Portfolio Management: Focus on the Future

Failures in Conventional Thinking

As we near the end of the first decade of the new millennium there are several new terms we use that rarely appeared in common conversation just 10 years ago, terms such as GPS, MP3, Blog, Plasma TV, Subprime and Stem Cells to name a few. All around our society, information describing our world expands at daunting rates and this explosion requires advancing analytics to make sense of it all. For most of the investment advisory business, portfolio building techniques and analyses sit in a conventional state lacking in thinking adapted to the world we know today.

Synonyms for diversification are words such as assortment, divergence, variety, and potpourri. In the in vestment business though, diversification has a very specific meaning: “A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”

The notion of this specific diversification definition shows up on a wide variety of advisory websites under common concepts such as ”reduce the fluctuations”, “moving in the opposite direction”,” least amount of fluctuation”, “reduce the overall variability”, and smooth out the ups and downs.”

Truly, combining one asset class in the top quartile of the correlation continuum and one in the bottom quartile will smooth returns. However execution of this concept fails theory. Over time, asset classes have become highly correlated mathematically, defined as the top quartile in the correlation continuum – or correlation values of 0.5 to perfect correlation of 1.0.

Consider these facts:
* There are over 300 benchmarks correlated to the S&P 500 and average correlations have increased from 0.38 in 1996 to 0.63 in 2008 – an average solidly in the top quartile where little diversification exists.
* Bonds which used to be uncorrelated to U.S. stocks have moved from a negative correlation (-0.77) during the period from 1997-2002 to a positive correlation (0.68) during the time period 2002-2007.
* Corporate bonds which were clearly not correlated to all stocks10 years ago moved from -0.686 to a positive correlation over the last five years of 0.203.

Many investors have noticed the increased correlations of the capital markets. In a recent study of wealthy investors by PNC, the following quote appeared:
“The ultra wealthy likely are looking longer term, knowing that historically the stock market has advanced when interest rates are falling.”

Actually, investment theory says that a market that is good for bonds (falling interest rates due to recessionary pressure) is bad for stocks. In recent years though, it’s clear that the stock market benefits with interest rate declines and suffers with interest rate increases - to cool down an overheating economy. We also can see in the newspapers that global markets are highly integrated with our markets, reflected in a correlation of the MSCI EAFE (Europe, Australasia, and the Far East) index to the S&P 500 of 0.9 – remember 1.0 is perfectly correlated!

What we end up with is a portfolio built with the presumption of return diversification – smoothing returns over time – but in reality, a portfolio that delivers little real benefit.
Many advisors are quick to show reduced return and volatility factors using a mixture of asset classes. This is a bit of investment sleight of hand. Correlations reflect patterns of returns, the ups and downs of the market as shown in the chart below. High correlations between investments do not mean the actual returns are the same, just the pattern of returns. That does not mean investment diversification has been achieved. Think of it this way, varying the ingredients will make cakes look and taste different, but, in the end, you still have cake!

The world is flat and correlated
A successful portfolio funds your future needs or liabilities; anything short of this is a failure. It makes sense, then, that the portfolio must handle future events, not those of the past. Investment analysis uses past returns as the essential data for risk and return statistics. Consequently, the advisory business puts too much emphasis on past returns of funds and managers, when in fact it is subordinate.
Returns are the result of an economic environment. An economic environment has vast numbers of variables that play out in unpredictable ways, to this point, would anyone dispute that a single industry (banks) can alter an economy? A portfolio defined today must play out in the uncertainty that is the future.
Proper diversification weights the portfolio toward asset classes with the strength to handle the future.

Chris Blakely - May 2009

Sources: Dictionary.com, Investopedia.com, Bloomberg L.P., Investment News (12/14/2007)

Phantom Wealth v. Real Wealth

I recently heard a radio interview with David Korten, an author and engaged citizen, who spoke about two forms of wealth creation – phantom and real wealth. It really got me thinking.

Phantom wealth is basically money that is created out of nothing. And Wall Street was masterful at phantom wealth creation. Like pumping up financial bubbles, it was tech 8 years ago and of course, the whole mortgage debacle, which was based on the assumption that housing prices would only rise - like the stock market. And housing prices did rise, year over year, even though there was no change in the size of the home, its livability, its location or anything else. It was pure inflation. But it was treated as though inflating housing prices was actually creating real wealth. And it did create wealth right up until it did not anymore.

Real wealth is anything of real value or utility. It can be land, labor, education and ideas. And at the most basic level its healthy children and a strong family, it's a healthy environment, its capitalism when working.

Adam Smith praised in “Wealth of Nations” – a market that looks very much like a local farmers market: a place where small producers and consumers come together in a community to exchange goods and services. My firm advises clients more efficiently and competitively than the largest providers, yet it’s common to hear that bigger is better. Now what his writing has been used to justify is the consolidation and monopolization of economic power and, in fact, those who study Adam Smith's work in depth conclude that he actually wrote “Wealth of Nations” as a tirade against the concentration of corporate power.

What we need to face up to is that we are exceedingly consuming beyond what the planet can sustain. Now, we're often told that any change in our consumption level will require sacrifice – not exactly true. There are enormous opportunities to at once reduce our consumption and increase our quality of life. But it requires a reallocation of resources from those uses that are harmful, to a focus on meeting real needs and meeting the real needs of people. This requires our economy doing a 180 degree turn to focus on life needs rather than on increasing the financial assets of the already wealthy. Banks collapse our economy about every ten years (S&L crisis late 80’s, global banking crisis late 90’s and the current situation) which puts the whole economy into a condition of instability. We need banks terribly but let’s not abuse debt such that we all end up working for the banks in the end.

We need to redesign around a primary value on life, on the health of our families, the health of our communities and the health of our environment. But it requires local economic control, it requires local ownership, it requires the broadest possible participation in ownership (investing), and it means managing the economy for the long term. Now that means, using locally owned banks and local businesses when appropriate.

CBlakely 04-2009

Source: NPR interview with David Korten