“The Black Swan: The Impact of the Highly Improbable” is the title of a book by Nassim Nicholas Taleb. It also has become a metaphor to describe any high-profile, hard-to-predict event. As such, the term “black swan” was bantered around to exhaustion during the 2008 stock market crash, when the world stock market dropped more than 40%. In my opinion, the public misunderstood what the term really means. Everyone latched on to the fact that these events only work asymmetrically when, in fact, a black-swan event isjust as likely to occur during an upswing.
The reason for this difference in perception is that stock market investing doesn’t work the way many people would like. They must assume more risk for a higher return. And risk means stock markets can fluctuate wildly up or down. In 2008, people claimed that diversification via a portfolio of funds with different investments (what we finance geeks call modern portfolio theory or MPT) was dead. Naysayers thought a portfolio of stocks and bonds should never decrease.
This line of thinking continues today, even though there was another black-swan event last year. The world stock market was up over 20% and our DFA U.S. Microcap fund had the second-best year in its 30-plus-year history (up 45%), while the DFA U.S. Large Cap Value fund had its best year ever (+40%). Despite this remarkable upswing, you would have been hard pressed to find the term “black swan” mentioned anywhere in the press. No one complains when the markets are up like that.
By no means, however, am I saying a black-swan event will happen on the downside. I am simply pointing out that the diversification concept isn’t dead and the naysayers were wrong. Good investors know you can’t have your cake and eat it too. If you’re willing to accept a large return on the upside, you also need to tolerate the down years. We can always have the inverse of the previous year.
The key is to remember that year-to-year fluctuations are insignificant, regardless of which way the tide turns. Instead, focus on the next 5 to 10-year period. It’s rare to see a portfolio like the one we build at Redwood go down for long period of time.
Having a well-diversified portfolio won’t shield you from losing money in a down market and that shouldn’t be your expectation. However, the bonds in your portfolio will lessen such losses and allow you to still participate in the upside. In the long run, you’ll be better off with a less risky portfolio that increases in value and enables you to live comfortably through retirement.
With all the hoopla surrounding the market last year, everyone seemed to look past the bond market. So in case you missed it, the bond bubble burst! Sounds scary, huh? Actually, it wasn’t. In fact, it barely had an impact. The Redwood bond portfolio was down only about 1.5%, while the overall bond market dropped over 2%; mainly due to the jump in the U.S. Treasury yields.
If you’re concerned about Treasury yields increasing significantly, keep in mind that the 100-year average for the 10-year Treasury is a little over 4%. The last time rates were this low was in the 1940s – a period when rates hovered around this level for 18 years.
Did you hear that Gene Fama, the aptly named “Father of Modern Finance,” recently won the Nobel Prize? We base quite of bit of our investment philosophy off his academic work, so we were quite pleased to see he was finally recognized. In a nutshell, Dr. Fama provided academic evidence around what Warren Buffet and his mentor, Benjamin Graham, discovered many years ago. Ben always told Warren to buy businesses cheap; figure out what a company is worth then pay a lot less for it. This is called value investing and the theory plays an integral role in how we build your portfolios here at Redwood. Gene and DFA take it step further by identifying large and small-value companies around the globe, which is why we include their funds in our portfolio.
If you have time, take a look at this video on Gene Fama. Also, Dimensional Fund Advisors and Gene Fama were highlighted in Barron’s magazine last month. Both are great examples of the value that this approach will have on your financial future.
Lane Steinberger MBA, CFA, CFP®
Partner, Chief Investment Officer