Showing posts with label Modern Portfolio Theory. Show all posts
Showing posts with label Modern Portfolio Theory. Show all posts

Friday 5 August 2016

A Random Walk Down Wall Street - Part Three 2: The New Investment Technology

Chapter 10. Reaping Reward by Increasing Risk

Diversification cannot eliminate all risk. Sharpe-Lintner-Black tried to determine what part of a security’s risk can be eliminated by diversification and what part cannot. The result is known as the Capital asset pricing model (CAPM). The basic logic is that there is no premium for bearing risks that can be diversified away. Thus, to get a higher average long-run rate of return in a portfolio, you need to increase the risk level of the portfolio that cannot be diversified away.


I. Beta and Systematic risk

1. Two kinds of risks: systematic risk and unsystematic risk. Systematic risk cannot be eliminated by diversification. It is because all stocks move more or less in tandem that even diversified stock portfolios are risky. Unsystematic risk is the variability in stock prices that results from factors peculiar to an individual company. The risk associated with such variability is precisely the kind that diversification can reduce.
2. The whole point of portfolio theory is that, to the extend that stocks don’t move in tandem all the time, variations in the returns from any one security tend to be washed away or smoothed out by complementary variation in the returns from other securities.
3. The beta calculation is essentially a comparison between the movements of an individual stock (or portfolio) and the movements of the market as a whole.  Professionals call high-beta stocks aggressive investments and label low-beta stocks as defensive.
4. Risk-averse investors wouldn’t buy securities with extra risk without the expectation of extra reward. But not all of the risk of individual securities is relevant in determining the premium for bearing risk. The unsystematic part of the total risk is easily eliminated by adequate diversification. The only part of the total risk that investors will get paid for bearing is the systematic risk, the risk that diversification cannot help.



II. CAPM
1. Before the advent of CAPM, it was believed that the return on each security was related to the total risk inherent in that security.
2. The theory says that the total risk of each individual security is irrelevant. It is only the systematic component that counts as far as extra rewards go. The beta is the measure of the systematic risk.
3. As the systematic risk (beta) of an individual stock (or portfolio) increases, so does the return an investor can expect.
4. If the realized return is larger than that predicted by the overall portfolio beta, the manager is said to have produced a positive alpha.


III. Look at the record
1. Fama and French found that the relationship between beta and return is essentially flat.
2. The author believes that “the unearthing of serious cracks in the CAPM will not lead to an abandonment of mathematical tools in financial analysis and a return to traditional security analysis. There are many reasons to avoid a rush to judgment of the death of beta:
a. The beta measure of relative volatility does capture at least some aspects of what we normally think of as risk.
b. It is very difficult to measure beta with any degree of precision. The S&P 500 Index is not “the market”. The total market contains many additional stocks in the US and thousands more in foreign countries. Moreover, the total market includes bonds, real estate, precious metals, and also human capital.
c. Investors should be aware that even if the long-run relationship between beta and return is flat, beta can still be a useful investment management tool.



IV. Arbitrage Pricing Theory

1. It is fair to conclude that risk is unlikely to be captured adequately by a single beta statistic. It appears that several other systematic risk measures affect the valuation of securities.
2. In addition, there is some evidence that security returns are related to size, and also to P/E multiples and price-book value ratios.
3. If one wanted for simplicity to select the one risk measure most closely related to expected returns, the best single risk proxy turned out to be the extent of disagreement among security analysts’ forecast for each individual company. Companies for which there is a broad consensus with respect to the growth of future earnings in dividends seem to be considered less risky than companies for which there is little agreement among security analysts.



To sum up, the stock market appears to be an efficient mechanism that adjusts quite quickly to new info. Neither technical analysis, nor fundamental analysis seems to yield consistent benefits. It appears that the only way to obtain higher long-run investment returns is to accept greater risks.

Unfortunately, a perfect risk measure does not exist. The actual relationship between beta and rate of return has not corresponded to the relationship predicted by the theory during long periods of the twentieth century. Moreover, betas for individual stocks are not stable over time, and they are very sensitive to the market proxy against which they are measured.

A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

Monday 5 December 2011

I don't understand why business schools don't teach the Warren Buffett model of investing.


I don't understand why business schools don't teach the Warren Buffett model of investing.


Or the Ben Graham model. Or the Peter Lynch model. Or the Martin Whitman model. (I could go on.) In English, you study great writers; in physics and biology, you study great scientists; in philosophy and math, you study great thinkers; but in most business school investment classes, you study modern finance theory, which is grounded in one basic premise--that markets are efficient because investors are always rational. It's just one point of view. A good English professor couldn't get away with teaching Melville as the backbone of English literature. How is it that business schools get away with teaching modern finance theory as the backbone of investing? Especially given that it's only a theory that, as far as I know, hasn't made many investors particularly rich.

Meanwhile, Berkshire Hathaway, under the stewardship of Buffett and vice chairman Charlie Munger, has made thousands of people rich over the past 30-odd years. And it has done so with integrity and a system of principles that is every bit as rigorous, if not more so, as anything modern finance theory can dish up.

On Monday, 11,000 Berkshire shareholders showed up at Aksarben Stadium in Omaha to hear Buffett and Munger talk about this set of principles. Together these principles form a model for investing to which any well-informed business-school student should be exposed--if not for the sake of the principles themselves, then at least to generate the kind of healthy debate that's common in other academic fields.

Whereas modern finance theory is built around the price behavior of stocks, the Buffett model is centered around buying businesses as if one were going to operate them. It's like the process of buying a house. You wouldn't buy a house on a tip from a friend or sight unseen from a description in a newspaper. And you surely wouldn't consider the volatility of the house's price in your consideration of risk. Indeed, regularly updated price quotes aren't available in the real estate market, because property doesn't trade the way common stocks do. Instead, you'd study the fundamentals--the neighborhood, comparable home sales, the condition of the house, and how much you think you could rent it for--to get an idea of its intrinsic value.

The same basic idea applies to buying a business that you'd operate yourself or to being a passive investor in the common stock of a company. Who cares about the price history of the stock? What bearing does it have on how the company conducts business? What's important is whether you can purchase at a reasonable price a business that generates good returns on capital (Buffett likes returns on equity in the neighborhood of 15% or better) without a lot of debt (which makes returns on capital less dependable). In the best of all worlds, the company will have a competitive advantage that allows it to sustain its above-average ROE for years, so you can hang on to it for a long time--just as you would live in your house--and reap the power of compounding.

Buffett further advocates investing in businesses that are easy to understand--Munger calls it "clearing one-foot hurdles"--so you can come up with more reliable estimates of their long-term economics. Coca-Cola's basic business is pretty staid, for example. Unit case sales and ROE determine the company's future earnings. Companies like Microsoftand Intel--good as they are--require clearing much higher hurdles of understanding because their business models are so dependent on the rapidly evolving world of high tech. Today it's a matter of selling the most word-processing programs; tomorrow it's the Internet presence; after that, who knows. For Coke, the challenge is always to sell more cases of beverage.

Buying a business or a stock just because it's cheap is a surefire way to lose money, according to the Buffett model. You get what you pay for. But if you're evaluating investments as businesses to begin with, you probably wouldn't make this mistake, because you'd recognize that a good business is worth buying at a fair price.

Finally, if you follow the Buffett model, you don't trade your investments just because our liquid stock markets invite you to do so. Activity for the sake of activity begets high transaction costs, high tax bills, and poor investment decisions ("if I make a mistake I can sell it in a minute"). Less is more.

I'm not trying to pick a fight with modern finance theory enthusiasts. I just find it unsettling that basic business-school curricula don't even consider models other than modern finance theory, even though those models are in the marketplace proving themselves every day.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/teachbuffet.htm

Wednesday 14 July 2010

Chuck out your CAPM and burst your beta, the truly chic academics are now seeking to explain why value stocks outperform.



The business schools reward difficult complex behaviour more than simple behaviour, but simple behaviour is more effective. - Warren Buffett

The Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT) are based on a simple assumption that risk is defined by volatility. According to the theory, investors are risk adverse: they are willing to accept more risk (volatility) for higher payoffs and will accept lower returns for a less volatile investment. The theory is simple and elegant, and can lead further into ingenuous mathematical proofs and equations, which probably has a lot to do with why it has become so widely accepted.

When Markowitz and Sharpe et al needed a definition of risk, they chose to define risk as volatility, the greater the volatility of the portfolio, measured either in terms of standard deviation or beta, the greater the risk.

How did these researchers know that volatility was a good measure of risk? They didn't, nor did they do any research to find out. The observation was made that the share market, which is generally thought to be more risky than cash investments, had the highest volatility. The principle was adopted generally without further evidence that volatility was a good way to measure risk.

Economists find this definition of risk compelling, because it is based on an assumption that makes perfect logical sense, that investors should be risk adverse, and that in today's well informed, sophisticated markets everyone acts perfectly rationally and takes no risk that is not justified by a bounty of evidence in support.

But the question is still there, why this measure of risk rather than securities analysis as espoused by Graham and Dodd, examining the virtues of each company by a good look at their financial strength, earnings, debt, sales success or many other measures that management use?

One doesn't have to get too far in examining the theory to find big gaps in the logic. Investors are very concerned by downside volatility, but how many object when their portfolio moves up? Volatility is a measure that regards upside movement as equally bad as movement to the downside. What about inflation and the terrible toll it extracts on non-growth assets? Finally, speculative stocks which are extremely volatile do not fit into this mold as they certainly do not give superior returns, as a diversified group or otherwise. Right from the start this definition of risk seemed unrealistic.

Unrealistic or not, an entire generation of investors has grown up with the idea that volatility is risk. Services that rate managed funds examine volatility as a central concern, and "risk adjusted" historic returns are frequently a major factor in determining how many stars a manager is given by the rating services.

There are many problems with the whole concept. For starters there actually isn't any permanent correlation between risk (when defined as volatility) and return. High volatility does not give better results, nor does lower volatility give lesser results.

In 1977, over a decade before Markowitz and Sharpe received their Nobel Prizes for their work on portfolio theory, a paper appeared reviewing the research on risk (J. Michael Murphy, "Efficient Markets, Index Funds, Illusion, and Reality", Journal of Portfolio Management (Fall 1977), pp. 5-20.). Some of the conclusions were startling, at least for EMH believers. Murphy cited four studies that found "realised returns appear to be higher than expected low low-risk securities and lower than expected for high-risk securities ... or that the [risk-reward] relationship was far weaker than expected." The author continued on: "Other important studies have concluded that there is not necessarily any stable relationship between risk and return; that there often may be virtually no relationship between return achieved and risk taken; and that high volatility unit trusts were not compensated by greater returns". (Italics original)

Another paper (Haugen and Heins, "Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles," Journal of Financial and Quantitative Analysis (December 1975), pp 775-84) concluded: "The results of our empirical effort do not support the conventional hypothesis that risk - systematic or otherwise - generates a special reward." These papers were published in the mid to late 70s, just as EMH and MPT were really taking off and "revolutionising" the way Wall Street invested money.

The total absence of a correlation between volatility and return for individual stocks is not the only thing that troubles this method and its exponents. Even more fundamental is the failure of volatility measures to remain constant over time. Any options trader will tell you immediately that volatility is not the same from day to day, nor hour to hour or even year to year. Volatility simply does not stay the same for any period of time and varies drastically from one time period to another. Stocks do not have a fixed volatility and hence it is absolutely impossible to use that factor to make meaningful changes to a portfolio unless you know what volatility is going to be; and we are no closer to finding a way to predict volatility than we are to being able to predict the general movement of prices.

Beta, as defined by Sharpe, Lintner and Mossin were shown to have no predictive power. The beta defined for one period differs drastically to that in the next and there is no way of using beta to predict future volatility.

Barr Rosenberg, a well respected researcher proposed a more sophisticated multifactor beta, including a large number of other inputs besides volatility to measure risk. These betas, called "Barr's Bionic Betas" proved as worthless as previous definitions in portfolio construction. Other betas were examined but none proved to have any usefulness at all for anything besides providing work for market statisticians.

The Capital Asset Pricing Model is based entirely on beta. Without a reliable beta you can't have CAPM any more than a value investor can buy stocks without knowing anything about assets or earnings. Somehow all this managed to be ignored until Eugene Fama, one of the original researchers who in 1973 had been right at the centre of the development of the Efficient Market Hypothesis, put out a new paper on risk and return in 1992. (Fama and French, "The Cross-Section of Expected Stock Returns" Journal of Finance 67 (1992), pp 427-465). Fama and French examined 9,500 stocks between 1963 and 1990, concluding that a stock's risk, measured by beta, was not a reliable predictor of performance. Fama stated "beta as the sole variable in explaining returns on stocks ... is dead. ... What we are saying is that over the last 50 years, knowing the volatility of an equity doesn't tell you much about the stock's return."

This was like the Pope announcing that there is no God, anyone who knows what a central role Fama's early 1970s work on EMH and MPT played would appreciate that this was an astounding development. As the Chicago Tribune put it: "Some of its best-known adherents have now become detractors."

If not volatility, then what? "What investors really get paid for is holding dogs." said Fama's coworker French. Their research found that stocks with lower price to earnings ratios and price to book ratios, as well as smaller capitalisation companies provided the highest returns over time. Stocks are more positively related to these measurements than to beta or other similar risk criteria.

Fama's words "beta is dead" reverberated around the world. As one finance professor put is in discussing the Fama and French findings:

Modern finance today resembles a Meso-American religion, one in which the high priest not only sacrifices the followers - but even the church itself. The field has been so indoctrinated and dogmatised that only those who promoted the leading model from the start are allowed to destroy it.

Other measures were developed do adjust returns by volatility to devise "risk adjusted" returns. I might return 40% over a few years but if I do this with sufficiently high volatility then someone who invested in treasury bills would have better risk adjusted returns. Remember that volatility, in its usual definition, is no different for upside or downside movements. If I achieved this with results ranging between +1% and +100% in any given year, but with no down years at all, then on the basis of that track record my strategy was obviously a risky one. Many contrarian and value investors whose track records include very little downside volatility but tend to make a lot of money when markets bounce have very poor "risk adjusted" returns as a result of this thinking.

Beta gives the appearance of a highly sophisticated mathematical formula but in reality it is data mining, looking at history you can find a number of factors that seem to be correlated, but these correlations are more often than not sheer coincidence. This is very bad science. I learned while doing my own studies that it is wrong to confuse correlation with causality, and wrong to just assume that correlations can be extrapolated to the future. Perhaps other researchers in finance and economics should study for a degree in the physical sciences as I did, maybe they don't teach this concept in economics.

Modern Portfolio Theory is based on a number of assumptions. Mathematically you would expect any conclusions to be drawn from the model to be correct as long as the assumptions are correct. In science we develop basic theories and understand basic principles. As long as the fundamental pieces fit, equations can be manipulated to provide new insights. This is why now that quantum mechanics and relativity are fairly well understood a large proportion of scientific discovery is purely mathematical. As long as the theory is correct you can make new discoveries by putting the theory into a mathematical model and giving it all a good shake. Physicists have found hundreds of subatomic particles that were originally predicted and described in complete detail by mathematics.

So what assumptions and fundamentals does Modern Portfolio Theory rely on? There are ten of them which are particular doozies. The following are key concepts around which MPT has been constructed:

There are no transaction costs in buying and selling securities. There is no brokerage, no spread between bidding and asking prices. You pay no taxes of any kind and only "risk" plays a part in determining which securities an investor will buy.

An investor can take any position of any size in any security he wishes. No one can move the market and liquidity is infinite. You can buy a trillion dollars worth of stock in a small speculative mining stock or buy one cent worth of Berkshire Hathaway. Nothing stops you from taking positions of any size in any security.
The investor does not consider taxes when making investment decisions, and is indifferent to receiving dividends or capital gains.

Investors are rational and risk adverse. They are completely aware of all risk entailed in an investment and will take positions based on a determination of risk, demanding a higher return for accepting greater volatility.
Investors, as a group, look at risk-return relationships over the same time horizon. A short term speculator and a long term investor have exactly the same motivations, time horizon and profit target. Regardless of who you are, you will always give an investment the same amount of time to work out and volatility will be your only concern.

Investors, as a group, have similar views on how they measure risk. All investors have the same information and will buy or sell based on an identical assessment of the investment and all expect the same thing from the investment. A seller will be motivated to sell only because another security has a level of volatility corresponding to their desired return. A buyer will make a purchase because this security has a level of risk corresponding to the return that he wants.

Investors seek to control risk only by the diversification of their holdings.
All assets, including human capital, can be bought and sold on the market.
Investors can lend or borrow at the 91-day T-bill rate - the risk-free rate - and can also sell short without restriction.
Politics and investor psychology have no effect on the markets.

In fact transaction costs have a major effect on whether you want to be a long term or short term investor, and taxes have a major impact on what kind of investments make sense. Liquidity is a major factor in keeping most people out of thinly traded issues and the difference between dividends and capital gains very much affects the type of securities an investor will buy.

Investors are not rational, they go for "hot" sectors and markets boom and bust regularly because of speculative excesses. Many people will buy stocks based only on rumour or hunches, the market for thinly traded issues would be wiped out if people really appreciated the true situation of the companies being traded.

Who could argue that a day trader and Warren Buffett would see eye to eye on the outlook of a stock. Does a long term investor buy the same stocks as a trader?

Only the government can borrow at the T-bill rate. No other investor in the world can borrow money at these rates unless they have some special concession. Short selling is illegal or severely restricted in many countries.

Three hundred years of Tulipomania, South Seas bubbles, Real Estate rushes, gold rushes, concept stocks, junk bond busts, dot coms and Asian Crises have shown that politics and psychology have a major effect on markets.

But don't let any of this dissuade you from believing in Modern Portfolio Theory or looking up tables of beta and alpha for various stocks. After all, almost every university throughout the world still teaches MPT to finance and economics students, fund rating services such as Morningstar allocate stars based to a large degree on "risk adjusted" returns, fund managers structure their portfolios based on the Capital Asset Pricing Model, which is a key part of Modern Portfolio Theory, and financial planners do their best to pigeonhole clients into one of five "risk profiles" where all but the most "aggressive" permanently devote large proportions of their portfolio to "low risk" investments such as cash and bonds, even though we do know that taxes and inflation make these classic loser's investments.

MPT is enshrined to the point that it is included in legislation. Risk profiles are an essential part of financial planning, and if I, as a financial planner, were to recommend a portfolio made entirely of stocks, I would probably be sued successfully if the market fell, even if the investor had a very long term outlook. ASIC requires diversification and require us to provide our clients with volumes of data calculated with the Capital Asset Pricing Model. The Diploma of Financial Planning, as well as many similar industry qualifications for those who wish to be advisers or analysts or portfolio managers teaches the Efficient Market Hypothesis and MPT as gospel.

The "prudent man rule", a concept where a fiduciary (professional funds manager) is obliged to invest in "safe" assets is based on a definition of risk that only goes as far as maintaining dollar amounts of a portfolio, even if purchasing power is lost. In our rush to protect funds, we find that a volatility definition of risk is important, and even though inflation and taxes may well destroy an investor's real wealth, as long as dollars are preserved a fiduciary can be said to have acted prudently; hence the popularity of bonds and cash in long term portfolios.

What about those studies that show that nobody in history has outperformed the market by a statistically significant amount?

Supporters of the Efficient Market Hypothesis gleefully point out that by their reckoning no investor in history has ever turned in a statistically significant outperformance of the market averages over a long period of time. Even Warren Buffett who has more or less consistently outperformed since the 1950s is regarded as a statistical freak, the guy that managed to flip heads on two coins one hundred times in a row out of sheer dumb luck.

What is this "statistical significance" and most importantly, what sort of performance does one need to turn in to achieve a statistically significant result?

David Dreman wrote about this in Contrarian Investment Strategies: The Next Generation in a section entitled "The Vanishing Support for EMH", so just how does a person go about proving that they can outperform the market, to the satisfaction of all parties?

The biggest problem with statistical significance is that it is a weak tool when there is very little data available. Statistics was designed for use with large sets of numbers, you want thousands of data points in your survey and simply put most money managers haven't been in the industry long enough to have thousands of quarterly performance figures out just yet!

When you have smaller data sets, you need to be looking for larger differences to be flagged as statistically significant. When you have one million data points you won't need very much of an outperformance to show up on a researcher's screen at the 95% confidence level (generally regarded as the minimum acceptable level of statistical significance), so when someone has clocked up 250,000 years worth of quarterly data it will be blindingly obvious to even the statisticians that his long term average return was pretty good! For most managers that have a career of maybe 30 years, that is only 120 data points. You need to be looking for a very severe outperformance to get good statistical significance with a track record so short.

One of the most important studies upon which the Efficient Market Hypothesis first drew support used a technique by Jensen (one of the important mutual fund investigators). One study showed that using the Jensen technique out of 115 funds only one demonstrated superior performance.

To even show up on the screen, the manager had to have a past performance beating the market by no less than 5.83% annually for 14 years! Books get written about guys that manage to outperform the market by only a couple of percent (ie John Neff, Peter Lynch), so I think it would be fair to say that this test of performance is unrealistic. Only someone in the league of Buffett or Templeton could hope to show up with such a high cutoff, and then you'll just get a few remaining sour grapes claiming that since only two people in history have ever achieved this performance it probably just comes down to dumb luck.

In another study using risk adjustment techniques the researchers showed that at the 95% confidence level it was impossible to tell whether a portfolio that was up 90% over ten years had outperformed one that was down 3%. (!!) They noted that given a reasonable level of annual outperformance and volatility, it takes about 70 years of quarterly data to achieve statistical significance at the 95% level.

Lawrence Summers, later Deputy Secretary of the Treasury of the United States under the Clinton administration estimated that it would require 50,000 years of data to disprove the Efficient Market Hypothesis to the satisfaction of the stalwarts.

Having said all of this...

I take the view that the market is not efficient, indeed there are numerous "anomalies", such as the outperformance of value stocks compared to growth stocks, various autocorrelation studies have established that momentum and regression to the mean are commonly seen, and that small companies do seem to outperform large companies.

The mere existence of Warren Buffett and John Templeton does prove that it is possible to select stocks and earn a higher return than an index fund. On a more practical level though, it is very clear that there aren't many of these people around, and it is also clear that identifying such individuals in advance (when selecting a fund manager to put your money with) is very hard.

Moderate academics acknowledge that there are inefficiencies, "free lunches" as some put them, in market prices. What few people doubt though is that spotting them requires more skill than most people have and that for the most part stocks are efficiently priced most of the time. As one researcher put it, there may be free lunches but you'll starve to death waiting for them.

One hedge fund manager I spoke to the other day had these words to say, "we find that 80% of all stocks are efficiently priced, we look for the 20% that aren't." It is fair to say that the majority of stocks are efficiently priced and that an index fund will thus be a relatively efficient vehicle. Maybe this hedge fund manager can identify the 20%, maybe he can't. The question that we as investors need to think about is whether we feel confident that the managers we invest with (or us, if you DIY) can successfully identify the 20% of incorrectly priced stocks and profit from them. Some can, obviously, but knowing if our strategy will work in advance, given that most active strategies don't, is the million dollar question.

A second question is whether these inefficiencies are really so profitable that they are even worth going for once identified. If your active strategy leads to more frequent realisations of capital gains then the loss of tax efficiency might do more harm than your strategy does good.

While I do encourage readers to study the great investors, I also encourage anyone that does not, after much honest self assessment, feel that they are not quite up to Buffett's standards, to consider an indexed approach instead.

I personally do keep an eye out for free lunches, but in the mean time I am happy enough to leave most of my money invested across a variety of index funds, including in particular value index funds. In the next article, I'll bring you a little closer to the state of the art in Modern Portfolio Theory. Chuck out your CAPM and burst your beta, the truly chic academics are now seeking to explain why value stocks outperform, given that they aren't actually more volatile.

http://www.travismorien.com/FAQ/portfolios/mptcriticism.htm

Tuesday 19 January 2010

****Constructing a Portfolio

Now that you have learned to analyse companies and pick stocks, it is time to focus on putting groups of stocks together to construct your stock portfolio.


No one answer is right for everyone when it comes to portfolio construction. It is more art than science. And perhaps that's why many believe portfolio management may be the difference that separates a great investor from an average mutual fund manager.


Famed international stock-picker John Templeton has often said that he's right about his stock picks only about 60% of the time. Nevertheless, he has accumulated one of the best track records in the business. That's because great managers have a tendency to have more money invested in their big winners and less in their losers.




The Fat-Pitch Approach


You should hold relatively few great companies, purchased at a large margin of safety, and that you shouldn't be afraid to hold cash when you can't find good stocks to buy. But why?


Most investors will discover only a few good ideas in any given year - maybe five or six, sometimes a few more. Investors who hold more than 20 stocks at a time are often buying shares of companies they don't know much about, and then diversifying away the risk by holding lots of different names. It is tough to stray very far from the average return when you hold that many stocks, unless you have wacky weightings like 10% of your portfolio in one stock and 2% in each of the other 45.


About 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks. If you own about 12 to 18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio.


If you want to obtain a higher return than the markets, you increase your chances by being less diversified. At the same time, you also increase your risk.


If you own more than 18 stocks, you will have achieved almost full diversification, but now you will just have to keep track of more stocks in your portfolio for not much marginal benefit.


When you own too many companies, it becomes nearly impossible to know your companies really well. When you lose your focus and move outside your circle of competence, you lose your competitive advantage as an investor. Instead of playing with weak opponents for big stakes, you begin to become the weak opponent.




Non-Market Risk and a Concentrated Portfolio


Interestingly, holding a concentrated portfolio is not as risky as one may think. Just holding two stocks instead of one eliminates 46% of your unsystematic risk. Using a twist on the 80/20 rule of thumb, holding only eight stocks will eliminate about 81% of your diversifiable risk.


Unsystematic Risk and the Number of Stocks in a Portfolio


Number of Stocks   Non-Market Risk Eliminated (%)
1======== 0%
2 ========46%
4 ========72%
8 ========81%
16======= 93%
32======= 96%
500====== 99%
9,000==== 100%



What about range of returns?


Joel Greenblatt in his book You Can Be a Stock Market Genius explains that during one period that he examined,
  • the average return of the stock market was about 10% and
  • statistically, the one-year range of returns for a market portfolio (holding scores of stocks) in this period was between negative 8% and positive 28% about two-thirds of the time.
  • That means that one-third of the time, the returns fell outside this 36-point range.


Greenblatt noted that if your portfolio is limited to only :
  • 5 stocks, the expected return remains 10%, but your one-year range expands to between negative 11% and positive 31% about two-thirds of the time.
  • 8 stocks, the range is between negative 10% and positive 30%.

In other words, it takes fewer stocks to diversify a portfolio than one might intuitively think.


Portfolio Weighting

In addition to knowing how many stocks to own in your portfolio and which stocks to buy, the percentage of your portfolio occupied by each stock is just as important.   Unfortunately, the science and academics behind this important topic are scarce, and therefore, portfolio weighting is, again, more art than science.

The great money managers have a knack for having a great percentage of their money in stocks that do well and a lesser amount in their bad picks.  So how do they do it?

Essentially, a portfolio should be weighted in direct proportion to how much confidence you have in each pick.  If you have a lot of confidence in the long-term outlook and the valuation of a stock, then it should be weighted more heavily than a stock you may be taking a flier on.

If a stock has
  • a 10% weighting in your portfolio, then a 20% change in its price will move your overall portfolio 2%.
  • a 3% weighting, a 20% change has only a 0.6% effect on your portfolio.

Weight your portfolio wisely.  Don't be afraid to have some big weightings, but be certain that the highest-weighted stocks are the ones you feel the most confident about.  And, of course, don't go off the deep end by having, for example, 50% of your portfolio in a single stock.



Portfolio Turnover

If you follow the fat-pitch method, you won't trade very often.  Wide-moat companies selling at a discount are rare, so when you find one, you should pounce.  Over the years, a wide-moat company will generate returns on capital higher than its cost of capital, creating value for shareholders.  This shareholder value translates into a higher stock price over time.

If you sell after making a small profit, you might not get another chance to buy the stock, or a similar high-quality stock, for a long time.  For this reason, it's irrational to quickly move in and out of wide-moat stocks and incur capital gains taxes and transaction costs.  Your results, after taxes and trading expenses, likely won't be any better and may be worse.  That's why many of the great long-term investors display low turnover in their portfolios.  They've learned to let their winners run and to think like owners, not traders.



Circle of Competence and Sector Concentration

If you are investing within your circle of competence, then your stock selections will gravitate toward certain sectors and investment styles. 

Maybe you:
  • work in the medical field and thus are familiar with and own a number of pharmaceutical and biotechnology stocks, or,
  • you've been educated in the Warren Buffett school of investing and cling to entrenched, easy-to-understand businesses such as Coca-Cola and Wrigley.
Following the fat-pitch strategy, you will naturally be overweight in some areas you know well and have found an abundance of good businesses.  Likewise, you may avoid other areas where you don't know much or find it difficult to locate good businesses.

However, if all your stocks are in one sector, you may want to think about the effects that could have on your portfolio.  For instance, you probably wouldn't want all of your investments to be in unattractive areas such as the airline or auto industry.



Adding Mututal Funds to a Stock Portfolio

In-the-know investors buy stocks.  Those less-in-the-know, or those who choose to know less, own mutual funds. 

But investing doesn't have to be a choice between investing directly in stocks or indirectly through mutual funds.  Investors can - and many should - do both.  The trick is determining how your portfolio can benefit most from each type of investment.  Figuring out your appropriate stock/fund mix is up to you.

Begin by looking for gaps in your portfolio and circle of competence. 
  • Do you have any foreign exposure?
  • Do your assets cluster in particualr sectors or style-box positions?
Consider investing in mutual funds to gain exposure to countries and sectors that your portfolio currently lacks.

Some funds invest in micro-caps, others invest around the globe, still others focus on markets, such as real estate.  Stock investors who turn over some of their dollars to an expert in these areas gain exposure to new opportunities without having to learn a whole new set of analytical skills.

Ultimately, your choice depends on your circle of competence and comfort level.  While many may feel comfortable with picking their own international stocks, others may prefer to own an international equity fund.



Our Objective

Modern Portfolio Theory has been built on the assumption that you can't beat the stock market. If you can't beat the market porfolio, then the best you can do is to match the market's performance. Therefore, academic theory revolves around how to build the most efficient portfolio to match the market.

We have taken a different approach.  Our objective is to outperform the market.  Therefore, we believe that our odds increase by holding (not actively trading) relatively concentrated portfolios of between 12 and 20 great companies purchased with a margin of safety.  The circle of competence will be unique to every person; therefore, your stock portfolio will naturally have sector, style, and country biases.  If lacking in any area, such as international stocks, a good mutual fund can be used to balance your overall portfolio.

Saturday 18 April 2009

5 Reasons To Avoid Index Funds

5 Reasons To Avoid Index Funds
by Wayne Pinsent (Contact Author Biography)


Modern portfolio theory suggests that markets are efficient, and that a security's price includes all available information. The suggestion is that active management of a portfolio is useless, and investors would be better off buying an index and letting it ride. However, stock prices do not always seem rational, and there is also ample evidence going against efficient markets. So, although many people say that index investing is the way to go, we'll look at some reasons why it isn't always the best choice. (For background reading, see our Index Investing Tutorial and Modern Portfolio Theory: An Overview.)


1. Lack of Downside Protection
The stock market has proved to be a great investment in the long run, but over the years it has had its fair share of bumps and bruises. Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside. You can choose to hedge your exposure to the index by shorting the index, or buying a put against the index, but because these move in the exact opposite direction of each other, using them together could defeat the purpose of investing (it's a breakeven strategy). (To learn how to protect against dreaded downturns, check out 4 ETF Strategies For A Down Market.)

2. Lack of Reactive Ability
Sometimes obvious mispricing can occur in the market. If there's one company in the internet sector that has a unique benefit and all other internet company stock prices move up in sympathy, they may become overvalued as a group. The opposite can also happen. One company may have disastrous results that are unique to that company, but it may take down the stock prices of all companies in its sector. That sector may be a compelling value, but in a broad market value weighted index, exposure to that sector will actually be reduced instead of increased. Active management can take advantage of this misguided behavior in the market. An investor can watch out for good companies that become undervalued based on factors other than fundamentals, and sell companies that become overvalued for the same reason. (Find out how to tell whether your stock is a bargain or a bank breaker in see Sympathy Sell-Off: An Investor's Guide.)

Index investing does not allow for this advantageous behavior. If a stock becomes overvalued, it actually starts to carry more weight in the index. Unfortunately, this is just when astute investors would want to be lowering their portfolios' exposure to that stock. So even if you have a clear idea of a stock that is over- or undervalued, if you invest solely through an index, you will not be able to act on that knowledge.

3. No Control Over Holdings
Indexes are set portfolios. If an investor buys an index fund, he or she has no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy. Similarly, in everyday life, you may have experiences that lead you believe that one company is markedly better than another; maybe it has better brands, management or customer service. As a result, you may want to invest in that company specifically and not in its peers.

At the same time, you may have ill feelings toward other companies for moral or other personal reasons. For example, you may have issues with the way a company treats the environment or the products it makes. Your portfolio can be augmented by adding specific stocks you like, but the components of an index portion are out of your hands.(To learn about socially responsible investing, see Change The World One Investment At A Time.)

4. Limited Exposure to Different Strategies
There are countless strategies that investors have used with success; unfortunately, buying an index of the market may not give you access to a lot of these good ideas and strategies. Investing strategies can, at times, be combined to provide investors with better risk-adjusted returns. Index investing will give you diversification, but that can also be achieved with as few as 30 stocks, instead of the 500 stocks an S&P 500 Index would track. If you conduct research, you may be able to find the best value stocks, the best growth stocks and the best stocks for other strategies. After you've done the research, you can combine them into a smaller, more targeted portfolio. You may be able to provide yourself with a better-positioned portfolio than the overall market, or one that's better suited to your personal goals and risk tolerances. (To learn more, read A Guide To Portfolio Construction.)

5. Dampened Personal Satisfaction
Finally, investing can be worrying and stressful, especially during times of market turmoil. Selecting certain stocks may leave you constantly checking quotes, and can keep you awake at night, but these situations will not be averted by investing in an index. You can still find yourself constantly checking on how the market is performing and being worried sick about the economic landscape. On top of this, you will lose the satisfaction and excitement of making good investments and being successful with your money.

Conclusion
There have been studies both in favor and against active management. Many managers perform worse than their comparative benchmarks, but that does not change the fact that there are exceptional managers who regularly outperform the market. Index investing has merit if you want to take a broad economic view, but there are many reasons why it's not always the best route to achieving your personal investing goals.

by Wayne Pinsent, (Contact Author Biography)

http://investopedia.com/articles/stocks/09/reasons-to-avoid-index-funds.asp?partner=basics4b1

Wednesday 14 January 2009

Is the market efficient, always?

Is the market efficient, always?

But these conditions do not always exist. Market pricing and volatility of the late 1990s give reason to believe that these conditions did not exist. Some companies trade at prices bearing a discount from their intrinsic value – the key claim of value investing. Numerous other flaws infect beta, widely documented in a burgeoning literature over the past decade showing its declining utility.

General faith in beta requires general faith in efficient markets. But belief in efficient markets means the equity risk premium in the late 1990s was negative, zero, or very close to zero – that is the only way to make sense of the high stock prices prevalent in the late 1990s if markets are efficient. Under CAPM, a zero-market-risk premium implies a discount rate equal to the risk-free rate. But this is a strange result, defying common sense that common stocks are riskier than U.S. Treasuries.

We are back to where we started: Estimating appropriate discount rates for equity securities requires judgment about how much riskier a particular business is compared to risk-free benchmarks of U.S. Treasuries. Modern finance theory assumes return is correlated to risk (you get what you pay for); value investing understands return as correlated to effort (you get what you deserve).



Also read:
  1. Understanding Discount Rates
  2. Risk-free rate
  3. Traditional Method: Discount rate or WACC (I)
  4. Traditional Method: Discount rate or WACC (II)
  5. Modern Portfolio Theory
  6. Portfolio Theory: Market Risk Premiums
  7. Portfolio Theory: Beta
  8. Is the market efficient, always?
  9. Discount Rate Determinations: Summary

Portfolio Theory: Beta

Beta

As for beta, it is intended to reveal what part of any “market risk premium” is borne by a particular company’s stock. Beta determines this component of the discount rate estimate for a company’s equity by using various assumptions to compare its stock price gyrations with those of the overall stock market or a market index such as the S&P 500.

A stock whose price is more volatile than the market’s is seen as “riskier” than one whose price gyrates less than the market as a whole. Multiplying this measure of price volatility by a “market risk premium” theoretically expresses the differential risk the particular stock poses. The result is added to the risk-free rate to give a discount rate.

Beta is only potentially useful if stock prices of the subject company and of all components of the market or market index result from investor behaviour that is, collectively, rational. Such conditions of “market efficiency” might substantially occur for some companies in some cases and for some markets or some market segments at some time.


Also read:
  1. Understanding Discount Rates
  2. Risk-free rate
  3. Traditional Method: Discount rate or WACC (I)
  4. Traditional Method: Discount rate or WACC (II)
  5. Modern Portfolio Theory
  6. Portfolio Theory: Market Risk Premiums
  7. Portfolio Theory: Beta
  8. Is the market efficient, always?
  9. Discount Rate Determinations: Summary

Portfolio Theory: Market Risk Premiums

Market Risk Premiums

The variables also are integrated so that changes in one may indicate modification of another. For example, increases in the risk-free rate entail decreases in the market risk premium (the latter supposedly measures the difference between the risk-free rate and the expected return on common stocks). The need for estimation judgment, and the complex interrelationship among these variables, means that prudent analysis draws on multiple reasonable data points (by applying alternative methods and taking alternative measures of each variable).

The “market risk premium: is a guess based on history of what special inducements it takes to attract investors into stocks rather than buying U.S. Treasury securities or alternative investments. The idea is that investors must be given special compensation to bear the special risks of stocks or else they will not invest in them.

Data on Market Risk Premiums

Common practice is to consult data books published by leading economists, such as the one published by a firm run by Yale University professor Roger Ibbotson called the Ibbotson & Sinquefeld Yearbook. The harder way is doing it yourself, which is virtually impossible for non-professionals. But it is useful to understand why, so here goes.

Market risk premium data can be calculated up-to-the-minute at any time. Three crucial assumptions must be made to estimate the market risk premium.
1. First, the estimator must choose either historical data or some measure of future performance.
2. Second, one must define a “market” for the measure, such as the Standard & Poor’s 500, the New York Stock Exchange as a whole, or some other index.
3. Third, the estimate is based on a specified time period.

Alternatives include the period from the late 1800s (when market data were first recorded) to the time of valuation interest; from 1926 (when the University of Chicago began a database, thought to have the virtue of including a full business cycle before the 1929 market crash) to the time of valuation interest; for the 30-year period before the time of valuation interest (reflecting business cycles exhibiting more relevant business and financial risks and factors); or for specific environments being analysed, such as the early 2000s.

Challenges in using "market risk premium"

Seizing on a measure of the “market risk premium” became acutely tricky during the late 1990s because any such thing seemed to be evaporating. Any premium that once existed – e.g., in the period before 1990 – dwindled toward zero, as the most powerful bull market in world history produced investors who needed no inducements to join. Even staunch devotees of modern finance theory lamented the declining usefulness of “market risk premium” device during the 1990s.

Despite this well-known fact even among its fans, analysts sticking with this learning adhere to favourite benchmarks, such as 9 percent based on long-run historical returns on stocks dating back to the 1930s. Others respond to their gut sense that this is almost certainly wrong, and opt instead for rates of 7 percent, 5 percent, or less. Some believe it was moving towards zero in the late 1990s.

A group of the country’s leading financial economists assembled in mid-2000 to offer their measurements of the market risk premium. Eleven participated. Their estimates of the risk premium were: 0, 1-2, 3, 3-4, 4, 6, 6, and 8.1 percent, with three refusing to venture a guess giv en the concept’s indefiniteness and uncertain reliability.

Reasons for the decline or evaporation include powerful forces, such as U.S. investors became more long-term oriented, U.S. business efficiency heightened, fiscal policies and monetary management improved, capitalism spread globally, wealth increased, and business fundamentals exhibited less volatility.


Also read:
  1. Understanding Discount Rates
  2. Risk-free rate
  3. Traditional Method: Discount rate or WACC (I)
  4. Traditional Method: Discount rate or WACC (II)
  5. Modern Portfolio Theory
  6. Portfolio Theory: Market Risk Premiums
  7. Portfolio Theory: Beta
  8. Is the market efficient, always?
  9. Discount Rate Determinations: Summary

Modern Portfolio Theory

PORTFOLIO THEORY APPROACH: BETA AND PREMIUMS

Modern finance theory uses the “capital asset pricing model” (CAPM) to estimate discount rates for equities.

Using CAPM requires estimating two inputs in addition to a risk-free rate. These are a “market risk premium” and “beta,” a measure of stock price volatility seen by backers as a risk indicator.
The mistake some analysts make is to assume that there is a single accurate data point for each of these inputs. However, each of these variables is an estimate requiring judgment.



Also read:
  1. Understanding Discount Rates
  2. Risk-free rate
  3. Traditional Method: Discount rate or WACC (I)
  4. Traditional Method: Discount rate or WACC (II)
  5. Modern Portfolio Theory
  6. Portfolio Theory: Market Risk Premiums
  7. Portfolio Theory: Beta
  8. Is the market efficient, always?
  9. Discount Rate Determinations: Summary

Friday 2 January 2009

Modern Portfolio Theory Made Easy

Modern Portfolio Theory Made Easy

You can divide the history of investing in the United States into two periods: before and after 1952. That was the year that an economics student at the University of Chicago named Harry Markowitz published his doctoral thesis. His work was the beginning of what is now known as Modern Portfolio Theory. How important was Markowitz's paper? He received a Nobel Prize in economics in 1990 because of his research and its long-lasting effect on how investors approach investing today.
Markowitz starts out with the assumption that all investors would like to avoid risk whenever possible. He defines risk as a standard deviation of expected returns.
Rather than look at risk on an individual security level, Markowitz proposes that you measure the risk of an entire portfolio. When considering a security for your portfolio, don't base your decision on the amount of risk that carries with it. Instead, consider how that security contributes to the overall risk of your portfolio.
Markowitz then considers how all the investments in a portfolio can be expected to move together in price under the same circumstances. This is called "correlation," and it measures how much you can expect different securities or asset classes to change in price relative to each other.
For instance, high fuel prices might be good for oil companies, but bad for airlines who need to buy the fuel. As a result, you might expect that the stocks of companies in these two industries would often move in opposite directions. These two industries have a negative (or low) correlation. You'll get better diversification in your portfolio if you own one airline and one oil company, rather than two oil companies.
When you put all this together, it's entirely possible to build a portfolio that has much higher average return than the level of risk it contains. So when you build a diversified portfolio and spread out your investments by asset class, you're really just managing risk and return.

http://finance.yahoo.com/education/begin_investing/article/101172/Modern_Portfolio_Theory_Made_Easy