Advanced Portfolio Building II

A couple of days ago I wrote a detailed post I called Advanced Portfolio Building. As of now, that article received only a single comment, but I think that comment merits a detailed discussion and I will do so in this post. Let's begin by reviewing the full text of the comment, left by Matthew from Crazy Money:

"There are two methods for reducing volatility in a portfolio: building a basket of assets with weakly or anti-correlated betas, or increasing your time horizon. No discussion of risk and reward is complete without including the impact of time on both quantities.Given a sufficiently long window, there is no reason to invest in anything but 100% equities. Diversifying beyond this asset class would only create a drag on your final return and increase transaction costs.

I agree with some of the points Matthew is making in his well thought-out comment, but I strongly disagree with others. Clearly, Matthew is right that the longer your time horizon the more aggressive your portfolio can be. This is a basic truth of investing.

However, let's make a distinction between risk and expected return. Risk is traditionally measured by the volatility of the asset class in question. Volatility is the relative change in price over time. The concept of risk is strongly related to but is very different from the concept of expected return. Expected return is the amount of money you would receive, on average, over a certain period of time, by investing in that asset class. Let me give an example that will clarify the difference between those two concepts:

The S&P 500 for example has historically averaged a return of approximately 7.3% per year since its inception (not including dividends). If you believe that the S&P will continue to behave as it previously did, your expected return is about 7.3% per year (plus dividends). However, the S&P very rarely yields exactly 7.3%. The return fluctuates. Some years the S&P returns double digit gains, other years investors lose an arm, a leg and one buttock. The S&P (as well as all other equity) is a relatively volatile and hence risky asset class.

Given the option between a volatile asset and a stable asset, both of which are expected to return the same amount, a rational investor chooses the more stable asset. Why accept uncertainty and risk if in the end you expect to make the same amount of money? Think of it this way: if you were able to get 7.3% on a CD, every year, for the foreseeable future, would you invest in the S&P which on average would yield the same return, but could have some seriously down years included in the mix? Of course you wouldn't.

With the concepts of expected return and volatility safely locked in out heads, let's go back to Matthew's comment. Matthew is saying: "There are two methods for reducing volatility in a portfolio: building a basket of assets with weakly or anti-correlated betas, or increasing your time horizon". That statement is not correct. By increasing your time horizon you are more likely to achieve the expected average return on the asset class in which you are investing (7.3% in the example we used above), but you are doing NOTHING about volatility.

Let me explain: in any given year the stock market may tank or soar, but if you stay in the market for a large number of years, your chances of achieving your expected return are high. Compare it to a game of heads or tails. If you flip a coin twice, you wouldn't be surprised if it came up heads (or tails) twice. However, if you repeated that coin flip 1,000 times you would expect (and the laws of probability are on your side) that the number of heads and tails will be pretty close to each other. You would be really surprised if you threw heads 900 times and tails only 100 times - although that too COULD happen. This is because the expected outcome of the game is that 50% of the time you will flip a head, and 50% tails will appear. However, the long term expected outcome has absolutely no bearing on the next flip of the coin.

Matthew is confusing volatility with expected return. By expanding your time horizon you are likely to achieve the expected return, over the life of your investment, but that does not reduce the risk that your portfolio will tank in any given year.

Enter diversification: going back to the coin flipping game. Diversification is akin to playing heads or tails with several coins simultaneously. Each coin represents a different asset class in your portfolio. The chances of flipping all tails when using, say, 10 coins simultaneously is vanishingly small. Diversification reduces the volatility of your portfolio, and in many cases it can do so without reducing your expected return. Matthew's statement that "Diversifying beyond this asset class [equity - Shadox] would only create a drag on your final return and increase transaction costs", is simply not accurate. More about this specific point in a future post.

In the meantime, I will let this excellent example from The Sun's Financial Diary, speak for the merits of diversification. I suspect that if diversification beyond equities was not a worthwhile undertaking, a sophisticated investment team such as Yale's endowment managers wouldn't bother with it... 'nuff said.

Advanced Portfolio Building

Warning: the information in this post is about how to achieve more effective diversification in your portfolio. It may actually be useful, but it might not be an easy read.

Diversification is a very useful trick. It allows you to maximize your return for a given level of risk, or to minimize your exposure to risk at any target level of return. Diversification works because different assets do not always move in lock-step, such that a decline in the price of one asset is often offset by an increase in the price of another asset.

Diversification becomes more effective as the correlation between your different asset classes declines. In other words, if you want to increase your level of diversification, your portfolio needs to include asset classes that have a more tenuous link with each other, or better yet, assets that are negatively correlated. For those readers who are less statistically inclined, if two assets are negatively correlated they tend to move in opposite directions.

Although our portfolio is well diversified by most measures, I noticed that during much of the market turmoil we experienced in July, most of our asset classes moved in the same direction: down. Domestic and international stocks, bonds and real estate all seemed to face the same price pressures. This prompted me to do some research, and led me to discover this phenomenal article, in the July issue of the Journal of Financial Planning. The article offers detailed correlation matrices between 17 different asset classes.

According to the article, the asset classes that exhibit the lowest average correlation with the S&P 500 are: U.S. Bonds (0.23); Global Bonds (-0.03); Cash (0.02); Natural Resources (0.01); and Long - Short investments (-0.01). Let me interpret these results for you: on average, if the S&P moves up by 1% on a given day, the average cash position will tend to move 0.02% in the same direction, while a diversified global bond position would tend to move 0.03% in the opposite direction.

Bonds truly are an excellent way to diversify a stock position. Global bonds are an even better way to achieve this goal. How many of us have global bonds in our portfolio? Not very many.

How do real estate (as measured by REITs) and International stocks fare in the diversification department? Good, but not great. International stocks have an average correlation of 0.55 with the S&P, while REITs have an average correlation of 0.52. In addition, at certain times these asset classes exhibit a substantially higher correlation with the U.S. equity market. So, while these asset classes offer substantial diversification, this benefit sometimes diminishes to a large extent.

Without boring you with the details of the statistical analysis offered in the article, you should note that the correlation values provided above are averages and that the correlations of some asset classes vary dramatically over the years. However, the article mentions natural resources, long-short, U.S. bonds, global bonds and cash as the five asset classes that consistently offer the best diversification benefits with an equity position. It is also interesting to note that the same asset classes also have a weak correlation with each other.

I highly recommend taking the time to read the full article for yourself.

More about this article and its take aways in the coming days.

Personal Finance: Intentions & Reality

A couple of days ago I ran across this interesting article. The article outlines the often huge distance between intentions and actions as far as personal finance is concerned. Here is a summary of one section that I thought was especially informative:

Attendees at a retirement planning seminar all claimed that they would be joining their company's 401K plan. In reality, only 14% of un-enrolled seminar participants actually joined the plan. For comparison it should be noted that only 7% of those that did not attend the seminar joined the same plan. This information could lead you to the conclusion that the seminar helped motivate people to take action, however, it could also be argued that there is selection bias at work: i.e. people that chose to attend the seminar did so because they were more serious about taking action regarding their retirement planning. This means that the seminar itself may not have influenced people's actions at all, rather it simply provided a gathering venue for those more serious about retirement planning.

The article also shows that a large majority of people who were already enrolled in their 401K but needed to take certain actions, such as increasing their contribution rate also failed to follow up on their intentions after the seminar.

Here is what I take from this article: people procrastinate. It is in our very nature. We mean well, but our intentions do not always translate into action. Take me for example. I have been meaning to take my car in for an oil change for the past three weeks, but somehow I just can't seem to get it done. I have many good excuses: work has been crazy; my brother is in town for a visit; I have to pick up the kids and so forth. All excellent reasons. Still, no oil change.

What does that mean for people who care about personal finance? A couple of things: first, recognize your tendency to procrastinate, and combat it by building a plan and attaching schedules and goals to it. You want to do something? When are you going to do it? Second, don't develop personal finance plans that require too much activity or that rely on perfect timing. Those would be the most susceptible to procrastination damage.

What does this mean for public policy planners? If you think people are going to plan for their own retirement or make provisions for their long term economic well-being, there is a very strong chance that a majority of the population, while very well intentioned, will never actually get around to doing so. In fact, Congress and regulators are trying to use people's procrastination and laziness as tools to promote healthy retirement savings. One of the ways to achieve this is automatic enrollment of people in their 401K plans. Congress ok'd auto-enrollment in the Pension Protection Act of 2006. Hopefully procrastination now becomes a tool for good, as people who otherwise would never have saved now don't actually get around to opting-out of their retirement plans.

I hope you enjoyed this post. I was actually planning to write it last week, but never got around to it...

Recommended Articles

Once again it is time for my Tuesday morning article recommendations:

This week's Carnival of Personal Finance is hosted by My Retirement Blog, an excellent blog that I read regularly. Our kind host did me the honor of selecting my article Rent is Not Waste as the top Editor's Pick for this weeks Carnival. Good deal.

This week's carnival included a whole bunch of articles that I read and appreciated last week here are some of my favorites:

Money, Matter and More Musings posted an article about the fact that signing the back of your credit cards is a useless security feature. Absolutely. Two of my cards are unsigned, and very few times does a sales clerk even check to see if there is a signature on the back. Even when they do check, and see that the card is unsigned, very rarely do they ask for an ID. Checking is sort of an automatic, meaningless gesture for them. The one exception to this rule: Best Buy. I always get asked to show my ID at Best Buy, and I am glad to do so.

Advanced Personal Finance has a good post about how to deal with a lousy 401K plan. The advice is all good, but he leaves out one critical piece of advice: lobby your company to change the plan. Companies are generally interested in offering a good 401K plan to their employees. The problem is that in many cases the person running the plan is someone from HR that has little or no understanding in personal finance or investment strategy. If you offer your insights or formally file your complaints regarding the plan, there is a good chance that your suggestions will at least be considered. Be aware that companies are always worried about the possibility of being sued by employees unhappy about the company's 401K plan. Each 401K plan is managed by at least one trustee who has a fiduciary responsibility to run the plan for the benefit of its participants. That’s a very big incentive to listen to employees.

For those thinking about asset allocation, the Finance Buff offers some useful advice about how to build a portfolio while limiting complexity to a level you are comfortable with. Generally speaking this is sound advice, but I have some posts coming up about other asset classes that are not adequately addressed by the proposed strategy. Stay tuned. It's going to be interesting.

Chief Family Officer has a post about how much you should stash away in your flexible medical spending accounts. Personally, I check our medical spending each year, using Quicken and follow that amount. However, I find it bizarre that the government (or employers) makes individuals guess their medical spending in advance, and penalizes them for guessing incorrectly by taking any remaining funds they haven't spent. Talk about promoting waste and creating unnecessary complexity.

Also, check out the Festival of Under 30 Finances hosted by How to Make a Million Dollars.

The Festival of Frugality this week was hosted by My Two Dollars. This week I also participated in the Carnival of Financial Planning.

Recession in the Cards?

The polls are closed and the votes are in: 56% of readers who responded to my latest poll voted that the economy will not be going into recession. However a large minority of 44% thinks that something is about to hit the fan.

Regardless of your own personal opinion, I think this survey shows that people that care about personal finance, and hence read personal finance blogs, are not feeling too confident about the state of the economy right now. The problem is that the economy is sort of a self fulfilling prophecy: if people feel that the economy is doing well and that they are on sound financial footing, they spend more, which actually boosts economic activity. On the flip side, if people feel that the economy is at risk for a recession, they may preemptively cut their spending to prepare for the bad times, thereby reducing economic activity and tipping the economy over the edge and into recession. If a large segment of the population think the economy is about to go into recession, chances for a recession increase.

One more interesting point about this poll. I ran this poll for the past two weeks, and have been following the way the votes were going from day one. Two weeks ago, the early votes that came in were pretty pessimistic, with most voters expecting a recession. When the Fed cut interest rates, there appeared to be a burst of optimism with positive votes quickly overtaking the nay sayers. In the past couple of days, a little bit of pessimism has returned to the vote. Of course, this survey is nowhere near scientific and no sane person can draw any conclusions from it, however I found the correlation between the votes and the Fed rate cut to be intriguing. It is either a co-incidence or an example of the type of change in investor psychology that the Fed wanted to create.