Using a Market Collapse to Benefit Your Portfolio

Finding opportunity in chaos is one timeless investment strategy that has been used by many saavy investors.  Recent events in the market prove that recent chaos is just as good an opportunity to benefit as any other time past.  Divergent monetary policy, commodity price implosions, mutual fund liquidations, and the list continues.  How could you position yourself to benefit from these events?  Let’s take a look:

Q.  What type of an event should I look out for?

A. An immediate or systematic liquidations of mutual funds.  The freezing of Third Avenue Management’s (“TAM”) high-yield fund and subsequent liquidation represents the constraint firms like that can experience during volatility.  Essentially, assets owned by the fund could not be sold for more than what they were supposed to be worth.  Since mutual funds are required to meet daily redemptions this situation posed a problem.  Some firms have increased their liquidity and cash on hand to meet investor redemption requests.  But in no uncertain terms is this a good trend for investors. First, you have the risk of loss of investment capital along with the opportunity cost of not being able to invest while the firm is liquidating. The lesson to be learned here is to know what you are investing in.  Investors with a shorter investing horizon and lower risk tolerance should avoid funds that place bets on the high yield sector or any other with limited liquidity. Decreased liquidity or loss of investment capital could always occur.  On the other hand, investors with longer investment horizons and increased risk tolerance could take advantage of these trends by accumulating assets like the ones TAM invests in as they would be “on sale” (more about this below).  You never know when you may be subject to a fund “freezing”, so owning the individual assets in a diversified portfolio is not that bad an idea.  As always, this should be done after prudent research and analysis or with a trusted professional.

Q. What is the best investment approach?

A.  Strategic or  tactical asset allocations.  There are essentially two investment strategies when it comes to the “how” of investing:  passive or active.  My purpose in this writing is not to espouse one or the other, but to explore the merits of each under a market collapse.  First, let’s explore passive or “strategic asset allocation”.  It is passive because the goal is to earn the return of the overall market.  One example would be buying a fund that mirrors the S&P 500 index (there are a number of funds that do this).  Your expected return would be no more or less than the return of the index.  Taking this a step further, suppose you own a fund that invests in an index that reflects the return of the entire high yield market.  That means you will get exposure to all sectors of that market without any over exposure in any one in particular.  Of note, will be the frequency of rebalancing or “turnover” inside of that fund’s portfolio.  Typically, this process is done to keep the fund from over-weighting any sector among other things.  If this were not done, winning positions would be in greater proportion than losing positions in comparison to the fund’s total market value.  However in the process of rebalancing, the winners can be sold and the fund manager is forced to buy more fairly priced assets.  This is the conundrum with passive investing.  On the other hand, active or “tactical asset allocations” allow for the over-weighting of a particularly favorable strategy to exploit opportunities and earn extra return above the index or benchmark.  This is what is referred to as “alpha“.  In an actively managed strategy, rebalancing won’t force the sale of winning positions.  The caveat of course being that you may become “out of balance” or “over-exposed” in one or more sectors.

Lastly, I’ll mention that focusing on total investment return is key.  Most investors primarily focus on change in value (“buy low, sell high”).  This is important, but it is not the easiest to guarantee.  Historically, it takes investors long periods of time (10 years or more) to have remarkable success with strategies that focus primarily on this component of total return.  This is usually the case because markets usually run in cycles of 7-10 years.  A broader perspective would take into account change in value as well as the income generated by investments.  This can be taken a step further to include the income generated from the income.  Or more simply put:

TOTAL RETURN = CHANGE IN VALUE + INCOME +  REINVESTED INCOME

Consider if you buy a stock and it goes up 5% in year 1, you cannot reinvest the 5% the stock made without selling the stock.  However, if the stock paid a 5% dividend, you could reinvest the dividend to buy shares that would then also earn a dividend.  You could indefinitely repeat this process to increase your total return on the stock regardless if the stock’s price.  Quite ironically, if the stock’s price decreased you could presumably buy more shares, increasing the amount of dividend income you earned.  The caveat is that the price would have some level that it could not fall to and still realistically pay a dividend.  My point in saying all this, is to illustrate the power of compounding.  If an investor focused on a sector or sectors of the market that are fairly priced that paid current income that could be systematically reinvested, this would be an excellent strategy to take advantage of a market collapse.

Happy Investing & Merry Christmas!

Five Keys to Great Portfolio Construction

What are the keys to great portfolio construction? I believe despite the following list, there are still ways to construct a portfolio that will outperform:

-Fear of the FED raising rates?
-Fear of the Chinese economy entering recession?
-Fear of the price of oil dropping so far it tanks the economy?
-Fear that the strong dollar slows down US GDP?

My thoughts are that the “FEAR” of (fill in the blank) can be overcome with proper portfolio construction. Here’s a step-by-step process to accomplish just that.

1. Formulate a return objective. I have written about creating an Investment Policy Statement (IPS) in previous writings and this is where the concept originates from. Everything starts with a return objective in goal-based planning. Simply put, how much do you want to make? An accompanying “why” you require this level of return helps, but is not necessary. Let’s start with this following:

Investable assets: $1,000,000
Annual after-tax income needed: $70,000
Tax Rate: 25%

Therefore, $70,000/$1,000,000 = 7% (after-tax) or,

7%/ (1-.25) = 9.333% (before-tax)

Therefore, 9.33% is the annual rate of return (before taxes) you would need to earn in order to achieve your return objective.

2. Assess risk tolerance. Risk assessments can come in all types of shapes and sizes, but the two important things are measuring both your ability to assume risk and your willingness to take risk. The former is more of a quantitative assessment and will take into account your net worth, income and those kind of factors. The latter is more of a qualitative assessment and has to do with your behavior and how your mind thinks about risk. Usually, a risk tolerance questionnaire is used to assess a person’s willingness to take risk. Here is a link to one that is really good (in my opinion!)

2. Set investment constraints. (Bear with me, we will get to the fun stuff!) Constraints are also very important because they set boundaries around your investment process. Many investors find themselves uncomfortable with portfolio investment choices well after they are made because this step is often missed or not even discussed. Will there be tax considerations to take into account? How much liquidity should the portfolio maintain? How long is the time horizon? Is this a single or multi-stage investment plan? Should the investments be socially responsible? Will there be a wealth transfer that involves gifting to heirs? As you can see the questions can go on and on as well as be complex. These should be explored with a qualified professional.

3. Create an asset allocation. Here is the part that most plans “skip” straight to. Now of course, the plan must include assets, but what mix is appropriate? Well luckily by now you have taken the time to go through the previous three steps making this process much less elusive. Let’s see what data we’ve collected so far:

Investable assets: $1,000,000
Annual after-tax income needed: $70,000
Tax Rate: 25%
Required return: 9.333%
Risk Tolerance: High
Current Age: 35
Time Horizon 25 years until retirement, then 30 years until death

From here, we can narrow down the asset classes we should choose from. For example, we know with such a long time horizon (25 years) this investor should have a large portion of “equity-like” (i.e. stocks) in the portfolio for growth. Also, from the risk assessment we see that equities as an asset class are appropriate. We could even diversify further between domestic, international and emerging equities. Next, we see that the tax bracket of 25%, would make municipal bonds more appropriate than government bonds and maybe even corporate bonds depending on the rates of return. However, we already know that bonds as an asset class will comprise a lesser portion of the portfolio due to the relatively high rate of return needed (9.33% per year).

5. Create a system to monitor results. Set it and forget it has rarely worked as a strategy. Portfolio winners must be eventually sold off as they will begin to become a bigger percentage of the overall portfolio. Losers may need to be sold in tax loss harvesting strategies or if they are just weak performers. The trimming of each, represent necessary portfolio rebalancing at regular intervals. The frequency of the intervals will most likely be a function of transaction costs.  Additionally, you will want to know how close you are coming to your return objective.  From the above example, approximately 0.78% must be earned each month to achieve the annual return objective of 9.33%.  This can be tracked by the monthly statements generated by your brokerage firm or investment advisor.

Invest wisely!