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October 28, 2015

Strong Dollar & Cheap Oil Impact Returns

How do you explain to clients that a strong dollar and lower oil prices are costing them returns? When we hear the term “strong dollar,” we picture Uncle Sam holding a greenback high in the air in a pose representing American spirit and dominance. What an encouraging image. How could that be a bad thing?

Many global investors have lost exponentially more money in their investment accounts—due to the 50 percent-plus drop in oil prices in the last year—than they have saved at the pump from lower fuel costs. Likewise, many global investors have lost more money recently in their investment accounts—due to the strong U.S. dollar—than they have gained in other ways.

It is important for investors to remember that their short-term expenses typically pale in comparison to the impact that efficient-market global forces can have on their life savings. This is a difficult thing for many of us to digest: Lower gas prices and cheaper European vacations are simple bird-in-hand rewards.

Risk & Performance

Let's say that you are considering two different investments that have long-term expected return distributions in the following ranges. For technical purposes, let's say these ranges represent two standard deviations:

Investment A: -5% to +5%

Investment B: -10% to +10%

Investment A would be considered by most to be a less risky investment since the standard deviation would be lower than Investment B.

Let's assume that, in a given year, oil drops significantly, causing Investment A to perform toward the bottom of its range, with a return of -4 percent. Investment B was less sensitive to oil, and returned 1 percent for the year.

What now changes? Do the long-term expected return distributions change? Not likely, and if they do, they would likely be adjusted upward for Investment A, given the low valuation for oil.

Investment A is still inherently a less risky investment than Investment B. Likewise, the fact that the combination of Investments A and B are not 100 percent correlated can have diversification benefits for a portfolio made up of Investment A and Investment B.

We would argue that a decision to reduce exposure to Investment A based on recent performance would be a speculation.

What Should Investors Do?

While adjustments may be necessary to reflect current market environment, it is important not to be surprised and overreact when an investment performs within its expected range.

In investing for longer-term cycles, it is important not to spend each day playing the role of judge and executioner, presiding over your portfolio like a small-town sheriff in the Old West.

We would remind investors to not be surprised when things happen that are statistically normal. If you understand the cause-and-effect relationship, and don’t purport to be able to predict the cause, don’t be surprised by the effect.

Most investors don’t have a strong conviction on the direction of oil prices or currencies. We suggest sticking to a well-thought-out strategic allocation, designed to perform over multiple market cycles.

Taking a shorter-term viewpoint without short-term conviction can leave investors disappointed, and leaves the door open to making several mistakes within the same shorter-term cycle.

At the time of this writing, VWO and EEM have been, may be and/or are currently held in several TOPS Portfolios. ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email: [email protected]; phone: 800-765-5201. For a complete list of relevant disclosures, please click here.

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