April 1, 2020
March 2020 Newsletter
How A Balanced Portfolio Protects From Downside Risk

It’s stunning how quickly everything has changed in the past few weeks.

As the coronavirus outbreak has continued to spread, so have local mandates to stay at home, which has put a strain on all of us. One thing that fascinates me about the whole situation is that none of us—not a single person of any age—has ever experienced this before. We’re treading completely new waters together. In many areas of our lives, that means that we have no ‘tried and true’ techniques for moving forward. And yet, from an investment perspective, we most certainly have been here before. Regardless of the cause, investors have experienced similar market drawdowns time and time again, and it is in the face of such scenarios when the power of a long-term, balanced portfolio truly shines.

As Marr wrote in this recent article about the origins of our firm, from the very beginning, our clients have included many of our close friends. That makes our mission to help them retire without worrying about the state of the market very personal, and it’s why we have always focused on creating balanced portfolios that take defensive positions to protect our clients’ savings. While some investment managers choose to chase returns in an attempt to beat the market, our portfolios are carefully designed to deliver a reasonable rate of return at an acceptable level of risk. Why does this matter? Because this defensive approach enables us to preserve assets during market downturns, yet meaningfully participate in the upside when the market starts to climb once more.

Over the past year, this approach has been a hard pill to swallow for some investors as they’ve watched the popular stock indices like the DJIA and Nasdaq outperform their own balanced portfolios. More than once, we’ve answered the question, “What are we doing wrong that we’re not capturing all of these gains?” The answer is all about what we were doing right at the time, and why that strategy is paying off today.

While every client’s personal portfolio is based on their personal Investment Policy Statement (IPS), a typical balanced portfolio includes 40% growth (based on the MSCI All Cap World Index), 40% fixed-income/bonds (based on the Bloomberg Barclays US Aggregate Index), and 20% multi-strategy investments (based on the Hedge Fund Research HFRX Global Hedge Fund Index). Here’s how this mix works together to help protect downside risk over the long term:

  • A balanced portfolio helps preserve capital.
    While a balanced portfolio can make it feel like you’re missing out on big gains when the stock market is flying high, there’s a very good reason we allocate 20% of our portfolio to multi-strategy or ‘alternative investments.’ Because these investments tend to be less exposed to the drastic movement of the equity markets, they are much less likely to align with significant drops in equity prices. During the longest bull market in history, it may have seemed like that inevitable drop would never come, but when it did, the decline happened faster than it ever has before. Our balanced portfolio was prepared. That 20% lower-risk position, combined with a fixed-income component that is included for the majority of our clients, did its job well. Though balances were certainly impacted by the market declines, these non-equity positions helped preserve capital to soften the blow.
  • A balanced portfolio fuels growth.
    This preserved capital is now ready to play a key role in fueling future growth. While it may seem logical that equity positions will simply rise again so investors break even when the market recovers, the math tells a different story. In fact, by the numbers, just breaking even after a 50% market decline requires a subsequent 100% gain. Getting to even after a 25% decline requires a 33% gain. However, by preserving capital, the required return to recoup losses is significantly lower than had the entire account been exposed to risk assets. Each client’s personal investment strategy dictates specific asset allocations within their portfolio. Whenever the percentage (or relative weight) of equities in the portfolio falls, we monitor those allocations and make adjustments to support that long-term strategy. Today, we are able to use the preserved capital within each balanced portfolio to purchase equities—many of which are now available at ‘fire sale’ prices—to bring allocations back to target. 

To illustrate how this defensive approach works in the real world, here’s a quick look at how a theoretical, index-based balanced portfolio has performed in the current market—and how it has provided significant downside protection relative to a portfolio fully exposed to the volatility of the stock market[1]:

  • In 2019, the aforementioned balanced portfolio returned 16.14%, lagging behind an all-growth portfolio which rose 27.33%. That difference caused some investors to feel like they were missing out on valuable gains.
  • However, from the peak of the market on February 19, 2020, until March 23, 2020, the balanced portfolio was down -16.00%, compared to the all-growth portfolio which was down -33.60%.

  • Comparing returns from December 31, 2018 through March 23, 2020, it’s easy to see how a balanced approach could enable investors to preserve wealth amid the downturn:
    Balanced Portfolio: -14.13%      vs.       All-Growth Portfolio: -31.74%

What does that mean for you as an investor? In short, a balanced portfolio can help limit losses during a significant market drawdown like what we’ve seen in recent weeks. At the same time, it can provide much-needed funds to reallocate your assets by purchasing lower-priced equities that will fuel growth when prices begin to rise once again.

Sticking to a long-term strategy can be a challenge, no matter which way the market is trending at the moment. Yet, time and time again, we have seen first-hand that a balanced portfolio can protect against downside risk. For investors who are seeking long-term financial security, the key—always—is to balance risk and reward. Investing in a balanced portfolio can help make that goal a reality. 

[1]As of 3/23/20. The “balanced portfolio” is comprised of 40% MSCI All Cap World Index, 40% Bloomberg Barclays U.S. Aggregate Index, and 20% HFRX Global Hedge Fund Index. The “all-growth” portfolio is comprised of 100% MSCI All Cap World Index.

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