Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Mastering Disciplined Investing: Insights with Stephen Parker (S2 E6)
Discover the secrets of disciplined investing and strategic asset allocation with Stephen Parker, head of specialized strategies at JP Morgan Private Bank. In our conversation, we explore the nuances of aligning investments with personal goals, focusing on the importance of understanding individual needs, investment horizons, and risk tolerance. Stephen shares JP Morgan's insights on long-term forecasts for over 200 asset classes, emphasizing the critical role of maintaining discipline and the power of staying invested over time.
Ever struggled with market volatility or wondered how to balance short-term needs with long-term growth? We unpack the concept of bucketing in financial planning, a strategy that segments investments into liquidity, lifestyle, and growth categories to meet various life goals. This approach not only helps navigate market fluctuations but also protects long-term plans from being disrupted by short-term market movements. Learn how strategic asset allocation, rebalancing, and viewing portfolio construction as a series of dimmers and dials can enhance your investment strategy.
Join us as we tackle the complexities of economic forecasting, market timing, and the active versus passive management debate. Stephen sheds light on the importance of seeking contradictory information to improve decision-making and the strategic use of alternative investments. Even seasoned investors will find value in the discussion on the role of recessions in investment decisions and the balance between active management and passive strategies. This episode promises a wealth of knowledge to enhance your understanding of disciplined investing, making it a must-listen for anyone eager to sharpen their financial acumen.
Show Notes:
JPMorgan, 2025 Long Term Capital Market Assumptions
Cembalest, Eye on the Market Outlook 2025
Marks, On Bubble Watch (Jan 7 2025)
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a sometime professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment Podcast. Here we explore topics in markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finlay. We have an incredible guest today, stephen Parker, the head of specialized strategies at JP Morgan Private Bank. Steve and I have known each other for a very long time.
Speaker 1:Steve started his career in finance as a summer analyst at JP Morgan some 23 years ago. He's held roles of various sorts in the firm, from working in the chief investment office to more than 10 years as a portfolio manager himself, and now he runs a team of portfolio managers for the private bank across multiple strategies, including multi-asset strategies of about $120 billion. Steve, welcome to the podcast. Thank you. It's great to be here. I'm delighted to have you, steve.
Speaker 1:What I would love to talk to you about is managing portfolios. That is what you have done for the vast majority of your career. You're good at it. You understand it in real life terms, not in academic terms. For listeners who have listened to core episodes already, we might use some phrases or talk about some things that you'll find in episodes seven and eight on building strategic asset allocation, as well as in episodes 20 and 21, which is about evaluating them, and so feel free to go back and listen to those again, if you want or not. If you feel like you've got it under control, that's great. So, steve, let's start with exactly that strategic asset allocation. The conventional wisdom right is that you should design a strategic asset allocation that's in line with your goals. What in the world does that mean in real terms?
Speaker 2:Yeah, I think you mentioned this in a previous podcast.
Speaker 2:At the end of the day, the strategic asset allocation that you select is ultimately going to drive 90% of the risk and return of your portfolio over the long run.
Speaker 2:So getting it right is really important, and I think one of the lessons that I've learned over the two plus decades that I've been doing this is this idea of measure twice cut once. I'm a terrible carpenter, but I think it applies to the idea of managing money, and what that means is sitting down with each individual client to really understand their needs, their goals, their long-term objectives. What's their starting point, what is their investment horizon, how much risk are they willing to live with and, ultimately, what are they trying to do with their portfolio. Are they trying to use it to buy a home, to fund a child's education, to fund a foundation? And when you get a better sense of that, it helps bring you to an understanding of what is the return needed to achieve those goals, but also, importantly, what is the risk that a client can stomach in order to stay disciplined and stay invested over the long term.
Speaker 1:So you mentioned two things there and I think it's useful to unpack it a little bit. First, once you have a full understanding of the goals, what's the return you need? And second, the risk. So let's take the return first. Over what time period should you be thinking about? Should you be thinking about hitting that return bogey every year at some longer time interval? How do you think about that?
Speaker 2:So we anchor a lot of our work around strategic asset allocation in our long-term capital markets assumptions. This is a project that we embark upon every year where we bring together 50 of the top minds around asset and wealth management to come up with our forecast for over 200 different asset classes over the next 10 to 15 years. So I think it's really important. Investment horizon is critical. We're not making forecasts, particularly strategic forecasts, for the next 12 months or even the next five years. We're really thinking longer term.
Speaker 1:So does that? I want to make sure I understand. So does that mean that, since you're using forecasts at longer time intervals, like five to 10 years, means that in executing the allocation you should expect your bogey return on average over five to 10 years, or does it mean something slightly different?
Speaker 2:No, you're right. So when we think about a strategic allocation and we will do analysis to say here's what we expect the return will be. That expected return is over the next 10 to 15 years and, importantly, we don't try to anchor just around a single number. What we do is we look at a wide variety of outcomes You've talked about Monte Carlo simulations in the past variety of outcomes You've talked about Monte Carlo simulations in the past understanding what is the potential range of outcomes. And if you talk about something that perhaps falls on the lower end of the range, is that still an outcome that you can live with to achieve your goal?
Speaker 1:I got you, and so let's go to the second key element, which is risk. First, how do you? Understand how much risk a client can take.
Speaker 2:You know it's funny. I remember heading into 2007, a lot of the conversations that we were having with clients were all focused on the return element of the component of the conversation. You know how can we maximize the return? And then the global financial crisis came along and everyone realized very quickly that the risk component was as important, if not more so. Risk is sort of an abstract concept, but I think the good news is we have a couple of test cases that we can use whether it was the global financial crisis or what happened around the pandemic to stress test portfolios and to say if this is your strategic starting point in 2008, this is what would have happened to your portfolio. Can you live with that, or would that cause you to make a change to your long-term strategy? I see so it's really.
Speaker 1:It's very psychological, but it's also very person dependent. There isn't kind of an answer. You mentioned Monte Carlo simulation, which is really a mean variance model. It's really thinking about risk in terms of volatility. Are there other ways to think about risk when you're designing a strategic asset allocation that are worth spending some time thinking about?
Speaker 2:Yeah, there's traditional risk, which is how much volatility can you withstand? How can you live through a particular market drawdown? I think the other thing that you need to think about is liquidity risk. How much of your portfolio are you willing to sacrifice short-term liquidity to potentially drive longer-term returns, or diversification? And then diversification risk, because one of the things that we talk about is the importance or diversification. And then diversification risk, because one of the things that we talk about is the importance of diversification and, frankly, diversification means always having to say you're sorry, there's always something in a truly diversified portfolio that's not going to work, but that's done by design, and so there's a number of elements of risk that we need to think about in building that strategic starting point.
Speaker 1:And so I like that answer because I think that it means both. The strategic asset allocation can be very person specific and there are tools. We can think about return, we can think about risk measured as volatility. Think about risk measured in terms of liquidity. I suppose you didn't mention it, but I suppose you could think of risk in terms of cash flows. You talked about those goals, and if the idea is, you know, this is meant to support some expense or some distribution, cash flows are going to be relevant.
Speaker 2:Well, that's actually an important component. If you start out with these sort of strategic templates that we come up with, then you have to incorporate specific client preferences and, as you said, a lot of clients need to lean on their portfolios more to support income generation, or they may have a preference for sustainable investing. There's a number of different preferences that can then be overlaid on top of a strategic allocation to try to get to those long-term that's a really interesting point.
Speaker 1:to think about risk in terms of those preferences like socially responsible or ESG or whatever it might be. You might have a very specific idea. I don't want to own anything in certain jurisdiction or certain type. I get that Okay. So you've alluded to this, but I'd love for you to just sort of take it apart a little bit. Once you've got what you think is the right strategic asset allocation, tuned to that person, how do you evaluate it?
Speaker 2:Yeah, so I mentioned our long-term capital markets assumptions and that's really the toolkit that we use every year to go back and look at strategic asset allocation. And that's really the toolkit that we use every year to go back and look at strategic asset allocation. And there's really two ways to look at it. There's top down how are we building the variety of different strategic asset allocations? That's where the change in returns or the change in market composition forces us to go back and look every year to see if something should change. The reality is, for most strategic asset allocations, they shouldn't change that often.
Speaker 1:Well, that's kind of what strategic means, like if they're changing often, then they're not strategic anymore. That's right.
Speaker 2:But there are times when you have to acknowledge that the market has changed. So, as an example, if you look at the global equity market, not too long ago the US was about half of the global equity market. Today it's over 70%. So when you see that type of market dynamic, it's important to go back and reevaluate. What does my strategic starting point look like? Should it change in the same way to reflect what's happened in terms of the change of the market? And then, of course, you've got the personal changes at the client level. Have your goals evolved? Have things happened in your life that might change what you're trying to achieve with that strategic allocation?
Speaker 1:When you're designing Steve. Then a strategic asset allocation how broadly or granularly do you allocate to specific risks?
Speaker 2:you allocate to specific risks? Yeah, so I think a lot of it depends on the client particular situation. So if you start top down, the first decision is do I want a global portfolio or do I want a US focused portfolio? Do I want to stay invested in liquid assets or do I want to incorporate alternatives like real estate or private equity or hedge funds into my portfolio? So at a high level we'll think about strategic asset allocations from kind of a stock bond alternative mix. But under the surface we're actually getting a lot more granular thinking about geography, thinking about capitalization, thinking about different asset classes.
Speaker 1:And does the average, let's say a person, let's say a listener doesn't have the benefit of working with JP Morgan Private Bank and instead they're accessing one or more of these fintech tools in which they query them on different goals and different aspirations and then spit out here's your asset allocation. Talk to listeners a little bit about what they're getting when they get that and what should be the things to be cautious about and what are the things to feel pretty confident about.
Speaker 2:Yeah, I think that there is a lot of value in being able to use some of these basic tools to understand very generally, across the risk spectrum, where should you fall? A lot of investors will tend to bucket risk profiles into conservative, balanced growth, which might mean a 40-60 portfolio versus a 60-40 portfolio, the mix of stocks and bonds. I think that generally tends to be the starting point for some of these very basic strategic allocations. I think what you lose out on is that next degree of granularity understanding. How should I think about geography? How should I think about alternatives? And, importantly, it doesn't give you the ability traditionally and typically to incorporate those preferences that are really important. That income component or the diversification component or the opportunity to invest in interesting thematic opportunities over the long term Got it.
Speaker 1:So one last question on strategic asset allocation before we move on. I've heard it said from some people that I think are very smart they're not investors, but I think they're very smart people and I've heard them say I don't need this money for the next 30 years. I don't care, I don't look at it, I add to it every year. So all of my preferences are like you know I just want to earn the maximum return and so therefore, why would I own anything but equities? What do you say to that person?
Speaker 2:One. You're in a very fortunate position, right. I look forward to the day when I don't need any of my investments for at least 30 years. But I think that concept that you're talking about is something that we refer to as bucketing, and we spend a lot of time with our clients not just thinking about their portfolio as a singular allocation of capital, but rather as different buckets meant to achieve different things in their lives, and we found this to be really helpful.
Speaker 2:So if you take a client and you think about building a liquidity bucket so the cash that they might need for taxes or their mortgage over the next 12 months or an emergency then you think about a lifestyle bucket so here's the money that I want to invest to be able to afford my vacations or that second home over the next couple of years and then the long-term growth bucket, which is really geared towards retirement or funding a foundation. I would argue that that instinct that you set up is right. Those buckets should probably be invested differently. That liquidity bucket should be much more conservative, Whereas that long term growth bucket, the answer might actually be 100% equity, if you truly have that long term investment horizon and, importantly, as long as you have the discipline to stick with that. When markets get rocky, that's where you get in trouble.
Speaker 1:So I love that, because that means that a person really even a modest person not talking about a super wealthy person but that a person probably should have multiple strategic asset allocations, not just one.
Speaker 2:That's right and in fact, what we've learned is, by taking that approach, by separating out the money that you need in the short term, there's a much greater likelihood that you're not going to derail your long-term plans when markets get rocky because you've mentally separated that part of your portfolio. Think about it as the way you invest your 401k or your children's 529 plans, as opposed to what you're doing in your brokerage account.
Speaker 1:So you open any newspaper today and what do you read? You read how last year was another banner year in equity markets 20 plus percent return. The prior year, 20 plus percent return. And so this is the news that you have in front of you, and I think the average person, in reading all of this news, might think to themselves gosh, you know, maybe I should own more equities, Maybe I should own that. Or they might read those same news articles and think, oh well, that's the end of that, I should own less in equities. When you've designed your strategic asset allocation, can you talk a little bit about managing the risks around it? You've used the phrase a few times now discipline. Break that out for me and for listeners to help them understand what that means like day-to-day reading the paper.
Speaker 2:I would argue you probably would benefit from reading the paper a little bit less, at least when it comes to managing your portfolio. I think the risk that you run is that those headlines, either positively or negatively, will tend to disrupt your long-term plans, and we've talked about this a little bit. But I've learned over the last 20 plus years that markets are both incredibly simple and painfully complex, and I will illustrate that with an example. So if you go back in history, do you know what the odds are that the stock market in the US would be positive on any given day? No clue, it's a little over 50%. So it's basically a coin flip, really Every day, every day. Slightly above%. So it's basically a coin flip, really Every day, every day, slightly above. But yeah, it's a coin flip.
Speaker 2:Now, if you extend your time horizon to a year, in any average rolling 12-month period, 70% of the time stocks are up. Now go to 10 years Now your odds are better than 90%, and there's never been a 20-year period when the stock market has been down. So incredibly simple in the sense that, if you can maintain that long-term discipline, markets and time are going to do a lot of the heavy lifting for you. If, on the other hand, you allow that noise, the headlines, the blogs, the headlines on CNBC to drive you emotionally, either positively or negatively, you're running the risk of you're basically going back to that coin flip, and that's where it becomes very difficult, and so we spend a lot of time trying to ensure that that strategic asset allocation that we just talked about is one that will allow our clients to withstand that noise and those ups and downs.
Speaker 2:The last thing I would say is, when it comes to this idea of market timing, which is, I think, a little bit what you're talking about, there's nothing wrong with market timing. In fact, when it comes to tactical asset allocation that we're doing on behalf of our clients, when it comes to managers that we think can add value through the stocks or bonds that they pick, there's a big opportunity there. But there's a saying that I love, which is that portfolio construction should be thought of as a series of dimmers and dials, not as an on-off switch, and where people get in trouble, and what a lot of people are tempted to do is to say either I'm all in, I think the market's going up, get me fully invested, all my chips.
Speaker 2:Or nope. You know what I think. Markets are going down. The headlines are bad. Move me all the cash.
Speaker 1:No, it's funny, isn't it? Like that statistic that you gave really colors the question beautifully At any given day. It sounds random and I bet I mean I won't ask you, but I bet that you have the statistics for one week, one month, right, and sort of different time intervals, and the longer you go the less random it is. And so let's unpack that idea. Let's talk about the various ways that investors professional investors like you, but also listeners who may just be doing their own investing, the way that we can avoid this risk of letting short-term market moves, economic news sentiment, sway us from our strategic asset allocation, and so one such way is rebalancing. What are we talking about when we're talking about rebalancing? Why is it good?
Speaker 2:So, again, we talked at the start about building a strategic asset allocation. Once you have that asset allocation, markets over time are going to move and, as a result, the value of the things in your portfolio are going to change and the size of those allocations within your portfolio are going to change. So I'll give you an example If you were a 60-40 investor, meaning you allocated 60% to stocks and 40% to bonds back in 2020, and you did nothing with it today, your portfolio would be 80% stocks and 20% bonds, which is not your strategic asset allocation, which is not your strategic asset allocation Now.
Speaker 2:Along the way, you benefited because stocks went up and that benefited your portfolio. But the reality is, if you look at where you are today, your risk profile looks a lot more like what we think of for a growth client than it does for a balance client.
Speaker 1:Which is to say it sounds like doing nothing is actually doing something.
Speaker 2:That's right. It's a decision that you're making to not rebalance, and so if you can add an element of discipline to your investment process and this can differ for each individual but to say, either every quarter or every year, I'm going to rebalance back to that strategic asset allocation. What that means is you're ultimately going to be selling things that have outperformed. You're going to be buying things that have underperformed, which is why you want to make it systematic, because that's often hard to do emotionally. But what it will also do is to ensure that you don't get too far out over your skis from a risk perspective, because you're constantly rebalancing that portfolio.
Speaker 1:So you mentioned the psychology of what makes it hard. Right, like the reality is. Is that just human nature? Is, if things are going up and I'm thinking to myself, well, I should be disciplined and sell the things that are up, it's really hard because we think, well, I think it's going to go up just a little more, I'll wait a couple of weeks. And likewise, when things are going down and you say, well, I should be buying that it's really hard because you'll think to yourself, oh well, it's going to go down more, I don't want to be buying it now. So psychology makes it very difficult to do this. Rebalancing. You mentioned quarterly or annually. How long should one be thinking about rebalancing and how long does it take to see the results? So it like, using your example of if I did nothing since 2020, if I did nothing since 2020. Okay, so that's four years. Is that too long to wait to rebalance? Is that too short?
Speaker 2:Yeah, so we typically talk to clients about rebalancing either on a quarterly, semi-annual or annual basis. That just gives you enough of a discipline, enough of a timeframe where you are getting the benefits of that diversification but you're not necessarily turning your portfolio over too much. I mean, there's costs that come with that, there's potentially tax implications that come with that. So you need to be thoughtful and, depending on how much things like taxes matter for an individual, that may steer you towards a shorter or longer rebalancing period.
Speaker 1:This goes back to your point that you made earlier right of these different buckets, because I suppose within a bucket there might be buckets. So within your very long-term bucket there may be a bucket which is just a brokerage account. You have somewhere where you're going to want to be sensitive to taxes and if you're churning that too rapidly, not only are you paying tax on those gains at a greater interval, but you're probably also going to be paying short-term capital gains tax, which is ordinary income about double the tax hit. But of course, if it's a portfolio that is in a 401k or an IRA, maybe you're less sensitive to that tax cost.
Speaker 2:Yeah, I think it's interesting because this has been a big shift in our industry since I began here 23 years ago. When I started, when we thought about this concept of alpha, it was really investments focused. It was picking stocks versus bonds or this company versus that company. Over the last five to 10 years, I think this idea of structural alpha meaning how do we lower costs, how do we make things more tax efficient whether it's through tax-focused strategies, whether it's through asset location, which is what you were talking about that's become a lot more important because that structural alpha, whether it's around expenses or whether it's around taxes, is much more easily projectable than investment alpha. So it's become a much bigger part of our discussion with clients.
Speaker 1:All right. So the risks to this strategic allocation we've come up with is that we let short-term swings. One way to avoid that is by rebalancing and be systematic. It's hard, we all know it's hard and it's not obvious how often you have to kind of think about it and think about the bucket. You mentioned market timing, so you know my example of reading today's headlines would be an example of market timing and notice listeners should notice that it cuts both ways, like I can read the same headline and think I'm out, as I can read the headline to say that I'm in, it's bad. Okay, I mean, we hear you saying that, but tell us a little bit more concretely why it's bad.
Speaker 2:Yeah, I think markets are challenging because they don't necessarily move on good or bad, but they move on better or worse. So this job would be very easy if you could just look at the headlines and say the economy is doing well, consumer confidence is high, the stock market's going up, therefore I should go all in. Or, conversely, the economy is really bad, people are losing jobs, inflation is high, I should sell everything. The reality is, markets don't tend to operate that way and in fact, when you look over the long term, a lot of the best times to be invested are when things feel the worst. Take the consumer as an example.
Speaker 2:Consumption is 70% of the US economy. A lot of people will look to consumer confidence as a gauge for the health of the economy and, by extension, the health of the market. Well, if you go back over the last 40 years, the troughs in consumer confidence, which generally tend to happen around recessions, have actually had a very good track record of predicting where the market is going. Just not in the way you think, because traditionally the worst sentiment has been the higher the probability that the market would be up going forward because expectations.
Speaker 1:That's super interesting, right. So it's not that market sentiment. It's not that listeners should think, oh, I should pay no attention to market sentiment. I once heard it described that markets are doing two things at once. Markets are at once computing valuation and simultaneously engaging in people's sentiments where their hearts are. And so what I hear you saying is well, sentiment. Using sentiment as a way to think about your market exposure isn't a bad idea. It just may not be how you think it should work. Right, when it's flying high and consumers are super confident, the sentiment is robust. Maybe that's the warning sign.
Speaker 2:Well, and I would give you an even more recent example. You talked earlier about how nice it would be to have a crystal ball as an investor. I would argue, even if you did, you're not necessarily going to be successful. Imagine you could go back in time to the beginning of 2020 and someone came and told you a global pandemic is about to hit. The entire economy around the world is about to shut down. Everyone is going to be forced to start working from home. What would you do in your portfolio? I think most people would say, well, I'm going to sell everything, I'm going to move to cash, I'm going to buy some gold. I don't think there were a lot of people saying I'm going to go out and buy stocks, and yet over the first two years of the pandemic, the US stock market was up over 50%.
Speaker 1:So even if you have that, crystal ball, markets don't always act in such a cooperative way. Yeah, and I think that brings us to this other idea, which is, you mentioned, economic forecasts. Markets are in the business of pricing the future, and I think so many listeners get confused by this that when they're looking at whether we're talking about market levels, whether we're talking about investor sentiment or the economic backdrop, we have to imagine that the market is not reflecting what's happening today. It's predicting what's going to happen tomorrow. So can you talk a little bit about the challenges there in terms of understanding economic forecasts and market exposure?
Speaker 2:I mean not to take any credit away from my colleagues who spent a lot of time thinking about the economic outlook, and I think there is a lot of value in that, but for a lot of investors, particularly those who have that sort of on and off switch mentality of all in or all out recessions are the things that they're trying to predict to say that's when I'm going to get out of the market. Now some challenges with that. One recessions are traditionally very difficult to predict. I remember visiting you down in Charlottesville back in October of 2022, and there were all of these headlines because a very popular indicator of recession risk came out, saying that there was 100% probability of recession over the next 12 months. Well, here we are, two and a half years later, still waiting for that recession. So, number one recessions are hard to predict. Number two as you said, markets are forward looking.
Speaker 2:So if you go back and look at the last eight recessions, the interesting thing is that the stock market tended to bottom about five months before the economy did. And here's the even trickier part After the stock market bottomed which, by the way, was still in the midst of the recession the rally that took place off of those lows tended to be dramatic and tended to be fast. So in those five months between when the stock market bottomed and when the economy bottomed, on average the market rallied 30% to 40%. So trying to predict the recession is hard. Trying to time it is even harder. And, by the way, even if you time it right and you sell just at the right time, there's a second part to that trade, because you need to decide when you're going to move back in. And the problem is, I've yet to see a market bottom that is accompanied by wonderful headlines and cheery excitement and everything is great.
Speaker 1:You know, those bottoms tend to take away this idea that the best and most an investor should do is rebalance, and to do it in a disciplined way, as hard as it is and at a periodicity that makes sense for that particular goal and that particular pot of money and all of the other stuff, trying to imagine whether the market has reached a peak or has reached a valley, whether the economy is turning around, whether sentiment is positive or negative. And this is what we read in the papers all the time.
Speaker 1:Your message is ignore all of that Just stay disciplined on rebalancing, is that?
Speaker 2:fair. I think that's the baseline. I do think that there are opportunities and we spend a lot of time working on this with clients to make tactical changes on the margin based on your outlook. But it's important again to go back to that dimmers and dials analogy. You want to make changes on the margin that can help you navigate shorter-term market moves, but the biggest risk is thinking that you're going to go all in on timing it, letting that emotion, letting those headlines drive your long-term strategic allocation.
Speaker 1:Tactical asset allocation. Again, listeners can go back to core episodes and understand, in episode 20 and 21, what we mean about tactical allocation, but suffice it to say is that, from time to time, you might want to adjust your holdings of different risks to accommodate the environment. The first question that I have, though, is when we say tactical asset allocation, is our overall level of equity risk supposed to change, or is that supposed to stay the same and we're just tuning dials down below?
Speaker 2:I think you can take both approaches. The way that we look at the world is that that level one, equity risk, can change, but within a range of outcomes to ensure that you're not straying too far from your long-term risk and return profile. So we may tilt into equities relative to fixed income, but it's probably going to be a couple of percent on one side or the other. I think there's also a lot of opportunities, as you alluded to, under the surface. Are there opportunities in the US versus emerging markets? Are there opportunities in technology versus healthcare, and so there's a lot of different dials that you can pull. But I think, importantly, with every tactical move that you make and every change that you make to move away from that strategic allocation, you need to make sure that you're re-underwriting the fact that you're not straying from that general long-term risk and return profile, because that's where the risk comes in. That's great.
Speaker 1:And your answer. In fairness, your answer is super precise. But I'm going to just blur the lens for a second and I think I'm not being unfair to say that strategic allocation to equity risk is probably pretty carved in stone. So, listeners, when they hear because I've spoken to a lot of lay people who say you confuse the hell out of me. You just browbeat me about strategic asset allocation and don't stray. And then your next topic was tactical allocation, and I think the way to make sense of those two ideas is you're not really changing your strategic allocation to risk. If it changes a smidge here and there, but you use the phrase in and out. Right, you're not going from 60% equity risk to 30. You might go from 60 to 59. You might go from 60 to 61. What you are changing tactically are the different kinds of those risks. So you alluded to international equities, to, I think you said, small and large. How important is it to think of just those categories, or are there other categories that one should think about in their tactical allocation?
Speaker 1:keeping that risk the same but changing the way you own that risk.
Speaker 2:Yeah, I mean there's a number of different dials that you can turn. So you talked about geography, you talked about capitalization and we were talking earlier about the decision around whether you use active or passive to implement. In our mind, the answer isn't active or passive, it's active and passive. We spend a lot more time thinking about where does it make sense to leverage active managers? Where markets are less efficient, so think small cap.
Speaker 1:By leverage, just to be clear, sorry by leverage.
Speaker 2:You don't mean debt, that's right. I don't mean debt, I just mean where do we want to use active managers? It's in less efficient markets. When you're thinking about mega cap US stocks, it's a lot harder to have an advantage, which is where lower cost strategic passive options can make a lot of sense in your portfolio.
Speaker 1:I got you. So it's important to adjust in your portfolio your exposures to different risks, keeping the overall level of risk the same. How does the lay person do that? How does the lay person come to some understanding of gosh? I should own more small cap or less large or more international and less US, and so on.
Speaker 2:I would actually argue for the person who's just out there looking to build their own portfolio. They don't have the time to necessarily spend thinking about markets or the dynamics of tactical asset allocation. Just taking a broader index-based approach using rebalancing is a really good starting point.
Speaker 1:But so it may be that this is the kind of topic for listeners who use a professional. They might want to evaluate their professional by asking questions like that how do you alter your exposure to different ways? How do you decide that? And you also mentioned active and passive, and the answer is yes to both, and I think I could pose the same question and we get the same answer, which is, for the average person, that may be above his or her pay grade, but if you're working with a professional, it's probably a good question to ask how do you make decisions about using active versus passive in a specific risk category? Is there anything else that a listener should be thinking about around sort of tactical allocation that they should be asking their professional about?
Speaker 2:You know I think we touched on it a little bit, but again I keep going back to this word discipline and when you look, for example, at the way that you use active managers to, you may think about it tactically, but really it should be a strategic decision. The types of managers that you're allocating to you should have a long-term investment horizon in terms of how you evaluate their success. There's a lot of different ways that you can be successful in building portfolios. There are growth investors, there are value investors, there are momentum investors and fundamental investors. All of those approaches can be successful. Where people tend to get themselves in trouble is when they think they're a growth investor at one time and then, all of a sudden, value works and then they want to chase value. That goes back to some of those psychological hurdles that you need to overcome, and so having that right investment horizon that we talked about earlier is really important in that active, passive decision.
Speaker 1:So I think what I'm hearing you say is you need to make sure, if you are working with a professional, you need to make sure that they have a philosophy around the risks that they own and a consistent philosophy that they're not chasing.
Speaker 2:So the interesting thing we have a very large global due diligence team here that goes out and looks at all of the different managers around the world to figure out who we should bring on to our platform, who should work with our clients, and we have what we call our 4P process and it's people process, philosophy and performance. And performance is intentionally always the last thing on that list because, at the end of the day, the people, the process and the philosophy are going to be the things that, in the long-term, determine success, and anyone, like most investors, will flip that, and the first thing that they will look at is performance. What's the best performance strategy over the last year or the last three years, the last five years? And that's where people tend to get in trouble.
Speaker 1:This brings us to the last item, I think, when we're thinking about managing portfolios, which is the selection choices and you've already alluded to active and passive and we just now started talking about the ways in which we can query professional managers about how they think of these things. Can we talk a little also? Listeners who have listened to earlier podcast episodes know about certain strategies have exposure to non-normal and non-linear risks here. Think hedge funds, for example, primarily when you're thinking about tactical allocation to non-normal risks and so hedge funds, let's just use that as the illustration.
Speaker 1:When is that a good thing to think about? How much, how to put that into the context of my overall strategic allocation?
Speaker 2:That's right. Well, the first question around incorporating alternatives and we're big believers that alternatives can play an important role both in terms of enhancing returns but also helping to manage risks within a portfolio. The liquidity question that we talked about how much of your portfolio can you really sacrifice liquidity on? That's an important part of the discussion when thinking about sizing and allocation. Bucketing can help with that right. If you're thinking about that longer term or even the intermediate term bucket, you know it might be a little easier to give up some of that liquidity. But I think the other piece that's really important is to understand what is the purpose of those allocations within your portfolio.
Speaker 2:We've been in a very interesting period over the last couple of years and I think you've talked about this on previous podcasts where the traditional relationship between stocks and bonds meaning usually when one goes up, the other one goes down, and so you get diversification Well, that hasn't worked. And why hasn't that worked? It's because, unlike most economic cycles where stocks have gone down because the economy rolled over, in this case stocks went down because inflation spiked, and that tends to be a bad time for bonds. That's where alternatives, whether it's hedge funds or whether it's infrastructure or real estate can play an important role in your portfolio. But again, you have to understand this is there for long-term benefits. This is there in a way where you may end up sacrificing some of your potential upside in exchange for that. Diversification, and knowing from the beginning what to expect in different types of market environments is really critical.
Speaker 1:And it's more complicated, isn't it? Because when you're doing something like that, there isn't the kind of, oh, I'll just own a passive hedge fund vehicle, I'll just own a passive real estate vehicle, right? That doesn't really exist, strictly speaking. Instead, these are active managers making active choices, and you know, evaluating those managers is a lot more complicated. I'm put in mind of just this week or last week, I think it was last week in the FT was an article in which Millennium, one of the world's largest hedge fund complexes, in their multi, in their flagship multi strategy, performed, I think last year I'm going to get this a little wrong but say 12 to 14%. And the newspaper article went on to say and that's in contrast to the S&P 500 earning 20%, so 12 is not so bad, but it really was less good. Talk about that. Is that the right way to think about that question?
Speaker 2:I would say no Is the short answer. This goes back to the idea of measure twice, cut once, and understanding the purpose of everything that is a part of your overall portfolio and also understanding the right way to measure. It is really important to long-term discipline. You can't be the type of investor who wants to be an absolute return investor in down markets and a relative return investor in up markets. That doesn't exist. Well, it exists, it just doesn't work. Yeah, exactly, We'd all like to have that ability, but the it just doesn't work. Understanding what is the right benchmark you're using, how does it fit into your portfolio and what is the right way to evaluate its success beforehand, not after the fact is really important.
Speaker 1:It's a terrific piece and we'll put a link in the show notes. And I'm also reminded that Howard Marks just released his letter in which he quotes Mike's piece, and so we'll put also a link to Howard's memo in the show notes. So, on the choices of the selection choices, it's bigger than just do I own a passive vehicle or an active manager? And among active managers, how do I evaluate? Because then there are also choices about do I maybe pick stocks myself? Maybe I have an idea about picking stocks or choices about owning these non-normal or non-linear risks and what's the role it plays, and so the selection here is tricky to do. You've said to me before and I really like this idea that a discipline that you like to instill on your portfolio managers is to have a shopping list. Tell the listeners I love this idea. Tell the listeners what this means and how you help your managers maintain the discipline around it.
Speaker 2:Yeah, so very simply, the shopping list is the list of things that you want to buy, whether it's a stock or an index fund or whatever it might be Because you're very optimistic about it Because you're optimistic about it, because you like the long-term prospects.
Speaker 2:but maybe, like over the last couple of years, the market has gone up a lot. A lot of these tech names have gone up even more and so maybe you're not ready to buy it today. But, importantly, you want to be prepared because when markets give you that opportunity, that you're ready to go. And I want to bring a concept to light a little bit as we start on this new year Calendar year.
Speaker 2:Investing returns don't really mean that much, but if you go back over the last 40 years and look at the experience of the S&P and try to aggregate it into what your average year looked like well one. In your average year you made about 12% on your money. There was an 80% chance that the market was up. In that year, there was a 40% chance that it was up more than 20%. Put all of that together, that's a really good environment. But here's the trick the average drawdown that you saw in any given year was 14%. So even though markets have been trending higher, even though they've gone up 12% a year on average, you're seeing a 10% to 20% correction each and every year and, as we know when that correction takes place. You know what they don't put on the financial headlines Totally normal market correction. Stay disciplined, think about buying.
Speaker 1:I wonder why.
Speaker 2:But it's markets in turmoil. That's what people want to tune in and listen to.
Speaker 1:Is this an idea that's different than rebalancing? It sounds like it's different than rebalancing.
Speaker 2:This is sort of one step further than rebalancing. Rebalancing, naturally, is going to do some of this for you, right? Because if equity markets sell off and you rebalance, you're going to be buying at lower levels, which should increase your forward-looking expected returns. This is sort of taking it one step further and saying we're going to add an active overlay on top of that, and it doesn't necessarily mean that it's just adding to equities, it may be. I want to rotate from something that is more defensive to something that is more leveraged to an economic recovery when you get that pullback.
Speaker 1:So I mean, let me test my understanding. Is this a good example that I think, long-term AI is going to be transformative and I think that companies even at the first threshold, namely chip manufacturers and data centers and so on, I think that they're going to be great beneficiaries. So it's on my shopping list, but when I look at prices for those today, they seem very high, measured by lots of different metrics, and so, if I'm understanding you, that doesn't mean I don't want to own them, because for the next 10 years I'm investing. For 10 years I think I want to own them. Your message is but maybe not today. Maybe you have it on your shopping list and you wait for a moment where some of those prices retrace. Am I getting the idea?
Speaker 2:Yeah, that's the idea, and it could either be going from something you don't own to something that you own or something that you already own. That you may want to own more of.
Speaker 2:And the other thing that I stress to my portfolio managers it's not just about having a shopping list for a single purchase decision. Purchase decision. If you're looking back to your AI example, this is a 10-year investment and I want to buy $100 worth of AI stocks. Pick a level where you're going to buy 25 and then pick another level where you're going to buy another 25. Because, again, all of these things are tricks to remove some of that emotion, to take away the fear that you need to time things perfectly. And there's something nice psychologically about doing that because, in that example, if you buy that first $25 worth of AI stocks and they go up, well, you feel good because you put some money to work. If you bought them and they go down, well, now you've got the opportunity to buy that next tranche.
Speaker 1:I think the way you just explained it is perfect To a listener who's thinking about what this means. What the shopping list means is really not, you know, okay, ai all seems overpriced today, so I'm not going to buy it. And then, five years later, it's still at this price level and you're like what happened? You're saying instead no, no, no. The shopping list means if you want to buy it, you want to own it for the next 10 years. Buy some, don't blow the entire amount that you want to do it. And then, little by little, piece by piece, over what time horizon?
Speaker 2:I think there's different ways to approach it.
Speaker 2:You can say this is a position that I want to leg into over the next six or 12 months, in which case you may just say a month from now, I'm going to invest a little bit in two months from now. That's one way to take the emotion out of it. You know, the other approach that some portfolio managers will take is to say that there's a price discipline and to say you know, this is a stock that today is trading at a hundred. If it gets to 90, I'm going to buy a little bit. If it gets to 85, I'm going to buy a little bit more. But I think the most important thing isn't necessarily whether it's a time-based approach, a price-based approach, but rather an approach where you're setting a systematic approach beforehand. We have a lot of conversations with clients who keep saying I've got cash, I know I need to put it to work, markets are up a lot, I just want to wait for a pullback. Everybody wants a pullback until they actually get one, and then nobody wants to do anything about it.
Speaker 1:Because now they're frightened. Well, steve, this has been tremendously interesting. I'm going to ask you now a question that we did not prep on and I do this at the end of each episode, which is share with listeners some words of wisdom, whether they're about this topic or other topics, personal, professional, anything you like. The mic is yours.
Speaker 2:So I mentioned earlier, we spend a lot of time looking at investment managers. I've been an investment manager. I now run a team of investment managers. One of the things that I've learned over the years is that most managers spend 90% of their time trying to find information that reinforces their view of the world the data that says why their view is correct. What I found is that the best managers spend 90% of their time looking for information on why they might be wrong. What are they missing in the story? And I think that approach leads to much better outcomes. And I also think that that approach can be something that we should consider more broadly in our lives, in a world where it's become easier and easier to find an echo chamber of voices or opinions that align with yours, whether it's on sports or music or politics take that time to look for differing opinions, to challenge your views of the world, and ultimately, I think it makes us all better Indeed words of wisdom.
Speaker 1:Steve Parker, this has been great. Thank you so much for joining us. Thanks, edward Finlay. You can find research links and charts at notanotherinvestmentpodcastcom, and don't forget to follow us on your favorite platform and leave comments. Thanks for listening.
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