This past Sunday the Denver Broncos, led by one of the NFL’s all-time greatest quarterbacks, were crowned champions of Super Bowl 50. They won the game just as they had won so many others this season, relying almost exclusively on their league leading defense to hide their offensive woes as age and injury took their toll on Peyton Manning.
Just as they had done with Tom Brady and the Patriots in the conference championship game, Super Bowl MVP Von Miller and the Denver defense were successful in shutting down Cam Newton and one of the league’s most productive offenses this season. Once again, the old adage was proven true.
Defense wins championships.
Forgive me for working yet another sports analogy into my blog. It’s certainly not the first time and probably won’t be the last. But, when I think about how we go about constructing portfolios and determining optimal investment strategies for our clients, a “defense first” mentality is definitely part of that process.
Think of building a portfolio as building a sports team. Different investors are suited to different styles of investing just as different franchises draft teams tilted more towards offense or defense based on their available resources, coaching style and short or long term goals.
As a refresher, asset allocation is simply the mix of stocks, bonds and cash in a given portfolio. When determining what mix is right for a particular client, we look at their ability to handle varying degrees of ups and downs in value throughout their investment experience. We also look at how much growth is necessary to provide the client’s lifestyle and income needs. We then recommend the asset allocation we believe best suits those needs and invest accordingly. In a sense, it’s determining how much of the portfolio is tilted towards offense (stocks) and how much is tilted towards defense (cash & bonds).
But, what kind of defense should we run? Do we want a lot of individual performers or a team based approach? The analogy here goes to support why we choose to use bond funds as opposed to individual bonds. Individual bonds, while potentially all-star performers in their own right, can become downright busts if rates move in the wrong direction. The bond market, as we’ve blogged about in the past, can be tricky in terms of knowing exactly what those individual players are worth at any given time and equally difficult at times to find a buyer to give you fair value for that player.
Funds, on the other hand, give you a true team approach. If one or two players falter, you have the benefit of lots of other bonds within the fund to keep from pulling the whole team down. In addition, as players get older (closer to maturity) and maybe their rates can’t cut it anymore (i.e. old bonds paying 2% when rates have climbed to 4%), funds have players constantly going into retirement with new players being brought in at the newer, more attractive rate. Sure, this can work against you in the short term if rates move lower instead of higher, but at least you’re certain you’ll always be relatively competitive with the rest of the league (the market).
The last piece of the puzzle is determining your defensive style. How much are you willing to risk on the defensive side of the ball? In the NFL, you have some defenses that take lots of risk. They focus on stripping the ball from a runner or grabbing interceptions at the risk of missing and having the runner or receiver break a big play. Other defenses prefer to be more stodgy and conservative. They know their role and stick to the fundamentals of strong tackling and tight coverage.
When it comes to portfolios, we believe in letting our offense (stocks) take the bulk of the risk and use our defense to provide a buffer for the volatility we know that offensive risk will create. In the bond market, as I blogged recently, you have the ability to take arguably more risk than you do with stocks depending on how far out on the quality and duration curves you choose to go. When it comes to the defensive side of our portfolios, we want that block & tackle approach, a defense that performs exactly as we expect when we need it the most. Using shorter term, higher quality bonds in our portfolios allows us to operate with confidence in stocks knowing that, when we go through tough markets, the tough, stodgy defense will be there to provide for clients’ income needs while we wait for our offense to heal.
A high powered offense is exciting to watch. It’s fun to talk about. The best quarterbacks, home run hitters, goal scorers and the like almost always get the limelight. But, it’s the defenses and other measures put in place to protect those offensive pieces that win in the end.
Having a clear sense of what you’re hiring the different parts of your portfolio to do, making sure they’re doing their job and making adjustments over time based on where you are on the field and how much time is left on the clock is the best recipe available, both on the field and in the market.
Have a great week!