The last 18 months in the financial markets have been described as a once-in-a-lifetime event. With financial and credit markets in turmoil, it seems that most investment portfolios, from individual 401(k)’s to large endowments suffered staggering losses. The result is that many advisors are now rethinking their investment philosophy.
Most mainstream investment theory has traditionally fallen into two distinct camps. Those that advocate a buy-and-hold strategy with periodic rebalancing of a diversified portfolio and those that espouse active trading based on short-term technical indicators.
Traditional Buy and Hold
Those that adopt this philosophy feel that over the long term, nobody can accurately predict the short-term movements of the markets and therefore cannot outperform the overall market. They argue that in order to maximize long-term results and reduce volatility, the best approach is to build a portfolio made up of numerous asset classes like stocks, bonds, real estate and private equity. The thought is that the different asset classes are not closely correlated, meaning that they don’t all go up or down at the same time. While one asset class (i.e. large cap stocks) may be dropping, another portion of the portfolio (bonds or commodities) should be rising. By periodically rebalancing back to the original allocation, as different asset classes over or under perform in the short term the overall volatility of the portfolio should be reduced and returns increased.
This latest bear market however, has seriously put to doubt the basic tenets of the buy-and-hold strategy. In 2008, while we saw some asset classes rise quickly for a short time (oil and commodities) eventually almost every asset class, except Treasury bonds and cash, showed negative results, decimating even the most diversified portfolios. Markets like the one we’ve seen recently add credence to those that favor active trading.
Active traders feel that by analyzing price patterns, they can capitalize on short term inefficiencies and broader movements in the financial markets, both up and down, to maximize returns over the long run. These traders are not concerned with which asset class they are trading, or whether that asset is trending up or down. Their approach is to get in and out of markets quickly, taking small profits as they go.
2008 was a potentially great year for active traders since there were large movements in numerous asset classes like stocks, bonds and commodities. By being able to profit from both up and down markets, some active traders were incredibly successful.
A Hybrid Model
After the last bear market, many advisors, including our firm, moved to a hybrid model, calling it things like ‘Buy & Hold with a Tactical Overlay’ (quite a mouthful) or ‘Core and Explore’. No matter what they call it, these advisors are using the same methodology. In this approach, they build the core portfolio across numerous asset classes just like the traditional buy-and-hold philosophy, periodically re-balancing to maintain the original asset allocation. For the balance of the portfolio they will use a limited form of active trading, taking advantage of shorter-term trends in the market to over or under-weight certain asset classes based on their judgment of their relative value. This allows them to reap the benefits of long-term investing while taking advantage of very real, short-term circumstances.
Which Approach is Right for You?
Like any long race, there are many ways to reach your destination and as a result, there is likely no single right approach to investing. The important thing to remember is that it’s the end result that’s important, not how you got there. Your choice of advisor and approach should come down how well the advisor articulates their particular philosophy to what you’re comfortable with that approach. The best thing you can do is to ask your advisor what their investment philosophy is and whether or not it suits your personality. The most important thing is that you understand how they do things and that you have a plan in place that you can stick to, even in challenging markets.
If you’d like to learn more about how RTJ Financial Management builds its portfolios and the investment approach we take, simply drop us an email at firstname.lastname@example.org with ‘Portfolio Review’ in the subject line, and we’ll schedule a free, no-obligation one hour portfolio review with you.