The last 18 months have turned many well respected and time tested portfolio management approaches on their head.  Professional investors with decade-long enviable track records saw their models reduced to rubble, and “conservative” investors who believed they had protected themselves from drastic losses quickly found that they were much more at risk than originally believed.

At ZachStocks, we certainly had our share of investment opportunities which quickly turned to disappointments as markets took out stocks of all shapes and sizes.  Aggressive growth opportunities quickly saw multiples contract as investors realized the new growth prospects no longer supported the generous stock multiples.  But conservative investments also took it on the chin.  Investors who expected stable rates of profitability also fell victim to declining margins, lower sales volumes, and anemic asset valuations which reduced equity levels on their company’s balance sheets.

Even fixed income investors were not spared.  Bonds which used to be considered suitable for “widows and orphans” folded quickly as the worlds financial system faced the very real possibility of melt down.  Even mortgage backed securities which had the implied full faith and credit of the US government behind them faced the possibility of failing to pay their coupons, principle, or eventually returning real returns to bondholders.

Opportunities for safe returns became harder to find as investors flocked to T-bills pushing rates on government backed treasuries to negative rates in some cases.  There’s nothing worse than putting your money in a vehicle which is guaranteed not to give you a positive return and has the possibility of significant volatility during the holding period.

So What Do We Take Away?

So why did many of the tried and true conservative approaches fail this time around?  Why did investors turn a blind eye to excesses which now seem so obvious in hind sight?  And what can we learn from this period in order to avoid the devastating results the next time we face a bear market?

While we may not totally be out of the woods yet, I think we are far enough removed from the October and March panic periods to begin to answer some of these questions from a rational point of view.  There are certainly well accepted rules of investing which need to be challenged and reviewed.  Human nature, on the other hand, continues to be relatively predictable which ensures that we will continue to see cycles of fear and greed in our markets for years to come.

So let’s look at a few of the accepted portfolio management tools.  I want to look at how well they stacked up to the bear market, and how we as investors can properly apply (or discredit) these approaches for use in future market environments.

Asset Allocation

Many investors were told that their accounts were safe from drastic returns due to proper asset allocation.  After all, investors with exposure to domestic equities, international equities, fixed income, commodities, foreign exchange, and alternative investments must see some of their investments rise even during a bear market.  Right?

Unfortunately, in many cases the answer was “Wrong!”  The argument that markets were increasingly decoupled from each other turned out to be quite inaccurate.  Emerging markets were expected to perform very differently from the markets of established global leading countries.  But it turned out that these emerging markets truly needed economically sound economies in order to promote their own growth and consume the goods these emerging markets were exporting.

Alternative investments were quite possibly the biggest disappointment as many ivy league managers turned out to simply be using leverage to accentuate returns which altered their risk profile to levels which were totally unacceptable.  Once the markets began to unravel, these funds were exposed and quickly turned out to have much higher correlation to established markets than many investors were led to believe.  As Warren Buffet says, once the tide goes out, you get to see who is swimming naked.

Investments in commodities did little to offset risk, as these positions turned out to be dependent on established markets to support prices.  Commodities are often tied to industrial production so when the majority of industrial economies began to decline, the diversification provided by this asset class did little to protect investors.

The bottom line is that during periods of significant market stress, all asset classes tend to increase their correlation to each other which provides less diversification.  One of the few exceptions would be foreign currency markets.  But this asset class truly represents a zero-sum game where for every dollar gained by one investor, there is a loser on the other side of the table.  This does not mean that foreign exchange does not offer utility to investors, but it is important for any foreign exchange investor to understand the risks, operate with skill, and to realize that there is certainly the possibility that forex positions could decline at the same time other positions are showing losses.

Diversification Can Be Over-Rated

In addition to asset allocation, many retail portfolio managers explain to clients how diversification can save them from losses should the market decline.  The argument is that if you spread your eggs into many different baskets, then at least some of your assets will be safe even when certain sectors turn lower.

The principal behind this move is certainly valid.  One need only to look at employees at Enron who had the majority of their retirement accounts in company stock.  One should never have their entire financial future pegged to a few carefully selected stocks.  No matter how much research you perform, there is always the potential for an unseen event to crush an individual position.  No one should ever put themselves in the place where the failure of one position brings irreparable damage to their financial goals.

But diversification has an ugly side to it as well.  As investors we rely on our ability to identify and select superior investment opportunities, and realize attractive returns on those picks.  No matter how much time I spend looking through opportunities, I will never be able to thoroughly analyze and track 150 different attractive investments.  It just isn’t humanly possible to have an edge on each of these names.

The danger with over diversification is that spreading yourself too thin can keep you from realizing above market returns.  The closer your portfolio mimics the entire market, the closer your returns will come to being exactly correlated to those market returns.  At this point it would be a heck of a lot easier to just buy a S&P ETF and spend the rest of your time pursuing other business opportunities.

There have been plenty of academic studies which prove that diversifying into 25 or 30 stocks gives a portfolio adequate diversification while still allowing an investor to realize outsized gains if his stock picking skills are sharp.  For this reason the ZachStocks Growth Model typically holds 15 to 30 core positions allowing us to capitalize on our strong analysis while at the same time protecting investors from any one position blowing up.

Many investors seek diversification by buying a handful of different mutual funds.  While this can be an excellent way of spreading risk, too often investors will buy similar funds who all have exposure to the same equity or fixed income trends.  If diversifying between different mutual funds, it is important to pick managers with different styles and expertise.  Five different large cap growth funds will simply have you owning exposure to the same companies five different times.

Timing the Market

In recent months, the idea of market timing has become more popular as investors who were out of the market free falls during October 2008 and March 2009 would have been significantly ahead of the game at this point.  It certainly makes sense to bypass these painful periods but the concept is much easier to explain than to put into practice.

We should note that even many of the most seasoned investment professionals had a difficult time determining the timing or validity of the market decline.  Several well known strategists warned us of a coming collapse in markets but were often discredited as their timing was off.  It does little good to have the foresight of impending doom if you are a year early and lose all your clients before the downturn occurs.

There is something personally satisfying about being right, but if you fail to make money or protect your client’s assets in the process, the victory is somewhat meaningless.  While I do believe it is possible to add value by adjusting exposure during times of exceptional risk (or greater than average opportunity), timing can certainly be tricky and it can be nieve to assume the ability to pick tops and bottoms of markets.

Investors are well served to pick a time frame for their investments which mesh well with their personality.  For years I tried to figure out how to profit from short-term trading in order to make consistent returns on a day to day basis.  I loved the idea of starting each day with a clean book and realizing gains or losses depending on my trading for that particular day.

What I realized, however is that my analytical personality did little to help me in my investment style, (or more accurately, this investment style didn’t cater to my strengths).  If I researched a company and realized they would have above average growth and the stock price should rise as a result, that did very little to predict what a stock would do on one particular day.  As it turns out, my strengths play towards identifying trends which last for a period of several weeks to a few monhts.  It wasn’t until I realized this and adjusted my investment approach that I began to make any substantial money in the market.

Long – Short approaches Can Offer Opportunity

One tool that I have found particularly helpful in negotiating a downturn is to have some short exposure to help offset losses if my long investments take on water.  While this approach is often seen as adding more risk (because short positions have theoretical unlimited losses), the combination of long and short exposure can sharply reduce the risk for an entire portfolio.

Now in order to be successful with this strategy, it is important to pair short exposure against long positions in a logical fashion.  For instance, being long consumer discretionary stocks with strong correlations to the domestic economy, and then being short conservative investments such as precious metals could be devastating.

If you are correct in your assumption that economic activity will pick up during a time of global growth, you will likely benefit from both the long exposure and the short side of your book.  But conversely if the economy begins to slump, you will likely realize losses on your long positions as consumers rein in spending, and also take on water from prices of precious metals rising.

Recently, mutual fund managers have had more opportunity to try their hands at shorting stocks with the advent of 130/30 funds (mutual funds who invest 130% of their assets long, and then 30% of their assets short).  Some of these funds have realized devastating results as managers simply used the short exposure as leverage to make even more concentrated bets on their expectations.

But when used properly, short exposure can be added to a long portfolio in order to not only cut back on risk, but also to enhance returns.  Successful short positions often drop much more quickly than long positions rise as panic can send investors fleeing from disappointing situations.  At the same time, confidence as a result of holding short positions can allow investors to be more aggressive on long positions taking more risk and consequently realizing larger returns on growth plays.

The key in this situation is to set up short positions that will actually trade down at the same time long positions would be hit with negative news.  A strong correlation between short positions and long positions enables managers to survive based on their skill level instead of simply making money during bull markets.

The ZachStocks Growth Model attempts to manage exposure through the use of inverse ETFs which essentially give us the ability to short markets or sectors.  The reason we use these vehicles instead of outright short positions is so that the model can be applied in retirement accounts which typically do not allow short sales.  This ETF approach has some drawbacks as we have discussed in previous articles, but can certainly be effective in hedging against short-term declines in the market.

Fear is Not An Investment Strategy

One thing to keep in mind after surviving one of the most vicious bear markets (which may or may not be complete at this point) is that fear rarely leads us to make wise investment decisions.  The natural reaction for many investors at this point is to shy away from the markets in order to protect against the visible risk.  However, investing from an overly conservative manner might actually carry more risk than expected.

The coming months will likely feature a sharp ramp in inflation which decreases the purchasing power of paper currency.  Investors who tread too conservatively will find their savings accounts hold a stable amount of dollars, but unfortunately decline in terms of what these dollars can buy.

It will be important to require your capital to grow in order to preserve value and so the important approach will be to foster safe, but purposeful growth in your portfolio.  Be aware of all of the tools available to you as an investor and if necessary, track down a responsible, seasoned veteran to help you review, rebalance, and maintain your risk level in order to recognize superior returns over time.

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