It’s a Scary World; Diversification Can Make It Less Scary

October 14, 2020 Updated: October 18, 2020

Commentary

We all know all the variables: Are we going to find a treatment for COVID-19, reducing the risk for at-risk population groups? Are we going to find a COVID-19 vaccine that will allow travel to reopen? Who’s going to win the presidential election? What does the economic data say? What does the economic data mean? How should I interpret all the earnings releases from companies over the next month?

And what do I do with all that information?

As an economist, investment allocation expert, and friend, I remind my friends that they want to build an “optimum portfolio.”

But, of course, one person’s optimum portfolio is really different from another person’s optimum portfolio. A young couple saving for their down payment on their first house would be wise to have a much higher portion of their savings and investments held as cash than a couple in their mid-50s who have been diligent about getting the right house and whose kids are already out of college and who have been good about saving the maximum allowable into their IRAs and 401(k) accounts.

But within their investment portfolios, there are many common attributes to discuss and consider when thinking about the goal of “optimization” and building a portfolio that’s “robust” to all the factors we all know we must consider—coronavirus, the U.S. elections, corporate earnings results, and so on.

Many asset allocation studies now assume that fixed-income investments will provide a return of 2.5 percent to 4 percent over the next 10 to 20 years and that equity investments will provide a return of between 5.5 percent and 7 percent over the same time period. However, the risk of loss in any given year in the stock market is much higher than in the bond market, so bonds can be considered the “ballast” supporting the weight of the locomotive, while equity investments can be considered the vehicle that drives long-term investment gains.

Fixed-income investments are tradable debt instruments called bonds. A bond investor owns part of a loan lent to a government (U.S. Treasury bonds, for example) or to a large group of homeowners (mortgage backed securities) or to a business (corporate bonds).

Most asset-allocation professionals start with the assumption that 40 percent of a total long-term investment portfolio should be invested in bonds and then adjust up or down, based on that person’s or family’s or institution’s need for cash and “risk tolerance.” The more a person or entity needs access to cash or the lower their appetite for volatility (a low risk tolerance), the more that family or entity should be invested in bonds.

Investment professionals might also recommend a special kind of tax-advantaged bond issued by states or local governments, called municipal bonds, if the family or entity will have to pay taxes on the income from their investments. Income earned on many municipal bonds isn’t taxed by the federal government. Investments held in a 401(k) account or IRA are typically not taxed until the money is withdrawn from the account.

A person with a low need for cash or a higher willingness to take on market volatility can have a lower allocation to bonds.

Stocks are an ownership stake in a company.

Another key way to diversify beyond just the bonds versus stocks question is determining how much should be held in domestic investments versus non-domestic investments. The diversification benefit of non-domestic investments is that such investments aren’t typically based on dollars and that such investments will have less exposure to the U.S. political cycle.

After determining with an investment professional how much to hold in non-domestic bonds, domestic bonds, non-domestic stocks, and domestic stocks, investors need to consider whether to invest in low-cost “passive” investments or higher-cost but possibly-higher-alpha “active” investments. A passive investment typically invests in some proxy for the entire bond market or stock market and doesn’t involve a portfolio manager looking for likely-to-underperform investments to sell, or for new, likely-to-outperform investments to buy. “Passive” investments just charge the lowest fee possible and give the investor “exposure” to the overall market.

Other passive investments might provide exposure just to certain sectors—such as technology, consumer staples, consumer cyclicals, or utilities.

“Active” investments, on the other hand, will generate a higher fee, which will be used to pay a team of investment professionals who seek to create “alpha”—investment returns over and above what the overall market would have provided. Active fund managers might be tasked with trying to beat the overall market or pick investments only within a certain sector and try to outperform measures of performance for that sector alone.

Generally speaking, many investment professionals typically advise investing only in actively managed fixed-income funds because there are so many ways to outperform in that market. For example, currently, the Federal Reserve is buying billions of dollars of U.S. Treasury bonds and U.S. mortgage backed securities as a way to prop up the U.S. economy during the pandemic.

And in all times, insurance companies have to buy certain bonds to match the payouts they have promised to make. Highly experienced fixed-income fund managers will know how to take advantage of these structural arbitrage opportunities to buy from forced sellers and sell to forced buyers.

Within a person’s or entity’s stock portion of their portfolio, many investment professionals advise some combination of actively managed and passively managed funds. Investing with a fund manager who can generate “alpha” will provide one source of outperformance, while investing with a low-cost fund manager will help make sure overall costs remain low and the investor gets to keep more of his investment gains. Active managers are sometimes more likely to outperform passive managers and sometimes the opposite is true. Investing with both active and passive managers is therefore a good source of diversification.

The last major source of diversification most consider when first setting up a long-term investment account is “growth” stocks versus “value” stocks. A “growth” investor is an expert in knowing what the stock market believes a company’s long-term growth rate will be. If the investor’s analysis shows that growth will be higher than what the market believes, then the investor will invest in that company.

Meanwhile, if the investor’s analysis shows that growth will be slower than what the market believes, then that company will be at least partially avoided to reflect that risk. A “value” investor, on the other hand, is someone, such as Warren Buffett, who values a company based on future expected cash flows to derive an “intrinsic value” for that company. If a company’s share price is less than the “intrinsic value,” a value investor will invest in the company.

Having all these sources of diversification—bonds versus stocks, non-domestic versus domestic, active versus passive, and, within equities, growth versus value, all provide for a more robust portfolio that might more likely do OK over long periods of time no matter how long the pandemic lasts or who wins the election. As an investor grows in his or her sophistication, he or she can build a portfolio that can weather even more possible future events.

Tim Shaler is a professional investor and economist based in Southern California. He is a regular columnist for The Epoch Times, where he exclusively provides some of his original economic analysis.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.