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Choosing The ‘Best’ REIT ETF

Summary Over the past 8 years, REZ has outperformed the other REIT ETFs. REITs are generally more volatile than the S&P 500. REIT ETFs help diversify a S&P 500 focused portfolio but are highly correlated among themselves. As a retiree looking for income, I am a fan of Real Estate Investment Trusts (REITs). I own some individual REITs, but for diversification, I tend to gravitate to REIT funds, especially Closed-End Funds (CEFs) or Exchange Traded Funds (ETFs). In July, I wrote an article on how to choose the “best” REIT CEF and selected the Cohen and Steers REIT and Preferred Income Fund (NYSE: RNP ) as my favorite. This article focuses on selecting the “best” ETF and also compares the performance of these ETFs with RNP. There are many ways to define “best.” Some investors may use total return as a metric, but as a retiree, risk is as important to me as return. Therefore, I define “best” as the fund that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”; I am just saying that this is the definition that works for me. For those that have not read my previous articles, I will quickly summarize some of the characteristics of REITs. In 1960, Congress created a new type of security called REITs that allowed real estate investments to be traded as a stock. The objective of this landmark legislation was to provide a way for small investors to participate in the income from large scale real estate projects. A REIT is a company that specializes in real estate, either through properties or mortgages. There are two major types of REITs: Equity REITs purchase and operate real estate properties. Income usually comes through the collection of rents. About 90% of REITs are equity REITs. Mortgage REITs invest in mortgages or mortgage-backed securities. Income is generated primarily from the interest that is earned on mortgage loans. The risks and rewards associated with mortgage REITs are very different than those associated with equity REITs. This article will only consider equity REITs. One of the reasons REITs are so popular is that they receive special tax treatment, and as a result, are required to distribute at least 90% of their taxable income each year. This usually translates into relatively large yields. But because REITs must pay out 90% of their income, they rely on debt for growth. This means that REITs are sensitive to interest rates. If the interest rates rise, the cost of debt increases and the REITs have less money for business investment. However, rising rates usually imply increased economic activity, and as the economy expands, there is a higher demand for real estate, which is positive for REITs. The effect of higher rates depends on the type of real estate owned by the REIT. For example, if the real estate has tenants with short leases, interest rates would have less impact because the rents could be raised quickly. Among the real estate sectors, hotels generally have the shortest leases followed by (from short to long) apartments, industrial property, retail properties, and healthcare. There are currently 16 ETFs focused on equity REITs. To reduce the analysis space, I selected only the ETFs that met the following requirements: A history that goes back to 2007 (to see how the fund reacted during the 2008 bear market). Generally, REITs were devastated in 2008, but, like other equities, they have recovered strongly since 2009. A market cap of at least $100 million. An average daily trading volume of at least 50,000 shares. The 6 ETFs that passed the screen are summarized below. Vanguard REIT Index (NYSEARCA: VNQ ). This ETF was launched in 2004 and is the largest REIT ETF. It tracks the MSCI US REIT Index, which is a pure equity index. The fund has 145 holdings diversified across real estate sectors with retail being the largest constituent at 25% followed by residential (17%), specialized (14%), Office 14%, and health care (13%). Specialized REITs are companies or trusts that do not generate a majority of revenue from rental and lease operations, such as storage properties. VNQ holds a large percentage (40%) of medium cap firms and also has 19% in small cap holdings. The fund charges a low 0.12%, which is substantially less than most of its competitors. The fund yields 3.9%. iShares U.S. Real Estate (NYSEARCA: IYR ). This is the only ETF that holds REITs of all kinds including mortgage REITs and timber REITs. The fund has 119 holdings spread over commercial (44%), specialized (37%), and the residential (14%) sectors. The fund has an expense ratio of 0.43% and yield 3.7%. iShares Cohen & Steers REIT (NYSEARCA: ICF ). This ETF is highly concentrated, holding only 30 of the largest REITs. The strategy assumes that large REITs will be better able to weather downturns. The holdings are spread across the commercial (51%), specialized (28%), and the residential (21%) sectors. The expense ratio is 0.35% and the yield is 3.2%. SPDR DJ Wilshire REIT (NYSEARCA: RWR ) . This ETF tracks the Dow Jones US Select REIT index. The fund holds 95 REITs spread over the commercial (53%), specialized (27%), and residential (20%) sectors. The fund has an expense ratio of 0.25% and yields 3.2%. i Shares Residential Real Estate Capped (NYSEARCA: REZ ). This ETF is touted as a residential REIT fund but only about 47% of the holdings are residential REITs. The other 53% are primarily specialized REITs. The fund has 38 holding, has an expense ratio of 0.48% and yields 3.3%. S&P REIT Index (NYSEARCA: FRI ). This ETF covers a large portion of the US REIT market with 156 holdings spread over commercial (55%), specialized (28%) and residential (17%) sectors. The fund has one of the highest expense ratios at 0.50% and yield 2.6%. For comparison, I used the following CEF: Cohen and Steers REIT and Preferred Income Fund. This CEF sells for a discount of 17.6%, which is larger than its 5-year average discount of 9.9%. The portfolio consists of 203 holdings with 49% in REITs and 49% in preferred shares. The fund uses 26% leverage and has an expense ratio of 1.7%. The distribution is 8.4%, consisting primarily of income with about 40% return of capital over the past 9 months. I also included the following ETF to provide a comparison to the overall stock market. SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09%. It yields 2%. For the funds that met my criteria, I plotted the annualized rate of return in excess of the risk-free rate (called Excess Mu on the charts) versus the volatility for each fund. This data is shown in Figure 1. The risk-free rate was assumed to be zero to make comparisons easier. (click to enlarge) Figure 1. Risk versus reward over bear-bull cycle Figure 1 illustrates that REIT funds have had a large range of returns and volatilities. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with RNP. If an asset is above the line, it has a higher Sharpe Ratio than RNP. Conversely, if an asset is below the line, the reward-to-risk is worse than RNP. Some interesting observations are evident from the figure. REIT performance is tightly bunched in the risk versus reward space with similar volatilities and performances. All the REITs were significantly more volatile than the S&P 500 but also delivered more total return. RNP was among the top performers illustrating that this CEF did as well or better than most ETFs. Cohen and Steers manages both RNP and ICF. RNP performed better than ICF, likely due to the use of leverage. REZ was the best performer on a risk-adjusted basis followed closely by VNQ and RWR. FRI was the least volatile ETF and ICF was the most volatile. FRI and IYR lagged in terms of risk-adjusted performance. One of the reasons often touted for owning REITs is the diversification they provide. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. To assess the degree of diversification, I calculated the pair-wise correlations associated with the REIT funds. The results are provided as a correlation matrix in Figure 2. (click to enlarge) Figure 2. Correlation matrix over bear-bull cycle As is apparent from the matrix, REITs did provide a fair amount of portfolio diversification for an equity based portfolio and a CEF based portfolio . However, the REIT ETFs were generally highly correlated with one another. This is not surprising since the number of REITs is relatively small and the ETF portfolios have substantial overlap. Thus, you do not receive much diversification by purchasing more than one of the ETF funds. Next, I looked at the past 5-year period to see if the REIT performance had significantly changed. The results are shown in Figure 3. The performances were tightly bunched, but RNP and REZ were still the best performers. IYR continued to lag. You should also note that with the 2008 bear market removed from the analysis, volatilities were substantially reduced. In fact, over the past 5 years, REIT ETFs were only slightly more volatile than the S&P 500. (click to enlarge) Figure 3. Risk versus reward over past 5 years Continuing the analysis, I re-ran the analysis over the past 3 years and the results are shown in Figure 4. During this period I was able to add the following ETF to the mix. Schwab US REIT (NYSEARCA: SCHH ). This ETF has the lowest expense ratio (0.07%) of any REIT fund. The fund tracks the same index as RWR but has a much smaller expense ratio. The fund holds 95 REITs spread over the commercial (53%), specialized (27%), and residential (20%) sectors. The fund yields 3.2%. Over this period, all the REIT funds were again tightly bunched, without a large variation in either return or volatility. For the past 3 years, the ETFs slightly outperformed RNP on a risk-adjusted basis. All the REITs performed significantly poorer than SPY over the period. (click to enlarge) Figure 4. Risk versus reward over past 3 years Finally, I looked at the past 12 months (Figure 5). What a difference a couple of years made. REZ continued to be the best performer, followed by ICF, and then SCHH and RWR. RNP had similar performance to SCHH. It is interesting to note that ICH outperformed RNP, illustrating that leverage does not always increase total return. Most of the REIT funds outperformed SPY over the past year. The popular IYR fund lagged during the period. (click to enlarge) Figure 5. Risk versus reward over past 12 months Bottom Line The performance of REIT ETFs depends on the time period analyzed. During some periods, REITs outperformed SPY but lagged in other periods. RNP (the reference CEF) held it own against ETFs, usually being among the top performers on a risk-adjusted basis. In terms of ETFs, REZ was clearly the best performer in all time frames analyzed. Since REIT ETFs are highly correlated with one another, you do not receive significant diversification by purchasing more than one. If you decide to invest in this asset class, I would recommend REZ.

Project $1M: Achieving A $1M Portfolio With Growth Stocks Pt. 3

Summary I’ve created Project $1M to try and attain a $1M capital base from growth stocks in 11 years. I’m focused on including stocks that have a moat and some strong growth drivers. I will introduce the final set of stocks in this update. I previously introduced the concept of my growth oriented model portfolio in a previous article. The focus of that portfolio was directed toward achieving a $1M capital base in approximately 11 years, starting from a base of $217,500. I previously introduced the first 6 stocks in the portfolio here , and the next 6 stocks in the portfolio here . I’d like to introduce the final set of stocks in the Project $1M portfolio here and show how the portfolio stands. My Criterion In addition to companies with moats and strong barriers to entry, I set a specific focus on companies with high returns on invested capital and that were generally achieving double-digit growth with respect to net income and earnings per share. My thinking here was that these types of companies would be likely be able to continue earning above double digit earnings while maintaining their market multiples, and thus generate strong rates of capital growth. The Remaining Companies Westinghouse Air & Brake (NYSE: WAB ) is a technology supplier to the freight rail and the passenger transit industries. The company provides engine cooling, braking and other design and engineering services. Wabtec holds a dominant market share position in North America for the supply of technology to the rail industry. In some specific component segments, such as pneumatic braking systems, Wabtec is part of a strong duopoly along with Knorr Bremse. This dominance is reflected in the significant positive trend in gross margin and operating margin for Wabtec over the last decade. Positive Train Control represents the next revenue driver for the company. Positive Train Control refers to the requirement that certain operational functions of a train be capable of being monitored and controlled electronically. Wabtec has almost tripled revenues from $1.03B in 2005 to over $3.04B in 2014, representing an annualized growth of close to 14%. The company derives returns on equity and returns on invested capital that are consistently over 15%. Celgene (NASDAQ: CELG ) is a strong player in the biotechnology space, with a portfolio of drugs targeted toward cancer and inflammatory conditions. The company’s Revlimid franchise is a blockbuster and delivered over $5B in revenue in 2014. Revlimid has received approvals for the treatment of a variety of conditions including lymphoma and myeloma. With patent protection on the franchise likely to last well beyond the end of the decade, Celgene is poised for long term growth. Celgene’s return on equity have been hovering around 30% for the last few years, which indicates that it is a good steward of shareholder capital. Celgene has managed strong double digit revenue growth for the last decade. I don’t see too many reasons why this won’t be the case for the coming decade as well. Medidata (NASDAQ: MDSO ) solutions provides cloud based simulations and prototyping for life sciences. Medidata provides a valuable service for company’s engaged in drug discovery by helping them to simulate and prototype the effect of a given molecular combination quickly and more cost effectively than with traditional methods. The company has been growing revenues at almost 20% annually, with gross margins seeing a positive upward trend, and hovering at around 75%. With the continued push for faster drug development and continued pressure on traditional pharmaceutical companies, the need for Medidata’s product offerings will only continue to grow. Vipshop (NYSE: VIPS ) is discount e-commerce retailer in China that has pioneered the concept of flash sales. The company aggressively marks down oversupplied or out of season stock, which it makes available on its platform. Vipshop has a particular focus on pushing product to consumers in Tier 3 or Tier 4 cities in China, where there are typically no malls selling brand name product. The company’s rate of growth has been nothing short of extraordinary, with revenue growth in excess of 100% annually for the last few years. While that will undoubtedly moderate overtime, Vipshop occupies a unique niche in the Chinese e-commerce market, With returns on equity in excess of 40%, and a long runway of growth ahead, I think Vipshop could be poised for good long term returns. Zhaopin(NYSE: ZPIN ) provides an online recruitment platform in China. Zhaopin offers online recruitment services, including executive search and campus recruitment. Zhaopin has maintained a strategy of moving into lower tier cities in the quest to drive further revenues. While LinkedIn’s (NYSE: LNKD ) entry into China remains a long term threat for this company, Zhaopin’s early entry and focus on smaller tier cities should provide a competitive edge that allows the company to continue to grow profitably for a number of years. The company has returns on invested capital of over 25%, with revenue growth also in excess of 20%. Polaris (NYSE: PII ) designs and manufactures off road vehicles and other sport utility vehicles including snow mobiles, ATVs and motorcycles. Polaris has a well deserved reputation for design excellence and innovation, which has helped the company stand out in an increasingly crowded market. Polaris has demonstrated a track record of financial discipline over the last decade. Gross margins have shown sustained increase, rising 600 bp over the last decade. This is coupled with returns on invested capital that have exceeded 40% over the last few years. When combined with strong double digit revenue growth over the last decade, Polaris looks quite attractive for future returns. United Therapeutics (NASDAQ: UTHR ) produces drug therapies for patients with chronic conditions and is focused on the unmet needs space. The company currently produces drugs for pulmonary hypertension, congenital heart problems and neuroblastoma. While the company remains exposed to the risk of generics eventually making their way into some of the key niches that the company currently occupies, UHTR is looking to expand the markets it currently serves, and is even looking at the manufacture of artificial organs as a new line of business. The company has grown revenues in the high double digits for the last decade, with returns on invested capital over 40%. This write up concludes the initial set of positions for Project $1M, which is currently fully invested. Below is what the portfolio currently looks like. I will provide periodic updates on portfolio performance and any new positions that are initiated, or existing positions that are existed. Name Shares Held $ Cost Per Share $ Total Cost $ Market Value $ Unrealized Gain/Loss Since Purch % Unrealized Gain/Loss Since Purch Baidu Inc ADR 54 187.47 10,123.38 11,161.26 1,037.88 10.25 Celgene Corp 122 122.71 14,970.62 13,848.22 -1,122.40 -7.5 Core Laboratories NV 64 116.33 7,445.12 7,190.40 -254.72 -3.42 Facebook Inc Class A 99 101.97 10,095.03 10,624.68 529.65 5.25 LinkedIn Corp Class A 42 240.87 10,116.54 10,620.54 504 4.98 MasterCard Inc Class A 305 98.99 30,191.95 30,347.50 155.55 0.52 Medidata Solutions Inc 174 43 7,482.00 7,830.00 348 4.65 Mercadolibre Inc 102 98.37 10,033.74 12,377.70 2,343.96 23.36 Moody’s Corporation 156 96.16 15,000.96 16,277.04 1,276.08 8.51 Novo Nordisk A/S ADR 235 53.18 12,497.30 12,861.55 364.25 2.91 Polaris Industries Inc 89 112.34 9,998.26 9,386.83 -611.43 -6.12 Priceline Group Inc 7 1,454.00 10,178.00 8,970.71 -1,207.29 -11.86 ResMed Inc 174 57.61 10,024.14 10,286.88 262.74 2.62 Starbucks Corp 201 62.57 12,576.57 12,459.99 -116.58 -0.93 United Therapeutics Corp 51 146.63 7,478.13 7,709.67 231.54 3.1 Vipshop Holdings Ltd ADR A 243 20.52 4,986.36 3,973.05 -1,013.31 -20.32 Visa Inc Class A 256 77.58 19,860.48 20,528.64 668.16 3.36 Westinghouse Air Brake Technologies Corp 121 82.87 10,027.27 9,285.54 -741.73 -7.4 Zhaopin Ltd ADR 314 15.19 4,769.66 4,788.50 18.84 0.39 Project $1M 217,855.51 220,528.70 2,673.19 1.23

Apply Kelly Formula To Investing: Is Volatility Just Risk?

Summary Kelly Formula is one of the most important formulas in the investment theories. It is also very interesting and useful since it is against our intuition. Volatility is commonly seen as just “risks”, but it is much more than that, since volatility can affect performance too. Theoretically, Kelly Bet is also the “optimal bet”, but that is often not true in practice. Since reducing volatility can help performance too, I will also talk about many methods to reduce the volatility of a portfolio. Kelly Formula Kelly formula or Kelly bet was found by John Kelly in 1956. This formula gives the optimal bet, given fixed odds in a gambling game. Although it has some fairly simple math behind, it didn’t get much attention from the financial world until much later. On the surface, its application is limited. Financial activities such as investments don’t always have fixed odds, and may not have a fixed period for its return either. However, what is profound in that formula is that it gives a “maximum bet” that is optimal even if one is completely non-risk-averse. If we really think about it, it is actually against regular people’s intuition. Normally we would think the returns are always related to the risk we are willing to take. The more risk we can take, the more returns we will get. So the investment return is a function of our risk tolerance. The Kelly Formula, however, says returns don’t always go up when we take more risk, even if we can ignore the risk completely, and have a very good risk appetite: there is a maximum risk we should take, more risk taking will only bring worse returns. In other words, “volatility” is more than just the risk we have to experience during the process, or more than just the wider dispersion of possible returns; higher volatility may also reduce the eventual expected return. Why is that? That is because the returns of sequential investments multiply on each other, instead of “adding” onto each other. For example, if you lose 50% in the first year, you have to make 100% gain on the next year to get back even. It is (100% – 50%) * (100% + 100%) = 100%, rather than (50% + 100%) = 150%. In math terms, the returns are multiplicative, instead of additive. (The log-returns or log-assets are additive instead). This concept is very interesting and very useful, when we start to apply it to many financial decisions. For example, many years ago, I used to think that I should invest 100% on stocks since historically stocks had higher returns than bonds or bank CDs, and since I was very young, I shouldn’t be too concerned about the risks of stocks. That seems very logical, right? Well, not after you get familiar with the Kelly Formula. The fact is, if stocks are very volatile, 100% invested in stocks may not give your best returns even if the stocks do turn out to have better returns than bonds/CD’s, and even when we assume you don’t care about the risks at all. Let’s work through an example to better understand this: Suppose you had $100 at the beginning of 2008, and stock market dropped 50% and it became $50 at the beginning of 2009. Two years later, the stock market fully recovered, rose 140% and your asset got back to $120, therefore you had a 20% gain in 3 years. Very bumpy and scary roller-coaster ride indeed, but assuming you have very good risk tolerance, that didn’t matter much to you. What if you had 70% on stocks and 30% on bonds? At the beginning of 2009, because of the government’s monetary policy, the bond interest rate dropped significantly, and your bonds had a 20% return in 1 year, but your stocks had a 50% loss. Together, it is $70 * 0.5 + $30 * 1.2 = $71, or 29% total loss. At this point, you should do a rebalancing (assuming you rebalance every year), and get back to 70% stocks and 30% bonds, so you would sell some bonds and buy more stocks. After that, you would have $49.7 in stocks, and $21.3 in bonds. Then assuming 2 years later, stocks went up 140%, and bonds had a return of 0% during these 2 years, your total asset became $49.7 * 2.4 + $21.3 = $140.58. This is a total return of 40.58% in 3 years, which is much more than the 20% return in the 100% stock case. What is more interesting here is that both underlying assets (stock and bond) only had 20% return in 3 years, yet the portfolio had 40% return, much more than the return of any of the underlying assets. (See the “magic” of financial engineering can sometimes turn toads into princes!) Now it seems to be a no-brainer for you to always invest some of your capital in bonds? After all, if it gives you more return and less risk, why not? Not too fast. In the example above, I used 2008 – 2010 as an example, and my figures are hypothetical. After all, you won’t see a lot of 2008s happening down the road. That said, the basic reasoning here still applies: Reducing the volatility of a portfolio can also help to improve returns, not just reduce the risks. The ultimate decision of portfolio allocation depends on how risky the underlying asset is. Maybe 100% stocks is optimal, maybe not, but it really requires you to have a fairly accurate estimate of the future volatility of your stock assets. Is Kelly Bet The Optimal Bet? Another interesting property of Kelly Bet is that it is the “optimal bet”. Well, I just said it is the “maximum bet”, but why am I also calling it the “optimal bet”? The reality is that the “maximum bet” part of the theory is actually agreed upon by almost everyone: normally you never want to bet more than Kelly Bet, unless you were too conservative on estimating your winning odds. In other words, if you bet more than Kelly Bet, you are not just aggressive, you are “insane”, since it will bring higher risk AND worse performance too. But calling it “optimal bet” becomes much more controversial among investors and traders. The theory does show that it is indeed the optimal bet, but that has a lot assumptions attached to it, such as: the bet can be made frequently (not exactly true for long term investments), the bets have the same odds, the odds could be estimated accurately, and you could never lose 100% of your asset. As you can see, the first 3 conditions are not true for long term investments, and the last one is probably true if you have fairly good diversification and don’t use any leverage. This is where the theory diverts from reality, and why we have to be careful when assuming Kelly Bet is the optimal bet. If you want to learn more about Kelly Bet, you can check out my blogs here and here . Common Methods on Reducing Volatilities As I mentioned above, reducing volatilities is so important that it not only helps to reduce your risk and overcome your emotions, but can also help to improve your performance. Therefore, managing volatilities of a portfolio becomes a central topic of risk management and money management. A following question is: how can we reduce the volatility? As you will find out below, this is much more than just diversification. Diversification Despite all the caveats and potential drawbacks, diversification is still the most powerful concept in financial engineering on reducing the volatility. However, people sometimes either over-extend this concept or didn’t apply it in full scale. Diversification should not be just among stocks Normally, money managers often talk about how many stocks they should hold, or how big each position should be, such as whether each position should be 1%, 5% or 20% of the portfolio. However, diversification should not just be among the stocks you hold. First, stocks usually have high correlations, or we can call it “systematic risk”. If they are in the same sector and the same country, they will have even higher correlations. So when you have more than 7 – 20 stocks in your portfolio, additional stocks may not do much good to your portfolio at all. On the contrary, it may harm you more than help you, especially when you are a small investor. This is because over-diversification will spread you too thin, make you have less information edge over the stocks you own. It may also make your performance suffer because you have to put money into your less favorable ideas. One thing we should all realize is that investment is hard and highly competitive. For this reason, the chance that you can find a good idea is slim. You may get 1 or 2 really great ideas in a year, but expecting to get many great ideas is not realistic, even for those superinvestors. As Charlie Munger said, if you remove the top 20 best ideas Buffett had in the last 40 years, the rest of the ideas’ performance is not much better than the average index. In this sense, while having low volatility is important to improve performance, having higher expected returns is just as important. (I’d like to think higher expected return as “offense”, and lower risk as “defense”.) Also, diversification is not limited to just stocks, since it can be done in many other ways: Diversify over different asset classes Bonds, cash, commodities, gold and real estate are all asset classes that could be used for diversifying risks. Historically, bonds are one of the most favorable choices since they usually have negative correlation with stocks, which helps to reduce the volatility even more. But since bonds are not attractive right now due to all the QEs, cash and gold are probably good choices, too. Cash is stable, but has inflation risk. Gold has no inflation risk, and is especially helpful in doom scenarios, but its value is more dependent on supply-demand since it has no clear “fundamental value”. Diversify over different strategies This method may not be very practical for small investors, but money managers can often utilize different investment strategies to diversify the risks, such as allocating capital among trading strategies and investment strategies, so that they have less correlations. Or they can maintain short positions in addition to long positions. Downside Protection Is As Important Instead of diversification, value investors often make very restrict requirement on the downside protection on their stock picks. In Buffett’s words, the secret of investing is his: Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. Here, “don’t lose money” doesn’t mean that there should be no loss at all, because that is certainly impossible. It only means “no significant loss” and you have to be really careful about protecting yourself from any significant downside on each individual stock you select. Usually this protection requires many of the following traits in the company you are investing in: Sufficient Margin Of Safety Low P/B ratio, and good tangible book value or liquidation value Durable competitive strength and low/reasonable P/E ratio Long product cycles Not overly dependent on one product, or one customer Low financial leverage and low operating leverage Good pricing power Recurring Revenue Good management Conservative accounting Non-cyclical industry Non-commodity product or has durable low-cost advantage “Certainty” is the basis of all investment theses As mentioned above, diversification has limited effectiveness and has significant drawbacks too. For this reason, successful value investors often use the downside protection of the business itself to reduce volatility. However, any investment thesis requires “certainty” or “information edge” as its basis. Without “certainty”, any conclusion could be built on imagination instead of facts. Therefore, to reduce volatility, investors have to devote their efforts to achieve an information edge and achieve high “certainty”, instead of just focusing on diversification. In other words, “certainty” and downside protection of each stock pick reduces the volatility of each position, and diversification reduces the overall volatility of the entire portfolio. Both of these methods are needed, but it is more of an art than science to find the balance between these two. In some sense, that also depends on personal style and personal strategies. Conclusion I remember Charlie Munger once said many smart people should better devote their talents to real engineering projects instead of financial engineering, since he thinks financial engineering doesn’t really generate much value for our society. While I am a fan of Munger, I don’t really agree with this particular comment. I believe understanding the math behind financial engineering can not only achieve better returns for our investments, but also help us to make better capital allocation decisions in general. There are many financial engineered products that are very useful to us, such index, index fund, ETFs, options, interest rate swaps, ABS or even the infamous CDOs. Many of these products used the powerful concept of “diversification”. It is undeniable that there are new problems coming up along with these new things, such as the loss of insight with over-diversification, or lack of incentives to ensure the quality. However, I would compare that with stock exchanges. While so many small investors unconsciously used the stock exchange as a casino (except that they wouldn’t bet all their savings in a casino like they did in the stock market), and sometimes lost all their lifetime savings (especially in immature markets, like the Chinese stock market), overall, stock exchanges still provided tremendous value for both businesses and investors. It does take time to get regulations in place to make it more mature though, as what we have seen in the US since 1930s. All in all, it is my opinion that financial engineering and the math behind it do provide good value to us, although it is also important to recognize its limitations and don’t lose our “common sense”.