Golden Rules are very appropriate to follow for our Process of Investing.
The Golden Rules
1. Know your objective. You wouldn't go on a long trip without taking a map. So why would you embark on an investment program without knowing where you want to wind up?
Establish a goal. Maybe it’s a comfortable retirement, or college education for a child or grandchild. Whatever it is make sure you’re clear about what you want to accomplish. Also know how much time you have to reach your goal.
2. Set up a regular investment plan. Investing regularly toward your financial goal puts a flow of assets to work for you. The sooner you begin contributing money toward your goal, the longer your money has to compound.
For example if you invested $200 monthly in an investment that earns 8% annually, you’d have $36,025 in ten years and $281,710 in 30 years. Of course the more you invest the greater your potential. For instance, if you added $100 each month to the same investment, you’d have $54,037 in ten years and $422,565 in 30 years.
3. Create a diverse portfolio. Diversification means putting your assets in a variety of investments. By diversifying, you reduce risk because no two investments are likely to go up and down in price at the same time, all the time. Some may be up while others are down. Those that rise in value will help offset the losses of those that decline.
4. Rebalance periodically. Investing is not a one-time event. As your needs change, so should your investment strategy. Moving assets from one investment to another to meet changing conditions is called rebalancing. It’s as essential to investment success as knowing your financial goal.
For example, if you’re interested in securing a comfortable retirement, you would make investments designed to achieve that goal. But after retiring, if you need current cash flow, you would want to select investments that generate income.
5. Think long term. Don’t let the market’s daily ups and downs scare you into selling a fundamentally sound investment when you’re investing for a long-term financial goal. That’s a mistake many individuals unfortunately make. In fact, if you’ve got a good investment, consider market downturns as opportunities to purchase more shares at lower prices. When investing long-term, think long term.
6. Rely on a professional. In today’s fast-paced financial world, it’s difficult for casual investors to monitor that market and stay on top of emerging investment opportunities. That’s why it’s wise to establish a relationship with a financial professional who will take the time to understand your needs.