Investment Basics And Balanced Accounts In 2016

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By Michael McNiven, Ph.D., Managing Director and Portfolio Manager

The notes below are a basic review of investment prudence. We discuss balanced accounts that are important investment vehicles for certain types of investable assets where risk management and diversification are essential. Some individuals, as well as institutional, endowment, and foundation investment committees, may find this commentary useful. Others may find it elementary.

By definition, an investment is a capital outlay with an expectation of return. The key word is expectation. If there is no expectation, then the outlay can be labeled as an expense, and no investment return or even return of capital is expected. The money is gone when something is consumed - there is no future benefit to be had or any expectation of future benefit.

Part of the practice of investing is to determine risk levels that the investor or the investing institution is willing to take. In short, how much you are willing to risk for gain is related to the acceptability of loss. In theory, the more risks you take, the more gains can be achieved... and the more losses can be forfeited. It is a classic psychological error in investing to yearn for gains, but then to be gobsmacked by fear and loathing when a subsequent large loss is realized instead.

Investing is not disciplined if outsized risk-taking does not match the ability to absorb losses. This reality leads us to consider the topics of allocation management and diversified investments, particularly as they relate to endowment and foundation funds. Allocation management and portfolio theory is a well-established discipline at this point. Investment nirvana rarely happens, which is why creating balanced accounts across asset classes of equities and bonds makes sense in the attempt to take on reasonable investment risks. Non-correlated assets have complementary properties over time. Due to the diversification of asset classes, balanced accounts rarely have dramatic swings. Using balanced accounts, there is a reasonable prospect of dampening some risks in volatile markets. It helps when there is a longer-term time horizon rather than a short-term imperative.

Let's look at 2016 in hindsight. It was a volatile year. January 2016 started off with large US market sell-offs in reaction to the December 2015 Fed rate hike. It was a month of fear and loathing AND risk-taking for the contrarians. The Brexit vote in June also created panic, with a much quicker recovery. For investors managing with a risk perspective, cash was important and seemed justified through the fall. Then there was a surprise election result, and the stock market raced to new highs. Fixed income has seen a dramatic move downward as a result of Treasury rates moving higher. If an investor was in the US market through all the twists and turns with index fund holdings and/or had a manager who was very astute, the year's returns have turned out to be quite acceptable. Bond accounts weathered the storm as a risk-averse asset - until the election result, whereupon they reversed course as the US equity market took off. Rising rates since the election have eroded bond values. International equity markets, on the other hand, had troubles to digest and were not robust. Careful selection was important there.

The only way to mitigate the unknown and to successfully manage some market risk is to have portions of all or most major markets in a balanced investment structure. Many endowments, retirement plans, and foundation accounts are best served in a balanced account structure. Long-term risks and returns can be coordinated and managed to good effect.

Cumberland Advisors manages three types of balanced accounts:

  1. US Balanced Portfolio Style - Active allocation adjustment among US equities using ETFs and individual taxable fixed-income securities
  2. US Balanced (Active Bonds/Passive Equities) Portfolio Style - Follows modern portfolio theory with a tilt toward mid-cap index exposure and active taxable fixed-income securities
  3. Global Balanced Portfolio Style - Active allocation adjustment using US ETFs, International ETFs, and individual taxable fixed-income securities.

As the investment year comes to a close and equities returns potentially end on a strong note, it is good to remember that a balanced approach to the investment of many types of money - particularly of the eleemosynary variety - is the defensible approach.