Delay Is Instinctive

Delay is natural to a writer. He is like a surfer - he bides his time, waits for the perfect wave on which to ride in. Delay is instinctive with him. He waits for the surge (of emotion? of strength? of courage?) that will carry him along. I have no warm-up exercises, other than to take an occasional drink. I am apt to let something simmer for a while in my mind before trying to put it to words. I walk around, straightening pictures on the wall, rugs on the floor - as though not until everything in the world was lined up and perfectly true could anybody reasonably expect me to set a word down on paper." 

- E.B. White, "The Art Of The Essay"

Recently, I've gotten a comment or two that I'm not writing as frequently as I used too. I'm not sure they were glad to not be getting the emails, or that they actually missed them. Well, I'm not procrastinating, its just that I don't want to write the same old stuff over and over again. I don't want to bore you or myself. 

I've also been a bit busy of late. I've picked up a couple of new investors, and have been busy getting their portfolios set up. 

Surprisingly, this email gets distributed to several hundred people, and I've found that more than a few don't really understand what it is that I do for a living. In simple terms, I manage money. I build and manage portfolios for my family and those like minded investors who want to come along for the ride.

This approach runs counter to nearly all of the financial industry, and with good reason. Most financial firms exist to make money for the firm. The way they make money is by having more money under management. Their overriding focus is growing assets under management. I know this because I spent 25 years working for these organizations. There is nothing wrong with this, if you are a shareholder in one of these companies. But handing my hard-earned money over to them to "manage" was the last thing I was going to do. 

Don't get me wrong, there is a place for these firms. Every investor is different. Some investors need special attention and a customized portfolio that suits their own levels of risk tolerance and return expectations. This is the role of a financial advisor. I've met hundreds of financial advisors, and some are real assets to their clients and worth every penny they charge. Some are also scary.

I am not a financial advisor. I am an investment manager. My goal is simply to preserve and protect my assets, while seeking the highest risk adjusted returns over time.

Yes, I do dispense a lot of financial advice, and it is OK to ask me for advice (I don't charge for it). And yes, I do think I am qualified to give advice, I am a CFA and have nearly 30 years in the business. I'm also registered with the SEC as a Registered Investment Advisor (RIA).

But financial advice is not my business. And because it's not my business, I can avoid a lot of the baggage associated with it, namely the conflicts of interest. Frankly, I'm free to speak my mind without worrying that I may offend my boss or scare a client. If I couldn't do that I wouldn't write at all.

My business is investing, to make money off of my personal investments. Over the years I've been fortunate enough to find like minded investors who share my investment beliefs. These individuals invest their money alongside mine, whenever I do a trade for myself I do it for all of my investors. We're in this together.

Diversification in a Risk-On/Risk-Off World

In the real estate market you have location, location, location, while in investment management we have diversification, diversification, diversification. We are all taught that the key to risk management is to diversify your assets, so when one thing isn't working something else will be.  When I got started in this business you could simply diversify a portfolio by investing internationally. When the US was zigging, Europe or Asia would be zagging. It worked for years, but eventually as corporations grew much more global in scope, their stocks started to move more in unison. Today whenever one market moves the others follow in lockstep. As the Table below shows the US market has a 0.91 correlation with EFAE and a 0.88 correlation with Emerging Markets (a correlation of 1.00 is perfectly positive). The chart below shows that this was not always the case, but today you do not get much diversification by investing internationally.

Over the years many of us have added bonds, real estate, commodities, and even gold in attempts to diversify. Generally this works to varying degrees, but not always. During the financial crisis we all learned just how poorly diversified our portfolios were. You see, just when you need diversification the most, during times of financial distress, is when all assets tend to move together. Correlation went to 1.00 during the dark days of 2008. This is by far the toughest part of our job.

 Rockhaven Correlation Matrix

The following table shows return correlations between the assets you entered for the past 618 days.

			VTI	EFA	VWO	GLD	GDX	VNQ	IFGL	DBC	MOO	CRBQ	BND	TIP	IGOV	WIP	EMB	CYB	FXA	BZF	Return	StdDev
	Vanguard Total St	VTI																			17.0%	1.1%
	I Shares Msci Eafe	EFA	0.91																		7.0%	1.4%
	Vanguard Emerging	VWO	0.88	0.90																	16.9%	1.5%
	Spdr Gold Trust	GLD	0.22	0.26	0.31																28.3%	1.0%
	Market Vectors Go	GDX	0.47	0.48	0.53	0.80															15.5%	2.0%
	Vanguard Reit Etf	VNQ	0.84	0.74	0.72	0.18	0.39														27.9%	1.6%
	I Shares Ftse Epra	IFGL	0.86	0.91	0.88	0.29	0.49	0.73													7.5%	1.3%
	Power Shares Db Co	DBC	0.61	0.65	0.65	0.51	0.55	0.51	0.63												20.0%	1.3%
	Market Vectors Ag	MOO	0.84	0.82	0.84	0.32	0.52	0.67	0.78	0.64											21.5%	1.5%
	Jefferies Tr/J Cr	CRBQ	0.87	0.88	0.89	0.41	0.63	0.70	0.84	0.71	0.91										16.6%	1.5%
	Vanguard Total Bo	BND	-0.39	-0.32	-0.32	0.08	-0.07	-0.28	-0.29	-0.22	-0.30	-0.28									5.9%	0.2%
	I Shares Barclays	TIP	-0.21	-0.16	-0.14	0.25	0.09	-0.16	-0.14	0.02	-0.12	-0.08	0.76								8.6%	0.3%
	I Shares S&P/Citig	IGOV	0.23	0.45	0.33	0.28	0.29	0.18	0.36	0.31	0.29	0.36	0.21	0.24							2.5%	0.6%
	Spdr Db Internati	WIP	0.46	0.61	0.55	0.33	0.39	0.36	0.55	0.48	0.50	0.59	0.04	0.16	0.67						8.2%	0.6%
	I Shares Jp Morgan	EMB	0.43	0.46	0.47	0.09	0.20	0.35	0.44	0.31	0.45	0.46	0.00	0.05	0.22	0.45					9.2%	0.5%
	Wisdom Tree Dreyfu	CYB	0.34	0.40	0.42	0.15	0.21	0.22	0.37	0.34	0.38	0.38	-0.20	-0.08	0.23	0.36	0.39				0.2%	0.2%
	Rydex Currency Sha	FXA	0.74	0.80	0.80	0.41	0.56	0.60	0.77	0.64	0.71	0.78	-0.19	-0.04	0.42	0.60	0.42	0.40			16.6%	0.9%
	Wisdom Tree Dreyfu	BZF	0.63	0.68	0.73	0.31	0.50	0.53	0.62	0.54	0.63	0.70	-0.20	-0.06	0.35	0.56	0.41	0.34	0.65		15.7%	0.8%
	I Shares Lehman Sh	SHV	0.03	0.01	0.00	0.00	0.02	-0.02	-0.01	0.00	0.05	0.02	-0.01	0.01	0.00	0.03	0.04	0.02	0.04	0.07	0.1%	0.0%
	Portfolio																				13.1%	0.7%

Intra-portfolio diversification	= 0.36
Start Date	= 2009-09-21
End Date	= 2011-06-01

Each cell represents the correlation between the two corresponding assets.

Cell Color	Description	Diversification Benefit
-0.65	Asset pair with negative correlation	Excellent Diversification
-0.15	Asset pair with slight negative correlation	Good Diversification
0.2	Asset pair with mild positive correlation	Moderate Diversification
0.8	Asset pair with strong positive correlation	Poor Diversification

Why is everything correlated?

First, is the highly intertwined global economy and all of those companies that operate globally. 

Second, and much tougher to pin down is the fact that all markets have become more speculative in nature. More and more portfolio managers are seeking those uncorrelated assets, and when they find one they tend to pile on in unison. Active allocation is by definition speculative. Previously non-correlated assets become more and more correlated, as investors seek their diversifying benefits. The ease of trading these once hard to get assets (commodities, gold, international socks & bonds, real estate) has also been a significant factor. 

In the end, asset allocation has been boiled down to one single trade; risk-on or risk-off. Investors of all shapes, and sizes from around the world are either buying risky assets or they are selling them. Risk-on/Risk-off makes the job of diversifying much more difficult because now it requires proper timing. Some say it's impossible.

The Solution

Is there a way to build a portfolio with lower risk and higher returns that doesn't require perfect timing? I believe there is.

Cash is still that one diversifying asset that isn't correlated to other assets. Sure the return is zero, and slightly negative after inflation, but at least it won't gap down by 20%. I believe, (and have shown that it works) that an investor can have a diversified portfolio that actively uses cash during risk-off periods to protect their assets. Using some relatively simple timing rules we move from fully invested, to neutral, to minimal weight in all of our assets when the markets dictate. We are not trying to forecast the future, we are just trying to stay in harmony with the markets. When they are working we want to participate, and when they are not we want to stand on the sidelines. 

This is Tactical Asset Allocation, and in todays market environment it works. 

Be careful out there, and keep the lights on,

Chris Wiles, CFA

412-260-7917

www.rockhavencapital.com

For prior Rockhaven Views visit:

www.rockhavencapmgmt.blogspot.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management.  The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.