Someone will refer to me as a “financial planner” or a ”financial adviser” or perhaps even a “broker.”  I refer to myself as an “investment portfolio manager.”

What’s the difference and why is it important?

There are many websites that you can wade through to determine the specific (or non-specific) differences between titles and designations.  Some even include exhaustive lists of requirements in order to be certified.

But I think there is a simpler way that cuts to the heart of the matter.  Look at the noun in the title or designation.

For example, a planner is compensated for making a plan.  An adviser is paid to provide advice. A broker is paid to, well, “broker a transaction.”  And a manager is paid to manage.

This is important to understand because it ties into what, realistically, a client can expect from the service provider.  If you hire someone to provide advice and you subsequently take action on that advice, the responsibility for the success or failure is ultimately yours.  You made the decision to follow (or not follow) the advice.

By the same token if you hire someone to create a plan it is not appropriate to blame him or her if the execution of that plan is less than satisfactory.  If an architect designs a house for you but the builder uses sub-standard materials in the construction, it’s not the architect’s fault if the house falls down.  It’s the builder’s fault (or your fault for hiring the builder).

‘Advice’, ‘plan’, ‘analysis’, ‘counsel’, etc tend to be rather abstract and suggest passive involvement. ‘Management’, on the other hand, suggests active involvement with some level of decision-making authority (and accountability commensurate with such authority).

This issue of accountability is one of the reasons that titles and designations are so confusing in the financial services industry.  In a society so quick to assign blame and to litigate, most firms (and individuals) will naturally counter by doing their best to imply performance while simultaneously attempting to avoid accountability in case of non-performance.

This isn’t necessarily good or bad; it all depends on the value you receive from the service.  Paying a 1% “advisory fee” to Jim Cramer may or may not deliver as much value as paying a 1% “management fee” to Warren Buffett.  It all depends on what you are wanting to achieve and the credibility and performance of the provider.

To add to the confusion, some advisers also do planning and managing.  Some planners provide advice and management.  And some managers offer advice and planning.

So how can you determine the extent to which their efforts are devoted to each area?

I suggest looking for two things:

1. Does your service provider have discretionary or non-discretionary authority over your investment account?  ‘Discretionary authority’ means that he or she can execute transactions in your account without first asking your permission.  ‘Non-discretionary’ means that you must agree to each transaction beforehand, which is in fact accepting the advice of the professional.

2. Is there a benchmarking metric in place to evaluate the service provider’s performance against agreed objectives?  Due to its passive nature, the quality of ’advice’ can be difficult to measure, benchmark, and track.  Managing to specific goals and objectives, on the other hand, implies the presence of a process by which this may be accomplished.  Large institutions such as non-profits and endowments use a document known as an Investment Policy Statement (IPS) to define their objectives, the investment boundaries, and the quality control metrics that will be used to evaluate performance.  From this document a dashboard can be generated that allows the institution’s leadership to see at a glance if their investments are on track.

So, if your financial services provider has discretionary authority over your account, and you have worked with the provider to develop an IPS and dashboard, then you have effectively hired a manager for your investments.

If not, you are paying primarily for advice and/or planning.

What’s notable about the Roundtable discussion is that each of the four participants, in their own way, reinforced (and amplified) the concerns I had (and continue to have) when I wrote my May 16 post.

Since May 16, the S&P 500 has declined by a little more than -4.5%.  Notwithstanding the frightening views of the “Roundtable” participants, you might at this point be more worried about further declines than you were last May.  But you also might think that, with the 4.5% decline already experienced, you’ve lost the opportunity to move to cash and don’t want to do so now for fear of missing out should the market rally based on, say, unexpectedly strong 2nd quarter earnings reports.

A compromise approach might be to view the ‘journey’ of uncertainty over the next 3 months the same as you might view the uncertainty related to an expensive vacation trip.

You can, in effect, purchase “travel insurance” to mitigate the effects of any “hurricanes” that may occur in the markets over the near term.  And with forecasts by Chairman Bernanke of “a stronger second half” for the economy, short-term insurance may well be all that you need.

Here’s how it works.

Say you hold a mutual fund or ETF (like SPY) that closely tracks the S&P 500 index.  As of close of market last Friday, SPY was trading at $126.81 a share.  You could purchase a put option on SPY with a strike price of $127 that expires on September 16 for $5.02.  This would assure that the value of your investment in the S&P 500 would be worth at least $127 on September 16.  But you would have paid a 4% ‘insurance premium’ for that protection.

If that seems too hefty of a price, you could reduce the level of ‘insurance’ by simultaneously selling a September 16 put with striking price of, say, 114 for $1.55.  This would protect you from a 10% decline in the S&P 500 between now and September, with a net cost of $5.02 – $1.55 = $3.47.  This equates to about a 2.7% ’premium’ for the ‘travel insurance’ to get you through September.

If the stock market rallies, you will participate in the gain.  If not, your loss will be 2.7% plus any decline beyond 10% in the market.

The strategy of buying a put and simultaneously selling a lower strike put with the same expiration date is known as a “bear put spread” in the trade.  It is a way to offer protection for an investor that is bearish in the short term but bullish in the long term.

This pretty much describes my sentiments and approach in managing client accounts over the summer.

Would it be worth a couple of percent to you to invest in this type of ‘travel insurance?’ It all depends, I suppose, on how bad you expect the weather to  get….

Full Disclosure:  I hold both long and short positions in SPY at the time of this writing.

Collectively, Congress is putting off our debt problems by arguing over spending cuts and balanced budgets that will take years or even decades to materialize.

And individually, many Americans are kicking their own cans down the road by adopting a retirement ‘strategy’ of either working into their 70s or, in some cases, planning to not retire at all.

This is one of the results published in the 12th Annual Transamerica Retirement Survey.  More specifically:

• 39% of workers plan to work past age 70 or do not plan to retire
• 54% of workers plan to continue working when they retire
• 40% now expect to work longer and retire at an older age since the recession

Now it’s one thing if (like me) these folks love their jobs and want to prolong the satisfaction as long as possible.

But the survey suggested otherwise:

• Workers estimate their retirement savings needs at $600,000 (median), but in comparison, fewer than one-third (30%) have currently saved more than $100,000 in all household retirement accounts.
• Most workers, regardless of age or household income, agree that they could work until age 65 and still not have enough money saved to meet their retirement needs.
• Of those who plan on working past the traditional retirement age of 65, the most commonly cited reasons are of need versus choice.
• Many workers (31 percent) anticipate that they will need to provide financial support to family members.

I can’t help but wonder how much thought the respondents gave to their answers, or if they even realized the implications of the questions.

Undoubtedly many, perhaps even most, suffered a significant devaluation of their retirement nest eggs during the 2008/2009 market decline.

Perhaps to a rough approximation (especially for those who have an aversion to detailed mathematical models) they concluded that it will take, say, 5 years to get their portfolios back to pre-2008 levels, and maybe throw in another 5 years to factor in notional “corrections” for inflation, reduced pension benefits, reduced social security, or what have you…  Under such an approach their targeted retirement age changes from 65 to 75.  …Oh well, C’est la vie.

My guess is that the younger one is, the more tendency there is to think like this, and to discount how one will actually feel at age 75.  After all, there are a lot of years between now and then…

I’m now a little past the halfway point as a pentagenarian and I can certainly feel myself slowing down a little each year (although, truthfully, I’ve been saying this for at least the past 20 years).  The 2-week business trip to Europe doesn’t have the same allure it had when I was in my twenties.  I’m no longer interested in major DIY projects around the house (like tiling the kitchen floor, rebuilding the deck, and crawling around the attic installing ceiling light fixtures).

Ernest Hemingway‘s situation was much more dramatic and tragic:

“At the age of 61 he had a bad combination of physical and mental ailments caused by a lifetime of neglect and fast living. Mentally he had lost his memory during electroshock treatment at the Mayo clinic. Physically he suffered from rapid weight loss, skin disease, alcoholism, failing eyesight, diabetes, hepatitis, high blood pressure and impotence. Basically his body had broken down, he could no longer write and he was severely depressed, and rather than endure a lingering and ugly death he decided, ironically, that the courageous thing to do was to shoot himself.”

So what’s a can-kicker to do??

Every financial adviser knows that there are fundamentally only four approaches that can be taken to alter one’s retirement finances:

1. Work longer (delay retirement)
2. Save more prior to retirement
3. Spend less during retirement
4. Improve investment results

Surprisingly the survey placed little emphasis on improving investment results.  Three out of four workers kept their investment allocations unchanged from the prior year, with “a significant number of workers being less confident about their understanding of principals of asset allocation.”

In a society where self-reliance, ingenuity, entrepreneurialism, and independence are so highly valued it is astonishing to me that there is such an apathetic and even fatalistic view towards controlling investment results.

And yet, more than any of the other three approaches, altering investment results can have a significant and immediate impact on the retirement calculus.  I further submit that it is the easiest of the four to control and to forecast.

I think the survey is a reflection of how, sadly, many Americans have been systematically conditioned into believing that investing is too complex and risky for them to manage.

It is the ‘unlearning’ of this conditioning for my clients and readers that I am most passionate about achieving…

In my view, if the old Wall Street adage “Sell in May and Go Away” isn’t true this year, then it will never be (assuming it ever was in the first place).

I see at least three potential sparks that might cause an “economic brushfire” this summer.

The first is the termination of QE2 at the end of June.  This is when the Federal Reserve removes the respirator from the U.S. economy and we see if the patient resumes breathing on its own….  But if the patient continues to have difficulty breathing, going back on the respirator may not even be an option (at least in the same fashion as before).

This is because Secretary Geithner told Congress today that the U.S. has officially bumped up against the debt ceiling.  Presumably, therefore, the Treasury can no longer hold bond auctions, at least until Congress authorizes an increase in the ceiling.

With no bond auctions, the Federal Reserve has no bonds to buy.  …Unless they go out on the secondary market and buy them from, say, the Chinese.  But it’s hard for me to see how buying back U.S. bonds from the Chinese would stimulate the U.S. economy.  After all, any smart investor is going to want to receive more than he paid for his investment.

Now someone might say that I just showed how ignorant I am of how the government, global economy, and monetary policy really work.  And they’d be right.  I must confess that I know almost nothing about what this all means.  After all, when the government shuts down because of the lack of a budget, it doesn’t actually shut down.

And when the government has tapped-out its credit line it doesn’t have to stop borrowing.  Geithner has already indicated a number of workarounds (such as suspending investments in federal retirement funds) he can use to continue borrowing until the ceiling is raised.  These workarounds can last until August 2.  But that’s it (he says).

So the second potential spark is the debt ceiling issue.  Now, no media source I have seen actually expects the ceiling not to be raised (any more than they expected that a budget deal wouldn’t be made earlier this year).  But they do expect a lot of ideological brinksmanship resulting in a last minute compromise a few hours before the deadline.

Up to that time we can presumably expect threats, amplification of rhetoric, and in general the type of behavior that leads to an increasing sense of angst and uncertainty.  In the markets this sense of angst and uncertainty manifests itself as volatility.

Add to this the third potential spark which is the ongoing confusion over the future of the European Union, and it creates enough stress to send even the head of the International Monetary Fund running naked down the hall after a parlour maid.

So I told my wife it might be a good idea to go overweight on cash for the next couple of months.  Come September, much of the above should (hopefully) have played out and we’ll have a better view of the outlook for the remainder of the year and on into 2012.

As for me and my investments, well…  that’s why options were invented.

There are certainly a lot of global economic concerns that might cause investors to get out of the equity markets.  So many, in fact, that it is hard to determine just where to place one’s investment capital if he or she does decide to exit the market.

Put options can provide a means by which downside investment losses can be limited while still being able to participate in upside gains.  Let’s consider an investment in the Japanese market to illustrate why put options could be of benefit to investors while they participate financially in the rebuilding of the Japanese economy.

When I went online this morning I saw that Japan’s Nikkei-225 index fell by 6.2% overnight.  Worried investors are fleeing the Japanese equity market.

This might be good for these investors, but it comes at the expense of the Japanese people who have already suffered so much.

When the market capitalization of a company declines, as happens when stock prices drop, it reduces the effectiveness of the company to raise investment capital by issuing more shares of stock.  It also makes it more difficult for the company to obtain a loan because the company is perceived to have a lower valuation in the market.

Here in the U.S., if one wished to invest in Japan as a means to support its rebuilding efforts one of the easiest ways to do this is through an ETF such as the iShares MSCI Japan Index Fund (ticker: EWJ).  This ETF owns stock in companies such as Toyota, Honda, Mitsubishi, Canon, and Sony (to name but a few of the 324 holdings as of December 31, 2010).

A rational investor, of course, would be concerned about exposure to further losses should the Nikkei-225 index continue to decline.  And this is where Put options can play a role.

As I write this the U.S. markets are not yet open and the prices of both EWJ and its options are quite likely to change dramatically.  But as of last Friday, one could purchase EWJ at a price of a little less than $11 a share and a 11 strike Put option expiring in January, 2012, for about $1 a share.

In this fashion, the Put option serves as a sort of ‘insurance policy’ on an investment in EWJ; the holder of the Put option is assured the ability to sell their EWJ (should they so choose) for $11 a share at any time between now and January, 2012.

Since the total investment is ~$12 a share (~$11 for the stock and $1 for the put), the maximum loss over this 9 month period is limited to -8.3%.

But this also means that the price of EWJ must also go up by at least $1 a share (9.1%) to breakeven on the combined (ETF and  Put option) investment over this same 9 month period.

There are, however, other relatively simple option strategies that can be used to help “pay” for the Put “insurance premium” and reduce to a significant extent this breakeven point. (My intention is to elaborate on such strategies in future posts but, for now, if you are curious as to how these might be utilized please feel free to contact me).

If the Japanese market happens to bounce off this current dip and recovers nicely for a handsome profit by January 2012, would it be predatory on the part of this investor to have profited from the disaster?

I don’t think so.  We also shouldn’t lose sight of the fact that by investing in an ETF, the capital provided by the investor goes into the purchase of stock in the companies held by the ETF.  This, in turn, provides investment capital to these firms that helps them to rebuild their infrastructure and provide employment for people who literally had their jobs washed out to sea.

Full disclosure: At the time of this writing neither the author nor the portfolios he manages on behalf of clients holds either long or short positions in EWJ. 

I’m now ready to emerge from this self-imposed isolation to begin sharing with you over the coming year all that I have learned, and more, since my last post.

But first, let’s try to catch up with John Doe by looking at his portfolio performance for 2010.

(A .pdf version of the dashboard can be accessed via this link)

A good dashboard should reveal a lot of information at a glance, and you can quickly see that John’s portfolio value (left side, halfway down the page) fell considerably short of target and was essentially unchanged since March of last year.

Why?

In August / September I began to observe a cycling nature in the portfolio (put your thumb over the bars from October to December to get a sense of what I was seeing at the time).  Valuations would tend to increase for a few months, and then a setback would occur.  This would be followed by increases and another setback a few months after that.  The net result was that the portfolio was going nowhere.

In my September 22, 2010, post I mentioned a series of events that helped me to comprehend what was going on.

The corrective action, however, took much longer to develop and implement than I had expected.  It involved a considerable amount of back-testing, forward-testing, optimization, and (for those of you familiar with the Black-Scholes model) a process for balancing Delta with Theta.

Plus some plain trial-and-error that produced little (other than learning) over the past four months.

Along the way I discovered the following:

1.  The control systems were fighting each other.  This resulted in the cycling nature of the portfolio valuations.

2.  The process had been subjected to sub-optimal selection of dashboard metrics and key performance indicators.  As a result, I’m now redesigning the dashboard to display more appropriate parameters that do a better job of indicating appropriate corrective action when parameter values deviate from target. (This may necessitate a future explanation of Delta and Theta effects…. Ugh!)

3.  Corrective actions were overly conservative.  By erring on the side of portfolio protection, the process was not able to achieve market gains consistent with each asset class.

In November I held a workshop that illustrated a much-improved investment process.  Part of the purpose in holding the workshop was to test my ability to explain the process in terms that could be understood by a cross-section of individual investors.  Based on the highly positive feedback I received, I plan to develop a video based on the workshop for posting on this site.

So is the Johnson Harper LLC investment methodology complete?  Absolutely not.  There will always be the need for further optimization, for model tuning as market dynamics change, and for continuous improvement based on developing advances in investment theory.

I continue to be excited about sharing future discoveries with you.  In addition to the workshop video, I’m planning a series of other short videos that (hopefully) can illustrate and explain in understandable terms what the Johnson Harper LLC methodology is attempting to achieve and the potential benefits of this approach.

The first should be out within a few weeks, and I’ll be interested in your feedback.

I hope you’ll stay with me on this journey…

As usual, please note the following:

1. Should you wish to have a copy of the Excel-based dashboard file and/or any of the accompanying brokerage statements related to John Doe’s portfolio history please let me know.  I can make them available for inspection on a limited basis.

2. Readers should not try to replicate this portfolio by purchasing the ETFs in the same percentages as shown in John’s portfolio.  The overall ETF valuations shown in the dashboard include the sum of any long holdings of the ETF itself as well as the sum of both long and short options positions in the ETF.  Also please see the disclaimer at the right for important information about this website and Johnson Harper LLC.

3. You can automatically receive email alerts of future posts on this website by entering your email address in the “Email Subscription” field near the top of this website.

Full disclosure: At the time of this writing the author holds both long and short positions in the ETFs shown on the dashboard (SPY, TLT, GDX, XLE, EWZ, EFA, IYR) as well as other ETFs not shown in the screenshot.

A properly designed dashboard with appropriate metrics should be able to both a) assist in answering this question, and b) provide an indication of corrective action going forward.  As I hope to demonstrate in this posting, our dashboard fulfills both requirements.

Looking at the Beta plot (lower right side of the dashboard) we see a rather consistent monthly change in the portfolio of about 14% (the Beta value) of the change in the S&P 500.  Multiplying this 14% times the 8.8% gain in the S&P 500 results in an expected increase in John’s portfolio of 1.2%.  This is almost double the value his portfolio actually achieved.

(A .pdf version of the dashboard can be accessed via this link)

Other gauges in the dashboard provide clues as to the reason for the significant underperformance.  For example, in my previous post that reported on John’s portfolio performance for August, I alluded to a “perfect storm” that resulted from a confluence of 3 separate events.  Part of the fallout from this ‘storm’ was the forced sale of John’s holdings in TLT (30-year U.S. Treasury bond fund) due to the assignment of covered calls held in his account.  The impact can be seen visually in the upper right corner of the dashboard which shows a big spike in cash balance in the month of September.

This cash was not reinvested during the month, and as a result it was not available to either generate income (by way of additional call writes) or participate in the equity run-up during the month.  From the ‘Allocation’ section in the upper left of the dashboard you can see that nearly 30% of John’s portfolio was in cash during the month; the ‘non-productivity’ of such a large position contributed greatly to the degree of underperformance.  Other factors include losses related to liquidating positions as a result of the assignment of the TLT options.

Going forward, we intend to reinvest a portion of this cash back into TLT at a price closer to its expected longer-term valuation based on interest rate forecasts.  The remaining cash will be reinvested in equity ETFs throughout October based on their relative attractiveness as corporate earnings are announced (domestic) and currency trends (international) hopefully become more apparent.     

We continue to be optimistic (and even excited) about the prospects for John’s portfolio during the final (4^th) quarter of 2010.

I hope you’ll check back in November for the next update.

As usual, please note the following:

1. Should you wish to have a copy of the Excel-based dashboard file and/or any of the accompanying brokerage statements related to John Doe’s portfolio history please let me know.  I can make them available for inspection on a limited basis.
2. Readers should not try to replicate this portfolio by purchasing the ETFs in the same percentages as shown in John’s portfolio.  The overall ETF valuations shown in the dashboard include the sum of any long holdings of the ETF itself as well as the sum of both long and short options positions in the ETF.  Also please see the disclaimer at the right for important information about this website and Johnson Harper LLC.
3. You can automatically receive email alerts of future posts on this website by entering your email address in the “Email Subscription” field near the top of this website.

Full disclosure: At the time of this writing the author holds both long and short positions in the ETFs shown on the dashboard (SPY, GDX, EEM, EFA, USO, XLE, IYR) as well as other ETFs not shown in the screenshot.

But taking a look at the dashboard below, you may wonder why I chose this word…

Dashboard John Doe 1008

To be sure, even a quick glance at the dashboard shows that August is basically a continuation of the same lackluster performance that has been exhibited throughout the year so far.

Furthermore, I am 3 weeks late in providing this update…  Why wait so long to share my ‘excitement?’

By way of explaining, I’ll start by admitting that John’s portfolio performance in August (and in September as well, as you’ll see in a few more weeks) was negatively impacted by a series of 3 events that came together in a kind of “perfect storm” in his portfolio.  Rather than go into significant detail as to the nature of these 3 events, let’s just say that it was a “once in a lifetime occurrence” that caused these events to occur simultaneously.

…But haven’t we been seeing a rather large number of independent, but nonetheless damaging, “once in a lifetime occurrences” in the financial markets over the past decade or so?  In case you’ve lost track due to the sheer volume, only a few of these are:  Asian financial crisis (1997), Russian financial crisis (1998), collapse of Long-Term Capital Management (1998), bursting of dot-com bubble (2000), Chinese market ‘correction’ (2007), U.S. subprime mortgage crisis (2007), Countrywide Financial failure (2008), Lehman Brothers failure (2008), Wachovia failure (2008), Washington Mutual failure (2008), failure of CIT Group (2009), General Motors bankruptcy (2009), and, more recently, the ‘flash crash’ (2010).   

So although I was able to satisfy myself that the set of circumstances that were responsible for John’s less-than-stellar portfolio performance in August would never again occur, this doesn’t rule out some other unrelated, but nevertheless damaging, confluence of different events occurring in the future… perhaps even near future.

If so, and particularly in view of general market volatility over the past couple of years, will I be offering in the future nothing more than a series of reasonably-sounding monthly explanations as to why John’s portfolio continues to lag well below target performance levels?

If the answer to this question is indeed ‘yes’, then over the long run the performance of both my own and my clients’ portfolios can hardly justify the tremendous investment of time and effort I put into managing (or attempting to manage) them.

Against this rather dismal scenario and prospect for the future of Johnson Harper LLC there came yet a 4^th event that, while totally unrelated to John’s portfolio results, nevertheless occurred at a most fortuitous moment.

That 4^th event was my having developed a severe case of (as my ophthalmologist described it) “wall to wall keratitis” in each eye.  I can’t remember having come down with anything as debilitating as this in my… well, let’s say, many years of existence on this earth.  It was as though someone had taken sandpaper to the inside of my eyelids (that ‘sandpaper’ was, in fact, a roughness of the cornea resulting from the infection).  Open or closed, the pain was present anytime I experienced eye movement.

The good news is that relief came very quickly once I paid a visit to the ophthalmologist.  Some antibiotic ointment, something to keep the pupils dilated (to prevent spasms), and various moisturizing drops made the pain go away.  But between the condition itself, the ointment, and the dilated pupils my vision was pretty much shot for the better part of a couple of weeks.

So how is this relevant to portfolio management?

Essentially my entire convalescence was spent flat on my back in the dark with cold compresses over my eyes and just…. thinking.  I drew probability distribution curves in my mind.  I solved (at least intuitively) Black Scholes options pricing models in my head.  I ran Monte Carlo simulations in my mind trying to think 6-12 moves (i.e., months) into the future.  I pondered the nature of Black Swans and how the possible occurrence of such events is managed in the chemical industry. I thought of PID controllers and SQC/SPC techniques and how to further refine these concepts in terms of smoothing capital market returns under conditions of high volatility.

… And I thought of all of these things in the context of John Doe’s portfolio and the Johnson Harper LLC investment process.

Perhaps by now you are getting the idea that my current state of excitement is the result of one or more epiphanies that came to me in the imposed isolation of my recovery.  And that is exactly what did happen.

I discovered the final piece that needed to be added to the Johnson Harper LLC investment model to make it generally applicable across the widest possible market conditions.

For me and (by association) my clients this is truly exciting.

Will the passage of time validate this discovery?  I can only wait and see.  I will say that, due to existing capital allocations in the portfolios I manage, the improvement is not likely to be seen until November or December.

…But if it’s there, the dashboard will show it.

I hope you’ll stay with me to see the outcome.

As usual, please note the following:

1. Should you wish to have a copy of the Excel-based dashboard file and/or any of the accompanying brokerage statements related to John Doe’s portfolio history please let me know.  I can make them available for inspection on a limited basis.
2. Readers should not try to replicate this portfolio by purchasing the ETFs in the same percentages as shown in John’s portfolio.  The overall ETF valuations shown in the dashboard include the sum of any long holdings of the ETF itself as well as the sum of both long and short options positions in the ETF.  Also please see the disclaimer at the right for important information about this website and Johnson Harper LLC.
3. You can automatically receive email alerts of future posts on this website by entering your email address in the “Email Subscription” field near the top of this website.

Full disclosure: At the time of this writing the author holds both long and short positions in the ETFs shown on the dashboard (TLT, SPY, GDX, EEM, EFA, USO, IYR) as well as other ETFs not shown.

If, for example, you happen to be bullish on oil, investing in a fund that holds a variety of oil company stocks greatly reduces the severity of decline in your portfolio if one of the companies experiences an Exxon Valdez or BP Deepwater Horizon event.  So diversification involves taking somewhat smaller positions in several companies that participate in similar markets.

But let’s now imagine that a major university reports that researchers have discovered a means by which zero point energy-based power generation systems can be commercialized, and with it the potential for electricity that is truly “too cheap to meter.”  In this scenario, the stock prices of all oil companies in your fund, and thus the price of your fund itself, would plummet.

This is an illustration of systematic risk, which is the risk inherent to the entire market or market segment.

It follows, therefore, that systematic risk can be mitigated by allocating one’s investments across various funds that represent dissimilar markets or segments.  In portfolio theory, such dissimilarity is measured using a mathematical term known as correlation (which we’ll get into later).

But aside from mitigating risk, allocation has another advantage.  This advantage is often illustrated conceptually using small business metaphors.

For example, consider a landscaping business in the northeastern U.S. where I live.  Profits are high in the spring and summer, dwindle somewhat in the autumn, and are practically non-existent in the winter.  On a monthly basis, the ‘returns’ of this business would be highly volatile (albeit predictable).  Let’s imagine profits of $10,000 a month for this small business from April through August; $5,000 a month from September through December; and $0 per month from December through March.  Over one year our imaginary landscape business has generated $70,000 in profits.  The monthly profits over the year range from a high of $10,000 to a low of $0.

Now, our small landscaper has a couple of heavy-duty pick-up trucks for hauling equipment and supplies to the various job sites.  Why not make a small additional investment in snow plow attachments and use these trucks to clear snow from driveways and parking lots during the winter months?  Given the vagaries of the weather, let’s say that our landscaper now earns an additional $20,000 over the 4 months from December through March in his snow removal business.  The monthly high of $10,000 and low of $0 may be unchanged, but the number of months in which profits are zero has decreased.

Two things have happened:

1)      Annual profit (or ‘return’) has increased from $70,000 to $90,000

2)      Because some income is now coming into the business over the winter months, the monthly fluctuation in profits (‘volatility’) has been reduced.

So we see in this simple thought experiment that allocation has the potential to both increase returns and reduce volatility in a business and, by extension, an investment portfolio.

Our thought experiment is a simplified illustration of a more complex investment concept known as modern portfolio theory.  Let me try to walk you through this using the diagram below:

It starts with the simple premise that an investor logically expects to receive a ‘reward’ (i.e., return) that is commensurate with the risk he or she is taking in making the investment.  In our diagram, Investment A has relatively low risk (as measured by the volatility, or extent of price fluctuation over time) but also has a relatively low annual return.  Typically, a bond fund or some other type of fixed income investment would have these characteristics.

Investment B, on the other hand, might be a stock or equity fund that has a higher expected return but carries a higher degree of risk as well.

An investor willing to ‘split the difference’ in terms of risk in his/her portfolio might expect that holding 50% of A and 50% of B might result in a combination of risk and return midway between that of A and B as shown by point C on the diagram.

But modern portfolio theory says that assuming risk midway between that of A and B by blending the two investments in one’s portfolio will, in actuality, generate a higher return equivalent to point D.  Moreover, point D is not the return one would receive in a portfolio consisting of a 50/50 mix of A and B.

Instead, a 50/50 blend of A and B would result in a return equivalent to the average return of both investments, but at a much lower risk (degree of portfolio’s fluctuation in value) equivalent to point E on the diagram.

So modern portfolio theory says that a blend of investments has the potential to increase overall return for a given level of risk, and/or decrease risk for a given return that the investor is trying to achieve.

The blue curved line defining the expected risk/return relationship is known as the efficient frontier.  Notice that, in moving from point A to point E by increasing the holdings of Investment B, a significant additional return has been received with only a small amount of additional risk.  But as more risk is assumed beyond that point, the benefit in terms of additional return becomes smaller and smaller.

If you do a Google search on images for ‘efficient frontier’ you’ll find all sorts of complicated and interesting curves, with all of them having a convex shape to some degree.

This convexity, by the way, illustrates what is sometimes referred to as the ‘free lunch’ of investing (the extent of which is shown by the green arrow in our diagram above).

So what determines the specific shape of the efficient frontier curve?

It is influenced by such things as the number of holdings in the portfolio, the risk/return characteristics of each holding, and the extent to which the returns of each holding are correlated with the returns of the other holdings.

The Takeaway

1. Systematic risk is the risk inherent to an entire market or market segment.
2. Asset allocation can mitigate systematic risk and has the potential to both increase returns and reduce volatility in an investment portfolio.
3. This is due to an aspect of modern portfolio theory which demonstrates that a blend of investments has the potential to either increase overall return for a given level of risk, or decrease risk for a given level of return that an investor is trying to achieve.
4. These advantages are influenced by such things as the number of holdings in the portfolio, the risk/return characteristics of each holding, and the extent to which the returns of each holding are correlated with the returns of the other holdings.

The correlation aspect is one of the trickiest to manage.  The idea is to select an appropriate number of asset classes with valuations that, while generally increasing, are not expected to move in precise tandem with each other over the investment holding period.

We’ll explore this aspect further in an upcoming post, including a way that you can potentially apply modern portfolio theory in allocating your investments in a company 401k account.

So I hope you’ll stay with me.  To be automatically notified of future postings, please enter your email address in the ‘Email Subscription’ section at the top right area of this website.

I think I’ve figured out how to get an article placed on SA’s “Most Popular” list. Pick one side of the ‘fundamental’ versus ‘technical’ approach to stock selection, and then develop an argument as to why the other approach is useless. This is sure to spark a heated debate, which in turn will draw spectators and other participants looking to join into the ensuing bar room brawl. Next thing you know, your article has generated several hundred comments and you’ve made the list…

Of course, a self-serving motivation such as this isn’t likely to be of much help to readers hoping to improve their understanding of the capital markets. And, taken to an extreme, it could cause SA to become viewed as just another source of financial ‘entertainment.’

But with an increasing focus on the need for financial literacy, my hope is that SA can play a vital role in contributing to knowledge, not just opinion. With that in mind, I’d like to offer some well-intentioned observations that I hope will be useful to those who may be confused about the appropriate use of fundamental and technical analysis.

First off, you should know that I’m an engineer by education and orientation. I also am an advocate of simulations and, in situations where mathematical models are inappropriate, the use of ‘thought experiments.’ My purpose in telling you this is to give you some insight into the way I think.

To illustrate this, imagine that you wake up one morning and learn that overnight someone (for reasons known only to them) has given you trading access to a brokerage account that contains $10,000. You are told that if, by the end of the trading day, you have grown the account to $11,000 you may keep everything. If you fail, you get nothing. Your access allows you only to trade the account; you cannot withdraw or deposit funds.

What would you do? I can think of a number of ways in which I would attempt to achieve the requisite 10% growth in one trading day, but none of them would involve the use of fundamental analysis. One way or the other, any approach I can think of involves the use, at least conceptually, of technical analysis methods.

Now let’s consider another thought experiment. Let’s say an aging relative who you love dearly is no longer able to manage her finances. You’ve been given power of attorney over her modest investment account and need a return of about 10% each year over the next 30 years to achieve a reasonable assurance that she will not outlive her assets.

What would you do in this case? Here again, I can think of a number of ways in which this type of stretch goal could be achieved, but (unlike the first example) none of them would involve the use of technical analysis. Every approach I can think of involves the use, at least intuitively, of fundamental assumptions about economic growth, inflation, fixed income returns, and likely equity market valuations over the 30-year horizon.

Now, as an engineer, I’ve just defined some boundary limits. On the basis of these thought experiments I regard technical analysis as being highly appropriate for very short time horizons, and fundamental analysis as being highly appropriate for very long time horizons.

Is there anything new here? Not really. The conclusion I reached with my thinking exercise is basically nothing more than a restatement of the Benjamin Graham quote about the market being a voting machine in the short run and a weighing machine in the long run. For short term trading, you try to anticipate the ‘voting trends’ (by charting). For long term trading, you try to estimate the ‘weight’ of the value that’s likely to be created (by, perhaps, discounting).

The trick is to determine how much of each approach to use in the intermediate term. Intuitively, one would expect that as the investment time horizon gets longer, one would increasingly rely on fundamental analysis over technical analysis.

…But quantifying the “percentage” of each approach to use as a function of the anticipated investment holding period is a bit like pondering the appropriate “percentage” of Newtonian versus quantum mechanical calculations to use as a function of particle size.

So what can you do with this information? I would suggest the following:

1. Understand your own time horizon and objectives. Are you more of a trader (short time horizon) or investor (longer time horizon)? This should help you to clarify the extent to which you should factor both technical and fundamental approaches into your decision making process.

2. Choose a methodology and time period consistent with your time horizon. For example, is a head and shoulder pattern that occurred over a 3-month period in 2005 relevant to a decision you are faced with today? Not likely. By the same token, are the reported financials from that hot IPO sufficient for a 30 year investment horizon? Again, not likely.

3. View commentary to SA articles through the lens of the individual submitting the comment. Many times you’ll see, for example, a buy and hold investor criticizing the use of technical analysis. Conversely, you may also see a day trader disclaiming the value of fundamental analysis. In each case, the commenter is effectively a highly-skilled surgeon criticizing the use of medicine to cure a stomach ache.

Oh, and by the way, in addition to being an engineer I’m also a wimp. If this post causes a bar room brawl, please don’t beat me up too badly. After all, I wear glasses…

Disclosure: No positions.