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Dear ,
Picking Up Where We Left Off
Last week I shared some good data with you from the PIMCO Due Diligence conference that I was privileged to have been invited to. Today I am going to continue with a look at how PIMCO is redefining risk. We will also take a look at what we believe are some areas of opportunity going forward. Let's get started.
Conventional Wisdom Dies Hard
Let's start with what we have been taught about risk.
To put it in a nutshell. The more risk you take the more your potential return and if you spread your investments around (asset allocation) to all of these asset classes then you diversify your risk. Because different asset classes go up and down at different times, theoretically this reduces your risk and improves your returns over time. But does it?
Different Seasons of the Economy
Here is the thing about asset allocation. Just like every other economic theory, it works right up until it doesn't. There is no investment strategy or theory that works 100% of the time. The reason is that things change in the economy. There are seasons if you will.
Here is what I mean. From 1950-1966 and again from 1982-1999 we were in a season of rising markets. In that season traditional asset allocation worked like a charm. Then in 1966 the Dow first hit 1000 points but then fell back. For the next 16 years the Dow would rally to a 1000 or so and then fall back. Over and over and over again. Then finally in 1982 the Dow crossed 1000 points and stayed above it as the great bull market of the 80's and 90's began. The seasons had once again changed.
We had tremendous growth in the 80's and 90's. That is when traditional Asset Allocation became the accepted wisdom of the markets. Unfortunately the seasons of the economy again shifted in 2000. On January 3, 2000 the Dow opened at 11,501.85. On November 2, 2012 the Dow closed at 13,093.16. That means that the Dow has returned 13.84% in the last 11.83 years. That is approximately a 1.17% return per year. In a sideways trending market asset allocation doesn't seem to work nearly as well.
So What's The Answer?
As our clients all know, we believe that you have to take a different approach. Before I share that approach with you I'd like to take a quick look at why traditional asset allocation isn't working as well right now.
The problem with traditional asset allocation in my opinion is that it starts by looking at the historical interplay of different asset classes in the past and then makes the assumption that they will always be that way into the future. That just seems odd to me. After all, every prospectus that I am aware of has words to the effect of "past performance does not guarantee future results". If that is the case then why is the most widely accepted investment philosophy based on exactly that?
Check Your Premise!
"Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong."
Ayn Rand
And I believe that is true in this case. The wrong premise being the belief that asset classes will behave in relation to each other just as they have in the past. Here is why traditional asset allocation has not been nearly as effective as it has been in the past at helping to reduce risk.
As you can see in this chart by looking at the bottom dotted line, from 1972 until about 2002 the correlation of international markets to stocks was about .4. That meant that the international markets moved the same as the S&P 500 less than 50% of the time.
But what has happened over time is that as more and more people started including international stocks in their portfolios, the correlation started to rise. If you calculate the correlation from 1996 or so until the present you will see that the correlation is now about .9. That means that the international markets now move in rhythm with the S&P 500 most of the time. That does very little to reduce your risk. Here is an example.
This was a study of the average endowment portfolio as of 6/30/2011. As you can see, even though the portfolio was fully diversified per traditional asset allocation theory, 82% of the risk was coming from equity exposure. Not very effective at reducing risk is it?
So What Do We Do Differently?
We start at the bottom by developing a market outlook based on current economic factors recognizing what season of the economy we are in. Then we focus on controlling risk. Do you remember the difference between the way that wealthy Americans invest vs. the way working American invest?
That right! Wealthy American focus on controlling risk first, and then they worry about getting a fair return on their money relative to the risk they take.
Then the final step is to make recommendations that align the investments with the economic outlook and risk control strategies that we have developed.
Need Help Reducing Risk?
Folks we've had a nice run up in the market the last 6 months or so. Have you developed a strategy to harvest those gains and start controlling your risk? If not then give us a call or write a quick email and invite us to help you. reames@reamesfinancial.com
Opportunities Going Forward
I'm going to give you some quick general themes that we think could lead to opportunities in the near future. We will explore these ideas further in future issues.
Mark Kiesel is the manager of one of the mutual funds that our clients have benefited from owning over the past year or so. He spoke at the conference that I was at and he has identified 6 diamonds in the rough as he calls them. Here is his list. Pipelines, Airlines, Gaming, Lodging, Autos, Chemicals, and Housing.
There Is A Huge Clue In This Chart
The concept here is simple. As many of you know, when interest rates fall the value of bonds usually goes up. US interest rates are already so low that they don't have much more to fall therefore they have limited upside appreciation. Interest rates in other countries are falling just like here but because the rates are higher they have further to fall. That theoretically gives you more upside potential.
Do you know how to take advantage of this interest rate differential? If not give us a call or send an email. preames@reamesfinancial.com
Real Estate
One area that does continue to give us diversification because of its low correlation is real estate. Here are a couple of interesting charts regarding REITs. In addition I ran across this article this morning. Well that wraps things up for this week.
Until next week , Protect Your Wealth!
Sincerely,
  
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