Many years ago, Jerry Wagner, founder and president of Flexible Plan Investments, recognized the value of incorporating multiple asset classes into a portfolio—not statically but dynamically. Using multiple asset classes was not a new concept at the time, but using them dynamically was.
Over the years, investors and their advisors have occasionally pushed back on the use of multiple asset classes. They fear they won’t achieve the returns that a portfolio of stocks alone may provide. But something is missing from that argument: The returns that stocks alone provide come with the substantial risks associated with the stock market.
Market lessons about the importance of a risk-managed, diversified core
Many of my recent discussions with financial advisors have been about the importance of including a substantial core strategy allocation in every portfolio. I start by noting that stocks (as represented by the S&P 500) are up approximately 20% this year. I then explain that the core strategy allocation serves as the foundation of the portfolio. It provides exposure to stocks, bonds, and alternatives (which we represent here by gold). The core strategy also provides exposure to intermediate-term and long-term strategy time horizons.
Next, I explain the benefits of core and satellite strategies and highlight the value of strategic diversification, meaning diversification among not only asset classes but also investment strategies (see the following graph).
Flexible Plan Investments’ implementation of strategic diversification is systematic. That means it is objective and rules-based. As investing rules are developed and tested, it is common to use lookback periods to determine the current state of the markets: bull, bear, or sideways.
When talking to financial advisors about strategic diversification and core holdings, I first present a three-month lookback. Many may be surprised to learn that both gold and bonds have performed better than stocks over the last three months. For this period, the multi-asset-class exposure of the core holdings would have worked to an investor’s benefit—both from a performance and a risk-management perspective.
Next, I present a six-month lookback. Once again, both gold and bonds have performed better than stocks. And, once again, the multi-asset-class exposure of the core holdings would have provided performance and risk-management benefits to an investor.
At this point, the conversation may turn to durable portfolio construction. At that point, I stretch the lookback of the markets further back in time. I then present a graph of the past nine months. In the case of the last nine months, once again, both gold and bonds have performed better than stocks. And, once again, the multi-asset-class exposure of the core holdings would have provided performance and risk-management benefits to an investor.
At the risk of overstating my point, I will also stretch the lookback period of the markets to one year. As you may have guessed, gold and bonds performed better than stocks—and, once again, the multi-asset-class exposure of the core holdings would have provided performance and risk-management benefits to an investor.
To show that the past 12 months are not a rare example of market behavior, here is a graph of the first half of 2016. During that period, gold and bonds outperformed stocks while all three were positive. This is very similar to the last six months. Also worth noting is the tendency for bonds, and often gold, to move higher when stocks decline. This occurred multiple times in just the six-month period shown in the following graph. It is also one of the market phenomena on which strategic diversification was designed to capitalize.
After presenting these examples of the stock, bond, and alternative (as represented by gold) markets, the discussion about the core foundation of a portfolio takes on a new level of importance. While forecasting which of these asset classes is going to outperform the others in the future is difficult, responding to which asset classes are performing better is where a “dynamic” approach comes in.
By continually monitoring and measuring the markets for many years, we at Flexible Plan Investments have been able to develop rules that direct us in changing our allocations to each of these asset classes as market conditions change. This ability to adapt to changing market conditions also means that success is not dependent on the performance of any one asset class.
There is another lesson unfolding in the markets these days: that all three asset classes do not all move higher together for prolonged periods of time. The money to drive an asset class higher generally has to come from another asset class. Therefore, to have all three asset classes move higher simultaneously, money generally has to come from cash reserves. Once those reserves are reduced, money has to come from other asset classes to sustain the leadership of any one or two of the asset classes.
In 2011, the leading asset class was gold. In 2013, the leading asset class was stocks. In 2014, the leading asset class was bonds. This brings us back to the need to have a dynamic core rather than a static, or fixed, core allocation.
My hope is that after reading this, you will think of the dynamic core of a portfolio differently, appreciating it as the foundation of every portfolio.