Rethinking How We Invest
By Matt Scales
August 31, 2012
Building portfolios to meet individual objectives is or should be a customized exercise, so this article should not be considered advice for any individual. Instead, it is an alternative philosophy to how investors have traditionally approached building portfolios. For the vast majority of us, we allocate our capital to asset classes with the highest expected returns. The most common result of this process has been the 60/40 portfolio (60% stocks, 40% bonds). The problem is that allocating capital is very different than allocating risk (which we define as volatility). Because stocks, on average, are more volatile than bonds, the risk in this portfolio is almost entirely concentrated in stocks.
For illustration purposes only.
For many investors, they intuitively understand this and have the time horizon and confidence that stocks will ultimately reward them. For others, an alternative to this approach may have some appeal – not because stocks are a poor investment, but because certain investors may not be comfortable concentrating their risk in a single asset class. There are many historical examples where single asset classes can struggle over long periods of time. And when the drivers of that single asset class where we have concentrated our risk turn sour, the effects can be devastating. Think of a retiree living off the fixed income stream generated by a portfolio of U.S. Treasury bonds back in the inflationary 70’s. Inflation erodes the spending power of nominal fixed income securities. That retiree would have lost one-third of their real spending power over the 16 year period from 1965 to 1981, inflation delivering a shock that perhaps they would have been unable to absorb at that stage of their life1.
Ultimately, risk contributions are a major factor that drives portfolio returns. Certain investors have the confidence and ability to determine which asset classes are most attractive and therefore where to concentrate their portfolio risk. That skill set is very valuable. For those that do not, balancing risk to asset classes that respond independently to different economic and market drivers may help smooth out the return experience. For example, stocks tend to perform well during healthy economic environments while bonds can provide protection during spikes in volatility and sluggish growth environments. Commodities may provide “real” protection during inflationary environments when both stocks and bonds tend to struggle. The hypothetical example below illustrates from a practical perspective what we mean by balancing risk:
For Illustration purposes only.
In future Perspectives, we will expand on this topic and incorporate more thoughts on building portfolios, though again we want to emphasize that every investor has unique circumstances and, therefore, unique portfolio needs. For now, we encourage all investors to better understand how their portfolio is allocated from a risk perspective. It can provide valuable insight into how it may perform during different market environments and what the corresponding impact may be to your wealth.
The views expressed are as of 8/27/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.
Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC.
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