Great Investors Don’t “Rubber Stamp”

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“We don’t make investors more successful by giving them portfolios that pander to their fears. We don’t change the portfolio, we change the person – if he will permit us to do so. We do that by leading him to better temperamental values, chief among which are 1. Tolerance for ambiguity and 2. Resilience.”
Nick Murray

In last month’s article, I shared some wisdom from the greatest investor of all time. This month, I discuss a new way to think about “asset allocation.”

To start, let me share that I am proud to announce the publication of my new book, “Clarity: How Popular Culture is Misleading You About Successful Wealth Planning and What to Do About It.”

While I was writing my book, I surveyed a group of clients and friends about some of the key wealth planning issues that were causing them confusion so that I could address them in my book. There was one response that I found particularly interesting: this “rubber-stamped” approach of being more conservative with assets as you age stops making sense if you have more than you will ever spend.

Conventional Wisdom: The Rubber Stamp Approach

The traditional approach to asset allocation advice is largely rooted in the desire among the financial media, financial advisors, and the firms they represent to pander to the fears of the investing public. Chief among these fears is the irrational fear of equity ownership.

If you open an issue of your favorite personal finance periodical, turn on CNBC, or walk into the office of your neighborhood brokerage firm, the odds are that you will be advised to fill out a “Risk Tolerance Questionnaire” as the first step in the process of designing your investment policy. You will have to answer a list of questions about your tolerance for the loss of your investment principal. These questions are generally asked before any discussion of your overall situation, your goals, liquidity needs, or your current asset base. Next, you will be “rubber stamped” with an Investor Type and provided with a set of rules for how your portfolio should be allocated between stocks and bonds:

  • You are a “Growth and Income” investor. You should allocate 60% to stocks and 40% to bonds.
  • You are an “Aggressive Growth” investor. You should allocate 80% to stocks and 20% to bonds.
  • You are a “Conservative” Investor. You should allocate 40% to stocks and 60% to bonds.
  • Or, God forbid, you should take 100 minus your age to determine your optimal allocation to equities.

The goal of this process is to help you match your portfolio allocation policy to your tolerance for risk and to help you to formulate a plan to maximize your “risk-adjusted return.” This approach tends to focus on the investor’s tolerance for risk, as if the reduction of risk is the only goal of the investing process and the job of a financial advisor is to deliver his client the portfolio that produces the highest return possible with a level of risk the client can stomach.

What if the “reduction of risk” is not really the most important goal of the investing process? What if the real goal of investing is to maximize return over the investor’s time horizon so that they might accumulate the wealth necessary to achieve their most important lifetime goals?

Asset Allocation Strategy: The “Time-Based” Approach

Most asset allocation “rubber stamp formulas” are based on an attempt to produce “risk-adjusted returns” for clients. Many advisors are seeking to dampen volatility (thereby eroding return) so that investors won’t panic and sell their equities during volatile times.

However, Great Investors don’t seek to “dampen volatility” by limiting equity exposure so that they can sleep better at night. Instead, they accept that volatility and return are forever linked, and they work to develop the temperament and emotional resilience to sleep at night, despite any volatility.

At Concentus, we have developed a simple approach to asset allocation that focuses on the goal of maximizing returns over time, while providing realistic protection against the “risk of loss,” which we believe can happen primarily as a function of investor behavior. Instead of adopting a “rubber stamp” – a static percentage asset allocation policy for clients – our strategy makes use of a customized asset allocation approach that we call “Time-Based Asset Allocation.”

In this approach, our first step is to work with our clients to carefully develop a liquidity plan. We also identify the expected needs for portfolio liquidity over the course of the next five years by calculating all of the spending needs that will require cash liquidity in the coming five years. Why 5 years? Good question. Because history tells us that even during the worst Bear Market periods, the market typically recovered all loses by the 5th year.

For context, think back to to ‘Great Recession’…from October 2007 to March 2009, the US equity markets (as measured by the S&P 500) went down 57% (the biggest bear market since 1929-32 Great Depression). But, as if on cue, it recovered all loses within 5 years. Ignoring dividends, the S&P 500 surmounted its previous (October ’07) peak at the beginning of February 2013. If you count dividends, the breakeven cam even sooner.

So, we believe we need to a) provide enough immediate cash for an emergency, b) provide a liquidity plan for 5 years to buffer against inevitable market declines.

Once we have determined a) and b) above, we establish three “Portfolio Buckets” as follows:

  • Short-Term Bucket. This is the “Cash Reserve/Liquidity” bucket. We recommend a certain level of emergency “cash reserves” to account for unexpected future cash needs or the possible loss of income. We typically recommend keeping 3-6 months of expenses. In addition to a cash reserve, we may chose to hold more cash for specific financial objectives to be achieved in the near term (i.e. purchase of a home, automobile, upcoming tax payment, etc.). We believe in maintaining cash, for upcoming purchases within 12 & sometimes 24 months. By maintaining a cash reserve, a forced sale of longer term investment assets at an inopportune time can be avoided. Because of the short-term nature of this bucket, this ‘bucket’ is holds assets with a high degree of liquidity and no volatility, such as cash or money market funds.
  • Medium-Term Bucket. This is the “Income” bucket. If income is to be paid from the investment portfolio (vs current or other passive income sources), this “bucket” is funded with an amount of money that represents the present value of all spending needs for the next five years. This may include retirement spending, education funding, purchase of a new home, charity, expected taxes, etc. Because of the timing of these needs, this bucket is also funded with investments with a high liquidity profile and low degree of volatility. Typically, we build a “Laddered Portfolio” of high-quality bonds or CDs, which will come due in each of the targeted years, for the required amount needed for that year. In this way, we maximize our interest return, while ensuring the certainty and defined result of proceeds coming due upon maturity.
  • Long-Term Bucket. This final bucket is funded with all of our client’s remaining capital, which is allocated to prepare for needs that will occur beyond a five-year time horizon. Because assets in this bucket have a time horizon for use of five years or longer, we can feel comfortable allocating this capital to a portfolio focused on long term growth (mostly from exposure to stocks) to maximize our expected return over time. The odds are favorable that our five-year time horizon will afford the portfolio the necessary time to recover from any temporary setbacks or volatility that may occur in the coming five years.

Once our portfolio buckets are established, the ongoing maintenance and rebalancing of the portfolio is relatively simple. As the year passes, one years worth of the Medium-Term Bucket assets are spent.  The bond ladder thus becomes one year shorter and so it must be “refilled”. We accomplish this by “harvesting” the return achieved from the Long-Term Bucket, selling some of our long-term assets to create liquidity to replace the fifth year of our bond ladder in our Medium-Term Bucket.

This “refill” process is done each year in a disciplined way, with one exception: we do not “harvest” from the Long-Term Bucket to refill the bond ladder in years during which the Long-Term Bucket declined in value due to a market decline. In so doing, we establish a “natural market timing” strategy – we harvest our returns in years when markets have done well (sell high), but we do not harvest and stay invested in equities after markets have declined and are ripe for recovery (invest low).

Of course, it is difficult to maintain the discipline to follow through on this part of the strategy, as it means our portfolio allocations will naturally become more skewed towards equities as we spend from the “Income” bucket and don’t refill it during periods of market distress – exactly the time when our emotions will tempt us to become more conservative in our investment allocations.

We believe that Time-Based Asset Allocation is a better way to think about achieving the maximum return our portfolios can earn over time, while adequately preparing for our liquidity needs along the way. Instead of slavishly following a “percentage-based” asset allocation policy in the pursuit of risk-adjusted returns, this approach seeks to maximize our returns as owners, as well as the odds that we won’t have to sell our equities while markets are down.

Having a Plan

The very best investors have a disciplined approach to making portfolio decisions and always stick to their plan, no matter what the rest of the world is doing. They are able to live through the peaks of euphoria, as well as the depths of terror, with a healthy understanding that a well-designed written investment and financial plan will get them through both.

No predictions. No witch doctor investment sorcery or magic investing formulas. Just hard work, patience, and discipline.

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About the Author:

Erik is one of the co-founders of Concentus Wealth Advisors and currently serves as the Chief Executive Officer of the firm. With over 25 years of industry experience, Erik guides the firm’s overall strategy. After graduating from Amherst College in 1991, Erik spent a year working with Rittenhouse Capital Management, before joining Gerald in 1992. Erik currently holds his general securities registrations and insurance licenses, as well as CERTIFIED FINANCIAL PLANNER™ and Chartered Financial Consultant designations. In addition to his formal designations, Erik has appeared on CNBC’s Worldwide Exchange, Fox News’ America’s News HQ, Live Well’s Mary on Money, CN8’s Money Matters Today and The Real Estate Connection. In 2012, Erik was one of thirteen advisors named to Main Line Today’s Top Financial Advisors list. Erik lives in Bryn Mawr, PA with his wife and three children. He serves on the boards of the Philadelphia Chapter of the Salvation Army, Acting Without Boundaries (serving young people with disabilities) and The Holy Child School at Rosemont. In addition, he is on the financial advisory board of the Sisters of St. Francis in Media, PA.

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