Today we have a guest lecturer for the Saturday Lecture Series, it’s Flyovercountry! And a well done lecture I might add!
An I do believe that the guest lecturer will be around to answer some questions, if not, you all know where to find him. Enjoy your coffee and donuts!
The Lecture comes with a caveat:
Here is the Saturday lecture series submission. I believe it may help some of the folks in our community. I feel the need to give some caveats though. Currently, I only hold liscensure in Ohio. While the concepts are valid even in an international context, by no means should anyone construe this as specific advice. A local trusted professional should always be consulted. The concepts are also very general, and as such advice given to one person may not be appropriate for another. I would be willing to have more individual conversations with folks, but these conversations, if held must remain private. (I am afraid of someone sharing their personal allocation model with their much older uncle, and having that advice wreck the much older uncle’s life, since a far different allocation model may have been appropriate for him.) If you feel it appropriate to do so, you may offer that people who inquire may be given my email address.
It happens all of the time, people I’ve just met find out what I do for a living, and they ask me to give them a stock tip. My first thought is invariably crap, how do I politely let this person down, and help them realize that they have asked me to behave in an unethical manner. The conversation I need in order to provide any advice is much more involved than engaging in what I refer to as picking ponies. A dinner party or another relaxed social environment is the wrong place to give involved advice or seek to have probing financial discussions. I almost always end up saying this, which by the way is the simple truth, I always advise my clients to utilize an investing technique termed, Asset Allocation.
To understand Asset Allocation, and the different kinds of this technique, I am going to give some background. During the 1950’s, an economics professor at Harvard by the name of Harry Markowitz conducted a study of the nation’s endowment and pension funds to try to determine what made a portfolio successful, how to measure that success, and how to measure the risks involved in investing. His study won him a Nobel Prize for economics in 1990 and is referred to as Modern Portfolio Theory. Successful mastery of his theory is the basis for the Finra exam which allows a securities professional to register as an investment advisor and charge a fee for advice. Here are some of the conclusions involved in Markowitz’s work:
91% of a portfolio’s performance is dependant on asset allocation.
6% of a portfolio’s performance is dependant on security selection.
2% of a portfolio’s performance is dependant on timing.
1% of a portfolio’s performance is dependant on other factors.
So, here I am, in a world were people love movies like Wall Street, The Boiler Room, Trading Places, and whatever else, thinking that really represents life. By looking at what particular stock to buy, people are generally focusing in on the bottom 7% of investing importance for whatever their goals are. The top 91% is most often ignored, because it is the least often talked about. It is the least often talked about because it is boring stuff indeed.
Everyone has the guy at work who brags about his great stock picks. He will tell everyone and their uncle how great he is doing during a bull market. Please keep in mind that during the late 90’s, when things were booming, the Today Show had a monkey on picking stocks against so called, “Wall Street Experts.” The monkey won. The Woolworth Store in my neighborhood had a stock boy in high school who’s dad was bragging about how his son was a super genius because he was able to direct his portfolio to make mega money. The funny thing is, when the bear market hit, as by the way it always does, not a single person was bragging about how their stock picks shit the bed. Such is the nature of picking ponies. You can get rich that way, but you can not stay rich that way. Love is never having to say you are under diversified. To properly diversify a portfolio using Asset Allocation and single stock picks will generally take about a $Million. So, that being said, let’s discuss what this term actually means.
Investments can be broken up into what we term as asset classes. Cash is one, precious metals another, Large Company stocks, Mid Sized Company Stocks, Stocks can be broken down into Value, Blend, Growth, Real Estate, Commodities, etc. All in all, there are 24 major asset classes. Putting a portfolio together is a function of picking which asset classes to use, and in what proportion. This is dependant on many factors, which include the growth rate needed, the growth rate wanted, a discussion about the amount of risk an investor is comfortable with and the amount of risk which an investor can actually afford.
So, now that we understand what an asset class is, and how it relates to a portfolio, how do we determine what mix is appropriate for each individual investor. This discussion involves something called the efficient frontier. This is a theoretical demarcation which proposes an optimal average rate of return based on a given amount of risk incurred. Risk in the world of investing refers to the amount of expected volatility an investment will likely incur over time. Smaller company stocks will likely fluctuate in value more than large company stocks, but have the greater potential for greater increases in value as well. Bonds will pay a more steady income, but will not appreciate in value as rapidly as stocks. I will often hear the phrase, “my broker is a genius, he got me an x percentage rate of return.” Then I will ask, how much risk did you take on to get that return, and over what time frame did you realize this bonanza. I can not tell you when the next market crash will be, or what will cause it, but I can promise you that it will happen. I can also promise you that we will average a bear market 1 year in 5 for the remainder of our lives. Each of these events will be duly reported as the end of financial life on our planet as we know it by an media that loves hardship and disaster. Each and every time it happens, the markets will recover.
Will it be possible to actually ever be on the efficient frontier, probably not, but we do have some techniques to help us get very close. There are several research firms who have backdated portfolios, I’ll give an explanation of backdating in the next paragraph, and developed model portfolios based on where this frontiers existed based on a historical perspective for the desired time frame. Generally speaking, it is remarkable how similar the model portfolios are between the different research firms. Typically, a portfolio will be rebalanced twice per year to maintain its overall target. This is done because asset classes rarely grow at the same rates. So for instance, during the year of 1999, Small Cap Growth Stocks were the top performing Asset Class with an average increase of 43.09%. During that same year, Real Estate was on the bottom with an average decrease of 2.58%. If you were in a portfolio where we had 3% of your assets invested in Small Cap Growth, and @% invested in Real Estate, at the end of 1999, we would have sold whatever portion of you Small Cap Growth Stocks necessary to reduce your total exposure to 3% and used those funds to purchase Real Estate to bring that exposure back to 2%. In 2000, Real Estate finished on top, and Small Cap Growth finished on bottom. No, the technique does not always work so perfectly, but it does insure that as a general rule, your exposure to risk will be consistent with your ability to handle risk, and will also force you to buy low and sell high, which is how money is made.
Backdating needs to be explained. I am not Nostradamus. To a large extent, anyone claiming to be able to predict the future is full of baloney. I like to tell people my expertise is in not knowing what will happen next. What I am able to do is look at historical trends over the last 130 years. I am able to determine that those trends have maintained relative consistency during that time frame. Using that as a guide, my best estimate will involve seeing those trends continue. While it is true that on a micro level, past results are not indicative of future performance, backdating a model portfolio, especially by looking at asset classes only, a reasonable assumption can be made about a portfolio’s risk reward characteristics.
There are different styles of Asset Allocation, but mostly they can be broken down into two distinct approaches. Strategic picks one model portfolio and always reverts back to that model, regardless of market conditions. Several studies have suggested that investors who practice this approach are the most successful investors. Part of the reason for this is that these investors are the least likely to completely leave the market during bear markets. A tactical approach allows for adjustments to a portfolio to attempt to capitalize on perceived changes to market conditions.
This article is meant for general informational purposes only. I have not met individually with any of you, so nothing here should be taken as specific advice. Also please note that there is a very high percentage chance that I am not licensed in your state. As such, I will say that you should seek the advice of a CFP, a CRPC, a Chfc, or a Clu within your community to discuss what is appropriate for you. If you have access to an employer sponsored plan through your job, (401k, 403b, or 457 plan,) there was probably a printed piece of material you were given which gave this same description as part of the enrollment package. I was designed to guide you to picking your own portfolio as close to the efficient frontier the specific funds within your plan would allow.
Further reading:
Markowitz’s 1990 Prize in Economic Science (9 page pdf)
(yes, it is required! 
)
.
Tags: Economic, Saturday Morning Series
my pension system OPERS seems to do a pretty
good job in investing and management of pension
funds
thanks flyover!
this is going to take some time to read, now where did i put that coffee…
@mawskrat
The only complaint I have about OPERS, and I admit to knitpicking here, is that the COLA is indexed to the year you retire and not compounded. If you live a long time past your retirement date, which I hope you do, it could possibly make income seem thin later on.
Flyovercountry wrote:
I recieve 3% a year no matter what the real cost of living is
after years of working in the private sector I topped it
off with public sector employment. I payed half of my
retiement cost and the university paid half. Walter Williams
would say I payed all of it since the employer half if not
mandatory by law could have been paid to me.lol
now in Ohio you can opt out of the public retirement system
(updated the lecture with markowitz’s 1990 nobel lecture 9page pdf)
…yeah..i’m an econ geek
A worthy thread.
@ coldwarrior:
Thanks for the update. I’ve already emailed it to myself at work.
@ mawskrat:
OPERS New plan or old? 3% a year seems a little low for the new system. The difference between indexing increases and compounding them is about to become obvious to you over the next 5 years. Inflation is about to take off here. I’m glad you had the foresight to supplement things with income from the public sector. It sounds like you did well for yourself. If I knew how to make one of those smiley faces, I would put it here.
@ Mike C.:
Thanks!
coldwarrior wrote:
had to repair a leaking 3 inch water line in
a econ profs office once….looked at some of his
books on the book shelf. they were all full of math equations
I could not understand.LOL some imes I wonder if economist
even understand them//
@ mawskrat:
some of the math gets really esoteric.
@ Flyovercountry:
can you speak on some of the foreign mutual fund invesstments?
do makowitz’s ideas hold in markets that do not have the same laws and maybe a little more corruption? (BRICs or say asian market funds)
@ coldwarrior:
I’ve seen 15-20 page papers in The Journal of Geophysics that have less than one page of English words in total. I opted out of getting it in dead tree form (as did the overwhelming majority of the SEG membership.) All hail to those that struggle in those particular trenches, because they bring advances to the rest of us, but I work in different trenches.
You just haven’t lived until you’ve sat through a talk on “particle motion in wave migration equations.” Definitely worse than a talk on bonding angles in micas, which I have also endured.
As to financial matters, I’m still at the stage of trying to remember if a full house beats a straight.
@ Mike C.:
yeah, i know what ya mean!
multiple regressions in spatial econometrics….and some such stuff.
Sticks head in the door. Oops
I was looking for the ag class. Mrs. Funn wants me to figure the following problem: shovel x dirt —-> wheelbarrow (up the hill) x 3
speaking of economics I need to erect my cold frames today
@ coldwarrior:
It’s funny you should mention that, I spoke recently with someone who manages a mutual fund for a fund family that I will sometimes use. He is on the international team, ie emerging markets, overseas development. Long story short, he showed me the morningstar model allocations suggested for people in spain. One of the things which struck me was this, the U.S. markets are considered an international investment for them, and Spain’s markets are considered their domestic investing vehicles. Makes sense right? International investments are usually part of any mix. I am not going to get too dorked up over which mutual fund you pick, except to say it should be somewhat in line with the domestic side of things. A consistent blend between large to small companies and value to growth.
While it is true that the foreign exchanges do not have our transparency or preventions against cheating and they are in many respects akin to casinos there are good reasons to add international exposure to investments. One being this. For many decades now the U.S. has been twice as productive as the rest of the world combined. This is a level of economic productivity that will be hard to maintain in a relative manner to everyone else in the world. As China and Russia free themselves economically, their companies are going to grow. If over the next two centuries, that balance turns to America being as productive instead of twice as productive as the rest of the world combined, the International equity asset class will be the top returning asset class for that time frame.
That doesn’t mean to go all in, but the 10 to 14 % range would be in line for most investors.
huckfunn wrote:
get to work or no potato for you comrade
I would share your burden my friend but I’m
more equal than you/////
<< needs to find a job that pays enough to be able to invest again!
Good stuff- thank you!
@ huckfunn:
Charts and graphs make my head explody
gulfloafer wrote:
meetings are great if there’s food involved!!
@ coldwarrior:
I long ago dropped my membeship in the International Association for Mathematical Geology because in 14 months of the journal, I never found a single article I could actually understand.
As Dirty Hary said, “A man’s got to know his limitations.” I’ll just have to keep plugging away at my own level, which is where most of the economic action takes place anyway. But I have the greatest respect for those working in the nosebleed realms above me.
gulfloafer wrote:
the charts and graphs are a whole lot easier to understand than the math and data behind them!
@ mawskrat:
Food should be mandatory.
Mike C. wrote:
yep. at some point, all the theoreticals turn into a giant, blurry ball of numbers and lines.
ADDENDUM – I do understand the basics and limitations of stochastic modeling of depositional systems, though, and I am a big fan of what that is good for. Still trying to get my hands on a license for that stuff, because learning how to use it would be money in the bank for me, even if I wasn’t as well-grounded in the mathematical part as some. I like to think the experiential, practical experience part carries it’s own weight.
well I’m off to be productive
Oh, man, this thread is bookmarked!
Any comment on Pimco dumping U.S. bonds?
coldwarrior wrote:
I don’t even try. I usually say something to the effect of ‘yeah that looks good to me, where do I sign?’
As Bismark once quipped: “God has a special providence for fools, drunks and the
USAgulfloafer.”@ eaglesoars:
Pimco didn’t dump its entire portfolio of U.S. bonds, they just lowered the weighting that they carried in their total mix. That’s an important distinction to make. Most bond desks are shifting to floating rates funds and into international income instruments. You can thank the quantitative easing and mounting U.S. debt for this. I put a comment on another thread about the in house economist at Littman Gregory making this very statement. As interest rates rise, bond values will fall. We are about 2 to 4 months away from a massive spike in both interest rates and prices paid for everything. for your fixed income portions of investments look for the terms foating rates, or inflation protected series. Don’t go all in, as I would never make that suggestion about anything, but overweight for sure.
heads up:
Fed’s Bullard Says ‘Pretty Good’ U.S. Economy May Allow Early End to QE2
U.S. Federal Reserve policy makers should review whether to complete a second round of quantitative-easing purchasing due to end in June because of strong U.S. economic data, Federal Reserve Bank of St. Louis President James Bullard said.
“The economy is looking pretty good,” Bullard told reporters in Marseille, France, today. “It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short.”
While the economy is clearly stronger than last summer and fall and QE should be reviewed, uncertainties remain, including Japan, Middle East political tensions, the U.S. fiscal position and the European sovereign debt crisis, Bullard said. U.S. first-quarter gross domestic product may not be as strong as anticipated several weeks ago, and some strengthening may get pushed into the second quarter, he said.
@ eaglesoars:
With teh Won in charge I’d dump US bonds too. Sooner or later we are going to go broke. Sooner at this rate.
@ Flyovercountry:
Thanks! I meet w/our financial advisor Tues. this is helpful.
coldwarrior wrote:
There, fixed that for ya!
Wow, Flyover~!
8-0
Well written, man.
I learned things….thanks.
Kind of puts my “Harbin Ice Festival” thingy to shame.
~ENT
mawskrat wrote:
Hey, Mawskrat~!
Do some of that fer me while yer at it, huh?
My Conservative Identity: You are an Anti-government Gunslinger, also known as a libertarian conservative or Tea Partier. You believe in smaller government, states’ rights, gun rights, and that, as Reagan once said, "The nine most terrifying words in the English language are, ‘I’m from the government and I’m here to help.’" Take the quiz at About.com Political Humor
mawskrat wrote:
Obama will never forgive you for that….
doriangrey wrote:
Well, they got me nailed pretty good.
I just got online, so if you see this, I’ll check for your answer. Jim Willie (a goldbug, since I read a lot of them) talks about the disaster in Japan and the economic effects of G7 monetization. Do you give his ideas any credit? With the U.S. already owning 70% of its own debt, don’t you think that this will be a problem going forward? Do you think that the ownership of precious metals (NOT through ETFs)is prudent as insurance against QE3? With another war front opened, I would think that ‘money printing’ is inevitable. Thanx.
coldwarrior wrote:
Smokescreen from Bullard to keep everybody at the Casino!
Also, I wanted to add this graph:
http://jsmineset.com/wp-content/uploads/2011/03/clip_image00116.jpg
@ yenta-fada:
I would like to appologize for taking so long to get back to this for the answer. Precious Metals are an asset class like any other. I agree that as such, they belong in many portfolios. Where I might disagree with the folks who seem to be all over the radio and T.V. hawking gold’s praises would be in what percentage of that portfolio should be. The value of gold currently is at an artificial high. People are scared, and feel that Gold will be their best hedge against financial armageddon. When the fear subsides, gold will drop like a stone. I can not say right now if you would be buying at the very top of gold’s run, but I would be willing to bet that you are near it. There are better hedges against inflation right now for something in an alternative asset class. For me personally, I am using Real Estate in the form of non publicly traded reits, and Commodities funds. Bear in mind also that the usage of these asset classes will usually not be greater than 8% of a total portfolio of even the most aggressive of investors.
Flyovercountry wrote:
I appreciate the time you took to answer my question.
We don’t have the range of choices in Canada that you have in the U.S. Since Toronto real estate is so expensive, we are already disproportionately invested in real estate. 
Definitely agree with you about commodities in general, especially energy given the additional mess president Clueless has embroiled us in. Canadians chose not to go into Iraq, so I’m not sure what we’re doing in Libya at all. Not counting the very volatile metal, silver, gold has passively returned around 17% per year during the past decade. In U.S. dollars, that is. That’s not bad for a lump of metal. lol
Now that we’re in a new format, I’ll compliment FOC on this informative post.