NCM Pension Portfolios - Monthly Update - Nov. 30, 2019

November 30, 2019

It is widely understood that risk and reward go hand-in-hand. The discipline of portfolio management is based upon that a desire for higher returns means that an investor must be prepared to assume a higher degree of risk (ie portfolio volatility). Conversely, lower tolerance to risk means acceptance of lower expected returns. Pretty simple stuff, right? Yes, it is. However, there is one part of this widely known gem that is often overlooked. In the world of investing one does not get paid to take “unnecessary” risks. Investment professionals know this, and they live it. Everything institutional investors and pension managers do is designed to minimize and/or eliminate unnecessary risks.

Why do money managers do this? Well, in finance lingo this concept is known as the Dominance Principle, which specifically refers to the superiority of one investment over another. While it is somewhat intuitive, it’s always a good idea to review what it means and how it applies to what your money managers are doing for you. The Dominance Principle states: among investments with the same rate of return, the one with the least risk is most desirable.

Sounds like common sense, right? It seems only logical that an investor would find the most practical investment to be the one that balances the expectations of gains with the lowest anticipated losses. Unfortunately, without a constant eye on the Dominance Principle, most investors fail to adhere to this fundamental investing tenet.

No doubt you have heard that Asset Allocation is THE most important decision an investor will ever make. Well, it is true. The actual individual selection of securities pales in comparison to the degree of importance to how the overall allocation of funds is split across the asset classes. Namely, the total proportion of the portfolio allotted to cash, bonds, stocks, alternatives and real assets in the portfolio have a significantly larger effect on the portfolio’s performance than any specific investment to a single bank, energy or tech stock. Asset Allocation ensures adherence to the Dominance Principle, provides unparalleled risk management, and always keeps the purpose of the portfolio at the forefront.

While it is true there is no simple one size fits all formula for the correct asset allocation, it is timely to run through four of the basic themes that all Institutional Investors, such as Endowments, Pensions, Foundations, and Mutual Funds utilize to ensure their investment program stays on track while paying homage to some of the greatest investors of all time:

1. Have a Plan for the Funds:
This can be very simple or extremely complex but ultimately it provides the overarching goals, objectives, constraints, parameters, and strategies that will be employed in the management of the portfolio. Besides explicitly noting return expectations and risk tolerances other issues that affect the management of the portfolio can be: time horizon, taxes, estate planning, liquidity and income needs.

“An idiot with a plan can beat a genius without a plan” – Warren Buffet

2. Embrace the Power of Compounding:
Whimsically compounding can be thought of as “earning money on money already earned.” It means the reinvestment of your returns on your initial savings so you can earn interest on the new total – the original amount plus the interest. The longer the time frame, the more significant the impact.

“Compound interest is the eighth wonder of the world. He who understands it earns it...he who doesn’t...pays it.” – Albert Einstein.

3. Volatility is Normal:
Volatility in the equity markets tends to average around 15% but it does moves around a lot from one period to the next. Although most of the time it generally falls within a range of 10% to 20%. That said, there have been periods when volatility was unusually high and periods when it was unusually low, in many cases, extreme periods in one direction are followed by periods at the other end of the spectrum.

“The fundamental law of investing is the uncertainty of the future” – Peter Bernstein

4. Diversification Works:
Diversification reduces volatility more efficiently than most people understand. Due to a statistical concept known as covariance, the volatility of a diversified portfolio is less than the average of the volatilities of its component parts.

“Successful investment is about managing risk, not avoiding it” – Benjamin Graham

In summary, here are three global products in low-risk categories meant for use in the four-step program.

  • Have a plan for the portfolio
  • Embrace the power of compounding
  • Volatility is normal
  • Diversification works

Thank you to all the supporters in the NCM Pension Portfolios.

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