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Efficient Market Hypothesis And Random Walk Theory: Buy ‘David Swensen’s Portfolio’

Summary The author recommends using “David Swensen’s portfolio” as a key component of the Core Portfolio. Recommendation for the Satellite Portfolio will be covered in a separate article. Recommendation is in line with the implications of Efficient Market Hypothesis (EMH) and Random Walk Hypothesis (RWH). EMH and RWH imply that it’s impossible to consistently beat the market and suggest the utilization of passive investment approach. Recommended Portfolio Allocation The main goal of this series of articles is to introduce new stock investors to academic theories and help them develop their own approach to stock investing. Knowing academic theories and their implications should help investors gain confidence in their chosen path. That confidence is key in ensuring that investors consistently execute their chosen investment strategy. As we will discuss in the next articles, consistency is one of the main friends of stock investors. I will be suggesting an approach to stock investing that will be based on findings of Nobel laureates and market practitioners. With each article, we will be moving one step closer to developing an investment approach/portfolio that individual investors will be comfortable holding on to through thick and thin. We will start with David Swensen, CIO of Yale endowment since 1985, where he manages over $20 billion (as of Q3 2014, endowment assets were $23.9 billion). Over the decade (through 2009), the endowment realized an average annual return of 11.8 percent. It is an impressive performance given that this period covers the financial crisis of 2008. David’s consistent track record sparked debates if the new college building should be named after him. He is believed to be the alumni who contributed the most to the school through his management of the Yale endowment portfolio. David is credited with inventing the Yale Model (an application of modern portfolio theory that we will discuss in the next article). David Swensen suggests that individual investors should limit their portfolio to a handful, well-selected ETFs that will provide diversification across major asset classes (e.g. stock, real estate, and bonds) and geographies (i.e. developed and emerging countries) at a low-cost and tax-efficient manner. His recommendation is very much in line with the approach suggested by John Bogle (founder of Vanguard). David lays out the proposed allocation across asset classes as following: Asset Class Allocation Domestic Equity 30% Foreign Developed Equity 15% Emerging Market Equity 5% Real Estate 20% U.S. Treasury Bonds 15% U.S. Treasury Inflation Protected Securities 15% Source: David Swensen Strategy’s Strengths and Limitations MarketWatch developed a list of funds that closely resembles exposures that David Swensen proposed. The list of funds and its historical performance is presented in the table below. As you can see from the table, the proposed allocation has underperformed the S&P 500. As of 11/14/15 Fund Allocation 1-Year Return 3-Year Return 5-Year Return 10-Year Return Total Stock Market VTSMX 30% 0.62% 15.89% 13.05% 7.45% Foreign Developed VTMGX 15% -2.85% 7.67% 3.98% 3.73% Emerging Market VEIEX 5% -16.37% -3.49% -3.85% 4.44% Real Estate VGSIX 20% 0.36% 10.45% 11.04% 7.05% Long-term Bonds VUSTX 15% 2.99% 0.92% 6.82% 6.66% TIPS VIPSX 15% -2.17% -2.64% 1.98% 3.85% S&P 500 1.29% 16.18% 13.40% 7.31% Source: David Swensen, MarketWatch Main drivers of the underperformance are allocations to foreign developed markets, long-term bonds, TIPS and emerging markets. It’s not much of a surprise to see fixed-income instruments (i.e. long-term bonds and TIPS) underperform stocks (due to equity risk premium) over the long term. Analyzing the shorter period (up to 3-5 years), one can think of many reasons for the outperformance of US stocks vs. foreign developed and EM stocks. For long-term investors, arguments of mean reversion should make them comfortable holding on to diversified portfolio over the long term. As such, investors should not discard the model portfolio proposed by Swensen just yet. As mentioned, the list of carefully selected ETFs (must be low-cost and tax-efficient) should form the base of your portfolio. We will refer to this portion of the suggested portfolio approach as “Core Portfolio”. We will discuss the second portion of the proposed portfolio “Satellite Portfolio” in the future articles and share the rational for having such a satellite portfolio that might utilize a non-passive approach. Suffice it to say that EMH and RWH should provide enough confidence to individual investors to stick with the Core Portfolio allocations as long as the investors keep in mind that over the long run stocks provide positive real return. Actual Portfolio Allocations and ETFs Given the tax efficiency of ETFs, the author finds it more appropriate to use ETFs instead of mutual funds for the Core Portfolio. The actual list of ETFs and corresponding allocations is presented below: Asset Class ETFs Allocation Domestic Equity VTI 30% Foreign Developed Equity VEA 15% Emerging Market Equity VWO 5% Real Estate VNQ 20% Long-Term Treasuries TLT 15% TIPS TIP 15% There are a number of reasons for this recommendation: 1. The actual allocation to various asset classes is in line with David Swensen’s proposed allocations. Theoretical underpinning for passive investing is presented in the last section of this article. 2. The approach utilizes low-cost and tax-efficient ETFs. Typically, Vanguard ETFs are on the low end of fees. Also, ETFs are more tax-efficient than the mutual fund structure. A word of caution before you start implementing the recommendation – I’m not a tax advisor, and therefore, I strongly suggest you consult your tax advisor for any tax-related matters. Also, I would like to mention that this article is just the first one in the series. In the next articles, we will continue exploring the stock market theories and how they impact the way I invest. Next stop will be Harry Markowitz’s Modern Portfolio Theory and the need to diversify across a broad spectrum of asset classes. This article will be followed by Noisy Market Hypothesis, which should lift the spirits of investors who would like to “beat the market”. Appendix: Theory Dr. Eugene Fama, a Nobel Laureate, is thought of as the Father of Efficient Market Hypothesis (EMH). EMH suggests that current asset prices fully reflect all currently available information. To put it simply, stock prices should react only to news; and as you know, news is random in its nature. Due to this randomness, EMH implies that consistently outperforming the market on a risk-adjusted basis is impossible. In other words, don’t put your money into an individual “hot” stock or entrust to an active asset manager. Talking about randomness, one cannot skip mentioning the Random Walk Hypothesis (RWH), which traces back to Louis Bachelier. RWH argues that stock prices are random: chances that a professional analyst identifies a winning stock is similar to a flip of the coin. In a 1965 article, “Random Walks in Stock Market Prices”, Dr. Fama draws the parallels between EMH and RWH. As already mentioned, EMH and RWH imply that stock investors would be better off investing in passive index funds or mimicking such fund investments. On average, active investing (e.g. intentionally investing a higher portion of the portfolio in a specific stock or sector) is expected to yield similar risk-adjusted returns as passive investments. Some behavioral economists (note: we will cover behavioral finance and its implications in the future articles) would even argue that active investing should result in inferior returns, as emotions of investors will make them buy hot stocks just before these stocks peak and throw the towel just before the market bottoms. Industry practitioners, such as John Bogle of Vanguard, would further argue that investing is a zero-sum game: few basis points of alpha that one active manager generates come at the expense of another active manager. Furthermore, a typical individual investor who entrusted his/her funds to an active manager would come out short after receiving an average market return, less management fees and tax bill. Typical high turnover of active asset management mandates leads to higher transactions costs (e.g. bid-ask spread) and higher tax bill (i.e. short-term gains are taxed at a higher rate than long-term capital gains and dividends). All of the above suggests that low-cost, tax-efficient ETFs are optimal investment instruments for the Core Portfolio. References/Bibliography George A. Akerlof and Robert J. Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism , Princeton University Press, 2009 John Bogle on Investing: The First 50 Years , McGraw-Hill, 2000 Colin Read, The Efficient Market Hypothesists: Bachelier, Samuelson, Fama, Ross, Tobin and Shiller , Palgrave Macmillan, 2012 David Swensen, Unconventional Success: A Fundamental Approach to Personal Investment, Free Press, 2005 Next article: M odern Portfolio Theory: Introduce Alternatives To Your Portfolio

Why Stocks Are Getting Riskier By The Day

Borrowing costs are set to move higher. Higher borrowing costs could force American companies to curtail the debt that they’ve raised to buy back shares of their own stock. Not only would stock prices struggle to move higher if corporations are not buyers of as many shares as they have been in the past, but a lessening in stock buybacks would reduce the perception of corporate profitability. These headwinds to stock valuations as well as future returns – near-term and longer-term – are not easily dismissed. The central bank of the United States (a.k.a. the Federal Reserve) may hike its overnight lending rate in December. Committee members are also discussing plans to phase out the reinvestment of principal on balance sheet securities. Translation? Borrowing costs are set to move higher. The Fed is tightening for the first time in nearly a decade. In so doing, it is implicitly signaling faith in the U.S. economy’s ability to accelerate. The question investors might want to ask is whether or not that conviction is misplaced. For one thing, if the U.S. economy continues to expand at the same sub-par recovery rate of 2.2% per year, stock valuations will move from overvalued to insanely valued. Consider the ratio of total U.S. stock market capitalization to the broadest quantitative measure of U.S. economic activity, gross domestic product (GDP). With total market cap at nearly $21.6 trillion and GDP at at roughly $17.9 trillion, the ratio sits at 120.8%. The historical average since 1970? About 72.5%. Investors should recollect that Warren Buffett described Market-Cap-To-GDP as the “best single measure of where valuations stand at any given moment.” It follows that stocks are more expensive than they were before the financial collapse in 2008, though they are less expensive than they were prior to the tech wreck in 2000. If the ratio reverts to the historical mean of 72.5%? Then hold-n-hope advocates should prepare themselves for stock prices lose HALF of their current value. There are other concerns for investors should the economy prove less resilient than the Federal Reserve would like us to believe. Higher borrowing costs could force American companies to curtail the debt that they’ve raised to buy back shares of their own stock. Why is this so problematic? Not only would stock prices struggle to move higher if corporations are not buyers of as many shares as they have been in the past, but a lessening in stock buybacks would reduce the perception of corporate profitability. Remember, when a public corporation earning $0.70 per share (EPS) has one million shares outstanding, lowering the share count by 10% to 900,000 artificially pushes profitability per share up to $0.778. Were any additional products or services sold? Nope. The accounting wizardly plays itself out in more “reasonable” price-to-earnings (P/E) ratios that investors often use to determine valuation levels. Keep in mind, the buyback game has been happening for more than six-and-a-half years. Since 2009, debt-fueled share buybacks pushed earnings per share up 190%. Revenue from sales of products and services? Sales have increased an exceptionally modest 23%. With buybacks primarily funded by debt, higher borrowing costs sank the debt-funded buyback connection that was part and parcel of the previous market collapse (10/2007-3/2009). Is it unreasonable to suspect that this connection will follow a similar pattern? (click to enlarge) So if the Fed is wrong about the growth of GDP, and if it is wrong about the effect that higher borrowing costs will have on corporate credit expansion, stock valuations will surge. That’s true for Market-Cap-To-GDP. And that’s true for price-to-earnings (P/E). Yet there may also be an issue with the perception of a directional shift from a stimulative environment to a less stimulative one. Take a look at the relationship between the S&P 500 and the Fed’s balance sheet throughout the current bull market run. Each time that the Fed created electronic dollar credits to buy assets, expanded its balance sheet, and subsequently lowered borrowing costs, stocks rallied dramatically. In each of the three instances since the 2009 stock lows where the balance sheet remained the same? Stocks struggled to make meaningful strides. (click to enlarge) The possibility of the Fed reducing its balancing sheet. The danger of share buybacks rolling over. The unlikelihood of the U.S. economy breaking out in dramatic fashion. These headwinds to stock valuations as well as future returns – near-term and longer-term – are not easily dismissed. And that’s not even addressing the possibility that the domestic economy and/or the global economy weaken further. Is the consumer truly in great shape? Retail stocks in the SPDR S&P Retail ETF (NYSEARCA: XRT ) suggest otherwise. The exchange-traded fund hit new 52-week lows below the levels that we witnessed in the August-September sell-off. What’s more, we already know the recessionary struggles associated with manufacturers. Industrial production, which measures the amount of output from the manufacturing, mining, electric and gas industries, has fallen in nine of of the previous 10 months. There are few, if any, ways to put a positive spin on the declines in industrial production. (click to enlarge) And then we have the Fed telling us that “global market risks have diminished.” Really? How much further does copper – the metal with a Ph.D. in economics – need to fall before global market risks reignite? The iPath DJ-UBS Copper Total Return Sub-Index ETN (NYSEARCA: JJC ) has not only broken below August and September lows, it might as well have fallen off a cliff. Similarly, how much further does oil need to drop before oil producing exporters begin falling apart. The iShares MSCI Canada ETF (NYSEARCA: EWC ) is still toiling near its 52-week depths. No Virginia, global market risks have not diminished. For that matter, global economic deceleration is still the prevailing prognostication by the International Monetary Fund (NYSE: IMF ). China’s economic output is decelerating. Japan is already in recession. And European quantitative easing is not stimulating borrowing activity the way that it did in the U.S. In the end, all we have is the collective hope of voting members in the Federal Open Market Committee (FOMC). Hope that economic improvement will overcome lofty valuations and a pullback in corporate borrowing. Don’t get me wrong. Based on everything from “tax-loss harvesting” to “window dressing” to momentum investing, the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) may still represent the best diversified stock holding around. How long one should stick with those brass tacks, however, is another matter entirely. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Twitter: How Emotional Investing Can Kill A Portfolio

Summary Twitter is a great example of emotional investing. How long can one hope for a turnaround? Twitter is also an example of how emotional investing can lead to big time losses. I have a difficult time understanding why many people want to hold onto Twitter (NYSE: TWTR ) and speak of its potential. The analyst community, who are supposed to be an unbiased group, does not want to openly admit that they were wrong about the stock. According to Investopedia the hold rating from the ownership perspective means that if you own the stock do not sell it. Therein lies the problem. It appears to me that analysts themselves have not invested their own money. If they did, they would not tell investors to hold onto a stock that has lost over 50% of its value. I do not mean to sound harsh, but cutting your losses is one of the first fundamental investment principles taught. You can always go back in if the stock starts performing again. If not, take your capital and move on to another security. (click to enlarge) Source: Yahoo Finance Dollar-Loss Averaging Dollar-cost averaging plays on the psychological aspect of human emotions as well. It adds to our nature of wanting to be right all of the time. We can interpret our deceptive actions as having a positive effect on our position. (I like to think of the concept as dollar-loss averaging.) Unfortunately, it is one of the worst concepts mainstream finance preaches. Basically if you buy Twitter at $60 and it goes down to $50 and $40 and so on you buy more because instead of paying $60 per share you effectively paid $50 per share assuming equal purchase amounts. However, this is very deceiving. Initially you paid $60 total, but now you paid $150 total. You have allocated more capital to a bad investment. Overhead Supply There is also another concept called overhead supply. According to Investor’s Business Daily , “Overhead supply represents price levels at which a stock’s recovery is impeded as it tries to rally back from a steep decline.” It is due to investors who got into a specific stock earlier and are waiting to get out at breakeven. Once the price hits specified levels a wave of selling hits the stock making it difficult to climb. This is exactly what is happening with Twitter. So many people want to get out of this stock that it is having a difficult time climbing higher. IBD also pointed out that this specific behavior is due to the loss avoiding nature humans have. Is Hanging On Worthwhile? Assume for a minute, Twitter stays in this $20-to-$30 range for the next 10-to-20 years or never recovers. Don’t think it’s possible? Take a look at the chart of General Electric (NYSE: GE ) below. You were much better off investing in the SPY (NYSEARCA: SPY ) or some other broad market fund. (click to enlarge) Source: Yahoo Finance Is Getting to Breakeven With Twitter Worthwhile? Additionally, I am assuming those in Twitter are hoping for a breakeven investment. For that, I have two scenarios to consider. Let’s say in a simple scenario you bought Twitter at its peak and it does recover in 10 years. Let’s also say you purchased the SPY ETF for the same monetary value. What have you gained? Getting back to breakeven after 10 years is no accomplishment for your Twitter holding. With the SPY, assuming its 10% annual return continues to hold, you more than doubled your money. You made approximately 159% of your initial capital. [(1.1^10)-1]/[1] Now let’s take this one step further with a much more concrete example. Assume you invest $10,000 in Twitter. Let’s say you were so emotional about the investment even though it was slowly declining. It finally got to the point where you could not take more pain and took a 50% loss. After taking a few hours to recollect yourself, you decide to invest the $5,000 you have left from Twitter into the SPY ETF. After 10 years, your account is $12,968.71. [(5000*(1.1^10)] Both are much better alternatives than hoping for a breakeven trade. Conclusion For those in Twitter, if you manage to make money, that is great. I am happy for you, but do not try to bank on luck. I think it is best to take the pain if you are in the stock.