Our Investment Methodology

We begin our portfolio construction by looking at 30-year historical correlation ratios and 30-year historical Sharpe ratios to manage portfolio risk. From there, we then optimize each strategy (conservative, moderate, and aggressive) to maximize each respective ratio.

The Sharpe ratio is one of the most widely used methods for measuring risk-adjusted relative returns. Sharpe ratio is a measure of each asset class’s historical returns compared to its standard deviation. The higher the standard deviation of an asset class, the more significant return discrepancy we may experience from year to year, which is a measure of risk.

In an ideal world, we would want a portfolio of assets with high returns each year with a low standard deviation, which means it consistently delivers a high return. Unfortunately, this is very difficult to achieve as the asset classes with the highest return potential generally carry the higher risk potential. Since there is typically an inverse relationship between return and risk, the more stock exposure we add to a portfolio, the lower the Sharpe ratio.

For example, US aggregate bonds have a 30-year historical Sharpe ratio of 1.23 while US large stocks have a Sharpe of 0.65 in that same period. However, US aggregate bonds have only returned 5.7% vs. 11.2% with US large-cap stocks in that same period. In conclusion, US aggregate bonds have been very steady compared to US large-cap stocks leading to a better Sharpe ratio. With this in mind, we study 30-year historical Sharpe ratios to build optimal portfolios for each portfolio strategy.

After constructing our portfolios, we then allocate our portfolios based on a variety of economic factors. There are over fifteen economic factors that we actively utilize for our portfolio strategies but we’ll highlight two here:

One of the more important economic factors that we allocate portfolios around is interest rate movements. If you’ve heard the saying, “Don’t fight the Fed, invest with it” or “Follow the Fed,” there is a strong historical correlation for this. In the chart below we’ve highlighted how growth vs. value stocks perform based on interest rate movements. As interest rates increase, we assume borrowing costs become more expensive. If borrowing costs become more expensive, companies and consumers will likely reduce their spending and borrowing, slowing the economy.

10 Year Treasury Move

On the other hand, when interest rates decrease, companies and consumers are likely to take advantage of the lower rates and subsequently increase their spending and borrowing. The movement in rates is often dictated by the Federal Reserve who has the ability to change the overnight lending rate of banks. Therefore, as they act, rates can go higher or lower depending on their monetary policies. If we consider the impact of the Federal Reserve, and more broadly, interest rates, we believe it makes sense to adjust your portfolio strategy based on interest rates. This impact of interest rates is visible in the historical returns below.

A second economic factor that we adjust our portfolios around is inflation. As inflation rises, it increases the cost of borrowing. Inflation also increases company input costs such as materials and labor. Each of these, in turn, reduces the expectations of earnings growth. If earnings slow down because of inflation, there will be downward pressure on stock prices. Historically, growth companies are most sensitive to this because they carry much higher price-to-earnings multiples due to higher expectations for growth. Similar to the impact of interest rates above, this impact is also visible in the historical returns below.

Inflation Move