February 11th, 2016

Subscribers Alerted to Imminent Market Sell-off

For those of you who aren’t subscribers, I’m sorry for you.  I’ve been warning my subscribers since last summer about the major correction we’re now suffering through.

You’re skeptical?  Here’s the post sent to members on Sunday, August 16, 2015.  The market closed at 2091.54 the previous Friday and within 7 trading days, on Tuesday, August 25, it closed at 1867.61, or 10.7% lower.

The question now is “Are we close to the bottom?” and “Is this a opportunity to pick up stocks at a discount?”  For my answers to whether the correction has bottomed and other questions, why don’t you join the other lucky investors who subscriber to Stock Chartist.


Next Chapter In Saga About to Begin

The longest novel, according to Wikipedia, was something called “Artamène ou le Grand Cyrus” written by Georges and/or Madeleine de Scudéry in 1649–53.  It was in 10 volumes, had 13,095 pages and 1,954,300 words.  Reading any long book takes patience and perseverance, about the same patience and perseverance demanded by the flat market we’ve had to work with over the last six month’s.

Even though the market is up 1.59% YTD, almost half of which resulted from last week’s 0.57% increase, I believe it’s the prelude of a “market reversal” that will begin soon after the Labor Day break and after everyone has returned from their summer vacations.  We’re about to open the next chapter in this correction saga (click image to enlarge).


S&P 500 - 20150814


I know this is beginning to sound like a broken record but there’s clearly been an erosion of bullish momentum.   We’ve can’t predict but what we are seeing is that the market is losing its bouyancy:

  • the lower boundary of the grand channel since the 2009 Crash bottom was broken in May,
  • pivoting channels emerged as the slope (small dashed lines) switched from ascending to horizontal (and looks now to on the verge of pivoting again to fully descending),
  • the 50- and 100-dma’s reversed their direction and are now descending,
  • the 50-dma has reversed alignment crossing under the 100-dma (average of past 50 days is now less than average of past 100 days).
  • Finally, adding to the weight of evidence, the 50- and 100-dma’s last week appeared to be acting as resistance obstacles preventing the market from checking its downward trend.

It seems to be so obvious to the naked eye that the market is losing steam that I can’t imaging anyone not seeing it and acting.  I can’t believe that every day that the market bounces on recovery, the CNBC or CNN Talking Heads are trotted out to give their “stock up on discounted stocks” spiel.  As quoted in a recent CNN Money article, for example:

  • “The U.S. is exhibiting tremendous resiliency and a lot of independence from the rest of the world,” said Seth Masters, chief investment officer at AllianceBernstein, and
  • “It leaves the U.S. looking attractive in relative terms. There’s a valuation premium on U.S. equities but perhaps that valuation is justified,” said David Lebovitz, head of the global market insights strategy team at JPMorgan Funds, and
  • “There’s every reason to believe this bull market continues. Unless you think we’re going to have a bear market soon — which we think is highly improbable — almost by definition the next move is higher” said Troy Gayeski, senior portfolio manager at SkyBridge Capital

We all know that charts reading is subjective but it’s incredible how there can be two so diametrically different interpretations of the same chart.  On the one hand there’s the my view of the chart we’ve been looking at for the past several months shown above.  Then there’s the following comment and chart from StockCharts.com:

“an inverse head-and-shoulders pattern could be taking shape since late May [in the SPY etf whose value is 1/10th of the S&P 500 Index]. With an overall uptrend, the inverse head-and-shoulders represents a consolidation within an uptrend and a bullish continuation pattern. A break above neckline resistance would confirm the pattern and target further gains. Typically, the height of the pattern (213 – 204 = 9) is added to the breakout for an upside target (213 + 9 = 222) [translated into a target of 2220 for the S&P 500 Index]…. The right shoulder looks like a falling wedge, which is typical for corrections after sharp advances. SPY surged from 204.5 to 213 in mid-July and then pulled back with a falling wedge the last few weeks. ”

StockCharts.com Inverse Head and Shoulders


An “inverted head-and-shoulders consolidation”?  A wedge after a sharp advance from 204.5 to 213?  Give me a break!  Both interpretations (the short-term StockCharts.com or the longer-term Stock-Chartist.com) can’t be right; one is going to be wrong.  “But that’s what makes a market.”  Obviously, we’re hoping we’re right.

The world economic fundamentals continue to deteriorate.  Oil and other commodities are falling stocking renewed fears of deflation.  And the Fed apparently may be “out of bullets” to fight it.  The Chinese currency revaluation put a scare in many central banks, the most significant of which are their neighbors in the Asian emerging economies, causing new fears of a currency war.  There are also rumblings again about Greece and its negative impact on the Euro and European economies.  Rather than their being a possible silver lining in these clouds, the next shoe to drop will more likely be a negative surprise.

We believe to be fortunate in having embarked on a conservative plan, taking “risk off” by liquidating positions to add to cash reserves and, selectively as conditions confirm our longer-term view, adding to our index short position.  When the “Death Cross” finally arrives [50-dma crossing under 200-dma], we’ll probably have wiped the Portfolio clean and add to the speculative Index short positions.

Only a few more trading days to suffer through and then, when the page is turned to a new chapter, the story could get really exciting.  At least I hope so because this has been an awfully boring book that I’m just about ready to give up on.

Technorati Tags: ,

July 11th, 2014

Lists of “Value” Stocks Often Miss Target

image“After 5 years of a bull market, the only place left to invest is in value names”
“The best protection in this volatile market are value stocks”

But how reliable are these sorts of claims?  Those promoting the approach offer lists of stocks that are considered undervalued typically when they meet such financial criteria as low price/sales, low price/book value, or high, stable and growing dividends. However, they rarely attach timeframes or price targets.

So I decided to do some “back testing”.  By searching the term “value stock lists”, I gathered a small random sample of such lists published in 2012-13; stocks in these lists met one or more of criteria that qualifies them as “value stocks” at the time.  I then compared their stock price on the publication date with that of twelve months later; as a benchmark, those changes were compared with against the S&P 500 change over the same period.  These were selected at random and space limitations prevented including more, I suspect others would show similar results:

  • MagicDiligence.com: “Top 10 Dividend Yields, Lowest P/S, and Lowest P/B Stocks” – 1/5/2012: “Every so often, MagicDiligence compiles a list of Magic Formula® Investing stocks sorted by their dividend yield, price-to-sales ratio, and price-to-book ratio for investors that like to use those metrics. The result produces a list of attractive value stocks for additional research.” The top 10 in each of the three metrics were:
    Value MagicDiligence
  • Valueline: “Value Line’s 6 Safe Dividend Stocks” – 11/22/12 : “Value Line is an independent investment research and analysis company that has developed a safety ranking methodology which focuses on the long-term stability of company’s stock price and financial standing.  The fund invests in companies that carry Value Line’s ratings of 1 and 2, representing the most stable and financially-sound dividend-paying companies and higher-than-average dividend yield, as compared to the indicated dividend yield of the S&P 500 Composite Stock Price Index.”  The top picks were:Value - Valueline
  • Forbes: “Return To Value Stocks: Cisco And Three Others To Buy” – 10/7/13 : “At ValuEngine.com we show that 77% of all stocks are overvalued, 40.8% by 20% or more. 15 of 16 sectors are overvalued 13 by double-digit percentages, seven by more than 20%.  This week there are four Dow components on this week’s ValuTrader watch list.”  The list included:Value - Fobes
  • SeekingAlpha: “12 Large-Cap Stocks Selling Below Book Value” : “Price-to-book ratio is used to compare a stock’s market value to its book value and it is calculated by dividing the stock price by the book value per share. The higher the price-to-book ratio, the higher the premium the market is willing to pay for the company above its assets. A low price-to-book ratio may signal a good investment opportunity, as book value is an accounting number and rarely represents the true value of the company.”Value - SeekingAlpha
  • 24/7 Wall St.: “Value Search: Dirt Cheap Tech Stocks” – 7/10/10:…” when you get companies that trade under 10-times believable forward earnings expectations and which have low multiples of sales and even a low implied book value, this is where value investors tend to focus.  Whether a turnaround comes or not might not even matter if stocks get “cheap enough” for the value investors.”Value - 24x7

The hit rate (performance exceeding that of the benchmark S&P 500 Index) of the 60 stocks for this random sample of five lists was 50%, not much better than randomly selecting 60 stocks from any or combination of the major Indexes.

We’re continually subjected to academic studies purporting to show the failure of technical analysis.  For example, Stockopedia had a piece entitled “Technical Analysis? 5 Reasons To be Sceptical about Charting in which they quoted an academic study that back tested the effectiveness of “5000 technical trading rules” grouped into four categories:

  • Filter Rules – prices move of various percentages.
  • Moving Average Rules – prices move above or below a long moving average
  • Channel Break-outs – prices move above or below a channel (trading range)
  • Support or Resistance Rules – prices move a certain percentage above or below a maximum or minimum price a number of periods back.

;The study concluded that “no evidence that the profits to the technical trading rules we consider are greater than those that might be expected due to random data variation.”

I’ve now turn the tables and measured the effectiveness of some fundamental trading rules.  Although perhaps subject to criticism for being insufficiently rigorous, I convinces me that there is “no evidence that the profits to the fundamental trading rules are greater than those that might be expected due to random data variation“.

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.

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.

Technorati Tags:

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.

Technorati Tags: ,

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.

Technorati Tags:

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?

Technorati Tags: