Evaluating risk in your portfolio.

Writtey by Nick Burwell & Craig Goryl, Portfolio Managers

balanceFor many of our clients here at Cabot Wealth Management, a typical Balanced Portfolio is comprised of a certain percentage of individual stocks, combined with individual bonds, bond funds/ETFs and gold. This mix of stocks versus bonds, commonly referred to as asset allocation, depends upon an individual’s risk tolerance and return objectives. Insights such as stage of life, source of wealth, perception of wealth, personality type, life goals, etc., are all things to consider when constructing a risk profile and critical to achieving the proper asset allocation.

Choosing the proper asset allocation is the first stage of managing risk. The second stage pertains more to our choices when selecting individual stocks and bonds to buy or sell, industries to emphasis as well as which bond sectors to overweight. In this piece, we set out to discuss some of the ways we manage risk, more from this second stage point of view. We hope to give a behind-the-curtain look into our Balanced Strategy decision-making processes. We’ve discussed four risk management factors we consider during the security selection process as (1) Diversification (2) Valuation (3) Duration and (4) Quality. We will attempt to dive deeper into these four factors, in the hopes that our readers may walk away with a better understanding of our investment process and rationale.

DIVERSIFICATION. The cardinal rule of risk management is diversification, but we think this term deserves a more sophisticated treatment other than the typical “don’t put all your eggs in one basket” interpretation. Proper diversification requires an understanding of two key concepts: volatility and correlation.There are many ways to measure risk, but the simplest is to look at volatility. The higher the volatility of a stock or bond, the greater its up and down price movement. In the context of a portfolio of stocks and bonds, it is a measure of how the total value of all the stocks and bonds move up or down over a specific time period.

With volatility still in mind, let’s now add correlation to the mix. Correlation is a mutual relationship or connection between two or more things. In the investment world, correlation is a statistic that measures the degree to which two securities or assets move in relation to each other. Positive correlation means the price of the two investments tends to move in the same direction at the same time. Negative correlation describes the relationship when two investments tend to move in the opposite direction at the same time. A good example of negative correlation that may not be obvious is the price of oil and airline stocks. Fuel is a large cost for airlines and can considerably cut into profits during times of high oil prices. Relationships like these exist all over the investment landscape. An important component of risk management is understanding these relationships in order to prevent unintended concentrated risk.

A good historical example of positive correlation would be junk bond prices and stock prices. Typically, companies that issue bonds in the high-yield sector hold higher levels of debt on their books, have more financial difficulties, are smaller and or emerging companies that are yet unproven in the marketplace. These characteristics make them riskier investments and more susceptible to worsening economic conditions. The positive correlation between high-yield bonds and equity prices is an important concept and one that is given a lot of consideration in our investment management process. To illustrate this point, let’s briefly analyze the performance of the largest high-yield ETF HYG. On the surface, HYG seems like a great investment for our current low-interest-rate environment, with a yield of approximately 5%, and a historical since-inception return of 5.5% annually. Why don’t we just load up on HYG for our bond allocation and shoot for that juicy 5% yield you might ask? Well, all we have to do is look at the last time the S&P 500 declined by 5% in late 2015, early 2016. How did HYG perform during that time period? HYG dropped close to 12% in price. HYG doesn’t add much diversification when combined with stocks.

Each investment decision must be weighed not just on a stand-alone basis, but also in regard to how the security or asset class fits within the overall portfolio. Understanding correlation, and the ways in which different sectors and asset classes are correlated with each other, is the bedrock foundation to risk management. A portfolio of highly correlated assets lacks proper diversification, even if it is made up of a large number of different individual holdings. The important objective is rather, how do we achieve proper diversification?

We strive to lower the volatility of our portfolios by spreading investments across many industries, many countries, many bond sectors, and “safe haven” investments such as gold, gold miners, U.S. Treasury bonds and cash. These sub-asset classes and how they correlate with each other, are critical to properly managing risk. At any point in time, we can raise or lower exposure to assets that exhibit negative or low correlation to the overall market. It is always our goal to try to deliver as much or more return to our clients, but with less volatility, or risk, than the overall market.

VALUATION. Another important tool we use to manage risk is valuation analysis. Valuation analysis gives us what famed investors Warren Buffet and Seth Klarman call a “margin of safety.” A stock or bond, if purchased at a discount to its intrinsic value, can give investors a bit of wiggle room if a company hits a rough patch or if the economy more generally slows down.

DURATION. In fixed-income security analysis, duration is a measure used to describe the relationship between fluctuating market interest rates and bond prices. Higher duration equates to greater price swings when market interest rates rise or fall. An important risk management tool we utilize is our proprietary duration calculation and monitoring software system. It fuses Bloomberg analytics, our portfolio accounting system, and database software to generate a precise portfolio duration level for our separate accounts. This allows us to finesse our interest rate risk exposure to reflect our forecast views. These views can be for either a shorter-term trade, or longer-term prediction related to our stance regarding Federal Reserve monetary policy or our macro-economic outlook.

QUALITY. The final risk management tool we’ll discuss in this piece relates to quality. When we refer to quality, we are generally referring to companies with low levels of debt relative to earnings, and with operations that generate significant cash flow. We do not want to own companies that rely substantially on funding from capital markets in order to run their operations. History has shown us time and time again that capital markets can turn off the liquidity spigot suddenly and sharply, causing businesses that rely on them as a critical funding source to become vulnerable. Companies with solid financial backbones are often in a position to benefit when times get tough. Through smart, strategic acquisitions, often at fire-sale prices, fiscally responsible companies may be positioned to benefit from economic slowdowns or market instability through mergers and acquisitions that seek to strengthen their longer-term business strategies. These are the types of companies we try to own. Quality also includes companies with a wide competitive “moat.” These are firms that may have differentiated products, sticky relationships with customers, solid patents or substantial pricing power. Businesses with these characteristics tend to have the ability to earn comfortable profit margins and tend to generate ample cash flow. Lastly, a quality company should have solid executive management with strong corporate governance. Evaluating management and corporate governance is more qualitative in nature than other risk management considerations but just as important. Proper corporate governance systems should align shareholder interests with company management, customers, suppliers, bondholders and the community as much as possible. Admittedly, it is important that we use caution when relying on management forecasts and other pronouncements. We must always conduct our own rigorous, independent analysis, as well as listen to what other market participants think of a company’s prospects.

We recognize markets have been rewarding of late. We’re experiencing the second-longest bull market in history and our Central Bank has embarked on a monetary tightening cycle. The time is approaching when we will need to take a more pronounced defensive positioning. We will follow up this piece over the coming weeks with an outlook for 2018. We will discuss many of the indicators we track closely to gauge changes in investor psychology and economic growth. We will take a deeper look into our current portfolio positioning and discuss further steps we may be contemplating. It is our hope that this writing will help our clients better understand our processes and investment philosophy. We both agree that education pertaining to the why, how, what and when we make certain investment decisions can be just as important as the results. Thank you for your continued confidence in us, as we work diligently to preserve and grow your capital.

Nick Burwell and Craig Goryl manage Cabot’s Balanced Portfolio strategy. Contact us if you have specific questions.

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