Avoid Value ETFs and Mutual Funds

Investors, especially value investors, should avoid most value ETFs and mutual funds because they are over weighted in high risk investments. As a value investor I am always looking for stocks that sell at low prices compared to their potential cash flow and risks associated with the underlying company. What was value and low risk in the past is not necessarily value and low risk today.

Most Value ETFs and Mutual Funds Are Loaded With Financial Services Stocks

Financial services, and particularly Bank Stocks, used to be the investment choice for “widows and orphans”. In other words they have been, in the past, considered safe dividend paying stocks with low volatility. The world has changed and these stocks are now investments with huge risks and considerable volatility.

So now value funds that used to have steady low volatility dividend paying stocks now own risky high volatility stocks with erratic dividend payouts. The question is: Are you getting what you intended when you buy these funds?

The percentage concentration of financial stocks in value funds is not insignificant. Many of these funds have considerable exposure to financial stocks.

Examples of Percentages of ETF Portfolios in Financial Services

iShares S&P500 Value Index Fund (IVE)              22.6%

iShares S&P500 Growth Index Fund (IVW)            3.8%

iShares Russell 2000 Value Index Fund (IWN)      23.0%

iShares Russell 2000 Growth Index Fund (IWO )    2.9%

As an investor interested in Value Investing Strategies; it is important to not get caught up in labels, but understand what you are buying. Sometimes investments are not what you think they are; so do your homework. An ETF or mutual fund investment labeled “growth” may have more value or less risk than an investment labeled “value”.

Many value investing funds have heavy exposure to financial service stocks which used to be stable dividend companies but are now volatile stocks with erratic dividends. Value investors should consider investing in individual undervalued stocks; but avoid value ETFs and Mutual Funds, until the environment for financial service stocks has changed.

Related Reading: Investment Portfolio Management

(Disclosure: The Arbor Asset Allocation Model Portfolio (AAAMP) is 2.5% long iShares Russell 2000 Growth (IWO) on 2/7/2012)

Making Probability Theory Practical

One of my favorite sayings is “Anyone who tells you they know what the stock market will do in the short term is either a fool or a liar”. The market cannot be predicted on a daily, weekly, monthly or yearly basis. This is NOT true for long periods of time; but we will talk about that later.

Probability Theory Illustrated

So how do some people correctly predict short term movements with great accuracy? Let’s look at probability theory illustrated in a simple example. If you flip a coin you have a 50% probability of heads and a 50% probability of tails. If you ask 1000 people to predict the outcome of a single coin flip the probability is 50% will predict correctly and 50% will get it wrong. Flip the coin twice and the odds are only 25% of predictors will guess both flips correctly. The accuracy will fall with each additional coin flip. At the end of 10 coin flips the odds are 1 out of 1000 will have predicted every coin flip correctly. Is that person the best prognosticator? These are completely random events and the odds were 1 out of the 1000 would get ten correct guesses in a row.

Probability in Investment

Although the stock market is much more complex, the same concept of probability in investment applies. Studies have shown that short term returns in the stock market are random, although with a positive bias. The positive bias is the difference between the coin toss example and the stock market; meaning there will be more positive than negative outcomes over time.

If you have enough prognosticators (and we do!); there will be a few who are able to successfully predict the short term moves in the stock market over several or even many time periods. Unfortunately, people begin to believe the stock market prognosticators are infallible and more and more people follow their advice. The more successful the predictions the greater number of followers. In addition to more followers, investors become more confident in their abilities, and make larger and larger bets. After all, the predictor has been correct many times; they must know more than anyone else? Of course, this is incorrect.

Inevitably the odds eventually catch up with the prognosticator. They guess incorrectly, and many people are harmed. But more damage can be done with a few incorrect guesses than all the correct guesses combined. That is because few are following when the prognosticator first starts his predictions. But at the end many people are following and many will most likely be making much greater bets than they were in the beginning. This is one of the reasons people get disenchanted with investing. They make poor investment decisions; usually based on greed and lack of understanding. They don’t have a solid investment plan.

It is easy to become lazy and attempt to follow an investment guru instead of implementing a sound investment plan. But there are no short cuts in investing. Any investment philosophy that is going to get you rich quickly is a scheme that will end badly.

Fortunately, for those willing to be patient and implement a long term investing plan, probability comes close to guaranteeing positive outcomes for those who do their homework. The stock market can be predicted in the long run.

In my next post, “Investment Decisions: Asset Allocation, Stock Selection, & The Dynamic Duo of Investing” we will look at two investment strategies that increase your probability of investment success to nearly 100%.

2012 Long Term View

The beginning of the year is a good time for asset allocation and risk management analysis for 2012. A view of the current long term investment environment is the first step.

Long Term View

The last 12 years have seen two bubbles; the dot.com bubble, and the housing bubble. Both market price bubbles produced extreme market volatility. I believe we are in a 15-20 year bear market that began in 2000, and still have one more bubble left to deflate; that being local, state, and federal governments. That probably means no bull market for several more years. It also means more challenging times ahead for investors with continued volatility and the need for a flexible asset allocation strategy that adapts to current market realities and valuations.

The next steps are risk management analysis and then an asset allocation management solution that allows the flexibility required to successfully build wealth in volatile and uncertain markets.

Risk Management Analysis

On the positive side, corporate America is financially sound and stock prices are not at the extreme overvaluation of a few years ago. Home values have fallen closer to equilibrium price where buyers and sellers will be equalized. Once that price is reached the housing market should improve. Unfortunately, that equilibrium probably won’t be reached in 2012. This is a requirement for job growth and a robust economy.

Global financial markets face hard challenges and many risks in 2012. Several European nations, namely Portugal, Ireland, Iceland, Greece, and Spain (PIIGS) have the potential to throw Europe into deep recession or even a deflationary depression. The European Union has only a few choices; all the options are hard and painful. The high probability of sovereign defaults that could spread through the global banking system means risk must to be assessed on an ongoing basis.

In the United States, all three levels; local, state, and federal governments, have increased their expenditures and unfunded liabilities to unsustainable levels. The governments, at each level, have exploding deficits, soaring debt, and mounting unfunded liabilities. All levels of government have to look at painful solutions to overcome short term and structural deficits. Cutting government services, employee layoffs, tax increases, restructuring of pension promises, defaults, and bankruptcies are all possibilities across the country. Any way you look at it, all the options will involve pain, economic dislocations, and most likely more stock market volatility for several years to come.

Asset Allocation in 2012

The lesson we should have learned from the past 12 years and our risk management analysis is that volatility will likely continue. Buy and hold strategies may work well when the stock market is rising in a cyclical bull market. But volatile flat and down markets require investors to use a tactical asset allocation to minimize investment loss. A tactical asset allocation provides the flexibility to rebalance the percentage invested in asset categories, depending on their valuation. The goal is to improve the risk adjusted rate of return of a portfolio as compared to a passive management strategy. The objective is to overweight asset classes that are undervalued and underweight asset classes that are overvalued.

Interest rates being at historic lows give a boost to the argument of owning dividend paying stocks with quality balance sheets. The AAAMP starts the year with an over weighted position in blue-chip dividend paying stocks and cash.

Cash is king now because we don’t have a clear inflation trend at the current time. It is the trend of inflation, not the absolute level of inflation, which has the largest effect on the direction of the market. As long as deflation and inflation are both distinct possibilities investors should overweight cash. Investors who are able to decipher the inflation trend ahead of the masses will be able outperform the market. Right now you must be prepared for both! There are too many variables in Federal Reserve and Government Fiscal policies for anyone to make more than a guess at this time.

The current investment environment makes asset allocation and risk management in 2012 critical to preservation of capital and long term performance.

Related Reading:   Risk Management

If you enjoy articles such as these consider our free E-mail Delivery Service.

 

Modern Portfolio Theory

Modern Investment Portfolio Theory was developed in the 1950’s with the belief that portfolio returns could be maximized for a given amount of investment risk by combining assets in a particular manner. The theory is that, using relationships between risk and return such as alpha and beta, and defining risk as the standard deviation of return, an “efficient frontier” for investing can be identified and exploited for maximum gain at a given amount of risk.

Much of Modern Portfolio Theory is now questioned. So why should you care? Why learn about something that is not 100% accepted as fact? The reason you should care is the principles and theories are foundations for building sound portfolio management strategies.  There is no “perfect” model. Those who believe they have perfect models find out that markets change, correlations change, people change, business changes; you get the idea.

What have we learned from Modern Portfolio Theory?

Asset Allocation works by reducing portfolio risk and/or increasing long term returns when non-correlated asset categories are combined.

Proper diversification reduces volatility risk by nearly eliminating specific or unsystematic risk.

Standard deviation provides a credible model for analyzing the probability of outcomes far away from the mean.

Portfolio management tools such as Alpha and Beta, Standard Deviation, the Sharpe ratio, Capital Asset Pricing Model (CAPM), Regression, and R-squared have provided a foundation for further investment research that has continued to provide additional insight into investment risk and returns.

How to Use Investment Portfolio Theory

One of the first lessons that should be learned from Modern Portfolio Theory is to not have too much faith in any model. Nothing is a sure bet; that is why it is called investment risk! Modern Portfolio Theory provides a foundation for learning and developing portfolio management skills.

Use investment portfolio theory to build your own foundation of beliefs and strategies for sound investing. Don’t buy into “trading systems” or theories that offer rewards that are too good to be true; because they will be too good to be true. Even the best and brightest believed they had theories that would stand the test of time; only to be proven wrong over time.

Conclusion of Series on Investment Risk and Returns

This concludes our weeklong series on Investment Risk and Returns. We have learned the importance of investment risk and explored some of the portfolio management tools to measure and mitigate risk when possible. Nobody will be right all the time; but we can greatly increase our chances to succeed by accepting only prudent risk.

The successful investor will take these investing principles and portfolio management tools to build discipline and employ investment strategies with high probabilities to succeed. Risk management and proper diversification will improve your portfolio rates of return.

Here are the other articles in this series:

Portfolio Management: Part I in Series on Investment Risk and Returns

Types of Investment Risk and Return in Portfolio Management

Standard Deviation and Probability – Financial Decision Making

What is Alpha and Beta? How Do They Relate to Investment Risk? 

 

Alpha and Beta

We continue our weeklong series on investment risk by looking at alpha and beta. These are two common measurements of investment risk that help an investor understand portfolio risk. By having a better understanding of investment risk an investor is able to mitigate risk and optimize returns.

Difference Between Alpha and Beta

Beta is a historical measure of volatility. Beta measures how an asset (i.e. a stock, an ETF, or portfolio) moves versus a benchmark (i.e. an index).

Alpha is a historical measure of an asset’s return on investment compared to the risk adjusted expected return.

What Does Beta Mean?

A beta of 1.0 implies a positive correlation (correlation measures direction, not volatility) where the asset moves in the same direction and the same percentage as the benchmark. A beta of -1 implies a negative correlation where the asset moves in the opposite direction but equal in volatility to the benchmark.

A beta of zero implies no correlation between the assets. Any beta above zero would imply a positive correlation with volatility expressed by how much over zero the number is. Any beta below zero would imply a negative correlation with volatility expressed by how much under zero the number is. For example a beta of 2.0 or -2.0 would imply volatility twice the benchmark. A beta of 0.5 or -0.5 implies volatility one-half the benchmark. I use the word “implies” because beta is based on historical data and we all know historical data does not guarantee future returns.

What Does Alpha Mean?

Alpha is used to measure performance on a risk adjusted basis. As an investor we want to know if we are being compensated for the risk taken. The return of investment might be better than a benchmark but still not compensate for the assumption of the risk.

An alpha of zero means the investment has exactly earned a return adequate for the risk assumed. An alpha over zero means the investment has earned a return that has more than compensated for the risk taken. An alpha of less than zero means the investment has earned a return that has not compensated for the risk assumed.

By risk adjusted we mean an investment return should compensate for Beta (volatility). If an investment is twice as volatile as the benchmark an investor should receive twice the return for assuming the additional risk. If an investment is less volatile than the benchmark an investor could receive less return than the benchmark and still be fairly compensated for the amount of risk taken.

Stock Beta and Alpha as an Example

Let’s assume company XYZ’s stock has a return on investment of 12% for the year and a beta of + 1.5; our benchmark is the S&P500 which was up 10% during the period. Is this a good investment?

A beta of 1.5 implies volatility 50% greater than the benchmark; therefore the stock should have had a return of 15% to compensate for the additional risk taken by owning a higher risk investment. The stock only had a return of 12%; three percent lower than the rate of return needed to compensate for the additional risk. The Alpha for this stock was -3 and tells us it was not a good investment even though the return was higher than the benchmark.

Alpha Investment versus Beta Investment

Beta investment is a choice. How much risk does the portfolio manager choose to take? That answer will depend on the objectives of the manager, the current investment environment, and should include consideration of asset valuations.

Everyone strives for positive alpha. This is the goal of a portfolio manager. A good manager uses portfolio management tools. Positive alpha is achieved with asset allocation, diversification, risk management, valuation strategies, and choosing individual investments with strategic advantages.

Understanding the difference between Alpha and Beta and how they relate to investment risk makes you a better investor. Use these tools for evaluation and risk management.

Investment Risk

Portfolio management requires understanding the types of investment risk and rate of return in today’s environment. It is a given that an investor must take risk in order to achieve rates of return above a risk-free rate of return. Because the risk-free rate of return (i.e. Treasury Bills rates) is near zero; most investors are being forced to accept additional risk to achieve investment returns that will meet their long term goals.

What is Investment Risk?

Most of us think of risk as negative. I’m going to try and get you to think a little differently about it. Risk is a deviation of an expected outcome. In investing, we can look at risk as a deviation of expected investment return. The deviation can be either positive or negative. The probability and magnitude of the deviation is what an investor is concerned about. There are many factors that can affect risk and there are portfolio management tools to measure and mitigate the factors.

Understanding risk and return allows a portfolio manager to manage risk and optimize returns. Before we examine how to analyze risk we need to look at some different types of risk and how a portfolio manager can use the tools available to improve their probability of higher returns.

Types of Investment Risk

Two Most Important Risks:

Specific Risk – The individual asset such as a company can have problems that are specific to that asset. Maybe a catastrophe (i.e. BP oil spill), bad management, a large product failure, etc. causes the individual assets price to fall. Specific risk can be mitigated with diversification.

Market Risk – In the short term stock market prices cannot be predicted. But long term returns can be predicted with some accuracy. In other words, the variation of returns (risk) is less over long periods of time than short periods of time. The stock market has fallen 30 -50% many times in short periods of time, but it has never fallen even 15% over a 10 year period. Market risk can be mitigated by long term investing, using a tactical asset allocation strategy, and hedging.

Other Risks to Consider:

Interest Rate Risk – When interest rates increase the price of bonds decline.

Default Risk – Sometimes a company is unable to pay back debts or bills.

Longevity Risk – Living longer than your money.

Inflation Risk – Higher prices lower the purchasing power of your investments. If your investment returns don’t exceed inflation you are losing purchasing power.

Economic Risk – Economic recession and depression can increase the risk of an investment.

Political Risk – Because the government is involved in a large percentage of our lives; changes in policies can have profound effects on entire industries or even the whole economy.

Self-directed Portfolio Management

I believe there are advantages to self-directed portfolio management. The person who has everything at stake can make the best decisions. I hope the importance of investment risk and rate of return in portfolio management is evident. It’s everything; and therefore critical for a portfolio manager to understand.

In the following posts, we will look at standard deviation, alpha and beta, and Modern Portfolio Theory. Before your eyes glaze over with boredom I promise to show you how these concepts are helpful without getting too technical.

If you enjoy reading articles such as these consider our Free E-mail Service. Sign up on the top right hand column ==>  

Definition of Diversification

The definition of diversification is the act of, or the result of, achieving variety. In finance and investment planning, diversification is a portfolio strategy combining a variety of assets to reduce the overall risk of an investment portfolio.

 

Purpose of Portfolio Diversification

The purpose of portfolio diversification is portfolio risk management and optimization. A risk management plan should include diversification rules that are strictly followed. Optimization occurs because risk is minimized, allowing the portfolio manager to seek out higher returns.

Your risk management plan should lower the volatility (risk) of a portfolio because not all asset categories, industries, or stocks move together. Holding a variety of non-correlated assets can nearly eliminate unsystematic risk. In other words, by owning a large number of investments in different industries and companies, industry and company specific risk is minimized. This decreases the volatility of the portfolio because different assets should be rising and falling at different times; smoothing out the returns of the portfolio as a whole. In addition, diversification of non-correlated assets can reduce losses in bear markets; preserving capital for investment in bull markets.

Portfolio optimization can be achieved through proper diversification because the portfolio manager can invest in more aggressive assets without increasing the risk of the overall portfolio. In other words, a portfolio manager with a target amount of total risk is able to invest in higher risk, higher reward assets because holding a variety of non-correlated assets has lowered the total risk of the portfolio. This is why some say diversification is the only free ride.

Can Over Diversification Hurt Investment Returns?

Some lessons can be overlearned. Over diversification is almost as large a problem today as under diversification. It is common for investors to believe that if a given amount of diversification is good; then more is better. This concept is false.

If adding an individual investment to a portfolio does not reduce the risk of the total portfolio more than it costs in potential returns; then further diversification would be over diversification. Most experts believe 15-25 individual investments are sufficient to reduce unsystematic risk. Therefore owning mutual funds, or many mutual funds, with literally hundreds of individual investments guarantees a mediocre return.

With a better understanding of what diversification is; now you can put together your risk management plan and increase returns through portfolio optimization.

Free Monthly Wealth Builder Newsletter  

Minimize Investment Loss

In our last post, “Probable Maximum Investment Loss and Asset Allocation” , we learned how to tailor our asset allocation to our assumed probable maximum investment loss. Now we can further explore the asset allocation strategy that can successfully maneuver through the volatile times we currently live in.

Investment Loss and Asset Allocation

Asset allocation is what will determine over 90% of your returns. It is the most important decision you can make in investing. The stock market has earned an average of a little less than 10% per year over a long period of time. But the average investor’s actual returns are much lower because people tend to buy when prices are high and tend to sell when prices are low. Because people allow their emotions to control their investment decisions, their form of “timing the market” has proven to be detrimental to investment returns.

Tactical Asset Allocation Strategy

An active or tactical asset allocation is a dynamic investment strategy in which investors change their asset allocation based on current circumstances. Historical analysis has proven the valuation of investment assets when purchased will determine long term returns (time periods of 10 years or more). Buying at high valuations produces low returns. Buying at low market valuations produces better than average returns. Doesn’t it make sense when you invest to make sure the odds are in your favor?

When you buy is something you can control. You can’t control what happens after you buy. The odds are, if you buy stocks when valuations are high, your returns will be much lower than when you buy stocks when valuations are low. Virtually every stock market crash has begun from abnormally high valuations. On the other hand, investors who buy stocks when valuations are well below average have always done well over long periods of time.

Be conservative when valuations are high. Hold cash and be mentally prepared to buy more stocks when prices are bargains. Take some profits and raise cash after the stock market rises because it makes sense to not be greedy. Yes, you will underperform the market when it goes up, but so what! Who says you have to match the market when it’s going up? The point is: The breakeven loss analysis chart demonstrates how long term returns are affected more by preserving capital when the market falls than making money when it rises.

It is the long term that matters. Most investors are too short sighted and impatient; wanting instant results. Are you a gambler or an investor? If you buy over valued stocks you are gambling that someone will pay more than its intrinsic value at a later date. You might gamble and win for a time; but that is not investing and the odds eventually catch up with you.

You have been warned that the odds are against you if you buy when valuations are high. Eventually buy and hold investors get burned and suffer severe damage to their portfolio. Instead of listening to the financial industries buy and hold mantra; use a valuation based tactical asset allocation to minimize investment loss and greatly increase your odds of high investment returns. 

Related Reading: Investment Portfolio Management