Hopefully The Short Run Doesn’t Kill You
By Roger Nusbaum, AdvisorShares ETF Strategist
Andrew Lo from MIT was featured in Barron’s over the weekend for several things including the roughly $7 billion he runs at AlphaSimplex Group. The focus of the strategies is alternative in nature and Lo had a lot to say about implementation and expectations.
The following quote from Lo was instructive;
The rules are not wrong, just incomplete. The rule that investors should own stocks for the long run may be right, but only if the short run doesn’t kill them.
This raises a higher level point about self-awareness about the need for growth, the need for protection and how the need for both is always present. The investor who is 60 and probably has enough is hopefully looking at many years ahead. At 3% average annual inflation expenses will be about 50% higher in 15 years (the “official” inflation rate is nowhere near 3% these days but unofficially…).
Our 60-year-old who probably has enough could live through a couple of those 50% increases so they clearly need some measure of growth that hopefully at least keeps them a little bit ahead of inflation but this person does not necessarily need to take on the risk and/or volatility of the 60-year-old who clearly does not have enough.
There is a balancing act that is crucial to effective asset allocation. If, talking generically, small can average 8% annualized over some long period of time that can do a lot of heavy lifting for a portfolio. There would be years much lower than the average and some that are much better than average. Some of the popular small cap index ETFs fell close to 60% in the last bear market but have outperformed during this bull market. It makes sense to expect that small cap would go down more than large cap in the next bear market and then rise more in the bull that follows.
That’s how it is historically worked and having those correct expectations should reduce the element of surprise and reduce the likelihood of any panic sales at the bottom.
Similarly, an alternative investment or strategy with a track record of low correlation, low volatility and a narrower dispersion of returns should reduce the element of surprise for the investor who realizes these have historically been the attributes of something like managed futures and also reduce the likelihood of an impatient sale at the top.
We’ve cited the example of gold several times this year as capturing this arc. Gold struggled as equities rose for many years. This year equities have gone sideways, turning up just recently, while gold rallied dramatically, turning down just as equities turned up.
This concept is what Lo talks about in the Barron’s interview. To the extent each holding should have a purpose (growth, income, correlation) it is important to understand the drawback each type of holding has. A growthy asset is probably going to go down more in a bear market, an asset with a low correlation to equities probably won’t go up a lot, maybe not at all, in a bull market and so on.