Shifting Times Require Modifying Methods: Chapter 2
A couple of weeks ago, we wrote the first chapter of this mini-series that talked a little about risk and how we identify and use it to drive our investment decisions. If you want to review, you can read it here: Because You Asked: How Do You Respond to Changing Times? Chapter One. Now that we have talked about the concept of risk, and how to identify it, we want to delve a bit more into the ideas around the risks associated with certain types of investment options.
Some younger, eager investors want to invest in just one or two favorite stocks, such as Apple or perhaps Tesla. Investing all of your cash in just one or two of these types of stocks is considered quite risky because your account balance will rise and fall with these companies alone. This will increase the volatility of their investments, meaning higher highs and lower lows. That choice might be ok for someone just starting out, trying to hit a home run of sorts on their first investments, and don’t have that much to lose.
What Is “Diversification”?
But, as you begin to accumulate wealth, and build up your portfolio, more people are reluctant to accept those roller coaster-like ups and downs, and while they still want a great return, they are not quite as comfortable with large, periodic losses. For these investors, we strive to build a portfolio to smooth out those swings, while trying to keep moving forward. Many investors have heard the term “diversified portfolio” which is kind of a fancy way to say: “Don’t put all your eggs in one basket”. It is the idea that when choosing investments, it can be wiser to select different types of investments, so that if one type does not result in a good return during certain time frames, another will hopefully be performing better, to balance it out and keep their portfolio growing.
One way to accomplish this “diversification” is to use the ETFs that we talked about in our previous posts: a basket of various stocks that have a particular focus, such as healthcare, or energy, or one of the myriad types of technology. Some ETFs simply invest in a very broad selection of stocks, such as the 500 stocks associated with the S&P 500, or the 30 stocks in the DJIA (Dow Jones Industrial Average). You often hear your news channels referring to “The Dow” or “The S&P”, and how much they increased or dropped on that particular day. The idea is that the broader your selection of stocks, the less volatility you should have.
A side note: we sometimes encounter people who think they are “diversifying” by having accounts with different custodians, such as: “I have an IRA at Schwab, one at TD Ameritrade, and a joint account at Edward Jones”. The custodian does not affect your diversification, it is what is actually inside each of those accounts, what you own, or how you are invested that make your portfolio diversified or not. Different custodians are similar to different banks; they are still just banks.
To further diversify, an individual may not only invest in individual stocks and ETFs, but may also invest in bonds, which are a type of loan that you make to a government or corporation, and in return, they pay you a rate of interest, along with a specific date to pay back the amount of the loan. You might also decide to buy some gold or silver, or perhaps to purchase an annuity from an insurance company, because it can guarantee you a certain income for life. These are many of the various ways that individuals seek to invest their money over a broad range of options to make money over time while smoothing out the highs and lows.
Mohammed El-Erian, the former CEO at Pimco, once said (paraphrased): “The essence of portfolio success is the management of risk, not the pursuit of gain.”
All Investment Types Have Risk:
Virtually all types of investment involve risk of one sort or another; for example:
- Products such as insurance annuities with a “guaranteed return” still incur some risk, in that you have to gauge the financial strength of the company that is providing the guarantee to fulfill that contract.
- Generally, the type of investments that are considered “Risk-Free” are instruments such as Treasury Bills or T-Bills. While they are among the lowest risk, backed by the full faith and credit of the US Government, the compensation for selecting them is minuscule: a 10-year treasury currently pays 0.66%. It is important to keep in mind that inflation is currently running around 2%, so even though the Treasury bill is considered “Risk-Free”, its returns are still subject to Inflation Risk, which means that in 10 years, it will be worth less than it is today, so in actuality, it is not completely Risk-Free. Given those factors, the effective return rate on a Treasury would come out to -1.34% per year.
- By way of contrast, just today I had a couple of folks ask whether investing in a company called Draftkings was a good idea. This company may have caught your attention with the recent addition of an adviser who is a rather well-known individual by the name of Michael Jordan. But regardless of the new star-power, research indicates that this company in particular would be a very risky bet. Using one of our software metrics, it has a risk score of 99, which is the highest level of risk available. Not for the faint of heart, nor certainly for those who prefer a more moderate approach to risk.
For many years, a strategic portfolio management principle that has frequently been used for investors with moderate risk tolerance was a combination of 60% stocks combined with 40% of bonds of different types, short-handed to “60/40”. Truth be told, it was an effective, diversified portfolio strategy, and investors could increase their percentage of bonds as they age, to lower even more risk in their portfolios. This strategy worked pretty well for years. But now…it has become steadily clearer that things are different, and consistent with what we wrote about last week about our new constant of Change, we have begun to re-examine this strategy.
We will wrap up next week by talking a bit more about why we think that this strategic change needs to be considered, and what we are doing about it now.