Want to Invest Like a Pro?

Want to learn how to invest like a professional investor?

Maybe a good plan, maybe not. But our friends at Investopedia discuss how to “Invest Like a Pro”.

Article highlights and my comments below:

Strategy Before Investing

A strong investment philosophy should be outlined before any investment  strategies are considered. An investment philosophy is the basis for investment  policies and procedures and, ultimately, long-term plans. In a nutshell, an  investment philosophy is a set of core beliefs from which all investment  strategies are developed.

Per Investopedia, the keys to developing a strong investment philosophy are in defining your: core investment beliefs; investment time horizon; risk tolerance; target asset allocation; diversification.

Basically what we talked about in developing your Investment Policy Statement.

You start out by creating a comprehensive Investor Profile. It takes into account your current financial situation, investment objectives and constraints, time horizon, and personal risk tolerance. The result should be used to drive your investment strategy. And by investment strategy, we are talking your target asset allocation, including diversification and asset classes.

I firmly believe that if you take the time to lay a proper foundation it will improve your actual investment decisions and long-term performance. Sadly, too many individuals ignore this part of the investing process.

Secrets of Success

Match Investments to Investor Profile

Successful firms also implement product funds that reflect their investment philosophies and strategies.

Develop an investment plan that meets your individual situation. Then invest in appropriate products that will best meet your goals.

If you are retired, highly risk-averse, and need investment income to meet your monthly cash flow requirements, then lower risk assets that provide a consistent cash flow are best. But if you are 25, with a 40 year investment window, and do not require investment income to live, then perhaps you are best suited for more volatile investments with higher potential returns.

Match your investments to your personal situation and profile.

As your circumstances change (family, approaching retirement, career success, etc.), you should adjust your profile. As a result, your investment strategy, target asset allocation, and individual investment choices will also evolve over time.

Avoid Sector Bets

Successful firms also limit their abilities to take large sector bets in their core products.

Not sure I necessarily agree with this one, or at least with Investopedia’s phrasing. I think what Investopedia means is that one should not deviate from the core approach to make significant bets in any specific sectors or sub-asset classes.

For example, you have a well-diversified equity portfolio, but the financial pundits all say that tech stocks are the place to be during the upcoming year. So you ditch your utilities, commodities, retail, etc., and load up on tech equities. This is what Investopedia seems to be referring to.

The issue here is essentially market timing. And can you, or even the professional investors, correctly time market (and sub-market) movements? History shows that very few professionals get it right.

How often to economists get it correct? I could post examples like this every week if I wanted. Or what about the best investment analysts out there. Why do the “best” seem to change every year? How many professional investors were screaming when Apple dumped Steve Jobs back in the 1980s? Or why do mutual funds typically lag their pre-determined benchmarks if fund asset managers can time short-term market movements and trends?

The classic passive versus active management debate. It is difficult to beat the market, do not try.

If you are jumping in and out of sectors, you will incur higher transaction costs, as well as lose potential capital by timing poorly. You are investing for the long run. Select a strategy that meets your unique situation and follow it. Do not get caught up in the short term noise and stay the course.

Fully agree. Well, with short term sector bets or chasing trends. However, I do make longer term sector plays. Does that make me a bad guy? A fool? Possibly.

Well, Avoid Short Term Sector Bets

I am more a macro investor, so that is what I do myself to a large extent. I study trends and recommend investments that fit those trends. But I am more interested in medium to longer term trends. I do not think it possible (at least for me) to time short term volatility and I utilize probabilities more than gut feel.

If you ask me what Apple will do over the next 6 months, I can analyze the data and provide a reasoned opinion, but my confidence level will be low. There are too many non-systematic risks in play with individual companies to assess performance. Consider UBS. How many people out there knew a rogue trader in London was going to create so much aggravation for the company? Not me.

This is why we use diversification. To minimize non-systematic risks in our portfolios.

It is also why I recommend passive investing, utilizing a diverse portfolio of low cost index funds.

Looking at systematic risk, how many investors anticipated the September 11, 2001 attacks? Huge short term impact on the financial markets. The S&P 500 fell 11.6% between September 10 and September 21. Yet a month later it was back to pre-attack levels.

So short term volatility and market timing is hard to accurately assess. Or so I believe.

But I do think that smaller, professional investors can take advantage of inefficient markets and longer term trends.

Consider interest rates in Canada or the U.S. Currently, they are extremely low on a historic basis. In a low, medium, and high probability analysis, the odds of interest rates falling are negligible. We can debate forever as to whether they will remain stable or increase over the next 3, 6, 9, 12, or 24 months. But I am pretty confident they will rise over the medium term, if not the short.

Without getting into the correlation between interest rates and fixed income prices, suffice to say when rates fall, bond prices generally rise. When rates rise, bond prices fall. And the impact is greater the longer the bond’s duration (term to maturity, in layman’s terms). If I think rates will fall, I want to own 30 year bonds. If I think rates will rise, I want to hold 1 year bonds. As I calculate a higher probability of rising rates going forward, I believe that investors should shorten their fixed income portfolio durations.

But that is me. I listened to the two top guys at Vanguard last week make a slightly different argument (when they put up a video for the talk, I will post it). They said that perhaps low rates will stay in place for a longer period. By reducing durations, you are giving up yield (generally speaking, longer maturities equals higher yield) needlessly if rates do not increase. And they made some excellent points in support of their position.

If Vanguard is correct and I am not, then I am costing myself income by placing a sector bet on short-term duration bonds. We shall see over time. But I do think for an amateur investors – the doctor, teacher, fireman, etc., who does not spend 10 hours a day studying the markets – stick to a general strategy and that will serve you well over time.

Stay Consistent and Disciplined

When defining an investment strategy, it is very important to follow a strict discipline.

The chasing trends part we covered above. But I highlight the discipline part also in respect of consistency over time.

Use a dollar cost average approach to gradually build your holdings. When markets are down, you will be buying at a discount. When markets are too high, you will buy less and avoid overpaying. You likely cannot time market or individual investment highs and lows. So buy a fixed dollar amount each week, month, or quarter. That will smooth your purchase prices over time and better serve you.

Stay disciplined in your investment style. If you cannot time market volatility, should you even try?

A Final Thought

It is said that a picture is worth a thousand words.

Here is a good example of market volatility and whether one can time markets.

How many investors were able to time the market lows in early 2009? Versus the number that bought in mid-2008? But if you consistently invested $1000 monthly over that period, you may have done all right.

SP500




A Somber Financial Outlook for 2012

A November 2011 survey of financial professionals predicts a somber outlook for 2012.

Each year, a worldwide sample of Chartered Financial Analysts (CFAs) are invited to participate in a Global Market Sentiment Survey. As the title suggests, the survey looks at “market sentiment, performance, and market integrity issues in 2012.”

The survey also provides predictions on growth in the global finance profession.

The report makes for interesting reading.

Although I did not participate in this years survey, I share many of the findings. 

Not surprising, because as the old saying goes, great minds think alike. I shall ignore the last half of the adage, that fools seldom differ.

Some of the highlights:

Market Performance

59% of respondents globally predict that asset classes other than equities will be top performers in 2012. U.S. respondents are outliers, with a majority predicting global equity markets to be top performers. Weak economic conditions and the overhang of perceived systemic risks may contribute to poor expected returns for risk assets like equities.

It is interesting that U.S. respondents differ from their international peers on this point.

I am quite cautious on global equities in the near-term as well. There is too much uncertainty around the world. Substantial deficit spending in many key countries, the monetary crisis in Europe, weak economic growth projections, political instability, are a few of the issues causing problems today.

Until these issues are resolved, there will be continued volatility.

For a little more information on systematic risks, please check here.

In APAC, however, an equal proportion of members believe precious metals will have the highest return.

Not a surprise on the precious metals. With concern over currencies, the fear of inflation, investors often turn to hard assets.

Economic Conditions

Local respondents in BRIC countries (especially in Brazil, India, and also in Australia – whose economy is largely tied to the BRICs through commodities) overwhelmingly predict economic expansion in their home markets in 2012. The outlook is much different in Europe, where 85% or more of local respondents in key countries (France, UK, Switzerland) see no prospect of economic growth in the coming year.

Worth noting here, is how countries with close economic ties to other countries share similar fates. Australia and the BRICs (Brazil, Russia, India, China). Same with Canada and the U.S., Switzerland and the Eurozone countries, etc.

Three-quarters of respondents see no improvement in the current sovereign crisis in 2012. Sentiment is fairly uniform across the globe in this respect.

If anything, I am a little surprised that only 75% see no improvement. I have yet to speak with anyone who believes the situation will materially improve.

The biggest perceived risk to global capital markets in 2012 according to members is “Systemic Disruptions” followed by “Weak economic conditions” and “Political Instability”. The biggest perceived risk to local capital markets according to members is “Weak economic conditions”.

To some extent, these conditions are linked. There are a variety of systematic risks that can impact the markets.

Market Trust

Most respondents feel that the impact of the global financial crisis on market trust and confidence will persist for another 3-5 years, similar to the sentiment expressed last year. But only 25% predict continued fallout beyond 5 years, down modestly from 32% who expressed that view last year.

The survey sees this as improving sentiment. A view I do not share. It is easy to say that 5 years from now, there will be improved trust and confidence in the markets. But all you need is another Enron or MF Global to occur and the level of trust will fall. And these events are hard to predict.

The most serious issue facing global markets for 2012 is “mis-selling of products by financial advisers” followed closely by derivatives.

I fully agree that mis-selling is a big concern. There are two key areas where this can occur.

The problem may arise due to a lack of competence on behalf of the financial professional. Who does not properly understand the client’s objectives and the available solutions. Then erroneously puts the client into inappropriate solutions.

Or the financial professional may put his or her needs ahead of the client. This includes selling products that yield the highest commission to the advisor, churning client accounts to generate higher transaction fees, etc.

As a client, ensure that you deal with knowledgeable financial professionals. And understand how they generate their revenue stream. Make sure it is compatible with your needs.

Employment Opportunities in Finance

A larger proportion of members in APAC (23%) expect employment opportunities to increase than those in AMER (13%) and EMEA (8%). Majority of members in EMEA (55%) expect employment opportunities to decrease. Globally, half of members expect employment opportunities to stay about the same.

Globally, the job market for finance professionals is expected to remain flat.

The best possibility for job growth is anticipated in the Asia/Pacific region, with China and India leading the way. Employment is also expected to grow in the Middle East, Latin America and Brazil in 2012.

The worst opportunities appear to be in Europe. Japan projects flat as well.

All in all an interesting survey as to what finance professionals think about the markets in 2012.

It is not a guarantee as to future events. But it is well worth your time as an investor to take a read through the report.




Is a Market Crash Coming?

Is a crash in the markets coming?

I am not sure.

If one does occur, experts will look back and see many clear warning signs. And there are a multitude of red flags.

However, governments, banks, investment companies, and the like, are doing their best to avoid a calamity. 

Of course, when we are talking governments, banks, etal., doing their “best”, I am not filled me with much confidence. To date, some of their “best” has been accumulating USD 15 trillion in debt by the U.S. government, creation of Dodd-Frank, Europe and the Euro crisis, the protests in Greece over any real reforms, MF Global, UBS rogue trader, etc., etc., etc. The list is a long one of “best” efforts.

One firm though is convinced that bad times are near.

One Company’s Approach

Ann Barnhardt of Barnhardt Capital Management has decided to cease operations. In a communication to her clients, Ms. Barnhardt states:

I could no longer tell my clients that their monies and positions were safe in the futures and options markets – because they are not. And this goes not just for my clients, but for every futures and options account in the United States. The entire system has been utterly destroyed by the MF Global collapse. Given this sad reality, I could not in good conscience take one more step as a commodity broker, soliciting trades that I knew were unsafe or holding funds that I knew to be in jeopardy.”

Ms. Barnhardt sees potential difficulties for companies other than MF Global.

“MF Global is almost certainly the mere tip of the iceberg. There is massive industry-wide exposure to European sovereign junk debt. While other firms may not be as heavily leveraged as Corzine had MFG leveraged, and it is now thought that MFG’s leverage may have been in excess of 100:1, they are still suicidally leveraged and will likely stand massive, unmeetable collateral calls in the coming days and weeks as Europe inevitably collapses.”

And she concludes her thoughts by recommending to clients that:

“The futures and options markets are no longer viable. It is my recommendation that ALL customers withdraw from all of the markets as soon as possible so that they have the best chance of protecting themselves and their equity. The system is no longer functioning with integrity and is suicidally risk-laden. The rule of law is non-existent, instead replaced with godless, criminal political cronyism.”

Perhaps Ms. Barnhardt is correct in her assessment. She knows her market segment well. For what it is worth, I agree that there are other dominoes likely to fall in the financial sector.

Which Companies Might Be in Trouble?

The difficulty is knowing which ones are in trouble.

Jon Corzine, (now-resigned) Head of MF Global, was a golden boy in the investment world. Right up until the moment that MF Global collapsed. He was a major link to Wall Street for President Obama and was widely rumoured to be the next U.S. Treasury Secretary if Tim Geithner stepped down. In August, 2011, everyone seemed thrilled by his performance. However, less than three months later, his MF Global clients (who are missing over USD 600 million in their client funds) or former employees (over 1000 employees that lost their jobs), you may get a different answer.

Which golden boy may be next? I have no idea. But there may be one. So if you are investing through one of these firms, be careful.

The Futures and Options Markets

I would also suggest avoiding both the futures and options market.

I think you need a relatively high level of investment knowledge and experience to be in these markets at any time. And now with all the economic issues, government problems, and financial mismanagement, these markets are even trickier.

As for general equity and bond markets, I still believe that there will be increased volatility over the next few months. Until the European situation clarifies in one way or another, markets will be unpredictable. The same is true as relates to the U.S. elections. Until the Republican nominee is known and the results of the November 2012 election become clearer, there will be swings up and down.

Dollar cost averaging will help smooth your purchase prices. If you are in the market, it is an effective tool, especially now. Or, you can sit on the sidelines in cash until some of the uncertainties go away.

Where things finally shake out will dictate where the markets ultimately end up. And right now it is hard to predict what will finally happen.




Buy and Hold, But Review

In general, I like the buy and hold investment strategy.

Assuming, that is, you passively invest in a well-diversified, low-cost portfolio.

But I also think that a buy and hold strategy needs a little tweaking.

One such tweak involves the need for periodic portfolio reviews.

Today we will look at frequency of reviews.  

There is no hard and fast rule as to the frequency of portfolio evaluations.

The number of reviews you conduct, if any, will reflect a few factors. As these differ between investors and their portfolios, so too will the periodicity of portfolio assessments.

Portfolio Risk Level

The timing of evaluations should be connected primarily to the risk of the portfolio.

If you have a relatively low risk, well-diversified portfolio of mutual and exchange traded funds, annual reviews may be adequate.

As the portfolio volatility (i.e., standard deviation) rises, you may want to increase the frequency of your evaluations. Maybe semi-annual reviews for portfolios with moderate risk levels. Perhaps quarterly reviews for portfolios with high standard deviations.

For portfolios that are not well-diversified, quarterly to semi-annual assessments are prudent. This holds true even for lower risk portfolios. And the less diversification, the greater the need for more frequent reviews (the exception being for single investments in extremely low risk assets such as Treasury bills, term deposits, etc.).

The logic of increased frequency for high risk or weakly diversified portfolios is that external factors can have significant and rapid impact on highly volatile and/or non-diversified investments.

For example, perhaps you have a concentration of investments in the Middle East. Given all the political turmoil there at the moment, you would want to monitor your assets very closely. If you wait a year to do an evaluation, you may find that the current governments have radically changed and that new business rules are in place that affect you investments.

General Market Volatility

Over time, certain events can cause excessive volatility in the markets. Most of these are systematic risk factors.

On the down side, events may include inflation, high unemployment, political turmoil, stock market crashes, wars, natural disasters, and so on. On the positive side, there may be long bull markets due to the opposite events, such as low unemployment, low inflation, peace, etc.

The greater the general market volatility, the greater the focus should be on your portfolio.

In part because strong systematic risk events can have wide ranging impact on one’s investments. Unlike nonsystematic risk factors that you can minimize through proper diversification, it is more difficult to protect against systematic factors.

And in part because your well-diversified portfolio of passively managed index funds should reflect the market itself. As general market volatility increases, so too does your own portfolio. Therefore, you should increase your amount of reviews accordingly.

Investor Personality

Periodicity of portfolio reviews will also reflect your personality and investor risk profile.

Not that it should, but an individual’s personality plays a role in how they manage their assets.

If you are a detail oriented person, you will likely be more comfortable reviewing your assets monthly, or even weekly. No doubt using spreadsheets or investment software to drill down into the numbers. If you are quite relaxed about life, then even an annual check-up scribbled on the back of a napkin may feel onerous.

The same applies to one’s investor risk profile. Low risk investors will normally want to monitor their portfolios more closely than a high risk investor. The opposite of what should be done, but it ties into their personality in many cases.

Given the importance in generating adequate wealth for a comfortable retirement, I suggest you put aside any personality traits that lead you to defer reviews. Put in a little time now on performing proper evaluations and you will reap the benefits down the road.

And Me?

I like to review portfolios quarterly or semi-annually as standard monitoring practice.

That is because I tend towards a portfolio with a moderate to slightly high risk level. I also include individual assets in my portfolio to complement my core fund holdings. So I want to keep a closer watch on my portfolio than perhaps someone with nothing but index funds spread across multiple asset classes and subclasses.

I also like to conduct an analysis whenever a systematic risk factor is either anticipated or unexpectedly arises.

Despite what the U.S. Fed would have us believe, we have seen the coming inflation for a while now. This is an anticipated risk. Once its approach has been identified and confirmed, I like to consider its impact on my portfolio.

The recent earthquakes in Japan, and subsequent problems, are examples of unexpected systematic risks. When something like this suddenly occurs, I will review its current and potential impact on my investments.

If I wait until my standard quarterly or semi-annual portfolio review before assessing the potential impact of either an anticipated or unexpected event, it will likely be too late.

So anytime there is a material event take place – that is, something that will affect my decision-making – I like to evaluate it against my assets.

Now you know that you should review your portfolio on a periodic basis.

Next we will discuss how to conduct those reviews.




Buy and Hold with Individual Stocks

A long-term buy and hold strategy can work with individual, non-diversified assets. For example, shares of Cisco or Swiss Re. Or General Electric Capital bonds. Or the Japanese Yen.

But I would not recommend it.

Here is why. 

Quality Can Change Over Time

If you find a solid company (or other non-diversified asset) with strong management and excellent long-term prospects, you can buy and hold individual assets.

However, few companies have been great investments over the very long term.

Yes, there are some, but will you be able to identify them? That is the question. At one point in time, Nortel, Bre-X, Enron, and General Motors were considered fantastic long-term plays. Industries and companies are not static. Good companies can fall and new companies can rise.

If you invest in individual companies, I suggest you spend more energy monitoring their performance and prospects. A rule of thumb should be that the greater the risk of the asset (i.e., the standard deviation), the more frequent the monitoring.

Systematic Versus Nonsystematic Risk

That is the difficulty with investing in assets which have nonsystematic risk components. Individual risk factors can significantly impact the fortunes of non-diversified assets.

Individual companies may face risks from management, operations, and competitors. They may also incur risk through key customers, suppliers, debt defaults, and legal problems.

Problems in any one of these areas may alter the future fortunes of a company and its stock.

That is the whole purpose of portfolio diversification. To spread out the investment specific risks amongst a variety of assets – preferably with low or negative correlations to each other – such that the nonsystematic risk level is minimized.

The goal is to eliminate all asset specific risks, so that only the systematic risk remains.

If you can achieve this, your portfolio will be more efficient, and likely more effective, than one that still contains nonsystematic risk components.

A Diversified Portfolio is Better

That is why I believe that a buy and hold strategy should be used primarily with diversified portfolios as opposed to single assets.

The concern over individual risks is minimized throughout the portfolio. One company may be devastated by a lawsuit, new competitor, patent expiration, departure of senior management, etc., but the impact on the entire portfolio from one of these events is small.

To some extent, this risk also exists in mutual, or exchange traded, funds.

The less the number of index components or the more that market capitalization is reflected in an index, the greater the probability that one company’s problems will impact the entire index. For a good example, google Nortel and its impact on the TSE 300 Composite Index.

While something to be careful of when investing, usually indices do have adequate breadth so that one company does not have inordinate impact on the index performance.

This is why index investing is a good way to minimize nonsystematic risks and enhance portfolio efficiency.

Indices Address Quality Change

With individual assets, you need to carefully monitor their changing risks and return prospects. A true buy and hold may not be wise. You may need to divest assets whose fortunes change and add new assets with better long-term potential.

With index investing, this process is built in to some extent.

Individual index components may change over time. As previously good companies fall, they are deleted from the index. And as new companies rise in value and prestige, they are added to their appropriate indices.

Not an exact science in any sense, as there are many factors that dictate inclusion in a specific index. But over time, there is a tendency for poor quality companies to be phased out and replaced with better potential components.

But even though the index components adjust over time, you only own the single index fund itself. This allows you to follow a buy and hold strategy with the fund.

Weak companies will leave the fund’s portfolio and other companies on the upswing will enter. In the extreme, over a long period the entire index could change. Not likely, but possible.

Yet you can continue to hold the same index fund throughout your entire holding period.

Additionally, there is less work for you to monitor the portfolio holdings. You only need to track the fund results itself.

Conclusion

While I tend to advocate a buy and hold investment strategy, I do so in the context of my overall investment program. That is, investing primarily in low-cost index funds.

I am much less keen on buy and hold for non-diversified assets.

If you intend to invest in individual companies, ensure that you monitor their performance and expected future results. As times change, companies that appeared solid may downgrade in relative value. Be ready for quality degradation and, if you think it is permanent, do not hesitate to divest.

But for well-diversified investments, a buy and hold strategy should be effective. Especially if you incorporate a couple of tweaks to the standard methodology.

We will look at those tweaks shortly.




Investment Lessons From Inflation

A very good article in The Wall Street Journal, How to Profit From Inflation.

It provides advice on how to survive the looming inflation. For that alone, it is worth a read.

But the article also reinforces some of the topics we have discussed in this blog.

Systematic Risk

Inflation is a systematic risk. It affects all entities in some capacity.

In Brazil, where the Consumer Price Index (CPI) is expected to rise 5.6%, all consumers and businesses will be impacted to some extent. While one can try and protect themselves or their companies, it is not an easy thing to do with a 5.6% rate of inflation.

When investing, always be cognizant of factors outside the control of company. Especially ones that can have adverse impact on the asset’s performance.

Nonsystematic Risk

While inflation is a systematic risk, other items mentioned are more nonsystematic in nature. That is, variables that affect specific companies or assets.

For example, consider silver which has increased in price 56% over the last 6 months.

The Downside to Nonsystematic Risk

Often, nonsystematic risks can negatively impact a company or asset.

Historically, silver has been a input in film manufacturing. As such, increased silver prices will increase costs for film related companies. To the extent these costs are not hedged or cannot be passed on to consumers, this will harm a company’s profitability.

For example, look at this Eastman-Kodak article.

A new problem for Kodak is the rising price of silver, a key ingredient used in the manufacturing process of the company’s film. Over the second half of 2010, silver rose to $30 per troy ounce from $16 per troy ounce, which will affect the company from an earnings and inventory standpoint, said Brad Kruchten, president of Kodak’s film business.

When seeing inflation, look at the individual components driving it. Those factors will affect some companies and assets more than others.

Be aware and protect your own positions through risk management techniques.

The Upside to Nonsystematic Risk Factors

Nonsystematic risk can also provide opportunities as well.

If you own shares in a silver producer, you may be a happy investor.

Look at Pan American Silver Corp. (PAAS), one of the world’s largest silver producers. Its share price has risen from $22.48 on February 11, 2010 to on $34.49 on February 11, 2011. An increase of 53.4% for the year. Not bad.

But that is stock picking, you say. And I recommend passive investing.

Fair enough.

How about the iShares Silver Trust (SLV). A fund that invests directly in silver. Its 1 year performance to December 31, 2010 (per iShares data) was 79.44%.

Or the PowerShares DB Silver Fund (DBS)  that invests in silver futures. Its 1 year return to December 31, 2010 (per Powershares data) was 81.53%.

Finally, we can look at a fund of silver producers.

PowerShares Global Gold and Precious Metals Portfolio (PSAU), while not a pure silver producer play, returned 34.57% for the year ended December 31, 2010 (per Powershare data).

And Global X Silver Miners ETF (SIL) increased from $14.74 on April 20, 2010 (day it started to trade) to $23.61 on February 11, 2011. An increase of 60.1% in less than 10 months.

As you can see, where there are risks, there may also be related opportunities.

Economics

If you want to become a successful investor or prosper in business, I think it is important to understand economics.

The linked Wall Street Journal article is ostensibly about investing and inflation. But consider all the underlying economic issues contained therein. Emerging market economies, banking capital requirements, interest rates, commodity prices, etc. To understand inflation requires a knowledge of other economic topics.

Many systematic risks relate directly to economics. Interest rates, currencies, sociopolitical issues, and inflation.

You need to be able to identify the relevant issues and know how they will impact your business or investments.

If you do, your probability of finding opportunities and minimizing threats will improve.

Portfolio diversification is another issue that resonates in the inflation story.

We will look at that next time.




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.




Systematic Risk

The complement of nonsystematic risk is systematic risk.

Systematic risks affect an entire market or a specific segment of that market.

Systematic risk factors are far reaching and impact all companies to some extent. These factors are not unique to the investment under consideration. They will harm a company regardless of how the company operates or manages its risks.

Systematic risk may also be known as nondiversifiable, non-controllable, or market risk.

In this post we will review a few key systematic risks that often affect investors.

Note that it is not an exhaustive list.

Interest Rate Risk

Interest rate risk reflects how changes in interest rates may affect a company or investment.

Individual companies have no control over interest rate fluctuations. Interest rates move based on a variety of high level factors, including: governmental monetary and other policies; Central Bank actions; supply and demand of money and credit; general economic conditions.

A company’s actions do affect their own credit worthiness and the rates that they pay relative to the benchmark (Prime, LIBOR, etc.) but they have no material influence on the benchmarks themselves. That is why interest rate risk is a systematic risk and not a nonsystematic risk.

Why is interest rate risk an issue for companies and investors?

As interest rates rise, the cost of borrowing increases for companies.

For example, last year a $10 million bank loan may have resulted in a 5% variable interest rate. So a company would have paid the bank $500,000 in interest. If general interest rates rise to 8% this year, the company will need to pay the bank $800,000 in interest payments.

That is $300,000 less money available for reinvestment in the business, paying suppliers and other creditors, or being available for interest or dividend payments to investors.

It is also $300,00o less in profits. Earnings are often a key figure used to value companies. With less earnings, the company and its public shares may also be worth less.

Inflation Risk

Inflation risk is the risk that the price of goods and services will rise, thereby reducing the purchasing power of your assets. Inflation risk is usually linked with interest rate risk as interest rates will normally rise as inflation increases. Or rates will rise as governments or central banks attempt to contain inflationary pressures.

Imagine that you need to purchase a specific set of textbooks, materials, and supplies for school in six months time. You can buy them all today for $1000 or you can wait until the school semester begins. You notice that your bank is offering a six month term deposit with a 3% return for the period. You figure that an extra $30 in interest will buy you a few coffees on campus, so you deposit your money with the bank.

Over the next few months you read in the paper about concerns in the Middle East impacting oil prices. The economy is also heating up and the newspapers are using the word “inflation”. A concept that was covered in the economics class you missed with a hangover.

When the semester starts and the term deposit matures, you take your $1030 and head to the local coffee shop with a stop at the bookstore on the way. You collect all the required items and go to the checkout to pay the $1000. You receive a bit of a shock when the bill totals $1050. Not the $1000 that it should have been.

The clerk, by coincidence an economics graduate, explains that during the past six months inflation has rose 5%. As a result, the general cost of living has increased and goods cost correspondingly more money.

That is inflation risk. Unless the return on your assets meets or exceeds the inflation rate, the value of your assets will fall.

As an investor if you invest your cash in fixed income instruments, you need to be aware of expected inflation rates.

For example, in late 2008 I could recommend an investment that would easily double in 30 days. In fact I would guarantee that return. Sounds good, no?.

But what if I told you that the investment was based in Zimbabwe which was experiencing a monthly inflation rate of 79,600,000,000% (no, not a typo). At that rate, prices double every 24.7 hours.

Even though you would double your Zimbabwe dollars in one month, they would have lost their entire purchasing power in only one day.

While the rest of the world may not be Zimbabwe, on smaller scales this regularly occurs.

Be careful.

Reinvestment Risk

Reinvestment risk arises primarily due to the impact of interest rate changes.

It is the risk that total returns are altered due to a shift in interest rates.

For example, you have $10,000 that you intend to invest for 5 years in a Guaranteed Investment Certificate (GIC) issued by your bank. You can purchase a 5 year GIC that offers a 5% compound interest rate. However, you notice that the 1 year GIC offers a 7% rate. You decide to buy the 1 year GIC now and then purchase another at the end of the year.

At the end of the year you receive $10,700. You reinvest in another GIC, but the best rate you can find is for 1 year at 4%.

That is reinvestment risk. The risk that when you go to reinvest your income you cannot obtain the same rate as you received on the initial amount.

This is a common issue for bond or dividend income.

In much of the world today, this is a real problem for retirees who live on fixed income from investments. As interest and dividend rates fell, income for retirees also decreased. And while inflation in North America has not been a major factor, prices never go down. This has caused financial difficulty for many of the elderly.

Like all risks though, there is potential upside to reinvestment risk, not simply downside.

Perhaps you own a 30 year bond paying 3% annually in cash interest payments. There may be periods during which market interest rates rise and you are able to reinvest at higher levels.

When we look at fixed income investment strategies, we will consider methods to address reinvestment risk. If you cannot wait, google “ladder fixed income” for one simple and effective method.

Currency Risk

Each country has a currency with which goods and services are paid.

Some countries share a common currency.

A single currency, the Euro, is shared by 16 of the 27 European Union Member States. The Euro is also the official currency for an additional 18 smaller countries, states, and territories.

Some countries maintain their own currency but have it “pegged” (i.e. linked) to another country’s currency. The pegging may be a one to one ratio or something completely different.

The Bahamas pegs their currency on an equal basis to the US dollar. In fact, payments can be made in either currency without a problem. And when you get money back, it can be a mix of Bahamian and US dollars. In the Cayman Islands (CI), 1.00 CI dollar is pegged at 1.25 US dollar. Payments may be made in US dollars at the official exchange rate, but any cash returned will be in CI dollars (there are a few exceptions in certain tourist shops).

Other countries take the pegging concept a step further and actually adopt the currency of another country. For example, Ecuador eliminated its own currency and adopted the US dollar as its official currency.

Finally, some countries let their currency “float”. A specific currency will float like a boat on the ocean. The country’s economic fortunes, as compared to its own expectations and the forecasts of other countries, will rise and fall over time. The country’s currency, by its movements, should reflect these relative changes in prosperity.

Well that is the theory. In reality, individual countries attempt to control the value of their currencies based on premeditated actions taken by the country and/or its central bank.

Currency risk can greatly affect investors in the global marketplace.

Perhaps you are an American investor who buys CAD 10,000 in 5 Year Government of Canada bonds with a 6% coupon interest rate paid annually.

Being an American investing in Canada you must consider both base and local currencies.

The base currency is usually your own domestic currency. The home market in which you operate. The local currency is the currency of the foreign market in which you are investing. In this example, the American’s base currency is the USD. The local currency is the CAD.

Note that for a Spaniard investing in a Moscow real estate project, the base currency is the Euro and the local currency the Russian ruble.

At the time of the investment, CAD 1.00 equals USD 0.80, so you pay USD 8000 for the bonds. Over the 5 years you will receive annual interest payments of CAD 600 and after 5 years, you will receive CAD 10,000. Cumulatively you will have received CAD 13,000; CAD 3000 in interest and CAD 10,000 in repayment of capital.

But what if the CAD has depreciated over the 5 year investment period? At the end of each year the CAD/USD exchange rate is 0.75, 0.68, 0.73, 0.64, 0.58. The interest you receive, assuming you immediately convert it back to USD, will only amount to USD 2028. The maturing bond will be worth USD 5800. This results in a total return of USD 7828.

You actually lost money on this simple fixed income transaction.

Thieving Canadians!

Sociopolitical Risk

The risk that instability in one or more regions of the world negatively impacts investments. War, terrorism, health scares are examples of this risk.

Wars in Africa continually impact markets in the region and spill over to international companies and consumers who rely on those markets and products.

Consider the global market reaction to the September 11, 2001 terrorist attacks. Regardless of the industry or company, there was a high probability the company’s shares fell that day.

Or how about the Severe Acute Respiratory Syndrome (SARS) scare in 2002. There was a tremendous impact in companies operating in Asia (and certain other areas), not to mention on tourism and export operations.

Individual companies had done nothing different in their operations. But the above risk occurrences may have had significant impact on their business and profitability.

That is an overview of both nonsystematic and systematic risks.

I hope you found it interesting and informative.

Next we shall look at the generic tools available to address risk in business.

After that, consideration of how to address risk as an investor.

Then we shall move on to looking at investment returns and asset classes.




Nonsystematic and Systematic Risk

When making investment decisions, one should always perform both quantitative and qualitative analysis.

By investment decisions, I include financial instruments such as stocks and bonds. But it also refers to any decisions you make when operating a business.

Do I buy or rent my office space or production equipment? Do I develop and market a new product? Do I move into a new geographic region? These are also investment decisions.

Quantitative Analysis

Quantitative analysis is number crunching.

Think of it as quantitative equals quantity.

You take raw data, perform specific calculations, and arrive at a hard number.

Quantitative analysis attempts to be objective. That is, for a given set of data, different individuals should arrive at the same conclusion.

With investment risk, calculating the standard deviation is an example of quantitative analysis.

Some people fall in love with quantitative analysis. It is reassuring to get objective results that can be directly compared against multiple investment options.

Plus it is nice to be able to “blame the numbers” when you make the wrong decisions.

For example, two possible investments both have 10% expected returns. You perform the proper calculations and find that investment A has a standard deviation of 5%, while investment B has one of 8%. You “know” that investment A is the less risky option.

While I agree that quantitative analysis is important, I am leery of relying solely on it.

As we saw previously, there are limitations to the use of standard deviations. The same is true for most quantitative analysis.

Often, historic data is a key input for quantitative analysis. Yet past results are no guarantee of future performance.

Also, when modelling future results, variable inputs (e.g. inflation, growth rates, etc.) must be determined. Often these require best guesses of the future. Even the best of guesses may not be accurate.

While quantitative analysis is very useful, it should never be used as the only means of decision-making.

You also need to deal with qualitative aspects to get the whole picture.

Qualitative Analysis

Qualitative analysis is more “touchy-feely” than quantitative analysis.

Whereas quantitative analysis tries to be objective, qualitative analysis is subjective.

Think of it as qualitative equals qualities of the investment.

There are no hard numbers that you can calculate in order to arrive at your decisions. The information is there, one just needs to know how to find it. Usually experience and intuition are key factors in arriving at the correct results.

What one person may discern may be completely different than another might find.

In the realm of qualitative analysis are the two major components of investment risk. Although they are called a variety of names, we will use the terms nonsystematic and systematic risk.

Each investment decision has components of both nonsystematic and systematic risk. If you can learn to identify the key subsets of these two risk components, you will have an advantage over others when making decisions.

Today we will briefly describe both components. In subsequent posts, I shall identify some of the more common subsets of each class and ways to deal with them.

Nonsystematic Risk

Nonsystematic risks are unique to a specific company, industry, asset, or investment.

Note that when I use the term “company”, for ease in writing, I shall also include sole proprietorships, partnerships, joint ventures, etc. under this heading. If there are any differences worth noting, I shall split them out at that point in time.

Nonsystematic risks may also be called specific, non-market, security-related, idiosyncratic, residual, unique, unsystematic, or diversifiable risk.

Systematic Risk

Systematic risk is derived from risks that effect the entire market or a specific segment of the market. Systematic risk factors are far reaching and impact all companies or other investments to some extent.

These factors are not unique to the investment under consideration. They will impact a company regardless of how the company operated or manages its risks.

Systematic risk may also be called non-diversifiable, non-controllable, or market risk.

Dealing With Nonsystematic and Systematic Risk

For passive investors (i.e. investors of financial instruments), minimizing nonsystematic risk factors is not difficult. By adequately diversifying your investment portfolio, you can effectively manage nonsystematic risks.

Some academics believe that by holding between 12 and 18 stocks (or bonds), one can achieve adequate diversification to eliminate nonsystematic risk. Yes, but they need to be the correct mix of assets. When we discuss portfolio creation later on, I will consider how to properly diversify an investment portfolio.

For those managing a business, it is impossible to diversify one company. However, by being able to identify the nonsystematic risks, you can take steps to reduce their potential impact. We will look at the specific risks and how to deal with them in my next post.

As some of the alternate names suggest, systematic risk is more difficult to manage. Although sometimes called non-diversifiable or non-controllable risk, you can actual take measures to reduce this risk. Diversification, insurance, and hedging are examples of ways to address systematic risk. When we look at portfolio construction, I will make suggestions on dealing with systematic risk issues.

Next up, a deeper examination of nonsystematic risk.