Benchmarks, Diversification & Time Horizons – Part 2 of 4

In this four-part blog series from Merriman Research, we’re offering our thoughts on the following important investment questions:

  • When evaluating your investment returns, what benchmark(s) are relevant?
  • What is the rationale for diversification?
  • How should your investment time horizon be considered?

Investors may overlook the fact that these questions are highly interrelated. To properly consider any one, you must understand the context the other two foster. We’ll just have to jump right in to explain. If you missed Part 1, start there and come back.

Part 2: Thoughts on diversification – Why is it a good thing?

Investors tend to appreciate diversification in bad times, but not so much in good times. Investors like the idea of diversifying to mitigate losses, but don’t like diversification when it suppresses gains. Just look back at 2013 – the S&P 500 was up 32.4%, but any version of a “diversified” portfolio would have gained much less. A balanced benchmark, along the lines of a 50%/50% stock/bond split, was up about 15% (if we just blend the returns of the S&P 500 and the Barclays U.S. Aggregate).

Why should I diversify?” a balanced client may ask. The answer is To control risk and we only need to look back to 2008 for an example. That year, the S&P 500 declined 37%, whereas a 50%/50% balanced benchmark was down only 16%. (more…)

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The Merriman Research Team discusses our TrendWise Investment Program

Recently, our Research Team of Dennis Tilley, Rafael Villagran, and Alex Golubev got together with Financial Advisor Mark Metcalf to discuss our TrendWise Investment Program. Many of the program’s details were covered, including the following:

  • Harnessing market momentum using objective data
  • Rules based trend following
  • Limiting subjective interpretation
  • Dealing with whipsaw trades
  • Small/Value tilt in the program

Enjoy!

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Risk mitigation

The return-centric environment in which we live too often gives little credence to an equally important measure – risk. Professionals and individual investors alike can often quote the return of a given stock or index, followed by silence when asked to recite its relative measure of risk. The financial crisis shouted to us the importance of understanding and controlling risk. If you did not hear the call – and hopefully you did before the fall – it’s not too late to answer it.

Two quantifiable means of controlling risk are diversification and asset allocation.

Proper diversification stretches well beyond your region and your country of residence. It has little to do with individual stock positions or individual sectors. It consists of all types of stocks – large, small, value, growth, etc., which are located all over the world. Global diversification is the goal.

Diversification is equally important for bond allocations. A bond portfolio consisting of high-yield bonds differs from one invested in U.S. treasury bonds. Obtaining an adequate amount of diversification on both sides of your portfolio is essential in controlling your risk.

Asset allocation speaks to the percentage of stocks and the percentage of bonds in your portfolio. While the specific mix has many variables, age and retirement goals are often large factors. Each investor’s situation is unique and there is no “one size fits all” solution. A good place to start is by answering the following questions:

  • At what age do I begin adding bonds? 40? 45?
  • How often do I add bonds and how much do I add?
  • What is an appropriate allocation once I am retired?

If you are struggling to answer these questions, it may be time to seek professional guidance. The answers are essential to your long-term investment success.

Investor discipline is a less tangible but equally important component of risk mitigation.

As stocks outpace bonds, a portfolio’s risk increases. At some point, there will be a need to sell the stocks to buy bonds and maintain the target allocation. In essence, this follows the golden rule of investing – that is to sell high and buy low. The same logic holds within each asset class of the portfolio, such as when international stocks outpace domestic stocks or small cap stocks outpace large cap stocks.

I can almost guarantee that when the time comes, rebalancing will not feel like the natural thing to do. Why, for example, would you want to buy into an underperforming asset class? Despite our rational brain, loading up on the winners will feel like the right thing to do at that moment. There are two questions you must ask yourself:

  • Do I have the discipline to rebalance my portfolio?
  • What mechanical process will I use to rebalance?

Your long-term investment success hinges on your answers to these questions. If you do not know how to answer them, seek guidance.

Investing is about risk and return. Understanding how much risk you can afford to take and how much risk you’re willing to take is the key. Quantitatively, two ways in which we control risk for clients is through diversification and asset allocation. Keeping clients disciplined in their goals and executing on a well thought out rebalancing process is another, less tangible means of controlling risk.

As Warren Buffet famously said, “It’s only when the tide goes out that you learn who’s been swimming naked.”

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All that glitters is not gold

Merriman does not include a specific allocation to gold in our standard portfolios. This article, by Bryan Harris of Dimensional Fund Advisors, discusses why gold has not been an ideal long-term investment. It includes the following key concepts:

  • Gold has done well since the year 2000 and in the 1970s, and can potentially be a safe haven during times of political and economic stress. However, for the entire period of 1971 – 2011 gold performed worse than the S&P 500, U.S. small-cap stocks and non-U.S. stocks on an inflation-adjusted basis.
  • From 1980 – 1999, gold experienced a negative return after inflation of -6.5%, vs. strong positive returns for stocks.
  • While gold has held its value against long-term inflation, there have been extensive periods when gold did worse than inflation. Gold is also much more volatile than inflation, and can add substantial volatility to a portfolio.
  • Unlike stocks, which are productive assets which generate growing levels of income and dividends over time, gold has no cash flow and costs money to own.

For more detail and some illuminating graphs, please see the article.

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European exposure and global diversification

Some of our clients occasionally express concern about the situation in Europe. Here’s what our Director of Research, Larry Katz, has to say about Merriman portfolio exposure to those markets:

Europe’s ongoing debt problems have prompted many investors to consider their European exposure, especially to the euro zone’s weaker countries. While there certainly could be global impacts emanating from any area of the world, a major benefit of true global diversification is the controlled direct exposure to the problems of any given geography.

For example, one of our major portfolios is MarketWise Tax-Deferred, a globally diversified, buy-and-hold portfolio with a value and small-cap tilt.  Half of the stock exposure of this portfolio is in the United States. The other half is distributed throughout the world.

Of the 50% overseas exposure, as of the end of March 2012 just over 22% was in Europe. Notably, most of that exposure was to the stronger European countries. The top six European countries by exposure (United Kingdom, France, Germany, Switzerland, Sweden and the Netherlands) comprised almost 18% of the total invested in Europe. The weaker countries of Greece, Ireland, Portugal, Spain and Italy totaled only 1.73%.

So a 60/40 stock/bond portfolio had just over 1% exposure to these five troubled countries.

Every portfolio has to incur various risks to generate returns. The key is to intelligently diversify so that, under a variety of market conditions, those risks remain under control.

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Convertible bonds as an asset class?


Please share your view of convertible bonds as an asset class for folks entering retirement.


Convertible bonds are a unique asset class in that they have features of both stocks and bonds. They are often referred to as “hybrid” securities. This, along with their typically sub-par credit rating, is why they do not fit into our bond portfolio.

We prefer to keep the stock and bond components of our portfolios separate. Our bond portfolio is designed to buoy the allocation in times of stock market stress. The potential for convertible bonds to act like stocks does not jive with this logic. If convertibles – due to their hybrid nature – were showing stock-like tendencies when stocks were declining, your portfolio would have much less downside protection. As we have seen in the recent past, it is extremely important that investors maintain some level of protection in their portfolio. We do not believe convertible bonds are the solution. (more…)

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How can I get hurt holding bonds?

I am considering buying bond funds and would welcome your recommendations. I recently read in Time magazine that you could get hurt if you’re invested in a bond fund. How can I get hurt holding bonds?


Many people think bonds are risk free, but that is not actually true. There are multiple risks associated with bonds, but they can be an extremely important component of a portfolio despite those risks. And, if properly allocated, they can provide a level of security above and beyond the equity markets. Of course there is no free lunch, and the added stability of bonds requires a tradeoff. Namely, you are foregoing the equity premium associated with stocks.

We recommend using a mix of high quality short- and intermediate-term government and Treasury issues. For tax-deferred accounts we include Treasury Inflation Protected Securities (TIPS). This allocation is purposefully designed to be very conservative. Nonetheless, it is still subject to certain risks. Interest rate and inflation risk make the top of the list. You can alleviate the risk of inflation through the use of TIPS. Interest rate risk is somewhat of a different story.

There is an inverse relationship between bond prices and interest rates. As rates rise, bond prices fall and as rates fall, bond prices rise. Longer-term bonds are hit hardest in a rising rate environment; short-term issues are hurt the least. Of course shorter-term issues generally pay less interest. If you want an appreciable return – especially in today’s low rate environment – you need to extend beyond extremely short-term debt. Our solution is to limit risk exposure and also gain some additional yield by using high quality short- and intermediate-term US government and Treasury debt.

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How risky is your portfolio?

One of the most important things you can do as an investor is keep your risks under control, and this is one of the most powerful lessons we teach at Merriman.

Our work has lots of fans. Allan Roth, a financial planner and author who teaches behavioral finance at the University of Denver, recently drew on some of our work to make the case that many investors are taking more risk than they realize. You can read his blog post on the topic at CBSMoneyWatch.com.

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Evaluating new investment products

“People calculate too much and think too little.”

This is a quote from Charlie Munger, Warren Buffett’s right hand man, and a world-class investor in his own right.

It is one of my favorite quotes and has rung true throughout my investment career. In my experience, many financial professionals accept numbers too easily without fully understanding assumptions, sensitivity to inputs, and general rules of economics and competition.

We are always looking for ways to better design client investment portfolios. Every year, we are bombarded with new investment approaches, new products and new trading strategies to beat the market. Most new products can be tossed aside immediately, but a few require more detailed investigation. (more…)

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Are dividend-paying stocks good bond substitutes?

A rose by any other name would smell as sweet.

With bond yields so low, is it a good idea to substitute dividend-paying stocks for bonds? Some would say yes, since dividend-paying stocks yield more than some bonds, and have more upside potential.

However, I don’t think this is a good strategy.

Obviously, dividends are an important component of stocks’ total return. From 1930 through October 2010, for example, dividends provided 45% of the annualized percentage gain of the S&P 500. Dividends also help sustain portfolio income when interest rates are low.

But there’s no getting around the fact that stocks, including dividend-paying stocks, are generally more volatile than bonds. Substituting dividend-paying stocks for bonds will lead to a higher risk portfolio.

Let’s take an example of how volatile dividend-paying stocks could be. We’ll look at three exchange traded funds (ETFs). The first is SPY, which tracks the S&P 500. (more…)

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