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CWG Insight Series: Investment Philosophy Refresher In These Volatile Times

Last month, we took a look at the history of market corrections, bull and bear markets, and the increasing trajectory of the stock market. Through all these events, we face many shocks and dips, but the end result is nearly always favorable.

Now- you’ve probably heard the term “asset allocation”, but what does that really mean, and how can we use it to your advantage? Asset Allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon. The three main asset classes- equities, fixed-income, and cash- have different levels of risk and return, so naturally each will behave differently over time. An overwhelming percentage of your overall return is dictated by your asset allocation, and not necessarily the individual holdings you have selected. Making sure this is done correctly is crucial to hitting your goals as a family. For example: If you have a long-term goal (i.e. retirement for younger clients), we would build an allocation that is high in equities, low in fixed income, and would most likely hold no cash. We take a larger risk for the potential of a larger return as we have plenty of time to navigate the ups and downs of the market. If your goal is more near-term, we would flip that strategy and have a high level of fixed income, some cash, and a lower amount of equity exposure. We aim to limit our downside risk while still being able to provide growth. At Crown Wealth Group, we utilize industry leading financial planning software to help us determine the allocation needed based on each specific goal- we call this ‘goals-based investing’.

Once we set the proper asset allocation, we begin the process of diversification.  Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.  Diversification happens across asset classes (i.e. large stocks vs. small stocks, or high yield bonds vs. treasuries) and across countries (i.e. domestic stocks vs. international stocks, or US corporate bonds vs. emerging market debt).  

By choosing many different asset classes across multiple countries, we reduce the overall correlation of your portfolio holdings.  Positive correlation is when holdings move in lockstep to each other, meaning if one is up, so is the other and vice versa.  Negative correlation is the opposite, meaning if one is up, the other is down.  When we build a mix of assets we are looking for a reduction of overall correlation, meaning while some things may be up, others may be down or flat.  What usually happens is when the ones that were up fall, the others rise.  This allows your portfolio to perform in all market environments.  When we talk performance, we not only look for growth, but we also look to be down less than the market in correction or bear market times; diversification is what helps us try to achieve this.

Even when all markets are rising, like we’ve experienced during this 9-year bull market (see last month’s article), diversification allows you to increase returns while looking to decrease risk and dependency on one market.  Based on Morningstar figures, the S&P 500 returned 21.83% in 2017 which was incredible, and anyone would be happy to have that growth in their portfolio.  That said, the MSCI EAFE, which captures large and mid-cap equities across the developed markets of the world (think Japan, Germany but exclude the US and Canada), returned 25.62% in 2017 - an outperformance of the S&P 500 by 17%.  The MSCI Emerging Markets index, which captures large and mid-cap equities across 24 emerging markets worldwide (think Brazil India, China), returned 37.28% - an outperformance of the S&P 500 by a whopping 71%!  If you only held US stocks in your equity portion of your portfolio you missed out on a great opportunity.  Now it is prudent to note that international stocks have reversed course in 2018 and are under performing the S&P 500, but we do not abandon the asset class, in-fact, along the way, we should do something that would be counter intuitive to most non-investment professionals…

It is commonly known that buying low and selling high is the key to winning at investing. The problem here is that most investors do the opposite because emotions control investment decisions. When something is doing well, you naturally want to buy more of it and when something is losing, you naturally want to get rid of it. We found a way to combat this emotional sabotage- by implementing a strategy of systematically rebalancing portfolios. Essentially, once a holding has increased in value above a set threshold, we sell the portion above the original intended holding amount. For example, if we want to hold 20% of large cap US stocks and they grow to be 25% of our portfolio, we would sell that extra 5% to bring the holding back down to the original 20% intended allocation.  When we do this, we take the cash from the gains sale and we reinvest it into the holdings that are below their intended percentage, thus buying them on a discount.  
Proper asset allocation, with well diversified holdings, and systematic rebalancing is the way to help you win long-term in investing and ultimately achieve all your financial goals.  As volatility increases, it’s important to review our investment team’s core philosophy and remind ourselves why we stick to the well-constructed plan.  

Disclosure: Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses