Things will probably stabilize at some point in the near future, but then a cascade of additional worries will take the markets down again shortly after that before a more permanent bottom is found. That's the typical pattern in these crises and I would be relatively shocked if that didn't happen now.
The fundamental question is then what should be done with one's personal investments? Well, there's little profit in rushing into this market at the moment to find a bottom. There is not a single event that could occur that would right all of the wrongs that ail the market at this point. There is no package that the EU could produce or is likely to produce that would soothe markets. There is no stimulus plan that the U.S. is remotely likely to put forward that would boost growth prospects. There is no sector of the economy that is poised to suddenly burst onto the scene with unexpected vigor and drag the rest of us with it. Political shackles have consigned us to quite difficult time at the moment.
For now, the most prudent thing to keep your current cash reserves and not deploy at this time. Also, any safer investments that hold up well will serve as reserves to take advantage of more speculative plays that get hammered. For instance, Brazil is getting destroyed right now: http://www.marketwatch.com/investing/fund/ewz
Before long, there will be fantastic opportunities. There always are after panics.
Showing posts with label Strategy. Show all posts
Showing posts with label Strategy. Show all posts
Thursday, August 4, 2011
Sunday, July 4, 2010
Strategy: How to manage future transaction costs in a small portfolio
As I am not a wealthy man, nor will I likely be working for my state's government, I, like many others, must pay a great deal of attention to transaction costs when executing trades. In what follows, I try to provide a few examples, all reasonably straightforward, of how to reduce the potential for ruinous costs.
Let us take the example of a brokerage account with $5,000 in it. You have this divided among five holdings at $1,000 each because you took the advice previous mentioned on this blog and attempted to build out core, meso, exploratory, and speculative holdings. That's all well and good, but let's say that you suddenly decide that you think all hell is about to break loose and you want to shield your assets in a bond ETF, say TLT. For the purposes of this demonstration, I'll say brokerage fees are $10 per trade just because it makes the math easier. First, in your initial sales, you incurred $50. Then, in your purchase of the bond ETF you incurred another $10. When the crisis passes you sell your bond ETF, incurring another $10, and then you buy back into your original five positions at another $50. Your total fees were $120 or 2.4%.
Now, you might say that 2.4% is not so bad because you may have averted far worse in the market as a result of your move. However, even among the best portfolio managers are wrong about as often as they are right. Over time, these decisions, even executed properly, are likely to be a wash for the typical investor. I know, speaking for myself, that they have been for me. The cumulative effect of multiple swaps over several years' time can be the loss of multiple percentage points of your assets with a devastating effect on your total return over the long run.
Even in a larger portfolio, if one divides their positions too thinly, the situation repeats itself. For example, the costs as a percent of assets for a $50,000 portfolio divided amongst 25 holdings at $2,000 a piece works out to be $520 total or slightly over 1% of total assets lost via fees. If this person is an active trader and does this a few times a year on average attempting to pick each point at which the market might turn, they could rack up 3 or 4% in fees. That's to say nothing of bad capital gains management, which I will discuss at some other point.
Now, the lower proportion of fees in the second example makes the point I would like to make. If you wish to engage in more active market timing, keep your number of holdings down significantly. In the first example with the $5,000 brokerage account, if you have only two holdings at $2,500 each your transaction costs for the whole series of transactions are only $60 or 1.2% of your portfolio. It's still a steep price to pay, but with larger portfolios keeping the number of holdings down drives these costs right through the floor. In the $50,000 portfolio example, if that investor only had five holdings at $10,000 a piece, they incur $120 in transaction costs or 0.24% in fees for a whole cycle of transactions. As such, the lesson is that consolidated, larger holdings give you a greater ability to engage in market timing if you feel that's what you should be doing. The risk is that, depending on how you do it, you lose out on diversification. You can make up for this in choosing broad market index ETFs and then have both flexibility and diversification.
Now, as to whether or not market timing is a good idea, that's a tricky one. There were people who sold out after the first 10% up from the March lows of last year waiting for a correction that never came. Even with the recent rout, we are still far above the levels that these traders were waiting for. At the same time, selling in early April of this year would have been a very prudent thing to do especially if you then stuck that money in TLT. You would have a spread of something like 2600 basis points over where your money would have been otherwise. Not bad.
Let us take the example of a brokerage account with $5,000 in it. You have this divided among five holdings at $1,000 each because you took the advice previous mentioned on this blog and attempted to build out core, meso, exploratory, and speculative holdings. That's all well and good, but let's say that you suddenly decide that you think all hell is about to break loose and you want to shield your assets in a bond ETF, say TLT. For the purposes of this demonstration, I'll say brokerage fees are $10 per trade just because it makes the math easier. First, in your initial sales, you incurred $50. Then, in your purchase of the bond ETF you incurred another $10. When the crisis passes you sell your bond ETF, incurring another $10, and then you buy back into your original five positions at another $50. Your total fees were $120 or 2.4%.
Now, you might say that 2.4% is not so bad because you may have averted far worse in the market as a result of your move. However, even among the best portfolio managers are wrong about as often as they are right. Over time, these decisions, even executed properly, are likely to be a wash for the typical investor. I know, speaking for myself, that they have been for me. The cumulative effect of multiple swaps over several years' time can be the loss of multiple percentage points of your assets with a devastating effect on your total return over the long run.
Even in a larger portfolio, if one divides their positions too thinly, the situation repeats itself. For example, the costs as a percent of assets for a $50,000 portfolio divided amongst 25 holdings at $2,000 a piece works out to be $520 total or slightly over 1% of total assets lost via fees. If this person is an active trader and does this a few times a year on average attempting to pick each point at which the market might turn, they could rack up 3 or 4% in fees. That's to say nothing of bad capital gains management, which I will discuss at some other point.
Now, the lower proportion of fees in the second example makes the point I would like to make. If you wish to engage in more active market timing, keep your number of holdings down significantly. In the first example with the $5,000 brokerage account, if you have only two holdings at $2,500 each your transaction costs for the whole series of transactions are only $60 or 1.2% of your portfolio. It's still a steep price to pay, but with larger portfolios keeping the number of holdings down drives these costs right through the floor. In the $50,000 portfolio example, if that investor only had five holdings at $10,000 a piece, they incur $120 in transaction costs or 0.24% in fees for a whole cycle of transactions. As such, the lesson is that consolidated, larger holdings give you a greater ability to engage in market timing if you feel that's what you should be doing. The risk is that, depending on how you do it, you lose out on diversification. You can make up for this in choosing broad market index ETFs and then have both flexibility and diversification.
Now, as to whether or not market timing is a good idea, that's a tricky one. There were people who sold out after the first 10% up from the March lows of last year waiting for a correction that never came. Even with the recent rout, we are still far above the levels that these traders were waiting for. At the same time, selling in early April of this year would have been a very prudent thing to do especially if you then stuck that money in TLT. You would have a spread of something like 2600 basis points over where your money would have been otherwise. Not bad.
Thursday, May 27, 2010
Threading Strategies Together
Several different strategies have been discussed here on Finance Monitor along with numerous individual investments and I thought I would provide some context on how to view the discussions in the context of your own investments. The fundamental goal of this post is to weave several different posts on different subjects together. I will try to provide links so that you can quickly look up the prior discussions.
I guess the proper way to start this conversation was with the prior post on risk reduction in portfolio construction. This is one way of looking at your macro strategy, though there are many potential variations on this broader strategy. Within the core portfolio, either use equity index funds or balanced funds and basically just try to keep your overall allocation right, unless you want to be a little more active here. Then, you can engage in what was discussed on the post on dynamic asset allocation.
To do this, use the SPY and TLT ETFs at a basic level. If you have less than $2,000, I strongly encourage you to only re-balance when interest rates suggest you make a large reallocation from stocks to bonds or bonds to stocks. If you re-balance with every twinge, you'll get eaten alive by commissions. For example, let's say the model changes each month and you re-balance with $7 commissions each time (on both purchase and sale) with a $2,000 balance. You will incur $14 a transaction 12 times for a total of $168 in commissions. That would be 8.4% of your portfolio or greater than your average annual gain. With $20,000, it's 0.84%, which is bad, but not ruinous. If you are so fortunate to get up to $100,000, the fees are very low indeed. The ETF fees for TLT and SPY are also very low. In the case of SPY they are 0.09% per year and 0.15% on TLT.
I guess the proper way to start this conversation was with the prior post on risk reduction in portfolio construction. This is one way of looking at your macro strategy, though there are many potential variations on this broader strategy. Within the core portfolio, either use equity index funds or balanced funds and basically just try to keep your overall allocation right, unless you want to be a little more active here. Then, you can engage in what was discussed on the post on dynamic asset allocation.
To do this, use the SPY and TLT ETFs at a basic level. If you have less than $2,000, I strongly encourage you to only re-balance when interest rates suggest you make a large reallocation from stocks to bonds or bonds to stocks. If you re-balance with every twinge, you'll get eaten alive by commissions. For example, let's say the model changes each month and you re-balance with $7 commissions each time (on both purchase and sale) with a $2,000 balance. You will incur $14 a transaction 12 times for a total of $168 in commissions. That would be 8.4% of your portfolio or greater than your average annual gain. With $20,000, it's 0.84%, which is bad, but not ruinous. If you are so fortunate to get up to $100,000, the fees are very low indeed. The ETF fees for TLT and SPY are also very low. In the case of SPY they are 0.09% per year and 0.15% on TLT.
Sunday, May 23, 2010
"In Defense of the Humble Balanced Portfolio" - Morningstar
I stumbled across this good article from Morningstar "In Defense of the Humble Balanced Portfolio". This relates to a previous discussion on overall investment strategies and several subsequent posts on asset allocations and portfolio construction.
Incidentally, they do note some shortcomings of a simple static 50/50 stock and bond mix, or any static ratio for that matter, which is what prompted me to work on the dynamic asset allocation model over the past year or so. Even the automatic rebalancing target date funds have their problems as they rebalance at linear rates that may not be opportune given market cycles. That's why I prefer the dynamic, interest rate signal approach.
What do you all think?
Incidentally, they do note some shortcomings of a simple static 50/50 stock and bond mix, or any static ratio for that matter, which is what prompted me to work on the dynamic asset allocation model over the past year or so. Even the automatic rebalancing target date funds have their problems as they rebalance at linear rates that may not be opportune given market cycles. That's why I prefer the dynamic, interest rate signal approach.
What do you all think?
Thursday, May 20, 2010
Strategy Sessions - Part 2: Building Your Portfolio to Protect Your Assets
As I have previously mentioned, there is somewhat of a trade off between the potential, and I will emphasize potential, for high returns and the volatility that you will incur. This relationship is not absolute as, for example, adding some stocks to an all bond portfolio actually reduces your volatility over time. However, it is a fair starting point for considering how to construct your portfolio. All of the following is based off of my own personal views and does not necessarily represent "best practices" in the industry.
Regardless of your volatility preferences, any portfolio should start with a core position or positions. Depending on how much you have to invest and whether or not you meet investment minimums, this position can either be an broad market index fund (S&P 500, Wilshire 5000, or something that tracks a global index like the FTSE All World Index) or a similar ETF. Balanced funds (a mix of stocks and bonds) are also a good choice for core portfolio holdings. If you don't meet minimum investment requirements from your desired mutual fund (ie Vanguard often has a $3,000 minimum), then I say go the ETF route. You also will have greater flexibility in changing ETFs than you will with conventional mutual funds. Just keep an eye on fees. For a small portfolio (<5,000), core positions should be the bulk of what you have. For larger portfolios, core positions can be as little as 25%, in my view.
A quick aside, on fees, you should never pay loads (up front fees) on your mutual funds and keep an eye on expense ratios. If you are paying over 0.80% in annual fees, reconsider your position. Just a .40% differential on fees can cost you 16% in long term returns. Put another way, if you would have had $100,000 in your fund at retirement, you will have $84,000. You want those extra $16,000, so keep your eye on fees.
The next layer of your portfolio can venture out a bit into more volatile, but not crazy investments. Along the fund route, these are things like sector funds that track individual market sectors you think will do well, or broad basket emerging market funds or their equivalent ETFs (EEM, for example). This can also be composed of a basket of positions in various blue-chip companies if you choose to use individual stocks. If the core portfolio is your castle, this is your outer wall. I don't know exactly what to call this, so I will go with meso-portfolio. You have your core portfolio, then your meso-portfolio. I like the scientific sound of it.
From there, you can build your exploratory positions. These can be specific country or region emerging market funds, mid and small cap stocks (provided that they have decent analyst coverage), and so on. The larger your portfolio, the larger these positions can be.
Regardless of your volatility preferences, any portfolio should start with a core position or positions. Depending on how much you have to invest and whether or not you meet investment minimums, this position can either be an broad market index fund (S&P 500, Wilshire 5000, or something that tracks a global index like the FTSE All World Index) or a similar ETF. Balanced funds (a mix of stocks and bonds) are also a good choice for core portfolio holdings. If you don't meet minimum investment requirements from your desired mutual fund (ie Vanguard often has a $3,000 minimum), then I say go the ETF route. You also will have greater flexibility in changing ETFs than you will with conventional mutual funds. Just keep an eye on fees. For a small portfolio (<5,000), core positions should be the bulk of what you have. For larger portfolios, core positions can be as little as 25%, in my view.
A quick aside, on fees, you should never pay loads (up front fees) on your mutual funds and keep an eye on expense ratios. If you are paying over 0.80% in annual fees, reconsider your position. Just a .40% differential on fees can cost you 16% in long term returns. Put another way, if you would have had $100,000 in your fund at retirement, you will have $84,000. You want those extra $16,000, so keep your eye on fees.
The next layer of your portfolio can venture out a bit into more volatile, but not crazy investments. Along the fund route, these are things like sector funds that track individual market sectors you think will do well, or broad basket emerging market funds or their equivalent ETFs (EEM, for example). This can also be composed of a basket of positions in various blue-chip companies if you choose to use individual stocks. If the core portfolio is your castle, this is your outer wall. I don't know exactly what to call this, so I will go with meso-portfolio. You have your core portfolio, then your meso-portfolio. I like the scientific sound of it.
From there, you can build your exploratory positions. These can be specific country or region emerging market funds, mid and small cap stocks (provided that they have decent analyst coverage), and so on. The larger your portfolio, the larger these positions can be.
Thursday, May 13, 2010
Why Does My Stock Give Me Heartburn?
A fundamental question that nearly all investors have asked at one point or another or even still ask after many years in the market: Why does my stock bounce all over the place? All stocks are volatile to some extent because the overall market is volatile, but some are much moreso than others. Why does this happen?
There is no simple answer to this, but there is a basic framework that drives volatility in individual stocks and it can also be applied to the broader market as well in particular circumstances. The basic framework is along the following lines:
1. Volume levels (What % of shares outstanding trade in a given day?)
2. Earnings certainty (How stable are projected earnings?)
3. Previous volatility (Investor expectations are heavily based on the past. If a stock has been volatile in the past, investors assume it will be volatile in the future and this becomes a self-fulfilling prophecy)
Volume is a major factor for determining the stability of stocks. While low volumes do not necessitate that every day will be an adventure, they do make a stock more vulnerable to large moves. The basic logic is that if a stock only trades 50,000 shares a day, one huge buy order or one huge sell order can have huge sway over the course of the stock because generally there is not enough liquidity to absorb a large spike. However, if, say, a large buy or sell order hits Walmart (WMT), the high level of volume in Walmart shares will moderate that movement and prevent aberrant moves because the market's opinion of where the price of Walmart should be is much more developed than for, say, Consolidated Graphics (CGX). Broadly speaking, this dynamic means that larger companies will be less subject to volatility, but it is slightly more complicated than that. Some large stocks are more volatile than small companies for other reasons, two of which are listed below.
There is no simple answer to this, but there is a basic framework that drives volatility in individual stocks and it can also be applied to the broader market as well in particular circumstances. The basic framework is along the following lines:
1. Volume levels (What % of shares outstanding trade in a given day?)
2. Earnings certainty (How stable are projected earnings?)
3. Previous volatility (Investor expectations are heavily based on the past. If a stock has been volatile in the past, investors assume it will be volatile in the future and this becomes a self-fulfilling prophecy)
Volume is a major factor for determining the stability of stocks. While low volumes do not necessitate that every day will be an adventure, they do make a stock more vulnerable to large moves. The basic logic is that if a stock only trades 50,000 shares a day, one huge buy order or one huge sell order can have huge sway over the course of the stock because generally there is not enough liquidity to absorb a large spike. However, if, say, a large buy or sell order hits Walmart (WMT), the high level of volume in Walmart shares will moderate that movement and prevent aberrant moves because the market's opinion of where the price of Walmart should be is much more developed than for, say, Consolidated Graphics (CGX). Broadly speaking, this dynamic means that larger companies will be less subject to volatility, but it is slightly more complicated than that. Some large stocks are more volatile than small companies for other reasons, two of which are listed below.
Wednesday, May 12, 2010
Strategy Sessions- Part 1: Overview of Asset Allocation Versus Individual Securities
Steve brought up an interesting fundamental debate that investors have to resolve in their own heads: Should I be a stock picker or should I focus on asset allocation?
To put my own chips on the table here, I do both. Yes, it's a cop-out, but at the same time there is some value in it. Spreading your bets around not only different securities, not only around different asset classes, but even among different strategies does reduce the possibility of catastrophic loss and that is one of the chief objectives that any individual must bear in mind when making investments. Part of the reason I pick individual securities is that it simply keeps me interested in the market. The other reason is that I firmly believe that, with a good research methodology based on the fundamental value of companies, you can beat the market. However, I made my peace with the idea that I will not always beat the market and a lot of people do not come to terms with that.
As to the issues regarding picking individual securities, you must have a stomach of steel to handle the volatility. I own upwards of 18 different stocks at any one time so a large move in any one of them does not usually phase me. However, this sort of environment is not appropriate for many people for any number of reasons. Quite frankly, there is nothing wrong with being uncomfortable with high levels of volatility. It's a natural human reaction. If you do not feel able to keep up with the pace of the market, I would recommend broader strategies that focus more on asset allocation. Quite frankly, there is a damn good chance you will actually do better than being a trader or a stock picker. There's a great deal of evidence from economists and financial historians to support that idea.
To that end, I have devised a dynamic asset allocation tool designed to allocate into appropriate levels of stocks and bonds based on credit market indicators. The basic theory is that credit markets give indications of when you should get in and out of the market. I have always believed, with substantial empirical research from countless economists to support this belief, that interest rates are vital market signals and that relationships between different interest rates and those interest rates versus equity prices can be valuable investing tools. The model I have worked on will need revision as time goes on, but I think the general premise is solid.
In a few future posts related to this broader subject I will:
1. Discuss the dynamic asset allocation model introduced here
2. Outline some reasons why some individual stock holdings may be more subject to volatility than others
3. Introduce some methods for reducing volatility while still leaving open possibilities for gains
4. Whatever else I might think of
I'm doing this somewhat backwards because I am actually somewhat giddy to share the dynamic asset allocation model.
To put my own chips on the table here, I do both. Yes, it's a cop-out, but at the same time there is some value in it. Spreading your bets around not only different securities, not only around different asset classes, but even among different strategies does reduce the possibility of catastrophic loss and that is one of the chief objectives that any individual must bear in mind when making investments. Part of the reason I pick individual securities is that it simply keeps me interested in the market. The other reason is that I firmly believe that, with a good research methodology based on the fundamental value of companies, you can beat the market. However, I made my peace with the idea that I will not always beat the market and a lot of people do not come to terms with that.
As to the issues regarding picking individual securities, you must have a stomach of steel to handle the volatility. I own upwards of 18 different stocks at any one time so a large move in any one of them does not usually phase me. However, this sort of environment is not appropriate for many people for any number of reasons. Quite frankly, there is nothing wrong with being uncomfortable with high levels of volatility. It's a natural human reaction. If you do not feel able to keep up with the pace of the market, I would recommend broader strategies that focus more on asset allocation. Quite frankly, there is a damn good chance you will actually do better than being a trader or a stock picker. There's a great deal of evidence from economists and financial historians to support that idea.
To that end, I have devised a dynamic asset allocation tool designed to allocate into appropriate levels of stocks and bonds based on credit market indicators. The basic theory is that credit markets give indications of when you should get in and out of the market. I have always believed, with substantial empirical research from countless economists to support this belief, that interest rates are vital market signals and that relationships between different interest rates and those interest rates versus equity prices can be valuable investing tools. The model I have worked on will need revision as time goes on, but I think the general premise is solid.
In a few future posts related to this broader subject I will:
1. Discuss the dynamic asset allocation model introduced here
2. Outline some reasons why some individual stock holdings may be more subject to volatility than others
3. Introduce some methods for reducing volatility while still leaving open possibilities for gains
4. Whatever else I might think of
I'm doing this somewhat backwards because I am actually somewhat giddy to share the dynamic asset allocation model.
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