Over the past week I have written a couple of posts on the topic of diversification and asset allocation. Today, I would like to discuss in a bit more detail a specific asset class that I am considering diversifying into: commodities.
For those readers who are not familiar with the concept of commodities, these are essentially the basic goods upon which the modern economy is built. They are typically divided into five categories: Energy, such as oil and natural gas; Industrial metals, such as copper and aluminium; Precious metals, such as gold, silver and platinum; Agricultural commodities, such as corn and wheat; and finally, livestock, such as live cattle.
Why diversify into commodities? The main reason is that, as explained in my previous post, commodities move independently of equity prices, or in more technical terms: the correlation between these two asset classes is close to zero.
While doing my research into the feasibility of commodity investing, I came across this informative article in the Journal of Financial Planning. One of the main points I wanted to research was the expected return of the commodity asset class. According to the article the average annual return of the Goldman Sachs Commodity Index (GSCI) between 1970 and 2006 was 11.5%. That is pretty impressive. Just as importantly, the commodity index seems to generate the highest returns in times of unexpected inflationary pressures. This means that while the rest of your asset classes may be suffering the twin scourges of inflation and high interest rates (which the Fed uses to combat inflation), investments in commodities tend to perform at their highest levels. For a more complete picture of the historical performance of this asset class, take a look at a chart of Dow Jones AIG Commodity Index (DJAIG).
The article offers a quantitative analysis of the diversification benefits offered by commodities. I will save you the suspense. According to the article a portfolio weight of 24% in commodities between 1970 and 2006 resulted in a a higher return compared to a portfolio of 60% stocks and 40% bonds; while simultaneoulsy reducing the volatility of the portfolio by 13.5%. That certainly gives me some food for thought.
Once again, it seems that the main issue is finding a good vehicle for investing in the commodities market. The article mentions two ETFs, GSG and DBC as funds worth considering, but both of these funds seem relatively new and don't offer enough of a track record for my taste.
I will do some more thinking on this topic. I am not quite ready to jump into that particular pool.
Tuesday, October 09, 2007
Monday, October 08, 2007
Seven Random Things
I got blog-meme tagged by Plonkee to join in the "seven random things about me" discussion. Well, here are seven things about me that you really did not have a burning need to know:
1. I have been on all continents, except one. The exception being Antarctica. One day...
2. I am a huge chocolate fiend. Before you say anything, Hershey's is not real chocolate. In fact, I don't think that there is such a thing as real American chocolate. Yes, I am also a chocolate snob.
3. I have no middle name.
4. I have three boys. The oldest is five.
5. I have a law degree, but after three years of practicing corporate law in a firm, I dumped that career and got an MBA. That was one of the best decisions I have made.
6. I love to watch sci-fi movies (and shows), pick them apart and complain about how stupid they are. Do you know how in the movie Armageddon in the final scenes they show the asteroid blowing up and then they show people around the world looking up at the sky an cheering? Yeah, right. The people in India, England and the U.S. see the same place in the sky at the same time. You know what I mean? It's just awesome to complain about fake science in movies.
7. I drink way too many cans of Diet Coke every day. It used to be regular Coke, but a couple of years ago I started watching my sugar intake.
I always seem to be at the tail-end of the blog memes, but let me try to tag Money Ning, Gen X Finance and The Div Guy. See if any of them has anything to say on the subject.
1. I have been on all continents, except one. The exception being Antarctica. One day...
2. I am a huge chocolate fiend. Before you say anything, Hershey's is not real chocolate. In fact, I don't think that there is such a thing as real American chocolate. Yes, I am also a chocolate snob.
3. I have no middle name.
4. I have three boys. The oldest is five.
5. I have a law degree, but after three years of practicing corporate law in a firm, I dumped that career and got an MBA. That was one of the best decisions I have made.
6. I love to watch sci-fi movies (and shows), pick them apart and complain about how stupid they are. Do you know how in the movie Armageddon in the final scenes they show the asteroid blowing up and then they show people around the world looking up at the sky an cheering? Yeah, right. The people in India, England and the U.S. see the same place in the sky at the same time. You know what I mean? It's just awesome to complain about fake science in movies.
7. I drink way too many cans of Diet Coke every day. It used to be regular Coke, but a couple of years ago I started watching my sugar intake.
I always seem to be at the tail-end of the blog memes, but let me try to tag Money Ning, Gen X Finance and The Div Guy. See if any of them has anything to say on the subject.
Sunday, October 07, 2007
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:
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.
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."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.
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.
Thursday, October 04, 2007
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.
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.
Wednesday, October 03, 2007
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...
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...
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