This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Steve Blumenthal, chairman and chief executive officer of King of Prussia (greater Philadelphia area), Pennsylvania-based CMG Capital Management.
Many investors gauge their advisor’s value by comparing their portfolio’s performance to “the market.” Often, the market—which is generally understood to be the Dow Jones industrial average or the S&P 500 Index—outperforms a professionally managed, broadly diversified portfolio.
Needless to say, this gives many investors pause, or maybe even heartburn, at times. Here’s what’s important to remember:
Your advisor’s job is to move you along the road to your long-term goals and to help you avoid the dangers when it gets bumpy along the way.
The Importance Of Diversification
One way to achieve this is through diversification. In an investment portfolio, diversification means that different investments perform differently at different times. A long-term portfolio is a surgically crafted, diverse mix of stocks, bonds and other instruments, each counterbalancing each other to offset risk and capture returns.
Your portfolio didn’t match the latest “market” rally? If you’re a long-term investor, that’s probably a good thing.
Indexes like the Dow and the S&P, on the other hand, are the very definition of blunt instruments. Both indexes measure stocks exclusively—not bonds, midsize companies, small-caps or any other asset class such as REITs, commodities or international equities. They gauge only stocks in the U.S. market and only a small sample of the largest companies.
As we’ve seen lately, any single, nondiversified benchmark can fluctuate wildly, creating losses that are difficult to recover from. Diversified portfolios are designed to help cushion against extreme losses. When they’re successful, you end up spending less time recouping losses and more time making new money.
Embrace The Efficient Frontier
In building long-term portfolios, a good advisor is guided by the principle of the efficient frontier. The research and math behind this approach allows the advisor to assemble diverse investments that have the potential to generate return but that are less likely to move in lock step when markets are volatile. The long-term result is the ability for a portfolio to achieve a desired return with less risk.
Efficient frontier portfolios aren’t designed to outperform, or even match, the Dow or the S&P in rising markets. They’re meant to lose less when these benchmarks are falling.
Remember that recovering from a 20% decline requires a subsequent 25% gain, overcoming a 50% decline requires a 100% gain and recovering from a 75% decline (think tech stocks in 2002) requires a 300% gain. In short, your portfolio and those one-dimensional “market” indexes are apples and oranges. Comparing them isn’t very fruitful.