I can remember the feelings of panic and helplessness in the huge slide of 2000 - 2002 when I did not have any strategy beyond what might be charitably called a vague intent to ''buy low - sell high'' (which turned out as often as not to be the reverse). Truth be told, vestiges of the random bargain-hunting thought process have manifested themselves lately when reading the prices of the banks like the Royal Bank and the Bank of Nova Scotia, which look cheap and are tempting to buy. But I am suppressing those successfully (so far, at least!) with reminders to myself that they don't fit into the plan.
Authors like Benjamin Graham, Richard Deaves, Richard Ferri and others caution that an investor's own erratic and emotion-driven behaviour is the investor's worst enemy. I am finding that having a clear and specific investment plan is helping me avoid doing anything rash like panic selling and is helping me feel calmer and in control. (Of course it always possible that we are in a financial Titanic having hit a seemingly innocuous debt iceberg, but I will at least look dignified going down with the ship.)
In short, here are the investing principles I am now trying to follow:
- create a specific plan, i.e. one with numbers; writing it down also helps
- make sure the plan is reasonable, e.g. explain it to your wife/husband, father, mother, uncle, best friend, co-worker, financial advisor and see if they are nodding in agreement and understanding or have puzzled and disbelieving looks on their faces afterwards
- follow it; if necessary, enlist someone's moral support; if the plan doesn't seem right, go back to the first two steps
Stumble It!
8 comments:
I couldn't agree more. I can recall looking at various mutual funds I owned in 2000/2001 and switching the poorest performers into money market funds.
Now that I have a bit of education of how risk/reward works (there will be some volatility to deal with) and can look ahead to a longer term, it's much easier to deal with the ups and downs.
Now if equities lose 90% of their value like in '29, that will be a true test of our investment plans!
Mike
I'm a true believer in "Modern Portfolio Theory" which is the mother of asset allocation. If you want to read up on it: Journal of Finance 1952 (I think October), Author: Harry Markowitz, Title: Portfolio Selection. Incidentally he won the Nobel prize for that article 38 years later in 1990 when the rest of the finance world caught up to his thinking! :)
I generally stick to putting 80% of a client's portfolio into a "Modern Portfolio Theory" portfolio, and we can take sector and style bets with up to 20% for those who "like playing the game".
Preet, when you make the ''sector and style bets'' do you use ETFS, mutual funds, individual stocks? And when comes time for rebalancing, is the 20% vs 80% re-established?
My reason for doing the sector and style ''bets'' is the non- or negative-correlation characteristics of those types of assets with the main equity and fixed income assets. However, I am not of the opinion that it is a bet in the sense of being more risky or a foolish flyer type of thing. I think it's a well-justified (by much financial research of other experts) core approach.
Sector and style bets can be made with any of those vehicles you mentioned, yes. All depends on the client's comfort level and knowledge.
There are some other non-correlating asset classes/vehicles that I like adding in there too. Infrastructure (usually closed end funds) is starting to become considered its own asset class by institutions - very low correlation with developed markets overall, and very low volatility for the returns. Given the gridlock inherent in a lot of countries these days, and the amount of attention that is needed to city infrastructure it is easy to see why - the amount of money being poured into maintenance and overhaul is growing at an alarming rate and is still considered not enough. Couple that with explosive growth in Chindia - and infrastructure is starting to take up 5-10% of my portfolios.
Water is another "asset class" as you will see more and more funds and mandates focused on water - there is a book out "blue gold" that talks about this.
Private equity funds are a good asset class to add as well. I have to admit I didn't realize the size and scope of private equity until a few years ago. For all the companies that earn over $100 million in revenues in North America, over 2/3 of those companies are private. So the exchanges represent only 1/3 of the mid to large caps in North America! Seems silly to preach diversification and limit yourself to 1/3 of the market...
I like Kensington in that space as well. They sort-of have a "fund of fund structure" in that they are a limited partnership that has not only their own private equity portfolio, but the fund also owns pieces of other private equity LP's. Low correlation with public securities - but valuations are funny because there is no bid/ask on a daily basis. On the other hand, these guys don't buy companies unless they can make big returns - so they are cash rich which is fine by me (due to no longer paying dividends).
I could go on and on... but when you find other low-correlating asset classes it will move the standard efficient frontier up and to the left.
I do like debentures too, I feel if someone is comfortable owning a company's secured debt, why not get a better yield for their slightly less secured debt? Convertible debentures offer some great arbitrage if you watch them enough too... Makes me wonder just how efficient and rational the markets are when price mis-matching occurs between convertible debentures and the underlying common stock...
I rarely use mutual funds, except for certain mandates. Won't use managed money for fixed income - any management fee will eat up 20% of the yield in the current environment. I'll actually create laddered bond portfolios (keeping them short) and bond ETF's (again, keeping short for the time being).
...oops, battery running low so I'll end here. Do want to add that I use the term "bet" not in it's strictest sense - don't believe in making uneducated guesses for the sake of it.
Cheers,
Preet
Okay, I'm plugged in now.
Generally speaking the 80/20 is not re-established unless the "20" appreciates drastically - then I prefer locking in gains and adding to the "Modern portfolio". If the "20" goes down, I leave it be and wait until it gets back up. Since the 20 is going to be slightly more aggressive than the 80 I don't want clients shovelling money back when the 20 is down because they believe more risk automatically equals more return.
In fact, the investment policy statement outlines all times that rebalancing is required, what the criteria is for adding or removing any investment etc. So nothing is "unexpected" and there is a game plan for all market conditions and events.
As an example for right now, someone's 20 might be adding to Yellow pages to take advantage of the 8.5%+ yield, and shifting to Banker's acceptances, along with buying BCE and getting the 13% return till delisting. The BA's and cash from BCE can then be deployed later when calmer markets or other opportunities present themselves... I LOVE fund IPO's with warrants attached so long as it's from a reputable firm (i.e. I will listen to anything Connor Clark and Lunn pitch).
Just an example, not hard and fast. A lot depends on the client.
Preet, these are very interesting comments on the various possible alternative asset classes. Do you have any references to studies that have measured the non-correlation effects and and what combinations of portfolios have been constructed with what degree of benefit? It would certainly be fascinating to us ''asset class junkies''.
I'm beginning to wonder if a new portfolio construction method should be based on sectors like commodities, financials, manufacturing, utilities etc instead of geographic regions globally. The objective would still be to hold the total market as efficient market theory maintains but using a different breakdown. ETFs are getting to the stage where that would be practical for the individual investor.
That's a good point Outr.
It really seems in the last several years that diversifying geographically doesn't seem to have much effect anymore.
With so much trade going on between different areas of the world and most of the larger companies going global - it makes sense that all the major indexes are more correlated now than in the past (I don't know if this is actually true or not).
I know the US has a pretty diversified economy which is why VTI is pretty attractive. As a Canuck the best diversifier is anything non-Canadian.
Mike
Curious to some of the follow up comments: MPT (Modern Portfolio Theory) and asset allocation are not based on geographic diversification alone. One needs to diversify along numerous "axes".
Asset class (equity, fixed income, cash)
Geography (Canada, EAFE, EM, US, etc.)
Market cap (Large, Mid, Small, Micro)
Sector (Energy, Material, Financials, Consumer Discretionary, etc.)
Credit Rating (AAA, AA, A, BBB, etc.)
Management Style (Growth, Value, Deep Value, Arbitrage, M&A, Blend, etc.)
And those are just the top level. For example within Fixed income one really should be analyzing how much is Gov't vs Corp. Within Gov't --> Fed, Prov, Muni. etc.
There are literally hundreds of "ingredients" as I like to call them that make up the universe of selection for your portfolio. MPT takes each of these ingredients' past performance (50 years plus) and if there are 3000 different combinations of these ingredients (think of them as recipes) then maybe 250 lie on the efficient frontier.
To make sure we are on the same page, the efficient frontier is the edge of the correlation matrix of risk vs return. If one person has a long term rate of return of 7% and a standard deviation of 15, and one person has a long term rate of return of 7%, but an SD of 10, then the latter is closer the efficient frontier. The efficient frontier is the "least amount of risk (standard deviation) possible for an expected rate of return." If you plot Return on Y axis and Risk (SD) on the X axis, you will find that the curve approaches a horizontal asymptote as risk increases. Therefore, since risk increases exponentially with return there comes a point where you just can't expect a higher long term rate given the almost quantum leap in risk you have to accept to get it.
Digressing: of the 3000 "recipes" of the different ways to combine the various "ingredients" that can go into your portfolio, maybe 250 were found to lie on the efficient frontier.
So now you can either figure out your risk tolerance and KNOW what long term rate you will get (in theory) or you can find out return rate you want and KNOW how much volatility you can expect at a minimum. In either case, wherever the point lies on the frontier will have a given "recipe".
Alternative asset classes (non-correlating) only serve to move this curve up and to the left.
And to make a long story short, I will try to source the data I have seen. I remember clearly the graph which shows the effect on the frontier with Private Equity, Mezzanine financing and Infrastructure, but all three were provided by different third party sources.
I suppose what I'm trying to say is that asset allocation, or moreso, Portfolio Construction is much more advanced than the public perceives, and becoming closer to that of institutional management (i.e. pension funds). Pension fund management is where all the GOOD portfolio managers end up BTW. That is why 75% of managers don't beat the index. I truly believe this. Their jobs are infinitely more complex than managing a fund trust. They have ongoing withdrawals through the active pensioners that they have to account for, along with the additions through payroll, changing life expectancies and longer time horizons. They migrated to MPT eons ago. (Proper MPT, that is.)
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