Build Your Own … Investment Portfolio

Teresa, February 25, 2008 @ 10:30AM ET | Link | RSS | Read via Email | 4 Comments

After completing Part II of Build Your Own Trading System, I spent nearly a week contemplating Part III. In the end, I realized that I was stuck. There was just no way to dumb it down.

Over the past ten years, I have answered untold thousands of emails. My general impression is that over time, particularly over the last two years, Main Street has developed extremely high expectations for trading.

Infomericals, system vendors and Forex brokers attract novices with get-rich-quick schemes; people really believe that a trading system can be pointed at anything in any time frame at any leverage and their account will be flooded with money.

While trading is not rocket science, it is probably harder than most people imagine it to be. The profitability of a directional trader is affected greatly by both the choice of trading vehicle, time frame and most of all, leverage. Trading techniques and systems provide decision and logistical support, but cannot replace skilled security/time frame selection and low leverage.

After some reflection, I decided to proceed with something useful and interesting for a change, something that all of my clients want to know more about: how to craft an all-weather investment portfolio. Besides, one should really have the long-term money sorted out before embarking on trading. Even Jim Cramer would agree that speculation should only be done with “mad money.”

It may sound strange to want to write about something as simple as investing, but trust me on this one: good investment advice is hard to find. Decent investment models are top secret. Successful navigation of sales literature filled with smoke, mirrors and fine print is no mean feat.

Compared to trading, constructing an all-weather investment portfolio is a tractable and elegant challenge. I originally planned to cover it after Chapter Seven of Own The Zone, so without further ado, here it is.

From Investor to Trader and Back Again

My participation in the capital markets began in 1982, as an investor of mutual funds. Stocks were historically cheap. By the time the Crash of 1987 took place, I was already working in the securities industry. The event had a long-lasting effect, not just on me, but on a generation.

The Dot com Crash of 2000-2003 had a lasting effect on another generation. What everyone learned was that investing for the long-run is bogus. Or is it?

In my opinion, the popular perception that long/short trading is preferable to long-term investing is a reflex to avoid pain: that timing has the potential to help avoid losses. If the market always went up, there would be no reason to conduct directional trading; therefore, the sole purpose of timing is to avoid the downturns. And the crashes.

There may be many reasons to trade, but as I eventually learned from the quants, trading in and out of an entire asset class such as U.S. domestic equities just to avoid downside “buy and hold” risk is simply not necessary. Even if Ben Stein says so [DOWNLOAD PDF].

Types of Risks

Countless studies and anecdotal evidence provide overwhelming support for academic research that concludes individual investors generally do themselves no favors. They tend chase performance — amongst the 50 ways to lose money — in effect buying high and selling low. Few even know about the logistics of trading, particularly the dangers of leverage.

In effect, obvious sources of risk that can be managed easily are virtually ignored. Instead, the focus is on price risk. But there is more, a lot more. Quants consider the following:

Market Risk - unexpected changes in prices or rates.
Credit Risk - changes in value associated with unexpected changes in credit quality.
Liquidity Risk - the inability to adjust positions.
Operational Risk - fraud, system failures, and trading errors.
Systemic Risk - breakdown in market-wide liquidity, chain-reaction default.

On Main Street, the average trader or investor worries about market risk. They may unwittingly take on liquidity risk playing low-volume stocks. Credit, operational and systemic risk is back-of-the-mind stuff, unless one happens to be a permabear newsletter guru getting rich by selling conspiracy theories or making predictions about the end of the financial system as we know it.

Required Reading

Keep It Simple, Says Yale’s Top Investor
For most people, he recommends a very basic approach: use index funds, exchange-traded funds and other low-cost instruments, and stick to your long-term asset allocation — even when the markets are in tumult. Don’t be distracted by market forecasts, he said. “You have to diversify against the collective ignorance,” he said. “I think nobody is in a position to react to these big macro-issues. Where is the dollar going to be or what is G.D.P. growth going to be in China? For every smart person on one side of the question, there is another smart person on the other side.”
The Hidden Fees in the 401(k)
Butler uses the example of a person who invests in the Fidelity Freedom 2020 Fund to show one way investors wind up paying more. If a person buys the fund from Fidelity, he pays a fee of 0.76 percent, Butler says, citing Morningstar Inc., which tracks fees and returns. An investor who buys the same fund through a 401(k) may pay 0.25 percentage point more via a so-called 12b-1 fee. This fee is designed to offset the 401(k)’s marketing and other expenses. The amount ceded to fees widens as investors lose the benefit of compounding returns during decades of working. An employee with $25,000 in his 401(k) and 35 years until retirement would see his savings reach $227,000 if the fee is 0.5 percent and he earns a 7 percent return, the Labor Department says. If the fee is 1.5 percent, the balance will be $163,000–28 percent less. “Fees of that size provide a powerful head wind to sail against,” Kasten says.
Simplification and Saving
Many financial decisions that individuals face are complicated and daunting for those who are not financial experts. One important consequence of this complexity is that individuals procrastinate in making these decisions. In this paper, we evaluate a low-cost intervention designed to simplify the retirement saving decision. Individuals received the opportunity to enroll in their workplace savings plan at a pre-selected contribution rate and asset allocation. By collapsing a multidimensional set of options into a binary choice between the status quo and the pre-selected alternative, this intervention increases participation rates by 10 to 20 percentage points among affected employees. We find that similar mechanisms can be used to increase contribution rates among employees who are already participating.
$100 Bills on the Sidewalk: Suboptimal Investment in 401(K) Plans
It is typically difficult to determine whether households invest optimally. But sometimes, investment incentives are strong enough to create sharp normative restrictions. We identify employees at seven companies who are eligible to receive employer matching contributions in their 401(k) and can make penalty-free withdrawals for any reason. For these employees, contributing less than the match threshold is a dominated action that violates the no-arbitrage condition. Nevertheless, between 20% and 60% contribute below the threshold, losing as much as 6% of their annual pay. Providing employees with information about the free lunch they are foregoing fails to raise contribution rates.
The Flypaper Effect in Individual Investor Asset Allocation
We document a flypaper effect in asset allocation: securities received in kind “stick where they hit.” We study a firm that twice changed the rules governing the securities in which its 401(k) matching contributions were initially invested. Both of these rule changes were economically neutral: employees were always free to immediately reallocate their match account balances. However, we find that most employees neither reallocate their match balances, nor offset employer-initiated changes in the match allocation by adjusting the allocation of their own contributions. Consequently, these rule changes caused dramatic shifts in participants’ 401(k)portfolio risk. After examining several alternative explanations for this flypaper effect, we conclude that it is largely due to a combination of passivity and mental accounting.
The Asset Allocation Debate: A Review and Reconciliation
This paper reviews several aspects of the asset allocation debate and offers observations to reshape or provide a fresh perspective on the debate. We start with the most widely discussed debate: the determinants of return variation (the focus of Brinson, Hood, and Beebower’s well-known 1986 study) versus the determinants of return (the heart of Jahnke’s 1997 critique of Brinson). We explore the impact of the sample used in the Brinson study on the results of the study and the implications for an investor with a broader set of investment options. We then suggest a refocusing of the debate to those matters critical to investors, namely whether active management increases return or decreases risk. Finally, we review the current debate over dynamic versus static asset allocation policies and conclude that the market-timing component of dynamic allocation makes it problematic.
Oldies But Goodies
Toward the end of 2007 I was working on accumulating material for a course in behavioral finance that I am teaching this semester (and a great source for future columns). In the process, I rediscovered many fascinating and important articles that had significantly influenced the way we manage our practice. The experience led me to wonder if perhaps we spend too much time looking for the next paradigm shift and too little time seriously considering the significance of the current paradigm. . . . As a consequence, I decided that this month’s column would introduce readers to what I believe are seminal articles that have (or should have) influenced the way we manage our practice.

CLICK HERE to read Part 2.

Join the Discussion

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George on April 26th, 2008 12:20 AM

well what an education, who would have thought all this. i am lucky i have survived. but i have not seen anything yet about the trading porfolio. i ll keep reading and see what else i cn find
Teresa on April 27th, 2008 12:53 PM

Portfolio Strategy is uploaded on Sunday afternoon (and also sent via email).
Daniel on April 30th, 2008 3:31 PM

Teresa & Peter,

You will like this article. :-)

Daniel
Teresa on May 7th, 2008 10:44 AM

What’s interesting is their observation that “[i]n this information age, stocks are traded primarily over computer networks linked to the hub at the New York Stock Exchange building, which seemingly would reduce the need for physical proximity. But the firms moved closer, sometimes by just a few blocks, in order to be able to execute trades just a few milliseconds faster, explained fellow commerce professor Stefano Grazioli.”

What they don’t mentione, of course, is that the firms make little money from trading compared to investment banking and corporate finance activities. This requires proximity, because the people from the firms must network. Can’t do that over the internet.

Build Your Own … Investment Portfolio

From Investor to Trader and Back Again

Types of Risks

Required Reading

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Build Your Own … Investment Portfolio

From Investor to Trader and Back Again

Types of Risks

Required Reading

More Articles from Our Blog

Recent Comments and Discussion

Join the Discussion

For Investors

For Traders

Read Blog By Category

In My Library

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