Strategic Investing

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Overview

Strategic investing describes an investment style that diversifies a portfolio into multiple assets, with the goal of improving the characteristics of the portfolio in comparison to those of the individual assets. The investment horizon is long-term, and the assets in the portfolio are typically not changed over the course of the investment. Consequently, this type of investment is also often called buy-and-hold investing.

Diversification

The key to strategic portfolios is diversification, a concept researched in depth by Harry Markowitz, the pioneer of Modern Portfolio Theory. Markowitz referred to diversification as “the only free lunch in investing,” because it improves investment characteristics with virtually no downside.

In a nutshell, diversification follows the idea of not putting all eggs into one basket: in a diversified portfolio, multiple assets — e.g., from different asset classes, sectors, regions, or strategies — are combined. If these assets have a low correlation to each other, some may rise or remain stable while others fall, in effect reducing the volatility of the portfolio.

The concept of diversification reduces unsystematic risk, which is the risk specific to a company, industry, asset class, or country. However, diversification cannot eliminate systematic risk that affects the market as a whole, e.g., through major geopolitical events.

Also, diversification does not guarantee profits or prevent losses. Instead, it reshapes risk and make outcomes more predictable.

Stock-Bond Investments and the 60/40 Portfolio

Typical strategic portfolios combine exposure to the stock market with other asset classes, most importantly bonds. Here, stocks may be further diversified into sectors or geographic regions, while bonds may benefit from further diversification into multiple maturities, regions, issuers, or credit ratings.

Stocks and bonds, most importantly government-issued bonds, are a very special pair. It can be assumed that in times of calm and economic success the stock market is doing well and providing ample, stable returns. In times of uncertainty and crisis, however, government-issued debt is among the safest investments available. It intuitively makes sense that in a stock-market sell-off, investors flee into safer assets, driving up the value and returns of bonds, resulting in a low or even slightly negative correlation between the asset classes.

By combining just these two asset classes, stocks and government bonds, an investor can significantly reduce volatility and investment risk, while increasing predictability and pessimistic returns, measured at the 5^th percentile of the range of investment returns. As a result, such a simple stock-bond portfolio is likely a much better investment in the Investing Toward a Goal and Investing for Income scenarios, as it offers a significantly higher probability of success.

The most widely referenced stock-bond portfolio is the ubiquitous 60/40. This is a simple portfolio, investing 60% of its assets in the stock market and the remaining 40% in bonds.

The cumulative returns show that the 60/40 portfolio slightly underperforms an investment in the S&P 500. Much more importantly, though, the underwater chart shows how the strategic portfolio has improved the behavior throughout the recessions of 1975, 1988, 2002, and 2008. This is what reduction of unsystematic risk looks like.

However, we also see something else: during the coronavirus pandemic in 2020, the portfolio did nothing to improve the downside. This is what systematic risk looks like.

But cumulative returns only visualize the history and provide very little information about potential outcomes. The Monte Carlo simulation shows how the 60/40 portfolio has greatly shifted the risk/return characteristics. While the average return is indeed a tad lower than that of a pure stock-market investment, the range of returns is much narrower and more predictable. The returns at the 5^th percentile especially — the dependable returns we need for Investing Toward a Goal and Investing for Income — are actually higher than those of an investment in the S&P.

The metrics table quantifies these observations. Compared to an investment in 100% stocks, we give up around 1.5% return with an investment in a stock-bond blend. At the same time, we reduce volatility to approximately 60% of an investment in stocks. As seen in the Monte Carlo simulation, this is not simply an emotional advantage for investors, but a tangible improvement to the likelihood of investment success.

Multi-Asset Investments and Robbins’ All-Seasons Portfolio

Expanding on the idea of diversification, many portfolios also add commodities to the mix. The intuitive explanation is that in times of financial distress, hard assets keep their intrinsic value. To achieve this exposure, portfolios often add small allocations to precious metals, most importantly gold or silver. Other portfolios add a commodities fund, which typically offers exposure to mostly energy, but also agriculture, industrial metals, and precious metals.

There are many different types of such multi-asset portfolios. For the purposes of this book, we are looking at Tony Robbins’ All-Seasons Portfolio, which well represents the characteristics of this category. This portfolio is a strategic take on Ray Dalio’s All-Weather Portfolio, an investment fund managed by Dalio’s firm.

The main idea behind the All-Weather and All-Seasons portfolios is risk parity. This concept attempts to maximize diversification benefits by assigning an equal amount of risk to the various asset classes. As a consequence, these portfolios are bond-heavy, since in times of peace and calm, bonds pose a much lower risk than the other asset classes.

The table above shows the construction of the portfolio. It’s worth noting that the portfolio invests in a combination of long-term and intermediate-term bonds. Long-term bonds promise greater returns, especially in environments of falling rates, but also carry higher volatility. Adding an allocation to intermediate-term bonds attempts to tame that down. We also note that the allocations to commodities and gold are rather small. This can be explained by these assets being of similar nature, and, outside of market crashes, showing long stretches of underperformance.

The chart above shows the cumulative returns of the All-Seasons portfolio compared to the 60/40. We can see that the returns are very close. Much more importantly, though, we see that with broader diversification, unsystematic risk has further reduced. At the same time, the COVID period in 2020 and thereafter shows that systematic risk has remained pretty much the same.

The Monte Carlo simulation shows that the additional diversification has indeed reduced volatility and improved the predictability of outcomes. However, when looking at the 5th percentile of expected returns, the advantage over the 60/40 is rather slim. Whether this advantage truly outweighs the reduction in average returns remains questionable.

The metrics help us quantify the effects. By increasing diversification, we had to give up another ~0.75% of returns. However, we’ve substantially reduced maximum drawdowns and sped up recovery time from drawdowns. And yet, the true value of these efforts is unclear. While the Ulcer Performance Index suggests a substantial improvement in risk-adjusted returns, the Sharpe Ratio is pretty much identical between the two contenders.

Conclusion

Compared to investments in a single asset, diversified strategic investments are a tremendous improvement. They reduce risk and volatility, and with that improve the likelihood of success in achieving the investment objective. However, they fail to address systematic investment risk. Consequently, they offer no protection against catastrophic events that affect the entirety of the market and threaten the stability of our economic order.

As we’ve seen from the examples above, diversification does a lot, but the combination of stocks and bonds really does the heavy lifting here. And while additional diversification through more asset classes might lead to some further reduction in unsystematic risk, these improvements are relatively small.

Further, it’s imperative to understand the assumption that went into the design of such strategic portfolios: that long-term returns of assets, and the correlations between them, remain constant. When this assumption no longer holds — e.g., when there are fundamental shifts in the market order — the portfolios may become less effective.

Of course, this risk applies to pretty much all investments. However, as proponents of strategic investments often accuse managers of tactical investments of data mining, it’s important to note that strategic investments are just as guilty of that as any other form of investment, where we use past results to guide our assumptions about the future. We’ll revisit this topic in the chapter about tactical investments.