S&P analyst Sam Stovall shows an 80 year model of how a 60% SP500 and 40% LT govt bonds “total returns” portfolio has performed. On balance, Sam gave this passive portfolio model a thumbs up, as the total return in 2008 was only down – 13%, less than the-14.8%in 1974,-19% in 1937 and -22% in 1930.
Sam forgets that in the final two months that the 30 year treasury was artificially manipulated by Ben Bernanke’s Dec 1 2008 QE announcement and race to embrace a ZIRP policy. Further, Stoval’s 60-40 model is theoretical. II do not know any portfolio manager that buys 30 year Govt Bonds (not that there may not be) exclusively for the fixed income side of their portfolios. The point here is that the 30 year bond’s pricing behavior in 2008 was anomalous to historical precedents due to one time Fed policies that induced a huge rally in the US 30 year bond to 142. That is just one statistical flaws one could cite in Sam’s model.
But, let’s ignore the obvious and not so obvious flaws in Sam’s S&P 60-40 model for now. Let’s just look at the premise of a diversified passive portfolio management model as a tool to reduce market risk and volatility.If this diversified model truly offered investors reduced market risk and volatility, the model oscillations from 1929-2009 on the chart (not shown in this post) would have or at least should have been much smoother. Instead what we see is a whipsaw of annual returns.
To smooth out market risk and volatility, I will argue that money managers and individual investors need to take a more active risk management approach with respect to their portfolios.
During years that produce high stock market returns such as 2009 (up 23.4% y-o-y), subsequent years are apt to reflect lower or negative stock market returns (such as 2010-2012) as valuations and other market considerations might become unsustainable. This suggests money managers should deploy asset allocation shifts in their modeling as risks shift in the marketplace. As the economic and financial landscape shifts in 2010-2012 desired asset allocation mixes might be 40-50% equity and 50-60% fixed income.
To reduce potential excess volatility and market risk, weightings of individual equities can be rebalanced upward or downward as needed. Stocks that really outperformed in 2009 could be rebalanced downward, stocks that underperformed in 2009 could be rebalanced upwards. In the event a broad market correction or bear market resumes, done correctly, these adjustments can protect against downside risks to one’s portfolio.
The one tool that money managers have at their disposal that is underutilized is their ability to control market risk. Diversification is a good start, but it is an insufficient tool for reducing market volatility and risk. This is a crucial point. Market risk is far more complex than Sam makes it out to be. Simple diversification is not a panacea that allows one to sleep peacefully at night. Put simply, if the price of an equity is misbehaving, it is probably doing so for good reason. The market is talking to you when prices misbehave and deviate from expectations. Listen and pay attention to what the market is saying. It behooves money managers to pay heed to these market signals and rebalance downward to reduce on’es net exposure for a spell.Once the storm passes, then it is time to consider rebalancing one’s equity positions upward.
Many equity issues that were hard hit in 2008 and underperformed in 2009 have spent most of 2009 forming a long term price base at attractive valuations. Many equity issues that outperformed in 2009 have reached unsustainable valuations. The 1st quarter of 2010 is a good time to consider downward rebalances in the 2009 outperformers and upward rebalances on the 2009 underperformers (with attractive balance sheets and valuations).A little active management will go a long way towards reducing mkt risk and volatility and outperforming Sam Stovall’s 60-40 model in the years 2010-2012, Go for it. Listen to the market and tweak your portfolios.
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