Investment advice from an unusual source
It was over 30 years ago. I sat in a pew in a little church on the village green of Franklin, Michigan. It was the usual Sunday service, but I was stirred by the sermon from a minister who was still relatively new to me.
Dr. Richard Cheatham began by recounting the hectic mornings from his childhood,
No matter how often or urgently Mom would remind us of the need for haste, I usually headed for the door at the last moment, grabbing for whatever the weather called for on my way. In winter, this usually required a bit more time. Michigan winters can be brutal. Coats, mittens, scarves, and headgear had to be in place prior to opening the door to receive the first blast of frigid air. I invariably began the buttoning process somewhere in the middle of my coat, donning hat and scarf between buttons. Often, in my haste, I began with the wrong button in the wrong hole. By the time I was finished, part of the coat was scrunched up around my neck, while one side dangled limply alone at the bottom. In frustration, I would turn to Mom and plaintively ask, “Can you make the buttons even?” In response, she would begin unbuttoning them and then start the process from the bottom, saying, “Dick, if you get it right at the bottom, it will come out right at the top.”
Dick went on to use the story to explain the meaning of the words from scripture, “Seek first the Kingdom of God and His righteousness, and all these things shall follow as well” (Matthew 6:33). He explained, in part, that this meant that to reach a goal, you must start with the basics: the way you lead your daily life and the priorities you set for yourself. To solve a problem, you don’t start from the middle and work up. Instead, you should use a bottom-up approach.
I’m not sure why the message from that sermon has stuck with me and guided me for so many decades. Dick once told me that it had been one of his most popular sermons and one that he repeated many times while serving four different ministries here in the Detroit area and then in and around San Antonio, Texas. It was even the source of the title to one of his many books, “Can You Make the Buttons Even?”
I later found out that Dick and I were the same relatively rare personality type. So, maybe we just connected. But I also know that I faced the same challenge with my buttons when I was a kid.
In the end, though, I think it was just that the sermon offered such sound advice for how to proceed with any project or solve any problem. If you break a matter down to the basics, beginning at the bottom and then proceeding to the top, reaching the goal or solution is so much easier and the result seems to better survive the test of time.
This approach also applies to investing. You cannot build a truly robust portfolio by starting in the middle and working to the end. What do I mean by a truly robust portfolio? It’s one that reasonably participates in asset-class returns while providing downside protection in uncertain markets of the future.
The danger of the single-asset portfolio
To begin with, you create a portfolio because owning just a single asset makes you susceptible to a very high level of risk. For example, for most of my life, Sears was a brand I knew and trusted. When I began investing 50 years ago, it was the nation’s biggest retailer and a centerpiece in most portfolios. Heck, its headquarters was even in the tallest building in the world at the time—the Sears Tower. Yet, this is a chart of the performance of Sears over the last 10 years:
Once over $60 per share, it recently sat at just 23 cents! This chart is a perfect illustration of the risks of single-decision, buy-and-hold investments and why you must diversify when you invest. Too many unanticipated events and circumstances can impact a single asset or company.
The risk of a single-stock or single-asset-class portfolio is too great for any investment professional to seriously suggest it. That’s one of the reasons I get so upset with the media’s stubborn focus on the S&P 500 as the proper benchmark for judging the performance of a portfolio.
Measure progress against a personal benchmark
To me, the use of an index that has fallen by more than 50% twice in the last 20 years as a benchmark is ludicrous. Would you really invest all of your dollars in such an investment? If not, why would you compare the growth of your retirement account to such a standard?
The S&P 500, or any other stock and bond index, is simply a representation of what the market environment has been for a single asset class over a predetermined period of time. It has nothing to do with the performance of your portfolio. You cannot take the same high level of risk for your hard-earned dollars that the committee sitting in some distant New York City tower is willing to take in formulating an index.
I much prefer a goal-based approach to measuring portfolio performance. In my experience, what investors most want to learn is if they are making reasonable progress toward their investment goals.
At Flexible Plan, the way we do that is with our OnTarget Monitor. It projects the probable course of your portfolio in advance and then compares your portfolio’s actual progress to that projection in each quarterly statement—now monthly on our OnTarget Investing website.
Building portfolios for performance and risk management
Now, what do I mean when I say that you can’t build a robust portfolio by starting in the middle and working to the end?
So often, investors and their advisers create a portfolio in a kind of ad hoc manner. They hear of something interesting, with past or promised high returns, and then add it into their portfolio. After a time, a portfolio exists but it consists of just a mix of investments that were not really chosen with any plan in mind.
While such a portfolio is more likely to be investor-created than one suggested by an adviser, many advisers prepare a portfolio that falls victim to the same likely result as the investor variety. They will try to create a portfolio made up only of asset classes that have been the best performers. That certainly looks great when they show it to a client. How well it has performed!
But, of course, the reason the charts look so good is because they have been constructed of the best performers for the period being shown. How can it be anything but great?
Unfortunately, we can’t invest in the period being shown in those historical charts. When we create a portfolio, it is not to invest in the past. It is to invest in the future.
We know all of the risks to defend against in that past period because it is in the past. We do not have the benefit of such hindsight when it comes to portfolios going forward. Our portfolios must be created to manage risk and perform in an uncertain future, not for a known past.
Building a robust portfolio starts with two goals: performance and protection. Starting at the bottom and working up, performance is driven by the returns of the various asset classes. Your portfolio must be designed to participate in the returns available from the various asset classes.
Notice I did not say that the returns need to match the returns of some stock or bond benchmark. Nor did I say that they need to equal or exceed the best of those benchmarks. These are unrealistic, unobtainable standards when one realizes that performance is just one of the individual investor’s goals. The other goal is protection.
I already discussed the fallacy of the S&P 500 as a benchmark for investors because it periodically loses 50% or more. Similarly, solely on a return basis, the NASDAQ Composite Index has even better returns in most bull markets than the S&P 500; however, since 1999, its losses on a buy-and-hold basis have twice topped the 70% mark.
Return alone cannot guide your decision. After all, lottery tickets have an infinite return, but we don’t invest everything in them because the loss is a near-certain 100%!
So how does an investor create a truly robust portfolio, one that reasonably participates in asset-class returns while providing downside protection in uncertain markets of the future?
To me, the best way is to “get it right at the bottom so that it will come out right at the top.”
Start with a strong core
The most important part of any portfolio is its core. The core of your portfolio is supposed to allow you to participate in the returns of the component asset classes. Almost all core portfolios do a good job of meeting this goal. This first goal of portfolio construction is satisfied by starting at the bottom, by putting the asset-class building blocks into the portfolio.
The problem with most portfolios is that they draw these building blocks from the wrong asset classes. They focus on stocks and bonds because they have the best track record since the market bottomed in 2009. They are great at optimizing history but are not prepared for a crisis in the future.
The history they are optimized for is one in which stocks have been on a tear. It is a history with a 20+-year bull market in bonds. It encompasses the longest uninterrupted period of economic growth in our history. Is that repeatable?
No one knows with certainty the answer to that question, and that uncertainty is the reason why core portfolio construction needs to reflect more than optimizing returns. It’s also why a buy-and-hold strategy should not be the only basis for a core portfolio.
Dynamic, risk-managed strategies must also be used in core construction to allow the portfolio to respond to changing conditions. Having responsive strategies instead of just passive ones not only allows your core portfolio to respond to changes but can even maintain the status quo if conditions do improbably remain constant.
A buy-and-hold portfolio cannot perform both of these services. Dynamic, risk-managed strategies are designed to do both.
One of the challenges of using these strategies, however, is that once you move away from the conventional buy-and-hold strategy, there are so many other core strategies to choose from. This can be intimidating to investors and their advisers.
And as with buy-and-hold strategies, dynamic, risk-managed strategies do not perform well in all market environments. Some are better in trending markets, while others do better in sideways markets. Some make more use of alternatives and bonds, while others employ leverage.
To solve these dilemmas, we’ve created a strategy called QFC Multi-Strategy Core. It’s offered for five different suitability profiles from conservative to aggressive. It combines a number of our dynamic, risk-managed core strategies into a single strategy for each of these profiles.
I’ve written before that investors should have at least 65% of their portfolio invested in core strategies. We believe that the core strategies should be responsive, risk-managed strategies and that investors would be wise to diversify among the many core strategies that we have offered.
QFC Multi-Strategy Core actively allocates among our many core strategies to take the guesswork out of choosing which strategies to include in the portfolio and when. It chooses the initial strategies and the percentage to own of each. It monitors their results and reallocates monthly. It can drop underperforming strategies from the portfolio, and it can add new strategies to the mix.
QFC Multi-Strategy Core is designed to deliver three levels of risk management:
- The dynamic risk management employed within the funds used in each strategy.
- The active management among the funds required by the strategies themselves.
- The dynamic allocation employed among the strategies by QFC Multi-Strategy Core itself.
QFC Multi-Strategy Core differs from our QFC Fusion 2.0 service. It not only uses a different allocation methodology, but it also confines its universe of strategies exclusively to core, suitability-based strategies.
If we combine these basics, we can achieve our goal of building portfolios that participate in asset-class returns while also helping to protect against risk.
The latest result of this process is our suitability-based QFC Multi-Strategy Core offering.
Because we built it right at the bottom, we believe it will come out right at the top.
All the best,
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. Inherent in any investment is the potential for loss as well as profit. A list of all recommendations made within the immediately preceding twelve months is available upon written request. Please read Flexible Plan Investments’ Brochure Form ADV Part 2A carefully before investing. View full disclosures.