Hold tight wait till the party’s over
Hold tight we’re in for nasty weather…
Burning Down the House – Talking Heads
Residents of Santa Rosa and Sonoma County don’t have to be reminded about the risks of wildfires during the dry and windy late summer months. They can still see the damage from last year’s blaze throughout their communities, and they can still remember the horrible smell. Yet, the Loma Prieta earthquake in 1989 is now just a distant memory for most people. We all know that risks exist, but our feeling about a particular risk is driven by our recent experience. Even knowing that we are likely to have another big earthquake, knowing that the risk exists, people don’t actually prepare because they have no recent experience of it. Lack of preparation can lead to a panicked decision-making process precisely when level-headed action is most needed.
At North Berkeley, we are always conscious of this, and we have an intentional process of assessing and managing risk for client portfolios.
The S&P 500, a prominent segment of the global market, just completed 68 months with significantly less volatility than its historical average.1 The next longest stretch of similar market calm was 1956-1962. Although world and domestic politics may have felt volatile over the last few years, securities markets haven’t reflected that. This has lulled many investors into a false sense of diminished investment risk.
…downside risk comes not from volatility alone, but also how each investor reacts to that volatility.
So, let’s get a quick refresher on the topic of risk.
The most common measure of risk in investment portfolios is a measure of volatility called “standard deviation.” Standard deviation quantifies how much a set of returns varies above and below its long-term average. Downside variation can jeopardize your long-term withdrawals, and depending on how stressful you find it, can cause you to make sudden changes, perhaps at just the wrong moment. Thus, downside risk comes not from volatility alone, but also how each investor reacts to that volatility. Our portfolios are designed to minimize volatility per unit of return; over the past two years they have had a standard deviation that is only 46% of the S&P 500. Similarly, our client portfolios only experienced half the downside during the volatile decline over the past two weeks.
Over a period like the last five years, with consistent increases in securities prices, it can be easy to forget the risk of decline. How does it feel? How does it smell? Last week’s sudden two-day drop of nearly 1,400 points (about 5%) in the Dow Jones Industrial Average is a reminder of what can happen when confidence ebbs in an expensive market – and history tells us that we shouldn’t forget what fire smells like just because we haven’t experienced a blaze in recent years.
How we address risk
In our portfolio management, we address risk in three ways: diversification, rebalancing, and dialogue.
We address risk in three ways: diversification, rebalancing, and dialogue
First, diversification. This is widely understood, so we won’t spend too much time on it here. Our portfolios are far more diversified than the Dow Jones or the S&P 500, consisting of 15 asset classes across US and international equities, short-term and longer-term fixed income, as well as real estate and other elements that behave in diverse ways. Diversification reduces concentration risk, whether in an industry or a single company. Thus, there is no outsized exposure to Wells Fargo or Enron when unsavory news comes out, and a collapse in energy or technology doesn’t drag down an entire portfolio.
The second way we address risk is through rebalancing portfolios on a periodic basis. This serves as a methodical process of ‘buying low and selling high’ (sounds so simple, right?). When a position grows beyond our target allocation (e.g. small cap stocks this year) we trim some of those gains at the higher prices. Similarly, when a position declines (e.g. international stocks this year), instead of abandoning the asset class we use it as an opportunity to buy more at lower prices and bring the portfolio back into balance. As advisors, we take the natural emotion out of the process, instead adhering to data and an understanding that markets revert to long-term averages.
Lastly, we understand that periodic dialogue helps identify personal circumstances that drive current or situational risk tolerance. For example, younger clients defy expectations and have low risk tolerance due to underemployment while raising children. Older clients have a higher risk tolerance with adequate fixed income sources, and an investment portfolio intended as legacy for the next generation. Clients receiving an inheritance are cautious due to inexperience coupled with a desire to “be a good steward, and not mess up this opportunity.” The risk-taking entrepreneur has a conservative portfolio to avoid loss of hard-earned wealth. Whatever the circumstances of change, we seek ongoing discussion to assess whether a client’s portfolio needs to pivot to better serve their new situation.
Fire season, that late summer period of dry conditions and stronger winds, generally warrants greater attention from fire departments and citizens alike. Similarly, when certain market conditions exist, such as elevated valuations (S&P at levels similar to 1929 and 1999)2, narrow leadership (S&P 500 led by only 5-7 companies, while 70% of companies are down 10% or more from their 52-week high), and rising interest rates (the Fed has signaled rate increases will continue independent from market reactions), these warrant greater attention to risk.
Circumstances evolve…but the process should remain constant.
We don’t offer an answer, we provide a process.
In predicting the long-term success of an investment manager, a head coach for a professional sports team, or a fire chief, it’s often said that their “process” is the most important thing. That is correct. Circumstances evolve, players get hurt, and weather conditions change, but the process should remain constant. Our process seeks to remove emotional decision making and maximize financial flexibility above inflation during our clients’ lives and often into future generations.
Our client portfolios hold investments that are far less expensive than broad indexes, buy businesses for less than their intrinsic value, and have a chunk of liquid, short-term bonds. The Fed’s interest rate increases have created positive returns for those short-term bonds, and give us and the fund managers the ability to behave opportunistically. We have mentioned before that volatility and interest rates have been exceptionally low the past few years; these conditions are now ripe for change, and we expect our strategies to provide an advantageous positioning as more historically common conditions return.