(Jerry Wagner, Flexible Plan) The concept of relativity, where what one experiences depends on their frame of reference, can help investors understand what’s happening in the financial markets.
Einstein’s special theory of relativity posits that time slows down depending on your perspective, like time moving more slowly for someone on a moving train compared to a loved one waiting at the station. In investing, the answer to “How is the market doing?” often depends on the time period referenced.
A short-term view of the S&P 500 can look this bleak:
While a longer-term view can convey a different message:
In building strategies, we try to take this into account by measuring what the market is doing over multiple time periods. We do this to obtain a different perspective by changing our frame of reference. In the long run, we believe that this makes a strategy more robust in dealing with the future.
Investing is about more than asset classes; it’s about time
Another method is to create strategies designed to perform in different time periods. One strategy may be created to capture short-term moves in stock prices, while another may focus on an intermediate-term period.
In creating a portfolio, it is just as important to reflect multiple frames of reference. We can do this by using multiple strategies that each focus on different time periods.
Of course, this is what we do when we use different assets to diversify a portfolio. Diversifying by strategies can accomplish the same thing but with the bonus of adding dynamic risk management to the picture.
When you look at the markets over a longer time, it is also clear that a longer frame of reference reinforces the view that different assets should be included within a core portfolio. In creating such a portfolio, it is important to have assets that have (1) positive returns over the long run and (2) a life of their own. In other words, they don’t always move in sync with one another.
Our All-Terrain and Multi-Strategy Core strategy offerings were formulated around these concepts. Performance is monitored and evaluated over multiple time periods within each. And each uses three asset classes (stocks, bonds, and gold) in the manner necessary to meet our two prerequisites for a core portfolio.
Of course, this is all consistent with a portfolio that is constructed using modern portfolio theory. The difference is that each of these core portfolios also includes dynamic risk-management tools designed to help defend against the ravages of super bear markets (markets that lose 20% or more).
Diversification certainly helps when the market goes through a correction, a sideways market, or a baby bear market (markets that decline less than 20%). But to avoid the worst of a major bear market decline, dynamic risk-management tools like hedging and moving to the safety of defensive holdings are essential.
A different way of evaluating your portfolio’s success
Evaluating the success of the resulting portfolio requires an understanding of relativity as well. Strategies should be evaluated not alone but rather relative to the performance of the other strategies in the portfolio.
When big events happen in the market, if all of the strategies in your portfolio move in the same direction, your portfolio is not diversified. You may not think this is a problem when your strategies are all moving up together; however, if this is what is happening in your portfolio, I can almost assure you, you will also see them all fall together at some point in the future.
Similarly, portfolios should be evaluated from different points of reference. Make sure to evaluate the portfolio as a whole, not just on a strategy-by-strategy basis. And make it truly relative by asking, “How is it performing relative to the risk being taken?”
Performance shouldn’t be judged in a vacuum or compared to an equity benchmark that is not relevant to the risk you are willing to take. Rather, it should be gauged by comparing it to like investments that are unmanaged (a 60/40 fund portfolio, for instance, if you are in a balanced suitability profile) and also to a customized benchmark based on your initial goals, like our OnTarget Investing Monitor.
Similarly, portfolios should not be evaluated over a single fixed period. Instead of looking at the results over a single bad week or a short, choppy period, take a step back and see if the portfolio did what you expected it to do during positive periods.
If it participated reasonably (relative to like investments) during these periods and mitigated some of the losses in bad periods, it probably should not be abandoned. This is so even if all of the strategies in your portfolio did not perform equally well.
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Investment performance, like most experiences in life, is relative. The key to successful investing is being able to answer the question “Relative to what?” Hopefully, this discussion gives us all the same necessary frame of reference to answer that question.
