At Clarity Investments + Planning LLC, client portfolios are designed for the long term. While many people perceive risk as the possibility of losing money, a different way to think of it is the possibility of not meeting your goal. For instance, a person may not lose money by saving solely in cash, but its failure to maintain purchasing power due to inflation could derail the investor’s retirement prospects. The fact is, nearly all investors must take some level of risk to attain the return required on the investment.
That said, there are different types of risk, and at Clarity, we make the distinctions based on the principles of Modern Portfolio Theory. This theory, which earned Harry Markowitz a 1990 Nobel Prize in Economics, was groundbreaking in its emphasis on evaluating investment performance (and risk) at the portfolio level, rather than at the level of the individual securities. Prior to the 1950s, when Markowitz developed the portfolio model, the focus was solely on selecting high-performing individual securities, with little consideration given to the relationships among the individual holdings.
These relationships, or correlations, are key to portfolio theory. Combining assets that change in value differently from each other reduces risk while maintaining a given level of return. For example, as the U.S. stock market suffered from the tech bust and 9/11 from 2000 through 2002, real estate and many bonds were doing very well. Even in 2001, small U.S. companies had a good year while large ones continued to suffer the dot-com fallout. In 2008, U.S. Treasury bonds offered double-digit returns on the positive side. Even with stocks, an investor suffered a smaller loss in the U.S. than in emerging markets, which had in recent years offered very good returns. Diversifying portfolios among many asset classes reduces the impact of any one asset class on the whole portfolio’s performance; in short, you should avoid the investing equivalent of “putting your eggs all in one basket.”
Our investment portfolios diversify within asset classes as well, by using mutual funds that typically hold thousands of securities. This decision is based on the concept of the Efficient Market Hypothesis, developed by Eugene Fama in the 1960s, and earning him the 2013 Nobel Prize in Economics. Simplified, the hypothesis states that it is impossible to consistently “beat” the market using public information and skill alone. While there are always investment managers beating the market at any given time, this outperformance typically ends after a brief period. This is not to say that markets are always “right” in setting prices, but rather, that investors cannot reasonably expect to profit from mispricing over the long term. It seems counterintuitive to imply that hard work does not pay off, but numerous studies have shown that on average, professional fund managers consistently underperform their benchmark index. Even if managers exhibit some skill in selecting stocks, they must first overcome the additional trading and research costs to simply match the performance of an index fund in the same asset class. The increased trading typically generates higher taxable income, which acts as another drag on your portfolio return. Yet another obstacle for the average investor is identifying these managers before the fact. As investment advisors, we face this same obstacle, and since strategic asset allocation drives the performance of a portfolio, we believe the expense and risk of choosing an underperforming active manager outweighs the possible benefit.
At Clarity, the focus is on choosing the appropriate asset allocation for your situation at the start of the relationship. Your goals, time horizons, and risk tolerance all factor into the proportion of equities to bonds, which is the primary asset allocation decision. Then the portfolio is diversified among a variety of asset classes, all while fund expenses, transaction costs, and taxes are minimized. As time passes, and asset classes perform differently, your portfolio is rebalanced to “buy low and sell high” in a disciplined fashion. While we do continuously monitor our investment choices, changes are infrequent because short-term trends are not being chased.
We also incorporate the research of Eugene Fama and Kenneth French into our investment philosophy, with the use of Dimensional Fund Advisors mutual funds. Fama & French have published seminal papers on the out-performance of value and small company stocks over the long term. While our portfolios are broadly diversified, we do implement small tilts in favor of these asset classes.