Build Your Own Investment Portfolio, Part 3

Teresa, March 6, 2008 @ 5:00PM ET | Link | RSS | Read via Email | Start a Discussion  

In Part 2, we reviewed the cornerstones upon which an investment portfolio is built: total return, asset allocation policy, Vanguard’s nine commandments, and rebalancing.

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Which fund should we buy?

Before proceeding to portfolio construction, let’s do a crash course on performance evaluation using a real-world example with three famous funds. If you are a quant, please avert your eyes. ;-)

Slow and Steady Wins the Race

The point of this exercise is to raise awareness among investors that — all else being equal — low volatility of returns is preferable to high volatility of returns. In other words, a lucky jackrabbit might dodge a few bullets but in all probability, only the tortoise will finish the race. Regardless of how attractive the “track record” of a stock or a fund may appear on the surface, it is the volatility of its performance from month to month that seals the fate of their investors.

The three funds we will analyze are listed below, including their policy regarding the use of leverage (borrowed money):

  1. Warren Buffett’s Berkshire Hathaway: BRK.B
    Leverage: BRK is an operating company that generally uses low levels of financial leverage. Bruni & Co reported that, in 2004, Buffett said “people tend to underestimate low probability events when they haven’t happened recently, and they tend to overestimate low probability events when they have happened recently.” He noted that it was his nature (and Munger’s) to think about low probability events, and that a ‘transformative’ catastrophe is less likely to come from natural causes (earthquakes, etc.) than from man-made causes, especially in financial markets. He also noted that “almost anything can happen in financial markets . . .[but] the only way really smart people can get clobbered is through the use of leverage . . . [because leverage] can keep you from playing out your hand.” Buffett added that, unlike some hedge funds, “we just don’t believe in lots of [financial] leverage.” A financial calamity may be painful for those affected by it, but it can also provide opportunities for others. Buffett noted that “Wall Street is awash in high IQ talent, yet extraordinary things [in financial markets] happen.” He noted that in 2002, when junk bond prices fell to ridiculous levels (and represented amazing bargains), some of the high-IQ Wall Street types wouldn’t buy them; yet now, when they are much more expensive, these same people are buying.
  2. Bill Miller’s Legg Mason Value Trust: LMVTX
    Leverage: “When cash is temporarily available, or for temporary defensive purposes, when the adviser believes such action is warranted by abnormal market, economic or other situations, the fund may invest without limit in investment grade, short-term debt instruments, including government, corporate and money market securities and repurchase agreements for such investments. If the fund invests substantially in such instruments, it will not be pursuing its principal investment strategies and may not achieve its investment objective.”
  3. Ken Heebner’s CGM Focus Fund (PDF): CGMFX
    Leverage: “The Fund may borrow for the purpose of purchasing portfolio securities and other instruments. The Fund may borrow from banks in an amount not to exceed one-third of the value of its total assets and may borrow for temporary purposes from entities other than banks in an amount not to exceed 5% of the value of its total assets.”

Analyzing weekly and monthly returns

On the surface, it would appear that investors would prefer CGMFX over BRK.B over LMVTX. Let’s crunch the numbers and see what they say. We took the weekly and monthly closing prices of the funds from Yahoo Finance and calculated the weekly and monthly percent change to obtain the return for the respective periods. We started in October 1997, the first month that all three funds were in existence. We compared the three funds against the S&P 500 Index.

We calculated the standard deviation of the monthly returns since 1997. This simple statistic indicates the percentage by which a fund’s performance has varied from its average performance in any given month since that time. The higher the standard deviation, the greater the range of performance, indicating greater volatility.

Monthly Returns and Standard Deviation
We can see that the S&P 500 Index has the lowest SD; the worst one-month performance was about -15%. The worst month for BRK.B was about the same while LMVTX was nearly -20%. CGMFX, with their use of leverage, had a number of -20% months.

We also looked at the dispersion of the dots to determine if the fund is a jackrabbit or a tortoise. Are they spread all over the graph? Are there a lot of down months?


Standard Deviation = .0425


Standard Deviation = .0590


Standard Deviation = .0591


Standard Deviation = .0845

Weekly Returns and Standard Deviation
We zoom down to weekly returns and the data tells much the same story as the monthly data. We can see that CGMFX has been down as much as -20% in a week with many -10% weeks ; if an investor had owned this leveraged fund on margin, the losses would have been stunning.


Standard Deviation = .0235


Standard Deviation = .0340


Standard Deviation = .0298


Standard Deviation = .0391

Weekly Performance Since 2002

We zoom in on weekly performance since 2002 for two reasons. First, we can see recent performance up close. Second, we illustrate visually the point of building a portfolio — to combine asset classes — is to diversify with the goal of reducing the volatility of returns:

In conclusion, even though CGMFX was by far the best “performer”, the investor might not have enjoyed much performance if he had purchased the fund at certain times. Its roller coaster performance makes it hard for a shareholder to stay the course.


Standard Deviation = .01753


Standard Deviation = .021265


Standard Deviation = .023011


Standard Deviation = .034741

The InVivo Model Portfolio

Our unleveraged model portfolio began in late-2002 when the ETFs required for our chosen asset classes became available. As we can see, diversification and a little engineering brought down the volatility of returns to a very narrow band.


Standard Deviation = .00756

In the next article, I will show you how we put it all together.

Additional Reading

CLICK HERE to read Part 4.

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