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The Garden Party

This soon-to-be-true story describes why investing is like planning for an outdoor wedding, and explains exactly how investors can prepare for any eventuality. Is your portfolio appropriately constructed?

I think we can all agree that managing one’s investments over the course of a lifetime is a daunting task. The investment process itself is often misunderstood and subjects many people to high levels of stress. To that end, I have set forth, below, an explanation of prudent financial management to which I believe everyone can relate. Like all of my stories, this one is true… it just hasn’t happened yet.

Coming from relatively modest means, Diane knew that she and her groom-to-be, Jack, would be paying for their wedding reception themselves. As they planned their outdoor wedding, they weighed their various options. Obviously, there would be costs involved for food, music, and entertainment, but there would also be revenues in the form of wedding gifts. The net return on investment (gifts minus expenses) could be maximized by avoiding costs that are not necessarily required such as tents, umbrellas, and heating systems. As long as the day was sunny and pleasant, they would be heroes, with everyone raving about the beautiful party she and Jack threw.

But what if it rained? What if a cold snap passed through town? They would then be very glad they had invested in the protection of tents, umbrellas, and heaters. Having the party completely washed out by nasty weather simply was not an option, and leaving everything to chance—just hoping it will be sunny—was too much of a risk to take. They need to protect the event by hedging out the impact of inclement weather, so that rain or shine, their wedding would be a wonderful day. Like their car insurance policies, they hope they won’t need the tent and umbrellas, but if it rains, they will be very glad they have them.

So too with your money. Your assets. Your future. You can rely on chance and hope, or you can plan properly, prudently, and appropriately; you can do that by constructing a portfolio that, when times are good, participates, and when they are not, insulates.

In my practice, I took a unique approach: the only thing we know for sure is that we don’t know—and we are honest enough to admit it. Because we don’t know, and because no one else does either, we structured portfolios in a manner that reduced much of the systematic risk that is inherent in capital markets. We helped our clients plan for a future that will be comfortable and enjoyable—no matter when the rain comes. Not to say they can’t lose—we did have down years, but rarely, and drawdowns were materially mitigated, allowing for stable and consistent growth.

One of the best ways to make money is by first not losing. My mantra was akin to the Hippocratic Oath—i.e. “First do no harm”. This allowed investors to remain emotionally comfortable enough to be invested while eliminating the need to then waste gains recovering from previous losses, and more importantly, to benefit from the magical powers of compound returns, as illustrated here.

A professional portfolio is not designed to chase the stock market, which looks great in up years and horrendous in down years. Of course, the rate of return one can earn on risk-free investments is not enough to preserve and grow one’s assets after inflation, so some risk must be taken. To begin, determine how much, and take only that.

Here’s an analogy Canadians will appreciate: your hockey team will probably score more goals if it puts five forwards on the ice with no defensemen. But the other team is likely going to exploit the fact that you have no defense and therefore, you probably won’t win many games. To win the game, you need both goal-scorers and goal-preventers, in order to maximize the number of pucks in the other team’s net and to minimize the pucks in your own net.

So too, a portfolio needs its defensemen—its hedges, as it were—to protect when the other team has the puck. The good thing about proper hedges, though, is that they can be like offensively-minded defensemen. They are skilled at guarding the blue line, but can also score goals—and in a different way than the forwards do. Think of Ray Bourque, Nick Lidstrom, or Bobby Orr, if you will. This is the value of a properly constructed portfolio comprised of assets that move in different directions at different times.

In 2008, investors learned very well (if they didn’t know already) that true diversification doesn’t mean diversifying equities by geography, capitalization, or style. When it “rains” (and even when it doesn’t), a portfolio needs components that are uncorrelated to equities and to each other so that not only can parts of the portfolio not lose, but they can actually gain in these adverse environments. When you have holdings that are up 30% in a market crash because they profit when markets decline, it does wonders for your overall portfolio.

So what is an investor to do?

1. Manage your risk by capping position sizes. One of the best ways to reduce risk is by ensuring no strategy, fund, or position can have a disproportionate impact on one’s portfolio. Any manager/strategy can and will be wrong, and can and will have bad years. 5% is a good number as a rule of thumb—big enough to have an impact but small enough not to be detrimental if something bad happens.

2. Returns cannot be controlled—but, to a certain extent, volatility can. If the variability of returns is constrained, predictive capacity increases. Manage the dispersion of returns (range of potential outcomes) and you will have a much better chance of making money. And you’ll do it consistently, steadily, and stress-free.

3. What’s the best manager/strategy? There isn’t one. It’s a non-starter of a question. No fund/manager/stock/strategy is a panacea. Each should be measured not only prima facie, but by its utility and contribution to the overall portfolio. The magic in all of this is not only in identifying the appropriate components, but in putting them together in the right way such that they contribute to a specific desired result.

4. Due diligence is far more than looking at past performance numbers. In the absence of a proven history, a manager is just a story and probably isn’t suitable for investment. From among those that do have a good history, one must determine how they earned their returns. Was it one large bet that happened to work out? Evaluate the attribution history (what led to the returns). Ensure the team is responsible for the record is still in place. Evaluate their performance over a cycle—in good markets and bad. Analyze the operational and business risks. These are just a few of the many considerations when evaluating an investment and its utility to the portfolio.

5. You must be hedged. Only holding assets that make money when things are going up is not desirable because the drawdowns are too costly. Understanding hedging is crucial though, as not all hedging strategies are created equal. Focus on those that hedge to reduce risk—as they were originally designed by definition. For example, not all market neutral funds use the same definition of neutrality, and some can be far more volatile and exposed than others. An expert in this space is essential to help guide you, make allocations, and adjust over time.

Building and managing your investment portfolio bears a lot of similarity to planning an outdoor party or building an effective hockey team. We looked for growth opportunities but ensured that proper protections were in place in case the environment did not cooperate. Further, we didn't simply build a team comprised of recent high performers. We built a team designed to maximize your collective wins over the long term by mixing in both offensive and defensive specialists.

In these days of turbulent markets, there is no doubt that many investors are feeling the pain of an unbalanced investment portfolio. The loss in value can materially hamper your life’s goals and therefore, needs to be addressed in a professional and disciplined manner.

(With thanks to a special client.)


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