Mar

17

Greenspan: No Perfect Model of Risk

Teresa Lo @ 2:54 AM | | 3 Comments

Former FOMC Chairman Greenspan wrote a lengthy article in today’s Financial Times:

Credit market systems and their degree of leverage and liquidity are rooted in trust in the solvency of counterparties. That trust was badly shaken on August 9 2007 when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems - and the models at their core - were supposed to guard against outsized losses. How did we go so wrong?

The essential problem is that our models - both risk models and econometric models - as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all riskasset classes ensued.

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

Also by Greenspan: The Roots of the Mortgage Crisis

Mar

7

Building Your Investment Portfolio, Part 4

Teresa Lo @ 4:00 PM | | Leave a Comment

In Part 3, we showed readers that volatility of returns is a critical statistic when it comes to avoiding funds whose performance might vanish overnight: “those who live by leverage can die by it too. Some hedge fund investors deliberately steer clear of funds that earn 87% returns; they prefer those who aim for a steadier 10-12%.”

All else being equal, rational investors prefer low volatility of returns and use leverage to increase the amount of returns where appropriate.

Smoke and mirrors (and worse) are found all over the financial services landscape. In this installment, I cut through the crap and show you how I created my own portfolio. It may not be suitable for everyone, but the principles will apply to most individuals.

Stay with Traditional Asset Classes

Let’s just keep it simple and start at the top. Investment management practitioners divide asset classes into two broad groups: traditional and alternative.

Traditional = marketable securities (stocks and bonds)
Alternative = absolute return, real estate, private equity, credit derivatives, commodity and managed futures (depends on whose book you read)

Purity of asset class represents a rarely achieved ideal. Carried to an extreme, investors define dozens of asset classes, creating an unmanageable multiplicity of alternatives. While market participants disagree on the appropriate number of asset classes, fewer tend to be better. Portfolio commitments must be large enough to make a difference. Committing less than 10 percent of a fund to a particular type of investment makes little sense; the small allocation holds no potential to influence overall portfolio results. Investors trade off the benefits of precise definition of an asset class with the costs of employing large numbers of classes.

Functional attributes play the dominant role in defining asset classes, with structural and legal characteristics taking secondary positions. Asset class distinctions rest on broad sweeping differences in fundamental character; debt versus equity, private versus public, liquid versus illiquid, domestic versus foreign, inflation sensitive versus deflation sensitive. Ultimately investors attempt to group like with like, creating relatively homogenous groups of investments that provide fundamental building blocks for the portfolio construction process. — David Swensen, Pioneering Portfolio Management

The recent trend has been the creation of new alternative asset classes such as art and infrastructure, much like the proliferation of exchange traded funds to cover every possible investment nook and cranny. Perhaps these niche investments provide ways to diversify within an asset class, but fads and fashion are not for my nest egg.

Which Assets Do We Choose?

In Part 2, we demonstrated the power of compounding dividends and interest over time to produce total return. All assets in our core investment portfolio MUST earn interest or dividends; therefore, stick to traditional asset classes (stocks, bonds) and for U.S. investors, protect purchasing power with currencies. Asset classes that pay no dividends or interest can be actively traded for capital gains.

1. U.S. Equities
The outlook for U.S. stocks has been negative for a long time, but the fact is that factors favorable for investment are entrenched in this country. Investors rarely reflect on the economic framework and the stability of the United States:

Why is this relationship between the rule of law and material well-being seemingly so immutable? In my experience, it is rooted in a key aspect of human nature. In life, unless we take action, we perish. But action risks unforeseen consequences. The extent to which people are willing to take risks depends on the rewards they think they may gain. Effective property and individual rights in general decrease uncertainty and open a wider scope for risk taking and the actions that can produce material well-being. Inaction produces nothing.

Rational risk taking is indispensible to material progress. When it is impaired or nonexistent, only the most necessary actions are taken. Economic output is minimal, driven not by the calculated willingness to take risks but often as a result of state coercion. The evidence of human history strongly suggests that positive incentives are far more effective than fear and force. The alternative to individual property rights is collective ownership, which has failed time and time again to produce a civil and prosperous society. — Alan Greenspan, The Age of Turbulence

2. International Equities
I only invest in top-tier international stocks. Emerging markets that pay few dividends and “frontier markets” not suitable for the core investment portfolio.

3. Treasury Notes and Bonds
7-10 year U.S. Treasury bonds are ideal:

By holding portfolios of high-quality, long-term, noncallable instruments, investors emphasize the attributes of bonds that provide the greatest protection in times of financial crisis. When investors seek refuge from the volatility induced by panics, securities backed by the full faith and credit of the U.S. government outperform risky assets, sometimes dramatically. — David Swensen, Pioneering Portfolio Management

4. Cash
Cash can be very useful, but those holding U.S. Dollars know that it is not always king. What role does cash play in my portfolio? Well, cash can be denominated in many currencies. Investors can choose from a tight list of reasonably well-managed countries to achieve several aims. For example, currencies such as the Canadian and Australian dollars are good proxies for commodity exposure. Other currencies may yield attractive interest rates.

The balance sheet of the U.S. has been deteriorating for a number of decades. Everyone knows it, but few did the right thing. In December 2001, I did a couple of e*Trade radio shows and “discussed the Dollar’s test of the 120 level. We didn’t think that it would pass the test and our strategy for the long-term was to shift into gold and the Swiss Franc.”

This position was reiterated at my old website on July 28, 2003 and January 7, 2004. Until something drastic changes in Switzerland or the U.S., or a massive depegging of Chinese and GCC currencies take place, the Swiss Franc will remain the core hedge for those earning or saving in U.S. dollars.

Asset Allocation Vehicles

Next, we determine how to deploy our assets. My vehicles of choice are exchange traded funds because they allow us to invest with low administrative costs and help reduce transaction costs upon rebalancing. In fact, our model U.S. core portfolio requires only four ETFs:

The SPDR S&P 500 (SPY) allows us to invest in the S&P 500 Index. I prefer this traditional cap-weighted index because, in effect, it buys stocks as they rise in price and sells them when they falter. Over time, the cap-weighted index functions as a Darwinian mechanism, ensuring that irrelevant companies are continually eliminated from my holdings.
The MSCI EAFE Index Fund (EFA) allows us to invest in publicly traded securities in the European, Australasian and Far Eastern markets, as measured by the MSCI EAFE Index.
The Lehman 7-10 Year Treasury Bond Fund (IEF) seeks to approximate the total rate of return of the intermediate-term sector of the United States Treasury market as defined by the Lehman Brothers 7-10 Year US Treasury Index.
The CurrencyShares Swiss Franc Trust (FXF)** is designed to track the price of the Swiss Franc net of Trust expenses, which are expected to be paid from interest earned on the deposited Swiss Francs.

**Some investors may be in position to hold Swiss Francs in an interest-bearing account, which is a fine alternative so long as transaction fees are competitive with brokerage fees.

As an aside, there has been a multi-decade argument going on since the publication of the Determinants of Portfolio Performance (DOWNLOAD PDF) by Brinson et al. Rather than wade into the debate, I shall let David Swensen have the last word:

Investors often treat asset allocation’s central role in determining portfolio returns as a truism. It is not. The Brinson, Singer, and Beebower study describes investor behavior, not finance theory. Imagine a buy-and-hold portfolio consisting of one (particularly idiosyncratic) stock; portfolio returns follow largely from security selection. Or consider the strategy of aggressively day-trading bond futures; market timing dominate returns.

Obviously, institutional portfolios usually consist of more than one stock and rarely engage in day-trading strategies. Instead, investors hold broadly diversified portfolios and avoid market timing, causing portfolio asset allocation targets to be the most important determinant of investment results. Given the difficulties in timing markets and selecting portfolios of securities that will outperform, such behavior provides a rational foundation for investment management. By avoiding extreme portfolio shifts and holding diversified portfolios, investor behavior causes asset allocation to account for the largest share of portfolio returns. — David Swensen, Pioneering Portfolio Management

Deployment and Rebalancing

The percent of assets to be allocated to each asset class can be determined using discretion or a formula or something in between. My view of classic rebalancing — selling winners and buying losers — is that the practice is probably acceptable so long as the allocation to stocks is invested in a quality cap-weighted index.

The best problems, like the best toys, are hard to exhaust. You can approach them from a variety of different angles, each new angle making the problem fresh again, and bringing the opportunity to discover something new. Any idea, no matter how crazy seeming, might work and can be worth exploring. Indeed, the harder the problem, the more degrees of freedom one can allow in tackling it. Fischer relished hard problems because he relished that freedom, but in practice he did not try just anything. In his view, if a problem does not yield to known methods, that doesn’t mean we need more sophisticated methods, indeed probably just the opposite. Usually problems are hard not because our technique is deficient but because our understanding is deficient. — Fischer Black and the Revolutionary Idea of Finance

Having been a trader for 20 years, it was my preference to sell both winners and losers under certain circumstances. With that in mind, I crafted a quantitative rebalancing algorithm that has served me well. Applied to the model portfolio, the performance has been very good indeed. Furthermore, the model portfolio displays many desirable characteristics:

1. Highly Defensive

Percent Allocated to Each Asset Class Changes Over Time
CLICK TO ENLARGE IMAGE

The rebalancing algorithm is dynamic; that is, the percent of funds allocated to each asset class is recalculated on a weekly basis. This is also convenient as it allows clients to fully implement the portfolio at any point in time, knowing that the algorithm has accounted for current market conditions.

As you can see from the chart above, the Model Core Portfolio has historically held a significant amount of Treasuries and cash. This serves as a ballast against the stocks in the portfolio since most public companies are quite leveraged.

2. Low Volatility of Return

Standard Deviation = .00756

As seen in Part 3, proper asset class selection, deployment and rebalancing results in a model portfolio that experiences only a fraction of the volatility of returns found in the S&P 500 index or the famous funds.

3. Slow and Steady Wins the Race

Steady Growth
CLICK TO ENLARGE IMAGE

The portfolio is balanced once per week to reduce transaction costs. Steady growth makes it easy to stay the course. Roller coaster rides are best experienced at amusement parks.

In Conclusion

Standard Deviation = .01753

A core portfolio achieves the investor’s goal of reducing the volatility of returns through disciplined and diversified investing in traditional asset classes. We avoid fads and fashion. No rear view mirror was used to dress up returns by adding commodities, considered an obsure institutional alternative asset class as recently as … 2006! Our proprietary allocation and rebalancing mechanism further enhances returns and decreases the volatility of returns of the portfolio.

Unleveraged Model Core Portfolio vs. S&P 500 Index Total Return
CLICK TO ENLARGE IMAGE

The characteristics of our core portfolio make it possible for those with risk appetite to use leverage to boost returns.

Leveraged Model Core Portfolio vs. S&P 500 Index Total Return
CLICK TO ENLARGE IMAGE

Consider the fact that the S&P 500 Index experienced 231% more volatility of returns than our Model Core Portfolio. Clients willing to endure that level of volatility could use margin to “gross up” the Model Core Portfolio to match that of the S&P 500 by using margin. For example, using 1:1 leverage (50% margin), the returns are doubled for the Model Core Portfolio while maintaining lower volatility of returns than the S&P 500 Index.

CLICK HERE to read Part 5.

Mar

6

Building Your Investment Portfolio, Part 3

Teresa Lo @ 5:00 PM | | Leave a Comment

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.

Which fund should we buy?
CLICK TO ENLARGE IMAGE

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):

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.
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.”
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:

IF the returns are stable, THEN one can always use leverage to increase the returns.
IF the returns are UNstable, THEN use of leverage eventually brings on sudden death.

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

An Overview of Leverage [DOWNLOAD PDF]
One from AIMA Canada’s Strategy Paper Series
Stock Market Volatility: Ten Years After the Crash
Read more papers by G. William Schwert

CLICK HERE to read Part 4.

Mar

4

Building Your Investment Portfolio, Part 2

Teresa Lo @ 4:45 PM | | 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

Teresa Lo @ 10:30 AM | | 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

19

Gold and the Return to “Sound Money”

Teresa Lo @ 3:21 PM | | Leave a Comment

The desire for economic stability has made many people nostalgic for a return to simpler times. No one has done a better job of dumbing it down for the masses than Ron Paul.

His message is simple: abolish the Federal Reserve (love the support from the Mises “Institute”) and return to sound money.

But nothing is ever simple. The devil is always in the details, so if you’ve hungered for real and substantial analysis, check out the research papers by Matthias Morys. His work was featured at the Austrian National Bank Workshop 13: The Experience of Exchange Rate Regimes in Southeastern Europe in a Historical and Comparative Perspective.

The Emergence of the Classical Gold Standard
This paper asks why the Classical Gold Standard (1870s - 1914) emerged: Why did the vast majority of countries tie their currencies to gold in the late 19th century, while there was only one country – the UK – on gold in 1850? The literature distinguishes a number of theories to explain why gold won over bimetallism and silver. We will show the pitfalls of these theories (macroeconomic theory, ideological theory, political economy of choice between gold and silver) and show that neither the early English lead in following gold nor the German shift to gold in 1873 was as decisive as conventional accounts have it. Similarly, we argue that the silver supply shock materializing in the early 1870s was only the nail in the coffin of silver and bimetallic standards. Instead, we focus on the impact of the 1850s gold supply shock (due to the immense gold discoveries in California and Australia) on the European monetary system. Studying monetary commissions in 13 European countries between 1861 and 1874, we show that the pan-European movement in favor of gold monometallism was motivated by three key factors: gold being available in sufficient quantities to actually contemplate the transition to gold monometallism for a larger number of countries (while silver had become extremely scarce in the bimetallic bloc, which was the single most important currency area in terms of GDP), widespread misgivings over the working of bimetallism and the fact that gold could encapsulate substantially more value in the same volume than silver (i.e. coin convenience). In our view, then, the emergence of the Classical Gold Standard was imminent in the late 1860s; which European country would move first – which is often erroneously attributed to Germany – is of secondary importance.
Adjustment under the Classical Gold Standard (1870s-1914):
How Costly did the External Constraint Come to the European periphery? (PDF)
This paper asks whether following a system of fixed exchange-rates is more difficult for poor countries than for rich countries by drawing on the European experience under the Classical Gold Standard (1870s – 1914). Conventional wisdom has that peripheral economies had to “play by the rules of the game”, while core countries could get away with frequent violations. We construct a data base unique in terms of frequency and the number of countries included. Drawing on the experience of three core economies (England, France, Germany) and seven peripheral economies (Austria-Hungary, Bulgaria, Greece, Italy, Norway, Serbia, Sweden), this paper shows that a careful analysis of the data tells otherwise. Our findings, based on a VAR model and impulse response functions, suggest that the average gold drain differed substantially across peripheral economies, with Austria-Hungary and Italy playing in a league with Germany and France rather than with the other peripheral economies. We also show that some peripheral economies enjoyed enough “pulling power” via discount rate policy to reverse quickly any such gold outflow. In essence, while the experience of some peripheral economies under gold was poor and hence normally short-lived, the experience of other peripheral countries resembled more those of the core economies. Our findings suggest that real economic performance and monetary performance are less closely intertwined than conventionally thought.

Nikolaus Wolf also had something to say…

What Europe’s exit from gold in the 1930s says about the euro
In 1929, tightening monetary conditions in the US reduced capital outflows to the rest of the world and forced deficit countries to tackle their imbalances. This put countries on the gold-exchange standard between Scylla and Charybdis. On the one hand, adherence to the system – neither imposing capital controls nor devaluing the currency – implied a painful increase in real factor costs and reduced international competitiveness. On the other hand, unilateral steps towards devaluation or capital controls risked diminishing confidence in the stability of the national currency. And such confidence was highly valued in European countries that had just experienced a hyperinflation, had not yet established any track record of monetary policy, or just badly needed foreign capital for domestic development.
Central Bank Gold Reserves: An Historical Perspective Since 1845
This paper examines the evolution of central bank gold reserves in the wake of the great gold rushes of the mid-nineteenth century, when for the first time gold really became a widely circulating monetary metal in the pockets of millions of people in many countries, as well as being held increasingly by central banks and treasuries.

Feb

14

How to Succeed in Love (and the Market)

Teresa Lo @ 2:01 PM | | Leave a Comment

On the occasion of Valentine’s Day, here is a bit of advice from Amir D. Aczel, author of Chance:

A mathematical theorem has been developed that gives us the best sampling and stopping rule for all these situations. It can be found and further explained in books on probability. But the strategy is as follows:

You will maximize your probability of finding the best spouse if you date about thirty-seven percent of the available candidates in your life, and then choose to stay with the next candidate who is better than all previous ones.

Isn’t it Romantic?
This is, indeed, a very strange-sounding rule. But mathematicians have proved it works better than any other. The number thirty-seven percent is an approximation of the exact number I/e, where e is the base for natural logarithms, or 2.71828 . . . Of course, this rule can’t guarantee success, but, as Churchill said of democracy, it’s the worst strategy except for all others, and it gives you a thirty-seven percent probability of making the best decision. Any other strategy — whether choosing earlier or later — significantly decreases your probability of success in finding the best candidate.

Feb

14

Brain Candy for Thursday

Teresa Lo @ 10:47 AM | | Leave a Comment

In light of UBS posting yet another writedown, these two papers are almost a walk down memory lane. For better or for worse, securitization removed the double edge sword that had always tied the lender’s fate with that of the borrower. And now we know: it was for … worse.

Securitization: The Tool of Financial Transformation
Securitization as a financial instrument has had an extremely significant impact on the world’s financial system. First, by integrating capital markets and the uses of resources - such as mortgage originators, finance companies, governments, etc. - it has strengthened the trend towards disintermediation. Having been able to mitigate agency costs, it has made lending more efficient; evidence of this can be observed in the mortgage markets. By permitting firms to originate and hold assets off the balance sheet, it has generated much higher levels of leverage and, though arguably, greater economies of scale. Combination of securitization techniques with credit derivatives and risk transfer devices continues to develop innovative methods of transforming risk into a commodity and allow various market participants to tap into sectors which were otherwise not open to them.
Collateralized Debt Obligations and Credit Risk Transfer
In this article, we describe one of these new credit risk transfer vehicles, the collateralized debt obligation. Synthetic credit debt obligations utilize credit default swaps, another relatively new credit risk transfer vehicle. Financial institutions face five major risks: credit, interest rate, price, currency, and liquidity. The development of the derivatives markets prior to 1990 provided financial institutions with efficient vehicles for the transfer of interest rate, price, and currency risks, as well as enhancing the liquidity of the underlying assets. However, it is only in recent years that the market for the efficient transfer of credit risk has developed. Credit risk is the risk that a debt instrument will decline in value as a result of the borrower’s inability (real or perceived) to satisfy the contractual terms of its borrowing arrangement. In the case of corporate debt obligations, credit risk encompasses default, credit spread, and rating downgrade risks.

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