In this series, we’ve asked Covestor managers: “What is the single most important lesson you’ve learned about being a successful investor, and how do you try to apply that today?”
Author: Kevin Shine, Shine Financial Services
Covestor model: Asset Allocation
During the 2001-2 market crash, I came to recognize the value of balanced portfolios. At the same time, I began researching ways to improve upon the standard, balanced stock/bond portfolios that had become conventional wisdom. I found that adding uncorrelated asset classes and weighting them in response to the current market environment could create more compelling portfolios.
Since that realization and change in my investment strategy, I have been through a bull market, a nasty bear market, then another bull market and feel fortunate to have learned this lesson early in my career.
I can sum up my single most important investing lesson in a single word: diversification.
How do you try to apply that lesson in your current investing? What do you find are the challenges to applying it?
As I learned about Modern Portfolio Theory, I began to use it as the framework to build my portfolios. Instead of the standard 60% stock / 40% bond portfolio, I try to add uncorrelated assets that can have compelling risk/reward potential.
For example, as I write this in mid-2011, interest rates in the US are near historic lows. I look at this from different angles and know with reasonable certainty that interest rates will rise over the long term. I then think about what effect this will have on a diversified portfolio and what moves to make to dampen the inevitable falling of bond prices.
The four most straightforward strategies are shorting treasuries, holding shorter term debt, buying commodities, or buying the US dollar. Shorting treasuries is an outright hedge, since once interest rates start rising, that position should gain. Holding shorter term debt just lessens the price movement of the bond, so you will not lose as much value as you would holding longer term debt.
Buying commodities is tricky. You think they will go up because low interest rates should equal cheap money, which in turn should bring inflation, but commodities are global and often priced in dollars, so this asset class depends on where the US dollar goes as well as interest rates. The reason it’s tricky is because as interest rates go up, so should the US dollar, which makes commodities more expensive for foreigners, therefore taking demand out of the market.
We had a huge commodity rally so far in 2011 (through 5/11) and many believe it’s because of looming inflation. Sure, that could be part of it, but the US dollar is down sharply over that same timeframe as we keep our cheap money policy intact. That means for the same amount of Euros, Yuan, Yen etc. you can buy more oil, gold and copper.
To sum up this example, I look at these four ways to hedge bond prices falling, how they correlate to each other and to the rest of the portfolio, and then rebalance the portfolio accordingly. This one little task is by far the biggest challenge to managing a portfolio.
