Today we have a guest lecturer for the Saturday Lecture Series, it’s Flyovercountry! And a well done lecture I might add!

An I do believe that the guest lecturer will be around to answer some questions, if not, you all know where to find him. Enjoy your coffee and donuts!

 

The Lecture comes with a caveat:

Here is the Saturday lecture series submission.  I believe it may help some of the folks in our community.  I feel the need to give some caveats though.  Currently, I only hold liscensure in Ohio.  While the concepts are valid even in an international context, by no means should anyone construe this as specific advice.  A local trusted professional should always be consulted.  The concepts are also very general, and as such advice given to one person may not be appropriate for another.  I would be willing to have more individual conversations with folks, but these conversations, if held must remain private.  (I am afraid of someone sharing their personal allocation model with their much older uncle, and having that advice wreck the much older uncle’s life, since a far different allocation model may have been appropriate for him.)  If you feel it appropriate to do so, you may offer that people who inquire may be given my email address.

 

It happens all of the time, people I’ve just met find out what I do for a living, and they ask me to give them a stock tip.  My first thought is invariably crap, how do I politely let this person down, and help them realize that they have asked me to behave in an unethical manner.  The conversation I need in order to provide any advice is much more involved than engaging in what I refer to as picking ponies.  A dinner party or another relaxed social environment is the wrong place to give involved advice or seek to have probing financial discussions.  I almost always end up saying this, which by the way is the simple truth, I always advise my clients to utilize an investing technique termed, Asset Allocation.

 

To understand Asset Allocation, and the different kinds of this technique, I am going to give some background.  During the 1950’s, an economics professor at Harvard by the name of Harry Markowitz conducted a study of the nation’s endowment and pension funds to try to determine what made a portfolio successful, how to measure that success, and how to measure the risks involved in investing.  His study won him a Nobel Prize for economics in 1990 and is referred to as Modern Portfolio Theory.  Successful mastery of his theory is the basis for the Finra exam which allows a securities professional to register as an investment advisor and charge a fee for advice.  Here are some of the conclusions involved in Markowitz’s work:

 

91% of a portfolio’s performance is dependant on asset allocation.

6% of a portfolio’s performance is dependant on security selection.

2% of a portfolio’s performance is dependant on timing.

1% of a portfolio’s performance is dependant on other factors.

 

So, here I am, in a world were people love movies like Wall Street, The Boiler Room, Trading Places, and whatever else, thinking that really represents life.  By looking at what particular stock to buy, people are generally focusing in on the bottom 7% of investing importance for whatever their goals are.  The top 91% is most often ignored, because it is the least often talked about.  It is the least often talked about because it is boring stuff indeed.

 

Everyone has the guy at work who brags about his great stock picks.  He will tell everyone and their uncle how great he is doing during a bull market.  Please keep in mind that during the late 90’s, when things were booming, the Today Show had a monkey on picking stocks against so called, “Wall Street Experts.”  The monkey won.  The Woolworth Store in my neighborhood had a stock boy in high school who’s dad was bragging about how his son was a super genius because he was able to direct his portfolio to make mega money.  The funny thing is, when the bear market hit, as by the way it always does, not a single person was bragging about how their stock picks shit the bed.  Such is the nature of picking ponies.  You can get rich that way, but you can not stay rich that way.  Love is never having to say you are under diversified.  To properly diversify a portfolio using Asset Allocation and single stock picks will generally take about a $Million.  So, that being said, let’s discuss what this term actually means.

 

Investments can be broken up into what we term as asset classes.  Cash is one, precious metals another, Large Company stocks, Mid Sized Company Stocks, Stocks can be broken down into Value, Blend, Growth, Real Estate, Commodities, etc.   All in all, there are 24 major asset classes.  Putting a portfolio together is a function of picking which asset classes to use, and in what proportion.  This is dependant on many factors, which include the growth rate needed, the growth rate wanted, a discussion about the amount of risk an investor is comfortable with and the amount of risk which an investor can actually afford.

 

So, now that we understand what an asset class is, and how it relates to a portfolio, how do we determine what mix is appropriate for each individual investor.  This discussion involves something called the efficient frontier.  This is a theoretical demarcation which proposes an optimal average rate of return based on a given amount of risk incurred.  Risk in the world of investing refers to the amount of expected volatility an investment will likely incur over time.  Smaller company stocks will likely fluctuate in value more than large company stocks, but have the greater potential for greater increases in value as well.  Bonds will pay a more steady income, but will not appreciate in value as rapidly as stocks.  I will often hear the phrase, “my broker is a genius, he got me an x percentage rate of return.”  Then I will ask, how much risk did you take on to get that return, and over what time frame did you realize this bonanza.  I can not tell you when the next market crash will be, or what will cause it, but I can promise you that it will happen.  I can also promise you that we will average a bear market 1 year in 5 for the remainder of our lives.  Each of these events will be duly reported as the end of financial life on our planet as we know it by an media that loves hardship and disaster.  Each and every time it happens, the markets will recover.

 

Will it be possible to actually ever be on the efficient frontier, probably not, but we do have some techniques to help us get very close.  There are several research firms who have backdated portfolios, I’ll give an explanation of backdating in the next paragraph, and developed model portfolios based on where this frontiers existed based on a historical perspective for the desired time frame.  Generally speaking, it is remarkable how similar the model portfolios are between the different research firms.  Typically, a portfolio will be rebalanced twice per year to maintain its overall target.  This is done because asset classes rarely grow at the same rates.  So for instance, during the year of 1999, Small Cap Growth Stocks were the top performing Asset Class with an average increase of 43.09%.  During that same year, Real Estate was on the bottom with an average decrease of  2.58%.  If you were in a portfolio where we had 3% of your assets invested in Small Cap Growth, and @% invested in Real Estate, at the end of 1999, we would have sold whatever portion of you Small Cap Growth Stocks necessary to reduce your total exposure to 3% and used those funds to purchase Real Estate to bring that exposure back to 2%.  In 2000, Real Estate finished on top, and Small Cap Growth finished on bottom.  No, the technique does not always work so perfectly, but it does insure that as a general rule, your exposure to risk will be consistent with your ability to handle risk, and will also force you to buy low and sell high, which is how money is made.

Backdating needs to be explained.  I am not Nostradamus.   To a large extent, anyone claiming to be able to predict the future is full of baloney.  I like to tell people my expertise is in not knowing what will happen next.  What I am able to do is look at historical trends over the last 130 years.  I am able to determine that those trends have maintained relative consistency during that time frame.  Using that as a guide, my best estimate will involve seeing those trends continue.  While it is true that on a micro level, past results are not indicative of future performance, backdating a model portfolio, especially by looking at asset classes only, a reasonable assumption can be made about a portfolio’s risk reward characteristics.

 

There are different styles of Asset Allocation, but mostly they can be broken down into two distinct approaches.  Strategic picks one model portfolio and always reverts back to that model, regardless of market conditions.  Several studies have suggested that investors who practice this approach are the most successful investors.  Part of the reason for this is that these investors are the least likely to completely leave the market during bear markets.  A tactical approach allows for adjustments to a portfolio to attempt to capitalize on perceived changes to market conditions.

 

This article is meant for general informational purposes only.  I have not met individually with any of you, so nothing here should be taken as specific advice.  Also please note that there is a very high percentage chance that I am not licensed in your state.  As such, I will say that you should seek the advice of a CFP, a CRPC, a Chfc, or a Clu within your community to discuss what is appropriate for you.  If you have access to an employer sponsored plan through your job, (401k, 403b, or 457 plan,) there was probably a printed piece of material you were given which gave this same description as part of the enrollment package.  I was designed to guide you to picking your own portfolio as close to the efficient frontier the specific funds within your plan would allow.

 

Further reading:

Markowitz’s 1990 Prize in Economic Science (9 page pdf)

(yes, it is required! 😆  )

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