Multi-Method Investing

When we look at the world of investment management, we can break it down into 4 primary categories of investment method that can be used by an investor to attempt to achieve his or her goals. We’ve found through both proprietary and third party research that no single one of these methods is effective in all scenarios, but instead that each approach tends to have a particular market environment or part of the market cycle to which it is very well adapted. Our conclusion is that in order to achieve one’s life goals, one should diversify at the level of investment method, applying the most effective aspects of multiple completely divergent methods of investing, and not be dogmatic about using a single method. The broad categories of investment method can be seen as four pillars of a complete investment portfolio management methodology:


— THE 4 PILLARS —

1. Liability Driven Investing

LDI is often used by large institutions such as banks, insurance companies, and pension funds.

It is based on the concept of directly matching investor assets with the entity’s known, quantifiable risks and liabilities in an attempt to transfer these (and possibly market-related risks) to another party. It often involves the heavy use of fixed income (bond) instruments, and possibly derivatives.

2. Strategic Asset Allocation

Strategic Asset Allocation is the most widely utilized and accepted method of investment, based on the original work of Harry Markowitz and his contemporaries in the academic community in developing Modern Portfolio Theory. In practice it involves setting a predetermined percentage split between stocks, bonds, and other asset types (an asset allocation); diversifying by asset type and number of securities as much as possible within these categories; and rebalancing back to the original splits as market values shift (making target allocation changes only as necessary based on changes in the investor’s objectives, risk tolerance, and life cycle).

This is by far the most ubiquitously used method in the robo-advisor and passive investment communities.

3. Opportunistic Investing

Opportunistic Investing is a very broad category that encompasses a vast number of sub-categories, all of them sharing the goals of beating the market (either on the upside, the downside, or both) or (such as in 4Thought’s case) providing low correlation returns with the more traditional stock/bond portions of an investor portfolio. Many hedge fund strategies fit in this category, as do tactical asset allocation approaches and absolute return strategies.

Based on our definition, opportunistic strategies are mainly focused on taking advantage of asset class market timing opportunities, and not necessarily on opportunities related to individual companies or stocks.

4. Selective/Concentrated Investing

Selective or Concentrated Investing is the oldest form of investing, and involves taking positions in one or more individual companies or securities in an attempt to take advantage of some inefficiency related to the price of that security, to capitalize on an associated idiosyncratic risk of the stock, or in expectation of future growth in the company. Most private equity funds apply this method, as do the more selective “Value” and “Growth” styles of stock investing.

The basic idea is that by knowing as much as possible about the very few positions one is invested in and acting on information related to them, it may become possible to beat the market or a more diversified portfolio over the long term.

We’ve identified the Wolf Market and Eagle Market in addition to the traditional Bull and Bear portions of the market cycle to aid in understanding the four primary market environments that an investor may face and which methods are appropriate.

4Thought_MarketCycles_Bull.png

Bull

Characterized by investor confidence and rising asset prices, a Bull market will be best attacked using Strategic Asset Allocation.

4Thought_MarketCycles_Bear.png

Bear

Characterized by investor fear and declining asset prices, a Bear market will be best attacked using Liability-Driven Investing.

4Thought_MarketCycles_Wolf.png

Wolf

Characterized by investor uncertainty and volatile or sideways asset prices, a Wolf market will be best attacked using Opportunistic Investing.

4Thought_MarketCycles_Eagle.png

Eagle

Characterized by investor exuberance and soaring asset prices, an Eagle Market will be best attacked using Selective / Concentrated Investing.

Human thought is like a vast ocean of stupidity punctuated by tiny islands of incredible genius. The purpose of an algorithm is to string together these tiny islands and make the genius process repeatable while excluding the stupid human effects.

  • Human creativity combined with formulaic data-driven (algorithmic) investment processes
  • Multi-Method Investing for a new layer of diversity
  • High Impact Strategies, Low Cost Management
  • Specialization in Systematic Investing

Risk Premium Capital Allocation

We do not suggest that one attempt to predict which type of market environment is coming, but instead build a portfolio that may use multiple investment methods at the same time so that the overall portfolio is prepared for whatever contingency it may face. The question is: What methods should one use, when should one use them, and how much of each? The theoretical framework needed to answer this question is something we call Risk Premium Capital Allocation, which describes the optimal percentage allocation of an investor’s capital to various “Risk Premiums”. A “Risk Premium”, is the reward that can be captured by attacking a specific type of risk. The ability to capture different risk premiums is what we believe makes each of the 4 categories of investment management successful in their own respective Bear, Bull, Wolf, or Eagle market environment. We have identified four major risk premiums that may be capitalized on by investors:

  1. The “Systemic Efficiency Risk Premium” reaps rewards from accepting the risk of fluctuation of the global financial markets as a whole, and is best captured by Strategic Asset Allocation.
  2. The “Credit Default Risk Premium” can reap rewards from accepting the risk of a potential default by a guarantor, such as a bond issuer. Liability Driven Investing is the investment method that most effectively captures this risk premium.
  3. The “Cyclical Inefficiency Risk Premium” accepts manager-specific unsystematic (tactical decision making) risk and can be captured by opportunistic methods of investment.
  4. Finally, the “Secular Inefficiency Risk Premium” accepts security-specific unsystematic (concentrated security selection) risk and may be captured by selective or concentrated investment in specific securities.

These four risk premiums can be plotted on a chart to create an “efficient frontier” similar to the one used in Modern Portfolio Theory, that tells us the most optimal combination of risk premiums (and thus investment methods) for a range of investor objectives, and thus gives us our appropriate “Risk Premium Capital Allocation” (RPCA) for a given investor. The end result of creating and managing this multi-premium, multi-method approach is an aggregate investor portfolio that is better equipped to handle a much wider variety of market environments and contingencies. We believe that by doing the right investment planning and making practical investment decisions using the Risk Premium Capital Allocation theoretical framework we can help to increase the probability that an investor will achieve their financial goals.

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4Thought seeks to optimize the balance of risks in your portfolio. We re-define the concepts of risk, investment method, and diversification in portfolios to attempt to produce better outcomes for investors.