by Rick Rubin

At Tufton Capital, we allocate portfolios based on our clients’ financial objectives, risk tolerance and time horizon, and we factor in our expectations for long-term investment returns.  For most clients, we manage balanced accounts that consist of diversified portfolios of stocks, bonds and cash.  Occasionally, a client asks us whether all their investments should be fully invested in stocks, because stocks have higher returns over time.  Our answer is usually … NO! A key reason to diversify your assets is related to a concept known as “correlation.”

How do we apply this concept to managing money?  Correlation quantifies the strength of the association between two variables.  Correlation is expressed as a value between -1 and 1, with 1 indicating perfect positive correlation and -1 indicating perfect negative correlation.  Our ultimate goal is to identify a portfolio of securities with high return expectations and with high negative correlation to each other (-1 or slightly under).  Said differently, we want to own securities that perform well in the long run and whose price changes do not track each other closely.

For example, we invest in stocks across a wide range of economic industries such as technology companies, utilities, financials, etc.  We like the long-term value characteristics of many technology companies (Microsoft, Oracle, Qualcomm), and yet we continue to have sizable investments in slower-growth utility and telecommunications sectors.  In part, we can justify these seemingly differing investment positions because of the “correlation” benefits.  That is, the technology sector’s stock prices behave quite differently than stocks in the other two sectors in the short term.

As compared to stocks, we view bonds and cash as “defensive” investments.  Typically, bonds we purchase tend to perform well when the stock market is weak.  In particular, U.S. Treasury bonds are viewed as a safe haven by investors, and these bond prices rise sharply during times of stock market turmoil (think 2008-2009 financial crisis).  Thus, we invest a portion of our clients’ money in U.S. Treasuries because these bonds have high negative correlation to the stock market.

We use stocks as the primary vehicle of producing capital appreciation, income and dividend growth for clients.  Stocks prices are volatile, and they can add stress to investors’ lives as they watch their investments fluctuate.  As your portfolio manager, we work to lower your portfolios’ volatility by using a balanced allocation and purchasing value-oriented stocks that offer a margin of safety.  It’s important to remember that even though stocks can be volatile in the short term, historically, stock returns far exceed the returns of bonds and cash.  Also, stocks protect a portfolio’s purchasing power against the negative impacts of inflation.

We believe above-average dividend yields of high-quality companies provide huge benefits to a portfolio.  One of the biggest advantages of reinvesting dividends is a compounding wealth effect.  Albert Einstein realized this concept when he said “compound interest is the eighth wonder of the world. He who understands it, earns it … He who doesn’t … pays it.”  Although slowly compounding dividends may not be as exciting as your friend’s hot stock tip, this strategy helps build and preserve your wealth over time.  We believe in owning shares of well established companies that consistently pay and grow their dividends!