Geoff Considine

Choosing Your Portfolio Risk Tolerance

UpToTibet:

For the sake of honesty: I am writing about portfolio theory and I do hope that readers will grasp that I am not laying claim to having invented the efficient frontier :) Harry Markowitz first showed the 'efficient frontier.' Bill Sharpe received the Nobel prize for his work on portfolio theory. I did not.

Geoff

The Humble Arithmetic of Portfolio Management

Hey guys! Great comments. Thanks.

On avoiding timing mistakes:

The research shows that the principle problem that investors face with timing is chasing performance. So, almost any discipline that avoids this will help. Fundamentals can help (a la Arnott). Betting on Reversion to the mean (RTM) also helps a lot. Dollar cost averaging is perhaps least effective because it is all about the new dollars going in. If you have a large portfolio and it drops 20%, it may be a small consolation that the next $40K you put in is buying stuff at a discount.

On taxes:

I was going to add this theme, but it gets complex. If you minimize churn in your portfolio and have individual stocks holdings that you time the sales of to work well with other income in terms of taxation, this can be a big boost. This is potentially a major issue, but its also very personalized to situation.

Regards,

Geoff

Asset Allocation and the All ETF Portfolio

To JAS:

QPP has been very well tested out-of-sample, as you will see from my articles stretching back two years and more. I believe that much of what passes as asset allocation misses some of the key benefits of diversification. The obvious question is why. I think that the reason is that the people designing the portfolios that emphasize US indexes, market cap weighted, etc. either don't use quantitative tools or don't think that the potential purchasers or their products are sophisticated enough to care.

There is also the problem of closet indexing. A lot of mutual funds are closet indexers and these tend not to perform all that well. If you want to get close to an index, you will not include low Beta / lor R^2 asset classes because these increase tracking error vs. an index like the S&P500. Closet indexing is, essentially, the enemy of really effective diversification.

What Is Diversification Worth?

To Montag:

Ahh--but perhaps you have missed my point. I consider Warren Buffett's portfolio to be well diversified. I analyzed top Berkshire holdings using Monte Carlo and the model showed that Berkshire is well diversified. When Buffett talks about diversification he is talking about the 'buying everything' school of diversification. Smater diversification is quite different:

seekingalpha.com/artic...

You can be well-diversified and concentrated--this is not a contradiction in terms. Diversification does not, by any real definition, mean buying some of everything. Diversification means having a portfolio in which the parts exhibit low enough correlation that you can extract more return for a given level of risk than you can with the individual parts. This does not require hundreds of holdings.

Monte Carlo Analysis of Major Berkshire Hathaway Holdings

Buffett's holdings exhibit very low correlation between them. I found GSK because it is low Beta, large cap, reasonable risk, and low R^2. Once I had gone throught this process, I tested in GSK in my total portfolio, looked at financials, and various valuation metrics. Then BRK disclosed they bought it in Q4 of 07. The yield was high (6% or so). QPP liked GSK and I bought it for less than Warren Buffett did and I got a 6% yield or so. Not bad.

Portfolio Theory Vindicated

Typo noted:

The table showing the performance of the portfolio for the 2.1 years through Jan 08 is labeled as going from Jan 2005-Jan 08, which is 3 years. The period used for the analysis is the 2.1 years specified: Jan 2006-Jan 2008.

GC

Monte Carlo Analysis of Major Berkshire Hathaway Holdings

Roger:

IMHO, really low allocations don't make sense. If you don't know enough to want to own more than 1-2%, why not just buy something in its sector index via an ETF?

I have found the Monte Carlo analysis of Buffett really interesting ever since I did it--and this is ongoing. I have found more and more instances in which QPP and Buffett like the same things. Recently, this was the case with GSK.

Geoff

Monte Carlo Analysis of Major Berkshire Hathaway Holdings

To User 173687:

To answer the question of why analyzing the ticker for the a fund might give different results than anayzing the individual holdings, please see this article:

seekingalpha.com/artic...

Geoff

What Is Diversification Worth?

Smart ETF:

First, QPP is non-stationary--which is really important. Second, I hope that you forwarded your insightful comments to David Swensen at Yale, Ray Dalio at Bridegwater, and Ibbotson. I am sure that all of these leading firms will gain value from your insights. BTW, you never mention that Mandelbroit himself has said that his methods are not ready for operational use.

If you can prove the superiority of your approach, just do it--and post your articles to SA, but its is not useful to say that you can do it without showing anything for support.

Outlook for Select Sector ETFs

Ben:

Good question. I would say that this could be one data point among several. Buying individual stocks means that you have a specific view of a firm and want to own it. I would never do so just on the basis of QPP. I would also want to consider default risk via the tails--see my articles on this. Underpriced can also mean 'distress.'

Geoff

What Is Diversification Worth?

To Gale Whitaker:

Your points are addressed in my article her on SA called Black Swans, Portfolio Theory, and Market Timing. Quite to the contrary of what you have said:

1) Market timing costs investors on average 2.5% per year (see DALBAR, for example)

2) People like David Swensen and Warren Buffett have delivered the most consistent risk adjusted returns we have records for and they believe in strategic diversification.

3) A solid diversification strategy does not incur high brokerage / transaction fees--but trying to time the market sure does. There is abundant data that the more, on average, people trade, the worse their results.

4) Actually, a well diversified portfolio has helped many portfolios to reduce losses substantially in this market, without incurring taxable events or transaction fees.

There are all these books on timing strategies for retail investors and they are in opposition to the solid research that institutions use. Hmm.

diversification does not mean simply "buy and hold"---read the article I refer to above.

Regards,

Geoff

What Is Diversification Worth?

To robohogs/jon:

The fundamental weighting issue is not the only reason that portfolios of individual stocks can be better--there are other important features of individual stocks, as I have shown in a range of my analysis. This remains a controversial topic among financial theorists.

QPP suggests that Buffett's highly concentrated portfolio of individual stocks is more diversified than many portfolios which employe massive diversification via index funds. This goes to one of my axioms: if your investing theory suggests Buffett is wrong, your theory is probably wrong.

Diversification can be statistically measured and its not just about buyign lots of individual holdings. This is considered common sense among the high end of institutional investors (as shown here) but this idea is radical for most individual investors and even for many advisors.

Risk Management Lessons from Bear Stearns

To Eric and User (above):

You are both correct that high volatility and higher default risk go hand in hand. This is actually a fact that makes portfolio theory look even more effective. default risk is the extreme tail risk in a fairly efficient market. These banks are high vol and therefore have higher tail risk. These are high risk / high return assets. I am working on a paper that looks at a wide range of financials and a significant fraction are very risky--but the spread is amazing. Some are reasonable and some are downright scary.

I am going to continue to study this theme and write more, so suggestions for stocks to examine are useful.

As far as 'false positives' this is always an interesting issue and it relates to QPP and Moody's KMV and CDS's. Because default and extreme distress is rare, you have limited cases to really validate against. People use case studies as I have done here--and Altman does in his work. It is often called stress testing.

Geoff

Risk Management Lessons from Bear Stearns

to comments above:

I did not profile BSC in my earlier piece because it was not something I was looking at. Many of the large financials are showing higher risk than I want. It is hard to screen the entire universe--your point is correct--but it is fairly easy to screen the companies you are considering buying or own.

A lot of my point here was the following. CDS (credit default swaps) are priced in large part by implied volatility, and QPP outlooks for volatility track implied vol quite well--hence the agreement (on average)--this is well documented in quant circles. The market data contains 'priced in' default risk--which is why CDS prices track implied vol. Many professional firms track these stats and use these models--but retail investors and wealth managers tend to be unaware of these tools / metrics / stats.

The BSC debauchle has brought this issue to the fore and it emphasizes the importance of risk management--as Enron and Worldcom did before.

From The Horse’s Mouth: Yale's Endowment Officer Makes Financial Sense

Pizon:

Good question on taxes. In taxable accounts (obviously) it is generally better to hold individual securities and to rebalance only when the risk-return balance of the portfolio shifts outside of your desired range or when the diversification benefits shrink because of some over-concentration. This is the best approach. Many investors and advisors feel uncomfortable comparing the risk/return benefits of ETF's / index funds to a basket of individual securities because they lack the tools to really capture equivalence and risks of default in individual stocks--but that can be handled.

The average retail investor will capture the vast majority of the benefits of this kind of strategy with index funds, however, and he/she is typically not willing or unable to manage the individual securities to capture these benefits.

Geoff