Build Your Own Investment Portfolio, Part 5

Teresa, March 19, 2008 @ 8:30AM ET | Link | RSS | Read via Email | 1 Comment  

I had expected Part 4 to be the last of the series, but after it was published, two things happened to warrant more articles:

  1. A (presumably) well-meaning skeptic wrote to me and ended up giving me all sorts of grief about portfolio construction. I didn’t think it was possible for the world of investing is an even bigger sideshow than trading, but then again, there is a lot more commission and advisory dollars at stake so anything goes. In trading, they always use the “well chosen example”; with portfolios, they dazzle and blind ‘em with statistics. Asset allocation is easily infused with the air of scientific precision, making it simple for vendors to pull one over their clients who in turn, hold on to their belief as dogma.
  2. One of my long time clients had trouble implementing the model portfolio because Fidelity provides limited investment options for his retirement plan. We came up with a client profile: professional, owns a house, 15-20 years from retirement, takes full advantage of an employer-matched plan, has 3 dollars in the retirement account for every dollar in the trading account. I then built a core/satellite portfolio combination that accommodates the needs of our archetype client.

In this article, I review two roadblocks that prevent people from reaching their investment goals.

Roadblock #1: Average Annual Return vs. Compound Annual Growth Rate

Figures often beguile me, particularly when I have the arranging of them myself; in which case the remark attributed to Disraeli would often apply with justice and force: “There are three kinds of lies: lies, damned lies and statistics.” — Autobiography of Mark Twain

19-xirr.gifIs it possible for a manager to claim 25% annual return while a client’s account balance remains unchanged after two years? The answer is a resounding YES.

The most egregious lies told in the investment world revolve around performance, the measurement of returns. Games are played with benchmarks, total return vs. nominal, and of course, arithmetic vs. geometric return.

Unscrupulous timing services, funds and managers tend to use arithmetic averages. In our example, the manager loses $50,000 of the initial $100,000 in the first year; the return is -50% for the first year. The manager makes $50,000 to bring the account back to $100,000 by the end of the second year; they count the second year return as 100%.

Using arithmetic averaging, the manager will claim that their “average annual return” is 25% return per year [(-50% + 100%) / 2 years]. In real life, your $100,000 is still $100,000; the compound annual growth rate (CAGR or geometric return) is ZERO.

Had the manager made $40,000 in the second year, the client would only have $90,000 left while the manager could advertise a two-year average annual return of 15% [(-50% + 80%) / 2 years], enough to recuit new clients to replace the burned ones.

Arithmetic averaging always inflates returns. For your money, insist on the geometric average.

Further Reading:

Roadblock #2: Spinoza’s Conjecture

While many people take pride in being contrarians, the thinking man’s skeptic refrains from immediate knee-jerk, tar-them-all-with-the-same-brush reactions. Being contrary is not the same as having an informed contrary opinion.

Michael Shermer recently reported a study by neuroscientists Sam Harris, Sameer A. Sheth and Mark S. Cohen:

Several psychological studies appear to support [17th-century Dutch philosopher Benedict] Spinoza’s conjecture that the mere comprehension of a statement entails the tacit acceptance of its being true, whereas disbelief requires a subsequent process of rejection. . . . Understanding a proposition may be analogous to perceiving an object in physical space: We seem to accept appearances as reality until they prove otherwise.

Let’s use a timely example. We are presently witnessing a tumultuous time in global capital markets. Everyone is bashing the Fed as if they are somehow unique in their understanding of the situation. How would you classify each article on the list below?

Few people possess the insight needed to particpate in a nuanced discussion of monetary policy; therefore, the majority have positioned themselves to simply be contrary, forever consigned to repeat mainstream rhetoric. What’s even more amazing is this: it was only 13 years ago that a strong U.S. Dollar was the devil.

Spinoza must be laughing in his grave.

Further reading:

CLICK HERE to read Part 6.

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  1. Damian on March 19th, 2008 12:10 PM

    I think the world is increasingly divided into extremes of opinion - so the you have two groups shouting very loudly: one says “Everything is fine” [Realtors Association, CNBC], the other says “The world is about to end.” [Everyone on Safe Haven]

    I remember reading somewhere that “It’s never as good as you think, and it’s never as bad as you think.” - meaning that we live in the grays, not the extreme.

    What one has to consider, I think, is that all of these commentators have an agenda - it’s either a talk-up of their book/strategy/portfolio, or getting advertising dollars. This is why I stopped reading most financial “news” (aka opinion) years ago - because it is, by it’s nature, flawed.

    “Few people possess the insight needed to particpate in a nuanced discussion of monetary policy; therefore, the majority have positioned themselves to simply be contrary”

    I think they may possess the insight - but does it benefit their position?