Frequent Changes in a Portfolio Seldom Produce Desired Long Term Results.

John J. Hohn and dog Jessie

There were no lakes large enough in South Dakota to entice anyone to go sailing until the mid-1950’s when the 37 mile long reservoir of Lewis and Clark Lake was formed on the Missouri River near Yankton. Locals then took to the sport in earnest. A sailing club was formed. Races were scheduled, and in the first several that were held, the rookies were no match for the few experienced sailors who had gained years of experience racing in adjacent states.

A sailboat will not go forward if the bow is pointed directly into a head wind. The breeze flutters through a slack sail and the craft stops dead in the water. To make headway, a sailor must tack, which means the bow must be headed at an oblique angle to the wind so that the air flows past the sail as it would the blade of a windmill and drive the boat forward. Over any great distance, the sailor will tack several times to create a zigzag pattern along the point-to-point line to the intended destination.

One leg of the every race is inevitably into the wind. The experienced sailors trounced the beginners on this leg. Beginners tacked, if anything, too often and lost momentum. The winds would gust and then drop off. At times, the direction of the wind would seem to change slightly. The inexperienced boaters often mistook these changes as a change in the wind direction for the day and scurried to take advantage. When they discovered their mistake, they were off course and out of position.

Veteran sailors minimized the number of tacks. At times, they appeared to be off course in the extended legs of their maneuvers. But as they came about and knifed back across the course several lengths ahead of the pack, they proved their tactics.

Beginning investors often want steer the portfolio like the inexperienced sailor. Afraid of missing a change in the market, they ask their advisors to change the way their assets are arrayed. They mistake the occasional rally for the start of a bull trend, or any pull back as the beginning of a dreaded bear.

Frequent changes in the organization of a portfolio almost always fail to produce the desired long-term results. But an investor should not be surprised if an advisor goes along and indulges every whim. Advisors often get paid a fee on each transaction, and if the client is requesting a change, the advisor has nothing to lose. It’s the client’s idea, after all. If it does not work out, it can be corrected with another series of transactions.

An advisor has other incentives. The client, despite the odds, might get lucky and if the advisor balks, the client may lose confidence in the advisor’s advice. On the other hand, if the client’s strategy fails, the advisor can disavow any ownership in the decision. “I expect you to disagree with me,” is a tough argument to win for the client who finds that pride is the final bet in calling the hand. The safest course for the advisor is simply to sit passively in the boat and let the client do the navigating.

Unlike racing, there is no finishing line to investing. The client may be building a portfolio to fund retirement, but most often, the advisor’s performance is judged on a month-to-month, if not week-to-week, basis. When the portfolio fails to participate fully in a rally, the finish line is the point at which the rally reaches its peak. When the market retracts, the loss of the first dollar becomes the finish line if the advisor does not move with alacrity.

I had a client in New York City who watched the market every day. He listened to the commentators. It was not enough for him to keep track of his actual gains and losses. He kept an accounting of hypothetical gains and losses. “Damn, wouldn’t you know,” he’d whine, “I sold ABC just when it took off. Do you see where that stock is now?”

He counted the gains in stocks that he did not own and looked upon his failure to hold them as losses. “We should have bought, XYZ. It has gone through the roof.”  Something was always wrong. The finish line was always the moment he telephoned. Efforts to orient and reorient him to the goals were swept away in the wake of his anxiety and need to compete with what he imagined to be optimal performance in the market.

In 1991, modern portfolio management was taking hold with stockbrokers. Sufficient data had accumulated to enable statisticians to back check theoretical investment strategies. Reliable statistics require a large database. The modern market, however, has only existed for a few decades, and much of the time, records were kept manually and not on computer.  The statistics proved, nevertheless, that different classes of investments performed differently depending on economic conditions. When stocks zigged, bonds zagged. Bonds fared well in a slumping economy when interest rates were likely to drop and demand was created as wary investors bought bonds for safety.

The zigging and zagging are measured in terms of their correlation to one another. Bonds tended to correlate negatively over time with stocks. A lower or negative correlation strongly suggests that any portfolio with an allocation to bonds is buttressed against losses that predictably occur when the economic conditions fail and stocks under perform.

As time passed, and modern portfolio management practice became more widely accepted, other classes of investments were studied and the degree of correlation determined for each class versus other classes. Foreign company stock correlated weakly with domestic company stock. A small allocation to foreign companies could then buttress against poor performance of domestic stocks. Commodities, such as precious metals, oil and gas, and agricultural products, provided yet another area in which a strategy can be developed to keep some of the portfolio in the most productive economic wind at any given time.

Portfolio management today takes advantage of the theories that were developed and tested in the last few decades of the 20th century. Advisors who employ the strategies recognize the need to orient the client thoroughly to the discipline of the strategy. The relationship between an advisor and client is a partnership. Before the first dollar is invested, the two must agree upon the objectives of the portfolio, the amount of risk the client is willing to assume, the manner in which performance is to be measured, and the end point for the portfolio, or points at which the goals may change because of a change in status for the client or because of a material change in economic conditions. Anything less is unfair to the advisor. Frequent tacking in the portfolio often creates the illusion of success but it shifts the focus of the portfolio to activity rather than results. Frequent tacking, in other words, not only loses in the long run but it also exhausts the crew.

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