Should You Be Selling Your Winners?

“It’s tough to sell winners and buy laggards, but it’s smart.”

That is the lesson from MarketWatch’s, “Force yourself to rebalance your portfolio.”

Good advice. But difficult for most investors to follow. 

Human Nature is to Ride the Winners

The basic human instinct when an investment gamble has been paying off is to let it ride; rebalancing involves culling winners and putting the proceeds into laggards in order to follow a plan.

It is hard for investors to sell successful investments and move the proceeds into underperforming areas. But that is the correct strategy much of the time.

Note that I (nor MarketWatch) am not talking about individual (non-diversified) investments like stocks. There are way too many variables that impact individual stock performance and often market leaders can maintain their edge for lengthy periods. Rather, we are talking about markets, as a whole, and asset classes and sub-classes.

Take Emotion Out of Investing

That is why, ideally, rebalancing is done unemotionally, based on a schedule set either by how far off-plan a portfolio gets, or by regular calendar intervals. The bigger the portfolio, the more these differences matter, creating more need to rebalance on a scheduled basis; experts note that average investors with moderate portfolios can get away with rebalancing every year or two, or when the portfolio is 5 to 10% off-target.

Take the emotion out your investment decisions. Adhere to a predetermined fixed plan for reviewing your portfolio. Rebalance as necessary.

As the above quotes states, reviews can be based on how much the actual asset allocation deviates from your target allocation. Or it can result from regular calendar intervals.

Personally, I would factor in the volatility of the portfolio (a.k.a., portfolio risk, portfolio standard deviation). The riskier the portfolio, the greater the frequency of monitoring. I would also review the portfolio in the event of a material event.

A key takeaway from the embedded quote should be: “average investors with moderate portfolios can get away with rebalancing every year or two, or when the portfolio is 5 to 10% off-target.” Moderate refers to portfolio investment risk.

The more you rebalance your portfolio, the greater the transaction fees (and potential triggering of taxable capital gains). Your investment goal should be cost minimization, so watch out for too much trading. If you decide to rebalance every month, expenses will impair long-term performance.

As well, the higher your portfolio risk, the greater the acceptable asset allocation variance. The article recommends 5-10%, a good range for moderately risky portfolios like an S&P 500 index fund. But what if your equity allocation consists of small African mining companies? Perhaps they can fluctuate up and down 30% each year. Do you want to be buying and selling the shares every time they get 10% from target allocations? No.

Momentum Investing

Browne, of FundX, follows a strategy of investing in funds and ETFs that have the hot hand, trying to ride category leaders in the areas that look best

As a side note, I want to mention momentum investing. Not quite what Browne is doing, but it came to mind when I read the quote.

If you are nimble, perhaps you can take advantage of short term movements. But there are a lot of traders out there playing this game. If you want to trade, trade. If you want to invest for the long-term, might be best to not worry about momentum investing.

I do not like momentum investing, although I will admit to following this path on occasion in my youth.

I do though, to some extent, tactically invest. But I prefer to do so using longer term trends, rather than simple pricing anomalies or short-term movements. And I prefer to utilize diversified investments (e.g., index funds) to take advantage of macro-economic trends, rather than guessing if Apple will continue to outperform over the short-term. Also, for clients, I recommend building a strong overall core portfolio, then utilizing tactical moves to augment the core. Not tactical as a stand-alone strategy.

I would caution readers that tactical asset allocation requires a fair amount of investment expertise and experience. If you wish to go this route, I strongly suggest working with a competent advisor.




Alternative Indexing

I typically recommend smaller investors utilize passive investment techniques. That is, investing in open-ended no-load index mutual or exchange traded funds.

I have not mentioned that there are different ways to construct market indices. There are.

The normal market index is weighted by market capitalization. The bigger the company, the higher the weight in the index. The vast majority of index funds you consider will be this type.

But there are alternative indexing options out there too. I want to touch on them today. 

Weighted Average Market Capitalization

The normal index methodology is the market cap index.

This index provides a realistic representation of the market. The big firms that drive the market and economy have weightings that reflect their stature. Key industries are strongly represented. This is a positive.

However, its biggest drawback is that it is a representative representation of the market.

What?

Consider perhaps the most famous index, the S&P 500. 500 key U.S. companies representing 80% of the U.S. equity markets. Good representation of the U.S. But under a weighted average system, the larger companies have bigger pieces of the index holdings. Exxon and Apple alone make up 5% of the index. And the 10 largest companies comprise 18% of the index.

A drawback, but not what I consider a deal-breaker. In fact, on the whole, I want larger companies to have more impact on the portfolio. Perhaps not to the extreme as South Korea (unless you want a pure play on Samsung), but I do want the bigger companies to dominate my weightings (unless I am seeking a small-cap or similar strategy, but then I am investing differently anyway).

For my money, this is a good methodology for smaller investors who seek well-diversified portfolios. Not that a market cap index guarantees strong diversification. But it is fine when building portfolios.

Equal Weight Market Capitalization

Each company in the index is given equal importance. With the S&P 500, the top 10 companies would only warrant a 2% share of the index. Not their current 18% under the weighted method.

If you want to get more bang for your investment dollar from smaller stocks, then this may be of interest. But there tends to be higher fund expenses due to typically higher turnover, rebalancing, pricing discrepancies, and trading costs with respect to holding higher proportions of smaller companies.

Also, smaller companies that may be less established than the mega-cap firms, like Exxon and Apple, may have higher stock volatility. By increasing their weights, you may be raising the risk level of your portfolio.

If I wish to strategically or tactically invest in smaller companies, I personally prefer to add small-cap funds (or stocks) to my overall portfolio (or weighted average index funds). Not invest in equal weighted indices.

Fundamentally Weighted Indices

This type of index fund is becoming more prevalent. I use them with my clients as they can satisfy a strategic niche or investment objective on a relatively low cost basis.

For example, perhaps you want to focus on dividend income to generate decent cash flow. Yet you also want to participate in the upside (capital gains) if the company does well. A generic index will include both dividend and non-dividend paying companies. What to do?

Well, how about investing in the S&P500 Dividend Aristocrats Index? This is a sub-index of the S&P 500 Index, but only includes companies from that index which have increased dividend payments annually for the last 25 years. Problem solved. Note as well that there are similar Dividend Aristocrats Indices for Canada, United Kingdom, and Europe.

You can find many fundamentally constructed indices that meet a multitude of criteria. I personally find them useful. But, as I always say, the more complex a fund, the greater the expense ratio will be. Always keep an eye on your cost structure.

Alternative Index Comparisons

Investopedia

Investopedia compares the above methodologies in, “3 Types of Indexing for ETF Success”.

I am not sure I agree with the conclusions as it is more an apples to oranges comparison. The apples being mega-cap stocks that dominate weighted average indices versus small and mid-cap stocks (oranges) that are higher weighted in equal weight or many fundamental indices.

That said, for long term investing, I personally like smaller cap, value companies (yes, based on historic research results), so it does not surprise me to see those conclusions. Just be aware it is not apples to apples. And that the risk profiles between large, established companies may be significantly different from small, relatively young businesses.

Vanguard

I also recommend Vanguard’s, “It’s Not Your Father’s Indexing” and the “Alternative Equity Approaches to Indexing: Buyer Beware” that is linked in the initial article. Maybe a tad (just a tad) technical, but some excellent points made. Note specifically:

Unlike a market-capitalization-weighted approach, none of these strategies will enable you to “own the market.” Instead, they will either do better than the market or worse. The trick in deviating from a market-cap-weighted index is to find the investment manager or the rule that puts you on the winning side. The risk is ending up a loser relative to the index or having a poor outcome given the portfolio’s specific exposures. The cost is whether you pay more than you would if you were in the (cap-weighted) index fund.

We believe that what investors expect when they buy an index is that they will own the market. However, a rules-based, non-cap-weighted strategy doesn’t give you that kind of exposure. You are, in fact, making a bet against the market or some segment of the market.

Using non-weighted indices is more a tactical play than a long-term strategy. I agree with that. And there is nothing wrong with that if you can consistently time market movements. But that is difficult.

In the “Alternative Equity Approaches to Indexing” analysis, Vanguard adjusts various factors to try and create an apples to apples comparison. Their finding?

Our research shows that alternative weighted indexes tend to tilt toward the smaller and value stocks in the targeted market. The chart above shows that, after controlling for these factors, there was no consistent significant excess return associated with these strategies.

We believe a better, lower-cost implementation option is for you to use cap-weighted indexes to get the risk-factor exposures inherent to these alternative strategies.

So on an apples to apples basis, “no consistent significant excess return” to invest in alternative indices. I agree, although if you are willing to increase your risk, you may see higher expected returns over the long term by increasing your share of smaller companies.





Financial Tips for College Graduates

U.S. News offers 10 financial tips for young adults.

Actually, financial advice for anyone starting out in the work world. Or even for those who have been working for awhile and now want to begin investing.

Good advice. A few comments from my side. 

I shan’t cover all the points, but do want to make a few observations.

Start Saving From Day One

Good investors save, invest, and grow their funds.

Enroll immediately in a plan where money is automatically deducted from your pay each period. Company plan, personal tax-deferred investment account, etc.

You did not have any income yesterday. Missing $50 or $100 per pay period will not be felt. But if you wait and get used to the extra cash in your chequing account, it will be more difficult to lose it later on.

Invest for the Long Term

How you invest should, in large part, reflect your phase in the life cycle.

Presumably you are young. With 40 plus years until you need to access your retirement funds. Starting out in the world, you hopefully are entering an accumulation stage of life.

With a long time horizon, you can handle some volatility in your portfolio. That means you should consider relatively riskier assets when you are young.

No, not betting double zero on the casino roulette wheel. Nor even putting half your money in corn futures. This is speculation. I am talking investment risk. Based on your personal risk tolerance and individual circumstances. For a typical young investor, that often means a well-diversified portfolio with an emphasis on equities.

Do not shun risk at a young age. Risk can be an asset for young investors. Just make sure it is well considered, prudent investment risk.

As your time horizon decreases and your personal circumstances change, then you can slowly move to a lesser risk portfolio.

Maintain an Emergency Reserve

Last in, First out (LIFO). An inventory term in accounting.

But also a reality for young employees who lack seniority within a company. If things go sour, new employees often suffer.

Start investing on day one. But also start accumulating an emergency reserve in case you suffer a loss of employment income. The amount should be based on various factors. A good benchmark is often 3 to 6 months of living expenses.

Don’t Live Like a King 

Or queen. Or my nephew.

Yes, it is nice to finally get out of your parents’ basement and begin earning real money. But live within, or even below, your means.

Try to keep life frugal and invest any spare cash. Take advantage of your youth and the power of compound returns. Yes, you may enjoy that week in the Dominican Republic. But investing the money and watching its compound growth over time will allow for many more weeks vacation down the road.




Investors Shun Risk

A relationship exists between investment risk and expected return.

The safer the asset, the lower the expected return. The greater the investment risk, the higher the required return. Or it can be a tad more technical if you like.

Investors should take an objective view of investment risk. Unfortunately, investors tend to be emotional creatures and these volatile times lead people to become fearful of investment risk.

So what is happening? And what should you do as an investor?

Investors Shun Risk

According to Morningstar, Shaken Investors Shun Risk.

The demographic bulge of aging baby boomers is becoming ever more risk-averse as it continues its march toward retirement. At the same time, investors as a whole have become financially and emotionally scarred by bear markets. The result, says financial-services consultant Goshka Folda, has been a flight to safety.

The first sentence makes sense. Younger investors have a significant time horizon. Young investors have more time to ride out the increased volatility of higher risk assets. As such, young investors should seek out relatively higher risk assets to reap higher expected returns.

As investors approach retirement, there is less time available to deal with highly volatile investments. Safety and certainty are more important. That is why you see older investors shift their capital into lower risk asset classes. And receive lower returns.

The second sentence though, reflects how emotions play a significant role with investors. Emotions should be avoided when investing. That said, I realize how hard it is to maintain a disciplined, unemotional, investment strategy when markets are moving like a roller coaster.

How This Impacts Asset Allocations

Of the more than $3 trillion in investible assets of financial wealth, more than $1 trillion is sitting in deposits (Source: Household Balance Sheet Report, 2011 Edition). In addition, close to another $1 trillion consists of short-term instruments with maturities of less than one year.

A lot of investors appear to be heavily invested in low-risk, low-return assets.

While this low risk approach might be reasonable for retirees (but beware that a 65 year old retiree may live until 90, so may still desire/need some higher risk assets to finance a 25 year retirement), a low risk strategy is probably not suitable for younger investors.

Asset allocation is extremely important for investing success. It should not be based on emotion and fear of loss. Your asset allocation should be unique for you, based on your personal situation.

What to Do?

“After so much damage, clients are now in a risk-averse stance,” says Folda, “But the reality is that many households still need growth, they need exposure to at least some equity.”

“So volatility, while damaging for everybody,” says Folda, “can be opportunity for advisors to even further underscore the importance of good advice and solid solutions in establishing the right risk profiles for portfolios.”

I think there are a few keys to effectively deal with volatile markets.

Investors need to construct investor profiles and Investment Policy Statements. These will determine a proper target asset allocation and help maintain long-term focus during periods of short-term volatility.

A properly diversified portfolio will reduce portfolio risk without lowering expected returns.

Low cost investments such as open-ended index mutual and exchange traded funds will help with diversification and cost-effective investing.

While I understand that many advisors, banks, brokers, etc., want to sell investors innovative new products (that usually are quite profitable for the seller), be cautious. Minimizing your costs is a key to maximizing long-term success. Do not pay someone else 1-2% of your capital each year simply to purchase the flavour of the day.

Dollar cost averaging will also assist in dealing with volatility and staying disciplined.

If you use these techniques you will reduce emotion in your investment decisions. This will improve your portfolio construction and your probability of long-term investment success.




Emotional Investing Decisions

Investing based on emotions or instincts is a difficult issue.

So challenging that an entire field, Behavioural Finance, examines how investor psychology and emotions affect investment decisions.

Recently I read an article where the author believes that financial planners prefer clients with little investment knowledge. That way, it is easier to sell them whatever you want.

Yes, there are financial planners, brokers, etc., that operate this way. But in my experience, good financial planners would rather deal with well-educated investors.

And often the reason relates directly to emotional investing. 

Rational Investors Are Better Investors

Investors who better understand the investment process have an easier time investing rationally. Investors who appreciate modern portfolio theory. The concepts of diversification, asset correlations, investment risk, asset allocation, etc.

By knowing the underlying principles behind successful investing, investors can make more rational and appropriate investment decisions.

A decent Investment Policy Statement should incorporate these aspects. It will help keep the investor focussed on the big picture. Especially during turbulent times.

The Investment Policy Statement allows investors to examine their unique personal circumstances and then create an asset allocation strategy that meets their investment objectives and constraints.

What Jim Cramer or the other media talking heads are screaming through the television play no part. Nor does the investment that made your sister-in-law some money five years ago.

Unfortunately, the vast majority of investors (yes, even many “sophisticated” ones) get caught up in this sort of emotional investing.

These investors want to fill their portfolios with the flavour of the day. The same investment everyone else is chasing. The end result usually is a bursting investment bubble.

Or they focus on past successes that may no longer be suitable in today’s world.

Are Your Investing Decisions Based on Emotions or Instincts?

The Vanguard Group offers a short video addressing this question. It is well worth watching.

Key comments in the video, include:

One of the biases that behavioral finance talks about is this selective attention to information: That in making a decision, you’re only listening to really confirmatory views about what you already believe.

Selective attention, also called “confirmation bias”, is a problem for many investors.

If you are simply looking for positive reinforcement on a decision that you have already made, feel free to “research” in this manner. But if you are truly trying to arrive at the optimal conclusion, keep an open mind. Consider all information, even if it does not coincide with your preconceptions.

be very careful about predicting the recent past, the information you have about the recent past, to the future.

Yes, trends can occur over time. Strong management today may continue in the future. Companies with monopolies yesterday may also have monopolies tomorrow. So look to the past for clues as to future events. That is much of how one researches investments.

But do not automatically assume that past events will continue. Sadly, this is another problem with many emotional investors.

Circumstances shift over time and their impact on investments change. Gold has performed very well in recent years. But has it reached a peak or will its relatively high returns continue?

Just because gold has performed well in the past does not mean it will continue to do so. You need to examine factors today to assess how they will impact future results.




Emotional Investing

Investment markets have resembled roller coasters in recent times.

Up, down, sideways, making many investors sick to their stomaches.

While investing is an emotional experience at any time, this turbulent period makes things even worse for lots of investors.

So what should you do? 

Avoid Emotional Investing!

Emotional investing should be avoided.

Easy to say, difficult to adhere to. It is extremely tough to maintain a level head when your savings are at stake.

George Loewenstein, professor of both economics and psychology at Carnegie Mellon, discusses emotions and investing in this CNNMoney interview. It is well worth a read.

I think that if you can identify areas where emotions may take over from rational investment practices, you can watch out for these potential traps and try to limit their impact.

Plan When Times are Calm

As Dr. Loewenstein states, it is “dangerous to make long-term decisions based on short-term emotions.” You need to develop a fundamentally sound investment approach on which to make your decisions.

This approach should include short, medium, and long-term investment objectives.

It should also provide guidance for dealing with future investing issues (e.g., investment bubbles, bear markets, inflation) before they actually arise. It is always easier to determine a logical course before a crisis erupts.

Stay Focussed During Volatile Markets

To counter emotional investing problems, Dr. Loewenstein suggests using a professional advisor. Preferably someone that understands the ups and downs of the markets and can advise in a rational manner.

I would also suggest using some tools that we have previously discussed.

Develop a written Investment Policy Statement (IPS) when you begin to invest. Your IPS will be the framework with which you invest. It will also keep you on the correct path and help you avoid making investment decisions based simply on short-term emotional factors.

Utilize prudent risk management techniques. Key among these are portfolio diversification with attention to asset correlations and proper asset allocation for your investor profile.

Use common sense to identify potential investment bubbles and do not get greedy with unrealized gains.

There is no evidence that investors successfully time market volatility over the long run. So invest in a diversified, low-cost investment portfolio using a buy and hold strategy. For those who say buy and hold does not work in volatile markets, I disagree to some extent.

When managing your portfolio, employ dollar cost averaging to take advantage of market dips and to reduce acquisitions when markets are potentially becoming overheated.

It also means that you should review your portfolio on a periodic and consistent basis. Do not wait until the wolf is at the door before assessing your investment holdings.

If your objective, non-emotional review indicates rebalancing is required, feel free to do so. This can be done by reallocating existing holdings, adjusting future investment allocations, or through profit-taking.

Following a well-designed investment framework and strategy as outlined in your IPS will help you keep calm when the markets are volatile. Put in the effort to develop a sound IPS when starting out on your investing path. If you do, you will be rewarded over your lifetime by (hopefully) solid portfolio performance and a less stressful investment life.




Cash and Cash Equivalents

We shall start our look at the different asset classes this week.

I do not intend to go too deeply into many of the assets themselves. There are plenty of good definitions on the internet or in textbooks.

Rather, I want to look at the asset classes from an investing perspective.

How liquid are the assets? What are their risk and return profiles? What other factors impact their performance? How should you consider their suitability in your investment portfolio?

Today we will review Cash and Cash Equivalents (CCE).

Cash is king.

In life, all things material revolve around the almighty dollar. Without cash, you cannot purchase those things you need to survive.

So this is an important asset class.

What is CCE?

As an asset class, CCE covers real cash, such as what you have in your savings or chequing accounts, or even hidden under your mattress.

It also includes other assets that possess these characteristics:

1. Extremely liquid,

2. Provide known rates of return, where investment risk is (almost) zero, and

3. Risk of capital loss is negligible.

Examples include: short term government treasury bills; short term government bonds; short term commercial paper, acceptance paper, or banker’s acceptances from highly rated companies; bank term deposits and Guaranteed Investment Certificates (GIC); money market funds.

As an aside, I was a little hesitant to label this category Cash and Cash Equivalents. Some expert commentators like to include many marketable securities as cash equivalent. This is due to the high level of liquidity for fixed income and equities that trade on major exchanges. Also, that most individual investors lack the capacity to influence the asset price through their own holdings.

Where including fixed income or other assets in CCE breaks down is in the investment risk. Both in the expected returns and in the potential for capital loss. As we will see in due course, other asset classes all have higher risk levels that CCE. 

Liquidity

Liquid assets can be quickly converted to cash; at minimal to no financial cost, nor impact on the asset price.

CCE are the most liquid of assets as they are already cash, or one small step from being cash.

In part due to the liquidity benefit, you should have your emergency funds primarily in CCE. This should amount to between 3-6 months’ cash requirements. As your general level of wealth increases, you can reduce the amount of liquidity held to some degree.

You should also invest in CCE with assets required for any short term spending requirements. The closer the time to the expenditure, the greater the need to keep the required funds in liquid assets.

For example, a house you plan to buy in 4 years. You could invest in a wide variety of assets, both liquid and illiquid. However, if you need to close the home purchase in only 4 months, you should have all the necessary funds invested in highly liquid investments.

Negligible Investment Risk

CCE are considered investments that have little, if any, investment risk.

That means the difference between the expected and actual rates of return is almost non-existent. There is no real volatility in the performance of this asset.

The Good News – Cash is Relatively Risk-Free

In investing, cash is considered certainty. With every other investment, there is some uncertainty that the amount you expect to receive in the future will be actually what you get.

If you recall our discussions on risk, the greater the uncertainty between what you expect to earn and what you actually earn is the risk (or volatility) of the investment.

With cash, there is no risk in the investment sense. What you have in your jeans is fully certain, assuming there are no holes in your pockets.

You know what you have and you can plan your spending accordingly.

Now there may be some investment risk with CCE, at least the CE portion of the term.

A GIC with a solid, national bank may have less risk than one with a small, regional institution which is having business difficulties. Although both GICs are considered cash equivalents, you need to look at the other risk factors also. We will look at this below.

The Bad News – Cash is Relatively Risk-Free

There is a direct relationship between risk and return.

The lower the risk of an investment, the lower the expected return.

So while CCE are risk-free to a great extent, the returns that you will earn will be low compared to other investments.

While this may protect you during the short term, when investing for long time horizons you should be considering higher risk assets, with better expected returns.

This is why many asset managers recommend only holding about 5-10% of one’s assets in CCE.

This amount typically covers the liquidity needs I mentioned above. It also serves as an investment reserve to allow for new purchases to be made without having to liquidate other non-cash assets.

Known Rates of Return

Time Value of Money

Knowing with certainty your actual return is useful when investing. When looking to the future, you can plan your investments to meet your upcoming cash requirements.

The higher the certainty, the better your planning can be.

You can invest that dollar today and receive more than that dollar tomorrow. Or next week or year. That is the basis for the time value of money principle.

In the case of CCE, your future return is almost certain.

For example, you need to pay $5150 for your school tuition and books in 6 months time. If you have $5000 now, you could invest in a 6 month Guaranteed Investment Certificate (GIC) from your bank paying 3% over the term. Upon maturity, you would receive your $5000 in capital, plus another $150 in interest income.

You have exactly enough to meet your requirements. Simple.

Now consider an investment in shares of Citigroup.

Over the 6 months, many variables could impact the share price. There is a possibility that the shares may be worth substantially more than the required $5150 in 6 months. But there is also a strong probability that the shares will be worth less than that amount. If the latter scenario occurs, you will not have enough money to fund your school needs.

So for short term requirements, focus on liquid assets with minimal investment risk.

Beware of Non-Investment Risk Factors

While the investment risk is negligible and the nominal return is known, other factors can greatly impact your real wealth accumulation.

Inflation

Inflation can erode the future purchasing power of your money by making goods more expensive over time.

In our example, you require $5150 for tuition and books. However, during the 6 months before you pay, inflation rises 4%. The equally affects your school requirements. Now your total costs have risen to $5356.

Had you not considered the potential impact of inflation, you would not have saved enough money for the required costs.

In our example, you would have invested in the GIC and ended up with $5150, but that would be $206 short.

A second takeaway concerning inflation is that it can reduce real wealth. In our example, you invested your cash in a GIC. However, inflation outpaced the interest rate and your real wealth actually fell. As we discussed before, you need to always focus on real returns, not nominal ones.

Currency

If you live in a country whose currency is declining, you may also see an erosion of your cash value on a global scale.

Say you live in the US and want to buy a new BMW. Specifically one that is manufactured only in Germany. The car costs Euro 100,000 and the Euro/USD exchange rate is 1.00. Over the next 6 months you save your money and finally have USD 100,000 in the bank. You head down to the BMW dealer and go to place your order.

Unfortunately for you, while the price of the BMW is still Euro 100,000 that crazy US dollar has fallen to 0.80 against the Euro. In US dollars, your BMW now will cost you USD 125,000.

So while your liquidity and short term investing were not issues, you nevertheless suffered a shortfall due to the currency fluctuation.

Business

As I wrote above, GICs are issued by different financial institutions. Some are financially more stable than others. The same holds true for many other financial instruments.

When reviewing investment options, do not assume that a term deposit, commercial paper, or even government treasury bill is entirely risk-free.

Always review the issuing entity and determine whether they are stable or not.

One way to quickly tell involves the returns being offered.

For example, banks A, B, and C all sell 1 year GICs. The GICs from both A and B offer 5% annual interest rates. Bank C offers 7%.

Exactly the same product, so why the difference is rates?

Remember that risk and return are directly correlated. The higher the risk, the higher the return.

If I analyzed bank C, I would expect to see that there is higher risk of non-payment for the interest or original capital as compared with bank A or B. Because of the increased risk, bank C must offer higher rates than A or B to induce investors to take on the higher risk. If C offered only a 5% return, no rational investor would purchased a GIC from them.

Conversely, if C was as secure a bank as A or B, yet offered higher interest rates, no investors would purchase GICs from either A or B. Those banks would need to increase their interest rates to be competitive.

For additional risks that may impact even liquid assets, please check this out.

So while CCEs may be relatively risk-free from an investment perspective, you need to be aware of other risks that can affect your cash’s value.

Next we shall look at fixed income as an asset class.




A Little More on Diversification

Today we shall look at a few more areas of interest relating to diversification.

In An Introduction to Diversification, we saw that Investopedia recommends holding a “wide variety of investments” to benefit from diversification.

Further, that a diversified portfolio will generate “higher returns and pose a lower risk than any individual investment found within the portfolio”?

Is this true? What does it mean?

A Wide Variety of Investments?

The greater the number of investments in one’s portfolio, the greater the diversification.

This implies that you should have as many investments as possible in your portfolio.

However, the greater the number, the less the impact from any one additional investment.

If you have a single asset portfolio and add a second asset to the mix, there will be significant impact from the new asset. But if you have 1000 assets equally in your portfolio, the addition of one more will have minimal influence.

So what is the ideal number?

The optimal number of individual investments, excluding such things as funds, fluctuates slightly from study to study. Some claim that 20-30 proper investments will result in strong diversification.  Other studies found that 15-20 stocks can provide adequate diversification to eliminate nonsystematic risk. Some studies even believe that the benefits of diversification are exhausted in portfolios with more than 15 investments.

As to what is the right number, I think it varies depending on the investor. I could build a portfolio of 10 or less assets that managed to diversify efficiently. Others might need 40 to properly diversify.

The key to effective diversification is the correlation between the investments.

If you are comfortable investing in fine art as part of your investment portfolio, you do not require many assets to diversify. If you only want to invest in North American based public companies, you will require significantly more assets to diversify.

Regardless of the “right” number, you can see that it is not substantial. And by that, I mean less than 50 individual assets.

Less investments are also better for long term compounding. Buying and selling multiple investments results in transaction costs and potentially taxes payable on any gains. As we discussed during our compound returns review, these two costs can significantly erode long term portfolio growth.

Another factor to bear in mind is that researching and monitoring 30-50 investments can require substantial time and energy.

Higher Returns Through Diversification?

I have thought a bit more about the Investopedia statement. It is still inaccurate, but I think I can explain it.

I do not believe that you can get higher returns just by diversifying. As I explained previously, a portfolio’s expected return is simply the weighted average of every component’s expected return.

But diversification does allow the ability to add higher return assets to the portfolio to improve the overall expected return of the portfolio.

Say you have a two asset portfolio. Asset A has an expected return of 10.0% and a standard deviation of 5.0%. Investment B has a 14.0% expected return and a standard deviation of 8.0%. Your portfolio is 50% of each and the correlation between the two assets is 0.70.

Skipping the calculations, click here if you want to see the basic formulas, the portfolio has an expected return of 12.0% and a standard deviation of 6.0%. Note that we have already breached the Investopedia statement that a diversified portfolio will yield higher returns than any individual investments in the portfolio.

But we can get a nice increase in expected returns by adding a high risk investment to the mix. Let us add asset C with an expected return of 50.0%, but a standard deviation of 30.0%. Further the correlation between asset A is 0.60 and 0.90 with asset B.

The ABC portfolio will have an expected return of 24.6%, a huge increase from the 12.0% expected return of an AB portfolio. But again, the higher average is less than the return of asset C on its own.

So while you may be able to increase expected performance in a portfolio, it will never be greater than the return of all individual assets.

What about risk though?

Lower Risk Through Diversification?

As we saw with our correlation calculations, proper diversification will lower portfolio risk. Again, not necessarily lower than all individual assets though.

In our two asset AB portfolio, the standard deviation is 6.0%. Less than asset B’s risk of 8.0% but more than asset A’s 5.0%.

Now let us look at adding asset C to the risk calculation.

The standard deviation of ABC portfolio is 13.5%. Now the combined risk is higher than both A and B on their own and even the AB portfolio itself.

Like returns, Investopedia’s statement on lower risk is faulty.

What Should Investopedia Have Stated?

I might have looked at the impact of diversification on portfolio returns and risk.

For a given return level, proper diversification will reduce the portfolio risk.

Or for a given risk level, proper diversification will provide higher returns.

But that is for the portfolio as a whole, not compared to its individual investments.

For example, you have a single asset portfolio, asset X. Its expected return is 20.0% and its standard deviation is 10.0%.

You like the return but are concerned about the amount of risk. You decide to add another asset in a 50% mix of the two assets.

You find two other potential investments that both have 20.0% expected returns.

Investment Y has a standard deviation of 10.0%, the same as your current asset X. Asset Y has a 0.20 correlation to asset X.

Investment Z has a standard deviation of 7.0%, lower than asset X. Its correlation to asset X is 0.90.

An XY portfolio will have an expected return of 20.0%. But an XY standard deviation will only be 7.8%.

An XZ portfolio will also have an expected return of 20.0%. But the XZ standard deviation will be 8.3%.

Both portfolios are more efficient than holding asset X alone.

For further points, note that the XY is more efficient than XZ even though Y has a higher amount of risk than Z. That is because of the differences in correlations.

The same may be said for someone wanting to enhance portfolio returns while keeping risk stable.

You own asset X and are comfortable with portfolio risk of 10.0%. However, you would like to increase your potential returns.

Perhaps you find investment option S with an expected return of 28.0%, a standard deviation of 13.0% and a correlation with X of 0.50.

In combining the two assets equally, the expected return of XS has increased to 24.0%, but the standard deviation remains the same at 10.0%.

Again, correlation plays a significant role in risk reduction. Had the correlations been 0.90 rather than 0.50, the standard deviation of XY would be 11.2%. For investment options with high correlations, you would need to accept lower risk-return profiles to equal the risk of X alone.

Okay, I hope that helps clarify diversification.

If not, do not worry. It is a rather complicated subject. I just want to lay the groundwork now for when we look at asset allocation and portfolio construction strategies.

I think we will move on to a discussion of investment returns next.




Diversification and Asset Correlations

In An Introduction to Diversification, we began our review of the subject.

Knowing something about asset correlations is crucial to better understanding why diversification is important in an investment portfolio.

So that shall be today’s topic.

Asset correlation is a relatively advanced topic. For some of you that means I will not get into it as much as you would like. For others, your eyes may glaze over in boredom quickly.

At the end of the day though, I hope you gain some insight about correlation and how it can help you improve your investment results.

What is Correlation?

Correlation is a statistical measure (we cannot seem to escape the world of stats!) of how one asset moves in relation to a second asset.

With investment assets, risk factors can significantly affect performance. We looked at many of these variables in our discussions of nonsystematic and systematic risks. Government policies, inflation, interest rates, hurricanes, company management are a few examples.

The closer in characteristics two assets are, the more they will be affected by the same risk factors. The more divergent the assets, the less impact individual risk factors will have on each at the same time.

Let us use coffee shops to illustrate this point.

Two Starbucks franchises located on the same city block in New York are almost identical in nature. Same clients, same products, same impact from changes in coffee prices, and so on. There may be some minor differences, but not many.

If the city suffers an economic downturn, each shop should suffer equally. If Starbucks is investigated for selling coffee laced with carcinogens, business at both will fall.

Now compare a Starbucks with an Italian espresso shop on the same block.

Many of the same risk factors will be identical because of their physical proximity and product offering. If the local economy falters, both businesses may have difficulties. But if Starbucks is sued for potentially killing customers, Starbucks will suffer whereas there will be no negative impact on the espresso bar.

What about comparing two Starbucks? One in Los Angeles, one in Zurich.

Again, there are similarities between the two, but there are also large differences. If there is an earthquake in Los Angeles that destroys every Starbucks in the city, there will be no problems for the Zurich franchise. If the Swiss economy struggles and customers look for more cost effective coffee options, that has no direct effect on business for a Starbucks in California.

We could look at many more combinations, but I think you get the idea.

Correlations and Investing

Like Starbucks’ franchises, some investments share many of the same traits and risk factors. Others have little in common. Some even react in opposite directions to the same risks.

How an investment moves or performs relative to another asset is its correlation.

And this correlation is the reason you want to hold a “wide variety of investments” (per Investopedia) in your portfolio.

When two investments are positively correlated, their performance will move in the same direction. Like two Starbucks on the same street.

When two investments are negatively correlated, if one asset outperforms its expected results, the other will underperform. Perhaps like a pawn shop on the same city street as the Starbucks.

When the economy is great, it’s frappuccinos for everyone. People are making money and not needing to hock their assets. The pawn shop is a lonely place.

But when bad times hit and people become unemployed, there is less money available for a premium priced coffee. Starbucks struggles and may incur losses. Meanwhile, the cobwebs have been cleared off the pawn shop cash register and business is booming. At least until the economy recovers and the Starbucks’ baristas are back at work.

If the movements of two assets are exactly identical, they are 100% positively correlated. If they move in exact opposite directions, they are 100% negatively correlated. If they have no relationship at all, the correlation is 0%.

In investing, correlations range from 1.00 (100% positive) to -1.00 (100% negative).

Most assets are positively correlated to varying degrees. In part this due to increasing globalization and far reaching risk factors that impact most assets. These include inflation, interest rates, government policies, and employment rates.

While most assets are positively correlated, few are perfectly correlated. That is, few assets have correlations of 1.0.

Consider the two Starbucks on the same street. As close in likeness as can be. However, one manager may be better than the other, resulting in customers buying more accessories. Or perhaps the baristas are better in the second shop. They are friendlier, faster, and serve better quality drinks. So although both shops have the same offering, customers over time may increasingly frequent the shop with better service.

Even in a small example like this, there are potential differences between almost identical businesses. This is equally true for investments. And, as we shall see below, these minor differences can play an important role in managing portfolio risk.

Correlations between two specific assets may change over time. As the characteristics and circumstances of the underlying investments shift, so too can the correlations.

Correlations in Action

Exxon Mobil is a multinational oil and gas publicly traded company. Let us pretend that your investment portfolio only holds shares in Exxon.

The expected return of Exxon is 15% and the investment risk (i.e. standard deviation) is 10%.

You have read that diversifying your portfolio helps reduce portfolio risk. So you want to sell half your Exxon stock and invest the proceeds in another instrument.

From your research, you find two possible investment options.

Option one is shares of Chevron, another multinational oil and gas company. Option two is the Fine Art Fund; a mutual fund made up of fine art investments. Both have the same expected returns, 25%, and standard deviations, 20%.

If they both have the same risk-return profile, does it really matter which one you select?

Yes!

In many ways, Exxon and Chevron are the same company. They are in the same industries, operate in similar countries, and are affected by the changing price of oil and related commodities. One should expect their share prices to mirror each other to a great degree.

Their performance will not be exact due to company specific risks.

In 1989, faulty equipment, human error, and fatigued crew were factors in the crash of the Exxon Valdez in Alaska. A crash that caused many problems for Exxon.

In Ecuador, Chevron is currently involved with the Ecuadorean government over environmental issues that may result in fines and costs to Chevron.

But for the most part though, in the absence of unique situations, the share prices of major oil companies generally move together up or down.

That is why I would anticipate the correlation between Exxon and Chevron being close to 1.0 (i.e. 100% positive). It would not be exactly 1.0, because the two companies do operate in some different markets, have different product mixes, different management, etc.

But I would expect over a long period for the two companies to track each other quite well in share price. I just looked at a five year performance comparison between Exxon (stock symbol: XOM) and Chevron (stock symbol: CVX) – you can compare companies using Yahoo Finance Interactive Charts – and the similarities over time are striking.

But although they are close, they are not exact matches. That is good for diversification.

But not great.

The Importance of Correlations

Anytime the correlation between two assets is less than 1.0, there is an advantage in reducing overall risk by adding the new investment to one’s portfolio.

That is because of the portfolio risk-return calculations.

In (very) short, by adding assets that are not perfectly correlated to each other, one receives the cumulative impact of the expected returns, but only a reduced impact on portfolio risk.

I have re-read the Investopedia definition of diversification a few times.

I do not really understand what they mean when they state diversification will “yield higher returns and pose a lower risk than any individual investment found within the portfolio.”

I agree with the latter part of the statement, but have trouble with the first section.

Correlations and Portfolio Expected Return

While diversification allows you to invest in assets with high expected returns, diversification does not give the portfolio any bump.

In an investment portfolio, the expected return of the portfolio is simply the sum of each individual investments’ weighted averages in the portfolio.

For a simple, two asset portfolio:

ERp = (Wa)(ERa) + (Wb)(ERb)

Where:

ERp = Expected return of the portfolio

Wa = Weight in percentage of investment “A” in total portfolio (“b” for investment “B”)

ERa = Expected return of investment “A” in the portfolio

In our example, the expected return of Exxon is 15% and 25% for Chevron. If you invest 50% of your portfolio in each asset, the portfolio’s expected return should be 20%.

ERp = .50(15) + .50(25) = 20%

Pretty easy.

Remember that expected returns are just weighted averages of all the individual investments.

Correlations between assets do not impact the expected returns of the portfolio.

Correlations and Portfolio Risk

However, it is not that simple a calculation for the risk of the portfolio.

You need to factor the assets’ correlations into the equation. In a two asset (A and B) portfolio:

℺²p = (W²a)(℺²a) + (W²b)(℺²b) + (2)(Wa)(Wb)(℺a)(℺b)(pab)

Where:

℺ = Standard deviation

Wa = Weight in percentage of investment “A” in total portfolio (“b” for investment “B”)

pab = Correlation between investments “A” and “B”

The first part of the equation looks a lot like the expected return calculation. In that sense, there is a weighted average effect from risk.

But let us see how the second part of the equation alters the equation’s impact.

Diversification Impact of Strongly Correlated Assets

In our example, the standard deviation for Exxon was 10% and for Chevron 20%. Because the two companies are quite similar, I shall say that the correlation coefficient is 0.85. Not quite 1.0, but close.

If we crunch the numbers we see that the portfolio standard deviation is 14.49%. Slightly less than if we simply took the weighted average (15%) as we did with expected return.

The difference is due to the fact that the two assets are not perfectly correlated. However, because the correlation of 0.85 is very high, the reduction in risk is relatively small.

Diversification Impact of Weakly Correlated Assets

Now let’s consider our other potential investment; the Fine Art Fund. It had the same expected return (25%) and risk (20%) as Chevron. Therefore, we would expect an Exxon-Fine Art portfolio to yield the same expected return and risk as the Exxon-Chevron combination.

Actually, no we would not expect that in the slightest.

Here’s why.

In the real world, the correlation between fine art and oil companies is negligible. In fact, there is no correlation between the performance of Exxon and a bunch of paintings. So we shall say that the correlation between Exxon and the fund is 0.002.

Now for the numbers.

The expected return of a portfolio consisting of 50% Exxon and 50% Fine Art Fund would be 20%. The same as with the combined Exxon-Chevron portfolio.

This is because both Chevron and the Fine Art Fund have the same expected returns. And, as we saw above, expected return calculations are simply weighted averages of the portfolio’s individual investments.

But the portfolio risk is a different story.

If we crunch the numbers we see that the portfolio will have a risk of only 11.2%. Much less than a pure weighted average of 15% and significantly less than the Exxon-Chevron combination of 14.5%.

Yet the expected returns of both a portfolio of Exxon-Chevron or Exxon-Fine Art Fund are identical at 20%.

From a risk-return aspect, the Exxon-Fine Art Fund is the much better investment choice.

Why is Option Two Superior?

Because of the correlation between the assets.

Assets with high correlations receive some impact through diversification. But as you move toward a perfect correlation of 1.0, the risk reduction benefits from diversification lessen.

If you really want to reduce portfolio risk, you need to add assets that have low, or even negative, correlations to the assets already in the portfolio.

Investopedia states that diversification “mixes a wide variety of investments within a portfolio”.

True.

But to make it worthwhile, be certain you consider the correlations between assets as well as expected returns and risk levels in your investment selections.

The impact on your portfolio’s efficiency could be huge.

As for the optimal mix, there are many other variables that need consideration. We will look at them down the road in asset allocation and portfolio construction.

Next up, a few more thoughts on the benefits of diversification.




An Introduction to Diversification

The key risk management tool for the average investor is portfolio diversification.

It seems like an easy concept, but it is a little more complex than it first appears.

Diversification and Investment Risk

Before we start our discussion on diversification, I want to point out a difference in my personal views and what is generally accepted in readings elsewhere.

In learning the distinctions between nonsystematic and systematic risk, diversification is normally number one on the list. In fact, that is why nonsystematic risk is also known as diversifiable risk and systematic risk is also termed non-diversifiable risk.

You will usually be taught that nonsystematic risk can be minimized through diversification. However, systematic risks cannot be diversified away.

If you are writing a finance exam, I suggest that you bear this in mind.

I think this is incorrect, but I do not want to be the one helping you to fail an exam.

As we go through diversification, I will provide examples of how to reduce systematic risks in one’s portfolio. You can decide if, in the world of non-academia, I am correct or not.

What is Diversification?

Investopedia defines diversification as:

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Okay.

This definition makes some sense if you already know what diversification is. But if you are unfamiliar with the concept, I think it makes little sense.

And it is somewhat misleading to a non-professional investor.

For those that want to understand this very important concept, we shall attempt to dig deeper into diversification.

Digging Deeper into Diversification

Diversifying a portfolio does require one to hold a “wide variety of investments”.

But it is not that simple. We shall consider the following questions:

Why must a portfolio contain a “wide variety of investments”?

What constitutes a “wide variety”? 5 assets? 50? 500?

Are any “mixes” of assets acceptable?

Will a diversified portfolio actually generate “higher returns and pose a lower risk than any individual investment found within the portfolio”?

The answers to some of these questions may be found in a look at asset correlations.

So correlations will be our initial foray into the world of diversification.