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SKARBECK: 'Conservative' strategies can lead investors astray

September 5, 2015

Ken SkarbeckWhat does it mean to be a conservative investor? Most of us would describe ourselves as conservative, which usually means we don’t want to take risks that will lose money.

Yet in certain circumstances, investors might believe they are taking a conservative approach, only to discover they were exposed to unforeseen risks. Investors in oil master limited partnerships that were paying high-dividend yields have found that out in the past year. When dividend yields are much higher than the norm, one must ask why.

Standard industry practice would characterize a conservative portfolio as one that is broadly diversified and well balanced in a variety of assets that provide both growth and income. In contrast, our firm defines it as investing in assets at a significant discount to intrinsic value.

Perhaps a better word than conservative to describe the oft-used methods of portfolio management is “conventional.”

Under the conventional “pie chart” approach, a broad asset allocation strategy means including a variety of investments such as stocks, bonds, real estate and alternative assets into your portfolio. The diversification helps eliminate risk under the guise that, if one slice of the portfolio is losing money, another slice will perform better. Thus, the zigs and zags get canceled out, providing a portfolio that is less “volatile” and that increases in value as the economy grows.

Unconventional portfolios can also reward investors while mitigating risk, although it is unlikely they would pass the industry’s definition of conservative. Here, investors who identify assets at bargain levels have less need for diversification. Their investment safety is obtained by acquiring assets at a discount to their underlying value.

For example, many would say it’s not conservative to invest in a stock at $1.03 per share, even though the firm has announced it plans to liquidate and distribute anywhere from $1.05 to $1.25 per share. Some brokers wouldn’t even allow the purchase of this security, labeling it a “penny stock.” Yet the same firms will gladly recommend their list of “leveraged-alternative” exchange traded funds for investment.

Fixed-income investments have always been considered conservative. Today, is it more conservative to buy a 10-year Treasury bond yielding 2.2 percent on the cusp of an interest rate increase or to buy shares in IBM that yield 3.25 percent and have a price-earnings ratio of 9?

Is it more conservative to invest in a portfolio of 10 different mutual funds that charge 1.5 percent in annual expenses and might hold a cumulative 1,000 stocks and bonds—including many that overlap—instead of investing in a bond and stock market index fund that charges 0.05 percent in fees?

Is it conservative to invest in a variable annuity that guarantees you will at least get your money back after 10 years, but restricts your liquidity with exorbitant withdrawal fees and offers a menu of mutual funds with annual fees of 3 percent?

It has been a while since investors have had to deal with a sizable drop in the stock market. Right on cue, the media’s anointed pundits are out in force spreading fear and confusion. Tune them out. The U.S. economy is in decent shape and there are some really cheap stocks worth buying in this decline.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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