In the world of investing, it's natural to seek out strategies and models that have delivered attractive short-term performance - especially after a rough year for both stocks and bonds. However, we have noticed a troubling trend of limiting the starting universe for the iQ Portfolio Optimizer to only those models that were positive (or nearly so) in 2022. This approach fails to harness the full capabilities of the optimizer and disregards the importance of historical correlations.
It's important to bear in mind that although this approach may yield an impressive client presentation, it lacks intellectual integrity and can have negative consequences in the long term.
In this blog post, we discuss the risks of a "what's working now" approach to building portfolios and emphasize the importance of a broad starting universe in order to unlock the true potential of a portfolio optimizer.
THE DANGER OF CHASING SHORT-TERM WINNERS:
By forcing the portfolio optimizer to select only from models that have shown positive performance in recent times, we risk falling into the trap of a short-term performance bias. Here's why:
1. Neglecting Historical Correlations: A robust investment strategy considers the historical correlations between different models and strategies. By limiting the starting universe to only those that have performed well in a specific period, we overlook the interplay of diverse models that may have historically complemented each other during various market conditions. This approach can lead to a lack of diversification and increased vulnerability to market downturns.
2. Putting the Advisor Behind the Eight Ball: Relying solely on investments that are currently performing well can put the advisor at a disadvantage. Markets are dynamic and constantly evolving. By adopting a "what's working now" mindset, we risk being late to the game, potentially missing out on emerging opportunities or being exposed to inflated valuations.
3. Cheating Ourselves from Optimizer Benefits: The primary purpose of a portfolio optimizer is to combine various models and strategies to maximize returns while managing risks. However, by constraining the starting universe to only models that have positive recent performance, we restrict the optimizer's ability to identify the most optimal combination. We cheat ourselves out of the full benefits offered by the optimizer, limiting the potential for long-term portfolio growth.
UNLOCKING THE TRUE POTENTIAL OF A PORTFOLIO OPTIMIZER:
To harness the full power of a portfolio optimizer, it is crucial to provide it with a wide-open starting universe. This allows the optimizer to consider the historical correlations and interactions between models and strategies. Here's how this approach benefits us:
1. Diversification and Risk Management: A wide-open starting universe enables the optimizer to identify diverse models that have historically exhibited low correlation with each other. This promotes effective diversification, reducing the portfolio's vulnerability to market volatility and downturns.
2. Long-Term Perspective: Investing is a journey that requires a long-term perspective. By embracing a broader range of models and strategies, we position ourselves to capture opportunities across various market cycles, mitigating the impact of short-term volatility.
3. Maximizing Risk-Adjusted Returns: A portfolio optimizer excels at finding the optimal balance between risk and return. By allowing it to explore a wide range of models, we increase the potential for superior risk-adjusted returns over the long run.
CONCLUSION:
It is crucial to remember the principle of "garbage in, garbage out" when utilizing a portfolio optimizer. By imposing limitations and attempting to produce a portfolio based solely on positive performance in a given year, we hinder the optimizer's true capabilities. This approach defeats the purpose of portfolio optimization, which aims to create a well-balanced and diversified portfolio that maximizes long-term returns while managing risks effectively. To fully benefit from the optimizer, we should have a wider view and let it take historical correlations into account. This way, it can create portfolios that match our long-term investment objectives.
A portfolio comprising investments that all experience positive performance simultaneously is likely to suffer collectively during downturns, whereas a portfolio consisting of models that do not move in sync will always have some positive contributors to offset underperformers and maintain overall stability.