Developing a Passive Management Investment Strategy

Passive investing is intellectually appealing to the investor willing to shun Wall Street propaganda and hype from a 200 billion dollar industry.  Just to be clear, we concede there are, and will be, active money managers who outperform their benchmark.  However, as the years go by the winners dwindle in number and it is very difficult to select which managers will be successful thirty or forty years from now.  Try identifying the next Warren Buffett, Michael Price, Max Hein or Charlie Munger.  What actively managed mutual fund will best the market index over the next ten years?  The probability of selecting the top performing funds is extremely remote.  Mathematically, it makes sense to take the index route to portfolio construction.

So you are going to manage your own portfolio through stock selection (not encouraged).  If this is the investment path of choice, here are a few guidelines to keep in mind.

  • Establish a benchmark that is appropriate for your portfolio.  If you are investing in small-cap stocks, don't use the S&P 500 as it is an inappropriate benchmark.  The S&P 500 has unfortunately become the default benchmark for nearly all portfolios.  If your portfolio holds a significant percentage in bonds, and that may well be appropriate for your situation, the S&P 500 is not the standard to use.
  • Know how to accurately calculate the Internal Rate of Return (IRR) for both the portfolio and benchmark.
  • Set up an appropriate benchmark for your portfolio.
  • Know what risk is involved in the portfolio makeup and measure it accurately.  Use a semi-variance measurement model instead of the standard mean-variance model.

Individuals who do not measure the performance of their portfolio and benchmark are engaged in self-deception as they don't have a clue how well they are doing.  "You can't manage what you don't measure."

The Five-Step Process to Passive Investing

  1. Lay out an investment plan.
    • The portfolio has an objective.  Is this a college fund portfolio or is it set up for retirement?  Think through the circumstances for which this portfolio is designed.
  2. Select the asset classes.
    • The maximum number I use is seventeen including cash.  At a minimum include; U.S. Equities, Developed International Markets, Emerging Markets, Domestic REITs, and Domestic Bonds.  Then considering adding Commodities, International REITs, and International Bonds.
  3. Determine the percentage to invest in each asset class.
    • As mentioned many times on this blog, this is the most difficult decision of investing.  No plan fits all investors so build your own customized portfolio to fit your situation.  There are many asset allocation plans provided on this blog.  Pick one that seems to best fit your situation knowing you can adjust later.  Read William J. Bernstein and others to pick up additional ideas.  Continue to adjust the asset allocation to fit your personal situation.  This ties back to step number one above.
  4. Choose index funds or non-managed index ETFs to populate the asset classes.
    • My preference is to use index ETFs as they are tax efficient and 101 are commission free to TD Ameritrade clients.  Commission free ETFs are of great benefit to investors starting out with very small initial investments.  It becomes easier to build a well diversified portfolio at no cost other than money you saved.
  5. Monitor the portfolio.
    • Search this blog for benchmarks or benchmarking portfolio.  There is a category for benchmarking so read those posts.  While somewhat time consuming, portfolio monitoring is essential if you are serious about investing.

Keep tracking ITA Wealth Management to see how different portfolios are managed.  Platinum members have access to eight portfolios where all the transactions are available.  These five steps will launch you on the path to passive-index investing.  Become a rational thinker rather than an ego driven investor.

Kiva Loans

Long-time Platinum members know that profits from this blog are donated to Kiva and MEDA Trust.  Search MEDA on this blog for more information.  MEDA Trust is shifting its focus of micro financing and as a result, I am now donating funds to those less fortunate through Kiva.  So far, seven "Kiva" businesses and over 300 "MEDA Trust" businesses have been helped or started through your membership here at ITA Wealth Management. 

Thank you for your confidence and support in these efforts to eliminate poverty from the earth.

'The poor stay poor not because they are lazy, but because they have no access to capital.' Milton Friedman, 1976 Nobel Prize in Economic Sciences.

Gauss Portfolio Review: Risk Reduction Model Update

At the end of each month the Gauss Portfolio comes up for its ITARR review.  Over the past few days I had some concerns that one or more of the eight critical ETFs would be sold out of the Gauss.  Fortunately, this did not happen as the closing prices today showed each of the ETFs priced above their 195-Day Exponential Moving Averages.  We may find a different situation when the Maxwell is reviewed on April 6th.

Dashboard:  Other than international bonds (slightly over target), the Gauss is showing all asset classes within the 25% threshold or target ranges.  One option is to sell off a few shares of PCY and bring the asset class into balance.  I’ll wait until a sell signal shows up based on the model and then make the change.  For now, this portfolio can be forgotten for another month as it is in great shape.

Platinum membership available for $5.00 per month.  Learn about the ITA Risk Reduction model and see it in action.

Performance Data:  While the Gauss appears to be completely out of whack with respect to the benchmarks, note the dollar difference is minor as this is a very young portfolio.  Even so, it will take some skill and luck to pull even with the VTSMX and ITA Index.  We’ve experienced a very strong market since this portfolio was launched a few months ago.  Don’t expect to see this continue.

High Yield Investments Fall Short of Goals

From a discussion on Seeking Alpha, a list of high yield investments were suggested for QPP analysis.  While a number of the suggestions lacked three-years of data, the following seven high yield investments met all the qualifications for analysis.  Below are the projections for this list of tickers.  HYG and JNK are part of many portfolios tracked here at ITA Wealth Management.

Here my observations if these were the portfolio under scrutiny. 

1) The projected return is 2.2% points below the objectives I use when setting up a portfolio.  Right out of the starting blocks, this set of high yield investments fail as a group.  This does not mean there are not a few worth considering.

2) The projected portfolio uncertainty of 11.3% is well below our goal of 15%.  This value is great, and it should be, considering the low projected return.

3) The Diversification Metric indicates this is not a well diversified portfolio.

4) At 8.6%, the Portfolio Autocorrelation is excellent.  The lower the percentage the better.

I did not bother to include a "Delta Factor" table as none of the tickers showed up as potential purchases at this time.

Six “Mad Money” Stocks

Here are six stocks that qualify for "Mad Money" investments.  Do your own thorough research.

These stocks are not for publication elsewhere.

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Super Charge Your Portfolio

In response to reader requests, I am posting a list of dividend oriented stocks.  Perhaps this is the beginning of a discussion of how one might add a few stocks to a core of index ETFs.

The following material is not available for publication elsewhere.

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Monitoring The Eight Critical ETFs For the ITA Risk Reduction Model

Photograph: Pinnacles National Monument – California

After the market closes tomorrow, I will be examining the Gauss Portfolio to see if any of the eight critical ETFs show prices crossing from above to below their 195-Day Exponential Moving Averages.  While we may avoid activity within the Gauss, if the markets continue to behave as they have for the last week, there most certainly will be changes taking place in the Maxwell Portfolio as it is up for examination on April 6th.  We are entering Sy Harding's Seasonal Timing Strategy period so it is no surprise some selling activity will likely take place over the next several months.

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Will An All Equities Portfolio Provide Superior Retirement vs. All Bond Portfolio?

We are trying to answer the assertion that the stock to bond ratio does not make a significant difference when it comes to retirement planning.  Yesterday, I posted two blog entries that dealt with the beginning arguments.  Here is the link to the first entry and the link to the second one where I focused on the all bond portfolio.  In this blog post I will show the results of an all equity portfolio.  The same assumptions will be used in the all equity portfolio as with the all bond portfolio.  Only the ETFs are changed.

All Equity Portfolio:  The following all equity portfolio consists of nine ETFs.  The ETFs provide coverage of developed international markets, emerging markets, domestic REITs and international REITs.  Readers will find all these ETFs used in many of the portfolios tracked here at ITA Wealth Management.

As will the all bond portfolio, four years of historical data is used for the projections.  These ETFs generate a projected return 2.34% points above that projected for the S&P 500.  We pay for that aggression with a projected standard deviation of 19.91%.  One could tone down the portfolio uncertainty or volatility by employing the ITA Risk Reduction model (ITARR).

Scrolling down the screen shot, one sees that the portfolio is not well diversified as the Diversification Metric is only 10%.  That is 30% points below our goal when setting up the asset allocation plan for a portfolio.

Retirement Projections:  Now we come to the projections that answer the question as to whether or not the stock to bond ratio makes any difference in retirement planning, as argued by the financial planner.  Checking out the Monte Carlo projections, we see there is not much difference in the early years.  With the all equity portfolio we have a 10% chance of running out of money at age 79 whereas the age was 78 with the all bond portfolio.  The big difference comes in the later years.  With the stock oriented portfolio we have a 50% chance of "hitting the wall" at age 115.  The projections definitely favor an all equity portfolio vs. an all bond portfolio.

Given the two choices, I will definitely go with the all equity portfolio and then use an ITARR model as an overlay to reduce portfolio uncertainty.


Does the Stock/Bond Ratio Make Any Difference?

Do you remember the following quote from this blog post?

"The CFP said the $250k should be invested across different asset classes but the stock to bond ratio doesn't really seem to affect the outcome. I was quite skeptical about that last comment."

To answer the question or the assertion that the stock to bond ratio does not affect the outcome, I set up a total bond portfolio and a total stock or equities portfolio.  In this post, I'll examine the total bond portfolio.

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Setting Up a Dividend Oriented Portfolio for Retirement

A number of months ago I came across advice from a Certified Financial Planner (CFP) that peaked my interest.  Using the data as given, what are the projections if one uses the Quantext Portfolio Planner (QPP) for the analysis?  Are the results similar to those posited by the CFP?  To answer the question, I set up a dividend oriented portfolio made up of fifteen ETFs.  Without considering the basic principles of asset allocation, I selected the ETFs with both dividends and global coverage in mind.  Described in the following quote is the financial situation faced by the retiree.  We don't know the age of the person in question or how much they may be adding to the portfolio each year.  Therefore, I will assume the person in question is 65 years old and no longer is adding money to the portfolio.

"A Certified Financial Planner (CFP) recently gave a seminar at work. She posed the question: "Do you have enough to live on when you retire?" She gave an example: Say you need $50k to live on. You have $40k in more or less guaranteed income stream through pension and social security. This means you need $10k more each year. How much do you need in your investment portfolio to produce $10k a year at a 4% withdrawal rate. Her calculation: $10k divided by .04 = $250,000 needed in your portfolio. The CFP then said that studies show that it is highly likely, though not guaranteed, that if a retiree takes 4% withdrawal ($10,000) that first year and subsequent years, that even with adjustment for inflation in future years the $250k should last 25 years. The question was raised: "Then, how does that $250k have to be invested in order for it to last 25 years through inflation and the yearly withdrawals, which would otherwise deplete the $250k sooner than 25 years?" The CFP said the $250k should be invested across different asset classes but the stock to bond ratio doesn't really seem to affect the outcome. I was quite skeptical about that last comment."

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