Part II: Benefits of a Broadly Diversified

Part II: Benefits of a Broadly Diversified. Part I looked at the performance characteristics of a broadly diversified portfolio versus a portfolio wholly invested in world stocks and a 60/40 portfolio. Given those characteristics, Part II will look at: 1. Why a broadly diversified portfolio represents an appropriate solution for the average investor 2. Why a broadly diversified portfolio represents a good choice given the likely market environment over the coming years As a reminder, the main performance characteristic of the Broadly Diversified Portfolio is that it generates steadier returns throughout the market cycle than either of the World Stocks Portfolio or the 60/40 Portfolio. 60 40 1990 - World Stocks Portfolio 60/40 Portfolio Broadly Diversified Portfolio long-term than others. Portfolios that are highly volatile and are subject to large drawdowns are more difficult for the average investor to endure than the more stable performance of the broadly diversified portfolio. So, investors in something like the Broadly Diversified Portfolio in the chart above, have a better chance of achieving their long-term investment goals simply because they are more likely to stick with this strategy over the long-term. Secondly, a broadly diversified portfolio generates less variability in long-term returns than other portfolio types, making financial planning easier. Portfolios that rely on a single asset to generate returns, such as a portfolio comprised solely of world stocks, are riskier than more broadly diversified portfolios. They are risker in the sense that a single asset can generate a wide dispersion of returns, even over long investment periods. For example, the chart below shows the rolling 10-year annualised returns for U.S. Stocks (S&P Composite index). Even over 10-years, there has been a wide variability of returns. There were some 10-year periods that generated annualised total returns (including dividends) of 15-2. But there were also 10-year periods that generated very low or negative annualised returns. 20 See Data Sources & Performance Notes for portfolio construction information. Given the above, why does a broadly diversified portfolio represent an appropriate solution for the average investor? 25% 2 15% 1 5% -5% U.S. Stocks: Rolling 10-Year Annualised Returns 1900 - There a couple of compelling reasons to favour the stable performance of a broadly diversified portfolio: Firstly, the average investor will find it easier to stick with the stable performance of the Broadly Diversified Portfolio, compared to other portfolio types. Investment success really boils down to 1.) having a strategy and 2.) sticking with that strategy. Now, there are many investment strategies that can deliver long-term returns. But some strategies are easier for investors to stick with over the U.S. Stocks = S&P Composite Index (Total Return) Such a wide dispersion of potential returns makes financial planning difficult: investing solely in stocks over a 10-year period could generate superb or lousy returns - that s not a great strategy for retirement planning. Even a 60/40 portfolio of stocks and bonds (what is usually considered a diversified portfolio) has generated a fairly wide range of long-term returns, historically. However, a more broadly 2016 Holborn Assets. All Rights Reserved. Page 1

diversified portfolio has generated less variability in longterm performance, by virtue of its more stable returns across market cycles. Ultimately, this makes the financial planning task easier, because less variability of returns means you can have greater certainty of future portfolio performance. Now, it s important to recognise that every investment approach has its drawbacks. A broadly diversified portfolio is no different. As shown above, there are advantages to stable portfolio performance. But there are also aspects of this approach that are difficult to live with. The main drawback of a diversified portfolio is its underperformance during strong periods for stocks as has been the case in recent years. However, it s important to understand that this is just a feature of a widely diversified portfolio. But this feature can be problematic for investors. As we know, investor become greedy in strong equity bull markets and the fear of missing-out on making money begins to drive investment decisions in such environments. While fear of missing out is certainly a reality that needs to be recognized and managed, it s a far less destructive investing foible than the fear of outright losses; persuading someone to stick with a portfolio that is generating lower returns than stocks in a bull market is much easier than persuading someone to stick with their portfolio after its lost half its value in a bear market. Given this, a broadly diversified portfolio still represents an appropriate investment approach for the average investor. Why does a broadly diversified portfolio represent a good choice given the likely market environment over the coming years? Some types of portfolio are sensitive to the ups and downs of the market cycle. This would include portfolios with high allocations to equities, such as the World Stocks Portfolio above, and even the 60/40 Portfolio. The Broadly Diversified Portfolio, however, is much less sensitive to the market cycle; performance tends to be more stable across different market environments, both good and bad. The benefit of this approach is that investors need to be less concerned with near-term market prospects than investors in other types of portfolio; investors in a World Stocks Portfolio or a 60/40 Portfolio can be forgiven for worrying about how the market will perform in the near future, especially the possibility of poor market conditions, given that the performance of these portfolios are sensitive to overall market conditions. That s much less the case with the Broadly Diversified Portfolio. That said, there s reason to believe that the market environment over the coming years will be more favourable to a broadly diversified portfolio approach than other portfolio types. As shown in Part I, the performance of a broadly diversified portfolio looks bad versus other types of portfolio in strong market environments (when stocks are performing well) whilst performance looks good in weaker market environments (when stocks are falling in value). It s no surprise that the performance of a broadly diversified portfolio looks bad given the strong performance of stocks in recent years. However, there are signs that market conditions could change over the next few years. If history is any guide (and it usually is) a broadly diversified portfolio approach will fare much better in these market conditions. Here s why. It s been over six years since the end of the last bear market in stocks. Over those six years, world stocks (MSCI World Index) have achieved an annualised return of about 15 per cent. The chart below shows the rolling 6-year returns for world stocks. As you can see, at an annualised return of 15 per cent, the current six year rally in world stocks is on the high side, from a historical perspective. 2 15% 1 5% -5% World Stocks: Rolling 6-Year Annualised Returns 1975-6-Year Annualised Return Data Source: Morningstar. World Stocks = MSCI World NR USD Index World Stocks Price data for world stocks only goes back to the early 1970s. For U.S. stocks, however, there s data going back 2016 Holborn Assets. All Rights Reserved. Page 2

over 100 years (the S&P Composite Index). The chart below shows the same rolling 6-year returns but this time just for U.S. stocks: 4 3 2 1-1 -2 U.S. Stocks: Rolling 6-Year Annualised Returns 1906 - Sept 2016 6-Year Annualised Return U.S. Stocks 1000 100 10 1 50 40 30 20 U.S. Stocks & CAPE Ratio 1900 - U.S. Stocks U.S. Stocks = S&P Composite Index (Total Return) Similar to world stocks, the current 6-year annualised return for U.S. Stocks, approximately 16 per cent, is towards the upper end of what stocks have achieved over this time period in the past. Now, on its own, the fact that stocks have performed very strongly over the past 6 years is not a reason to be overly worried about future stock returns. However, it is the combination of strong 6-year performance and the current valuation levels for stocks that are a cause for concern. Valuations drive long-term stock returns. This is closest thing the financial world has to a law of gravity. Quite simply, the more you pay for a given level or earnings (which is what you re paying for when buying stocks) the lower the long-term return on that investment. There are many ways to measure the valuation level of stocks, both individual stocks and broad stock markets. A popular valuation measure for broad stock markets is the Cyclically- Adjusted Price Earnings (CAPE) Ratio. The chart below shows the performance of U.S. Stocks (S&P Composite Index) going back to 1900 (top chart) and the CAPE Ratio (bottom chart) showing how the valuation level of U.S. stocks has changed over time. 10 0 CAPE Ratio The green short-dashed lines in the chart above correspond to low valuation levels (low CAPE ratio) and the red longdashed lines to high valuation levels (high CAPE ratio). What can be seen is that following low valuation levels, U.S. stocks have tended to perform strongly. The opposite is true following high valuations; U.S. stocks tend to perform poorly. The current valuation of U.S. stocks is 27.4. Historically, this is a very high valuation level; U.S. stocks have only seen higher valuations in 1929, during the Dotcom bubble in 1998-2000, briefly in 2004 and then in 2007. The relationship between valuation levels and subsequent market performance is captured in the chart below. Historically, when valuation levels have been in the lowest decile (a CAPE Ratio falling between 4.7 and 8.9) the average annualised return over the next 6 years has been nearly 15 per cent (leftmost bar in the chart below). As valuations rise, the pattern is for subsequent 6-year annualised returns to fall. The performance of U.S. stocks following the highest valuations levels (a CAPE Ratio falling between 26.1 and 44.2) saw negative 6-year annualised returns (rightmost circled bar). At a CAPE Ratio of 27.4, the current valuation of US stocks falls in this highest decile, 2016 Holborn Assets. All Rights Reserved. Page 3

which implies very low annualised returns over the next 6 years. 19% 14% 9% 4% -1% S&P 6-Year Forward Annualised Returns at Various CAPE Ratio Levels CAPE Ratio Level So, we currently have a situation where stocks have risen significantly since the end of the last bear market and, in doing so, have pushed valuations to levels that are very high by historical standards, for U.S. stocks at least. In the past, high valuation levels have been followed by low longterm stocks returns. However, valuation levels, on their own, tell us very little about the how the market will perform in the shorter-term. All we know from the current high valuation level for U.S. stocks is that the stock market probably won t be much higher in 6 years time than it is today. What is doesn t tell us is how those poor returns will manifest; there are many ways (infinite, in fact) that stocks could generate zero returns over the next 6 years. years, if not sooner, is high. And that s an environment where the performance of a broadly diversified portfolios compares most favourably to other portfolios. To demonstrate this, let s take a look at last two significant market highs and subsequent decline in stocks to see how the World Stocks Portfolio, the 60/40 Portfolio and the Broadly Diversified Portfolio performed over these periods. The chart below compares the performance of each portfolio around the 2000 stock market high (vertical dotted line). The top chart compares performance in the two years leading up to the market high (March 1998 to March 2000) and the following three years after the market high (March 2000 to March 2003). The bottom chart compares performance in the one year leading up to the market high (March 1999 to March 2000) and the following three years after the market high. So, on the only difference between the two charts is that the chart on the left starts two years before the market top in March 2000 whereas the chart on the right starts just one year before the market top: 145% 12 95% March 1998 - March 2003 However, the combination of high valuations (overvalued) in the presence of a stock market that has already rallied very strongly over the past 5-6 years (overbought) usually points to nearer-term difficulties for stocks. It is this combination of overvalued and overbought conditions that almost always present themselves at or around the high points of the market cycle (aka, market tops). 7 1.35 1.1 March 1999 - March 2003 So, why might a broadly diversified portfolio be the best option given this outlook? Well, as we saw in Part I, a broadly diversified portfolio, given its diversified nature, lags the performance of stocks in the bull market phase of the market cycle. However, diversification performs a lot better versus other types of portfolio during the bear phase of the market cycle. Given the analysis above, the potential for a meaningful decline in stock prices over the next 2-3 0.85 0.6 World Stocks Portfolio 60/40 Portfolio Broadly Diversified Portfolio See Data Sources & Performance Notes for portfolio construction information. 2016 Holborn Assets. All Rights Reserved. Page 4

The following chart are the same as the above but compare portfolio performance around the February 2008 market high (vertical dotted line): 175% 15 125% 10 75% 5 Feb 2006 - Feb 2011 that s likely to be a bad decision over the completion of the current market cycle. In summary, there are some compelling reasons to favour a broadly diversified portfolio approach. Historically, this approach has generated more stable returns than other portfolio types, which translates into a more pleasant journey for investors. Additionally, given U.S. stock valuations, it s likely to be a more challenging environment for stocks over the coming years. Historically, in such environments, a broadly diversified approach has performed relatively well compared to other portfolio approaches. 1.45 1.2 Feb 2007 - Feb 2011 Part III, the final part of this series, will look at how the broadly diversified approach used in the Holborn Portfolios differs from the very simple Broadly Diversified Portfolio approach used in the examples above and in Part I. 0.95 0.7 0.45 ---------------------------- World Stocks Portfolio Broadly Diversified Portfolio 60/40 Portfolio See Data Sources & Performance Notes for portfolio construction information. The charts above show that the Broadly Diversified Portfolio performs favourably compared to the other portfolios over periods encompassing the run-up to market highs and subsequent declines. Even if you think markets are two years away from any trouble, it still pays to take a diversified approach over the medium-term. Given the current overvalued nature of U.S. stocks and overbought nature of world stocks, it s probable that market conditions, as in the examples above, will be better suited to a broadly diversified approach than either a 60/40 Portfolio and especially a portfolio heavily weighted to stocks. Of course, given the performance of a broadly diversified approach over the past 3-4 years, both on an absolute basis and relative to stocks (see Part I), it s no surprise that many investors are abandoning this type of portfolio. However, 2016 Holborn Assets. All Rights Reserved. Page 5

Data Sources & Performance Notes: Data Source: Morningstar, BarclayHedge Portfolio performance represents simulated performance based on the following data: World Stocks Portfolio = 10 MSCI World NR USD 60/40 Portfolio = 6 MSCI World NR USD Index, 4 Barclays Global Aggregate TR USD Index Broadly Diversified Portfolio = 2 MSCI World NR USD Index, 2 Barclays Global Aggregate TR USD Index, 2 LBMA Gold Price PM USD, 2 Managed Futures (pre 2000 = BTOP 50 Index, post 2000 SG Trend Index), 2 Barclays 1-3 Year Treasury TR USD Index. All portfolios are rebalanced on a monthly basis. Simulated performance is hypothetical and does not reflect actual investment performance. Unlike actual performance, simulated results do represent actual trading and do not account for fees, commission and other real-life costs. Disclaimer: This document is for information and illustrative purposes only and does not purport to show actual results. It is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable people may disagree about the opinions expressed herein. In the event any of the assumptions used herein do not prove to be true, results are likely to vary substantially. All investments entail risks. There is no guarantee that investment strategies will achieve the desired results under all market conditions and each investor should evaluate its ability to invest for a long term especially during periods of a market downturn. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those discussed, if any. PAST PERFORMANCE IS NOT A RELIABLE INDICATION OF FUTURE PERFORMANCE 2016 Holborn Assets. All Rights Reserved. Page 6