Asset Allocation – Page 18

Segmenting to Make Better Decisions

Posted on 21 May 2011 by David Merkel

This post was stimulated by this academic research piece: When Smaller Menus Are Better: Variability in Menu-Setting Ability.? The truth is, we do best in choosing between a limited menu of options.? Let me give you an example.

For a while, my wife asked me if we could replace our living room furniture.? Trying to be frugal while starting up my business, I showed her some items from Ikea, and she said yes, but I could not replace the recliner at Ikea.

So, after a month, she asked about the recliner.? I did a little searching and went to La-Z-Boy.? (Note: she uses the recliner most.)? I looked around the place and had three thoughts:

Low price
Reclines the way she likes.
Fabrics/colors that I know she likes.

Those criteria enabled me to narrow down the field to two recliners, and a field of six or so “maybes.”? I know my wife pretty well; she trusts me in purchases that many wives would not let their husbands touch.? But for something she uses so much, I took her to the store, along with our youngest (who got a kick out of playing with the electronic recliners).? I took her to the two recliners.? She oohed over them and sat in both.? She liked the fabric better in one, and the comfort of the other.? She tentatively chose the latter, and went on to look at other recliners. As she went on, she said that she wasn’t finding anything that she really liked.? We ended up buying the second chair.? It’s at home now, and she likes it.? Score one more for the husband.

The key to my success was winnowing down the choices.? There were over 100 recliners at the store. But by eliminating options that I knew would not work, I came to solutions that would save my wife time, while making the decision truly hers.

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Now let’s talk about 401(k) and mutual fund investing, and asset allocation more generally.? There are more investments out there than there are recliners.? How to wade through the mess?

The first thing is to set the asset allocation.? How much stocks, bonds, commodities, and cash?? Look at your age and future needs, but look at the markets as well.? If the market is dirt cheap and you are 70, it may be time to move to 80% equities.? If the market is rich, and you are 30, it may be time to move to 20% equities.? Those are extreme moves, but I am trying to point out that when risk assets are rich or cheap, it is time to adjust holdings.

After that comes questions of:

how much foreign/emerging exposure you want in stocks and bonds
active vs passive — look at any active manager and try to ask whether he isn’t a closet indexer, or worse.
large vs mid vs small capitalization
value vs growth

That list is roughly in order of importance.? Now, for 401(k) plans, or working through a single mutual fund company, going through it this way will enable you to narrow down the field so that you are able to make comparisons against similar funds, making the comparisons relatively simple.

That’s the outline — implementing this takes some work, but the process is more orderly, and likely to yield better results.

Book Review: How To Smell a Rat

Posted on 11 May 2011 by David Merkel

I have written reviews on two Madoff books, No one Would Listen, and The Club No One Wanted To Join.? In the latter of those book reviews, I argued that the Madoff fraud was detectable in advance, which offended one who was defrauded by Madoff.? Ken Fisher lays the blame at her door; she should have been able to see it coming.

Look, I sympathize with her loss, but there are basic rules that are common sense for any investment where discretion is given to a money manager.? I am such a money manager, but I consider it a benefit to me and my clients that I have no ability to touch their funds.? The third-party custodian takes care of that.

Imagine playing a game — before we enter the game, both teams want to know that the umpires will be neutral.? So it is in investment management — we need neutral custodians to assure fairness between investment advisors and clients.

Ken Fisher manages ten thousand times more money than I do.? But he is aware of the many ways that people get skinned by fraudsters.? The leading way is to get investors to give the investment advisor both discretion and custody over the assets.? That opens the door for unscrupulous advisors to misappropriate assets.

This is critical.? Don’t entrust your assets to an advisor without a neutral third party providing custody.? This is more than normal — it should be expected.

There are four other lesser signs of fraud:

Returns are too good to be true — volatility that is too low, or returns that are too high.
Not being able to understand what is going on as the money is invested.
Being blinded by the trappings of wealth.
Trusting the opinions of others, rather than doing your own due diligence.

You have to understand that there are no magic bullets, and those who have great past returns should be willing to undergo extra due diligence, because great returns are rare, and need extra due diligence to prove that they are valid.

Beyond that, don’t be greedy or credulous.? Ignore wealth, and do your own due diligence — the book provides a good outline for doing so.? And unless you are so wealthy that you hire someone else? to hire your asset managers, don’t hire any manager whose processes you don’t understand.

These are basic rules that all investors should heed.? Enough said.

Quibbles

None.

Who would benefit from this book:

Most average investors would benefit from this book, because they are the ones who get targeted for fraud — not that all of them will be defrauded, but all of them need the warning, so that they can be prepared against those who defraud.? I wish I had read this when I was 25.

If you want to, you can buy it here:?How to Smell a Rat: The Five Signs of Financial Fraud (Fisher Investments Series).

Full disclosure: I asked the publisher for this book, and they sent it to me.? I read and review ~80% of the books sent to me, but I never promise a review, or a? favorable review.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Book Review: The Ivy Portfolio

Posted on 11 May 2011 by David Merkel

This is an unusual book, and a good book.? Unlike the book, “Outperform,” which reviews lesser known endowments, and endowment investing generally, this book reviews the Harvard and Yale endowments, which up until 2008, the year before the book was published, were among the best in terms of performance.

But this book is more than that.? It goes through the strategies of the major endowments, and looks for ways that average people can try to replicate the results.

But average investors don’t have the same set of investments available to them as the large endowments do.? If you aren’t a qualified investor who has access to the full range of investments ordinary mortals are denied — private limited partnerships (hedge? funds, private equity, commodity funds, etc), what can you do?? This book discloses investments that are similar if not equivalent, and versions that are lower cost through ETFs.

After that, the book takes a direction that would initially seem different than endowment investing.? It discusses trend following, which endowments do not in general use as a strategy.? Now, some hedge funds use it, but few endowments actively embrace it.? The book shows how return can be enhanced and volatility reduced by buying investments that are over their 200-day, or 10-month moving averages.? From my own research I can partially validate the approach.? It is a clever way of implementing a form of momentum investing, which may be a cheap way for average investors to mimic hedge funds who follow trends.

Then mimicry moves to a new level as the book goes through the basics of mining data out of 13F filings, where large investors file their long investments with the SEC.? Guess what?? Imitating bright people can help an investor beat the market — it can allow a bright person to mimic the long side of equity investing on the cheap, but with a lot of data analysis (or you can pay up for Alphaclone).

In one sense, the book seems like two books — one on endowment investing, and another on tools for clever investing available to average investors.? My way of reconciling the two is that the authors are clever guys who are trying to give their best ideas to retail investors so that they can do as well as sophisticated institutional investors who have a wider array of investments to choose from.? The retail investors don’t have the same array of investments to choose from, but they have the advantage of flexibility that institutions don’t and can more quickly trade out of investments that may be on the way to underperformance via trend-following.

And so with much effort, if you apply their ideas, you have the potential of doing as well in investing as the major endowments.? Or, absorb one of their passive strategies with little effort, and maybe you will do as well.? Strategies that have done well in the past may not do so in the future.

But on the whole, I heartily recommend this book.? There is a lot for investors of all types to learn from it.

Quibbles

Those reading the book should also read my essay, “Alternative Investments, Illiquidity, and Endowment Management. (Google it if there is no link)”? Taking on illiquidity is not a free lunch.? It can impose real costs when there is a need for cash among those endowed.? Personally, I think that ten years from now, illiquid investments will only be taken on by those that can lock them away.

Who would benefit from this book:

Those wanting to potentially mimic the high returns of the Harvard and Yale endowments could benefit from the book, but realize that a lot of the past is an accident, and that it might be difficult to achieve high returns in the future from strategies that worked in the past.? That said, the authors have offered strategies that take some degree of work to apply, so there may be barriers to entry for applying some of the strategies.

If you want to, you can buy it here: The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.

Full disclosure: I asked the publisher for this book, and they sent it to me.? I read and review ~80% of the books sent to me, but I never promise a review, or a? favorable review.

When Things are Nuts

Posted on 7 May 20118 May 2011 by David Merkel

When Everything is Strong

When Everything is Strong, Redux

It Would Have Happened Already

It Would Have Happened Already, Redux

Four recent posts of mine.? They warn against assuming that trends will continue.? This past week, we gained some evidence that trends won’t continue.? I’m not talking about the upset in commodities, led by silver and crude oil.

Those matter little compared to the low yields for Treasury bills and notes (from Bloomberg.com).

3-Month	0.000	08/04/2011	0 / .01	-0.005 / -.005	05/06
6-Month	0.000	11/03/2011	0.06 / .06	0 / -.000	05/06
12-Month	0.000	05/03/2012	0.16 / .16	-0.01 / -.010	05/06
2-Year	0.625	04/30/2013	100-04+ / .55	0-01? / -.024	05/06
3-Year	1.250	04/15/2014	100-29? / .93	0-01? / -.020	05/06
5-Year	2.000	04/30/2016	100-21? / 1.86	0-03 / -.020	05/06
7-Year	2.625	04/30/2018	100-20 / 2.53	0-02 / -.010	05/06
10-Year	3.625	02/15/2021	104-00 / 3.15	0-01 / -.004	05/06
30-Year	4.750	02/15/2041	107-24? / 4.29	-0-17 / .030	05/06

These low rates threaten the repo market and money market funds.? They also force people into riskier investments.

This is why I view the commodity market weakness as a hiccup.? Speculators, those that follow momentum, got ahead of themselves.

But there is weakness in Europe that should not be ignored.? Will Greece be tossed out of the EU or not?? Given past actions, the answer is no, but who can tell for sure?

We face cross-currents here, there is no yield for savers, which makes many speculate.? But speculation in commodities has blown up recently.? What to do?

Personally, I would edge into commodities, and commodity-related stocks.? When one-year Treasury rates are so low, it is an incentive to buy stuff/commodities.? Why should I hold a worthless dollar when I can hold a lump of copper?

This is a guess, and it is only a guess, but I would favor commodity strength over the weakness in short-term bond yields.? Play it carefully, and wait for strength before joining in.

Most People are not Better off Buying Common Stocks on their own

Posted on 4 May 2011 by David Merkel

Human nature is not changeable.? If people do significantly less well managing defined contribution assets on average than a comparable index fund, then they should not be managing their own assets, much less concentrating into a small number of stocks.? I don’t care what Baruch says (whoever he is), or what my friend Josh says.? Markets are complex, and investing is hard, not easy.

Just as I believe that most people don’t have the capacity to run their own businesses, the same is true of investing.? Both require a lot of discipline, and most people do not have a lot of discipline.

It takes time to learn how to analyze investments.? I think of people taking the CFA courses/exams, and I say to myself, “”Yes, better than nothing, but we need practical experience to truly train them.”

As an aside, when I went to take CFA exam level one, a few younger people snickered at me and said, “Who’s the old guy?”?? (Note: I was 34 at the time; the beard probably didn’t help, and I sometimes let it grow longish back then.)? I turned to them and said, “I am an actuary.? I have already been through a set of ten-plus exams far more difficult than the CFA exams.? I am skilled in compound interest, accounting, statistics, economics, modern portfolio theory, and mathematics to a degree that AIMR does not consider. I am battle-tested in exams more difficult than this, where we had to read far more, and wonder whether we would be tested on minutiae such that AIMR would never consider for CFA candidates.? Further, I have lived under an ethics code for ten years, so I get the AIMR code.? Do you get it?”? After an uncomfortable silence they looked away, and I did too.

My portfolios are concentrated by industry, but diversified within industries.? I have worked hard at my theories for around 18 years now, with my current strategy running for 10+ years.

It is not easy to do well in investing.? First, you may not understand the basics of valuation.? Second, you may not understand what factors can drive stock prices.? Third, you may not understand how industries move a groups.? Fourth, you may not understand how changes in the economy may affect your investments.? ANd there is more.

What’s that, you say?? You don’t need to know those things because you can read a chart?? Okay, good.? Momentum tends to work, but chart-reading after momentum may not work.? Yes, things that have gone up tend to go up further, because of disbelief among investors.? Here’s the test — how often have you made money buying negative momentum, or selling positive momentum?? My guess is that momentum incorporates most of technical analysis, and that most of the detailed technical analysis ideas are empty.? Test: show your technical analysis idea to technicians of a different flavor, and see what they say.? It’s like Evolution versus Special Creation — Evolutionists trash Creationism, but they don’t agree among themselves to any significant degree.? There are few, if any ideas, that all Evolutionists agree on except the negative, “Not Creation.”? (I had a more offensive version using Canadians and Americans.? I passed.)

I incorporate momentum into my fundamental investing.? It helps to erase the problem of value investors always being early.

Most people that I have known that have ventured into individual stocks gave up because they lost money, or didn’t make much money.? Skilled amateur investors are few.? This is my razor: if they can’t manage owning an S&P 500 index fund, what makes us think that they can manage a more volatile portfolio of common stocks?

It Would Have Happened Already, Redux

Posted on 26 April 2011 by David Merkel

I went to a set of presentations at Towson University this evening and heard two panels on the investment outlook — one domestic, one international.? What fascinated me was the relative unanimity of opinion.? All or almost all agreed that:

Bonds are overvalued.
Stocks are slightly undervalued.? Large Cap Value is attractive.
Commodities, especially gold, are a bubble.? ETFs are driving that bubble.
Interest rates will rise soon.
Avoid emerging markets.
Inflation is coming.

As I listened to the relative unanimity of opinion, I began to think, “Okay, what can go wrong with this?? If they are all invested to reflect these outcomes, maybe we will see things run more against them before an eventual correction takes place.

I think that some of what I heard at Towson University this evening does express the consensus for a number of markets.? Now the consensus is not always wrong — in the middle of a move the consensus is usually right.? But these calls, aside from equities, call for a change in direction.

Beyond that, a rise in bond yields would increase competition for stock valuations.

Also, some agreed that the Dollar was the best of a bunch of bad currencies, and would remain as the global reserve currency.? But then they said that commodities were a bubble.? Okay, stop.? If you say that all major currencies in the world are bad, what will you do to maintain purchasing power?? Buying commodities no longer looks so bad.? Commodities become what most currencies aren’t — a store of value.

I did not hear one argument for deflation this evening, nor did I hear anyone discuss the overindebted nature? of the American public.? There were many, many comments about the overindebted US government, but few comments on how it would affect other US investments.

Look, I am not saying that those in the panels are wrong — some of those biases are mine.? But when you hear little difference in the spread of opinions, it should make you re-examine your theses, because it is possible that all money has been committed to an idea, and even if the idea is right, we should see a counter-rally the other way before the smart money is proven right.

In closing, remember, if it were certain, prices would have adjusted already.? What this says is that we are not certain.

Valuation & Momentum — The Impossible Dream

Posted on 16 April 201116 April 2011 by David Merkel

This piece is a brief and final update to the piece The Holy Grail Projects, which I have since renamed “The Impossible Dream” projects.? I have solved both of them, and with far less effort than I would have anticipated.? There is a way to gain superior bond performance, with one factor, at least as far as the past is concerned, but with higher volatility.

For equities, two simple factors are required, but they beat the market by 2%/year with 70% of the equity volatility over 130 years.

Personally, I find these two results surprising, particularly in the short time that I received them.? That said, I only passed over the data once for each project, which gives me more confidence in the results.

If you have interest in this, e-mail me.? In general, I have not favored tactical asset allocation in the past, but these measures have given me some confidence.

PS — from my days at Provident Mutual in the 90s, what I have replicated is similar? to what one firm I interviewed showed us who had the best track record.? I was really impressed with them and that gives me more confidence.

The Holy Grail Projects

Posted on 9 April 201110 April 2011 by David Merkel

When I started my asset management business, I did not know what I was doing.? I probably still don’t, though finally I have a little more assets under management than I have of my own assets managed by my strategies.? I learned that I needed to manage both stocks and bonds, in order to provide both enterprising and safe investments, respectively.

But in an environment like this, where bonds are overvalued in general, is the safe option safe?? My methods of bond management produce rather blah yields at a time like this, because I am trying to preserve capital.

But then potential investors talk to me, and they ask two things of me.

1) Can’t you create a strategy that shifts between your stock and bond strategies, such that we can minimize losses and maximize gains?

2) Can’t you create a bond strategy that provides more yield on average, while still preserving capital?

I am tempted to say, “If I had such a strategy, I would be employing it from my yacht.”? Then again, the last time I went out on he open seas, I was as sick as a dog.? Time for a new analogy.? Okay, I am searching for the Holy Grail.? Not likely to find that… and as Calvin noted, if all of the alleged relics from the days of Christ were real, the amount would be a large multiple of what was there.

All that said, there are some cofactors for each problem that might work.? With bonds (problem 2), there are momentum effects, as well as mean-reversion effects.? Those can complement the intelligent bond manager who looking at the situation may see risk and return out of line, or fairly priced.

I may have a solution to this problem, which partially benefits from the ideas of Mebane Faber.? Buy the bond classes where the prices are above their 200 day moving averages.? This is an oversimplification, but it seems to work.

But stocks are more difficult, and I do not know whether I will end up with a solution here or not.? Here’s the trouble:

Stocks are driven by earnings expectations
Stocks are driven by valuation
Valuation is drive by cost of capital, as well as yield spreads.
Cost of capital is on average similar to BBB bond yields.
There are still momentum effects, as well as mean reversion effects

I don’t have a solution to the first problem, though I am struggling with it.? Truly if anyone had a good timing algorithm, would he share it?

Book Review: Super Boom

Posted on 5 April 20115 April 2011 by David Merkel

This is a modest book with an immodest title.? Stocks will return 9%/year over the next 15 or so years.? Dow 38,820? C’mon, round it to 39,000 or 40,000!

Or, is the book so modest?? The Lehman Aggregate yields 3.5%.? Puny.? Moody’s Baa bond index yields 6.05%.? Since 1967, we are near the lows on that yield.? In relative terms, also puny.

It would be extraordinary for stocks to move ahead at 9% while low investment grade long bonds yield 3% less.? The same applies to the wider spread over the Lehman Aggregate.

Bonds are saying that the returns to capital are low, and given the artificial capital created by quantitative easing, that is not a surprise.? The Fed has consistently stopped the healthy process of failure, which redeploys capital to healthier and more profitable uses.

Now, maybe we get inflation to show up in a big way, and Dow 38,820 is the new 20,000 in real terms.

I agree with the thesis that the stock market has tended to move in waves.? I think Hirsch is jumping the gun a little on the next wave, and overstating the amount of likely return.

Now, as for the book blurbs — they are all overdone.? Better to understate the case.

Now, as to the book itself:? Hirsch thinks we will work through our problems.? So do I, but with more difficulty.

With hindsight, he critiques those who wrote Dow 36,000 ably.? He then critiques current bears, and I think he is right there as well.

He describes the last few stock market cycles of stagnation then boom.? But is past prologue?? I think it is in qualitative terms, but maybe not in degree, unless inflation reduces the real value of stocks.? The author thinks that is likely, even with the biased measures of inflation employed by the government.

Finally, he shares some investment strategies that he thinks will be useful in the future.? They aren’t worth buying the book, in my opinion.

Quibbles

If my father were the notable Yale Hirsch, I would have spent more time going over his stock picks in the appendix; the performance is better than the author conveys.

Who would benefit from this book:

If you lack optimism, you could benefit from this book.? If you are optimistic already, you don’t need this book.? Just realize that things are not likely to be quite so good as the author portrays.

If you want to, you can buy it here: Super Boom: Why the Dow Jones Will Hit 38,820 and How You Can Profit From It.

Full disclosure: This book was sent to me, and I did not ask for it.

Book Review: Financial Jiu-Jitsu

Posted on 24 March 2011 by David Merkel

The genre of personal finance books is crowded.? I have read my share of good and bad books in this area, and the book that I am reviewing this evening falls in the good column.

It covers all of the main areas of personal finance adequately, and makes analogies from the world of martial arts.? Now, personally, to me that is an odd place to source analogies for investing.? I remember being in a meeting when I was a corporate bond manager, and the new head of credit research said to the credit analysts, “Credit analysis is war by another name.”? I rolled my eyes, and said to myself, “Oh, please, this is a business, and no more than a business.? Don’t make my analysts non-economically aggressive.”

This book is long on structuring your finances, and short on how one invests, as is common for most personal finance books.? The advice is simple and practical, and will benefit most individuals/families.

One of the many places where I agree with him is that you don’t have to have a budget.? Save first, and then survive on the remaining cash flow.? This is an excellent way of managing finances, but it takes discipline.? Not everyone can do this because they lack discipline on a month-to-month basis.? Those that don’t have that discipline should craft a budget.

I also found his approach to financial goals useful, because it asks the deeper questions on what the ultimate reasons for living are: not only ways in which we want to be served, but ways in which we want to serve.? Figure out the broad goals for life first, then figure out the financial means to serve those ends.

He also takes a conservative approach to how much money one needs in retirement, using a 4% withdrawal assumption, which in a low interest-rate and mid-to-high P/E environment like today is only reasonable.

It was a breezy read for me, getting through the 180 pages in 90 minutes or so.? Part of that is that it is a very familiar topic to me, but I suspect more of it is good structuring and chapter ends that repeat the main points in summary form, so that the main ideas are difficult to miss.

Everything important gets covered here for the life of an average person/family.? The reader faces the challenge of executing on the good advice, or finding a good adviser to guide him.

Quibbles

Though I was a wrestler in high school, I sometimes found the analogies to martial arts to be strained.? More importantly, I had a hard time following the logic in the appendix regarding investment performance.? I am no fan of Modern Portfolio Theory, but MPT does not require the concept of buy and hold.? Buy and hold stems from the idea that equities outperform equities and fixed income by a wide margin (the “equity premium”), so one can always win by holding onto equities, and not ever switching into safer asset classes.

The author’s concept of capital preservation investing does not get adequately defined.? Indeed, that could be a book in itself.? The idea? that there are seasons to take more risk and seasons to take less risk is obvious in hindsight, but implementing that idea is tough, and the author leaves us with not enough to do it.? That should not be too much of a surprise though, because if there were an easy solution here, we all would have adopted it years ago, and I would be opining to you from a life of leisure, rather than that of a working stiff.

As such, I don’t penalize the author too much, no one has the holy grail of market timing nailed down yet.

Who would benefit from this book: This is a basic book, and most suited for those that need to get their lives in order.? Personally, I suspect younger males would find the analogies between investing and martial arts most appealing.? I should try it out on my son who wants to be a police officer.

If you want to, you can buy it here: Financial Jiu-Jitsu: A Fighter’s Guide to Conquering Your Finances.

Full disclosure: The author sent this to me after asking me if I wanted it.