Breaking With Tradition

A new way of looking at diversification.

Conductor and composer Gustav Mahler (1860-1911), while classically schooled, was an enormously innovative musician. Composers of classical music, by definition, are expected to adhere to traditional orchestral disciplines. But Mahler, a demanding conductor, was notorious among musicians for his motto, "Tradition is slovenly."

His openness to creative inspiration eventually brought him fame for the emotional range and clarity of his works. For example, in his Second Symphony, "Resurrection," perhaps his most famous work, we experience the power of big horns and the beauty of choral arrangements in the middle of the symphony... both of which were radical breaks from classical tradition.

Most of us who earn our living by navigating the capital markets eventually come to appreciate that successful investing, like successful symphonic composition, requires both discipline and creativity. The fundamentals must be understood and incorporated in our daily work, yet there is a role for vision, for insight, even sometimes for departing from the herd in search of value. But for most of us, it seems, innovation is uncomfortable.

Thousands of professional musicians have mastered the fundamentals. It is the openness to inspiration and the courage to innovate that separate the Mahlers, Mozarts and Bernsteins from the merely skillful.

A daunting list of variables confronts the personal financial advisor. Investment issues are so complex and the inputs change so rapidly that the portfolio management task cries out for a reliable, simple framework for managing the decision process. Over the last quarter century, personal advisors have embraced just such a framework, loosely formalized under the rubric "modern portfolio theory." The average advisor is now quite familiar with beta, duration, efficient frontier modeling, indexing, benchmarking, style boxes, Monte Carlo theory, and Ibbotson data on the history of interest rates, inflation and stock and bond returns. These have become our fundamentals, our tools, our "tradition," if you will.

Challenging his orchestras to stretch their skills, Mahler constantly reminded them that, "Tradition is slovenly." In investing, as in music, I believe there is a way in which an unexamined adherence to tradition tends to dull the mind, prevent insight and suppress inspiration. A comfortable professional routine can make us insensitive to changes in the investment environment and less prepared to adapt.

Free capital markets are dynamic, with every participant vying for advantage. In open markets with significant participation by non-professionals, securities prices tend to reflect cyclical waves of emotional buying and selling as well as traditional economic influences. Long-term success in this semi-rational competitive environment, it seems to me, requires alertness to change, an eagerness to realistically appraise both rational and emotional variables, and a willingness to re-examine the adequacy of our traditional tools.

Traditional Diversification

Modern Portfolio Theory, or MPT (I use the term generically, not referring to the work of any particular theoretician), is established upon the principle that a large market with free access to relevant data will efficiently incorporate that data into the prices of all securities. "The market" is so efficient that it is a waste of time to seek an advantage from one's interpretation of available data.

A corollary to this principle maintains that the more risk (meaning volatility of return) that one takes, the greater the long-term return one should expect. Stocks, being inherently more volatile than bonds, will provide superior returns over time; hence, to the extent that an investor can ignore price volatility in the short run, stocks are always the preferred asset class.

A second principle is that risk can be separated into business risk (an investment in a particular company's securities can be negatively impacted by poor management, competitive developments and the like) and market risk (the volatility of securities prices in general). MPT maintains that business risk can be virtually eliminated (a very attractive idea, to be sure) by including in a portfolio such a wide variety of securities that an implosion of any one or even several issues would have negligible impact on the whole.

In short, MPT teaches us to minimize business risk by diversifying our stock holdings very broadly, and embrace market risk (volatility) as the most reasonable source of acceptable, even generous, returns. The ultimate diversification is an equity portfolio weighted in concert with the capitalization distribution of all publicly traded stocks so as to experience pure market returns with negligible "business risk." Where necessary, we can manage market volatility with appropriate doses of less-volatile, lower-return assets like short-or medium-term bonds.

Changed Circumstances?

Today, many independent advisors are finding that investing for clients with investment horizons of less than ten years is unusually challenging. They are skeptical of traditional long-term return assumptions because they share an uneasy consensus that both stocks and bonds are expensive. I say "uneasy" because to eschew a whole asset class because it seems expensive is to actually veer from MPT orthodoxy; it's like questioning your religion. If the market is really efficient, everything that can be known is already reflected in prices and there is no need to worry about valuation. Unless acclaimed author and practitioner Peter L. Bernstein is right ...

In the past year, Bernstein, an ever-cautious observer of the investment world, has made some radical-sounding statements. To paraphrase:

Long-run evidence (that stocks will provide superior returns) doesn't fit the circumstances as they are today.

Policy portfolios (i.e. fixed asset allocations that are regularly rebalanced) are obsolete. Managers will need to be more opportunistic.

More than a 50% stock allocation doesn't make sense (because the prospective equity risk premium is so small).

For now, equities are not the best place to be for the long run (ten years).

It sounds like Mr. Bernstein has concluded that it may now be worth the effort to measure stock valuations against current "circumstances," and to make investment judgments based on that appraisal. That is very different from MPT's working assumption that the market efficiently processes all information, and that one only need endure the short-term "noise" of cyclical corrections in order to achieve long-term returns superior to other asset classes.

I like Bernstein's choice of the word "circumstances." It is broad enough to include valuation concerns (is the P/E unrealistically high, even for a low-interest-rate environment?) as well as a wide range of economic variables that may impact future corporate profits and dividends.

We have enjoyed in these United States almost 60 years of peace and prosperity since the Second World War. Insofar as we humans tend to rely on recent experience in forming our expectations, it is not surprising that investors tend to anticipate a future similar to our past: 3.5% real GDP growth, 3% inflation, persistent productivity gains, stable currency, access to capital at a reasonable cost for both consumers and businesses, domestic tranquility and a smooth transfer of government power every four years. These "circumstances" are consistent with MPT's stocks-for-the-long-run philosophy.

But introduce the possibility of some meaningful change in the expected circumstances, and overlay it with a valuation that is more optimistic than any we've seen since WWII, and you may have a new set of risks and the justification for a new approach to pursuing return and managing risk.

If, in fact, the stock market as a whole is overvaluing our economic future and/or underestimating its risks, perhaps the sun has already begun to set on the efficient market premise of modern portfolio theory. Although MPT's principle that diversification reduces risk remains indisputable, it may be worth re-examining its widely accepted notion of diversification.

New Approach To Diversification

I believe that future "circumstances" are unlikely to be as fecund as those of the past 60 years. A survey of concerns would include: aging populations in the industrialized West, rising cost of government, soaring debt service costs, overcapacity and globalization, beggar-thy-neighbor currency policies, trade imbalances and military concerns.

As Peter Bernstein likes to insist, we cannot know what the future will bring. I realize that there is always trouble someplace on the horizon, much of which blows over and some of which our resilient economy handles well. Nevertheless, as I weigh the current crop of concerns against a market valuation that seems to anticipate an economic future even better than the past, I am uncomfortable with the MPT idea of embracing stock market risk with the majority of our clients' retirement assets. Because I expect an environment of P/E compression, a better idea seems to be to minimize market risk as much as possible and, instead, to embrace selective business risk as a possible source of excess returns. This is the exact reverse of MPT's approach. If we want to minimize market risk, we need a different approach to diversification. Here is our approach.

Rather than begin with an allocation between equity and debt, our first-cut distinction is between what we call Safe Assets and Risk Assets. We call safe those kinds of securities where returns are expected to be stable and unexciting. The makeup varies depending upon available yields; the actual percentage allocated to safe assets is determined by the overall portfolio return our clients need to achieve their personal goals. Safe assets consist primarily of well-diversified, liquid, short-and medium-term, high-quality debt positions.

Risk assets are ones where we realize that there will be volatility and things can go wrong, but where the return potential seems appropriate to the risk. These can include individual equities, actively managed focus funds, limited partnerships of various kinds, leveraged portfolios such as closed-end preferred stock funds, TIPS, lower-quality credits and non-callable long-term bonds where the greatest risk is the sensitivity to interest rate changes.

Having decided on our allocation between safe and risk assets, we then make an effort to diversify our risk holdings based on how each would be affected by the different possible economic scenarios that the future may bring, and we overweight those investments that would do best if our highest-conviction scenario comes to pass. In this way we acknowledge our inability to know what the future will bring, yet we try to add value through our understanding of the way the world works.

We have been developing a grid in which to analyze our diversification, based on three generic economic scenarios: Recession, Muddle and Growth. Each investment is color-coded to the scenario in which its returns would be highest. We make a further effort to understand how each security's return might be influenced by inflation, deflation, changes in the yield curve and such other variables as we can array on our grid. In this way we are satisfied that without having to own every style box or every geographic region we can enjoy the benefits of true diversification, yet hope to realize portfolio returns greater than (what we believe to be) an over-priced equity market can provide.

Our goal of preferring specific risk (business risk, interest risk, inflation risk, etc.) over market risk as a source of returns has led us to a) Do our own securities research on individual equities; b) Favor actively managed focused funds over mutual funds with hundreds of stocks; c) Consider occasional positions in Rydex Ursa (essentially shorting the S&P 500); d) Become comfortable with illiquid issues; e) Place greater emphasis on the micro-cap universe; and f) Favor upfront cash returns from dividends.

Modern portfolio theory's strategy is a lot easier to implement than our scenario-based allocation process and our effort to prefer business risk over market risk, which may partially explain MPT's continuing popularity in the face of so many academic studies suggesting disappointing future results.

Dare To Be Different

Sir Francis Bacon (1561-1626), the father of deductive reasoning, maintained that, "If we are to achieve results never before accomplished, we must expect to employ methods never before attempted."

Those of us who counsel retirees or others with investment horizons of less than ten years hope to achieve for them stable positive returns on their invested capital. Today we accept this assignment under circumstances of extraordinarily high prices for stocks relative to any reasonable calculation of earnings and, simultaneously, nominal bond yields that are almost equally unappealing. This is a challenge not previously confronted, certainly not in the past 20 years.

Bacon's counsel suggests that investment success may require us to employ methods different from those that brought us prosperity in other circumstances. The history of our species suggests that only a minority will want to discuss change, and even fewer will be willing to embrace it. But that's what makes markets so interesting.

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.