Columnists John Grace Opinion

ON THE MONEY: Ready for a market correction? Probably not

What it takes to be a successful investor these days can be summarized in four words: bigger gambles, lower returns. It used to be the case that reducing risk was accomplished by holding bonds. Now the job of risk reduction has simply become more complicated.

Former Lehman Brothers analyst Brian Sozzi asked and answered a very important question of investors. “Ready for the stock market correction? Probably not.”

Sozzi is now a columnist at The Street where the title of his Sept. 11, 2018, article declared “Investors Have Learned Squat 10 Years After the Lehman Brothers Bankruptcy.”

There are three things we have learned since the financial crisis.

First, as opposed to the ancient mantra “Buy & Hold” no matter what, investors can put technology to work to ascertain in advance of the grits hitting the fan how much risk they are willing to accept. Then they can see how their portfolio might be designed to perform within the specific risk parameters. 

Second, since savvy investors hate losses more than they love gains, many have put strategies into the equation that can move money out of risk assets in a bad year like 2008 to cash or alternatives to limit losses. The same systems move back into risk assets like 2009 to limit the downside and participate in as much of the upside as possible.

The third piece to the puzzle includes learning from the endowments and institutional investors by diversifying into more asset classes unlike ever before.

With low interest rates in the U.S., negative rates in in other countries, and lackluster growth, investors have become more creative by embracing increased risk to bolster their performances. Twenty years ago it was possible to earn 7.5% just by owning investment grade bonds. To come close to what is considered a strong return of 7.5%, endowments and pension funds are moving into riskier investments by adding large positions in global stocks, real estate and private equity investments to the once standard investment of high grade bonds.

In 1995, a portfolio made up wholly of bonds would return 7.5% a year with a likelihood that returns could vary by about 6%, according to research by Callan Associates Inc., which advises large investors. To make a 7.5% return in 2015, Callan found, investors needed to spread money across risky assets, shrinking bonds to just 12% of the portfolio. Private equity and stocks needed to take up some three-quarters of the entire investment pool. But with the added risk, returns could vary by more than 17%, per The Wall Street Journal, May 31, 2016.

In the past, bonds produced a source of safe, consistent streams of profit that allowed long-term, risk averse investors to hit annual targets. The era of low rates has all but made that buffer disappear. Investors must now compensate by embracing other bets that could be a home run or a strike-out.

The Callan reports highlights how risky an endeavor that is. It also shows to produce the same 7.5% annual return additional diversification is necessary. 

This isn’t your typical 60% stocks and 40% bonds retail portfolio (or vice versa). Let’s look at the smart money as represented by The Yale Endowment, June 2018 annual return (net of fees) 12.3% valued at $29.4 billion.

Yale continues to maintain a well-diversified, equity-oriented portfolio, with the following asset allocation targets for fiscal year 2019: absolute return, 26%; venture capital, 18%; foreign equity, 15.5%, leveraged buyouts, 15%; real estate, 9.5%; bonds and cash, 6.5%; natural resources, 6.5%; and domestic equity, 3%.  

Three things to take notice here. The first observation that strikes this observer is that Yale has allocated 3.0% to U.S. equities, 6.5% to bonds and cash, and 15.5% to foreign equities, which makes for a total of 25.0% in traditional asset classes.

Secondly, when looking at the ratios I am struck by the small bets. The largest position is 26% to absolute return. Another way to look at it is retail investors have been told you were diversified with a mix of 60% this and 40% that. Clearly, Yale has a different perspective. Finally, where many investors have placed two or three legs under their portfolio stool, Yale counts eight asset classes.

Please do not read this to be a template for you to follow. But if success leaves clues, and I believe it does, there is a lot to learn from the best and the brightest. It is also interesting to note as compared to its peers, Yale’s endowment finds itself in an unfamiliar spot as it came in last in the Ivy League, posting a 5.7% return in fiscal 2019, as Bloomberg News reported Sept. 27. At the same time, David Swensen, Yale Endowment’s CIO, took over the job in 1985. 

Under his stewardship during the past 34 years, the Yale Endowment generated returns of 13.5% per annum, a record unequalled among institutional investors.

Yale’s endowment was worth $1 billion in 1985 when Swensen took on the job. Now it’s 29 times that, according to Bloomberg News. It would not surprise me to learn that Swensen follows the thinking of Mahatma Gandhi, “Live as if you were to die tomorrow.”

John L. Grace is president of Investor’s Advantage Corp, a Los Angeles-area financial planning firm that has been helping investors manage wealth and prepare for a more prosperous future since 1979. His On the Money column runs monthly in The Wave.