This past year and a half has been trying, indeed. As far as most investors are concerned, things have gone well beyond any conceivable worse-case scenario. As a result, so much has to be re-thought and re-learned, mostly the concepts of risk, various asset correlations, liquidity, and diversification. It is safe to say that, in the aftermath of the credit and financial crises, Wall Street has spent most of its time focused on managing and, more importantly, on reducing risks. But, before discussing where today’s returns worth pursuing might lie, it is always useful to reminisce a bit on the lessons learned. I promise I won’t be beating this particular dead horse too long.
Firstly, in order to get returns, you have to take risks. However, this lesson is useless without understanding that risks drive the good returns just as they drive the bad returns. Hence, you should only take calculated risks. Second, markets are relatively efficient over the long term. However, in the short term, the pendulum swings in both directions and, at times, even violently, which means there is no one-size-fit-at-all-times investment strategy. Finally, all that economists and analysts can do is make educated guesses as to what lies ahead. They may or may not be right. However, well-structured portfolios should be ready for every plausible scenario, both good and bad.
Risk models can be useful if investors are knowledgeable enough to understand the mathematical concept of variable change. For the rest of us, the concept of using different risk frameworks when designing a portfolio might do the trick. For example, dividing investment strategies into divergent and convergent could help structure both long and short portfolio exposures. For example, if an investor believes the markets are stabilizing, using a convergent strategy and going long on sectors believed to be the first to recover makes sense, and vice versa. For example, when Lehman Brothers collapsed last year and the shock had spread globally like a brush fire, bearish investors who had exercised divergent strategies by deleveraging and shorting weak sectors were the only ones who reaped any kind of profit during those awful times.
One other type of risk should be on the mind of investors when designing their portfolios — that is, liquidity risk. The gut reaction to reduce liquidity risks is to transform majority of assets into cash and to sit on it. But it is not a profitable strategy. There are other ways to seek real returns while minimizing liquidity risks. For example, there are ways to equitize cash by investing in exchange-traded funds (ETFs) or in investment trust that can be used as proxies for certain sectors, such as real estate or oil and gas.
Another helpful strategy would be to look into diversifying away from, or towards, (equity) beta. In simple terms, beta is a number that quantifies the relationship between a security’s return versus that of the financial market as a whole, or usually a well-known and broad benchmark, such as the S&P 500. If a stock has a beta of zero, for example, it means it is not correlated to its benchmark. If beta is 1, it means the stock follows the market. If beta is below 1, it signals that the security is inversely following the benchmark and vice versa.
Finally, in the past 18 months we have learned that, despite the beauty of Efficient Market Hypothesis (EMH), ignoring the emotional factor hides huge dangers. After all, the market is not some perpetuum mobile that swings by its own devices, but it is a complex structure driven by people, who think and who also are emotional beings. This is how markets can overshoot in both directions, depending on whether its players feel overly confident or extremely panicky. This also means investors can no longer afford to rebalance their portfolios once a year or longer. In fact, when the market is fast and volatile, rebalancing every month or less might be a good idea. Of course, there is the question of costs incurred when trading frequently. But that is something that individual investors will have to decide for themselves.