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Economy, Investing  | February 22, 2019

The stock market has been on an impressive recovery since the end of the most recent, short-lived bear market. But as the S&P 500 inches closer to its all-time high once again (it's only 5% off the late September 2018 levels), concerns over yet another market correction, perhaps caused by high corporate debt levels or a weakening economy, have not been fully put to rest.

Amid all the worries and uncertainty, it may be hard for some to decide whether to stay fully invested or, at least partly, on the sidelines. Even experts seem confused. A study of market timers suggests that recommended equity exposure has swung drastically from -72% as recently as December 2018 (i.e. nearly three-fourths of one's trading portfolio allocated to short-selling) to +73% today (by contrast, a robust bullish stance).

I have a clear opinion on this subject. In my view, now is as good a time as ever to buy risky assets - provided, however, that they are the "right ones."

Let me explain my point further.

Bullish or Bearish, Stay Invested

No one knows what the future holds. Investing out of conviction about what could happen in the markets over the next month, quarter or even year is, in my opinion, pure speculation - remember my late 2017 article about how professional forecasters, on aggregate, have historically done a worse job at anticipating the direction of the markets than random chance alone would predict. Therefore, trying to figure out the "right assets" to invest in today (if any at all) may be a fruitless exercise, since the future is unknown.

Embracing one's lack of insight about what lurks around the corner is, in my view, an important first step in successful investing. This concept may sound counter intuitive to those who, despite mounting evidence, still believe that a number of experts can consistently outsmart the market. When it comes to money management, this is perhaps my most contrarian belief:

The most successful investor is not the one who can foresee the future better than others. Instead, it's the one who knows what he/she does not know, takes full advantage of portfolio diversification, and diligently stays the course over the long run.

Now, I invite the reader to think about the implications of the phrase "full advantage" above. Diversification is often thought about within the context of an all-equities portfolio - for example, investing in all 500 names contained in the S&P 500 index instead of in only a handful of high-conviction stocks. But at the core of my investment philosophy is the idea that diversification can only truly unlock most of its benefits when applied to a multi-asset class investment strategy.

Thinking Beyond Equities

I have recently written an article supporting the idea that small quantities of gold, perhaps even as much as one fourth of a portfolio's value, can help to produce better risk-adjusted returns than an investment in a diversified basket of stocks only. To support my point, I presented the following fun fact:

A portfolio invested 75% in stocks and 25% in gold since 1968 would have produced slightly superior risk-adjusted performance compared to an all-equities investment: Sharpe ratio of 0.44 vs. 0.42, with the worst month throughout the period reaching -17.5% in April 1980 vs. the S&P 500's -21.7% in November 1987.

This may sound counter-intuitive, considering that gold has produced lower annual returns than stocks since the late 1960s while being exposed to higher levels of volatility. What makes the diversified portfolio more attractive, from a risk-adjusted perspective, are the very low levels of historical correlation between stocks and gold: -0.01 over the past 50 years. This is Harry Markowitz's free lunch effect at full force.

I could go further. Since 1987, another asset class has behaved very much independently from stocks: U.S. bonds, at a correlation factor of only +0.07. The graph below illustrates how a $10,000 portfolio invested 35% in stocks, 40% in U.S. bonds and 25% in gold (portfolio 1, blue line) compares to one of similar size invested in stocks only (portfolio 2, red line), both starting in 1987:

There are a few very important observations and conclusions that can be drawn from the chart and table above.

  1. First, the most diversified of the two portfolios produced impressive risk-adjusted returns, as suggested by a high Sharpe and Sortino ratios of 0.63 and 0.95 (vs. the all-equities portfolio's 0.51 and 0.72), respectively. Portfolio 1's solid relative performance metrics were backed up by annual volatility of only 6.8% that was about two and a half times smaller than that of portfolio 2.
  2. Second, the multi-asset class investment never entered bear territory, even during the highly destructive 2008-2009 recessionary period. From peak to trough, portfolio 1 lost at most 17% of its value in 2008. Meanwhile, portfolio 2 saw more than half of its market value get wiped out within a matter of less than 18 months, right around the same time.
  3. Third, it's important to recognize that a well-diversified, multi-asset class portfolio that contains less risky fixed income securities (in this case, as much as 40% of the total) will likely never outperform an all-equities investment in the long run, in absolute terms. So, in general, broad diversification beyond stocks is often considered a more risk-averse approach from those willing to give up aggressive returns in exchange for a bit more peace of mind.

Although I believe the last bullet point above to be generally true, certain techniques might still allow long-term, high-growth investors to take full advantage of the perks of multi-asset class diversification.

A Sample Portfolio Idea That Could Outperform Stocks

Since early 2017, I have been invested in (while also fine-tuning) a portfolio that I believe could at least keep up with the S&P 500 over the long run without being exposed to the same level of downside risk. My general approach is to use, although only in moderate doses, leveraged ETFs to construct a portfolio that will hopefully endure less volatility and fewer painful dips. I understand that leverage can be controversial and that it may scare the less sophisticated investor - maybe it should, as leveraged instruments are a double-edged sword that can be both useful and dangerous at the same time. So, a word of caution here is certainly warranted.

Take portfolio 1 above as an example: 35% stocks, 40% bonds and 25% gold. Were I to replace half of the bond position with a leveraged treasury instrument like Direxion Daily 10-Year Treasury Bull 3x ETF (TYD), I would be effectively achieving a total portfolio leverage factor of 1.4x:

  • 35% in stocks, plus
  • 20% in unlevered bonds, plus
  • 60% in the form of levered bond funds, plus
  • 25% in gold

At these levels, matching the absolute returns of the stock market over time might become a bit more plausible, while the portfolio's downside risk should still be less substantial than that of a pure-equities investment.

Of course, the allocations above could be further adjusted to achieve a better balance between the different asset classes. For example, I believe the 80% allocation (out of 140% maximum) toward bonds and only 35% to stocks would likely lend to this portfolio too conservative a profile for most growth investors' taste. In my core portfolio, for example, (which I have named Storm-Resistant Growth, a reference to its dual mandate of market-like capital appreciation and superior downside protection), I have chosen to allocate 45% of the total portfolio to stocks instead.

Notice that leverage in this case is used for the counter-intuitive purpose of reducing a portfolio's risk or exposure to the downside without losing much in terms of growth potential. This, in my opinion, is one example of when leverage might be deployed responsibly. The multi-asset class approach, in which riskier assets (stocks, gold) are blended together with substantially less risky ones (high-grade bonds, treasuries), facilitates the use of leveraged instruments to ultimately create what I believe should be a better balanced, less fragile (i.e. storm-resistant) investment strategy.

Key Takeaway

I do not know what the future holds. And in my profession as a portfolio strategist and analyst, I regret to see many market participants spending precious time trying to figure out what stocks or asset classes will outperform in the foreseeable future, believing that they (or experts that they follow closely) may hold the hidden key to riches that other investors do not have access to.

As I have mentioned earlier in this article, professional market timers have drastically and quickly changed their opinions about whether one should bet on or against the stock market in the early weeks of 2019. The tail-chasing exercise has proven fruitless as these experts' December bearish stance probably caused them and their clients to miss out on the strong early-year rebound in stocks. I hope that lessons have been learned out of this experience.

I, on the other hand, continue to hold the same opinion that the great majority of investors will almost always benefit from being fully invested in risky assets at all times. Being out of the financial markets is, in my view, a strategy best suited for those who might have short-term cash commitments - while being short risky assets that have an expected future positive return is a game of chicken that only gamblers should consider playing, at their own peril.

On my end, I attempt to achieve the goal of generating market-like returns with lower risk through multi-asset class diversification alongside my Storm-Resistant Growth premium community on Seeking Alpha. For example, I have used some of the ideas discussed in this article to create my flagship SRG Base portfolio -- one of four investment strategies that I currently track.

A revolutionary initiative is helping average Americans find quick and lasting stock market success.

275% in one week on XLF - an index fund for the financial sector. Even 583%, in 7 days on XHB… an ETF of homebuilding companies in the S&P 500. 

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