I suppose we have all heard the phrase” black swan event”, which is a metaphor to describe an event that comes as a surprise and has a major effect. Black Swan is derived from the Latin expression coined in the 16th-century when the thinking was that there were no black swans, only white. But in 1697 Dutch explorers first saw a black swan in western Australia. The sighting opened the door to the theories of statistical outliers happening when it was thought they could not. We tend to remember black Swan events as surprises that are typically negative such as the attacks on the World Trade Center’s twin towers in 2001. While this is certainly a black swan event, so is the discovery of the Internet which I think, most people would perceive as incredibly positive. Was and is the pandemic a black swan event?
So how does all this relate to the management of your assets and investments? You cannot manage or should not manage for black Swan events, but your portfolio of investments should be managed per modern portfolio theory and as your needs for the money dictate.
Harry Markowitz wrote an essay in 1952 on modern portfolio theory. Markowitz, an economist, wrote about mean-variance analysis. These phrases are straight out of the statistics textbook and I’m sure many of you are familiar with. But it is how they are applied regarding your investment portfolio what makes them significant and extremely relevant. In the event of a black swan event you will likely see world debt and equity markets react in an extreme manner. In 1987, black Monday saw the Dow Jones industrials lose significant amounts of value. Those who were using margin or sold near the bottom did not recover. But if you remember the bell curve, as things move away from the statistical mean or average they will in fact revert to the average.
Markowitz believed having a variety of non-correlated assets you would enhance the return of your portfolio and reduce the risk. This is absolutely true today if you can obtain real asset class diversification.
Unfortunately, what I see all too often, are mutual funds with different names which would you lead you to believe that they are diversified but often have very similar holdings in very similar asset classes. I personally have not seen an occasion where one family of mutual funds can provide true asset diversification.
In a truly diversified asset mix, not all your investments will be doing great at the same time and conversely, they will not all do poorly at the same. Bull markets in equities often give us a false sense of security and tend to make us chase the winners and shun the laggards. Things change and go through their various cycles. Rebalancing a diverse portfolio is necessary otherwise you no longer have properly diversified asset mix. Risk and your portfolios objective will also determine the asset mix. Is growth your objective? Income? Capital preservation? All these objectives can be managed in a properly diversified mix of low fee, high value investments.
Mark Patterson is Chief investment officer with MHP Asset Management and can be reached at (603) 447-1979 or mark@mhp-asset.com.
