On Why Diversification? – Part Two; Four Things to do to Help Prevent Most Disease!

From: aditya rana
Date: Sat, Oct 4, 2014 at 2:18 PM
Subject: On Why Diversification? – Part Two; Four Things to do to Help Prevent Most Disease!

Hi!,

To follow-up on last week’s newsletter which makes the case for "why diversification", this week’s letter will focus on how diversification works. These are based on the writings of portfolio manager and financial blogger Ben Carlson. To summarise:

“The only investors who shouldn’t diversify are those who are right 100 percent of the time.” – John Templeton.

-Diversification is a process and not a one-time decision, as it only works if you regularly rebalance your portfolio by reducing assets which are performing well and adding to assets which are not.

-Diversification sounds easy in theory but is hard to put into practice as it forces you to make counterintuitive decisions.

-Financial markets since 1999 have been through periods of booms and busts with the S&P index being up by a meagre 4.9% per annum. Comparing that with a equally-weighted portfolio of U.S. stocks, foreign stocks and the U.S. bonds constructed from index funds or low cost ETFs and rebalanced back to equal-weight at year-end, is illuminating (see table below).

-Contrary to what one might expect, the rebalanced portfolio actually outperformed the three underlying component assets – as you would have been selling some bonds and buying stocks during the 2000-2002 bear market, selling some stocks and buying bonds during the 2003-2007 bull market and selling some bonds to buy stocks during the 2008-2009 bear market.

-In addition, the diversified portfolio had 60% of the volatility and largest annual losses compared to the underlying stock assets. While the decrease in volatility is helpful, the main benefit of diversification in the management of emotions rather than volatility.

-If we look at the ’90s, the U.S. stock index would have outperformed the diversified portfolio, but the purpose of a diversified portfolio is not to maximise returns but ensure you don’t get the worst return.

-It is impossible to predict which asset class will do best from year to year as the table below illustrates. In almost half the years, one of the asset classes lost money, providing an opportunity to rebalance and boost future returns. By contrast, the balanced portfolio was positive over 70% of the time.

-It is also important to understand that a diversified portfolio may not protect you from short term losses lasting as long as a year. However, it will protect you during bad cycles which can last for several years or even decades for specific asset classes.

-Lastly, please note that diversification is the easy part – rebalancing is the hard bit which requires discipline.

As I have reiterated on numerous occasions in my newsletters, diversification should be the cornerstone of an investment strategy, and being disciplined about rebalancing forces one to incorporate a "buy low, sell high" strategy which is fundamental to long term outperformance.

I had previously mentioned my portfolio base case being 40% equities (developed and EM), 40% bonds (developed and EM), and 20% cash. Based on some queries, I thought it might be helpful to elaborate further on how a balanced portfolio could be constructed (based on the writings of investors like Ben Carslon and others plus personal experience over the last six years).

-The approach is built on two basis premises:

1) Major stock market downturns tend to last anywhere from about one to 2 years.

2) Major stock market upturns tend to last anywhere from 4 to 8 years, and recover fastest in the first two years.

-The first step is to start with how much cash is required to fund expenses over the next five years or so. This can then be increased appropriately depending on how conservative you would like to be.

-The base case cash reserve can be increased (or even decreased) based on asset market valuations – i.e. as market valuations head towards bubble territory, which is defined as a two standard deviation move higher than the long term trend valuation (based on CAPE, GMO or other similar methodologies), the cash weighting can be increased at the expense of the risk assets.

-The next step is to then construct an international portfolio roughly equally distributed between stocks and bonds (a variant around the classic 60-stocks/40-bonds rule which has worked well over history). The portfolio can be skewed more to developed markets or EM depending on which region you are based in, your appetite for volatility and return objectives.

-The basic three rules of the thumb for managing the portfolio are:

1) During major stock market down cycles draw on cash reserves and income from bond funds (plus stock dividends) to fund expenses.

2) Once the major stock market down cycle is over, wait another 2 years (when typically the market rises the fastest) before selling stocks to fund expenses.

3) During major market up cycles fund your expenses by selling stocks (and bonds if they are in an up cycle as well) and rebuild your cash reserves.

It is important to understand that there is no one-size-fits-all rule here as portfolios would depend on individual requirements and constraints.

-However, approaching the problem from a spending perspective rather than the typical advice given which focuses on portfolio distribution rates, percentage of income to replace, asset allocation changes or suitable risk profile, can be useful in devising a suitable solution by inverting the problem at hand.

4 Things To Help Prevent Most Disease.

A great note written by Dr. Greger recently on the underlying simplicity of disease prevention and curing diseases.

http://nutritionfacts.org/2014/09/30/4

-Most of the reasons we go see our doctors are for diseases that could have been prevented. But lifestyle medicine is not just about preventing chronic disease—it’s also about treating it. And not just treating the disease, but treating the causes of disease.

-If people just did four simple things—not smoking, exercising a half hour a day, eating a diet that emphasizes whole plant foods, and not becoming obese—they may prevent most cases of diabetes and heart attacks, half of strokes, and a third of cancers.

-Even modest changes may be more effective in reducing cardiovascular disease, high blood pressure, heart failure, stroke, cancer, diabetes, and all-cause mortality than almost any other medical intervention.

-The key difference between conventional medicine and lifestyle medicine is instead of just treating risk factors, we treat the underlying causes of disease, as Drs. Hyman, Ornish, and Roizen describe in their landmark editorial Lifestyle medicine: treating the causes of disease.

-Doctors typically treat “risk factors” for disease by giving a lifetime’s worth of medications to lower high blood pressure, elevated blood sugar, and high cholesterol. But think about it: high blood pressure is just a symptom of diseased and dysfunctional arteries. We can artificially lower blood pressure with drugs, but that’s not treating the underlying cause.

-As Dr. Dean Ornish is fond of saying, disregarding the underlying causes and treating only risk factors is somewhat like mopping up the floor around an over-flowing sink instead of just turning off the faucet, which is why medications usually have to be taken for a lifetime.

-As Dr. Denis Burkitt described, “if a floor is flooded as a result of a dripping tap, it is of little use to mop up the floor unless the tap is turned off. The water from the tap represents the cost of disease, and the flooded floor represents the diseases filling our hospital beds. Medical students learn far more about methods of floor mopping than about turning off taps, and doctors who are specialists in mops and brushes can earn infinitely more money than those dedicated to shutting off taps.”

-And the drug companies are more than happy to sell rolls of paper towels so patients can buy a new roll every day for the rest of their lives. Paraphrasing poet, Ogden Nash, modern medicine is making great progress, but is headed in the wrong direction.

-When the underlying lifestyle causes are addressed, patients often are able to stop taking medication or avoid surgery. We spend billions cracking patients’ chests open, but only rarely does it actually prolong anyone’s life. Instead of surgery, why not instead wipe out at least 90% of heart disease through prevention?

-Heart disease accounts for more premature deaths than any other illness and is almost completely preventable simply by changing diet and lifestyle, and the same dietary changes required can prevent or reverse many other chronic diseases as well.

-So why don’t more doctors do it? One reason is doctors don’t get paid to do it. No one profits from lifestyle medicine, so it is not part of medical education or practice. Presently, physicians lack training and financial incentives, so they continue to do what they know how to do: prescribe medication and perform surgery.

-After Dean Ornish proved you could open up arteries and reverse our number one cause of death, heart disease, with just a plant-based diet and other healthy lifestyle changes, he thought that his studies would have a meaningful effect on the practice of mainstream cardiology. After all, he had found a cure for our #1 killer! But, he admits, he was mistaken. “Physician reimbursement,” he realized, “is a much more powerful determinant of medical practice than research.”

-So Dr. Ornish went to Washington. He argued that if we train and pay for doctors to learn how to help patients address the real causes of disease with lifestyle medicine and not just treat disease risk factors we could save trillions of dollars.

-The Take Back Your Health Act was introduced in the U.S. Senate to induce doctors to learn and practice lifestyle medicine, not only because it works better, but because they will be paid to do it. Sadly, the bill died, just like millions of Americans will continue to do with reversible chronic diseases.

By treating the root causes of diseases with plants not pills, we can also avoid the adverse side effects of prescription drugs that kill more than 100,000 Americans every year, effectively making doctors a leading cause of death in the United States.

Here’s to keeping it simple and making those dietary and lifestyle changes!

I will be travelling over the next two weekends so the next newsletter will be sent out on October 25.

Regards,

Aditya

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