As featured in Investment Advisor magazine’s January/February issue
Financial TV networks are filled with investors offering their insights into where markets will move in the future. Will there be a recession in 2020? Will the S&P hit new records? The reality is no one knows.
I recently traveled through the Highlands of Scotland, whose poet Robert Burns in 1785 wrote the well-known line: “The best-laid plans of mice and men often go astray.” That line, in a verse about a plowman churning up a field mouse’s nest, is preceded by the not-so-famous but equally prescient: “But mouse, thou art not alone in proving foresight may be vain.”
So why, when our powers of prediction are so inadequate, do we rely heavily on recent past experiences to inform our decisions about future outcomes, such as portfolio construction?
From 1978 through September 2009, the Sharpe Ratio for a typical 60-40 portfolio was 0.45. For the same portfolio in the 10 years since, the ratio, which tells investors how much excess return they can expect to earn for the additional risk they’re taking, is 1.25.
Because the Sharpe Ratio is almost three times higher than its historical norm since 2009, while bonds have performed strongly and equity and interest rate volatility has been low, portfolio optimization tools now routinely recommend a 60-40 split.
That’s akin to driving while only looking in the rear-view mirror, because it fails to take into account constantly shifting probabilities.
That’s especially so when signals are mixed. With 40% of S&P 500 companies reporting third-quarter results, 80% had a positive earnings per share surprise and 64% had revenue that exceeded estimates, according to FactSet.
That helped to push the S&P 500 to a record high close on Oct. 28, yet two days later, even after third-quarter real GDP came in at a higher-than-expected annualized 1.9%, the Federal Reserve cut rates by 0.25% for a third straight time in a bid to boost business investment and exports. Two days after that, the Labor Department said the economy added 128,000 jobs in October, far surpassing the 85,000 expectation.
Given such conflicting data, it would seem logical to look beyond the recommendations of optimization tools and create portfolios that perform in more volatile and uncertain circumstances. Further, rather than “predicting outcomes,” use scenario analysis to inform your outcome.
If you assume there is an 80% likelihood that equities will rise 10% over the next 12 months and a 20% chance that they will decline by that amount, the inferred forecasted return from unhedged equity is 6%, versus 4% from a hedged option such as long/short equity with 40% downside capture and 60% upside capture. If that’s your base case, stick with 60-40.
However, should you assign an 80% chance of a 10% fall in equities and a 20% probability of a rise of the same magnitude, a hedged equity option with the capture ratios used above provides a forecasted return of -2% versus -6% for an unhedged strategy.
If you’re like me, and are unsure of the outcome, then use a 50/50 chance and you’ll find the hedged equity portfolio is up 1% and an equity portfolio is flat.
That’s the reason why people should diversify using alternatives like hedged equity: It provides more predictable and potentially positive outcomes in the face of uncertainty.
If you are that rare beast with perfect foresight and you know the bull run will continue unabated, then go all-in on risk assets. Or, if you’re convinced the world is about to fall apart, lose your market exposure entirely.
But if, like most of us, you don’t know which direction things might turn, then it’s probably prudent to look to alternatives like hedged equity to provide growth now and capital protection when the next recession inevitably comes — whenever that may be.
That’s one prediction I’m comfortable making.
Read our recent blog post, Who Needs a Strong House When the Weather is Fine? >