You Can’t Run A Portfolio Like a Business – Part 1
By: Scott Middleton
Effective leadership, clear strategies and perseverance are successful elements of both business and portfolio management. However, some of the skills needed to run a business are diametrically opposed to those needed to manage a portfolio. Being a successful long-term investor encompasses not only understanding these distinctions, but practicing the proven, if somewhat counterintuitive, skills of portfolio management. The first of this two-part article examines the merits of responding to buyers’ demands.
In a free-market economy, businesses need to keep up with consumer demand and innovate or face severe consequences. There are few corporate blunders as staggering as Eastman Kodak. In its hey-day Eastman Kodak employed 140,000 workers and retained a 90% share of the personal camera film market. In 1996 the company was ranked as the fourth most valuable brand in the United States, behind Disney, Coca-Cola and McDonald’s.
However, Kodak’s management refused to quickly embrace the advancements in digital photography and consumer preferences, and by 2012 the company filed for bankruptcy. Perhaps the most tragic aspect of Kodak’s decline was that the company invented the digital camera in 1975.
Alternatively, companies like Apple and Google have been quick to embrace new technologies and consumers’ changing demands. The use of voice-assisted technology took a big leap forward in 2011 when Apple added Siri to its iPhones. Not to be left behind, Google and other companies invented “Siris” of their own to avoid being crushed by the competition. Responding quickly to consumer demand has so far kept Google and Apple from making the mistakes of Kodak.
With investing, quickly adapting to changing trends and pursuing what is successful can lead to disaster. For the eight-year stretch from 1991 to 1998 the S&P 500 Index of large cap US stocks had annualized gains of nearly 21%, far outdistancing the 9% annualized returns of high-quality bonds, as represented by the Bloomberg Barclays Aggregate Bond Index. Focusing on what had become successful, investors in 1999 redeemed a net $7 billion in bond funds and purchased $162 billion in equity funds, according to Vanguard. In 1999 large cap stocks gained another 21%. In 2000, when the technology bubble began to burst, investors purchased an additional $258 billion in equity funds; bond funds were reduced again, this time by $51 billion. However, from their peak in 2000 to their subsequent low in 2002, U.S. large cap stocks dropped by 49%, severely punishing those who had followed the crowd.
The flip side of chasing returns occurred after the 2008 credit crisis and the worst economic conditions since the Great Depression. In 2008 large cap U.S. stocks fell 37% and were priced at arguably their cheapest valuations since the early 1980s. How did investors respond to stocks being marked down at steep discounts? According to Morningstar Direct Fund Flows, in 2009 they sold a net $69 billion in U.S. equities and purchased $404 billion in taxable bonds, a decision based on past regret rather than current opportunity. However, from the end of 2008 to the end of 2016, the average annual gains for the S&P 500 Index were nearly 15%; for bonds, 4%. It is a powerful and highly unfortunate tendency of human nature to make investment decisions based on what would have been a profitable decision a few years prior.
There are three time-proven strategies that effective investors use to avoid the traps of return-chasing and the cycle of market emotions:
1) Look ahead, not in the rear-view mirror, to the expected risk-reward of each asset class and especially the whole portfolio. When valuations on equities have run up (such as in 2000), future long-term returns are likely to be more modest. Alternatively, expected returns are likely to be brighter after stocks have declined (in 2008 and early 2009, for example). Innovest’s expectations for long-term equity returns have become more modest in recent years as stocks’ valuations have climbed.
2) Rebalance the portfolio’s allocations back to their strategic targets on an ongoing basis. Portfolio rebalancing avoids being overexposed to stocks and other riskier assets at the peak of a market and underexposed at the bottom of a market. The discipline of rebalancing is one of the best methods to avoid chasing returns and manage volatility, though it is somewhat counterintuitive to trim what has done well to add to what has not.
3) Constantly look for opportunities to improve the risk-reward profile of the portfolio, including the addition of asset classes and strategies that improve the portfolio’s diversification and risk management. The current environment of low yields—and low future returns–on high-quality fixed income investments has made it very challenging to mitigate portfolio volatility and meet long-term return goals. The next bear market in stocks will test how effectively investors have designed their portfolios to manage downside risk.
The first of this two-part article has focused on the portfolio skills necessary to avoid chasing consumer demand and to effectively implement asset allocation decisions. In part two, to be published in the Summer Research Report, our attention will turn to hiring and firing decisions and how standard business practices can often be detrimental to effective portfolio management.
For more than 20 years, Innovest has provided excellent client service as well as forward-looking, innovative investment solutions for endowments and foundations, retirement plans and families. We are an independent provider of investment-related consulting services and work on a fee-only basis.
The Metro Denver Dental Society is a not-for-profit component society of the American Dental Association and the Colorado Dental Association.