An article providing Mr. Foley\'s thoughts on portfolio construction in today\'s volatile market environment.

1. Thoughts on the Mess We Are In
Portfolio Construction in a High Risk Environment
Patrick M. Foley, CFP®, QPFC
December 2012
Our Chief Investment Strategist Bruce Bittles’ primary theme has long been the problem of systemic
debt. In that context, the turmoil in Europe and the volatile markets and our nearly 9%
unemployment rate should come as no surprise.
Since our National debt is not going away anytime soon (and demographic and market trends are
not helping), we expect conditions will remain challenging for the foreseeable future. With that in
mind, I would like to discuss strategies for investing in difficult markets.
In the good ol’ days of the great bull market of 1982-2000 constructing portfolios was relatively
easy. You used a mixture of stocks and bonds, with some of the stocks being in the then almost
exotic category of “international”. How much of each? That was simply a matter of your personal
tolerance for risk. If you could stomach ups and downs you used a lot of stock, and you got higher
returns. Likewise it was presumed that stock ownership should correlate with age: more stock for
younger investors, less as you got older.
It was a beautifully straightforward system… if you wanted higher returns you simply dialed in a bit
more risk and that’s generally what you got. Actually, that is a fundamentally sound concept in some
ways, except that it does not always work.
The chart below illustrates the concept of secular (long-term) bull and bear markets. There is no
question that we have been in a secular bear market; the only question is how much longer it will
last.
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2. Most of today’s investors, and the modern investment industry for that matter, learned how to
invest during the greatest secular bull market of all time. As a result, there are some investment
theories imbedded in our collective psyche that might not be all that effective at the moment. It is
not necessarily a case of “this time is different”, but rather that this cycle is not like the last.
Looking at the period between the 2000 market peak and now, it seems that increasing one’s
allocation to stocks would not have been a path to superior returns. In a secular bear market, there
may be a temporary disruption in the traditional relationship between risk and reward, at least in
terms of stock allocations. It is as if we are sitting on such a mountain of risk that any additional risk
fails to be rewarded in the usual way. I believe this calls into question the investment industry’s
reliance on “risk tolerance questionnaires” as a primary tool of portfolio allocation.
Another point about risk tolerance in secular bear markets is that we have been seeing less variance
between younger people and older people, or between more adventurous investors and conservative
investors. In times like this, most people seem to want the same thing… to have their money grow
without getting crushed in the process.
This collective desire for asset protection has helped create another complication: interest rates are
near zero, so traditional safe havens such as CDs and government bonds provide little to no return.
This is partly a function of government actions (keeping rates low in an effort to spur growth), and
partly a function of a “crowded trade” (the mutual desperation for safe harbors drives down rates
because people are willing to accept low returns to achieve low risk).
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3. So, high debt has helped to create an environment of high risk, slow growth, and low interest rates.
Now what?
There are a number of ways to approach the problem, each with certain drawbacks. Actually, they
all share the same drawback, but more on that later.
One popular approach is to simply sit this mess out. There is an obvious appeal to staying out of
markets that are short on returns and high on volatility. Your money will not grow, but at least it is
not exposed to huge drops. The problem with this approach is that it accepts the likelihood of loss
in the form of inflation. If inflation were visible, if you could see the way it eats away at your
money, people would be more wary of its effects. Inflation is relentless, and its impact though
subtle is just as real as drops in value that occur in the market. At the moment the rate of inflation is
relatively low, although in certain areas - healthcare and education in particular - it remains
dangerously high.
Another way to attempt to deal with risk is through active trading. Get out when the market is
dropping; get back in when it is heading higher. This approach has obvious appeal, but practical
limitations. The problem simply put is that the market does not announce its intentions in advance.
It is easy to look back at 2008 in retrospect and think how great it would have been to avoid the
whole mess, but retrospect is never available when we need it most: now! Sometimes the market
experiences its biggest surges when imminent doom seems unavoidable. This is often referred to as
“climbing a wall of worry”, and we can see a couple of notable examples from the post-2008 period
in the chart below:
Sourced from finance.yahoo.com
For most people the three low points indicated on the chart did not “feel” like times to buy. In fact,
they were times when headlines, market conditions, and gut instinct were all arguing in favor of
panic!
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4. The way many people think about trading is that if the market starts plunging and things look really
bad they will get out, and when the coast looks clear they will get back in. The problem is that I just
described “sell low / buy high”. And the reality is that most investors who attempt to time the
market end up with subpar results1.
The flip side of that would be to sell when the market rises and buy when things look ugly. This
idea would seem to have more logical and statistical merit, but it can cause problems during
particularly bad plunges such as 2008, when “buying the dips” led to some very ugly results
(particularly with regard to financial stocks).
A more methodical approach would be to apply specific limits, such as selling when your positions
drop 10%, in an attempt to prevent steep losses. But what if the market drops 10% and then heads
back up, leaving you to have to buy back in higher? In a particularly volatile market this approach
can lead to a lot of expensive and tax-inefficient trading activity, with no assurance of positive
results.
Aside from staying out of the market entirely or trying to time it, there are a number of other tactics
that attempt to provide returns that deviate from the stock market or mitigate its risk. There are
strategies that focus on mergers and acquisitions, and those that buy assets from companies in
default. Investors can trade or hold international bonds, currencies, oil, metals, agriculture, or
almost anything else you can imagine. There are “long-short” strategies that bet for and against
stocks or other securities. These various “alternative investments” are a very hot subject these days
as people seek out ways to make money in difficult times.
In addition to various asset classes and trading approaches, investors can access a variety of
investments that carry bank or insurance company backing (subject to the credit worthiness of the
backer!). There are variable annuities, market-linked CDs, structured notes, and other vehicles that
attempt provide upside potential with some measure of principal protection.
The problem with each tactic I have referenced is that they come with certain tradeoffs or
downsides. Some are essentially market timing / trading strategies that face the same limitations as
the trading of stocks. The ones that offer guarantees come at a price in the form of fees or limited
upside. I mentioned earlier that all of the various methods of dealing with the current environment
have the same drawback. That drawback is a tendency to provide somewhat modest returns, at least
in the conditions we face now.
Whether by virtue of limits inherent to active trading, or because of the costs of guarantees, or the
drag of low interest rates, it seems that none of the strategies I referenced can be expected to create
the sort of 10-12% annual returns we became accustomed to during the great bull market. No one
strategy appears to be a magic bullet.
So which strategies do we recommend? All of them! Or at least a broad selection. Casting a wide
net is one of our core methodologies as we believe that extra measures of diversification are
warranted in dealing with heightened uncertainty.
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“Quantitative Analysis of Investor Behavior” Report, 2010, Dalbar, Inc. (January 1990– December 2009)
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5. Below is a picture of my four year-old. It was taken this October, and the weatherman was certainly
not calling for snow. But… she was PREPARED!
More fun than a chart.
Also, note the diversity of colors in the suit. And the helmet is not highly correlated with the rest of
the outfit. Preparation, diversification, and lack of correlation!
That sums up our themes for investing in a secular bear market: diversify among asset classes and
investment methods, seek non-correlation, and prepare for market downturns in advance. Finally,
and maybe we should do this with my daughter in terms of the forecast for snow, we think investors
must temper their expectations. The relationship between risk and return is not truly broken, and if
we are to mitigate risk we must expect to forgo some measure of return. With that in mind, our goal
in building most portfolios these days is to achieve a positive return above inflation. Despite the
challenging conditions, we think that is attainable over intermediate to long time frames.
Ask yourself if 2008 happens again (or worse), would you be comfortable holding your current
portfolio until the storm blows over? Is there enough variety, are you invested in quality companies,
do you hold debt investments that are unlikely to default, do you have enough guarantees in place?
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6. The time to ask these questions is before things go bad. To use another weather analogy, you do not
want to be out in the yard trying to nail boards to the windows when the hurricane has already
arrived. On the other hand, if we do not revisit the abyss, are you positioned to benefit? Does your
portfolio have upside potential as well as downside protections?
Remember that we began this discussion by talking about cycles. I believe that someday I will write
a market letter about how to invest in a secular BULL market. Maybe I will call it “Revenge of the
Risk Tolerance Questionnaire!” In the meantime though, we advise you to be wary, to use
protective strategies, to be hyper-diversified… to be prepared.
____________
The Foley Group
Michael C. Foley Janet G. Kelly Patrick M. Foley, CFP®, QPFC
Senior Vice President Assistant Vice President First Vice President
(610)239-2627 (610)239-2629 (610)239-2628
Visit the Foley Group website:
www.foleywealthmanagement.com
Important Disclosures
Past performance does not guarantee future results. Diversification does not ensure against loss. Any transaction that may
involve the products, services and strategies referred to in this presentation will involve risks, and you could lose your entire
investment or incur substantial loss. The products, services and strategies referred to herein may not be suitable for all investors.
While further diversifying a portfolio with alternative investments can help to reduce risk, this asset class can include higher fees,
greater volatility, higher credit risk, can be more complicated, less transparent, less liquid, less tax friendly, may disappoint in
strong up markets and may not diversify risk in extreme down markets. You should consult with your Financial Advisor prior to
engaging in any transaction described in this communication.
Robert W. Baird & Co. Incorporated, member SIPC
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