Hedging the Startling: The Might of the Passive and Well-Diversified

mount-merapi-113620_1280To say that there are some serious headwinds that we as the collective investment community must face these days is putting it lightly. Between financial downturns and outright crises including Japan’s return to recession, Greece’s distaste for austerity, and Russia’s woes with sanctions, collapsing energy prices, and a devastated ruble; the perceived need (not unanimous) for quantitative easing (QE) in Europe eclipsing $1 trillion EUR; stark observations that the world economy is shrinking; and the actions of central banks that catch us on the toilet such as that of Switzerland removing the cap on its currency vis-รก-vis the Euro, there is much to digest. How do you protect and defend your financial positions, your financial worth, your current and future holdings against such startling occurrences and circumstances? How do you protect and defend your financial, and hence personal, goals? You can do so by ensuring that you are passively invested in a well-diversified portfolio of broad-based assets with low intercorrelations, in-line with your true risk profile and investment horizon, and take advantage of the might it affords you.

It’s true, many hedge funds (including quant and algo houses) and investment banks have been sent scurrying by OPEC’s current supply stance and Switzerland’s currency change-up. For all their investments in technology, analytics, methodologies, and the “right” people, many are in trouble. By virtue of the fact that some institutional investors have holdings in hedge funds or investment banks or are (or were) similarly invested in particular sectors especially hard hit, their portfolios have correspondingly taken hits. If all this is the case, you may wonder how things can bode well for anyone else without the resources and size of these other market participants? They bode well for you because the might of the passive and well-diversified is not in the multi-digit percentage returns of the gamblers who infrequently catch lucky breaks, it is in the defense it provides you when confusion reigns and the advantageous position it grants you when the equity markets come up for air.

While you may not be making money hand-over-fist right this very moment, if you are nevertheless currently invested in a passive and well-diversified portfolio, you have at least three basic reasons to be thankful. One, you are faring better than you would be otherwise. Two, you are set to continue to do so without, and this is a critical point and immense bonus, having to suddenly modify your game plan in the slightest. Three, by tending to your portfolio with simple management tasks like rebalancing (and hopefully even having a little dry powder on the side to be able to add to your portfolio), you will be set to take advantage of lower asset prices and the next wave up while others are looking around in stupid shock.

To highlight the first point, you’ve probably heard that a well-diversified portfolio of broad-based assets with low intercorrelations cuts your risk considerably. It’s one thing to discuss it and another thing entirely to see it in action. The numbers speak for themselves. While individual stocks and entire sectors get rocked by the proverbial financial explosions occurring, the lazy portfolio rides it out like a well-built bomb shelter. That, in and of itself, is worth a great deal. You need look no further than the recent behavior of certain US Treasuries and gold, both considered safe-haven assets, when compared with that of stocks. These assets tend to be poorly correlated with stocks and as equities take hits, they often shine, meaning at a minimum less downside for your portfolio overall (though their inclusion in your portfolio could actually lead to gains – it all depends on your allocation percentages).

January has been a very difficult month for equities with major seesaw action taking place, but charts show that the same is not true for ultra-safe short-term US Treasuries (or really the total bond market in general) and that strange psychological asset, gold. There is a clear divergence in performance across these different asset classes due to their being poorly correlated, as the following chart of stand-ins for the total US stock market index (VTI), short-term US Treasuries index (VGSH), and gold index (GLD) shows.

VTI VGSH GLD Chart Jan 2015

The divergence can be seen over a much longer period than just the last month, as this next three-year chart illustrates.

VTI VGSH GLD 3 Years

Because bonds, equities, and commodities such as gold don’t often perform the same, they go great together as components in a lazy portfolio. Together they shield your portfolio from worse losses that you would otherwise experience. They can conversely limit upside potential, but you can surely see the benefit of recovering from a 6% loss with an 8% gain thereafter as opposed to a 15% loss with a 15% gain later.

Secondly, you don’t have to fiddle with anything to reap the benefits of diversification and a broad-based asset approach. While investment bank Goldman Sachs completely backpedals on their recommendation to clients that they short the Swiss franc versus the Swedish krona upon the realization of the Swiss National Bank’s move, highlighting the danger of one-sided or directional bets, the investor holding a well-diversified, broad-based asset portfolio absorbs the news with far less performance impact and without the need to tweak anything – the protection is built in, unlike with an exposed directional trade. That’s nothing if not stress-reducing. You can stick to your plan and avoid being reactionary or emotional (and making bad decisions in the process).

Thirdly, as for rebalancing in times of market uncertainty, we’ve certainly covered that, but it bears observation that trading your winners for losers and sticking to your allocations as markets correct not only helps you manage your exposure to risk but also leaves you sitting pretty when it comes to taking advantage of any future equity waves up. As stock markets move lower your safe-haven assets will appreciate. As your rebalancing parameters are triggered, and you sell some of those safe-haven assets and purchase those equity assets that are losing value, you are lowering your average cost and minimizing the size of the hole you have to dig yourself out of while increasing your upside potential for when the trends reverse, as they tend to do. Yes, you might still have to dig yourself out of a hole, but then let it be a small one and not a crater. Additionally, keep in mind that even doing nothing through the financial crisis of 2008 would still have left you with a more sizeable portfolio today than before the crisis, so imagine how much better off you’d be if you had rebalanced.

If you’re sitting on a passive, well-diversified portfolio of broad-based assets that is inline with your true risk profile and investment time horizon right now, rest easy and don’t touch that dial. Maintain your focus, tend to your portfolio, and let others get startled.

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