Substantial losses realized over the past decade have forced many to reassess future goals and retirement objectives, and dramatically reduce allocations to risk in their portfolios. Confidence in the long-term contribution of equity markets to investment portfolios has substantially eroded, with the S&P 500 posting a 10-year cumulative decline of 9.1 percent, even after the 26.5 percent rebound for 2009. Investors conditioned to believe that well-diversified equity exposures would achieve growth over long-term horizons experienced not one, but two dramatic corrections over the past 10 years: the bursting of the technology bubble (2000-2002) and then the housing bubble (2007-2009).
What happened? Does all that we learned about investing for the long term no longer apply? Do we need to develop new investment frameworks to meet long-term objectives? Do we need to adopt the yet-to-be-proven aggressive trading and market-timing strategies that many are advocating as the “new normal” to meet our investment goals? Or do we need to adopt more conservative, realistic and sustainable goals going forward?
The goal of this paper is to demonstrate that the “old approach” to core investing is not dead. Time-proven tenets of investing for the long term—realistic expectations, asset allocation driven by sustainable long-term objectives and prudent diversification—will continue to provide the foundation for successful long-term investing.
What Is Core Investing?
Before we can assess its suitability, we need to define what the “old approach” to core investing is all about.
A core investment program is the result of a careful assessment of how to deploy existing assets and projected earnings to fund future goals and objectives (liabilities). Investment portfolios need to be structured to protect future purchasing power from inflation, provide reasonable and sustainable growth to fund projected liabilities, meet projected income distribution needs, and ensure risks taken are consistent with individual circumstances and investment horizons.
The keys to successful implementation of a core investment program are: setting reasonable growth objectives to meet projected liabilities, developing realistic asset class return expectations, and deploying resources across asset classes to capture their long-term risk premia in mixes consistent with meeting growth objectives and investor risk profiles.
It is important that return objectives be defined and set to match projected liabilities. All too often, investment objectives are set at absolute levels of return or at a target excess level of performance over an asset benchmark. This approach may not provide for the funding of projected liabilities, or worse, may introduce unnecessary risk to the investment program.
Asset classes are the fundamental building blocks for a core investment approach. Realistic projections of asset class expected returns and their projected contributions to portfolio risk are critical to the development of asset allocations consistent with funding projected liabilities. Appropriate allocations across fixed income, equity, real estate, commodities, private equity and other alternative asset classes result in prudent levels of diversification, minimizing risk and improving investors’ ability to meet long-term objectives.
Notable studies demonstrated1 and reaffirmed2 that strategic asset allocation is the primary determinant of returns variability for investment portfolios over long-term investment horizons.
Once the asset allocation has been determined, a core investment program will deploy portfolio assets across investment pools. These investment pools should provide well-diversified exposure across the asset class to maximize the opportunity to capture its long-term risk premium (reward for assuming systemic risk) and to minimize the impact of issuer risk (diversifiable risk not compensated by markets).
Core investing is all about implementing sustainable investment programs where asset allocations and exposures can be sustained through difficult times in order to realize long-term returns to meet projected liabilities.
Why did advocates of a core investment approach endure such pain over the past decade? Investor experience could have been substantially improved with a greater focus on three key tenets of a core investment program: realistic return expectations, sustainable asset allocations and appropriate levels of diversification.