Thursday, June 24, 2021

Diversifying Time?

While managing an investment portfolio, we need to consider diversification. Be it asset class, regions/countries, sectors or even companies, diversification helped to spread the risk across positions. Hence, we have the adage of “do not put your eggs in one basket”.

 

We can do our due diligence in diversifying by selecting appropriate investments to fit our portfolio, there is one asset that, despite our best efforts to “control” it, it is not possible to do so.

 

And that asset is time.

 

Different investment portfolios, as I had stated before, perform well at different points of time, e.g., a United States (U.S.) based 60/40 equities/bond portfolio performed better than the U.S. based Bedokian Portfolio between the years 2011 and 2020, but it is vice versa for the 2001 to 2010 timeframe.

 

And that is not all; what if we decided to drawout the portfolio and it so happened on a very bad year, like in 1997, 2009 or 2020?

 

The Future Is Unpredictable

 

The key thing about why time as a variable is hard to gauge is because of its unpredictable nature. When most of us were young, we held lofty ambitions and goals; fast forward till now, I guess most of us did not achieve those dreams due to circumstances and experiences. Let alone a 10-year investment plan, we do not know what is in store for us at the end point.

 

In these situations, how do we really protect our investment portfolios to withstand the test of time? Short of just waiting for your portfolio to get better, there are a few ways, though all are not totally robust, but at least they can give some fighting chance in protecting your monies.

 

#1: Staggered Portfolios

 

Instead of starting an investment portfolio at a point in time, why not create one or two others at different points of time down the road, say at a few years later? To begin, first create a portfolio a year zero, then start off the next portfolio when there is a prolonged market pullback. If you can afford, create a third portfolio at another later pullback. You can adopt the same portfolio make-up for both or all, or do different ones (e.g., Bedokian Portfolio as the first portfolio, then the 60/40 equities/bond for the next).

 

This is a good form of diversifying time, and the plus point is pretty obvious; you can choose the better/best performing portfolio to drawout first years later, and can afford the time to wait for the other(s) to reach their deemed high before liquidating them.

 

The minus points are the opportunity cost of storing the cash for the next portfolio(s) and the large capital outlay in servicing the portfolios. If planning is done properly, new capital can be raised in the years leading to the next portfolio, while still injecting monies piecemeal into the current one.

 

#2: Low Volatility Portfolios1

 

Low volatility portfolios tend not to have extreme up and down movements due to its non-correlated features of the asset classes in their make-up. They usually display lower standard deviations and/or drawdowns and the growth of the portfolios are relatively steady. With formulas that utilise the standard deviation, like the Sharpe and Sortino ratios, their scores of the said ratios are comparably higher.

 

The advantage of such portfolios is that on an annual basis, the positive returns were quite respectable, and the negative returns were not so disastrous (around single digit based on my findings). The disadvantage is that generally, the overall returns were somewhat lower than portfolios with higher standard deviations and/or drawdowns.

 

Thus, the compromise of low volatility portfolios is the assurance of having some growth with little deviation over having better returns that comes with a roller coaster ride. They are, in my opinion, are suitable for passive investors with very low risk tolerance/appetite.

 

#3: Sector/Region/Country/Market Rotation

 

An active investment strategy, sector rotation involves the movement of investment monies from one sector to another. Rather than sitting tight on a mix of sectors regardless of economic conditions, rotating to different sectors is seen to generate more returns as the capital is shifted from down or loss-making ones to those which are rising in the prevailing market period.

 

Like sector, regions and countries can be rotated, too. Even though the various economies in the world are interlinked with one another, there are bound to have instances where one part of the planet is doing better than the other. Related to this point would be the shift between developed, emerging and frontier economies and markets. With rotation, in theory we are capturing the “best moments” and the returns would highly likely be in the positive side.

 

Although this is one of the ways of diversifying time, time itself is also this method’s disadvantage, specifically timing. You may know of some strong and/or seasonal indicators to point to one or a few sectors/regions/countries/markets, but if the shift was short-lived and/or when you are in the last to jump on the bandwagon, then you may be caught off-guard.

 

Conclusion

 

Diversifying time is understandably a tricky business, since we really do not know what the future really holds. Some of the mentioned methods are based on past data, in which ironically does not take the future into account (so it goes “past performances are not indicative of future results). Still, we need some form of hedge, and having this hedge is better than none.

 

Disclaimer

 

1 – Backtesting of Harry Browne’s Permanent Portfolio and Ray Dalio’s All-Weather Portfolio using statistics from Portfolio Visualizer (www.portfoliovisualizer.com)