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2016 Q3 Newsletter

Asset Allocation versus Diversification and Discipline

After plunging over 10% during the first six weeks of trading this year, the S&P 500 went on to skyrocket from its lows to finish the third quarter with a gain of about 8%. As if anyone needed a reminder, equities are volatile. Unfortunately for their clients, most advisors rely on traditional asset allocation models that add healthy doses of fixed income and/or cash to their clients’ equity portfolios in an effort to dampen these kind of short term fluctuations…at the expense of lowering their long term returns. But if the losses are temporary (as not only this year’s but all years’ have turned out to be) while the gains are permanent, why in the world would anyone choose to do that?

We must be careful not to confuse volatility with risk. Witnessing a temporary decline in one’s portfolio value does not constitute risk, unless of course it is acted upon. But running out of money during a typical 30+ year retirement that requires a near tripling of inflation-adjusted portfolio withdrawals is a very real risk indeed. As such, our investment approach is designed to deliver the equity returns our clients not only need, but are entitled to, using a combination of diversification and discipline.

First, we engineer intelligently diversified equity portfolios consisting of not only large US companies such as those found in the S&P 500, but global companies from other major developed countries in Europe, Asia, Australia, and the Far East . Furthermore, we add smaller, more nimble companies from both the US and around the world. And finally, we add companies from rapidly growing emerging market countries such as Brazil, Russia, China, and India. The end result is a low-cost, tax-efficient, globally diversified portfolio comprised of equity asset classes with (1) similar expected long term returns but (2) low correlation amongst eachother. For those who argue that the benefits of diversification are somehow disappearing in an increasingly connected global economy, consider the profound differences in performance of each over the past three years:

Equity Performance by Asset Class*

Once constructed, we implement a disciplined rebalancing strategy to maintain our pre-determined target weightings by trimming appreciated positions (sell high) and using the proceeds to purchase additional shares of beaten down positions (buy low). A review of our transactions over the past few years reveals that this strategy forced us to systematically add to our worst performing equity asset classes in 2014 and 2015 (international small cap and emerging markets, respectively) right before they went on to become our best performers in each of the subsequent years. Imposing this disciplined rebalancing strategy within our intelligently diversified equity portfolios allows us to achieve much of the same volatility reduction as traditional asset allocation, without compromising our clients’ progress toward their real world goals.

The enclosed performance report quantifies the gains our approach has delivered in dollars. However, our hope is that you and your family have received far greater value from our financial planning, coordination of your financial professionals, and most importantly, from our unwaivering assurance that, even during the most extreme periods of volatility, “This too shall pass”.

*Source: DFA Returns Web for S&P 500, Russell 2000, MSCI EAFE Index, MSCI EAFE Small Cap Index, and MSCI Emerging Markets Index

Don Davey
Senior Portfolio Manager
Disciplined Equity Management
Plan Appropriately, Invest Intelligently, Diversify Broadly, Ignore the Noise

2016 Q3 Market Index Returns

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