In today’s global, event-driven economy, everything that happens, everywhere it happens, can and will affect us directly, immediately and unpredictably. Markets in the United States are increasingly reacting to domestic and global events. To survive in this volatile new market, investors require more information, more education, and more qualified expertise than ever before. Unfortunately, many investors continue to be influenced by self-appointed financial gurus. Popular culture has positioned financial expertise as a self-served commodity for the masses. Investing in financial products has become the consumer equivalent of choosing a movie based on a good review.
For traditional investors, another negative influence has been group think or the herd mentality. This can lead to vastly overpriced stocks and huge bubbles that always burst eventually leaving many people with far less wealth. This is not strictly the result of malice or criminal intent or even stupidity. More often, it’s just human nature at work; good people of average ability playing with fire and getting burned. More astute investors relied on traditional investment principles. These principles taught that the stock market can be a solid investment over the long term. We were taught that time in the market, not timing the market, was critical. We were also taught that diversification can reduce portfolio risks. These principles remain true. But after living through several major declines and the havoc they can cause in our lives, we all learned the hard way that over the long term protecting and growing assets is more complicated than these principles.
These investment principles were improved by a group of economists back in the 1970’s. They developed a revolutionary concept, an investment engine designed to mitigate the inherent ups and downs of the stock market. They called their theoretical engine modern portfolio theory and it revolutionized the way investors would view the importance of the different domestic market classes of their day. Stocks, bonds, cash, and real estate were thought to be four completely separate markets. It was thought that each investment in one of these classes had very little to do with the other three. What modern portfolio theory conveyed was an understanding of how allocating assets across all of these domestic markets rather than diversifying within any one category could enhance the stability and performance of a portfolio. Through research these Nobel prize winning economists prove there was a natural balancing that typically occurred between the fluctuations of separate markets. They noted that when one class of investment was up, another was usually down much like the piston movement of a four-cylinder engine. The frequent probability of these opposite effects occurring at the same time is called a negative correlation and skilled financial advisors would quickly learn to use negative correlation to serve their investors in a positive way. The idea is that gains will mitigate losses helping to maintain the stability of the overall portfolio.
Powered by four markets instead of just one, the four cylinder engine gave investors enough power to manage the risk of individual domestic markets over the long haul. Over the past 30 years many professionals have agreed this four cylinder engine has served investor’s needs for managing risk while enhancing return potential in a portfolio. These asset classes should always play a dominant role in portfolio management; however, given the events in our recent past, we must now acknowledge the significance of global markets and economies and the influence they have on our traditional investment strategies.
In times like these, where news from far away places can affect markets around the world, how does one maintain relative returns while managing ever-increasing risks? Today’s forward-thinking advisors believe they have an answer, a new kind of investment strategy designed for a new kind of investor. They contend that the time has come for the traditional four cylinder engine to be rebuilt. They call this innovative investment strategy global asset allocation. The theory behind global asset allocation doesn’t abandon the four cylinder domestic model. It expands on its strengths by adding four more cylinders to our engine, each chosen specifically for its global presence as an asset class; raw materials and commodities, the energy complex, precious metals, and foreign currencies. These are the same asset classes where some of the world’s wealthiest investors and institutions have made and typically protected their fortunes. Raw materials and commodity prices, like stocks, move in alignment with supply and demand. For most investors, there are ample opportunities to take advantage of price trends in raw materials and commodities. And interestingly, these trends typically have no correlation to the trends in traditional markets. It is well-known that many of these raw materials and commodities have higher volatility than blue chip stocks and are much riskier. But the trading managers who manage these positions seek to take advantage of both negative and positive trends. Overall, they believe this asset class is an excellent alternative investment where trading managers have the potential to profit on trends independent of the equity market. In the energy complex, some savvy oil and gas managers take advantage of daily price changes and longer-term trends betting on price fluctuations in the energy market. Other experienced managers are able to strategically position themselves long or short because they monitor the capacity of supply reserves and increases in global consumption, yet other managers take advantage of opportunities presented in owning companies that benefit from the use of energy commodities. These companies may include the travel, tourism, transportation and plastics industries. Investment advisors may recommend precious metals to provide capital appreciation potential, liquidity, and a hedge against conventional paper assets. Because precious metals have a negative correlation to paper assets, the intention of diversification into gold, silver and platinum is to reduce the total risk within the overall portfolio and preserve wealth. Because the characteristics of gold, silver, and platinum differ substantially and because each metal reacts differently to economic and world events, some managers build positions in all three.
Currencies are unique because they form the largest capital market in the world yet most U.S. investors have little knowledge of the trading of currencies or how they are viewed globally as a separate asset class. There are several hundred managers who specifically trade currencies as an asset class based on technical trends and fundamental data. As an example, in its simplest form, a portfolio manager may believe the U.S. dollar will gain against the yen because of interest rate differentials and price trends. That manager will purchase the dollar versus the yen in the cash market. Currencies are typically traded by every large multinational institution; banks, central banks, and government. Combined with the original domestic asset classes, these four additional cylinders make use of alternative investment classes to create a stronger, more responsive engine, an eight cylinder dynamo that finally brings to personal investing the one thing it has sorely lacked, global equilibrium. Investments are balanced across eight areas instead of four with the intention of further reducing risk and increasing stability. The natural balancing effect of negative correlation is actually magnified giving investors increased potential for a positive return by actively managing risk. Global assets allocation is more than a common sense theory. It has already been put into action over long- and short-term financial periods. Consider what might have happened to an investor from the end of 1996 through the end of 2002 if that investor had diversified his portfolio using global asset allocation theory. Through this period, the most widely held investments for most Americans were in the S&P 500, the Nasdaq, U.S. government bonds and cash. A moderately aggressive investor who is willing to take on the normal risks associated with an allocation in those indexes would have seen $1 million dollars grow to over $2.4 million by March 1999, and sadly, just as quickly, given most of that profit back. By December 2002, the value of that portfolio had fallen by over $1 million dollars. The worldwide events that affected and influenced the equity, fixed income and money markets during that market cycle had far-reaching impact, but during that same period of global volatility, investments in currencies and multiple alternative strategies performed very differently. Had the investor in our example incorporated a global asset allocation strategy during the same period of time by including a 25 percent allocation of alternatives to his existing asset mix, the outcome of two critical indicators would have changed very favorably.
While at first glance this change does not seem to be dramatic, a closer look at the outcome actually shows a 27 percent increase in the rate of return on his investment and most importantly, a 25 percent reduction in the risk he has taken to achieve this enhanced return. Many professionals believe that alternative assets, by their very nature, tend to be less sufficiently priced than traditional marketable securities offering the potential to exploit market inefficiencies through active management. When applied with the appropriate expertise, the intention of global asset allocation is to not only protect wealth but also advance growth even under the worst short-term market conditions as our example has shown.
Fortunately, there are portfolio engineers who understand and embrace the significance of global asset allocation. They are dedicated, even driven, to manage risk, preserve wealth, and help their clients face the future with confidence again. Quick to read trends, look forward, and rebalance investments as needed, this new breed of professional is using the power and diversity of the eight cylinder global asset allocation engine in their quest to succeed in today’s volatile global marketplace.
Today’s economic landscape forces us to challenge traditional thinking and acknowledge one cold hard fact; changing the way we invest is no longer an option, it is a necessity. As Americans, we will continue our dream for a better future. With confidence we will take command of our financial course. We will prepare ourselves to overcome inevitable challenges and we will answer the hard questions that the world will continue to throw our way.
Am I prepared for the impact of world events on today’s markets? Will I have the strength to weather the next decline? Will I have enough time to recover my losses? Am I confident my dreams will come true? But most important, will I take action to protect my dreams?
For more information, contact: CoreStates Capital Adivsors
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