Thursday, May 11, 2023

The Benefits of Long Term Thinking

Charlie Bilello Tweeted about portfolio diversification saying "if you have a diversified portfolio, you will always have something that is underperforming." This is a point I have been making since I started blogging. If everything goes up together, it will probably go down together. Because I think it is related, there is no strategy, fund, stock or whatever that can always be the best. If you have a diversified portfolio that is more than just a couple of funds, then it's a good bet that in some given period, some holdings would be doing very well versus the benchmark and some that will look like stinkers. And then they could reverse later. That's the nature of it. 

 

In the examples above, the blue line portfolio, Portfolio 1 correlates closely to Portfolio 3 which is a 60/40 mutual fund. You can see the make up of Portfolio 1 labeled on the chart and I threw in 100% equities with Portfolio 2 to add some volatility context. 60/40 is certainly valid but we learned last year that it is not always optimal. Portfolio 1 seems valid to me but in the period studied it was not always optimal. None of the three was always optimal because that is not possible. 

Looking year by year at those three;

 

Portfolio 1 only outperformed 60/40 in four out of the 12 years studied. If you grant that Portfolio 1 is valid, lagging in 8 out of 12 years might be a challenge leading to impatience. Investing is about having patience, that is where the most success comes from. I would say Portfolio 1 was close most years but there were a couple where it really lagged 60/40 and much of the long term outperformance can be attributed to outperforming 60/40 by 23 percentage points in 2022.

If we stopped the study at the end of 2021 then Portfolio 1's CAGR lags 60/40 by 1.46% but Portfolio 1 would have kept it's lower standard deviation. If I wrote this blog post in January, 2022 and these were the numbers we were dealing with, would Portfolio 1 be as compelling? 

Maybe no because the numbers appear to be inferior. Maybe yes however because interest rates were so low as to make most parts of the bond market incredibly risky. That's a drum I've been banging since the Financial Crisis. Of course I was nowhere near 40% in managed futures, that to me is a bet I'm never going to make but cobbling together a bunch of things to offset equity market volatility that greatly reduces interest rate risk is something I did and what we talked about.

Knowing a risk exists, there was very little value or safety in the intermediate and far ends of the curve, doesn't mean you know when the consequence of that risk will hit.

Going forward, there is no way to know what will happen but an idea I've been putting out there for a while now, after the huge jump in interest rates last year is that intermediate and longer term bonds have become sources of unreliable volatility. If you take on the risk of that unreliable volatility now, at least you'll get some yield if you're wrong. If you bought a 10-15 year corporate a few years ago, you were wrong and you're not getting much yield. Yield curve dynamics these days seem to favor shorter term paper. Any volatility is muted due to the short duration and 18 months or whatever isn't that long to wait for maturity to bail you out. 

Avoiding the worst outcomes is one way to outperform over the very long term but then that requires patience over the shorter term. Investing really does get easier if you can think in terms of many years, not several weeks

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time.

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