Diversification vs. Chasing Performance: And the winner is…

2016-03-16 Annual Asset Class Performance1Our regular readers have come to expect an updated version of this “Asset Class Performance” chart about once a year.  (Click on it to enlarge.) It’s a little like running the Charleston’s Cooper River 10k Bridge Run once a year.  It puts things in perspective.  Things that go up, also go down.

Take a look at REITs in 2006 and 2007. From first to last in performance. And, Emerging Markets from 2007 to 2008, same thing. Bonds were almost a top to bottom in 2008 and 2009 and after Emerging Markets topped in 2009, it took them two years to hit bottom. Do we see a trend here?  Yes, we do.

As we discussed at our seminars in October, we’re all hard wired to want to jump on to winners and discard current losers.  We have a short memory – we place more emphasis on recent performance rather than long-term.  Furthermore, our emotions are aided and abetted by the media- always happy to make an up-and-comer sound like the perennial winner for decades to come and an asset class that is struggling to appear to have no hope of ever turning around.

We saw it earlier this year.  After a fairly dismal year of returns for all asset classes in 2015, 2016 stock markets got off to a slow start and then accelerated downward as pessimism, exacerbated by uncertainty in the world economy, interest rates, oil prices, U.S. Presidential politics and the media drove down performance until the second week in February.  And then, the pendulum starting swinging the other way, pushing markets upwards for the last four to five weeks.

A lot can happen in just a few years.  If we were looking at this same chart for the ten years ended December 31, 2013, the top performers were much different.   Emerging markets were the top performer, followed by mid caps, small caps, REITs, international stocks and then large caps.  Going back even farther, large caps for the ten year period 2000-2009 were negative.  Of course, they’ve come back strongly in the last five years, up 12% per year.

The key is that there is no “silver bullet”- that is, there is not one asset class that provides a simple and magical solution to asset allocation.  To illustrate this, let’s say we had decided to “chase performance” by investing 100% each year in the top performer of the prior year.  We can start with the results of 2006 and invest in REITs in 2007.  For 2008, we’ll invest in Emerging Markets, the top performer in 2007, and so forth for each of the next nine years.  The result: an annualized return of -4%.

Okay, how about if we invest in the most underperforming asset class instead.  We’ll invest in TIPS in 2007, REITs in 2008 and so forth. Our result is only slightly better, -3% annualized return.

Lastly, how about being a disciplined investor, using all asset classes and maintaining a balanced allocation, for example, of 50% equity, 35% fixed income, 10% REITs and 5% commodities for ten years?  The result:  An average annual return of 5.2%. With annual inflation at 1.6% for the decade, that’s quite a respectable real return of 3.6% per year for the last ten years.

The moral of the story is always the same.  Don’t follow your emotional biases.  Don’t chase performance.  Don’t try to time the market.  Instead, focus on what you can control:

  • Maintain an investment plan that fits your needs and risk tolerance
  • Identify an appropriate asset allocation target mix
  • Structure a diversified portfolio between and within asset classes
  • Reduce expenses and turnover
  • Minimize taxes
  • Rebalance regularly
  • Stay invested
  • Stay disciplined

If you have any questions or need any assistance with any of the above, please let us know.  At DWM, we’re ready to help and are passionate about adding value.




Ask DWM: How Does the Likely Fed Rate Hike Impact Your Asset Allocation and Investments?


Investors and markets are watching this week’s Fed meeting very carefully. Fed Chairwoman Janet Yellen and Fed officials appear to be moving toward raising short-term interest rates this year. Most expect September will mark the time of the Fed’s first rate increase since 2006. A key challenge for the Fed will be the communication of where future rates are going.

We all remember two years ago when Fed Chairman Ben Bernanke created a “taper tantrum” (and threw all markets in chaos for one month) when he signaled it was thinking about ending the QE program. Chairwoman Yellen wants to avoid that and has recently been emphatic that she expects rate increases to be slow and gradual once they start. In fact, in a March speech in San Francisco, she used the term “gradual” or “gradually” 14 times.

The U.S. economy is making progress, with strong job gains and rising wages. Auto sales are way up and factory machines are humming. Small business and consumer sentiment is up as are retail sales. The Producer Price Index rose slightly higher than expected. This data is likely too strong for investors or the Fed to ignore. So, yes, it looks like a rate hike will likely occur this year.

Of course, none of us can control when the Fed will raise rates, what rates will be longer term and how well the Fed communicates the future. We can, on the other hand, control our asset allocations and our investments. That’s where our focus should be.

Let’s revisit our annual DWM seminar in October 2013 entitled “Rising Interest Rates: Should I Be Concerned?” Here’s a quick summary of the key points that are still valid today.

  • The bond bull market may be over.
  • Bonds still play a vital role within an overall portfolio as do all of the asset classes.
  • Equities typically perform well in rising interest rate environments, with the “sweet spot” being when the 10 Year Treasury Bond rates are between 3% and 4%.
  • Use of multiple asset classes lead to non-correlation effects that ultimately lead to better long-term results.
  • One needs at least 15% in alternatives to make a difference.
  • Stay invested.

So, focusing on asset allocation, you should start by revisiting your risk profile. This includes risk capacity, risk tolerance and risk perception. Your risk profile is unique. You need to look at your long-term financial goals and plan and honestly assess how you are “wired.” It’s not as simple as looking at your age. We work with clients in their 80s who have an aggressive risk profile and clients in their 30s who have a conservative risk profile. Your risk profile will determine your asset allocation and therefore your portfolio mix of equities, fixed income and alternatives. In the long-term, your asset allocation is the primary (90%) determinant of the return of your portfolio.

2013 was a watershed year for fixed income. For three decades, fixed income had always been an asset class with low risk and good returns. The “taper tantrum” signaled the start of the end of the bond bull run making fixed income riskier and reducing the likelihood of 8% annual returns going forward. Given this change in risk/return characteristics within the fixed income area, the same risk tolerances score from prior years may not necessary lead to the same asset allocation mix. Hence, many DWM clients reduced their allocation to fixed income in 2013, some quite significantly.

At the same time, DWM fixed income holdings were re-positioned in an effort to reduce risk and potentially increase returns for an expected rising interest rate environment:

  • Reduced duration (when interest rates rise, bond with the longest maturities suffer the greatest drop in price)
  • Added international developed and emerging exposure
  • Added floating rate exposure with very low duration and ability to perform in rising markets
  • Continued diversification through low cost vehicles
  • Kept credit quality solid

So, with all the uncertainty regarding when, how high, and how often the Fed raises rates and how the markets will react to these changes, we suggest you focus on what you can control. If you haven’t already done so, now is a great time to review your asset allocation and your investment holdings. Our DWM clients know that is one of the highlights of our meetings with them, hopefully quarterly or even more often when appropriate. For others, we’re happy to help provide a second opinion. Just give us a call.

So Many Numbers: Which Ones Are Important?

stock-photo-old-typeset-166120136Our world is full of numbers. They’re everywhere. Our calendars just moved from 2014 to 2015. We get bombarded continually with numbers representing time, temperature, and, yes, stock market reports. NPR’s Eric Westervelt last week called numbers “the scaffolding that our economy, our technology and huge parts of our life are built on.”

For this blog, I thought it would be interesting to look at the origin of our numbers and then highlight five key numbers that are of real importance to your financial future.

Mr. Westervelt was interviewing Amir Aczel who has written a new book “Finding Zero: A Mathematician’s Odyssey to Uncover the Origins of Numbers.” Mr. Aczel believes the invention or discovery of numbers “is the greatest intellectual invention of the human mind.” We use Hindu-Arabic numerals. Before that, there were many other systems including the Mayans, the Babylonians, and, yes, the Romans. The big problem with the Roman number system is that it had no zero. The numbers didn’t cycle and hence multiplication or division was almost impossible. Five (V) times ten (X) is 50 or L in the Roman system. Each value was unique in the Roman system whereas in our system, numbers can cycle. Two with a zero after it is 20. And, zero is very important. Without it, numbers couldn’t cycle. It’s the reason that 9 numbers plus a zero allow us to write any number we want. Pretty amazing.

stock-photo-old-typeset-166120136Our world is full of numbers. They’re everywhere. Our calendars just moved from 2014 to 2015. We get bombarded continually with numbers representing time, temperature, and, yes, stock market reports. NPR’s Eric Westervelt last week called numbers “the scaffolding that our economy, our technology and huge parts of our life are built on.”

For this blog, I thought it would be interesting to look at the origin of our numbers and then highlight five key numbers that are of real importance to your financial future.

Mr. Westervelt was interviewing Amir Aczel who has written a new book “Finding Zero: A Mathematician’s Odyssey to Uncover the Origins of Numbers.” Mr. Aczel believes the invention or discovery of numbers “is the greatest intellectual invention of the human mind.” We use Hindu-Arabic numerals. Before that, there were many other systems including the Mayans, the Babylonians, and, yes, the Romans. The big problem with the Roman number system is that it had no zero. The numbers didn’t cycle and hence multiplication or division was almost impossible. Five (V) times ten (X) is 50 or L in the Roman system. Each value was unique in the Roman system whereas in our system, numbers can cycle. Two with a zero after it is 20. And, zero is very important. Without it, numbers couldn’t cycle. It’s the reason that 9 numbers plus a zero allow us to write any number we want. Pretty amazing.

Now, knowing a little more about our number system and with numbers seemingly everywhere, where do we focus our attention? Here are five key numbers that have a big impact on your ability to meet your financial goals:

Percentage of your paycheck that goes to savings/investments. This may be the most important decision in your life. By saving early, you can have a portion of earnings grow in a compound fashion for decades. Furthermore, by “paying yourself” off the top, you limit the amount available for everyday living expenses during your working years. This discipline helps you in two major ways to obtaining early financial independence- first, by creating the fund for “retirement” and second, by reducing the expenses you will likely have during “retirement.” BTW- there is no magic percentage. Everyone’s circumstances are different. Consider an amount of 10-20% of your gross pay.

Your Annual Living Expenses. Monitor your expenses for last year and group them in three categories- needs, wants and wishes. Review the data from a long-term perspective. Spending a considerable amount now on wants and wishes will obviously reduce the amount available in future years. It’s all about choices and accountability. For the most part, you alone can determine and control your level of expenses.

The Asset Allocation of Your Portfolio. This is one of your most important investment decisions. Based upon your risk profile you need to determine how best to split up your investment funds between stocks, bonds and alternatives (which can include real estate). Studies show that 90% of your investment returns are the result of your asset allocation.

The Net Returns on Your Portfolio. Research shows that fees really matter. A $1,000,000 portfolio that earns 5% net per year will grow to $4.3 million in 30 years. The same portfolio that earns 4% net per year will grow to $3.2MM. The difference is $1.1 million- a 26% reduction. Over long periods, loads, commissions, high operating expenses and management fees can be a significant drag on wealth creation. Low cost passive investments are best for stocks and bonds. Make sure you understand and monitor all fees charged to your portfolio. Make sure you are getting real value for all the fees. And certainly, know what your net returns have been, are expected to be and how they compare to the appropriate benchmarks.

Your Effective (average) and Marginal Tax Rate. Tax costs on earnings, investment returns and other income can be huge, particularly as a result of the increases caused by the Affordable Care Act. You and your advisors should know your tax rates and use them as a key factor in decision making and investment strategy. Furthermore, proactive planning designed to minimize taxes is a must for you and your advisors.

Over the last 45 years, I have worked with clients of all ages, income levels and circumstances. A common thread among those who have achieved or are achieving their financial goals is that they all knew of and monitored these five key numbers regularly, making adjustments as appropriate. And, of course, they use objective, proactive, value driven advisors like DWM to help them as well.

Why not make it a New Year’s Resolution to know and monitor these five key numbers for your financial future? It could change your life.

Why You DON’T Want to Load Up on The S&P500

The most popular of all market indices, the S&P500, which is made up of the 500 largest domestic public companies, just hit an all-time record high. It is up around 3.5% Year-To-Date (through May 13, 2014) and also is outperforming most of the other equity investment styles, i.e. mid cap, small cap, international, emerging in that same time period. So what’s not to love about it?!?

Whereas our DWM Core Equity Model currently has about a 35% weighing in large caps, we have received a few questions about why our models don’t have more. Several questions have also arisen about why we have the allocation that we do toward small caps, which have suffered so far this year, down over 3%.

There are a few main reasons which I’d like to explain here:

  1. U.S. large caps stocks alone do not provide appropriate diversification – We constantly are preaching about asset allocation and how by adding multiple asset classes one can bring non-correlation benefits to your overall portfolio, which produces a smoothing effect to the return profile, minimizes the downside, and ultimately leads to better long term results. The same concept applies within an asset class. So the more investment styles within equities – large cap, mid cap, small cap, international, emerging – the better, thus ultimately leading to better long term results.
  1. The biggest factor in investor under-performance is from chasing returns; i.e. buying after a streak of hot performance and selling off after a period of weakness. So don’t get caught up in the “investment style du jour”. Large caps are in vogue right now, but that certainly is not always the case. Take a look at the chart below.

Randomness of Returns

As this chart depicts, in both US and non-US markets, there is little predictability in asset class performance from one year to the next. Studying the annual data in the slide reveals no obvious pattern in returns that can be exploited for excess profits, strengthening the case for broad diversification across many asset classes. Investors who follow a structured, diversified strategy are more likely to capture the returns wherever they happen to occur.

That being said, over the past 50 years, academic research has identified variables that appear to explain differences in average returns among stocks. The variables (or premiums) that have stood up to rigorous testing are considered dimensions of expected returns. One of these dimensions is “size effect”. In 1981, Rolf Banz observed that small company stocks tended to have higher returns than large company stocks, as measured by their market capitalization. The size effect provided a more detailed framework for understanding the dimensions of equity performance. No one is certain why small cap stocks have offered an average return premium over larger cap stocks, but many economists assume that markets rationally discount the price of such securities to reflect higher systematic risk.

The chart below shows that this small stocks size effect premium is actually quite significant, leading to an increased annual return of 3.58% since 1927.

US Size Premium

So what’s not to love about small caps then?!? The small cap premium is great, but one can also see that this size premium is neither consistent nor predictable, as the chart above demonstrates. Another reason why we chose not to load up in any one area but to diversify. Therefore, a minority allocation of 15-25% of your total equity portfolio may be appropriate for small caps.

In conclusion, don’t get caught up in the latest fad and chase short-term outperformance by putting all your marbles in one basket such as the S&P500. Instead, think long-term and diversified. Diversified global investors who maintain a long-term outlook are the ones that are rewarded.

Media Scare Tactics: The Coming ‘Bond Bubble’

Is the media scaring you about the so-called coming ‘Bond Bubble’? Block out the noise and focus on what matters: asset allocation.

With all the hoopla going on about fixed income being the possible next “bubble”, I thought it prudent to talk about asset allocation. Fixed income is just one part of a well-balanced portfolio. At DWM, we believe in multiple asset classes including traditional asset classes like fixed income and equities, along with alternatives.

You do not want to all-out avoid or shun an asset class. We’ve seen people that have been out of equities since 2008 and they’ve missed one of the biggest bull markets in history.

You also do not want to load up in just one asset class. We saw people that were in 100% stocks going into 2008 that felt the full pain of a 35-50% drop. That’s a deep hole to dig out of.

The key is balance. A case can be made that everyone should have about at a minimum 20% allocated to each asset class. So how does one determine what percentage of equities, stocks, and alternatives their portfolio should have? DWM does this by identifying your goals, risk tolerance, return objectives, income needs, time horizon, and other special requirements. As every client is unique, so is each client portfolio. A younger client with a high risk tolerance may be 50% equities / 20% fixed / 30% alternatives. An older client with low risk tolerance may be 20% equities / 50% fixed / 30% alternatives.

Take a look at the graphic below which shows a sample individual investor portfolio versus an institutional portfolio from 2009:

pie charts 061313

You can see that institutions have the majority of their assets allocated to alternatives. And because of it, they have had pretty good success. The individual investor is just starting to catch up, as access (or rather the previous lack thereof) to alternatives has changed. Until the last several years, only institutions and the extremely wealthy had access to alternatives. Furthermore, there were high minimums, lock-up periods, bad transparency, and high expenses that were not practical for the individual investor. But that is really changing. We at DWM have been using liquid alternatives for the last several years. More and more of these liquid alts come available almost every day.

In a time and age where the 30 year bond bull market may be coming to an end and a time when the equity market is being called “overheated”, alternatives may offer a complementing asset class that can give your portfolio better overall risk-adjusted returns. Alts can play many different roles in a portfolio from return enhancer to fixed income substitute to diversifier. They can provide investors insurance against declines to the traditional 60 / 40 model. They can mitigate downside risk and lower volatility.

Now, don’t get me wrong: there is no silver bullet. Not all alternatives are created equal, and not all are going to be consistent winners. But with a diversified portfolio consisting of all asset classes, you should have a much smoother, consistent ride which can ultimately lead you to better financial success.

Don’t Neglect the Emerging Markets

From The Charleston Mercury, February 7, 2013:

financial advisors, asset allocation

Yes, 2012 was a great year for U.S. equities. The S&P 500 index rose 13%. However, did you know that the MSCI Emerging Markets Index was up 15%? Emerging market results were uneven. Turkey and Thailand had exceptional performance. China and India did well. Chile and Indonesia did poorly.

Bond returns in the U.S. were lower in 2012; the U.S. Aggregate bond index was up 4%. Not so with emerging market bonds. The JP Morgan Emerging Market Bond Index returned 18% in 2012 (11% per year in the last decade.) Even countries like Mongolia, Zambia and Bolivia are issuing sovereign bonds and receiving favorable terms. The world is changing every day.

You and your financial advisor should consider including emerging markets as a small part of your diversified core portfolio of stocks and bonds. Here’s why:

The demographics are great in the emerging countries. They have an expanding middle class, low debt to GDP and improving credit quality. Growth prospects in emerging countries are much better than developed countries. The IMF forecasts an increase in GDP in emerging markets from 5.3% in 2012 to 5.5% in 2012. Developed countries will likely be around 1%. 

An additional reason for considering an allocation to emerging market stocks includes current valuations. Emerging market stocks are selling for around 12 times earnings for the past 12 months versus roughly 16 times for S&P 500 stocks. 

Emerging market bonds are certainly a more risky investment than the bonds that compose the U.S. Aggregate bond index; which is roughly 2/3 U.S. treasuries and agencies and 1/3 corporates. With a credit quality rating generally comparable to high yield bonds, emerging market bonds would be expected to produce a higher return. However, some of the emerging market countries are stabilizing and, in fact, receiving upgrades in their government bond ratings, while the ratings of some developed countries are being downgraded.

Certainly, there are risks with emerging market securities. First, we are interconnected in the global economy. When growth stagnates in mature countries, this has a direct impact on emerging markets. Second, emerging market stocks and bonds are more volatile. During the last bear market from April, 2011 to October, 2011, the MSCI Emerging Market Index plunged 28%, while the S&P 500 index dropped 19%. In a flight to safety, both emerging market stocks and bonds will likely fare worse than domestic stocks and bonds.

Even so, don’t neglect to allocate a small part of your portfolio to emerging market securities. Over the long-term, you should be well rewarded for your foresight and incurring slightly more risk on a small portion of your portfolio.

Les Detterbeck is one of a small number of investment professionals in the country who has attained CPA, CFP®, and CFA designations. His firm, DWM Financial Group, Inc., a fee-only Registered Investment Adviser, has offices in Charleston/Mt.Pleasant and Chicago. Les may be contacted at (843)-577-2463 or les@dwmgmt.com

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



Liquid Alts*









5yr annual return through 9/30/12





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.