Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

For regular SAA and TAA portfolios, the next re-balance will be on next Monday, August 26, 2013. You can also find the re-balance calendar for 2013 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Risk Management: Upside Risk

We discussed downside risk in portfolio management in our previous newsletter August 12, 2013: Risk Management: Downside Risk. In this newsletter, we will discuss another type of risk: upside risk. 

Compared with downside risk, upside risk is less well known and understood. At the first glance, you would say, what upside risk? Do I care?

You should care. Upside risk means the risk an investor can have if she/he behaves overly conservative or way too risk averse. When an upside risk occurs, investors can suffer from some real damages: 

  • If you are too afraid of market risks and put most or all of money under the mattress for a long period of time, you will actually lose money due to the loss of purchasing power. The main problem here is the inflation: a phenomenon that your money will not be worth the same (or have the same purchasing power) due to the continuously rising prices for most consumer goods and services. In today’s environment, the sub-zero interests paid by banks are much less than 2-3% Consumer Price Index (CPI), a metric for inflation, even though the inflation rate is already subdue. After the long 20 some years low inflation period, with today’s ultra loose monetary policy, one should not be complacent that the double digit inflation period in 1980s will never return. Putting money into growth assets or hard assets with limited supplies is the most sensible way for most investors to keep up with inflation. 
  • The second consequence for being too risk averse is equally troublesome: if you are sitting on the sidelines either because of being too risk averse or having second guess on an investment strategy, you might see that markets are soaring above you. You will be pressured, either by yourself or by others, to chase an already elevated market, only to find out you are late to the party and suffer from real loss. This phenomenon should not be under estimated and ignored. It is in fact a real danger that can cause serious damage to your investments. 

Upside risk specific to investment strategies

Different investment strategies can have different upside risk. We will discuss the two popular asset allocation strategies MyPlanIQ uses here. 
  • Strategic Asset Allocation (SAA):  the biggest problem of using SAA is its likely large downside risk. However, if you could not withstand the big loss incurred to your portfolio during a severe downturn and liquidate or reduce risk asset exposure (close) at a market bottom, you will probably suffer from downside risk’s symmetric evil twin: upside risk. As the saying ‘once bitten, twice shy’ goes, you probably will be very hesitate to jump back to stock markets when markets are recovering: my portfolio has been down 40%, what happens if I get another 20% or even 30% loss? We don’t know how many people actually have behaved like this since the 2008-2009 crisis, but you can bet there are a lot of them. For these people, unfortunately, upside risk is very real. Put simply, if you are not a true buy and hold investor, you shouldn’t pretend to be one. 
  • Tactical Asset Allocation (TAA): Tactical asset allocation can dynamically reduce or increase stock and other risk asset exposure based on market and underlying economic conditions. The real problem with TAA is the strategy’s frequent adjustments. Not only it can be out of sync with general market direction, it can also incur frequent small loss. Cases in point: since market low in 2009, TAA has not performed as well as SAA; Furthermore, many TAA portfolios did rather badly in 2011, much worse than S&P 500. These out of sync behaviors can cause a lot of investors to second guess such a strategy. Some of them abandon it all together, some slack off and invest randomly again. The upside risk here is that when such behavior occurs, investors can be forced to chase markets at a later point, at a much higher level. Furthermore, as we pointed out in July 22, 2013: Tactical Asset Allocation: The Good, The Bad And The Ugly, buying in a rising market (which is the MyPlanIQ’s TAA does) can be a psychological challenge: many times, people asked us whether they should wait till markets come down to rebalance. Bear in mind, however, this is perfectly normal: that is why there is an anomaly such a strategy can still exploit. Or put in another way, Consistency Is Your Biggest Investing Edge

How to avoid upside risk

So how to avoid upside risk? It turns out it is not much different from deal with downside risk. It is just from different angles: 
  • Properly set up your downside risk tolerance and your risk profile. We can’t emphasize how important this is. By now, you should probably know this is the most important factor to avoid upside risk too. Not only you should be ask yourself real hard on whether you can truly withstand the risk, you should even have a drill to go through the worst scenario and see how you can respond. As a sailor or a pilot, you should have adequate expectation for the adverse situations. 
  • Again, you need to thoroughly understand the investment strategies you are using, especially their pros and cons and their associated risks in various market cycles (again, see our previous ‘The Good, The Bad and The Ugly’ newsletter series). Simulate through these scenarios and see how you will behave. 
  • Finally, you will need to stay on course to let a full market cycle play out. Don’t skip and/or second guess. When in doubt, ask yourself whether this is the normal part of the strategy or this is a nasty surprise you (and others) don’t know beforehand. You will need to differentiate whether this is caused by implementation errors. You can fix an implementation problem (but might have to pay hefty price) but you can’t fix a fundamental flaw. It is sure an expensive price to pay if you have to abandon that in the middle of the road. This is not about the subscription fees or management fees you pay, it is about your hard earned money in investments. This again shows the above two points are paramount: you don’t start a long journey without knowing whether the boat you are on can withstand a hurricane. 
To summarize, upside risk is a real risk that comes with downside risk hand in hand. One should always have this box checked before embarking on any investment strategy using the risk profile you decide to use so that you have the right expectation to sail through safely.

Portfolio Performance Review

The following compares the tactical portfolios with their lazy portfolio counterparts:

Portfolio Performance Comparison (as of 8/19/2013)

Ticker/Portfolio Name YTD
1Yr AR 3Yr AR 5Yr AR 5Yr Sharpe 10Yr AR 10Yr Sharpe
David Swensen Six ETF Asset Individual Investor Plan Tactical Asset Allocation Moderate 3.7% 6.1% 10.4% 8.1% 0.8 9.7% 0.82
P David Swensen Yale Individual Investor Portfolio Annual Rebalancing 1.7% 5.6% 9.6% 6.4% 0.35 8.9% 0.53
Permanent Portfolio ETF Plan Tactical Asset Allocation Moderate 0.8% 0.8% 7.0% 6.6% 0.65 7.2% 0.66
PRPFX (Permanent Portfolio Fund) -3.7% 0.2% 5.7% 6.4% 0.5 9.1% 0.75
VBINX 8.8% 11.4% 11.3% 6.9% 0.46 7.0% 0.49
VFINX 16.9% 19.6% 17.0% 7.1% 0.28 7.3% 0.3

*: NOT annualized

**YTD: Year to Date


David Swensen’s portfolio has been under pressure lately mostly due to its weighted exposure in long term Treasury bonds. Similarly, permanent portfolios are not doing well as both gold and Treasury bonds were hit hard recently. On the other hand, their TAA counterparts are doing better in this environment: mostly due to the reduced or eliminated exposure in the troubling assets mentioned above. However, one should understand these portfolios’ pros and cons: they will surely go through this type of market cycles one way or the other. 

Market Overview

Broad risk asset markets are all under pressure recently. US stocks and international developed country stocks are truly the last two standing above cash in our asset class ranking. REITs again suffered from heavy sell off, along with virtually all of the bond segments (especially long term bonds). One should understand how severe the recent bond sell off is: even the famed Vanguard Short Term Investment Grade fund VFSTX has year to date loss now (-0.4%). We reiterate this is a tough environment going forward: rising rate, over valued and over bought (yes, VEA and SPY are still over bought). We call for cautions. 

For more detailed asset class trends, see  360° Market Overview.

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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