It’s that time of year — you’re looking at your investment returns from last year and, most likely, not feeling too great. Add the large losses already sustained this year, and you’re probably turning a little green.
We all know the conventional wisdom when the markets are in free fall: Don’t panic. Buy and hold. That’s great advice if you can answer “yes” to this important question: Is your portfolio specifically designed, implemented and managed for that hands-off approach?
I like to use the analogy of building a sailboat. There are all types of sailboats: ocean racing, coastal cruisers, day sailors and blue water explorers, to name a few. These boats react to the wind and waves in very different ways. While a blue water boat may be slow and out of place on Lake Tahoe, it may be the only type of boat that can safely weather a major storm at sea. With a coastal cruiser, the best advice when the weather turns rough may be to run for shore, while the blue water boat may be just fine sailing onward. Boats have missions and are designed for certain purposes, and one should never sail one’s boat in conditions it’s not designed to withstand.
Your portfolio is no different. You need to ask yourself, how is my portfolio designed? And is that design meant to ride through this storm (buy and hold), or is corrective action appropriate?
Now is an excellent time to do a formal portfolio review that focuses on your portfolio’s purpose, build and design, which will help you answer the question of whether “buy and hold” makes sense for you right now. The review should cover three main areas: investment policy, expenses and performance.
With the current market volatility, your portfolio evaluation should focus on the investment policy, which has three parts: the Investment Policy Statement, the implementation and the ongoing execution.
Having a plan is not enough
Every portfolio needs to have an Investment Policy Statement. Ideally, the IPS should be in writing, so you can evaluate the document over time to make sure it’s still appropriate for your goals. The IPS should clearly state the investment philosophy, how it will be implemented, the evaluation process, and what to do during major market downturns. If your plan is to buy and hold, then that should be the stated strategy in the IPS. If you do not have an IPS, you should strongly consider creating one immediately. You would never build a home, a boat or even a tree house for the kids without some written plan.
Having the IPS is just the first step. Next, you should make sure that you’ve implemented the plan. Is the portfolio allocated as stated in the IPS? Are you tracking and benchmarking your investments and portfolio appropriately for your goals? If the IPS is the blueprint for your boat, implementation is the construction stage. If the boat required three bulkheads for structural integrity, did you build three, or did you change on the fly and build only two?
The final piece of the investment policy is the execution. As it relates to your portfolio, the execution is the final implementation of the IPS and the ongoing management of the portfolio as outlined in the IPS. We separate implementation from execution because sometimes the overall implementation is correct and follows the IPS, but the final execution is faulty.
How execution can go wrong
For example, the IPS may say that 20% of your portfolio will be invested in U.S. large-company stocks. The implementation was to evaluate many active managers, and select and monitor their performance relative to a benchmark, say the S&P 500. All good so far.
Then, the final execution saw the purchase of three actively managed mutual funds, each fully diversified. This gets an F grade on execution, because an actively managed, diversified investment in an oxymoron. The goal of active management is to select securities that the managers believe will outperform the market as a whole. But the goal of diversification is to own enough securities so that no single security has a meaningful effect on the portfolio.
In other words, if a manager’s bad pick cannot hurt — a classic reason for diversification — then a good pick cannot help. The very act of diversification cancels out the potential benefit of active management.
In this example, the mistake is compounded by the selection of three different managers. Fewer than 20% of managers outperform the market, and there is no proven way to determine in advance who will outperform. The odds of being lucky enough to select three managers who outperform is incredibly small. This “diversification of managers” also runs counter to the very goal of active management. This is a case where the execution falls apart, even though there is a clear investment policy.
Poor execution of investment strategies becomes particularly damaging during market downturns. As the saying goes, a rising tide lifts all boats. The same can be said for the execution of an IPS — a rising stock market will hide poor execution. With the current market turmoil, poor execution may be exposed.
To be clear, even if the execution in the above example were perfect, it still would not be an example of a buy-and-hold strategy. A buy-and-hold strategy is often referred to as “passive management,” which in many respects is the opposite of a true active strategy, like the one in the example.
The only true ‘buy and hold’
There is only one investment philosophy where buy and hold is appropriate: a globally diversified portfolio strategy implemented with diversified investment management and executed with a disciplined approach. (Buy and hold, after all, should not suggest complete passivity; for example, you still should rebalance your portfolio to adhere to the asset allocation set up in the IPS.) Such strategies, for example with index funds, can be implemented and executed in many ways.
An investment approach like this leads to “unsinkable portfolios.” Simply put, the IPS is designed and implemented to ride through major market movements. Much of its structure is purposely constructed to take the rough seas. And while it may make you feel sick, it will continue through the storm to calmer waters, eventually delivering you safely to your destination.
If your portfolio is not designed to ride the storm, you may want to consider running for a safe harbor before your boat is at the bottom of the ocean.
This article was originally published on NerdWallet.com.
