Can A Well-Defined Portfolio With Enough Cash Weather Major Storms?

 |  Includes: BND, TIP, VEU, VTI, VXF
by: O. Young Kwon

Today (September 15, 2013) marks the fifth anniversary of the historic day that Lehman Brothers collapsed. The stake of the investment bank's bankruptcy was outrageously high, initiating a severe market crash. James Sterngold and Matt Wirz of The Wall Street Journal reported, "Despite a government bailout of financial firms that totaled hundreds of billions of dollars, 8.8 million jobs and $19.2 trillion in household wealth were lost."

To combat the onset of the global great recession and market crash, the group of 20 (G-20) was immediately organized in 2008. The G-20 has pursued the coordinated macroeconomic policy among major twenty economies - developed and developing. Since 2008 the Federal Reserve (Fed) has led other countries by launching easy-money policies. Other central banks have followed suit. The enormous amount of liquidity has been injected globally.

In retrospect, we have a question about the Fed's stimulus policies; whether they were the right ones to deal with the 2007-08 financial crisis. This issue has been debated extensively, without any conclusive view. David Wessel of the Wall Street Journal recited, "Americans could rightly wonder why things are still so bad and ask if anything could be been done differently - some policy pursued, some step avoided - to have eased the prolonged economic pain."

What can we learn from the crisis, as investors? Overconfidence or greed makes a market spike that can't be sustainable. Over-pessimism or fear brings a market plunge that can't be justified. Investors easily make mistakes either betting too much or getting out too completely. Investors are wrestling two fundamental questions: (1) Does the risk-on and risk-off strategy make the traditional 60-40 portfolio obsolete? (2) Can the current comeback of the stock-pickers' market downgrade the merits of index funds? The focus of this article is to answer these questions.

The market is cautiously bullish in the coming months of this year. The budget and debt-ceiling negotiations and the U.S.' military strikes on Syria would be the possible head winds, but a sharp market slide is not expected. A serious debacle would be avoided, by kicking the can to the down road as the U.S. did in January. The Syrian situation would not affect the market significantly no matter how the campaign would go. In the next year, the market is expected to make a volatile and tepid advance all year. The turning points in market cycles and business cycles would be set in 2015. The question is how to craft your portfolios to reflect these market perspectives.

Investors has two operations. One is security trading, and the other one is portfolio management. Trading is an easy part, and the portfolio is not an exciting part. A portfolio is not just a list of your holdings. It is designed to make a collection of different assets and different securities to achieve your investment goal. The success of investing depends not on a gain or loss of your individual securities, but on the performance of your all holdings as a whole. In a long term, your success relies on your efficient management of your plausible portfolios year after year.

A two-tier (or dual) portfolio is suggested. The first tier is a long-term portfolio with say 80% of your capital, reflecting your long run market perspective. The second tier is a short-term portfolio with say 20% of your capital to fill a short-term gap between a target allocation and an actual allocation in the first tier, buying/selling bonds/equities daily. The second tier can be used to make quick profits (or losses) by trading whenever you see any near-term mispricing securities.

The ratio of cash to total capital ("The CC Ratio") is a built-in safety measure in a dual portfolio. The CC ratio moves in the same direction of the market. The market moves higher or lower, so does the CC ratio. For example, if the market reaches highs, the CC ratio is say 30%. If the market downs a 5%, the CC ratio is 25%. It the market falls 10%, the CC ration is 20%. If the market plunged 30%, the CC ratio is 10%. And so on.

The CC ratio changes not only by the actual movements of the market as seen above, but also, more importantly, by expectations for the downside risk in a very near term. For instance, since May, the negative market reactions had been expected. The negative expectation was intensified after the first round of the market rout (6/18-6/24). The 10-year Treasury yield shot 15.5% and the S&P 500 index plunged 4.9% for just four sessions.

A bottom of the market slide was expected to be imminent. As a result, a cash build-up had been made in my portfolios until the second round of the rout (8/13-19), as shown in the following Table. In the second round the yield rose 6.0% and the S&P fell 2.9%. In this case, the CC ratio has the reverse relationship with the imminent market expectations: The CC ratio rises when the market is expected to fall, vice versa.

The Cash Build-Up and Depletion


CC Ratio



















Note: The second Round (8/13-8/19)

Click to enlarge

It's important to distinguish between the effect of market expectations (in a near term) to the CC ratio in the opposite direction, and the effect of market movements to the CC ratio in the same direction. Therefore, quite often, the effects of market expectations and market movements are offset each other. The CC ratio is inflated during downswings and deflated during upswings, but it's easily cured by using a moving average of capital. The level of the CC ratio can be generous now because the opportunity cost of holding cash is very low now. The level should become lower when interest rates of money market funds rise.

In the long-term portfolio, asset allocation is most important. There are basically three financial assets - bonds, stocks, and cash. Any other assets, related to the so-called "alternative investments" such as commodities, real estates, or farm lands must be disregarded for individual investors with a moderate amount of capital..

A traditional asset allocation is a 60% stocks and 40% bonds (or "60-40"). The macro-events has affected investors' decisions more than fundamentals since the financial crisis, focusing central banks' policies and economic indicators. Can the risk-on and risk-off strategy replace the 60-40 (or 50-50) "grandma" portfolio? The answer is no because the data show that the latter has not been inferior to the former.

A dual portfolio is a sort of a modified grandma portfolio, not just holding, but managing gradually whenever market trends and asset (sector) preferences change. A first-tier portfolio is anchored firmly by a long-run expectation for the market (or simply a long-term target). In the long run the market has a strong tendency to regress to the average that is perhaps a 60-40 or a 50-50.Diversification can be easily confused with asset allocation. The former is to get several securities in a selected asset (bond or stock by asset allocation) to reduce the market risk. Since the correlations among securities have been constantly increasing, diversification becomes less promising.

A few of index mutual fund ETFs (or their counterpart mutual funds) such as Vanguard Total Bond Market ETF (NYSEARCA:BND), Vanguard Total Stock Market ETF (NYSEARCA:VTI), Vanguard Extended Market ETF (NYSEARCA:VXF), i Shares Barclays TIPS Bond ETF (NYSEARCA:TIP), and Vanguard FTSE All World ex-US ETF (NYSEARCA:VEU) are suffice to set your long-term portfolio with just two - BND and VTI - or all five. They are well-diversified, low-cost investment vehicles. There are two approaches for rebalancing: calendar and threshold. A Vanguard study: suggests an annual or semiannual rebalancing and a threshold of 5%. The combination approach produces a balance between controlling risk and minimizing costs. A better way is to vary both calendar and threshold: an annual and a 15%, a semiannual and a 10%, and so on.

Whoever takes the Fed's leadership next year, one of his or her top-priority jobs is to make the Fed's forecasting models more intelligent to be able to foresee bad financial storms or hurricane. In addition to the stress test, the Fed should develop more policy tools to check the soundness of major banks' activities and the most vulnerable spots such as mounting "junk" bonds and margin loans, as James Sterngold and Matt Wirz of the Wall Street reported.

In a short run (six to none months) the market is going to be very choppy, but the trend would be slightly upward. Syria, another fiscal cliff, and the transition of the Fed's leadership are on our agenda. Keep away from the "binary trap." All binary events become binary eventually when we ultimately have a comprehensive resolution, but until then they are progressive because many parties are involved. If you make prematurely a binary decision on any intermediate stage, your decision is a fallacy.

A Dual portfolio with the CC ratio would shield you. The portfolio reflects not just the long-run market perspective, but also the short-term market outlook. The effectiveness of a defensive strategy has weakened noticeably in recent years. Therefore, careful maneuvers of the CC ratio can reduce the blow of sudden severe downswings. The portfolio is also flexible enough to capture a near-term profit opportunities. As a consequence, a dual portfolio minimizes the downside risks without losing the upside potentials significantly.

Disclosure: I am long BND, VTI, TIP, VXF, VEU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.