In our blog post “Investing 101,” we describe how and why we build diversified portfolios across different asset groups and geographies to help investors navigate market turbulence and achieve their long-term financial goals. We set the weighting of the different groups to match the risk profile and objectives of each investor, and we rebalance to those custom weightings to help keep the risk profile in line.
As you might expect, there are times when prices for a specific group may go up so much, or down so far, that it may present above-average risk or return than usual. With our data models, we strive to recognize those extremes and adjust portfolio weightings for the “rebound” to capture incremental gains.
In this blog post, we provide an overview of that activity, which we call “tilting.”
Signs of Extreme
You can think of movement in broad market prices like the swings of a pendulum. Prices may move up or down day-to-day, but over long cycles they can swing far in one direction—sometimes too far, where they overshoot what is a sustainable position.
These swings too far in one direction often happen in periods of extreme greed (the Dotcom Bubble in 2001, or the Real Estate Bubble of 2007) or extreme fear (High Dividend Stocks in 2015, or historically low bond yields).
We aren’t looking for small price swings (less bang for the buck). Instead, we look for big swings that usually take time to build…and can unravel quickly.
We have calibrated our investment models to give a signal when those meaningful imbalances are likely to have occurred, allowing us to tilt away from the riskier extreme (e.g., reduce its weighting in the portfolio) and toward what we believe to be the group offering better return potential (increasing its weighting).
We measure those extremes across three principal dimensions:
• Market sizes (large stocks or small stocks)
• Investment styles (Value, Growth, Momentum, Quality, etc.)
• Global regions (US, international, or emerging markets)
Keeping the Risk Profile Aligned
Importantly, when tilting, we strive to position the portfolio for incremental gain without significantly changing the risk profile of the portfolio. We believe we can do so by:
1. Keeping the portfolio’s investment objectives the same—meaning, the allocation to what we call OFFENSE, also known as APPRECIATION, (risk-seeking opportunities like stocks and equity-like investments) and DEFENSE (fixed income, to help manage risk and volatility) remains unchanged.
2. Tilting between what we see as the better opportunities within those allocations—meaning, we might give more weight to large value stocks over small- or –mid-sized growth stocks. These groupings both reside in the OFFENSE/APPRECIATION category, which contains those risk-seeking opportunities.So, for example, if an investor’s risk profile requires 80% offense /appreciation and 20% defense, we will rebalance to those targets and not change their weightings. But within that 80% allocation, the mix of stocks by size, style or even region might evolve based on our view of the best opportunity.
The “Where” vs. the “When”
Successful tilting requires discipline and patience. We believe our research can do a good job of signaling WHERE meaningful imbalances are occurring, but it is very difficult to predict WHEN those imbalances will correct. Why? Because the pendulum swing of prices is often driven by collective investor sentiment (high expectations, for example) rather than grounded behavior or fundamental support. How far that sentiment pushes prices for the group is anyone’s guess. Those prices can swing much farther—and hold longer—than what many would call reasonable.
Bottom Line
Setting the right investment parameters for an investor is the first and most important step in wealth management. Those parameters reflect the risk profile of the investor, aligning the expected return with the expected volatility of the portfolio. Rebalancing to those parameters keeps the risk profile in place as prices swing through the years. At times, those prices can swing to extreme points. Those swings can create incremental opportunity and risk. Knowing when those swings change is more luck than skill, but we believe it is possible to recognize where those swings are occurring. Acting on those signals requires discipline and patience, but we believe proper tilting can add incremental gains to investor returns.