OUR INVESTMENT PHILOSOPHY
The process of building and effectively managing an investment portfolio has become increasingly challenging over the last few decades. A dramatic increase in the number of assets one can invest in, a more global economy and instantaneous access to virtually limitless information are just a few examples of what has made portfolio management a more difficult task. However, through many years of education, academic research and personal experience, we feel that we have developed a philosophy on investment management and a set of core beliefs that provide us a long-term advantage over most investors. The first of those core beliefs is that this process, the creation of an Investment Policy Statement, is essential in achieving investment success in the years ahead. It will help to eliminate the negative effects that emotions like fear and greed can have on our investment results, and will promote patience, discipline and a long-term focus, which have proven to be the cornerstone of most successful investment strategies.
Our view on Asset Allocation
The single most important aspect of our philosophy on portfolio management is that an investor’s asset allocation, that is, the relative amounts invested in different asset classes like stocks or bonds, large companies or small companies, foreign or domestic assets, is what ultimately drives the returns an investor will achieve over time. This is supported by the widely referenced studies done in the mid-1980s and early 1990s by Gary Brinson, Randolph Hood and Gilbert Beebower called “Determinants of Portfolio Performance”, which showed that 90-95% of the returns generated by a large sampling of pension funds over a 10 year period was due to their asset allocation decisions rather than their ability to select specific securities. In other words, the fact that an investors portfolio performs well is not really because they owned stock in Exxon Mobil rather than Chevron, but because they owned a domestic large company stock. An underlying concept of asset allocation is diversification, which is investing in multiple assets that have different risk/reward characteristics. By dividing a portfolio among carefully selected asset classes, an investor has the ability to maximize the return they can achieve at the level of risk (chance of investments declining in value) they are willing to take on. For these reasons, we spend the bulk of our time and effort on determining what the optimal asset allocation is for our portfolios.
Our view on Fixed Income and Equity Investing
The key first step in establishing the proper asset allocation for your portfolio is to determine how much should be invested in income oriented assets, like bonds, and how much should be allocated to equity, or stock, oriented investments. Many investors mistakenly make this decision based on their need or desire for current income. We, however, focus on your cash flow time horizon and need for safety as the primary determinants of your fixed income weightings. While assets like bonds offer investors more certainty as to the timing and amounts of cash flows, they typically do not offer much, if any, opportunity for growth. Equities, on the other hand, carry more risk with regard to when and how much return an investor may receive, but there is the opportunity to realize a higher total rate of return in the form of price appreciation for taking on that risk. Because of the higher certainty of fixed income investments, the day to day changes in market prices are reduced, so the higher the allocation a portfolio maintains in fixed income the less likely that portfolio is to move down in value over the short-term. Our approach to determining how much of a portfolio should be allocated to fixed income is based on two factors, how much cash are you planning to withdraw over the next 5 years from this portfolio, coupled with an assessment of your tolerance for a decline in the value of your portfolio in the near future (less than 5 years). We feel that in order to generate the best long-term rate of return, a portfolio should be as heavily weighted in equities as possible while still offering protection of near-term liquidity needs and allowing you to sleep at night without worrying about the value of your portfolio declining. As investors we must understand that there are several types of risk, and sometimes reducing one risk actually increases another. Such is the case with the fixed income vs. equity decision, by reducing the risk of a decline in portfolio value in the near-term by investing in bonds we are actually taking on another risk known as inflation rate risk. Inflation, the rise in prices of goods over time, makes tomorrow’s dollars worth less in real purchasing power terms. Therefore, we need to control that risk by investing in assets that grow in value over time to maintain our real purchasing power, and equity investments are far more likely to accomplish this over the long run than fixed income investments.
Our view on International Investing
Many people perceive investing in assets outside of the U.S. as being more risky, and if we analyze historical return data for the last three plus decades we see that this is in fact true. However when we apply portfolio theory, which is analyzing investments not just on their specific attributes but on how they fit into a portfolio of other investments, we actually find that by adding international investments to a portfolio of domestic investments we can achieve the same, or better, rates of return while reducing the overall risk of our portfolios. This is due to the fact that while the volatility of international investments may be higher than that of domestic ones, the correlation between the two is not direct, so when one is falling in value there is a good chance that the other will not be performing exactly the same. Other reasons supporting an allocation to international investments for U.S. based investors are that an increasing proportion of the global economy is coming from markets overseas, many of the economies with the fastest growth rates are outside the U.S., and as these economies continue to develop they become less risky (though likely more correlated with the U.S. markets) than they have been historically. Because of these factors, we feel it is essential to maintain a significant allocation to international markets for both the fixed income and equity investments in our portfolios.
Our view on Style Investing
Equities, or stocks, can be categorized into “growth stocks” and “value stocks”. Growth stocks are typically those of companies who are growing their earnings more rapidly due to increased adoption of their products, and typically reinvest those earnings back into research and development or future capacity. The prices of these stocks tend to be more volatile since the expectations around these companies and the uncertainty of the cash they will generate in the future is higher. Value stocks are the stocks of companies that are usually more established and/or offer a product for which consumption is more predictable. These companies often generate more cash flow than they can redeploy on new projects and often pay dividends to shareholders, increasing the certainty of a return on investment for owners and decreasing the volatility of their stock prices. Over time, the two styles have generated returns that are very comparable, but often at different times. This is driven both by business cycles and by investor preferences. Our belief on the return pattern of the two styles is that over time there is a “reversion to the mean”, in other words when one outperforms the other for more than a year or two the leadership usually changes to the other style. To take advantage of this, we employ a contrarian strategy of style “tilting”, or biasing the domestic equity portion of our portfolios to the style that has lagged for an extended period on the theory that they will average out over time. We will bias the portfolios in increments, so as periods of superior performance by one style get longer, we will increase our weighting in the other style as we expect the reversion back to the norm to be both more imminent and more dramatic. This is one way that we attempt to add incremental return above that expected for our asset allocation.
Our view on Special Situation and Sector Investing
While our overriding philosophy is that the majority of the return achieved on our portfolios will come from our “big picture” asset allocation decisions, we feel that there is an opportunity to also generate some incremental return by investing a small amount, not to exceed 10%, of the equity portion of our portfolios in assets that we feel offer an attractive return relative to the near-term risk of the investment. These will often be sector focused investments based on our research of the 11 Dow Jones sector indexes. Our goal with this part of the portfolio is to outperform our domestic equity benchmark, the S&P 500 Index. The time horizon for these investments will typically be 1-5 years, but will be regularly evaluated and replaced when more promising alternatives present themselves.
Our view on Fund Investing vs. Individual Securities
One aspect of investing that has greatly enhanced the ability of investors to build effective portfolios has been the rise of pooled investment vehicles known as funds. Funds allow investors the ability to invest relatively small amounts of money in a single investment that then pools that money with money from other investors, and invests this pool into different individual securities such as stocks and bonds. The benefits of fund investing are many, such as having teams of experienced professionals selecting and monitoring your investments, fewer items to keep track of, ease of diversification and access to investments such as foreign securities that would otherwise be difficult to purchase directly. We will use actively managed mutual funds (where the managers seek to outperform an index through investment selection) whenever we feel that the management of that fund can deliver better risk adjusted returns, net of taxes and fees, than a passive index approach could. Otherwise, we will use passive index funds or Exchange Traded Funds (ETFs) to obtain our desired asset class exposure.
