Pure’s Senior Investment Strategist & Financial Advisor, Brian Fahey, CFA®, shares practical strategies for building a portfolio designed to weather any market environment.
Outline
- 0:00 – Introduction & Webinar Overview
- 03:25 – The Institutional Approach to Portfolio Building
- 06:41 – Historical Asset Class Returns
- 09:04 – Diversification Through Styles & Factors
- 11:47 – Fixed Income Fundamentals
- 17:07 – Q&A: Evaluating Accounts & Alternative Investments
- 25:33 – Managing Drawdowns & Volatility
- 30:44 – Alternative Investment Strategies
- 48:41 – Today’s Volatility, AI Bubble, & Closing Q&A
Transcription:
(NOTE: Transcriptions are an approximation and may not be entirely correct)
Kathryn Bowie, CFP®: Welcome to our Investing Smarter webinar, How to Build a Resilient Portfolio in Any Market, with our very own Brian Fahey. He is our senior investment strategist as well as a financial advisor here at Pure Financial Advisors, and we are excited to hear everything that he has to teach us today. Hey, Brian.
How are you?
Brian Fahey, CFA®: Doing well, Kathryn. How are you?
Kathryn Bowie, CFP®: Doing well.
Brian Fahey, CFA®: Thanks, everybody, for joining us. Hopefully, you find this informative and maybe even entertaining. Building a portfolio, you really need to start with assessing your portfolio’s re- resilience. We’ll talk more about that. But how you build a resilient portfolio is gonna depend on how well you can diversify between stocks and bonds.
We’ll get into a little bit more detail on that. Managing risk without giving up growth, that’s ideal, but that really comes down to some other aspects that we’ll discuss. And then finally, we’ll talk about today’s volatility maybe even touch a little bit on AI, which is front of everybody’s mind these days.
So what is the ideal portfolio? Sometimes people ask me, what should my portfolio look like? What’s the best way to go about this?” And the answer really is, it’s unique to every individual. So before you can build a portfolio, you need to start with planning. And that’s probably pretty obvious coming from a financial planning firm, but it really drives results.
And that’s where you need to start. So the more in-depth you can build your financial plan, the better your portfolio will be constructed and the better experience you’re gonna have over time. So you really need to look at what kind of income are you gonna need in retirement. Maybe retirement’s pretty far away, maybe it’s closer.
But when you need that income is important. You need to pay attention to taxes. Your income’s gonna be related to, in retirement, it’s gonna be related to any kind of pension that you have coming in as well as Social Security. If you have any big cash flow needs, you may wanna plan for that in advance.
What type of healthcare you have and your personal health situation might require additional cash on hand. Insurances are obviously gonna be important, especially if you’re towards, later years and you might be looking at long-term care. And then obviously, if you’re moving into retirement, you wanna make sure that you have plenty of money around to fund fun things, like maybe you’re looking at a boat or a second home or a big trip to Europe or something along those lines.
But what you’re trying to accomplish is directly gonna relate to how you construct your portfolio. So how much risk and return you need is gonna be directly related to the income that you need And how you get diversification is gonna matter a lot diff- a lot differently to somebody who’s in their maybe early 20s to somebody who’s in their 60s or 70s, and volatility is directly related to that.
If you’re early into retirement, the sequence of returns is really key. If you retired into the financial crisis, you had a really big drawdown on your portfolio in those first few years. It was really hard to make it back up. So how those returns are actually realized can be pretty impactful, which again, gets back to the planning idea.
Inflation, obviously for the last five years or so inflation’s been quite a bit above target, and that’s had negative impacts on fixed income. So we’ll talk a little bit more about that. And then obviously, fees and liquidity. So there are investments out there that some people choose to use that don’t have regular liquidity, and if your plan requires and you need whatever the number might be, 10 grand a month, 20 grand a month, if your portfolio has a lot of illiquid investments, maybe they’re great for the long haul, but in the short term it can be pretty detrimental.
So planning answers why you invest. The investments are how you invest. So the ideal portfolio is where those two meet together So don’t just take our word for it. This is how institution, institutional portfolios are built. So when you think about big endowments, pension funds, they’re gonna follow a s- pretty similar process to what we use here.
They’re gonna start with planning. They’re gonna see what objectives do, do we need to do. Are we building an expansion to our museum? Are we hiring additional people? That kind of stuff. And then their portfolio is gonna be built not just on returns, but correlations between those underlying positions.
So you wanna make sure that you might have three different equity funds or three different equity investments, but if they all move in lockstep, you really just have one. So that’s not gonna help your diversification. The other thing, and I think this is really key and a, a big stumbling block for a lot of individual investors, is you wanna look forward.
You wanna anticipate where the puck is going. So, if equities are pretty overvalued relative to history, maybe you wanna dial that down a little bit and increase your allocation to something that’s maybe has better future returns. But that’s a pretty big area that I think a lot of investors fall into, is they look and see, the Meta Cap 7 have done really well for the last four or five years.
I’m just gonna put all my money in that. Well, they haven’t done particularly well for the last, call it, nine months or so. And some of that is forecastable. You can see that maybe coming when you see really high return assumptions being built into individual ac- sectors of the economy or market.
Again, you always wanna have liquidity available in the portfolio for unexpected expenses. It’s important to monitor your costs and taxes, obviously. You th- always wanna try to get those fees as low as you can. But if you’re looking at something that might be a little bit more expensive, maybe an alternative fund, is that gonna fit a really important role in your portfolio?
Is that gonna help you get to your goals? Is it gonna increase returns or maybe decrease correlations? Is it something that looks good on a go-forward basis? Last piece on this slide, really important, is rebalancing and governance. So we’re always gonna be going towards or have some kind of event on the horizon, and unexpected things obviously happen all the time.
Having a plan on what to do when things go wrong is really important. So you wanna build that when the sun is shining and not come up with a plan in the heat of battle. So knowing when you’re gonna rebalance, what targets are you gonna have? Is it at the asset class level? Is that at individual security level?
How are you gonna manage that rebalancing? Because that can be pretty impactful on portfolio performance over time. And then governance if you’re looking at a particular investment, are you going to change that investment if the fund manager changes? Are you gonna change that investment if the fees increase?
So having those ideas ahead of time so you’re not dealing with issues in the heat of battle is pretty important. So obviously, this is a lot. There’s a lot that goes on to building a, a portfolio. Start with planning, which the better data you have going into your plan, the more impactful it’s gonna be.
Garbage in, garbage out. It can be a little overwhelming, so certainly if you feel like you want a little additional help, please feel free to reach out to us. We’re happy to do that free assessment. And honestly, I think what we do for free is better than what a lot of firms might do on a fee basis.
So Here we have a slide that’s a little busy, but it, it’s– we’ll circle back to it. Obviously, the S&P 500, and we have this, this data’s through 1988, which is when the emerging market index was created. S&P 500 has blown the doors off of everything. You’re looking at a 2800% return. Quite a bit better than anything else, even emerging markets, which went through a really good decade couple of decades ago.
That was up 1400%. That’s MSCI EM is emerging markets. MSCI EAFE is basically developed Europe and Asia, so Japan and Australia. Basically tied with investment-grade credit, which is the yellow slide there or the yellow bar on the slide. And then good old safe treasuries still gave a pretty decent return, 500% but nowhere near the return that you got on equities, which makes sense ’cause treasuries should be nice, boring and stable.
Haven’t always been for the last couple of years, but that’s what the role that they’re supposed to play in the portfolio. So that gives you a sense of where equity returns have been for a longer period of time. But how is that ride actually… Well, before I pause move to the next slide, diversification is more than stocks and bonds.
So a lot of times with individual investors they’ll say, “Well, I just own the S&P 500. I’m good. US companies sell stuff overseas. We don’t really need to worry about looking into Europe ’cause they haven’t done anything, and emerging markets are too volatile.” What you really want is a portfolio that’s gonna go up and to the right most of the time.
Can’t do that exactly, but that’s what you’re running for, gunning for. To do that, you’re gonna wanna have multiple return streams. You’re gonna wanna have diversification on how you, you get up and to the right. The US has done amazing for a very long period of time, but that wasn’t always the case.
Prior to the financial crisis, Europe and the US were kinda neck and neck most years. And, in the early 2000s, emerging markets, particularly China, were growing gangbusters. They were growing better, faster than the US. So over a long period of time, which hopefully your portfolio is in place for many years, decades, what’s hot today will not necessarily be hot tomorrow.
These things are gonna change over time. The economy’s gonna develop. New technologies are gonna come into place. Things are gonna go away. So you do wanna have your equity allocation spread out across multiple different regions of the world Within that, and this is what we do a lot of here at Pure, is you wanna have different investment s- styles as well.
So traditional way of breaking that down is to value companies. So think, like JP Morgan or Berkshire Hathaway, those are big companies that aren’t priced for a lot of growth, so they tend to be a little bit cheaper than the overall market. That’s a value company. A growth company would be any of the big tech stocks.
So, you look at Microsoft, which is down the street from me that’s traditionally been considered a growth company. But you want exposure to both of those because over time you’re gonna see growth… Well, for the last, call it, five or six years, you’ve seen growth, even really longer than that, you’ve seen growth just go much faster, grow much fa- faster than value companies.
But that’s not always the case. So you do wanna have exposure to both. How you break down that allocation between growth equities, which tend to be, tend, at least in the last handful of years, to do better than value, but they come with a lot of extra volatility, is what we’ve seen just in the last couple of weeks when you look at some of the big memory companies that have done really well, and the chip companies have done really well this year.
You’ve seen them decline by, and depending on which one you’re looking at, 20 to 50%. So those are growth companies. They’ve done really well this year in, in area, but you also have just had to endure a, up to 50% drawdown in some of these individual names. So you do wanna spread those bets across different styles.
Another thing that we do, and is pretty prominent in the financial industry, is not just look at styles but also factors. So factors are just a way of organizing stocks within an indices. So you can look at size, large companies versus small companies. Value, same kind of thing, companies that are priced for growth versus companies that aren’t.
Quality is usually a reference to balance sheets or income statements. Profitability is just how profitable is a company. Usually, it’s return on equity. But there’s hundreds of different ways you can break these factors down. I think on my Bloomberg screen on the factors to watch page, there’s 250 kind of mainline factors that you can incorporate into your portfolio.
And again, if you have different factors, you have different companies that are maybe valued or operated under different scenarios, that can help build a more diverse, more diversification into your portfolio and a more resilient portfolio. So again, the more diversification you have, the more stable your ride’s gonna be.
But how you go about that can vary, and it certainly should relay back to your plan. So if you need a lot of growth, maybe you’re young, you’re adding money to the portfolio on a regular basis, you can afford to be more growth-oriented. Maybe you have a little bit more into emerging markets, maybe you have a little bit more into, to growth companies.
Maybe you’re looking more for companies that are hopefully gonna do, do well over time but come with a lot of volatility. And if you’re older, maybe you wanna shy away from that So let’s talk about fixed income. Fixed income is something most people don’t like talking about. It’s just a bunch of math.
But for most people it’s an important piece of the portfolio just because that’s the piece. If for no other reason, having fixed income in your portfolio should be the ballast for when things go sideways in the equity market. So when things pull back in, in equities, you do want to have a piece of your portfolio that’s gonna…
it’ll hopefully withstand whatever other events going on. Ideally, it’ll appreciate. Why? Because when equities draw down, you wanna have something that you can sell to replace your diminished equity exposure, so that when we hit the rebound, you have as many dollars as you’re comfortable with in those growthier style equities, so that you can experience the rebound faster than just the overall market would.
So within fixed income, there’s a lot of different things you can do. So the piece that’s gonna be most stable, or at least historically has been most stable, is Treasuries. They come in different maturities. So you could have something like a T-bill that’s gonna mature in a couple of months, or you could have a 30-year bond.
So Treasuries can fit different needs within the portfolio. If you’re saving for a big purchase in a year, maybe you’re using a one-year Treasury, or maybe you’re rolling three-month Treasuries, whatever you need to do. But Treasuries are a great place to s- keep your safe money. Treasury Inflation-Protected Securities have been maybe a little bit more popular in recent years just because you have that inflation rider on there, so you’re getting a little bit extra return to compensate you for the risk of inflation.
Still have a underlying Treasury under there, so you still have market risk, but you are getting that additional protection for inflation. Municipal bonds are pretty important if you’re a high-income earner or happen to be in a high income state tax. The municipal bonds, you generally get a little bit lower coupon, but the benefit is you don’t pay tax, federal tax, on munis.
And then maybe you… if you’re in a state with state income tax and you have a state municipal bond, you won’t pay state tax, and you can even get that down to your local tax authority. So municipal bonds can be pretty useful if you’re at high income or you’re in a high-tax state High yield bonds are bonds that are below investment grade.
The more common name for it would be junk bonds. So these are bonds that have a reasonable chance at defaulting. Again, they come in different flavors. You can have just barely junk. You can have triple Cs, which, basically have a coin flip on whether you’re gonna get your money back or not.
They do trade with the volatility more in line with equities. But they can have a role in a portfolio if you’re, younger or maybe a little bit more comfortable with risk. High yield bonds can be a place to look. Investment grade bonds are a little bit– yield a little bit more than treasuries, but have pretty similar risk characteristics.
Most companies that are triple A-rated, in investment grade, they don’t have a printer in their basement to print currency like the treasury does, but they have pretty strong balance sheets. They have big established businesses. So investment grade credit can give you a little bit extra return over a comparable treasury.
But you do have the possibility that some of those investment grade companies are going to fall below investment grade. So you do have some risk there. Mortgage-backed bonds, one of the biggest areas of fixed income market. So that’s– anybody that has a mortgage knows what a mortgage-backed security is.
It’s going to pay you interest and principal every month. Mortgage-backed bonds, again, come in different flavors. So you can have something that’s backed by a federal agency, Fannie or Freddie or Gennie. Or you can have what’s… a private issued mortgage. We use a lot of mortgage-backed securities.
Everybody does. If you buy the Barclays Agg or Bloomberg Agg, you’re gonna have a pretty healthy piece of your portfolio in mortgage-backed securities They’re a heck of a lot better than they were prior to the financial crisis. So the, the risk there is usually pretty comparable to treasuries if you’re dealing with an agency.
There’s a little bit different risk characteristics because you’re getting your principal and your interest at the same time, but that can be a pretty useful piece for any fixed income portfolio. Lastly on there, we have global bonds. Again, a pretty good place to look, especially if you have any currency risk that you’re tuned to because global bonds can be priced in foreign currency.
So if the US dollar is weakening relative to the foreign currency bond that you have, you can have a little bit extra return there. And then within maturities, bonds behave differently depending on when they mature. So a bond is just essentially a loan. So you’re gonna get interest every six months usually with bonds.
And then at the end of that, you’re gonna get your principal back. So the bond could be issued for a year, could be five years, could be 30 years, somewhere in between. Generally, we break that down into different segments. So short-term, kind of the one to three-year space. Those are things that shouldn’t move around too much in terms of interest rates.
And then they shouldn’t have too much default risk because you’re gonna be getting your principal back relatively soon. Intermediate’s gonna be more from the, call it five to 10 range. Those bonds are gonna have a little bit more risk ’cause the chance of a company defaulting increases over time, and also you’re gonna be a little bit more exposed to interest rate risk.
So as the Fed raises and lowers interest rates, as investors respond to where the economy’s going and where inflation is going, you’ll see a little bit more volatility in those intermediate bonds. Long bonds have had a really rough go for the last handful of years. Not a place that people spend a lot of time on but certainly something to consider.
And we talked about credit quality, investment grade, very low chance of default. High yield, it can be up to 50%. Usually it’s, a standard high yield bond’s gonna have about a 80 to 90% chance of getting repaid. So it was kind of a lot. Maybe I’ll just pause there. Kathryn do we have any questions?
Kathryn Bowie, CFP®: If you have money in a brokerage account that is actively managed as part of a broader self-managed account, how can we re- determine if it is efficiently invested and safe?
Brian Fahey, CFA®: Yeah, so the, that’s a good question. The way that we would do it is run it through software that tells you what are the underlying things.
So it’s still gonna wanna start with good financial planning, so that’s gonna give you the roadmap on kind of what investments you should be considering. And then we w- if you had an existing portfolio, the way to do it is to take a look under the hood. What are the actual underlying holdings? Does that match with what your financial plan suggests?
Are you taking enough risk? Are you taking too much risk? Where does it put you? So that’s how you would figure out, with an actively managed fund, what’s really going on. Now, that’s one way to do it. Another way would be you go to Morningstar, and you go and look up the fund, and it’ll tell you, is this a large cap growth fund?
Is it blend? Is it value? Is it small cap? Is it international? Whatever it might be it’ll be in a nice little chart on Morningstar, so you can look there as well. Generally, if a manager has a mandate to be large cap growth, you’re gonna see a large cap growth portfolio. Y- There is something called style drift, where a manager’s supposed to be X and they’re really Y.
Usually, it’s because they think they can get better returns by straying outside of the box, but that’s how you would do it. Either take a look at the underlying holdings in your prospectus if you wanna read that or you can just plug it into, a Morningstar. You could probably even use AI for something like that.
But again, you wanna look in terms of your overall p- planning, is this gonna help you reach your goals?
Kathryn Bowie, CFP®: Great. Now, as a reminder, we will be we offer a free consultation for, to answer all of your very detailed questions. So if you’re already a client and part of our Pure family, then reach out to your financial advisor.
If you are not, then I’m gonna be putting in a link for you to just click on, and then you can get a personal one-on-one conversation with a p- Pure financial professional. All right, so this one is a bit, you might need to dissect it a bit. But what are some of the options for integrating alternative investment vehicles into my retirement portfolio, such as REITs, real estate purchases via self-directed IRA, and he goes on, precious metals, crypto, and other products?
Are there reputable companies offering well-diversified investment op- options in these areas?
Brian Fahey, CFA®: Yeah, there definitely is plenty of people that are happy to take your money in the alternative space. One thing that’s probably coming, maybe later this year or next year, would be availability of things like private credit and private equity, and maybe even crypto, who knows in retirement plans.
So one thing to kind of keep in mind is the alternative asset universe infrastructure historically has been in pri- spaces where endowments, pension funds, really big family offices, really big investors are using those types of products in their portfolios The alternative space wants to continue growing.
They’ve kind of done all that they can do with big pension funds and endowments, so now they’re trying to get into your 401. There’s a huge variability in the quality of those products, whether if you’re looking at private equity, private credit, any kind of other alternatives, REITs, non-trade REITs, all that kind of stuff.
So I would suggest that it– you really have to look at the underlying manager, who’s doing the work. Look at their track record. The, a lot of these things come in different vintages. There’s a lot going on. Reporting standards are different. It’s almost a whole different language on how they report, especially if you’re used to traditional stocks and bonds.
And then in light of the idea that a good private equity manager might give you, just to pull out a number, a 400% return over a timeframe, the average guy is maybe 100, and then the bottom quintile is zero. There’s a huge discrepancy in performance when you talk about a lot of these alternative investment options, and it’s hard to get reporting on it, and especially in like a REIT world, there’s these non-traded things.
It’s, can be really complex. I’ve been doing this for 20 years. My general philosophy is stay away from it. If you do it for a really defined purpose. Again, getting back to the idea of planning. Understand exactly what you’re looking at, how it’s gonna respond. It’s just tough. I do this for a living, and I’ve still been surprised over the years looking at alternatives.
And then the– lastly, I would say use them sparingly because they are complex. They tend to be expensive. They aren’t always gonna do what they’re supposed to do. Managers change, all these kinds of goofy things. They can be additive to the portfolio. We use them. I use them personally. But I don’t think it’s something that should be a big chunk of your portfolio.
There’s people that disagree with me on that, that idea, but professionally and personally, I think it’s something you should use, but be very cautious about what you’re doing. And you don’t have to use them. A lot of times, especially the last handful of years, a lot of things that used to be really expensive, private, had to sign your life away to get into it, now are, been wrapped up into ETF form.
So we’ll talk about the, that a little bit more in, later in the presentation, but there are ways to get the types of exposure that historically have required a million dollars and, a seven-year lockup into something that’s more palatable for, normal people like you and me. So yeah, that, that’s my take on alternatives.
Kathryn Bowie, CFP®: Because as you said, the fees are typically very high on those.
Brian Fahey, CFA®: Typically pretty high. Not to say that it’s not justified in certain cases. But it’s not s- it’s not do all, save everybody, everybody’s gonna get rich using it kind of investment.
Kathryn Bowie, CFP®: Gotcha. And then another question, what are some credentials I should be looking for when considering working with a new investment partner that isn’t a well-known brand such as Charles Schwab, Fidelity, et cetera?
And then other than the Better Business Bureau, what are the some of the licenses and credentials I should want to be sure that my financial advisor is carrying? And should they be a licensed fiduciary? I know that’s a lot in one question, but yes.
Brian Fahey, CFA®: Those are all really good questions.
Kathryn Bowie, CFP®: I know. I– That’s why I gave it to you.
Brian Fahey, CFA®: Yeah. So, like I said, I’ve been doing this for 20 years, and I think the financial industry kind of has a bad reputation because there’s a lot of people that sell stuff where the person selling it, the agent, gets rich and then the, the client’s left holding the bag. I’ve worked with many clients over the years that came in with just absolute garbage portfolios.
They worked with somebody that, they met through a bowling league, and they’re left with something they can’t get out of. They’re paying a bunch of fees, the performance is poor. So that’s why people have, not contempt, but a little bit of sensitivity to working with a financial professional.
I think we’ve done a pretty good job to get away from that, particularly, with Pure, we’re the only fiduciary. So if you’re somebody who’s looking for a new advisor or stepping into the space for the first time, I would argue that’s what you want to look for. Absolute first deal breaker. You don’t want somebody that’s gonna get paid based on putting you into a product.
That’s not the right way to do it. You want somebody that’s gonna get paid by helping you reach your goals. Way to do that is make sure you’re working with a, a fiduciary. Beneath that, you can check on FINRA, what is this guy’s back- or woman’s background? Who have they worked for? Do they jump, from firm to firm every couple of years?
Do they have a complaint on their record? You pull it up. It’s public information. You can see. Did this guy scam somebody or, do something they shouldn’t have and had to pay somebody hundreds of thousands or fifty thou- whatever, some amount of money to settle a complaint. Probably not somebody you want to work with.
Professional designations, I’m partial to the CFA, Chartered Financial Analyst. That’s what I have. That’s kind of a pain in the butt to get. But any CFP is a, a great place to start as well. All this information is available publicly, and you can go and see, does somebody have the nick on their license because they did something wrong?
Did they shop jobs every couple of years ’cause they’re not good at what they do? And if they’re not a fiduciary, they’re not working for a du- fiduciary-oriented firm, I’m not saying you shouldn’t work with that person, but you– I don’t know that I’d want to have a relationship where I have to double-check everybody’s motivation.
And with a fiduciary, you know that the motivation is to help you be successful
Kathryn Bowie, CFP®: Excellent. Well, we have more questions, but I’m gonna go ahead and let you get back in, and then we’ll come back. Go ahead and pause when you’re ready for more questions. All right?
Brian Fahey, CFA®: All right. So f- few slides earlier, we showed what the S&P 500 has done since 1988, and it was like a 2,800% return.
But over that timeframe, you had to deal with a fair bit of volatility. So remember the financial crisis, max drawdown, this is monthly data, was 52%, and it took you five years to get back to where you started. And that’s assuming you just left the money, you didn’t do anything else. Dot-com bust maybe in front of people’s minds with AI going on like it is now.
The max drawdown was 45%, and it took you almost seven years to get back to where you started. So these are the kind of vol- volatility events that you need to be prepared to deal with if you’re gonna have a healthy allocation to equities. This is why financial planning is so key because if you’re taking on a lot of risk, and you’re gonna need to use your portfolio for living expenses in a handful of years, you need to be prepared.
You need a plan. What happens if one of these events happens? That’s gonna help you design a portfolio that’s more resilient for you. If you understand where you’re going, you understand the risk that you’re taking, you can build a portfolio that’s gonna help get you there. But I put this slide in to make sure that everybody understands that equity returns over the long term are fantastic, but to get there, you had to go through some pretty rough times Other side of the coin is fixed income.
Now, I don’t know how front of mind this aspect is for people, but we’ve lived through the worst bear market in history for bonds. We’re not quite back to where we started from the drawdown when the Fed started cranking rates. Remember at the tail end of COVID the 10-year Treasury was up forty-seven basis points in yield, so zero point four seven percent was your yield on a Treasury.
Right now, it’s about four point six. So bond prices and yields are inversely related, meaning as yields come up, bond prices go down. So as we’ve dealt with inflation, as we’ve taken inflation from nine down to, whatever, three point eight-ish now, bonds have gotten shellacked. We’ve lived through the worst bond bear market in history.
This only goes back to seventy-six, but there’s data that goes back to the inception of the US and looks at Treasuries or, various forms they’ve been in over that timeframe. And what we’ve gone through is worse than anything that we’ve experienced going back to the Civil War. So even the worst bond bear market, you’re down seventeen percent.
It’s been about six years, still going. But other than that event, other than the COVID event, your typical drawdown is, high singles, low digits, and you’re back to where you started pretty quick, about a year. So what we’ve gone through is a pretty remarkable event. Hopefully we never see it again.
But bonds tend to be more safe. This event could manage around it a little bit because we did see, inflation coming when it did. But just overall, other than COVID, a bad year for bonds is you’re down about five percent. Flipping back to equities, a bad year for equities, you’re down forty, thirty to fifty percent.
And that’s why, going back to here, the cost of dealing with that volatility that we saw, the potential for a fifty percent decline, is why you have this twenty-eight hundred percent number and why the bond market, why those drawdowns are significantly less. That’s why your return’s only five hundred percent.
Still a good number but significantly less than equities that bear substantially more risk. So those are drawdown charts. Just in case you’re not familiar, the, the line coming down is just you’re at a peak, and you’re drawing down to, negative forty percent back here. And then as it gets back to the flat line, that’s you’re reclaiming your previous high.
All right, so there’s a lot of conditions that your portfolio should be able to sustain. Equity drawdowns are a fact of life. It’s gonna happen every year on average, you’re gonna see a decline of somewhere around 14%. That’s the cost of having equity exposure. Inflation shocks, we talked about the worst bond market in history.
We’re still kind of living through that. Hopefully, the worst is well behind us, but a portfolio that’s designed for stability is gonna be a… need to be able to deal with inflationary bursts, like what we went through with COVID. Liquidity events, obviously, you wanna make sure that you have cash when you need it, and you’re not scrambling to create liquidity in the middle of a bear market or just a bad day in the market.
So you do wanna have that cash buffer. Correlation spikes, this kind of ties back to the previous question about alternatives. How do you deal with events that really hurt, say, all equities or all fixed income or maybe even your entire portfolio? What can you do to build a portfolio that’s gonna sustain or be able to re- bounce back from that?
They do happen. The financial crisis is a good example. Correlations on all equities basically went to one. Didn’t matter if you had large, mid, or small, foreign, domestic, whatever factors you wanted. They all came down. But it recovered pretty quickly, and if you have a portfolio that’s well-diversified you will deal with those periods of correlation being relatively high, but it’ll disperse back to where it should be, hopefully relatively quickly.
Your portfolio c- hopefully can be designed to weather that correlation increase so that when it re- returns to normal, your portfolio does what it’s supposed to do
So that question about alts or alternative investments, there’s a lot of them out there. Here’s four strategies that, that we use, that we do a lot of research on that we’ve done manager research on so we’re comfortable using these ones. Again, there’s a million of them out there. This is just the ones that we’re most familiar with.
Trend following you can access this through an ETF. Commodity trading advisors is just kind of the, the general term there. Could be related to equities or fixed income or rates or currencies. Whatever it is, it’s basically just saying, “When the line goes up, I buy more. When the line goes down, I buy less or short.”
It’s obviously a little bit more complex than that, and there’s different ways to do it, but CTAs or commodity trading advisors can be a way to add a non-correlated return stream to your portfolio. It’s, and again, something that you could use an ETF for, you could use a fund for. It is a good diversifier.
Typically, they’re gonna be in commodities, but again, it can be extended into equities and fixed income and currencies and other aspects. But that is something to consider. Again, probably not something you wanna put your entire portfolio into. Two to five-ish percent, maybe a little bit more is kinda ideal.
Alternative risk premium, that’s more kinda hedge fund territory, but it is something that you can get in mutual fund format and I think probably some ETFs these days. Basic gist there is you can see appreciation in that investment without the stock market necessarily going up. So you can harvest things, relative value such as actual valuations carries, things that pay, pay income.
Momentum is a really popular trading strategy. The benefit of this is it tends to have a lower correlation to equities because it can do well in sideways markets and even potentially in down markets. So that’s a nice diversifier to have in your portfolio. Reinsurance is a little bit tricky but it is something that, that we use and it’s pretty well-established.
Reinsurance is basically when your insurance company… Let’s say you’re an insurance company and you cover Southern California and are really worried about wildfire risk. You can sell that risk to the market in the form of a, a catastrophe bond. So that bond will pay usually a pretty high rate of interest, but if there’s a triggering event, maybe it’s an earthquake, wildfire, hurricane, something along those lines part of that bond is gonna go to the insurance company, part of the principal is gonna go to the insurance company, and you’re not gonna get any more coupon payments.
So nice thing about it is you can diversify globally, so you can have exposure to wildfires maybe in Southern California or earthquakes in Japan or tsunamis in somewhere else in the world. None of those events are gonna be correlated. They do- We have gone through periods where reinsurance bonds don’t do particularly well, and then the next year they’re up twenty-two-ish percent.
Point being Reinsurance or cat bonds are not connected to the economy. We’re not gonna necessarily get a series of wildfires and earthquakes because the stock market’s down or because the stock market’s up or inflation’s high or low. So this is something that can be used to diversify your portfolio.
Again it’s not going to be your portfolio, but it can be a useful piece in your overall allocation. Maybe it’s 2%, maybe it’s 5%, but it is a way to get a return stream into your portfolio that’s not gonna be directly related to, US GDP and companies doing well. Finally, for alternative diversification beyond stocks and bonds is private markets.
Private credit particularly has been in the headlines quite a bit for the last year or so. Still probably a pretty good asset class if you’re positioning it appropriately. Again, you don’t wanna build a portfolio just of any of these items, particularly private credit or private equity, ’cause you’re typically tying those investment dollars up for a longer period of time.
But you can get a better than normal return because you’re getting that, it’s called an illiquidity premium. Basically, you’re getting paid for not having access to your money on a daily basis. So something to consider. Again, not right for everyone. It’s certainly not, shouldn’t be a large piece of your portfolio.
But it can be helpful, especially if you have a longer time horizon and you’ve done your planning appropriately where you can dedicate, 5 or 10% of your portfolio to something that is illiquid but should give you better returns over the long-term. So if it’s money that can be stashed away for a decade-plus, private markets are a good thing to consider, but it’s, shouldn’t be an overwhelming position in your portfolio, and it definitely needs to be planned for appropriately.
So again, the goal isn’t to get rid of stocks and bonds or replace your traditional allocation with alternative investments. It’s to get a difference return stream, different diver- more diversification into your portfolio so that you can benefit from a, an environment potentially where stocks and bonds just aren’t performing
So really been harping on this point, but planning needs to be done first. If you have a good plan, you can manage your risk without giving up on your growth. So if you have a plan, you’re comfortable with knowing, “Hey, what’s really gonna happen if we’re down 30-ish percent in the equity market?” And you have money y- in your plan, you have money that’s set aside for a few years’ worth of living expenses, it’s still gonna be uncomfortable, but it’s not gonna be dire, and that’ll help you s- weather the storm.
It’ll help you stay in the market and stay fully invested, which is the chart on, or the bar on the chart on the far left. That’s 63,000 bucks. That’s following through the market without pulling out and missing any of those good days. The next bar on the chart is showing if you just miss the 10 best days, your return is about half.
Well, less than half. Now, wise guys will say, “Oh, well, what if I just m- miss the 10 worst days?” Well, the problem is, the 10 best days and the 10 worst days are usually right next to each other. We saw that, you particularly remember around Liberation Day. We had terrible, this was last April with the tariff announcement.
We had a terrible string of market days, and then r- on a random Tuesday or Wednesday, the market was up 10% in 15 minutes. You can’t plan for that. Nobody can trade on that. The only thing you can do is stay invested through the cycle, through those bad times. It was the same thing, remember, during the financial crisis.
The market would be down 5% because a bail out package didn’t pass through Congress, and then it would be up 10% the next day because people were optimistic that the next batch or the next vote would pass. So y- you can’t plan for that. Or excuse me, you can’t trade around for that. You can just plan for the idea that something like that could happen, and you need to have your portfolio positioned so that you can weather that ’cause those kinds of things happen.
So if you have good cash flow planning good diversification, you can stay invested. Diversification means those drawdowns are gonna be smaller. Cash flow planning means you’re gonna have the cash available when you need it to cover those living expenses, the trip to Europe, whatever it might be.
So again, doing solid financial planning, keeping that updated, is gonna help create the portfolio that gets you through the bad times and captures the good times So today’s volatility, we’re pretty average. Despite the fact that we’ve got a war, we’ve got new tariffs we’ve got inflation that’s running high, equity markets have actually been pretty well-behaved and totally normal.
So on average, you’re gonna see a drawdown of about 14% in the equity market. That’s the S&P 500. That’s gonna happen more often than not. Sometimes it’s more, sometimes it’s less, but, consider a 15% drawdown par for the course. Even though on average you’re gonna have a 14% drawdown over the course of a year, you’re still gonna h- be positive three out of four years on average.
So you’ll dip down just, we did something similar this year and fe- into March, basically the month of March that kind of drawdown is, it’s totally normal. And then getting back to the idea of being able to time the market to avoid the volatility, nobody can do that. Nobody has a crystal ball.
Anybody that tells you otherwise is selling you something. So what you should work on is making sure that you rebalance, making sure that you tax loss harvest and then revisit your allocation as your goals change. As your financial plan gets updated, it’s important to make sure that your investments reflect those changes.
So what does that give you? It gives you the ability to be patient to kind of ignore the headlines, at least not act on the headlines. Forecasts are gonna be all over the place. We’re never right, nobody ever is. But it kind of gives you an idea. And then also to stay invested as we go through these various events that are always gonna pop up
So A good portfolio should be a good portfolio in as many markets as you can manage. So it’s gonna be a good portfolio when you have inflation. It’s gonna be a good portfolio when you have an equity drawdown because you can’t exactly time any of these things. You have a pretty good idea, and I think the inflationary example’s a good one, but you can never perfectly time it.
So you want a portfolio that’s gonna be able to weather these, these storms or these events, and to do that, you need a lot of diversification. Maybe it means talking about alts, maybe not. Maybe it means more allocation to fixed income and more time spent on how that bond portfolio was created. Or maybe it’s more diversification on the equity side, or maybe it’s the opposite.
Maybe it’s more concentration because you’re young and you’re trying to save for the long haul, and you’re willing to take that volatility. But the point is, you need to have your… Your plan needs to drive the portfolio. Managing drawdowns is really key because we’re always gonna have a chaotic event.
It’s always gonna happen. And if you have a good plan in place, you can weather those events and stay invested. Finally, volatility is totally normal. You just need to plan for it. We have plenty of software to help show, okay, if we went through another financial crisis, what does my portfolio look like?
And talk through it, look at the cash flows and all those different things. We’re happy to help you through this. It is pretty complicated. There’s a lot of ins and outs. We didn’t even talk about taxes, which is directly related to how your portfolio should be constructed. But if you need help, you want help, let us know and sign up for the complimentary portfolio analysis and, we’ll give you some pretty good results and some things to think about.
Kathryn Bowie, CFP®: Excellent. Thank you, Brian, for all the information. Let’s go with a couple more questions. So first of all, can you talk a little bit about gold and silver in your portfolio? What kind of percentages are… I know it’s different for everybody, but they’re asking about percentages.
Brian Fahey, CFA®: Yeah. I still, I work with clients and s- I do have one client in particular who loves gold.
And for her financial plan, we committed 5% would go into gold, ’cause that was the most that I felt comfortable with after going through all the details of her situation. When it gets to be 6, 7%, like it did last year, we’re harvesting those gains and we’re putting it back into the portfolio and other investments.
Is 5% a good amount for gold? If that’s something that you’re interested in and you really have a deep passion for it, then sure, go ahead. It’s fine. It, performance on precious metals has actually been pretty good for the last, we could call it decade. So if that’s something that, that drives your interest, you can absolutely have it, and I don’t think you’re gonna see a huge detriment, but it needs to be sized appropriately.
And not to beat on a dead horse, but it comes back to your financial plan. How much of it… Because you don’t get any income from any precious metal. If your scenario is such that you need regular income, gold’s not gonna be a great thing for you or s- or any precious metal’s not gonna be a great thing for you.
Kathryn Bowie, CFP®: All right. How about what’s the best practice for keeping cash on the sidelines for drawdowns and opportunity for buying when the market goes down?
Brian Fahey, CFA®: Yeah, I think there’s really two ways to look at it. There’s how much money do I need in my checking account to make me feel comfortable, may
whether you’re using it or not. That answer is up to each individual. Maybe it’s 5,000, maybe it’s 50,000, maybe it’s 200,000. And it’s up to you. But the first part is how much money do you need liquid, I can write a check on it immediately kind of money versus I’m buying a house in two years or a year or I’m buying a boat or I have a big expense coming up or I’m just precautionarily saving.
That kind of money, if you’re gonna need it in, say, a year or two, probably look at a treasury or a money market, something that can’t lose value, that’s … If you’re looking at a treasury, just make sure the maturity date lines up with when you’re gonna need it. So that’s another place. And then the other thing that you could look at, if it’s really just precautionary savings to be that one to three year kind of cash bucket in your portfolio, you could look at, say, a, a bond ladder that’s gonna be maturing in a relatively frequent basis and providing that, that extra cash, and is gonna be invested in nice, safe, boring securities that are about as exciting as watching paint dry.
So that you can turn that into liquidity if you needed it. So what are potential options? Short-term, high-quality munis are a good option. Treasurys obviously are an option. Money market works. There’s a few things you could look at for that kind of scenario.
Kathryn Bowie, CFP®: Excellent. All right. So what resources do you recommend for helping build a financial plan?
Brian Fahey, CFA®: That’s a great question, Kathryn. You could sign up for one of our free complimentary analysis. Honestly, our, we do have really good financial advisors. We have a lot of resources, and we can help anybody. That’s part of our goal as Pure Financial. One of the things that I like about working here is we do put education front of our pra- our practice and our business.
It’s not just a sales line. We honestly believe that. Go to our website, look at how much information we have available. Talk to any of our advisors. You’ll see that education is a big part of what we do, and I think everybody that works for Pure shares that message. Beyond my self-serving answer it depends on what you’re looking for.
If you’re looking for investment side information really, you gotta pick up a book. I don’t have any great ones front of mind other than, Benjamin Graham kind of stuff. But- CFA books work. But probably shy away from the CNBC kind of stuff, ’cause again, that’s gonna be based on trying to sell you something.
And usually that kind of stuff’s kind of transactional. They’re not gonna… The advice you get from there is not gonna be customized to what you need, and there’s nobody that’s accountable for that information they’re giving you. Gotcha. So probably work with a fiduciary to get more information.
We’ll help you. But probably a good question to be answered by an advisor you sit down with and kind of give you some guidance on what it is you need to work on, where the strengths of your portfolio or your plan are, and where it could be improved. ‘
Kathryn Bowie, CFP®: Cause everybody’s different, right?
Brian Fahey, CFA®: Everybody’s different, that’s what makes it fun.
Kathryn Bowie, CFP®: Yeah. What can I do to my portfolio to be more tax efficient? Anything. It’s kind of a big question, but…
Brian Fahey, CFA®: Yeah. It’s a good question. So probably the first thing, and one of the big things we do here is asset location. So that’s just the idea that certain types of investments should be in certain types of accounts.
So if you have a taxable account, an IRA, and a Roth, maybe your most aggressive investments are in that Roth account. Maybe your bonds are in your IRA, ’cause they’re generating regular income, and you might not necessarily want to pay tax on that. And then your taxable account’s kind of sh- maybe it’s your middle of the road kind of equities.
So asset location is a good way to start. Number two would be the types of investments that you use. So maybe you’re looking at individual securities, maybe you’re looking at ETFs. Mutual funds, it’s not as big as it used to be, but generally, mutual funds kick off capital gains, whether you…
independent of what you’ve done. So just how the fund is operated. If there’s gains that are realized at the fund level, it gets distributed to the shareholders. If that’s in your taxable account, you’re paying tax on that investment, even if you didn’t sell. So if you are using mutual funds that generate capital gains, like most equity funds, it’s probably better to hold that in an IRA or a Roth.
Lastly, and there’s been a lot of kind of growth in this area is individual securities through direct indexing, and that’s where you own a portfolio of individual securities that are designed to replicate a benchmark Over time, it’s gonna track that benchmark, but under the surface you’re gonna have certain securities that did well, certain securities that didn’t.
So the securities that did poor, you can sell them and harvest the losses. Still track the benchmark. Your dollar is hopefully gonna grow, to $1.10 next year and so on and so forth over time. But at the index level, there’s always gonna be companies that aren’t doing so well, and you can sell those companies if they happen to be in your portfolio and replace them with something similar.
So you still look like the benchmark, but for tax purposes you’re realizing capital losses that you can use to offset capital gains either in that portfolio when you’re ready to take money from it or somewhere else in your financial life. So those are kinda three examples on how to look at your portfolio, your investments to be as tax efficient as possible.
Kathryn Bowie, CFP®: Excellent. We’ve been talking about AI. Well, real quick just popped up, what about convertible bonds? How do you feel about convertible bonds?
Brian Fahey, CFA®: Yeah, that’s a less trafficked area of fixed income market. They certainly go through periods where they’re more attractive than other times. Little bit of it depends on issuance, so who’s actually issuing these convertibles.
A convertible is just a, a bond that can convert into, to equity. It pays generally a pretty small coupon or interest because you have that, that option to convert it into equity and it has certain strike prices on when that would happen. It is a good diversifier. So getting back to the idea of fixed income in general, you don’t want just all treasuries or just all munis or something along those lines.
Convertibles trade more like high yield so it is gonna be kinda treated as… You should treat it from a risk perspective as if it’s a junk bond. The performance is gonna vary over time. Absolutely, completely reasonable thing to have in your fixed income portfolio. And, normal allocation 2%, 5%-ish percent
Kathryn Bowie, CFP®: All right, what about AI?
We talked a bit about AI, but is AI a bubble we’re in right now?
Brian Fahey, CFA®: Yeah, so we’ve got a couple of big companies reporting just in a few hours Facebook or Meta and Microsoft, two of the big hyperscalers that are building out these big data centers. What we’ve seen just in the last four or five months is really a shift in how investors are looking at AI.
So a couple of months ago, well, maybe even a little bit longer than that, companies couldn’t shovel enough money into AI data centers, and the more money they were spending, the better their stock price went. That has shifted. Now investors are becoming a little bit more skeptical of what AI is becoming and if it’s going to be as profitable as what everybody’s assuming.
So one of the questions that at least I’ve been getting from clients is, are we in a bubble with AI, and how do we respond to it? I don’t know if we are or not. Nobody can tell you that with certainty, but I can tell you, you can prepare for it. So maybe your portfolio doesn’t have as much exposure to tech as the benchmark.
Maybe you have a little bit more in fixed income because you just don’t want the risk of AI exposure, and it’s kind of hard to get rid of AI exposure, to be perfectly honest because not only is it the companies that we just talked about, like the Microsofts and the Facebooks, but it’s companies you wouldn’t really associate with AI, like Caterpillar.
Caterpillar’s having a great year because they’re selling equipment to AI data centers or generators. Or Cummings, same kind of story. Last week we had big financials report, so Morgan Stanley Goldman Sachs, Wells Fargo, Bank of America, they all had incredible numbers. They made a lot of money on underwriting bonds and trading activity.
A lot of that’s related to AI. So now your financials, your exposure to JP Morgan is partially impacted by them underwriting new bond issues and equity issuance related to AI. If you’re buying a muni bond, maybe your municipality is seeing more money come in because of tax revenue from tech workers.
So the, the reach of AI is, it’s getting pretty significant. A- again, I don’t know if we’re in a bubble or not for AI, but I can tell you it’s probably a good thing to at least think about. If the odds of a AI bubble are 5%, or you think they’re 20% or whatever, it’s probably big enough that you should prepare for it, and maybe that means you’re adjusting your equity exposure.
Maybe it means you’re buying a little bit more fixed income. Maybe it means you’re buying more Europe and less US, more value and less growth. There’s different things you can do to compensate for the risk of AI. But I think it, it’s goes back to the idea of planning and diversification. What does it look if we go through another tech bubble and your portfolio’s down 40%?
Do you have enough cash on the sidelines to get through that? That one was a particularly nasty one. It took you about six, seven years to get back to where you started. So it is something to plan for even if you think the chances of it, and fingers crossed, are really low.
Kathryn Bowie, CFP®: If you don’t know the language of investing, I’ve had a couple of people talk about, “Well, I don’t really know what to ask.”
Well, that’s the best time to come in and either via Zoom or come into one of our offices and speak to a Pure Financial professional. Ask those questions and say, “I’m new to this. How can I understand it a little bit more?” But we will get to your personal financial questions, and we will be able to then talk to you and help you get through the financial journey that you’re on and help you and guide you and hopefully add value to your situation.
So we’ll look into your entire financial picture. Sign up for that free assessment and get your personal questions answered. So thank you all. We appreciate it. We hope that you’ve gotten a lot out of this time with us.
Subscribe to our YouTube channel.
IMPORTANT DISCLOSURES:
- Neither Pure Financial Advisors nor the presenter is affiliated or endorsed by the Internal Revenue Service (IRS) or affiliated with the United States government or any other governmental agency.
- This material is for information purposes only and is not intended as tax, legal, or investment recommendations.
- Consult your tax advisor for guidance. Tax laws and regulations are complex and subject to change.
- Investment Advisory and Financial Planning Services are offered through Pure Financial Advisors, LLC an SEC Registered Investment Advisor.
- All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.
- Neither Pure Financial Advisors nor the presenter is affiliated or endorsed by the Internal Revenue Service (IRS) or affiliated with the United States government or any other governmental agency. This material is for information purposes only and is not intended as tax, legal, or investment recommendations.
CFA® – Chartered Financial Analyst® designation was first introduced in 1963. The CFA Program contains three levels of curriculum, each with its own 6-hour exam. Candidates must meet enrollment requirements, self-attest to professional conduct, complete the approx. 900 hours of self-study, and successfully pass all three levels to use the designation. The program curriculum increases in complexity as you move through the three levels:
- Level I: Focuses on a basic knowledge of the ten topic areas and simple analysis using investment tools
- Level II: Emphasizes the application of investment tools and concepts with a focus on the valuation of all types of assets
- Level III: Focuses on synthesizing all of the concepts and analytical methods in a variety of applications for effective portfolio management and wealth planning
CFA Institute does not endorse, promote, or warrant the accuracy or quality of Pure Financial Advisors. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
CFP® – The CERTIFIED FINANCIAL PLANNER® certification is by the CFP Board of Standards, Inc. To attain the right to use the CFP® mark, an individual must satisfactorily fulfill education, experience and ethics requirements as well as pass a comprehensive exam. 30 hours of continuing education is required every 2 years to maintain the certification.
