Investment Articles

01/12/04 - Kissed by Randomness

By: Frank Armstrong, CFP, AIF

It's a matter of faith with me that owners of diversified accounts cannot expect to ever have the top performing portfolio on their block. Last year I was wrong! Nobody is more surprised than me.

Diversification reduces risk. Our objective is to smooth out the ups and downs of the market while capturing global equity returns. We tilt on a global basis toward small and value companies to enhance returns over the long haul. Still, it's not possible to have a diversified portfolio and have all your assets in the top performing asset class. The two are mutually exclusive. So, in return for relative safety we give up bragging rights at cocktail parties. We think this is a solid strategy for the long haul, backed by both academic research and real world experience, however it's unlikely that we should be short haul top performers. But, this year was strangely, wonderfully, randomly different.

The equity portfolio we recommend contains nine equity asset classes with allocations divided equally between domestic and foreign exposure. Each portion's returns are best explained as the sum of several factors.

Domestic Equity:

Zero Risk Return

Market Premium

Size Premium

Value Premium

Foreign Equity:

Zero Risk Return

Continental Market Premium

UK Market Premium

Pacific Rim (ex Japan) Premium

Japan Premium

Global (ex US) Size Premium

Global (ex US) Value Premium

With the exception of the Zero Risk Return, none of these premiums are assumed to be positive. They can be either positive or negative in any particular time frame. The factors are random and uncorrelated. Our hope is that most of these factors will be positive most of the time. I'd settle for 60% of them being positive in any year. But, last year they were all positive, and all at values a multiple of what we might expect. This is about as likely as being hit by lightning! In a total reversal of Murphy's Law, everything that could have gone right, did!

Of course, there may come a time when all the factors are negative. Nothing about diversification insures that we will be profitable in every time period. But for investors focused on the long haul, diversification reduces risk, and the strategic tilt toward small and value on a global basis should enhance returns. That fits our definition of a superior strategy.

So, we have been kissed by randomness. You may, if you are so inclined, brag about your portfolio at cocktail parties. You are highly unlikely to come across anybody there with better performance in 2003.

However,  let's not kid ourselves. This is not a result that we could have predicted, or due to the brilliance of your investment manager. Rather, it's our turn to be blessed by the flying fickle finger of fate. Still, I'll take it. And I'm glad you were all along for the ride.

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