Originally published in the Brandywine Asset Management Monthly Report.
Gambling vs. Investing
In a conference presentation given by Mike Dever to a group of retail investors last year, 10% of the audience walked out before he even got to his first slide.
Mike started his talk by asking how many people in the audience were investors. Virtually everyone raised their hand. He then asked them if their portfolios made money when the market went up, and lost when the market went down. Again, virtually everyone in the audience raised their hand. His next statement was intended to get their attention. He told the audience that contrary to what they thought, they actually were NOT investors. They were gamblers. Following that, 10% of the audience, insulted, got up and left. His point was that if any single market dominates your performance, you’re gambling.
He followed this by explaining to the remaining people that he never told them which “market” he was referring to, yet they all assumed it was the stock market. This underscores the level of fixation people have on owning stocks. No other markets enter their thoughts, when in reality there are literally hundreds of other, equally valid markets across which they can profitably diversify their portfolios.
The Stock Fixation
In several prior reports(1), we discussed the fixation people have on stocks and how they intentionally hold over-weighted long equity positions. In fact, it is often touted that the model diversified portfolio is one that is comprised of 60% long stocks and 40% long bonds. But as Mike Dever states in “Myth #8: Trading is Gambling – Investing is Safer” of his best-seller, “A person who is 60% long stocks and 40% long bonds is taking unnecessary risk. They are gambling.” That is because they are unnecessarily dependent on just three dominant return drivers – investor sentiment and earnings growth that power stock prices(2), and interest rate levels that power bond prices. If those falter, so does their portfolio. That doesn’t even come close to defining “diversification.”
True portfolio diversification can only be achieved by diversifying across return drivers and markets. Because stock prices are powered by only two principal return drivers, a portfolio that is dominated by long stock positions will never be diversified. As a result, you will get performance that looks like this:
Don’t get seduced by the fact that this graph ends on a high note and many stocks are now at all-time highs. People who concentrate their money in stocks have exposed themselves to unnecessary risk. The risk is unnecessary because it is easily diversified away. While academics and conventional financial wisdom tout the benefit of diversifying across additional “asset classes” such as bonds, gold and real estate, this displays a lack of understanding of the return drivers that drive the prices of each of those markets. Owning bonds at 3% is not the same as owning bonds at 10%. Return driver based investing adjusts for that fact.
To illustrate this point, let’s add a second return driver to the portfolio, in the form of a fundamentally-based strategy trading in commodity markets. When combined with the long-only S&P 500 strategy, not only is performance improved, but risk is also dramatically reduced.
The smoother blue line (the two-strategy portfolio) is clearly more desirable than the erratic red line (the S&P 500 Total Return index). The concept of portfolio diversification is really as simply as what we’ve just shown. But it doesn’t stop there.
The fact is there are potentially hundreds of return drivers that can be employed to truly diversify a portfolio. This diversified return driver based approach is at the heart of Brandywine’s Symphony Program, which employs dozens of trading strategies – based on a diversity of return drivers – to trade across more than 100 global financial and commodity markets. The result is a portfolio that targets returns in excess of those that can be earned from stocks, but with substantially less risk. This is not just theoretical. You can see the actual results now.
A Comparison: Brandywine vs. Stocks
U.S. equities have had a great run over the recent past. Since the launch of Brandywine’s Symphony Preferred in July 2011, the S&P 500 has gained 56%. But as shown in the first graph in this report, this return, because it was dependent on two dominant return drivers, subjected its participants to high levels of event risk.
In contrast, Brandywine’s Symphony Preferred gained almost 100% over the same period. And because its returns were produced from the interaction of dozens of disparate return drivers applied across more than 100 global financial and commodity markets, Symphony Preferred’s event risk is much lower. In other words, poor performance for stocks does not mean Brandywine’s performance will suffer as well. In fact, some of Brandywine’s best performance has come during some of the worst-performing periods for stocks, as is illustrated in the following chart. This shows how Brandywine produced substantial profits at exactly the worst period for stocks over the past five years.
And Brandywine hasn’t just provided “tail risk” protection. Brandywine outperformed stocks over the entire period as well.
If it really is that simple, then why do so many people; individuals, professional investors, financial gurus, public pension plans – the list includes virtually every ‘investor’ – gamble their money in risky, stock-centric portfolios? The answers are numerous, and one of the best compilations of well-researched reasons can be found in Daniel Kahneman’s excellent book, Thinking Fast and Slow. But the very fact that people behave in irrational ways (we measure rationality as desiring to earn the most money with the least risk) is what allows so many under-exploited return drivers to exist and to be developed into profitable, and diversifying, trading strategies. That said, there are a few answers that stand out:
- All their friends are doing it. This is a cute way of saying that people define investment risk less by actual investment results and more by how different their results are compared to the “market.” In other words, reputational risk, or career risk, dominates true portfolio risk.
- They, themselves, are unable to uncover return drivers, other than those currently in the public domain (which are referred to as “beta,” or for those less well-known, “alternative beta”).
- They fear missing out on the returns they can get from holding stocks. It’s been banged into their heads that stocks outperform in the long-run and the best way to earn high returns is by putting money into stocks.
We can’t help with reason #1. If someone is truly more concerned with “fitting in” than making money, their affliction is outside of our domain expertise. But we can help with reasons #2 & #3. Over our 30+ years of investment research and trading, Brandywine has developed dozens of trading strategies based on numerous return drivers. These return drivers are generally obscure and not in the public domain. For example, where there might be thousands of academic papers and articles written about the long-term “risk premia” earned from buying-and-holding stocks, there is very little written about the return driver underlying the commodity markets strategy that produced the smoothed results in Graph 2. This is despite the fact that the commodity strategy is potentially even more soundly based. (We allude to the triviality of the “risk premia” construct is this past report).
When Radical is Rational
So what is a reasonable allocation to be made to long equity positions in a portfolio? For those who have bought into the conventional portfolio diversification advice, the correct answer – although quite logical – can appear radical and shocking. Let’s assume you are able to diversify your portfolio across 50 return drivers and 100+ markets. Everything else being equal, the allocation to a buy-and-hold strategy in stocks would approximate 1/50 of your portfolio allocation, or 2%.
The fact that this allocation appears radical to most people is due to “reference” bias, not logic. If 60% is the reference point for an allocation to buying-and-holding stocks, any dramatic deviation from that level is “radical.” In addition, because people are battered with stories of how equities produce a positive return over time, they are blinded to both the existence of – and equal profit opportunities offered by – other return drivers. As a result, they are never presented (except in limited distribution reports such as this one) with research showing the true source of the returns driving markets. Without this understanding, they are constrained to gambling on a distinctly inferior, stock market dominated “Poor-folio.”
There is clearly a better way. When the next stock market decline occurs, wouldn’t you prefer to be invested in a program that has the ability to not only weather the storm, but, as demonstrated by the actual performance of Brandywine’s Symphony Preferred in Q3 2011, profit from it as well? We’re guessing that would be interesting. And if you could have that potential protection without giving up the ability to perform well during equity bull markets, would that increase your interest? Brandywine’s Symphony Preferred did just that. This report gave you a glimpse as to how and why.
If you’re intrigued and would like to learn more, please contact Rob Proctor, one of Brandywine’s principals, to have him take you through our online presentation. We look forward to helping you earn greater returns with less risk.
(1) Past monthly reports that discussed the conventional bias towards holding long stock positions:
(2) The two dominant return drivers powering stock prices are revealed in the opening chapter of Mr. Dever’s book, which you can read here: http://bit.ly/xrz2Ur