Mar

4

Building Your Investment Portfolio, Part 2

By Teresa | Filed Under Knowledge Base | Leave a Comment

In Part I, we discussed the reason why trading does not replace long-term investing. In this installment, we will review the cornerstones upon which an investment portfolio is built.

These cornerstones may be unfamiliar to most traders, but as John Maynard Keynes wrote, “The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future,” while directional trading is relatively a straight-forward beauty contest.

Cornerstone: Total Return

Traditional asset classes earn dividends and interest payments that compound over time to produce total returns. This fact is rarely mentioned in “avoid bear market” sales literature designed to promote trading as a “risk management” tool.

CLICK TO ENLARGE IMAGE

This chart shows the power of total return. The Dow Jones Industrial Average closed the first week of October 1987 at 2,640.99. The total return index (pink line) shows the true return for the buy-and-hold investor while the blue line is the index quoted in the newspapers. So the next time someone tells you that “the Dow has gone nowhere since 2000″, just smile and walk away.

The Dow Jones Industrial Average: The Impact of Fixing its Flaws [DOWNLOAD PDF]
Clemens Sialm; John B. Shoven, Winter 2000
Ignoring dividends dramatically underestimates the long-run returns earned by stock market investors. If Dow Jones & Co. had included dividend returns in the DJIA when it was formed in 1928, the index would be over 250,000 today.

Cornerstone: Asset Allocation Policy

As the old saying goes, do not put all eggs in one basket. We would go further to check that none of those eggs are rotten to begin with, and not always keep them in baskets. Some eggs should be stored in the fridge, while the golden ones should be locked in a vault.

How your assets are allocated will influence the returns on your investments a great deal:

Defining and selecting asset classes constitute initial steps in producing a portfolio. Many investors simply allocate among the asset classes popular at the time in proportions similar to those of other investors, creating uncontroversial portfolios that may or may not address institutional needs. By relying on the decisions of others to drive portfolio choices, investors fail to consider the function of particular asset classes in a portfolio designed to meet specific goals. — David Swensen, Pioneering Portfolio Management

Be on the lookout for managers that “tactically” shift their asset allocation to hot or “alternative” asset classes (that generally do not pay dividends or interest) to boost return. It’s market-timing in disguise. Investors must not chase performance, use hindsight and follow fads and fashion.

Cornstone: Vanguard’s Nine Commandments

Please keep in mind that Vanguard is not referring to buying-and-holding QCOM, TASR, CROX, AAPL, GOOG or any individual stock du jour as a long-term investment strategy like many retail investors do. They are referring to quality asset classes:

Successful investing is difficult. Some of history’s most successful investors, such as my friend Warren Buffett, were early to understand the now well-documented anomaly that the rate of return on stocks, even adjusted for risk, exceeds that on less-risky bonds and other debt instruments, provided one is willing to buy and hold equities for the very long run. “My favorite holding period is forever,” said Buffett in an interview. The market pays a premium to those willing to endure the angst of watching their net worth fluctuate beyond what Wall Streeters call the “sleeping point.” — Alan Greenspan, The Age of Turbulence

Vanguard’s Investment Philosophy [DOWNLOAD PDF]
Successful investment management companies base their business on a core investment philosophy, and Vanguard is no different. Although we offer many strategies with both internally and externally managed funds, a common theme runs through the investment advice we provide to clients.
Vanguard’s Investment Philosophy: We Believe #1 [DOWNLOAD PDF]
Investing is for meeting long-term goals; saving is for meeting short-term goals.
Vanguard’s Investment Philosophy: We Believe #2 [DOWNLOAD PDF]
Broad diversification, with exposure to all parts of the stock and bond markets, reduces risk.
Vanguard’s Investment Philosophy: We Believe #3 [DOWNLOAD PDF]
An investor’s most important decision is selecting the mix of assets to be held in a portfolio, not selecting the individual investments themselves.
Vanguard’s Investment Philosophy: We Believe #4 [DOWNLOAD PDF]
Consistently outperforming the financial markets is extremely difficult.
Vanguard’s Investment Philosophy: We Believe #5 [DOWNLOAD PDF]
Minimizing cost is vital for long-term investment success.
Vanguard’s Investment Philosophy: We Believe #6 [DOWNLOAD PDF]
Investors should know how each investment fits into their plans and why they own that particular asset.
Vanguard’s Investment Philosophy: We Believe #7 [DOWNLOAD PDF]
Risk has many dimensions, and investors should weigh “shortfall risk”–the possibility that a portfolio will fail to meet longer-term financial goals–against “market risk,” or the chance that returns will fluctuate.
Vanguard’s Investment Philosophy: We Believe #8 [DOWNLOAD PDF]
Market-timing and performance-chasing are losing strategies.
Vanguard’s Investment Philosophy: We Believe #9 [DOWNLOAD PDF]
An investor should not expect future long-term returns to be significantly higher or lower than long-term historical returns for various asset classes and subclasses.

Cornerstone: Engineered Portfolios

After establishing asset allocation policies, risk control requires regular rebalancing to policy targets. Movements in prices of financial assets inevitably cause asset class allocations to deviate from target levels. For instance, a decline in U.S. stock prices and an increase in bond prices leads stocks to be underweight and bonds to be overweight relative to target, causing the portfolio to have lower than desired expected risk and return characteristics. To restore the portfolio to target allocations, rebalancing investors purchase stocks and sell bonds.

Investors debate the frequency with which porfolios should be rebalanced. Some follow the calendar, transacting monthly, quarterly, or annually. Others attempt to control transaction costs, setting broad limits and trading only when allocations exceed specific ranges. Pursuit of continous rebalancing provides greater risk control with potentially lower costs than either the calendar or trading range approaches. — David Swensen, Pioneering Portfolio Management

After the appropriate asset classes have been chosen, the proportion assigned to each must be determined. The portfolio must also be rebalanced on a regular basis but things are never that simple. Do we allocate the assets based on discretion? Equal weight? Or something else? Do we rebalance daily, weekly or monthly?

Feb

25

Building Your … Investment Portfolio

By Teresa | Filed Under Knowledge Base | 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.

Feb

8

Build Your Own Trading System: Part Two

By Teresa | Filed Under Knowledge Base | Leave a Comment

The Greek mathematician Archimedes once said, “Give me a place to stand on, and I can move the earth.” Apparently many traders believe they can do the same.

In Part One, we made a checklist of the factors that must be addressed by any trading program:

leverage
position sizing (and pyramiding)
security/time frame selection
entry criteria
exit criteria/stop placement

Leverage is at the top of my list because it is the defining factor that determines how long a trader can expect to stay alive. Leverage undermines traders, both big and small:

[Long Term Capital Management]’s trading strategies were secret. …One thing was disclosed. LTCM used a lot of leverage. That was how they were able to obtain better-than-market returns from a nearly efficient market.

…In 1996 one of LTCM’s investors spoke by phone with several of the partners. …[he] learned that the fund was using leverage of about thirty times. For every dollar of investor money, the fund borrowed $29 more. — Fortune’s Formula

Hedge funds employing 20:1 leverage routinely go bust. Failure is typically not due to lack of skill; it happens because the higher the leverage, the smaller the adverse price move needs to be in order to wipe out the capital in an account.

A minimum of US$25,000 is required for active stock trading. Switching to options, futures, Forex or CFDs for the sole purpose of circumventing this capital requirement makes little sense. The reason is leverage. The higher the leverage, the larger the position size.

If you are trading Forex at 1:100 or can barely make intraday margin for e-mini futures, pray for a miracle that you will succeed where hedge funds failed. But you don’t have to believe me: code it up and see for yourself.

Doing it Right

By default, TradeStation allows users to select a fixed number of shares/contracts per trade (assumes that you can come up with the money necessary to buy X shares every time, regardless of stock price) or a fixed amount of money to deploy per trade (assumes unlimited funds, no margin). These are not real-world conditions.

NOTE: Tharp’s “R” and The Turtles “N” suffer from the same problem: the amount of capital required is open-ended and does not address the leverage issue.

One way to solve the problem is to turn the amount of capital the trader contributes and the amount of leverage he plans to use into inputs. This can be accomplished with a few lines of code. This approach also allows the trader to calculate return on capital.

The Code

The Effects of Leverage
How much leverage are you using?

Inputs: OwnCapital(25000), PercentOwnCapital(50);
Variables: nMarginFactor(0), Num_initial(0);

OwnCapital = the amount of cash the trader contributes
PercentOwnCapital = Buying Power/OwnCapital

For example, if OwnCapital = 25000 and PercentOwnCapital = 50, the trader would have buying power of $50,000 for the first trade. Another example: A pattern day-trader with OwnCapital = 25000 using 3:1 intraday margin would have $100,000 buying power, hence PercentOwnCapital = 25.

Next, since TradeStation keeps track of the account equity, we can use the reserved word NetProfit in our calculations. For example:

nMarginFactor = PercentOwnCapital * .01;

If Close > 0 Then
Num_initial = (OwnCapital + NetProfit) * (1/nMarginFactor) / (Close * BigPointValue)
Else Num_initial = 0;

I then add a couple more lines to perform a sanity check to make sure that the system never deploys more than margin allows.

Pyramiding can get a little tricky because several ducks must be lined up before adding to an existing position. First, the existing position must be profitable, or else there is no increase in account equity to play with. Second, the account must make use of margin in order to tap into the increase in equity. Third, traders may wish to impose additional conditions (above and beyond a simple increase in equity) before pyramiding.

TradeStation reserved word OpenPositionProfit becomes part of the equation. The way I do it is to calculate the maximum allowable position based on the account equity:

If Close > 0 Then
Num_max = (OwnCapital + NetProfit + OpenPositionProfit) * (1/nMarginFactor) / (Close * BigPointValue)
Else Num_max = 0;

Once again, I add a couple more lines to perform a sanity check to make sure that the system never deploys more than margin allows. Once Num_max is known, we use the TradeStation reserved word CurrentShares OR CurrentContracts to calculate the number of shares/contracts we can add:

Num_add = Num_max - CurrentShares;

The first pyramid is pretty easy; repeat pyramids may require a bit more code. Don’t forget to add Num_max(0) and Num_add(0) to the list of variables.

It’s all pretty simple; to think that commercial vendors refuse to add this is an indictment of their business practices. But then again, it pays to ignore the issue since “assumption of unlimited capital” guarantees that their systems will never go bankrupt like their users.

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