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  They claim that the only way to protect a portfolio against uncertainty when funds need to be withdrawn is to allocate assets among different classes based on today’s predictions and then rebalance periodically.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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July 15th, 2013

Portfolio Management – Part 2: Managing Against Risks Today

Risk Management Process

Risk Management Process

I bought my first stock with gift money and money saved from summer jobs when I was in high school in the hopes of trying to make some extra spending money.  So, obviously, I looked only for stocks that I thought, based on their charts, would appreciate fairly quickly.  When I was lucky enough to buy one that did appreciate 20-40% in short order I felt both smart and proud that I then had some extra spending money to buy some of the latest sweaters and shirts, to go out on dates and to replace the gas I’d used driving my parents’ car around.

I must confess, looking for winners was my exclusive objective for many years.  What I hadn’t done nor even gave much thought to was what most financial advisers recommend should be done first.  I never consciously evaluated my tolerance for risk (truthfully, I was actually a stock market gambler) nor my objectives beyond winning in the stock market game.

I’ve had friends tell me

  • they want to keep a year’s worth of their normal cash requirements on hand as insurance it might needed or
  • they want their investments to generate a high dividend or interest yield because they need the income for living expenses without having to dip into principal or
  • they pay 1-2% of capital to an investment advisor and wish they could manage their money themselves but just don’t have the time to do it or
  • they have always invested exclusively in fixed income securities because they liked the security and steady income stream it provided but with rates being so low they have to now look at some stocks; what should they put their money into now that’s safe, they ask?

Wall Street has an answer to these questions and concerns.  They can deal with investors who make the mistake of merely wanting to make money in stocks and they call it “portfolio management”.

SEI Investments Co. is a publicly-owned investment management firm who, according to their Yahoo Financial profile, provide wealth management and investment advisory services to corporations, financial institutions, financial advisors, high net worth families, banks and trust institutions, investment advisors, financial planners, not-for-profit organizations, and pension plans.  Like other similar firms, their service offering is neatly package in what they call a “client-centric approach to wealth management“.

According to a brochure they provide to prospective clients and investment advisors [I’ve added the emphasis]:

“Goals-based investing offers a client-centric approach to wealth management, above and beyond investment management. It allows the advisor to combine the traditional methodologies of modern portfolio theory with the latest research on investor behavior.


The value of a goals-based investment strategy is that it goes beyond traditional yardsticks like relative performance against a benchmark. The focus is on goal achievement, which is what distinguishes SEI’s approach from others. Investment strategies are specifically designed around client goals, and performance is measured by the clients achieving their goals.


Goals-based investing involves creating a separate portfolio for each goal, as opposed to lumping all assets into a single portfolio. Whether the client is saving for retirement, funding a four-year education, or passing wealth to their heirs, there’s an investment strategy specifically tailored to meeting that goal.”

Other investment advisory firms offer similar approaches.  For example, another describes their approach this way:

“Through personal discussions and/or use of a Risk Tolerance Questionnaire, goals and objectives based on a client’s particular circumstances are established. We then develop a client’s personal investment policy and create and manage a portfolio based on that policy. During our data-gathering process, we determine the client’s individual objectives, time horizons, risk tolerance, and liquidity needs. As appropriate, we also review and discuss a client’s prior investment history, as well as family composition and background.”

What these firms are really saying is that they will help you focus on your goals and then divvy up your assets into a number of different buckets, selecting mixes of investment offerings for each with different return, volatility and expiration.  They give you a feeling that you actually are in control of your financial future and that, when you achieve the goals you have set for each bucket, you have performed well even if those results are significantly less than the most common benchmark, the S&P 500 Index, over the same period.

Obvious from the quotes above is the fact that most professional managers believe their chances of holding on to customers improve if they can encourage their clients to focus on the risks of losing principal rather than opportunities for portfolio growth. Individuals can anticipate how much and when they might need to withdraw sums of money in the future than it is for them to figure out how much profit a company will earn in future years, what the risk is that the company will miss those projections and whether domestic and international economics will put the projections in jeopardy.

Investors have seen and, perhaps, experienced the financial pain and wealth destruction that bear markets and crashes have caused and are afraid of becoming victims themselves. So “investment advisory” firms help them anticipate what amounts they’ll need for certain in 2, 5 or 10 years for such expenses as college tuition, wedding, house or retirement – expenses that may exceed income at the time and will need to be funded by savings.  Advisors will then match those future financial demands with various funds they suggest which they believe will minimize the risk of not having the full amount when needed.  The more chucks of “capital expenditures” you identify in your personal financial plan, the greater the number of segregated funds you’ll set aside today.

Your projecting your future financial needs, income and assets may be financial planning but is it “portfolio management”?  Having someone tell you what asset classes and individual securities give the adequate returns with acceptable risk may satisfy your financial needs but does it provide the best management of your portfolio?  Should we attempt to insulate our portfolios against risks determined from our projected expenditure needs or from economic, industry and company risks?  Can individuals manage their portfolios in such a way that they contain portfolio risk yet still achieve better than adequate returns?

In the remaining articles in this series I’ll describe a portfolio management style that has worked for me and, perhaps, can work for you.

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July 9th, 2013

Portfolio Management – Part 1

Portfolio Management Puzzle

Portfolio Management Puzzle

A good place as any for jump-starting the blog after an extended absence is with a question I recently received from a new Instant Alerts Member.  It’s a vexing question for which there really is no easy or objective answer.  It’s a question I continually think about and search for answers to.  The question was:

If you where starting now, what number of stocks would feel is manageable and comfortable for starting a $50K or $100k portfolio?”

Those who’ve read my book know that I omitted the topic of portfolio management … the omission was not an oversight but intentional.  As a matter of fact, I had even considered the topic to be a follow-up second volume. Since the question was asked, however, I’ll begin answering it over the next several articles, comprehensive but not overly exhausting or esoteric.

Those who’ve searched for an answer on their own have discovered that there are hundreds of thousands of academic books and articles available on the subject of “stock portfolio management”.  The introductory paragraph of one such academic articles entitled “How Many Stocks Make a Diversified Portfolio?” in the The Journal of Financial and Quantitative Analysis of Sept, 1987 is typical of what you might find if you were to accumulate a couple of hundred such articles [my emphasis added]:

“How many stocks make a diversified portfolio? Evans and Archer concluded that approximately ten stocks will do …. rais[ing] doubts concerning the economic justification of increasing portfolio sizes beyond 10 or so securities ….. The primary purpose of this paper is to show that no less than 30 stocks are needed for a well-diversified portfolio.”

In the next section, the authors add [my emphasis added]:

“The risk of a stock portfolio depends on the proportions of the individual stocks, their variances and their covariances.  A change in any of these variables will change the risk of the portfolio.  Still, it is generally true that when stocks are randomly selected and combined in equal proportions into a portfolio, the risk of the portfolio declines as the number of different stocks in it increases.”

In the end, like most research in financial and investment management is constructed in a fantasy world with unrealistic or incomplete assumptions. For example, another textbook on the subject focuses on the process involved in managing the risk of a portfolio as contrasted with determining the criteria for portfolio management success.  The article summaries the process into the following steps:

“Portfolio management is a process encompassing many activities aimed at optimizing the investment of one’s funds.  Five phases can be identified in the process:

  • Security analysis
  • Portfolio analysis
  • Portfolio selection
  • Portfolio revision
  • Portfolio evaluation”

In short, most of the literature aims at identifying the ideal combination of various assets to construct a portfolio that offers the required trade-off between risk and return.  The approaches used, however, are complex, they assume that the state of the market at the time the analysis is irrelevant, they are indifferent as to the source of those investment funds (i.e., whether reallocated or new cash infusion) and often ignore the unique characteristics of the specific individual investor and assume they will balance risk against desired risk themselves.

In the next several posts I’ll give you my view of the best way for individual investors to manage their portfolios based on my own personal experience.  Rather than assuming from the start, as do the academicians, that the market is perfectly efficient and the future is known and measurable with near certainty, I start with a different set of assumptions:

  • Market timing is possible and an integral part of portfolio management
  • In some ways, stock selection is like buying a lottery ticket since no one can know with certainty what is the future of any individual stock
  • Because of the risks and uncertainties inherent in investing, we seek to optimize rather than maximize performance by continually comparing our performance against external benchmarks.

As this discussion of portfolio management unfolds, more basic assumptions will be added.  But for the time being it’s a beginning that underscores the difference in this approach to the classical academic one, a foundation for beginning to build a different approach to portfolio management for individual investors.

A member’s question launched this discussion so other topics that might be of interest or are puzzling you are welcomed.  They might include such topics as (not necessarily in this order):

  • How many stocks should be in your portfolio?
  • What is the nature of risk and can you actually inoculate yourself from it?
  • Is portfolio management different for a young investor adding new funds to their portfolio than a retiree with a stable portfolio?
  • Is portfolio management different if you’re investing in mutual funds, fixed income, individual stocks or ETFs?
  • How should a person’s investment horizon preference (for example, several months vs. several years) factor into their portfolio management practices?

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