The Cost of Superior Returns

We decided to write this WJNotes, not because the declines we’ve seen recently are that unusual considering market history, but because they were quite rapid and seemingly came out of nowhere. Without a doubt, the type of market increases we’ve seen over the past month, year, and 10 years probably set us up for the dramatic move in the opposite direction that we just experienced. There is a good reason stocks provide superior returns to other asset classes over time. Higher long-term returns in asset classes are directly tied to exaggerated short-term price movements. If stocks acted like cash, with very little price movement, their return would look like cash. So, what are we doing to protect portfolios in the event of further market declines?

1. Your portfolio is not the stock market. When the Dow or S&P 500 declines 5%, as it did yesterday, your portfolio does not drop 5%. You own many other types of investments. Some of the investments act like stocks, but in a muted fashion. Other investments move without regard to how the stock market is performing. Finally, some investments can go up when stocks go down. This is diversification, and it is the cornerstone of our investment philosophy.
2. We increase exposure to investments that appear cheap and reduce exposure to investments that appear expensive. When markets sell off, expensive investments decline more than cheap investments. Therefore, investing more money overseas rather than in the U.S. helps reduce losses.
3. We’ve incorporated momentum into a portion of portfolios. If stocks were to continue trending down, we would reduce our stock position to further protect portfolios. Losses have not been significant enough to warrant a change, but we are watching closely.

While these strategies will reduce portfolio losses if market decline continues, your portfolio will still decline. As stated above, this is the “cost” of earning superior returns long term. If you are personally uncomfortable with the volatility in your portfolio, please let us know so we can discuss your current asset allocation. More importantly, have a good weekend. The market is closed!