August 23rd, 2013

Portfolio Management – Part 5: The Hidden Cost of Diversification As “Insurance”

Risk and Opportunity

 

In economics, risk is defined as volatility. Furthermore, one truth of economics is that high risk accompanies high return while low risk means lower return. Investment managers put us in a dilemma when they play on our fears by asking us to take the safe course by accepting low volatility and lower returns. They want to convince us to diversify away from the higher volatile and higher return of stocks by adding a large dose of lower volatility/lower return fixed income securities to our portfolios (the standard is a 60/40% mix). But what are the sorts of risks they warn us of? How likely are they to actually materialize?

Investor advisors essentially try to convince us that sometime in the future, they don’t know what or when, our portfolio could be significantly impaired sometime in the future if we don’t diversify to reduce its volatility, probably just when we need to liquidate some of the assets to provide funds for a specific large expenditure like tuition, a wedding, a 25th anniversary trip, extraordinary medical costs, job loss or retirement. They claim that the values of our portfolios are vulnerable to a wide range of real world risks, including:

  • Company risk from
    • financial or operating performance which, if the market perceives to be negative, adversely impacts the price of that company’s stock
    • technological risk
    • competitive risk
  • Industry risks including
    • government regulation
    • product or technological obsolescence,
    • international competition
  • Economic risk arising from
    • either governmental fiscal or monetary policy,
    • international events and
    • inflation risk
    • interest rate risk
    • exchange rate risk
  • Political risk

There’s no question that these sort of “risks” can actually happen; they happen all the time but how significant is that risk? For the time being, let’s put aside individual stock risks and focus instead on risks that influence most stocks, the economic or political risks that are characterized as “systemic” risks. No one knows what, how or when these sorts of risks will become real events but, when they do, their impacts are huge and affect nearly every single stock. As a matter of fact, in today’s global investment climate, they impact most investment vehicles both domestic and foreign stocks and bonds. There’s usually no place to hide, no safe haven. These risks often manifest themselves as stock market crashes.

For example, the recent Financial Crisis Crash significantly damaged real estate values, cut stock prices in half and even brought down international stock markets. Because of the fear of financial collapse and corporate failures, the value of all debt with the exception of US debt was also adversely impacted (until the Fed stepped in with their Quantitative Easing program that drove debt values higher and interest rates down).

Since the stock market suffered two major crashes in the past decade, investors are especially loathe to invest in stocks. Investment managers play on these fears and push such strategies as the “Ultimate Buy-and-Hold Strategy” as a panacea. But how unusual were the events of the past decade and how likely is it that they and other risks will occur over the long-run future? Should any of these risks materialize, what sort of impact might they have on the stock market and a stock price volatility? Putting individual companies risks aside for the moment and instead focusing exclusively on systemic, total market risk, we find that the probability of significant stock market declines (i.e., declines of more than 15% in a year) are actually quite rare:

Risk Dimensions

There have been 894 months over the past 75 years since 1939 when, during that period, the market suffered monthly declines 41% of the time however in 57%, or more than half, those declines were less than 2%. In fact, during any single month, almost none of those declines were more than 10%.

What happens when the holding period is extended to a year? During the 882 rolling, sequential 12-month periods, 70% ended in a gain; 12 month loss occurred in less than 30% of the cases. In fact, many of those declines were bunched together in short time periods since they occurred during extended market crashes. In the 30% of cases when there was a loss at the end of 12 months, the losses were less than 10% more than half the time. The market increased fairly regularly over the past 75 years and the increases have been substantial:

Profit Opportunities

The market closed higher in 70% of the 12-month periods since 1939 and in almost half of those instances the gains were 10% or more; in a third of those periods, the gain was 15% or more. Among the nearly 900, shorter 2-month holding periods, the market advanced 62% of the time and nearly half of those gains were 2% or more.
One way of interpreting the trade-off presented by the market In the very short-run (i.e., each and every single month):

  • hold stocks for a month for a near 60% likelihood of capital growth with a 35-40% probability that the growth would be 2% or more and
  • a 30% likelihood of a capital loss that has a 57% probability of being less than 2%.

For two months is succession, clearly enough time for someone to evaluate the market’s longer-term risk and adjust a portfolio’s exposure to that risk the market, a typical trade-off is:

  • hold stocks for two month for nearly a 62% likelihood of capital growth with a nearly 50% probability that the growth would be 2% or more and
  • a 37% likelihood of a capital loss that has a 44% probability of being less than 2%.

The past 75 years probably cover nearly every possible type of macroeconomic, technological and geopolitical event and the above statistics summarize the stock market’s reaction to them all. Could the future introduce anything more dramatic than these and could the stock market’s behavior in the future be much different? I think not. These statistics cover all sorts of market conditions including:

  • World War II, Korean, Viet Nam, Iraq and Afghanistan and the first attach on U.S. soil,
  • two secular bear markets (the 1970′s and the 2000′s), crashes (Tech Bubble of 2000-2003 and Financial Crisis of 2007-2009)
  • 17-year bull markets (post war 1949-1966 and 1962-2000)
  • technological upheavals with the beginning of space age, biotechnology, PC’s and the introduction of the Internet into everyday life
  • major geopolitical events like the fall of Soviet Union
  • global economic crisis including the 20-year Japanese economic winter, Federal budget and debt ceiling crisis and the launch and near collapse of the Euro
  • presidential assassinations, resignations and near impeachments
  • natural disasters including hurricanes, earthquakes and tsunamis
  • market flash crashes and the largest single day stock market loss of 22.6% on October 19, 1987

Even though they say they are looking out for you personally, the typical investment manager has many clients and protects you through a cookie-cutter, one size fits all approach. You don’t want your manager to be a passive manager but instead an active one continually reacting to ever changing environments.  Instead of paying your investment advisor fees to continually anticipate extreme yet relatively infrequent market declines, expect them to navigate around major declines when and if they happen. You should expect them both to protect your portfolio and to earn returns greater than could be earned by owning an index fund.

During the next parts of this series, I’ll discuss my approach that’s less costly than the “insurance premium” by intentionally foregoing profit opportunities (higher volatility); that approach is to incrementally, in part or totally, move to the sidelines when volatility increases in the wake of bear markets and crashes.

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August 8th, 2013

Portfolio Management: Part 4 – “Preservation” or “Growth”? Why Not Have Both

Asset Allocations

 

The debate about portfolio management centers on whether one needs to “predict” or “react” for good performance.  The professionals settle that for themselves by claiming that since no one can predict the future, the best anyone can do is to diversify into many different asset classes (i.e., equities, fixed income, commodities, currencies, domestic and foreign, income and growth, large and small capitalization).  Economists like John Mauldin fall into this camp.  He and other perma-bear economists have been seeing top for most of the last 10-15% of the market’s move.  Mauldin recently wrote:

“This is a terrific time to take some profits and diversify away from the growth-oriented risk factors that dominate most investors’ portfolios. Instead of concentrating risk in one asset class or one country, investors can boost returns and achieve more balance by taking a global view, by broadening the mix of core asset classes, and by weighting those return streams to achieve balance across potential economic outcomes (rather than trying to predict the future) …..

 

broadening this mix of core assets – so that you have some element of your portfolio that responds positively to every potential economic season – and managing the relative allocations to each economic scenario may be your biggest opportunity to add value in the investing process.  You have a lot to gain from diversifying as broadly as possible, eliminating unrewarded costs, reducing your reliance on equity risk, and reining in the emotional mistakes that often lead investors to dramatically underperform.”

What these portfolio managers don’t understand is that one doesn’t necessarily have to predict where the market will be next week, next month or next year.  They claim that the only way to protect a portfolio against uncertainty when funds need to be withdrawn is to allocate assets among different classes based on today’s predictions and then rebalance periodically.  But an alternative approach is to aim for the highest returns while at the same time reacting and responding to abnormal and unexpected volatility immediately after it occurs.

In the previous article about the “Ultimate Buy-and-Hold Strategy” , the basic premise was that by assembling a specific mix of asset classes for a very long time (actually, 42 years) you would have reduced the volatility of a portfolio without significantly and not reduced its return.  However, nearly everyone would agree that, looking back with the benefit of hindsight, it would have been wonderful to have had the foresight to assemble a portfolio in 1970 and hold it until today, or 42 years.  But would that same approach produce the best results if you were to assemble the portfolio today, at the end of a 13-year secular Bear Market?  Thirteen years hence would we be better off if we assumed today that the next 13 years would be more similar to the 1982-2000 Bull Market than either the secular Bear Markets of the 1970′s and 2000′s?

We can’t predict the future but the odds are that the next 13 years won’t be even similar to the past 13 years.  Using the same data as Merriman’s, the “Buy-and-Hold” portfolio management approach delivers much different results had the portfolio started at different points and had different end dates?  As an alternative test, four hypothetical $200,000 portfolios were split into two parts, 60% in equities and 40% in fixed income, and rebalanced annually.  The annual returns since 1970 for equities and fixed income securities came from the St. Louis Federal Reserve Bank.  The four test portfolios were:

  • 1970-2012 (the 42 year “buy-and-hold” base case),
  • 1982-1999 (the last 17 year secular bull market),
  • 2000-2012 (the current 12-year secular bear market) and
  • 1970-1982 (the previous 12-year secular bear market).

There’s no question that, regardless of when the Portfolio was originally created, the 60/40 blended portfolio would always have been less volatile (as measured by the standard deviation of the portfolio’s annual change in value) than a 100% stock portfolio but more volatile than a 100% fixed income portfolio (click on images to enlarge).

Portfolio 1970-2012
Portfolio 1970-1982
Portfolio 2000-2012
Portfolio 1982-1999 But what is also true is that at end of the holding period, your portfolio would be worth more if you had been 100% in stocks than if you had blended in a percentage of fixed income …. sometimes much more.  As a matter of fact, if you had started your portfolio at the beginning of 1982 and held it somewhere close to the top of the Secular Bull Market when the Tech Bubble burst, then your portfolio would have delivered an average annual 19.12% and wound up worth 166% of the 60/40% mix and 388% of a fixed income only portfolio.  [Due to the spectacular decline in interest rates since the crash of the real estate bubble in 1977 - a trend that was as unprecedented as the secular bull market of the 1980-90's - a fixed income portfolio would have out-performed an equity portfolio by 152% but neither delivered much more than 7.2% average annual return for the 12 years.]

As I see it, you shouldn’t have to pick a single goal.  Are you wealthy enough to focus on “preservation” rather than “growth” in your portfolio?  Are you so preoccupied in other matters than you can’t react to changes in trend of any particular asset class; remember, both the Tech Bubble burst and the Financial Crisis evolved over 6 months.  Catch up on the major economic and business news once a week, make only incremental adjustments (i.e., not more than 10% of the portfolio at each decision) and you’ll be able to manage your portfolio.  You don’t need to predict the future you only need to review, react and respond as changes demand.  Portfolio management shouldn’t be day-trading but it can be more than just a “buy-and-hold” portfolio.  You can generate growth as well as preserve your capital.

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July 29th, 2013

Portfolio Management: Part 3 – Is Passive or Active Better?

Portfolio Management Action Reaction

In the previous article, I accused investment managers of encouraging their clients to “focus on the risks of losing principal rather than on opportunities for portfolio growth“.  I suggested that their aim was to match what you identified as future demands on your finances “with various funds they believe will minimize the risk of your not having the full amount when it was needed.”

This was reinforced to me when I came across an article in MarketWatch, entitled “The Ultimate Buy-and-Hold Strategy” by Paul Merriman in which the author states that his approach works “in portfolios big and small, doesn’t rely on predictions or require a guru or special knowledge of the markets or economy.”  He claims that his overriding goals are to build portfolios that deliver returns that exceed those available in “industry standard 60%stock/40% fixed income allocation” portfolios while subjecting investors to no additional risk as measured by the standard deviation of the Portfolio’s fluctuations.

To prove that his portfolio had returns greater than 8.5% and a standard deviation of no more than 11.6% (the long-term experience of a typical “industry standard portfolio”), Merriman assumed creating a hypothetical $100,000 in 1970 and allocating the funds into index funds and exchange-traded funds.  He concluded that over 40 years, “by far the biggest contributor to investment success (or lack of it) is your choice of asset classes.”  In other words, it’s not when you bought but what you you bought and that you not trade any of the individual securities during the period that improved results.

The conclusion sounded similar to notions I’ve heard over the years from the Efficient Market Theory crowd, the folks I wrote about extensively in my book, Run with the Herd.  According to the theory,

“Many investors think success lies in buying and selling at exactly the right times, in finding the right gurus or managers, the right stocks or mutual funds.  But being in the right place at the right time depends on luck, and luck can work against you just as much as for you.  Your choice of the right assets is far more important than when you buy or sell those assets.  And it’s much more important than finding the very ‘best’ stocks, bonds or mutual funds.”

Merriman takes a step-wise approach to assembling his “ultimate” portfolio by starting at the 60/40 mix and then adding higher return, lower volatility asset classes in relatively arbitrary proportions.  He then measures how much $100,000 would have grown to over 42 years, rebalancing the portfolio annually to keep the percentages fixed and what the volatility (how much the portfolio might have fluctuated over the period) might be.   The process results in the following model portfolio (right column is the end result):Buy and Hold Portfolio

The advice offered by most investment advisers is similar to  Merriman’s Ultimate-Buy-and-Hold Portfolio: assemble a portfolio of a diversified list of ETFs or mutual funds (which translates into hundreds or thousands of individual securities) and hold it for the long run (20 to 30 years).  It doesn’t matter when you by only that you hold the portfolio long enough for economic growth to make up any and all bear market draw downs (i.e., losses).   So the trickiest part of the Ultimate Buy-and-Hold Strategy is matching the right level of risk for each individual investor’s financial needs, in other words, the most important asset-class decision an investor makes is what percentage that investor should have in stocks and how much in bonds to his portfolio’s volatility to his future financial needs.

The final makeup of the Ultimate Buy-and-Hold Strategy is in the right-hand column and this hypothetical portfolio would have generated an average annualized return of 10.5% (compared with the 60/40% portfolio return of 8.0%) with a much lower volatility (11.7% vs. the standard portfolio of 17.0%) over 42 years.  However, at the end, Merriman discloses the caveats (my emphasis added):

“Every investment and every investment strategy involves risks, both short-term and long-term.  Investors can always lose money.  The Ultimate Buy-and-Hold Strategy is not suitable for every investment need.  It won’t necessarily do well every week, every month, every quarter or every year.  As investors learned the hard way in 2007 and 2008, there will be times when this strategy loses money….. this strategy requires investors to make a commitment.  If you are the kind of investor who dabbles in a strategy to check it out for a quarter or two, this strategy probably isn’t for you.  You may be disappointed, and you’ll be relying entirely on luck for such short-term results….. [the strategy] is not based on anything that happened last year or last quarter.  It’s not based on anything that is expected to happen next quarter or next year. It makes no attempt to identify what investments will be “hot” in the near future…. strategy is designed to produce very long-term results without requiring much maintenance once the pieces are in place.”

But here’s another catch!  According to Merriman, ” the best way to implement this strategy is to hire a professional money manager who has access to the institutional asset-class funds offered by Dimensional Fund Advisors (DFA).”  So is the study unbiased?  Is it self-serving?  Was there be any doubt as to what the study’s conclusions would say?

There’s wisdom in the saying “timing is everything” or it wouldn’t have survived for as long as it has?  You could still be trying to break even on a portfolio of large tech stocks like Cisco, Oracle, Microsoft, Ebay and Amazon had you bought them in 2000, at the peak of the Tech Bubble.  If you had bought your home in 2006 hoping that it would continue increasing in price and some day be your retirement nest egg then you’d have to put off retirement since it fetches a 10% lower price today.  You could have sold the gold coins inherited from a grandparent for $750/ounce in 2009 thinking the precious metal prices just couldn’t possibly continue increasing but recently discovered that it hit a peak of $1700 just two years later.  Or you might be that person who continues buying long-term government bonds today without questioning whether the secular bull market in fixed income securities be close to peaking; let’s ask them whether timing is important 3-5 years from now when his principal had declined 35% in value.

Timing does matter for individual securities, it matters when it comes to your portfolio and it matters for your financial well-being.  Portfolio management should be an active process not a passive one.  It’s a cop-out for investment advisers to tell you to predict your financial needs but not to try to predict the returns and future value of your investments.  There is an alternative.  There is a difference between predicting and reacting and it’s the same as the difference between gambling and managing your investments.  Market timing isn’t predicting the market’s future direction, it’s reacting to changes in the market’s trend as you see them taking place.  Strategies like the Ultimate Buy-and-Hold Portfolio doesn’t sound like management to me.  It sounds more like gambling that my portfolio isn’t depressed due to a bear market just when I need to unexpectedly withdraw funds or for planned needs.

The next article will focus on various types of risks and their relationship to portfolio management.

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