Focus on Asset Allocation-Not Uncertainties

fee-only financial plannersAre you nervous about the fiscal cliff (or speed hump)? How about the U.S.budget and debt? Europe? Sure, all of these uncertainties are concerns. But none of us can control those outcomes. What we can control is our asset allocation. That’s where we need to focus.

 Ask yourself these two questions:

1) How will your portfolio withstand the next bear market?

2) Will the returns in your portfolio likely outpace inflation?

Let’s start by reviewing what happened in the last two bear markets; the financial crisis starting in September of 2008 and the Europe/US Debt ceiling and downgrade concerns of 2011. For simplicity, we will use the S&P500 index plus dividends as a proxy for equity returns, the aggregate bond index (“AGG”) as a proxy for the fixed income returns and a basket of liquid alternative securities* as a proxy for liquid alternatives (“liquid alts”).

 

  Last Bear Markets:

Asset Classes

Equity

Fixed

Liquid Alts*

9/1/08-3/31/09

               -37%

3%

-4%

4/29/11-9/29/11

-14%

5%

-3%

5yr annual return through 9/30/12

1%

6%

7%

                                    

What this demonstrates is that in bear markets, fixed and liquid alternatives perform much differently than stocks. AGG, which is comprised of 40% treasuries and 30% agencies, actually performed inversely to equities. That is, when everyone is concerned about stocks, there is a rush to safety. U.S.treasuries may not be what they always were, but they continue to be the safest port in the storm. Liquid alternatives, as DWM clients know, are designed to participate in up markets and protect in down markets. Hence, they are uncorrelated to the stock market.

Let’s average the two most recent bear markets and see how three hypothetical portfolios did. Portfolio #1- 80% equity/ 20% fixed, Portfolio #2- 50% equities/ 50% fixed, and Portfolio #3- 25% equities/ 50% fixed/ 25% liquid alternatives. You can do the math. Portfolio 1 would have been down about 19%, portfolio two down 10%, and portfolio 3 down about 4-5%. If you can’t withstand a 4-5% hit to your portfolio, you should highly consider reducing the equity exposure to 15% or even less.

Of course, we haven’t discussed diversification of the portfolios within the three asset classes. Our typical DWM client has their equity exposure currently allocated to ten different equity subclasses, their fixed income exposure to eight fixed subclasses and their liquid alternative exposure to ten different yet complementary strategies.

Now the second question:  If you are sitting in 50% to 80% equities, you could be looking at a loss on your portfolio during a bear market of perhaps 10-20%. If the next five years are similar to the last five years, your upside potential is small. Furthermore, if you have a portfolio of 50% equity and 50% cash, you may have the worst of all worlds: A portfolio that likely will be down 10-15% in the next bear market with only a small upside. Sure, if you are nervous about the future, you can keep all of your money in cash. But, that is a losing long-term strategy, since inflation will continue to erode your purchasing power.

No one can predict the future. We believe your portfolio should be allocated based upon your risk tolerance and goals and should be designed to help you protect your assets and grow them. We suggest you not focus on the many uncertainties that exist, but rather focus on getting your portfolio in a position to withstand the next bear market while at the same time providing expected returns in excess of inflation. I’m pleased to say our DWM clients have already done that.

‘*The basket of liquid alternatives used for this writing was an equal weighting of the following public securities that are generally considered to be in the “liquid alternative” strategy:  ARBFX, MFLDX, RNDLX, AMJ, PAUDX, FLARX, SCNAX, RWO, GLD, GCC.  This basket may or may not match DWM’s specific Liquid Alternatives Model and is for discussion purposes only. One cannot directly invest into an index. Past performance is no guarantee of future performance.