Portfolio Strategy for Individual Investors

Must we climb a mountain simply because it is there? Probably not. Like the stock market, the descent often turns out to be much more perilous than the ascent. Risk should be taken only when warranted, not because greed and avarice are a sign of the times.

We believe capital preservation should be the first and foremost objective of any investment program. The measure of a manager is how well risk is managed while discipline, know-how, cost control, diversification and hedging combine to drive superior returns.

We provide a core portfolio strategy for retirement plans and/or the wealth-seeding phase. Our satellite strategy is risk-oriented, suitable for trading accounts and/or the wealth-building phase. [MEMBER Q&A]

Performance Benchmarked to Reality

Portfolio reviews are published monthly, approximately two weeks after month-end.

27-aprilperformance

CLICK IMAGE TO VIEW PERFORMANCE

NOTE: For ease of comparison, returns for all InVivo model portfolios are based on a “fully invested”, UNHEDGED position with regular re-weighting and does not include gains from our September 24, 2008 call to go to cash and our March 16, 2009 call to return to the market.

For details, please read the April 2009 Portfolio Review. If you have time, join me and David Fry as we discussed portfolio strategy on March 13, 2009:

  1. Part One
  2. Part Two
  3. Part Three

Weekly Email

Members are notified by email each Friday at approximately 3:15PM Eastern as to the preliminary calculation of the weightings for ETFs found in the Strategic Satellite portfolio. Members that adjust their holding on a weekly basis OR those who find that their portfolio has drifted materially from the targets can adjust their portfolio on Friday afternoon before the market close based on these preliminary numbers in order to avoid gap opens that may occur on Monday.

Official results are published online each Sunday and archived in the Model Portfolio Allocation section of the website. Members are advised to seek out a reputable discount broker (such as Interactive Brokers) to reduce commission costs.

Matching Asset Classes with Wealth Levels

David M. Darst is Chief Investment Strategist for Morgan Stanley’s Global Wealth Management Group. In The Art of Asset Allocation, he made a case for matching asset classes to wealth levels and income needs.

He wrote, “As investors progress through the main stages of wealth creation and wealth realization, their needs and concerns evolve, as does the array of asset classes appropriate for their investment portfolios. This progression is depicted in Figure 2.1.”


The Three Phases of Wealth

The vast majority of our readers are in the first two phases:

In Figure 2.1, investors are shown to generally progress through one or more of the following wealth stages during their lifetime.

  • Wealth-Seeding Phase: Investors at the beginning–or wealth-seeding–stage are concerned with basic needs such as housing, healthcare, food, clothing, and insurance. If surplus capital is available for investments, such investors should consider asset classes that are easy to understand and that offer a reasonable degree of liquidity. These asset classes generally include cash equivalents, domestic equities, and domestic fixed-income securities, held directly or through mutual funds.
  • Wealth-building Phase: As investors progress through the growth–or wealth-building–phase, their needs expand to include education, lifestyle enhancement, retirement, and intergenerational transfers of assets. As the same time, their range of investable asset classes may expand in many cases to include not only the asset classes described in the wealth-seeding phase, but also to international equities, international fixed-income securities, real estate and REITSs, and perhaps commodity-related investments.

He continued:

Other features of asset-allocation styles include the objectives and intended price behavior of the portfolio. In general, a conservative asset-allocation style should exhibit lower price volatility (as measured by standard deviation of returns from the portfolio) and, possibly, generate a somewhat greater proportion of its returns in the form of dividend and interest income rather than primarily through capital gains. By contrast, an aggressive asset-allocation style may exhibit higher price volatility and generate a somewhat greater proportion of its returns in the form of capital gains rather than income. A moderate asset-allocation style attempts to exhibit price volatility below that of the aggressive style and above that of the conservative style, and generate returns from a mixture of income and capital gains.

Investment Philosophy

Our investment process is based on principles employed by David F. Swensen, Chief Investment Officer of Yale University’s $22 billion endowment fund. They are outlined in Unconventional Success and Pioneering Portfolio Management.

For most people, he recommends a very basic approach: use index funds, exchange-traded funds and other low-cost instruments, and stick to your long-term asset allocation — even when the markets are in tumult. Don’t be distracted by market forecasts, he said. “You have to diversify against the collective ignorance,” he said. “I think nobody is in a position to react to these big macro-issues. Where is the dollar going to be or what is G.D.P. growth going to be in China? For every smart person on one side of the question, there is another smart person on the other side.” — Keep It Simple, Says Yale’s Top Investor

In connection with his books, Mr. Swensen has given a number of interviews that are worth reading:

The cornerstones of long-term investment success are diversification, discipline and cost control. While “copying the strategies of institutions like Yale is virtually impossible”, the fact is that exchange traded funds (ETFs) have dramatically leveled the investment landscape, providing individual investors with access to almost every imaginable asset class.

Portfolio Strategy

We have combined the flexibility of ETFs to build a number of model investment portfolios based on typical investor requirements. One, or a combination of these, will be right for you.

Our core and satellite investment strategies employ a number of asset classes: U.S. stocks, U.S. Treasury bonds, U.S. Treasury inflation protected securities, international stocks, emerging market stocks, currencies, commodities, and REITS.

The percentage allocated to each asset class is adjusted on a regular basis based on our own proprietary algorithm in response to prevailing market conditions.

CORE PORTFOLIO - Capital Preservation
Many retirement plans offer access to only basic asset classes and limit how often the mix can be adjusted. Our model portfolios for capital preservation or the wealth-seeding phase are adjusted monthly:

  1. InVivo U.S. Dollar Core Portfolio
    This model is suitable for conservative taxable accounts AND retirement accounts denominated in U.S. Dollars where the plan administrator severely limits investment choices and restricts rebalancing activities. To implement this strategy, your account must be able to buy and sell the equivalent of four exchange traded funds: SPDR S&P 500 ETF (SPY), MSCI EAFE Index Fund (EFA), Lehman 7-10 Year Treasury Bond Fund (IEF), and Lehman TIPS Bond Fund (TIP).
  2. InVivo Canadian Dollar Core Portfolio
    This model is for conservative taxable accounts AND retirement accounts denominated in Canadian funds. To implement this strategy, your account must be able to buy and sell the equivalent of five exchange traded funds: iShares CDN Composite Index Fund (XIC), iShares CDN S&P 500 Index Fund (XSP), iShares CDN MSCI EAFE Index Fund (XIN), iShares CDN Real Return Bond Index Fund (XRB), and iShares CDN Long Bond Index Fund (XLB).
  3. InVivo Thrift Savings Plan Portfolio
    We provide two models — conservative growth and income — for individuals participating in the Thrift Savings Plan, a retirement savings plan for civilians who are employed by the United States Government and members of the uniformed services. The income model portfolio uses all of the funds offered (G, F, C, S, I) while the conservative growth excludes the G fund.

For Fidelity and Vanguard equivalents, please CLICK HERE.

SATELLITE PORTFOLIO - Risk Oriented
Individuals with flexible retirement accounts or trading accounts can take advantage of a larger universe of asset classes and make tactical adjustments more frequently. Our model portfolio for the wealth-building phase are adjusted weekly:

A core portfolio that incorporates the four traditional asset classes is just right for the wealth-seeding phase. A satellite portfolio builds upon the core portfolio by adding asset classes. We added IWM to gain exposure to smaller cap stocks of the Russell 2000 Index. Emerging markets (EEM) was added to own a more-complete range of international equities. TLT further diversifies the U.S. bond portfolio, to provide additional protection against unanticipated deflation and market shocks.

We also added three new asset classes — real-estate, currencies and commodities — to further diversify the satellite portfolio for individuals progressing from the wealth-seeding to the wealth-building phase. IYM provides commodity-like exposure while IYR diversifes into commercial real estate. Finally, GLD represents currency diversification.

The core portfolios are extremely well-balanced while the satellite portfolios are tilted toward more volatile asset classes such as international emerging markets, real-estate, commodities and currencies. Individuals in the wealth-seeding phase should have the bulk of their retirement funds in core portfolios to ensure the maximum likelihood of pulling through difficult market conditions with small losses.

Those in the wealth-building phase should allocate a portion of their funds to the Strategic Satellite model to potentially enhance returns of the core portfolio.

TO SUM IT UP, EACH INDIVIDUAL MUST DETERMINE THE APPROPRIATE ALLOCATION TO THE CORE AND SATELLITE PORTFOLIOS BASED ON THEIR PERSONAL FINANCIAL SITUATION.

Hedging A Portfolio

Diversification is the first line of defense in normal market conditions. Under certain conditions, it may become necessary to liquidate a portfolio or (for tax purposes) hedge exposure with inverse funds.

These are the inverse ETFs that correspond to components of the core and satellite portfolios:

Reweighting the Portfolio

Our model portfolios are dynamic and employ tactical asset allocation — change in the percentage allocated to each asset class — that adapts to ever-changing market conditions. Our satellite model portfolio is reweighted weekly while all core portfolios are reweighted monthly to conform to limits imposed by plan administrators of conservative retirement plans and the U.S. government Thrift Savings Plan.

Investors debate the frequency with which portfolios should be rebalanced. Some follow the calendar, transacting monthly, quarterly, or annually. Others attempt to control transaction costs, setting broad limits and trading only when allocations exceed specified ranges. Pursuit of continuous rebalancing provides greater risk control with potentially lower costs than either the calendar or trading range approaches.

Continous rebalancing involves as frequent as daily valuations of portfolio assets. If asset class values deviate by as much as one- or two-tenths of one percent from target values, managers trade securities to achieve targeted levels. Trades tend to be small and accommodating to the market. — David F. Swensen, Pioneering Portfolio Management

Results achieved will be much closer to the model portfolio returns if members reweight as directed. Due to the value of the account, tax status, commission and other transaction costs, many of our members reweight only when their portfolios drift away from the allocation posted by a material amount.