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A Diversified Investment Portfolio Versus The Dow And S&P 500

Many people initially evaluate their investments based on the movement of the stock market's two primary indexes, the Dow Jones Industrial Average and the S&P 500. As they go up, people might assume their investments go up proportionately. A similar perception occurs when the markets go down. It's important to know that the Dow consists of the largest 30 U.S. stock companies and the S&P 500 contains the largest 500 U.S. stock companies. Both reflect only one asset class of the many available. Some examples of other asset classes, but not limited to this list, are:

  • Small and mid-size U.S. companies
  • Large, mid and small size international stocks in developed countries
  • International stocks in emerging countries
  • Real estate
  • Commodities
  • Treasury Inflations Protected Securities (TIPS)
  • Absolute return
  • Managed futures
  • Timber
  • High-quality corporate bonds
  • Long-term government bonds
  • High-yield bonds
  • International bonds
  • Floating Rate notes
  • Cash equivalents

As you can tell by this partial list, the Dow and S&P 500 represent only a very small portion of investments available and are not good indicators of return for a diversified portfolio.

Our approach to investing is to try to diversify a client's portfolio to increase the potential return for a certain level of downward risk. A key component of this is to include investments that don't move in the same direction at the same time in order to produce a more stable return over time. We want to avoid having to dig out of any large “holes” due to big market losses. By diversifying outside of the Dow and S&P 500, the potential risk of loss to a client's portfolio may be lessened. Two of the primary methods used to diversify this risk and potentially get more stable returns are by 1) using Frontier Asset Management, an institutional investment manager, to help with investing in the stock and bond markets and 2) using alternative investments, such as private debt, Real Estate Investment Trusts (REITs), managed futures, etc., which do not move hand-in-hand with the stock market and provide different investment opportunities.

Frontier allocates a client's account amongst 16 different asset classes and will periodically reposition based on an asset class' future expected return AND also trying to make sure that the asset classes are not likely to all move in the same direction at the same time. Simply put, as the U.S. stock market rises significantly, as it has over the past year, then its probability to continue to rise at the same rate decreases. This is true for each asset class. Thus, Frontier will use their proprietary analysis techniques to reallocate a client's account to move it around to the asset classes that they predict may have a higher probability of future returns. By doing this, it may reduce the potential risk of loss to each portfolio. As an example, their Focused Opportunities strategy is currently around 67% of the risk of the S&P 500 and their Absolute Return Plus strategy is less than 50% of the risk of the S&P 500.

Since alternative investments are not publicly traded, like stocks which can be bought or sold on any given day, the share price does not change daily and is much less frequently updated. While the value reflected on your statement may be adjusted for fees and periodically for an updated market value, it is common to see infrequent change in the value of your investment(s) when you look at an account report or statement even though the value of the investment could actually be changing due to market and economic factors. For example, the value of the real estate held in a REIT will be impacted by current conditions, yet the share price for that REIT will not change each day based on that day's developments. This lack of pricing can skew a portfolio's listed return on a report or statement and the investor's perception of how it's performing even though the true value might have changed, yet won't be reflected until sometime later. Since many of the alternatives are illiquid and can't be sold until a liquidation event occurs several years later, the value to the investor that matters is the value when the liquidation occurs and the investor then has the option to sell the shares.

While being more diversified might produce lower returns when compared to the returns of any single asset class, such as the Dow or S&P500, it may reduce the risk to the value of a person's account and the risk of a person being derailed or slowed in achieving their desired goals. In baseball, the goal is to score as many runs (and more than your opponent) before getting 27 outs in a typical game. While it's always exciting to watch a player hit a 450 foot home run, “swinging for the fences” also increases the risk that the batter will get out. Strategically, putting together a string of singles and walks will produce more runs. Let's continue to focus on the goal while managing to reduce the risk in getting there.

Please call me if you have any questions about the performance of your investments and how your portfolio is constructed. Similarly, please forward this email to anybody that would enjoy reading it or might benefit by speaking with me about their financial questions or goals.

There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values.