Richard Wood explains the benefits of an evidence-based approach to investing.
If you ask many investors what the definition of a ‘good’ portfolio is, they will respond that it is one that has performed really well. Yet, inevitably, that is something that can only be measured retrospectively.
A good place to start is to look at the investment process from a risk perspective, not a performance perspective.
Risk is the flipside of returns. If you focus on attractive returns, you are in danger of taking on unknown or poorly understood risks. If you focus on risk – only taking on those that are understood and adequately rewarded – you provide yourself with every chance of a successful outcome (although, in investing, nothing is ever guaranteed).
A ‘good’ portfolio is not about generating the best performance (with hindsight), but about how well the portfolio is likely to survive a wide range of market scenarios that may lie ahead.
Building a portfolio driven by risk management makes great sense, even if it seems a little unexciting. We can either take, avoid, reduce or transfer the plethora of risks that investors face. Each decision is grounded in the academic theory and empirical evidence that is available to us.
Let’s consider some of the key risk decisions made when establishing client portfolios.
Decision one: Own a highly diversified pool of global companies to avoid concentration risks
Owning a broad exposure to thousands of companies, in all sectors and in (most) stock markets around the world allows you to capture the broad dynamism and wealth creation of capitalism.
Decision two: Tilt the portfolio toward higher risks to pick up higher returns
Empirical research suggests that smaller companies and those with value characteristics (often less glamorous stocks that are financially less healthy) deliver returns over and above the broad markets, most likely due to the higher risks they entail. Taking some extra risk to try to capture this premium is a reasonable course of action.
Decision three: Own shorter-dated, higher quality bonds to balance equity downside risk
Short-dated, high quality bonds bring strong defensive characteristics to portfolios, as they are far less volatile than equities and exhibit returns that may even be negatively correlated to equities, from time to time. Investors who cannot stomach a 100 per cent equity portfolio (very few can) need to take some of the risk of material losses off the table, which is achieved by owning bonds.
High quality bonds protect against awful times in the equity markets. Lower quality, long-dated bonds act like equities at times of market crisis. Money flees these riskier assets, pushing prices down, while shorter-dated high quality bonds act as safe havens, attracting the scared money, pushing prices up.
Decision four: Use systematic rather than judgemental fund managers
Choosing which funds to recommend to clients is a big responsibility that all good advisers take very seriously. Although picking a manager who promises to beat the market sounds appealing, the stark reality is that true skill is hard to discern from luck, it is extremely rare and it is almost impossible to identify in advance.
It makes good sense to employ managers who adopt a systematic (rules-based and disciplined) approach to capturing the returns delivered by taking on specific market risks.
Decision five: Avoid owning an increasingly risky portfolio by rebalancing
Over time, the more risky assets (equities) in a portfolio tend to rise in value and begin to overpower the more defensive assets (bonds) in the portfolio, and the risk level starts to creep up. Periodically realigning – or rebalancing – a portfolio back to its original structure avoids this risk.
Rebalancing involves selling out of better performing assets and buying less well performing assets; selling, rather than buying ‘hot’ performing asset classes. This enforces a systematic, rather than a market valuation-based, defence against possible market bubbles.
Rebalancing is simple in concept, but in practice it is hard to do; it requires considerable discipline and fortitude, particularly at times of market turmoil, when our emotions, particularly fear and greed, are heightened.
The role of the investment committee
A firm’s investment committee is responsible for the oversight of the risk in portfolios and the wider investment process. It should be focused predominantly on the risks that have been taken in the portfolio – both at portfolio structure and at a fund level – rather than discussing whether to jump in or out of markets or which manager to hire and which to fire.
The committee’s responsibilities include:
- Ongoing checking that the investment process continues to be in clients’ best interests
- Reviewing the ‘best-in-class’ funds recommended
- Reviewing the portfolio structure
- Screening for new funds – due diligence and approval of new products available
- Reaffirming or revising the investment process
It is likely that your portfolio will look much the same between one time period and the next with little activity, except for rebalancing. That most definitely does not mean that nothing is happening; it takes quite a lot of work to keep portfolios the same!
By keeping their risk management hats firmly on their heads, evidence-based advisers avoid the siren song of rapidly rising markets and ‘hot’ fund managers that see those wearing their performance hats dashed onto the rocks of market timing and stock and manager selection.