Portfolio Performance

Photograph:  Dome of Blue Mosque in Istanbul, Turkey

If you hear someone come across a bit strong when it comes to portfolio performance, ask a few simple straight-forward questions.

1.  How is the performance measured and does it meet AIMR standards?  Professionals will know AIMR stands for Association for Investment Management and Research.  ITA Wealth Management readers know performance as the Internal Rate of Return (IRR) since we are calculating one portfolio at a time and we are not comparing portfolios.

2.  How is portfolio uncertainty or volatility measured?  One expects better performance from high volatile portfolios.  We also expect high volatile portfolios to do worse in bear markets.

3.  What is the Return/Uncertainty ratio for the portfolio and is uncertainty measured using mean-variance or semi-variance?  Once more, ITA Wealth Management readers understand what is going on with the Sortino and Retirement Ratio calculations.  At least those experienced with the TLH spreadsheet understand the importance of using semi-variance where the money manager is only penalized when the portfolio under performs the benchmark.

4. Mention of benchmark brings to mind the fourth question.  What benchmark is used as a portfolio standard?  How is an appropriate benchmark defined and what are the requirements?

While the TLH spreadsheet seeks to answer the above questions, it is not a perfect tool.  Despite our best efforts, there remains some "splinters" in the calculations and I've pointed them out in past blog posts.  When I spot new issues, I will bring them to readers attention.  If there is one thing that is needed in the world of investing it is honesty.  Rather than cover up inherent performance problems we seek to uncover them and make corrections when possible.

Eight Asset Porfolio

Photograph: When I first walked Devastation Trail in late 1961 or early 1962, there was no vegetation to be seen as it was soon after the eruption.

Consider the following portfolio that holds eight assets including cash.  In this analysis, I am using the 20-year treasury ETF, TLT, to represent cash, a substitution that gives the portfolio a slight boost over current money market rates.  The portfolio holds 22% in two actively managed funds, 63% in four ETFs, 9% in a stock, and the remainder in cash.  When applying a QPP analysis to this portfolio, what are the results?  Check out the slide below for the analysis.

In the following analysis, I am assuming the S&P 500 will return 7% a year and the uncertainty or volatility will approximate 15%.  The actual performance of the portfolio is projected to lag the S&P 500 by one percentage point and the projected uncertainty is much lower (a positive) than what we expect from the S&P.

Scrolling down the page we note the Diversification Metric is 11% points below our stated goal of 40%.  The Portfolio Autocorrelation (PA) indicates this portfolio will have wider price swings than we prefer.  We want PA to be as low as possible.

Would any reader care to posit what the weakest link is in this portfolio?  With a few changes we should be able to strengthen the projected outcomes.

The Return/Uncertainty Ratio

Formerly, the title of this post would have been the Return/Risk Ratio.  However, Risk carries many meanings so I am switching to Uncertainty to describe portfolio volatility.  The whole notion of Return/Uncertainty is at the forefront of my thinking today since this is the end of the first quarter for 2011.  Platinum members using the TLH spreadsheet will need to update the SR worksheet after all the data is in late this afternoon so the semi-variance uncertainty calculation is current.

There will be a slight error in the calculation since the portfolios will not include all the first quarter dividends.  In the big scheme of things this will not make all that much difference, so go ahead and record the most accurate IRR data for both the portfolio and the benchmark you are using for your portfolio.

"You can't manage what you don't measure."

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Solving Investment Problem #5: It is too late to start saving.

Balderdash!  It is never too late to begin saving for retirement.  Yes, it is preferred to follow "The Golden Rule of Investing" and start saving as early as possible, but it is never to late to begin.  Let me illustrate with a short story.

I know of one family that had almost no savings by age 57.  The house was paid in full, but savings for retirement were close to nil.  A friend of this family suggested they begin saving and putting money away in the stock market.  Several mutual funds were identified – not the best recommendation.  Nevertheless, disciplined month after month saving allowed this family to build a nest egg of $700,000 over the next 30 years.  Frugal living, long life, and disciplined saving were the key factors in building this retirement portfolio.  It was not astute investing.

While I do not recommend readers putting off saving for retirement till age 57, don't take the attitude it is too late to begin saving.  Get started today or when your next paycheck arrives.

Ultra-Conservative Portfolio

This morning I came across an ultra-conservative portfolio that I thought would be of interest to Platinum members.  When a portfolio projects to outperform the S&P 500 by 275 basis points, with much lower risk and carries a Diversification Metric of nearly 70%, one takes notice.  Here is that portfolio.

Platinum membership is available for $5.00 per month.  Three dollars off the first month through 4/2/2011.

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Solving Investment Problem #4: Fear of losing money.

The fear of losing money once it is invested in the stock market is quite natural.  Investing in the market from early 2000 through early 2009 was a particularly volatile period and not one to inspire investor confidence.  The alternatives to building adequate savings for retirement are limited.  Banks are paying zero to very little interest.  CDs are also generating low interest rates.  The best way I know to reduce risk over the next 30 to 50 years is to dollar-cost average into the market over the next two to three year, assuming one has a large account.  If you are adding dollars on a monthly basis, as is the case with the Kenilworth Portfolio, then build the different asset classes much as one would raise a brick or cement block building.

Diversify all over the world.  We can easily do this using VEU and VWO for starter ETFs.  These two ETFs will put us in the developed international as well as emerging markets.  As William Bernstein recommends in his three investment books, we want to be diversified in hundreds of stocks and the only way to do this is to use index mutual funds and/or index ETFs.  My preference is ETFs as they generally carry lower expense ratios and are more tax efficient.

While the stock market is not risk free, index investing through the use of ETFs places the law of averages on our side.  It is time to get involved in building a retirement nest egg.

Photograph: Castillo de San Marcos Fort in St. Augustine, FL

Platinum membership available for $5.00 per month. 

Solving Investment Problem #3: I don’t know the language.

Bringing a beginning investor up to speed with the investing vocabulary is not an easy task.  This problem does not have a quick solution.  However, it is made much easier if one takes the path of passive investing vs. active investing.  There is much less to learn and the fundamentals are quite basic.  Here at ITA Wealth Management, our preference is passive investing through the use of index ETFs.  ETF stands for Exchange Traded Funds and it is nothing more than a basket of stocks that one can buy and sell through a broker such as TDAmeritrade.

How does one learn the vocabulary to the point where one can ask intelligent questions.  1) Read the two elementary volumes I mentioned earlier.  2) For a little variety, when you check in on this blog, scroll down the page and off to the right you will find something called Random Entries.  Select one or two of those random posts to read each visit.  It will not be long before the lingo begins to catch hold and become second nature.

Solving Investment Problem #2: I don’t know where to begin.

For readers or prospective investors who don't know where to begin, one place to start is to click on the Category to the right titled, Beginning Investors.  My second recommendation is to read two short books.  The two easiest investment books that will put you on the right path are: "The Investment Answer" by Daniel Goldie and Gordan Murray and "The Elements of Investing" by Burton Malkiel and Charles Ellis.  The first book is about 80 pages and the second is approximately 135 pages. Both are useful reads for the beginning investor.

If you feel you need an advisor to manage your money, look for someone who will put you in DFA index funds.  One such advisor is Mark Hebner and you will find his web site one of the very best on the Internet.  I have no financial connections with Mark Hebner.

Platinum membership is available for $5.00 per month.

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Solving Investing Problem #1: I have no interest in investing.

 Individuals who have no interest in investing better hire a fee-based advisor.  Whether or not one is interested in the intricacies of investing, it is important to save for retirement or other goals.  Decision number one is whether or not you will manage your own money.  Just remember that paying someone else is going to cost a lot of money and place a performance burden on the portfolio.  Why do I recommend individuals manage their own portfolios?

It all comes down to fees.  If you can read, you can set up a very basic portfolio that has a high probability of outperforming the majority of professional money managers.  At least that is the statistical evidence from academic paper after paper.  Saving 70 to 100 basis points per year adds up to a nice nest egg over a lifetime so why send that money to someone else.  100 basis points on a $100,000 portfolio is $1,000 per year.  Here at ITA Wealth Management you will pick up more ideas for $60 per year (Platinum membership) at a fraction of the cost. 


Asset Allocation: Kenilworth Portfolio

Never mind all the red and purple colors in the Kenilworth asset allocation plan.  This is to be expected when putting together a new portfolio with limited cash.  It takes time to bring the different asset classes into balance.  Let's walk through the following foundation of this portfolio.  I did make some minor Tactical Asset Allocation changes as I will explain below.

Platinum membership is available for $5.00 per month.

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