Each week, we tap the insight of Sam Stovall, Managing Director of US Equity Strategy for S&P Capital IQ, for his perspective on the current market.
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EQ: They say there’s no such thing as a free lunch, but diversification is as close as investors can get. What does that actually mean when they say that?
Stovall: In most cases, “no free lunch” means investors don’t get a higher return without paying for it in the form of higher risk. You don’t get something for nothing. If Sir Isaac Newton had a fourth law, it would be that for every level of return there would be an equal level of risk.
So actually, a diversified portfolio is the closest thing to providing you with a free lunch because if you put together asset classes that have low-to-negative correlation, then they might both take the stairs, but at different paces.
For instance, when you think of modern portfolio theory, it says that you want to maximize returns while minimizing risks. You can’t necessarily eliminate risks, but you can certainly minimize them. That’s why investors typically match up stocks with bonds because bonds usually have low correlation and even a negative correlation at times to stocks.
Sometimes, however, people don’t go far enough and they confuse quantity with correlation, thinking that having exposure to large-, mid-, and small-U.S. stocks, while also having developed international and emerging markets, as well as commodities and real estate, makes them well diversified. But, in fact, they are not because all of these asset classes are economically sensitive. They’re markets that are triggered by global economic declines, which tend to bring all of these asset classes lower.
In a nutshell, a free lunch comes from properly diversifying a portfolio where one asset class zigs when the other one zags.
EQ: In this week’s Sector Watch report, you discussed the “Free Lunch Portfolio,” which focuses on three sectors of the S&P 500: Technology, Energy and Consumer Staples. Why focus on these three?
Stovall: It was sort of a building process. I first was a little bit surprised to see that even when you include the dot-com bubble bursting in the early 2000s, Technology was still the best-performing sector within the S&P 500 since the sector indices were first introduced in 1990, producing a 9.6% compound rate of growth. However, investors paid for that return in the form of very high risk and volatility as defined by a standard deviation of annual returns.
So if Technology is the poster child of cyclicality, I wanted to identify the section that is regarded as the most defensive. That’s when Consumer Staples came up. For Energy, it tends to behave like a stray cat marching to its own beat, but at the same time, is also a late-cycle performer and an inflation edge.
So those were the three sectors that caught my attention. Then, when developing a strategy of one-third Energy, one-third Staples, and one-third Tech, and seeing the returns on an absolute basis as well as a risk-adjusted basis, I got my confirmation that these three were very good holdings within an overall sector portfolio.
EQ: What kind of performance did this strategy produce as compared to just investing in the S&P 500?
Stovall: My assumption was that by offsetting the volatility of Technology with the defensiveness of Consumer Staples, I would not get an absolute return that exceeded that of Technology, but I would’ve received a risk-adjusted return that was better in comparison, and hopefully better than that of the market as well.
As I mentioned, since 1990, the Technology sector has posted a compound annual growth rate of 9.6%, but its volatility was almost twice that of the S&P 500. The return of the S&P 500 was 7.1%, but surprisingly, the “Free Lunch Portfolio” posted a compound rate of growth of 9.8%—better than Tech—and its volatility was even less than that of the overall market.
So indeed we did get something for nothing. We got a substantially higher return with remarkably lower volatility by holding an early cycle in the form of Tech, a late cycle and inflation hedge in Energy, and a sector that holds up best in a declining market with Consumer Staples. We also ended up with a strategy that beat the best-performing sector of all.
EQ: As you stated, this is a good strategy for those that want a simple set-and-forget portfolio. Considering that investors are faced with so much more technology, information, opinions, and just all-around options now, do you see an increase in the tendency to overthink how they approach the market?
Stovall: Yes, I think investors do, mainly because I know I do. We have so much information available to us, so much historical data and so much academic research that we can apply to our portfolios that you end up being your portfolio’s worst enemy, and probably because you’re frozen by indecision.
There is so much data that could end up talking you out of making wise investment decisions. The reason why I say this is a set-it-and-forget-it type of portfolio is because you don’t need to know where we are in the economic cycle. If we’re in the early phase, then Tech will do well. If we’re in a late phase, then Energy will do well. If we’re in a contractionary phase, then Consumer Staples will do well. Over the long haul, stocks in general will do better than cash or bonds.
So my feeling is you just put it together and not worry about where we are in the cycle since most people don’t know anyways, and just let it ride. If you wanted to engage in rebalancing, which is recommended in order to get similar kinds of returns—but there’s no guarantee you will—you don’t have to sell anything. Just simply purchase more of those sectors that did not do as well, and that will allow you to rebalance without having to take any taxable consequences.