The Future is Unknown. How Do We Deal with It?
How Do You Properly Position a Portfolio While Dealing With an Unknowable Future?
When it comes to optimal portfolio construction and prudent portfolio management, investors face a common conundrum: how to properly position a portfolio while dealing with an unknowable future.
They are not alone.
Statisticians, who continually test theories and hypotheses, also grapple with similar uncertainties. Statistically significant outcomes, which are 95% certain, still leave an uncertainty level of 5%. As Howard Marks correctly points out in his well-written 2015 memo Risk Revisited Again,“The devil is in the residuals, as all of us have discovered to our sorrow.”
So, how can the astute investment manager design a portfolio that provides its investors with the confidence level necessary to navigate through the cunning financial markets?
An asset manager must manage assets based on probabilities of various scenarios (think base case, best case, and worst case). Prudent asset management can be achieved through a mixture of asset allocation and diversification. Security selection, both on the individual stock side and the hired investment manager side, also plays a role; however, that role is typically less significant in determining total returns than the higher-level asset allocation decisions. On the margin, experienced investment managers with strong quantitative acumen and a healthy dose of intuition can engage in some tactical positioning, should certain asset classes give signals that they are vastly oversold or, conversely, completely overvalued.
We investment managers are cognizant of the plethora of risks but try not to become so caught up that we “over-diversify” and take too little risk in our portfolios. We also need to have the humility to realize that the future is (mostly) unknowable and we, therefore, do not want to get into the prediction business given the countless, and at times random, factors that influence financial markets.
Market timing is not a reliable tool in our arsenal. Informed decision-making based on the prevailing market environment and specific client circumstances is preferred.
Accepting that a degree of uncertainty always exists, our primary objective is to consider each client’s specific risk tolerance and design a durable portfolio for all market environments, according to the level of risk they are willing to accept. Our clients invested in a conservative manner will have more assets that mitigate risk built into their portfolios than those invested with growth as their primary objective. Furthermore, conservative portfolios will likely be able to weather a downturn more easily. At the same time, the trade-off is that conservative portfolios will not enjoy as much upside during bull markets.
Three Techniques to Better Manage Your Portfolio
We use all tools at our disposal to create, implement, manage and monitor our client’s portfolios. Items that are in our control go a very long way in helping to take advantage of the opportunities the markets present. There are three specific techniques we can consider:
Asset Allocation and DiversificationWe do not want our clients to be unfairly penalized for any unnecessary, or unsystematic risk we take in their portfolios. An extreme example of unnecessary portfolio risk would be having 80% of one’s investable wealth tied up in the stock of one’s employer.
An Adjustable Portfolio
Having a portfolio that can be slightly adjusted to take advantage of market dislocations is another way we are able to capture tiny bits of outperformance over the market cycle. That is, we can have a tactical overweight or underweight to a specific asset class for a period to take advantage of temporary mispricing in the market. We also can outsource this type of market maneuver to the investment managers we employ in our recommended fund portfolios.
Rebalancing is another technique we employ liberally to assist our clients in locking in gains in frothier markets or in purchasing riskier assets when markets appear to be generally oversold.
As one would imagine, none of the above techniques are fool-proof and each has its drawbacks. However, over time, with discipline and pragmatism, the above investment management tools allow us to try to control what we can control and to give our clients the best chance to reach their long-term goals while preserving their hard-earned capital throughout the process.We do not want our clients to be unfairly penalized for any unnecessary, or unsystematic risk we take in their portfolios. An extreme example of unnecessary portfolio risk would be having 80% of one’s investable wealth tied up in the stock of one’s employer.
Ready to Take Control of Your Financial Future?
At Wolf Group Capital Advisors our collaborative approach — paired with our strong client relationships — enable you to establish a clear vision for your future while gaining the confidence you need to get there.