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Nov 1, 2015

A New Dawn, A New Day, A New Life… Are You Feeling Good?

by Derek Henderson

Derek Henderson

As Nina Simone suggested, it is indeed a new day, but unfortunately, many investors aren’t feeling as good as they’d like to these days. Sure, the birds are still flying high, and the sun is still up in the sky, but given the volatility and uncertainty that has plagued the global economy this year, many are left to wonder how?

 

 

How will the unrelenting doldrums in the economic climate affect me and my family? How will my investments fare if this volatility persists? How will all of this affect my retirement plans? These are all questions I have been hearing from our clients on a daily basis.

Yes, folks, it’s true. It’s a new life—a life in which the terms grexit, china slowdown, rising rate liquidity crisis and oil glut have become part of our everyday vocabulary. As Bob Dylan so poetically put it, “the times they are a-changin’.”

Now, I wouldn’t go so far as to say desperate times call for desperate measures, but it would be fair to say that different times require different measures.

Letís get back to the question of how?

The big question you should be asking yourself is, “How can I implement a new investment strategy that will allow me to maximize my opportunities in this ever-changing market?”

To do this, you need the proper tools, tactics and plan. And you need to be prepared.

Tools

Would you go golfing with just a driver and a putter? Would you give a formal presentation without preparation? Of course not!

Whether you are on the golf course or in the boardroom, you need to be prepared and use the best tools available to you for your best chance of success.

Financial planning and investing are no different. As times have changed, investment solutions have evolved. The traditional stock-and-bond approach is much like hitting the links with just two clubs. Today, there is a whole set of new and efficient tools available to you—alternative tools that you need to have in your bag for those challenging times and difficult conditions.

In a recent article published by BlackRock, Dr. Christopher Geczy1, Academic Director of the Wharton Wealth Management Initiative and Adjunct Associate Professor of Finance at the Wharton School, points to the need for alternative tools in our new reality. He says, “The notion of alternative investing is often misunderstood. Gaining access to different types of investments is an approach that almost everyone should employ, and many strategies are now available to a broad range of individuals.”

This is a very relevant article that indicates we should all be expanding beyond the traditional approach to investing through alternative investment tools. Dr. Geczy continues to explain that “alternatives provide access to sophisticated investment strategies and types of investments that cross asset classes, and broaden diversification opportunities…”

On the alternative front, an increasing number of options are available to you, including specialized commodity- and currency-related tools, easy-to-use long/short strategies, and structured products.

Below is a quick example of an alternative investment tool that could be added to your repertoire. If you are looking to diversify, manage risk, or gain exposure to a certain market sector, ETFs are certainly an option. They are relatively simple to understand, liquid, transparent, and, most important of all, a cost-effective way to diversify and build a strong core for your portfolio or add a component of torque to your investment style. Of course, this is just one example of an alternative solution you could be using. Remember, it’s important to ensure you have all the resources you need to manage today's realities and tomorrow's uncertainties.

Tactics

If the right tools are important, a relevant investment strategy is equally so. The traditional buy-and-hold approach is a thing of the past. The static investment strategy is by no means optimizing your portfolio or maximizing your investment opportunity. Your portfolio strategy should be constantly evolving.

In today’s world, everyone should consider incorporating a wider range of investing strategies as part of your overall financial plan. It’s quite simple really: to maximize your returns, you need to be more dynamic in your investing strategy, particularly as it pertains to your asset allocation strategy.

Over time, you will notice that most of my articles revolve around one consistent theme—asset allocation. There have been many conflicting views and research on how investors should construct an optimal portfolio. Historically, investors have relied on research introduced by Harry Markowitz in 1952, the Modern Portfolio Theory and Mean-Variance Optimization framework around the efficient portfolio, correlations and risk/reward characteristics of asset classes. Historically, for decades, investors and the investment industry have used this research as a backdrop to portfolio construction discussion, decisions and approach to investing.

Similarly, investors have incorporated findings from the 1986 research by Brinson, Hood, and Beedower2 around asset allocation in their approach to investments. Their findings suggested that 93.6% of the average return variation can be explained by asset allocation. This research was followed up by Ibbotson and Kaplan3 in 2000, who found that asset allocation explains 90% of the variability of portfolio returns over time. These studies, amongst others, suggest that asset allocation will contribute overwhelmingly to the success of one’s portfolio over time.

However, the one thing these studies do not account for, in our mind, is one of the most important aspects of investment management, and how our asset allocation decisions adapt to change.

There’s that word again: change.

Before I elaborate, let me explain two traditional approaches to asset allocation, strategies that are largely based on the findings of the research referenced earlier: strategic asset allocation and tactical asset allocation.

When investors adopt the strategic asset allocation approach, they are completely adhering to the thesis that, once an optimal asset allocation has been established for the investor, all decisions should revert back to the developed asset mix. The investor establishes an optimal asset allocation using a proportional combination of assets, based on expected rates of return for each asset class. Complementary asset classes are chosen and given their specific risk/reward characteristic that, ideally, complement each other at a given point in time. A portfolio will always be adjusted and rebalanced back to the established strategic asset allocation.  

Tactical asset allocation takes it to the next level. Utilizing a tactical approach, the investor develops a strategic asset allocation and will occasionally engage in short-term, tactical deviations from the strategic mix to capitalize on short-term investment opportunities. The tactical willingness to change allocation does add an aspect of decision-making to the portfolio and will enable you to participate in some of the changing market conditions when one asset class may be more favourable than another. This is a moderately active strategy, moderate because one always reverts back to the established strategic allocation once the market opportunity has passed.

Now, let’s revisit the word “change”.

As you know, the only certainty in life is change and, surprisingly, it’s the one thing for which the referenced research and these two approaches to asset allocation do not account. As we know, in any given market, return expectations are not static; they change. Risk and our tolerance for risk change, asset correlations change, and variables such as expected inflation and risk-free return change. Just as our own personal circumstances change, so too does the market.

We agree that setting an asset allocation is a step in the right direction, but in today’s ever-changing market, you can also adapt a more active asset allocation strategy, which we refer to as dynamic asset allocation. Adopting a dynamic approach will ensure the investor is continuously adjusting the mix of assets and allocations as markets and variable changes. It is a dynamic process, and it plays a key role in determining your portfolio's overall risk and return. As such, your portfolio's asset mix should reflect your goals, not at a single point in time, but at any point in time. Adopting this approach enables us to utilize new information and adapt to ensure that we are consistently maintaining an optimal allocation to accommodate change.

You need to monitor your investments and, in appropriate situations, employ a dynamic tactic to your allocation framework. This willingness to change, coupled with the tools and investment vehicles that allow us to capitalize in volatile and downward trending markets, opens up a whole new world for us.

Plan

With the tools in hand and your new tactical approach, it’s important for you to sit back and formulate your goals. Near-term goals such as your children’s education or that trip to Europe are important, as well as defining those long-term retirement goals we all dream about. I was told recently by a CFO friend of mine that dreams were goals with deadlines, a statement that I find resonates well because goals are actually attainable. As long as we have a plan, dreams can come true!

We all have dreams; dreams are still very much within our reach. When developing the strategic dream plan, I always focus on three specific areas: preservation, integration, and growth.

The foundation of any long-term plan should be preservation, first and foremost. Sustaining your wealth that has taken you all those years to accumulate should be of primary importance.

Secondly, integrating your wealth is an important attribute of any successful plan. Finances have traditionally been segmented into groups such as personal banking, investments, insurance, accounting, tax and estate planning, all typically handled separately. Taking steps to integrate everything financial into what we refer to as a complete financial optimization strategy will create a more manageable, efficient, cost-effective platform.

And last but not least, remember financial growth. Implementing and maintaining your focus on preservation and integration enables you to use the appropriate tools and tactics that will help you to grow your wealth and, in turn, allow you to reach your goals and live out those dreams.

As the world around us continues to rapidly change, so too must the way we live within it. It’s extremely important for us to continuously evolve and not forget to:

i)         Use all the sophisticated investment tools and resources that are available to us, where and when appropriate

ii)        Maintain a current and tactical investment approach

iii)       And, most importantly, have a dream plan

Be nimble in this fickle and unpredictable environment, and work closely with your trusted advisor to ensure your portfolio is well positioned to not only withstand the volatility but ensure you are able to seize upon opportunities as they arise.

 

G. Derek Henderson, Investment Advisor, Bush-Henderson Investment Team, CIBC Wood Gundy ,Waterloo ON

(519) 883-5353 Toll Free: 1-800-891-1004

www.bush-henderson.com, Derek.Henderson@cibc.com

 

 

1 Dr. Christopher Geczy, The New Diversification: Open your eyes to alternatives, Blackrock.

2 Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, Determinants of Portfolio Performance, The Financial Analysts Journal, July/August 1986.

3 Roger G. Ibbotson and Paul D. Kaplan, Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?, The Financial Analysts Journal, January/February 2000

CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor. The views of G. Derek Henderson do not necessarily reflect those of CIBC World Markets Inc.