Tag Archives: portfolio

The One Thing You Must Do When The Market Tanks

By Tim Maverick It’s a scenario that repeats itself during every stock market downturn: At the first sign of distress, mom and pop investors head for the hills. And the year 2015 is no exception. During July and August, investors withdrew money from both stock and bond mutual funds. According to Credit Suisse, this is the first time withdrawals have occurred in both categories in consecutive months since 2008. That was, of course, during the last financial crisis. I believe Yogi Berra said it best: “It’s like déjà vu all over again.” Here’s What You Need to Do I’ve been in the investment business since the 1980s and have been through every market selloff since 1987. Even though I’m no longer a professionally licensed advisor, I do have a few thoughts on investor behavior during selloffs. First of all, if you’re in your 20s, 30s, or 40s, don’t worry. The stock market’s long-term track record is undeniable. For those of you in your 50s or 60s, I would’ve, at one point in time, warned about bear markets possibly lasting as long as a decade. But with the Federal Reserve reacting to every market sniffle with lots of money, the dynamics have changed. Look at last week’s turbulence. Already, prominent voices like Bridgewater Associates Founder Ray Dalio have said that further turmoil would encourage more quantitative easing (QE). Thus, for regular investors, the only real danger point – as I’ve described in a previous article – is shortly before and shortly after your retirement . And if you’re in such a time frame, your stock allocation should’ve already been lowered. Thus, the one thing investors should do during this current downturn is take a serious look at their portfolios and make sure everything is allocated properly. Most likely, a rebalancing is in order. Rebalancing Really Works Rebalancing a portfolio between stocks, bonds, and cash is important – and it can actually improve your returns. In 2012, Columbia Business School professor Andrew Ang conducted a study. He looked at returns from January 1926 through December 1940, a period that includes the Great Depression. Here’s what he found: A portfolio of 100% stocks returned 81% with dividends reinvested. A portfolio of 100% government bonds returned 108%. But a portfolio of 60% stocks and 40% bonds, rebalanced quarterly, returned 146%! Now, I don’t think rebalancing quarterly is necessary. And you definitely shouldn’t rebalance in the midst of market volatility. Instead, get your game plan in order now, and put it in place after the dust has settled. That will likely be in a few months. After all, we’re in that nasty seven-year cycle period (1987, 1994, 2001, 2008, 2015) when bad things tend to happen to the stock market. One final point: If you do rebalance in a taxable account, there will be tax consequences. How to Reallocate What do I mean by reallocating or rebalancing your assets? Well, I use the words of legendary investor Sir John Templeton as a guide. He recommended “to buy when others are despondently selling and to sell when others are greedily buying.” This translates to a counter-intuitive action: Sell a portion of your winners and add those funds to lagging categories. But only do so if your percentages are seriously out of whack. Here’s a hypothetical, simplified example: A year ago, in the stock portion of your portfolio, you had 20% in technology and biotechnology stocks, and 20% in energy and emerging market stocks. But now, with tech and biotech red-hot, these stocks represent 30% of your portfolio. Meanwhile, ice-cold energy and emerging markets stocks are down to 10% of your holdings. You should sell where the greed is – where analysts are saying the “trees will grow to the sky” – and buy where investors are fleeing en masse. In other words, bring them back into balance at 20% each. This strategy will still keep you exposed to the current winning sectors while also boosting your exposure to tomorrow’s winners. Take a look at this data from Franklin Templeton on emerging markets. It shows that the bull phases are longer and stronger than the bear phases in these markets: Thus, you want to be positioned to take advantage of such situations. You also don’t want to be highly exposed to a hot sector if it crashes, a la tech stocks in 2000-01. John Wooden on Investing To summarize, I’d like to quote legendary basketball coach John Wooden: “If you’re too engrossed and involved and concerned in regard to things over which you have no control, it will adversely affect the things over which you have control.” That’s a great philosophy for life – and it applies to investing, as well. Don’t worry about the stock market. You can’t control it. On the other hand, you can control how you put your money to work for you. Original Post

Less Pain, More Gain

Summary Pain felt from losses far exceeds joy caused by gains — this psychological asymmetry is called loss aversion. The more often you check your portfolio, the more losses you’ll see, and the more emotional discomfort you’ll feel. If these emotions get the better of you, it can lead you to make investment decisions that you may later regret. This is why investors would do better (and be happier) if they monitored their performance less frequently. If it bleeds, it leads — bad news makes news; good news is no news. That’s the motto of today’s media. It’s no wonder people tend to think the world is always getting worse. But this asymmetry between bad and good is a much broader phenomenon. Our brains are in fact hardwired with a “negativity bias” — that is, we notice, remember, and give more importance to negative things than to positive ones. It’s why one little thing can ruin a good day. Why a reputation that takes decades to build can be destroyed by one mistake. Or why a single cockroach will completely wreck the appeal of a bowl of cherries, while a cherry will do nothing for a bowl of cockroaches. “Loss aversion,” or the tendency to weigh losses more heavily than gains, is another way this negativity bias manifests itself. Consider the following question: You are offered a gamble on the toss of a coin. If it comes up heads, you win $1,500. If it comes up tails, you lose $1,000. Would you accept this gamble? Although this gamble has a positive expected value of $250, you probably dislike it. And you’re not alone — for most people, the fear of losing $1,000 is more intense than the hope of gaining $1,500. In fact, numerous studies have shown that the average person won’t accept this gamble unless the potential gain is about $2,000, twice as much as the loss. This led researchers to famously conclude that “losses are twice as painful as gains are pleasurable.” That asymmetry between losses and gains has important implications for all investors. For instance, the more often you look at your portfolio, the more losses you’ll see, and the more emotional discomfort you’ll feel. The best solution, therefore, is to look at your portfolio as infrequently as possible. A simple example can illustrate this point. Let’s say you had invested $10,000 in the S&P 500 (NYSEARCA: SPY ) in January 1980. By the end of 2014, this would have grown to roughly $481,489 (which includes reinvested dividends) — an attractive return of 11.71% with a reasonable 16.76% volatility per annum. That return/volatility combination translates into a 76% probability of making money in any given year (and a 100% probability in any 10-year period). Sounds pretty good, right? But if you looked at your portfolio on a more frequent basis — say every hour — you’d have observed it making money only 50.65% of the time. In other words, even though you only had a 24% chance of losing money in any given year, the same portfolio when observed on an hourly basis would have disappointed you with losses 49.35% of the time. And since losses hurt twice as much as gains feel good, you’d be incurring a large emotional deficit by examining your performance at such a high frequency. This emotional deficit can actually be approximated mathematically. Simply assign a score of 1 for each positive return observation and a score of -2 for each negative return observation and then add them together to get a “reward-to-pain score.” The higher the score, the better. The table below shows that it’s not until we reach the annual portfolio observation that the reward-to-pain score turns positive. Checking your portfolio more frequently than that would cause you more emotional harm than good — which is why I shake my head when I see investors constantly monitoring their portfolios on their smartphones or tablets. It’s always easy to tell who’s making money and who isn’t (the look on their face says it all). Chances of Positive Returns on an S&P 500 Portfolio (1980 – 2014) Notes: (1) The above calculations assume that stock market returns are normally distributed (an imperfect but workable assumption). (2) Volatility is measured using the standard deviation of annual returns. (3) There are, on average, 252 trading days in a year and 6.5 hours in a regular trading day. (4) Reward/pain score = (1*probability of price increase) + (-2*probability of price decline). Source: A North Investments (“ANI”) Now let’s view this from another angle. The more frequently you look at your portfolio, the more randomness you’re disproportionately likely to get. In other words, you’ll see the short-term volatility of the portfolio, not the returns. This can be illustrated by taking the ratio of volatility to return at different observation frequencies (as shown in the table above). At a yearly observation frequency, the ratio is about 1.4 — or 59% randomness, 41% performance. But if you looked at the very same portfolio on an hourly basis, as many investors have a tendency to do, the composition changes to 98.4% randomness, only 1.6% performance. Yes, that’s right — you get over 60 times more randomness than performance! You’d be drowning in randomness and incurring emotional torture; it’s nearly impossible to make rational investment decisions under such conditions. The obvious moral here is that investors would do better (and be a lot happier) if they monitored their performance less frequently. Because the less often you look at your portfolio, the more likely it is that you’ll see gains. On the other hand, checking your portfolio more frequently increases the likelihood that you’ll see losses and hence suffer emotional distress. Avoiding the latter and focusing on the former prevents you from being fooled by short-term randomness — making it easier to stick to and achieve your long-term financial goals. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

PFF: A Quick Way To Get Your Preferred Stock Exposure

Summary There are two issues with the ETF, one is a high expense ratio and the other is sector concentration. The geography exposure is not a problem for me, but I wouldn’t mind seeing a little more diversification. The fund offers negative correlation with at least one treasury ETF while delivering a beta of around .22. Many investors build their portfolio without any meaningful positions in preferred stock. The iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) is one quick solution to that problem. Expense Ratio The expense ratio on the ETF is .47%. I’d really prefer to see a lower expense ratio with long term holdings since the nature of preferred stock suggests positions would not need to be changed frequently. When I pulled up the turnover ratio for the portfolio, it was coming up as 13%. That is higher than I would have expected but not high enough that I would expect the high expense ratio to be necessary. This may simply be a case of an ETF in a niche market having a long track record (established in 2007) and high volume (over 3 million shares per day) being a position where it can demand a higher expense ratio. Largest Holdings The largest holdings of the ETF show a heavy concentration towards the financial sectors. It isn’t just the top 10 though, as you’ll see in the next section. The sector exposure for PFF is heavily concentrated on banks and “Diversified Financials.” Sector The sector exposure is extremely concentrated and that would be an area of concern for me. Since my goals in using preferred shares within a portfolio would be to diversify the risk factors for the portfolio, I would prefer to only need one ETF of preferred stock and to have that ETF bring in a substantially lower level of concentration. I don’t know what would cause the sector to tumble, but very heavy sector exposure leaves investors hoping no black swans appear. This is a risk I would prefer to avoid if possible. Since black swan events by their very nature are unpredictable, the most effective defense is simply to include substantial diversification. Geography The map below shows the geographic distribution of the holdings. I don’t see any problems here. It is interesting that the U.K. was showing up as more than 12% of the portfolio, but diversification is exactly what I was wanting. I’d be interested in seeing even more diversification here, but doubt it will happen. That could make PFF an interesting fit with an international bond portfolio. Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) for higher yielding debt from emerging markets and the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) for medium term treasury debt. IEF should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The position in the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting,” but there are plenty of other areas to find excitement in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in the PowerShares Buyback Achievers Portfolio ETF (NYSEARCA: PKW ) makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to SPY and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard, the Vanguard S&P 500 ETF, (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion PFF has a positive correlation with each of the hypothetical holdings except for the treasury ETF which is interesting. Since PFF should have more duration exposure than IEF, but also more credit risk, there is some fairly solid diversification benefits here. The beta of only .22% is also excellent for indicating that PFF will fit very well within a portfolio. While EMB (emerging market bonds) also have a very low beta, PFF is has done it without having a positive correlation with treasury ETFs. That makes it a great fit for the more conservative investor that is holding more treasuries in the portfolio and less equity. The distribution yield on PFF is over 6%, so this is an option for solid income while maintaining a favorable risk profile. Ideally an investor would be able to combine this with a position in an emerging bond fund like EMB to avoid concentration of risk and then toss some higher dividend yielding ETFs in at the core position and offset the equity risk with some long term treasury exposure. In short, I’m not thrilled with the expense ratio but the fund fits very well within a portfolio. I would love to see more preferred share ETFs coming out to drive up competition and drive down expense ratios. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.