portfolio management

Letters to Our Children #7: Know Your Assets

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Our previous letters have talked about the three buckets you have for your money: short term, long term, and in-between. Each one serves different purposes. Today we will dive into the details of the different assets you can put into those buckets.

The simplest and most familiar asset class is cash. It has a fixed value and is completely liquid, available to spend any time you want. While the change jar on your counter is not exactly an investment, you can put it in a savings account and generate a little bit of interest. Short term certificates of deposit and Treasury bonds can also be considered cash equivalents as long as the maturity is within a few months. They can not be spent without notice, but could be turned into cash quickly for major expenses.

Longer duration CDs and bonds fall into another asset class: fixed income. You can expect higher interest by accepting longer maturities and shakier credit ratings, so fixed income will generate more income than cash. There is a reason for this: your risk exposure also increases. Buying bonds with poorer credit quality increases the risk that the borrower will go broke and default. And if you lock in your money long term at a fixed interest rate, you will be in for pain if inflation and interest rates rise. This can make fixed income investing difficult in a low interest rate environment.

The third main asset class are equities, or stocks. These are what you are thinking of when you talk about the stock market. Stocks represent partial ownership in a given company. Exchange-listed stocks are liquid, and owning a share of a rapidly growing company offers the potential for higher returns. But again, these returns come at a trade-off of volatility and risk. There is no fixed face value or interest rate on equities, and the market price can change rapidly.

There are also alternative investments outside of these three main asset classes. Most alternative investments are tangible assets such as real estate or physical commodities. These assets are largely speculative: they do not grow on their own and do not pay out interest. As such, we do not generally recommend them.

Different assets are useful for each bucket. Your short-term bucket needs both liquidity and stability, so it should be mostly or entirely in cash. Your long-term bucket can tolerate more volatility and will probably want to seek higher returns, so equity investments may be more appropriate. The intermediate-term bucket can hold a range of investments, although you will probably want a healthy proportion of cash and short-term investments.

Your financial situation is unique, and there is no one-size-fits all approach. Clients, if you want to discuss what is in your buckets, please call or email us.


Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

CDs are FDIC Insured to specific limits and offer a fixed rate of return if held to maturity.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Stock investing involves risk including loss of principal.

Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

The Hidden Trade-off: “Risk-adjusted Returns”

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You surely have noticed this by now: we disagree with conventional ways of doing many things. Modern Portfolio Theory (MPT) forms the theoretical underpinnings of a lot of investment practice today, without adequate understanding of its deep flaws.

MPT defines volatility as risk. We believe, as Warren Buffett does, that volatility is just volatility – the normal ups and downs – for long term investors. So one common practice is to promote the advantages of getting 80% of the market returns with only 50% of the risk (for example). This supposedly is a superior “risk-adjusted return.”

But you could use the same statistical methodology to show that it may cost you about one third of your potential wealth in 25 years to have a 50% smoother ride on the way. For an investor with $100,000 in long term funds, this might be a $250,000 future shortfall. The question might be, “What fraction of your future wealth would you sacrifice in order to have less volatility on the way?”

The idea of sacrificing future wealth is a lot different than the idea of reducing risk. But they are two sides of the same coin. This is the hidden trade-off in superior risk-adjusted returns.

Our experience is that people can learn to understand and live with volatility. We believe investors get paid to endure volatility.

Of course, our philosophy is not right for everyone. Volatility is easier to tolerate for investors with a longer time horizon. But we believe everyone should see both sides of the coin before making a decision to forego significant potential future wealth for a smoother ride, less volatility, along the way.

Clients, if you would like to talk about this or anything else, please email us or call.


Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

This Will Pay Dividends

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One of the joys of thinking is that every once in a while, you might come up with a good idea. We are hoping we just did exactly that.

Our buy list, the securities we believe have favorable prospects for the years ahead, provides the building blocks for your portfolios. We rank them in order of timeliness, together with a weighting or percentage each should have. When funds are available in a portfolio, we start at the top of this cascade and fill up each holding to the desired weighting.

In our research and portfolio management, our object has long been to maximize total returns.

The bright idea? We re-ranked the Buy List based on dividend yield, and changed the weightings to reflect an income emphasis. By taking the top twenty dividend payers on the list and putting more weight on the better payers, we come up with a healthy dividend yield in a portfolio that has the potential to grow, too. Income and growth.

Dividend payments could be used to reinvest and compound your income or taken as a monthly payment, your choice.

Is this right for you? Maybe, maybe not. Our traditional “total return” approach is more suitable for many. Both alternatives feature holdings that fluctuate in value. These “income emphasis” portfolios will be more concentrated, although having twenty holdings provides diversification.

If you would like to talk about this, or anything else, please email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.

Writing the Book on Investing

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In the 21st century, it is possible to be more open about every aspect of business than ever before. Digital communications enable us to describe in real time what we are doing, why, how, and for whom with a level of detail that was not possible in the last century.

We have always had a well-defined investment process. We know what we want to own, and why. Since 2015 we have been able to share insights about our views, thinking, philosophies, strategies, and tactics here on the blog at 228Main.com. Those of you who are regular readers have perhaps gained a good sense of what we are about.

It is time to take it to the next level. We are working to comprehensively document our investment management process, from philosophy to research sources to investment selection methods to portfolio structure to tailoring client fit to trading protocols to client and account review process. We will be writing a book.

As great thinker Morgan Housel wrote, “writing crystallizes ideas in ways thinking by itself will never accomplish.” So we expect to come out of this exercise with a tighter, better-defined set of processes and protocols. No guarantees, of course.

This will take time and effort. What are the other advantages in doing it?

• To provide even greater clarity for you.
• To gain a comprehensive business operating manual.
• To help new associates understand what the enterprise is about.

Bottom line, this is a step toward greater sustainability, one of our major objectives for the years ahead. Clients, if you would like to talk about this or anything else, please email us or call.

All That And More!

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The narrow part of our duties here at 228 Main is striving to grow your buckets. (By this we mean trying to help you build your financial wealth.) But a much broader range of topics comes into play.

The next layer out from investment research and portfolio management, equally important, is effective investing behavior. Some of you seem to have been born with great instincts; others have proved to be trainable. We invest energy and time into describing what effective investing requires, as accurately as we are able, to help you be sure we are all on the same page.

Then there is the matter of how to connect your money to your life. What do you need in terms of portfolio cash flow or withdrawals to meet your goals in the real world? Which forms of investing for retirement are likely to get you to your goals? How much of an emergency fund is optimal for you? We work with you on nearly any money question.

If you take a step back from that, you find a whole philosophy of money and life. We attempt to provide perspectives on things that will help you and us find confidence, comfort and happiness with the choices we make. Achievement, reaching goals, spending wisely (as vital as investing well), perspective on events of the day, economic history, biographies of giants who have come before us… all find their way into our communications.

We get paid for managing wealth. All this other stuff is intended to help you have the resources you need to live as you would like to live. (We have longed believed that the better off you are, the better off we are likely to be.) Whatever counsel you need from us is free; anyone may read our essays, watch the videos, and follow us in social media.

Speaking of that, if you have reason to wish others could see our perspective on money and investing and life, you may point them to our digital communications. Better yet, we will add anyone you want to the list for our weekly short email—friends, children, whomever. Of course, we are too busy trying to grow your buckets to bother them, so being on the email list is a low-risk proposition. Just let us know.

Clients, if you would like to talk about this or anything else, please email us or call.

Passion and Indifference

© Can Stock Photo / Vicheslav0

“Indifference is as important as passion.” Organizational expert and author Robert Sutton (no, not THAT Bob Sutton) included this on his list of 15 things he believes—his core principles.

In recent years, seeing the occasional life and death struggle up close, juggling time constraints and geographical complications, most of the non-essentials have been stripped from life. Time and energy must be focused on the things that really matter.

Health and family are at the top of the list. But business provides the resources for the necessities of health and the niceties that keep life worth living. So 228 Main is really integral to everything else. It is fair to say I am passionate about my work for you.

What makes room for our passions, our priorities, is indifference to many other things. If it has a spark plug in it, chances are good that I am indifferent to it. If it is on television, ditto. Worrying about my appearance? That would have to rise a thousand places to get on the bottom of my list. Yardwork, fine wine, dust, arguing with strangers on the internet, complaining about things beyond my control…we do not have enough space to list the things to which I am indifferent.

Connecting with you, time with family and those I love, attending to health, the economy and markets, striving to grow your buckets, building an effective organization, these are the things that matter to me now. It is an interrelated, integrated life.

We all have interests, preferences, and our own ways to regenerate. But we can’t focus on our passions unless we let go of a lot of things that really don’t make much difference. Wise clients, mastering the art of contented retirement, made this point to me recently. Many things that seemed important enough to worry about years ago don’t even appear on their radar anymore—indifference is the word.

Clients, if you would like to talk about your passions or anything else, please email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Portfolio Hiccups

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We have all had the experience of getting interrupted by a hiccup. Do they serve any useful purpose? A momentary dislocation, each spasm passes quickly.

Over the course of our lives as investors, we similarly experience a spasm through our portfolios from time to time. We feel this way about the year so far. Unlike hiccups, which sometimes feel like they come out of nowhere, in this case we can clearly spot some of the causes:

• Your portfolios are generally overweight in select natural resource holdings, a sector that may do better or worse than the major market averages in the short run. So far this year? They haven’t been great.

• We began adding overseas equity exposure a while back, as we saw better bargains emerging after a decade of underperformance. These bargains have become even better bargains, which is another way of saying they haven’t been great either.

• In recent years, cyclical holdings have found a home in our shop. Many of these have been affected by trade war talk and tariffs.

At the start of the year, we were focused on the years and decades ahead, as always. We prefer up years to down years, of course. But the best time frame for effective investing is one measured over many years. That is why we see this year so far as a hiccup—in the grand scheme of things, a momentary dislocation that will pass.

Paradoxically, those things that hold us back in the short run are often the things that provide above-average results in following periods. It has happened before; it will happen again. We counsel patience with our current holdings.

Clients, if you would like to talk about this or anything else, please email us, or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

 

Change is Still Constant

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We wrestled for a long time with the issue of how to build portfolios in a zero-interest environment. The crushing of interest rates distorted values in the investment markets. The old ways of thinking carried too much risk, in our opinion. (When interest rates rise, bond prices tend to fall.)

So about a year ago, we settled on the concept of ballast. This enables us to tailor portfolios to address individual preferences. Different clients can have differing portfolios, while retaining common elements that enable efficient management.

Ballast refers to holdings that might be expected to fall and rise more slowly than the overall stock market. Ballast may reduce the volatility of the overall portfolio, thereby making it easier to live with. And it may serve as a source of funds for buying bargains when the market seems to be low. We’ve been able to put this thinking into effect.

A little over a year ago, monetary policy in the U.S. shifted from zero interest to a plan to raise interest rates over time. As we foresaw, this has not been great for bond prices. But now U.S. Treasury securities actually have a little bit of a yield these days, with short term maturities recently reaching over 1% for the first time in years.1

The return of interest rates on lower volatility, short term, liquid balances makes it easier to hold cash and cash substitutes as part of a portfolio structure. As interest rates continue to normalize, returns on cash could increase.

We like the portfolio framework, shown above, that we developed a year ago. We will continue to assess clients that may be suitable for this strategy. As the economic environment changes, we will review the need to adjust the tactics used in each layer of the portfolio. Change is still constant.

We will update you soon on the trends we are seeing in our long term core investments. Clients, if you would like to talk about this or anything else, please email us or call.

1Effective Federal Funds Rate. Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. Accessed March 2018.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Tactical allocation may involve more frequent buying and selling of assets and will tend to generate higher transaction cost. Investors should consider the tax consequences of moving positions more frequently.

Win, Win, Win

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Remember ‘win-win thinking?’ This phrase became popular in business a long time ago to describe interactions in which everybody comes out better. Our favorite example is as familiar as the grocery store. The grocer wants your money more than he wants the can of beans. You want the beans more than you want the money. A trade is made; everybody wins.

“Win-Win” is a fair description of how our business works. In our investment advisory accounts offered through LPL Financial, we are compensated by a percentage fee on account value. Our best path to growing revenues is growing account values. When you do better, we do better.

In the old brokerage model, products are sold to investors for a one-time commission. We think of this as the Good Luck plan, because the salesmen get paid up front and can wish you good luck, as they head down the road to find another prospect. They have no skin in the game, so to speak.

This does make sense in some situations. If you know what you want and do not plan on trading it, the one-time commission model probably works well for you. In a brokerage account, after you pay the sales charge you can hold on to your investment without paying ongoing management fees as you would in an advisory account.

However, we are in the business of trying to figure out how to grow your bucket, which often involves many trades over the course of a year. This creates a conflict for us: the more we trade in a brokerage account, the more commission charges add up, which is great for us but not for you. But our advisory accounts do not pay us on commission. When we switched to focus on advisory business, your interests and ours became much more closely aligned: we were free to make trades we believed would help you without worrying about commission costs. Life got simpler for us and better for you, we believe.

Win-win thinking also led us to introduce longevity discounts to our fee schedule. The longer we are in business with you, the better we understand each other. Longer time horizons and longer relationships are good for you and good for us. Another win-win deal.

It runs deep. From time to time we find that a client is paying for advice which they do not care to follow. This is win-lose, not win-win. We endeavor to get out of these situations as soon as we figure them out.

The biggest advantage of win-win thinking is that all of our energy can be devoted to striving to improve your situation. Relief from worrying about our position is quite liberating. Clients, if you would like to talk about this or anything else, please email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs.

The Model Prisoner

© Can Stock Photo / 4774344sean

Model students do all their homework and get top grades. A role model is someone to look up to. Model prisoners earn time off for good behavior.

Model portfolios are a whole different thing.

Model portfolios are the predominant method of managing wealth these days. There is an understandable reason: they can be profitable for the financial firm. Simple to operate, standardized, easy to talk about–and the pie charts look great on paper.

Out in the real world, models have a glaring flaw. Typically, every client in the model owns the same thing—no differences. But there are valid reasons why people with the same investment objective might have portfolios that vary one from another.

For example, our midwestern clients often want to follow the “Oracle of Omaha.” People everywhere would like to own a piece of the hometown company that does well.

A larger source of variation arises from investment ‘holds.’ Think of shares in a leading, well-run company that was trading at an attractive low price years ago. Once purchased, it may make sense to be a percentage owner for the long haul. But after it goes up in value, it is not the bargain it once was, and new clients find better bargains elsewhere.

Or clients may come to us with long-held stocks purchased at low cost many years before. Income taxes would be a problem if they were all sold at once.

These factors and more create valid, useful variations in client portfolios. When we began to build our systems and processes to tailor portfolios to each client, we quickly realized that model portfolios would only be good for us, not you (our opinion). That isn’t how we conduct business.

At 228 Main our research drives the development of rules-based trading protocols that we can effectively apply across client portfolios. Our systems accommodate the concept of the investment ‘hold,’ and your specific instructions about specific holdings. Our rules-based trading helps us aim for the efficiency of models without the drawback of mass standardization, regardless of your circumstances.

Two things help us immensely. You and we seem to be on the same page with how we think about investing—we are a tight group. And the mutual trust is key: you trust us to make the most of whatever is going on; we trust you to persevere.

Clients, if you would like to discuss this or any other pertinent topic in more detail, please email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

Stock investing involves risk including loss of principal.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.