This week’s reading and viewing list covers the new Apple Vision, the birth of Bulls (markets), the value of good ideas and walking away with Peter Lynch, amongst other ideas we are sure you will find interesting and useful…
This week’s reading and viewing list covers, what Richard Bernstein is seeing that is making him bullish, Professor and Hedge Fund Manager Chris Beggs, conquering your fears with Tom and Jerry, techs big bets and a keynote by Howard Marks amongst others…
Successful investing goes beyond making smart decisions; it requires avoiding mistakes and adopting a mindset of longevity and endurance. While taking risks and investing optimistically are important for building wealth, keeping your wealth also demands a mix of humility, frugality, and steering clear of catastrophe.
All investment journeys evolve in different ways, with many twists and turns along the road. Everyone has different goals which have varying return requirements in a landscape of changing risk profiles. As investors, if we invest in just one asset class today and then go to sleep on it for years, we could wake up to a rude shock. Not only do investment goals evolve as time goes by and experience accumulates, the assets that we invest in also have varying risk/return profiles over time.
Finance and investment writers tend to lend attention to things that are huge, profitable, famous, or influential. Of course, celebrating wins and helping investors find tails that wag the dog i.e. security selection is important. However, it is equally (if not more) important to emphasise one crucial aspect that is often less spoken about in achieving long-term financial success: asset allocation.
What is Asset Allocation?
Asset allocation is the process of determining where to invest money in the market. It involves apportioning a portfolio’s assets across different asset classes, such as equities, real estate, bonds, cash, and other options like private equity and alternative investments. The key principle behind asset allocation is that different asset classes do not move in perfect correlation with one another, meaning their performance doesn’t rise or fall at the same magnitude simultaneously.
Why is Asset Allocation Important?
Asset allocation has a significant impact on the overall returns of a portfolio. Choosing the right asset allocation maximises returns relative to an investors risk tolerance. This means it helps an investor get the highest payoff possible for the amount of money willing to be risked in the market.
Diversification is a key component of asset allocation. It applies not only to the split between asset classes but also within asset classes. By diversifying across different regions, sectors, and investment styles within equities, and across various segments and durations within bonds, investors can reduce risk and potentially achieve a less volatile overall portfolio return. Diversification protects wealth by spreading investments wisely, mitigating the impact of a decline in any single investment or asset.
Types of Assets to Consider: Avoid Putting All Your Eggs in One Basket
The famous saying “don’t put all your eggs in one basket” is especially relevant in asset allocation. By diversifying investments across various asset classes and within each class, investors can reduce exposure to any single investment’s risks. This strategy helps mitigate losses if one asset performs poorly while others compensate.
When allocating assets, investors have a wide range of options to choose from. These may include:
Equities: Investing in stocks represents ownership in publicly traded companies and offers the potential for long-term capital appreciation. Equities can be diversified across different industries, sectors, and geographical regions.
Fixed-Income Investments: Bonds and other fixed-income instruments provide a steady income stream and are considered less risky than equities. They can include government bonds, corporate bonds, municipal bonds, and treasury bills.
Cash and Cash Equivalents: These include money market funds, term deposits (CDs), and savings accounts. Cash investments provide stability and liquidity, making them suitable for short-term needs and emergencies.
Real Estate: Investing in real estate can provide both income and potential appreciation. This can be achieved through direct property ownership or real estate investment trusts (REITs).
Alternative Investments: Hedge funds, private equity, commodities, and other alternative investments offer diversification and potential returns not correlated with traditional asset classes. However, they often involve higher risks and may require specialised knowledge.
Portfolio Rebalancing and Asset Allocation
Asset allocation isn’t a one-time event. Your desired asset allocation changes over time as you get closer to your goals. But even before then, you may notice portfolio drift, or the movement of your allocations away from where you set them. This could happen if stock values rise suddenly or if bond interest rates (and their associated prices) fall.
Most experts recommend you check in on your portfolio once or twice a year to see how it’s doing. Depending on your holdings’ performances, you may need to rebalance, or sell some securities and buy others to bring your asset allocation back into line.
Risk-Reward Ratio and Individual Goals
By clearly defining target returns and assessing risk tolerance, investors can align their asset allocation with their individual goals. Remember, striking the balance between risk and reward is an individual pursuit – time horizon, risk tolerance, personal preferences and goals vary from person to person. For example, here are retirement scenarios for three different investors:
Investor A, a 22-year-old with a retirement goal in 40 years, possesses a high tolerance for risk. Their main objective is to increase their retirement savings over the next four decades. They acknowledge the market’s fluctuations but prioritise investments that offer the potential for higher returns. Their ideal portfolio would be diversified and expose them to the stock market, known for its historically high rates of return. Here’s an example of asset allocation:
80% allocation to equities
Within equities:
30% in mid-cap & large-cap stocks
70% in small-cap stocks
15% allocation to real estate
5% in cash
Investor B is 40 years old and plans to retire in 15 years, indicating a moderate risk tolerance. Although they have more than a decade left until retirement, the limited time frame hinders their ability to recover from significant market losses. They are open to taking some risk to continue growing their money, but they cannot afford to lose substantial amounts before retirement. They seek a diversified portfolio that offers moderate upside potential while safeguarding them against major market downturns. Here’s an example of their asset allocation:
40% allocation to equities
Within equities:
50% in mid-cap & large-cap stocks
50% in small-cap stocks
40% allocation to real estate
10% in bonds
10% in cash
Investor C is 65 years old and has just commenced retirement, possessing a low tolerance for risk. Their primary goal is to preserve their capital while still seeking selected opportunities for growth, without taking on excessive risk. As they plan for their retirement savings to last for at least the next two decades, avoiding losses becomes crucial. Their preferred retirement portfolio would be diversified and structured as follows:
30% allocation to equities
Majority of holdings are income producing large-caps with long operating history
Smaller allocations to growth opportunities
30% allocation to bonds
20% allocation to real estate
20% allocation to cash
While the above are just examples, they do illustrate how investors allocate assets in their portfolios based on their risk tolerance and time horizons. It is important to note that these profiles serve as samples and demonstrate how asset allocations may vary according to different risk tolerances and time horizons.
The TAMIM Takeaway:
Understanding the importance of asset allocation is crucial for investors. By diversifying portfolios across different asset classes and within each asset class, investors can optimise risk-adjusted returns. While not as “fun” to talk about as individual stock selection, asset allocation plays a dominant role in determining the overall return of a portfolio.
Diversification is acritical element in protecting and sustaining wealth by ensuring that investments are spread wisely across various baskets. Building a well-diversified portfolio aligned with individual goals and time horizon is key to long-term success in investing.
This week’s reading and viewing list: Why Monetary Policy still confuses economists, the legendary Sam Zell’s Final Wise Words, don’t listen to stories and an interview with valuation guru Aswath Damodaran
Crucial to successful investing is recognising the difference between price and value. In the 2008 Berkshire Hathaway letter to shareholders, legendary investor Warren Buffett wrote, “Long ago, Ben Graham taught me that price is what you pay; value is what you get.” This is an easy to understand idiom that people would be used to in everyday life, but often have difficulty applying in their investing life.
In the stock market, there is a wide range of factors that impact prices in the short term. Many are “human” influences–emotions such as fear and greed, reactions to economic and political news, under- and over-reactions to short term events. A stock’s value on the other hand is a less volatile and more objective number, one that can be determined by methods such as assessing cash flows (fundamental value) or comparing to other similar assets (relative valuation).
Price vs Value
The difference between price and value can be small at times and magnified during market bubbles and crashes. When the market is rallying, investors have the tendency to rush in and buy a stock because of a “fear of missing out”. The future is bright, money abounds, and there’s no price too high. On the other hand, when the market is falling, investors become nervous. Their time horizons shrink, their wallets get tight, and prices fall. As Michael Santoli from Bespoke Investment Group once said, “appetites and crowd psychology drive markets in the shorter-term, not math.”
Price Moves A Lot, Value Less So
It’s important to recognise how wildly share prices can fluctuate. As shown below, the S&P 500 has declined by more than 20% 12 times since World War II (and it fell just short in 2022). Smaller fluctuations happen even more frequently, with a greater than 10% decline happening on average every 2 years. Remember that this is for the overall index, which contains 500 large and profitable companies. Individual stocks can move to much greater extremes, particularly those that are smaller, less diversified, and more sensitive to the economy. Even Berkshire Hathaway, known as one of the highest quality and most successful companies in the world has experienced a share price decline of more than 50% three times in its history.
However, rarely do these rise and falls in the share prices reflect how much the value of the underlying company has changed. As previously mentioned, the short term moves in shares are an emotional response, as investors react to the news of the day. The good news for investors is that a stock’s price usually returns to its fundamental value eventually. As the father of value investing Benjamin Graham said, “in the short run, the market is a voting machine but in the long run, it is a weighing machine.” Recognising and taking advantage of this dislocation is exactly why Warren Buffett and many other value investors have been so successful.
What Happens if You Pay Too Much? The Lost Decade of Microsoft
Microsoft’s (NASDAQ: MSFT) share price hit an all time high in 1999, after more than doubling from $25 to $58 in the previous 2 years. Investors who sold out the previous year were initially left wondering what could have been. But at a staggering 74 times annual earnings, Microsoft was priced to perfection. The company delivered a very healthy earnings growth of 10% per year between 2000 and 2009, and yet its share price remained basically unchanged (it had also declined back to $25 in 2000). Even though it grew at a very healthy rate, the severe overvaluation back in 2000 meant that Microsoft shareholders received very little return for their efforts. In fact, investors who parked $100,000 in a 10-year treasury bond (which was yielding 4.66% at the time) would have almost doubled the return generated from investing the same amount in Microsoft, with far less risk.
It Sure Does Rhyme
Following the initial covid crash in March 2020, the stock market rebounded hard and fast in 2021 driven by rock bottom interest rates, mammoth government spending, and a boom in retail trading. The big tech stocks (Microsoft, Apple, Facebook, Amazon and Google) soared at an average of 40 times annual earnings, and Tesla rocketed to a staggering 234 times earnings (with a market capitalisation higher than all of the other car manufacturers combined). The record highs of the NASDAQ had people asking if this was indeed a “new normal” or dotcom 2.0? For one, Berkshire Hathaway vice-chairman Charlie Munger called the sharemarket “crazier than the dotcom boom.”
Since then, the market has taken a dramatic hit, with Facebook (NASDAQ: META), Tesla (NASDAQ: TSLA), and Amazon (NASDAQ: AMZN) each declining more than 50%. The story was even more fatal for heavily-promoted smaller tech stocks. Cathie Wood’s high profile Ark Innovation (NASDAQ: ARKK) fund fell 80% from its peak, and companies such as Snapchat, Paypal (NASDAQ: PYPL), Robinhood (NASDAQ: HOOD), Zoom (NASDAQ: ZM) and Nikola (NASDAQ: NKLA) all declined more than 70% from their respective peaks. Yet even after such dramatic declines, many of these stocks remain expensive relative to their underlying value. Aside from a few exceptions such as Zoom and PayPal, most never made an annual profit and it’s uncertain whether they will in the future.
Taking full advantage: Davis Double Play
An investor can, on the other hand, benefit substantially by identifying a company trading below its intrinsic value. One such master of this was the first generation of “The Davis Dynasty”, Shelby Davis, who generated phenomenal returns of more than 20% per year for decades. Mr Davis was most well-known for the “Davis Double Play,” where an investor benefits from both the growth in earnings at the company and an increase in the valuation multiple applied to the shares.
Let’s look at one such example that needs no introduction: MasterCard (NYSE: MA). An outstanding company that well-respected investor Chuck Akre called “one investment every investor should own some of.” In the 5 years between 2016 and 2021, MasterCard’s earnings per share (EPS) increased a very attractive 276% from $3.70 to $10.20. Even better for investors though, the Price to Earnings (P/E) of MA shares increased from 27.5x to 40.5x, adding another 47% to investors’ returns!
Putting It All Together
One of the keys to successful investing is understanding the difference between the price and value of a company’s shares. Share prices can fluctuate dramatically, and they often don’t accurately reflect the value of an individual company–particularly during market booms and busts when human psychology takes over.
As we saw with Microsoft and MasterCard, identifying a company’s strengths and future prospects is only one part of the equation. There’s no doubt that these are both high-quality companies that delivered strong earnings growth and dividends for shareholders. But the return that investors received was highly dependent on the price they paid. Assessing the true underlying or intrinsic value of a company is the mainstay of successful investors such as Warren Buffett, Chuck Akre and Shelby Davis, and it can be well worth the effort.
