In designing portfolios, we talk about the term ‘weight’ (as a percentage of the total portfolio) to asset classes, strategies, and styles. We throw around the word like everyone knows the meaning as we intend.
However, this is not always the case! Let’s define a few things we believe.
Most predictions aren’t worth the paper they are written on. From sports to markets to politics, we humans always are underestimating the likelihood of events. The best move is to avoid predicting at all.
Instead, we can start with the Normal Distribution. Most of the time, market conditions over the long-term will be average and follow this well-known statistical rule. Sometimes the scenario could end up bad (banks going down over 50% in 2008) or quite good (technology stocks in 2017). Still, we must act as if tail events (the far left and far right of the distribution) are much more likely and more impactful than the “normal” picture would have us believe. This is because tail events can impact your portfolio in outsized ways.
Instead of predicting, we look at the information currently available in asset prices. This can give us a range of what to expect. For example, the starting yield on a bond is easy to determine and a very good indicator of its expected return. The process is similar for stocks or real estate, adding in the growth rate of the yield and ending value level.
After we determine the worth of an asset class, we can now compare it to historical data to determine whether a specific asset class is priced as cheap, fair, or expensive. If an asset is cheap, its expected return is greater than its historical average. If expensive, the asset’s expected return is below average (and not enough compensation for its risk).
Once we individually measure the worth of different asset classes, we now can piece them together in a portfolio. For every asset class, we have a strategic target weight. When the percentage weight is on the target, portfolios are “Equalweight.” This means the analysis leads us to believe the current price level is fair. In this case, during short to medium-term, we want to be aligned with the strategic target.
Ideally, we want to buy assets when they are cheap. When cheap, there are a greater range of scenarios for the asset to create average to excellent returns. In this case, portfolios are “Overweight” from the target. The opposite would be when an asset is rich (or expensive). In this case we would own less than the asset class target and be “Underweight.”
The table below goes over the various asset values, scenarios, and resulting portfolios weights.
Given today’s valuations, and which asset classes are ‘rich’ or ‘poor’, where should you be watching your weights? For us, U.S. small caps look priced for an optimistic outcome. Meaning, to meet average returns, a good case scenario would need to happen. The same thing occurs with high yield bonds, where the extra return gained is near the lowest levels in the last ten years.
Emerging markets still look interesting to us for two reasons. Share prices are near the same levels from 2008 for many countries. Secondly, emerging market currencies have depreciated greatly over the past several years. Because prices are so cheap, even a bad case scenario coming to fruition should result in average returns (compared to history). If the scenario turns out just “Average” or even “Good,” the expected results could be excellent for investors.
It is an ongoing process to observe asset prices and determine the upside or downside cases that will influence the path of stock or bond market returns. In what areas of your portfolio are you watching your weight today?
This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.