The Three D's
Despite the modern advances including Modern Portfolio Theory (described below) and its later development, the Fama-French Three Factor Model (described below and in the section on Foreign Investments), there remains considerable room for variation and innovation in portfolio management. In the end, an approach must be found that works for the individual. My own approach, which works for me but might not be suitable for others, involves what I will call the "three D's": Discipline, Diversification, and Dividends.
Discipline involves risk management (especially avoiding losses) and cost and spending control. It also occasionally means having the courage to go against the crowd, buying what everyone is selling and selling what everyone is buying - something far more difficult than it appears. Discipline in investing has to be learned, and the lessons are usually expensive.
Diversification requires subdivision of the portfolio into a large number of different and independent components.
Dividends are used to maintain a minimum acceptable level of income, regardless of market conditions.
Diversification and Risk Management
Asset allocation is predominately a risk management strategy. To quote Sir John Templeton, the role of the manager is to manage the risk. As pointed out by John Bogle in The Four Dimensions of Investment Return, which is included in his book "Common Sense on Mutual Funds", the precepts involved with portfolio management are: risk; costs; time; and returns. The latter can not be managed. Although lack of cost control will damage a portfolio, improper risk control can destroy it. Manage the risk first. That means selling, in part or in whole, an asset that has become too risky, and accepting the tax consequences.
The first precept of risk management is effective diversification. The principles were developed by Harry Markowitz (who received the Nobel Prize for the work), and are deemed "Modern Portfolio Theory" (MPT). Markowitz showed that it is possible to reduce the overall volatility of a portfolio by adding to it assets that moved in different ways. Basically, the downward movement in one asset class can be at least partially cancelled out by the upward movement in another asset class.
The relationship between the movement of various asset classes is defined by the correlation coefficient, which can range from +1 to -1. Assets with a large positive correlation coefficient - say, 0.7 or more - tend to move in the same direction. An asset with a negative correlation would move in the opposite direction. A correlation coefficient near zero means that assets move independently; such assets are said to be uncorrelated. Investors thus should design a portfolio that meets their expected return while including a variety of uncorrelated or weakly-correlated assets. In practice, it is difficult to find negatively-correlated assets that offer a positive return. Assets that should be included in most portfolios are: Canadian stocks; Canadian bonds; US stocks; and international stocks.
It is also possible to subdivide equities not only by country, but by company size (capitalization), by industry sector, or by "growth" (rapidly-growing companies) or "value" (companies that are trading at a lower than average price when measured by certain ratios). Researchers Eugene Fama and Kenneth French have shown that higher returns obtained with small-capitalization ("small-cap") and value stocks than are obtained with large-capitalization ("large-cap") or growth stocks, which dominate the major market indices. This result, which has been shown to hold for several different time periods and for different international markets, is incorporated in what is called "the Fama-French Three Factor Model". Thus, the investor can boost his overall return by overweighting small-cap and value stocks. Because the small-cap and value sectors have correlations of less than one with the total market, the increased return is achieved with a lower standard deviation (i.e. lower risk). This approach is recommended by Frank Armstrong in Investment Strategies for the 21st Century, and also by authors William Bernstein, mentioned above, and Larry Swedroe, author of "What Wall Street Doesn't Want You to Know".
Canadian bonds can be subdivided into normal bonds and inflation-indexed Real-Return Bonds (RRBs). Normal bonds, when arranged in a "bond ladder" of different maturities, give 100 cents on the dollar at regular intervals, regardless of market conditions or interest rates. RRBs protect against inflation, and give better diversification with less risk than do long-term normal bonds. US bonds, which might be added to a portfolio to increase diversification, are also available in normal and inflation-indexed forms. Other asset classes that can be added if desired include global bonds, high-yield bonds, real estate (via Real Estate Investment Trusts, or REITs), gold (or gold stocks), and emerging-market funds.
It is important to realize that the very best asset allocation can only be determined retrospectively - that is, based on historical analysis of what would have been best if only we had known. Also, the best asset allocation for one time period will be different that the best allocation for a different time period. In real life, we are interested in the best allocation going forward, not backward - and, since future returns are unknowable, for that we can only make an educated guess. Our goal should therefore be to achieve a good, broadly-diversified asset allocation that, over time, is likely to meet our investment goals in a variety of future circumstances.
Investors can get an estimate of their portfolio risk based on historical data at Riskgrades.
"Black Swan" Events
One of the more subtle aspects of risk control relates to the fact that stock markets are reasonably efficient (see the next section). Because of this efficiency, anticipated risks are largely (but sometimes not completely) discounted into current prices. Therefore, the main risk investors should be wary of is that of unanticipated or unexpected occurrences. These are sometimes called "black swan" events, because an observer that has only seen white swans can never be certain that black swans don’t exist. Since such events can not be anticipated, at first glance it would seem they can not be protected against. Nonetheless, conservative investors can design their portfolios so that the damage resulting from unanticipated events is minimized. The basic technique is to limit the amount of the portfolio in any single company, sector, or market, and to include a bond component to protect against a simultaneous world-wide market drop. Investors who manage their portfolios in this way are, in effect, deliberately giving up some of their upside in order to protect against downside risk. For many, this is harder to do than it seems, since it means winning positions will periodically be reduced - and the securities sold may well continue to go up for some time.
Some examples of historical events that have resulted in large price drops include the following:
The greatest risk that most equity investors face is that of a simultaneous worldwide market correction. Such a correction occurred in 1997 and 1998, and was precipitated innocently enough by the devaluation of the Thai baht. The resulting correction, sometimes called the "Asian contagion", spread to several countries, and caused a significant drop in commodity prices. This affected not only the Canadian market, but caused a financial crisis in Russia, which defaulted on its loan payments. That in turn caused the collapse of Long-Term Capital Management in the United States. A major financial crisis was averted when Federal Reserve Bank chairman Alan Greenspan organized a bailout.
As the crisis developed, investors in both Canada and the United States saw brief but sharp market drops of about 25%. Because of the drop in commodity prices, single-sector investments faired much worse, with drops approaching 50% in some cases.
Measures to control some of the potential risks are given in the following table.
Risk Control Measures
Efficient Markets, Risk, and Contrarian Investing
One of the more difficult concepts for beginning investors to grasp is that, in a market-based system, the consensus estimate of risk is embedded in the market price of any security. This means that an inexperienced investor can not make any extra money by trading on the basis of what "everybody knows"; such knowledge is said to be "discounted" into the price. To make extra money, the investor either must trade based on inside knowledge - which is illegal - or have some reason to think the consensus risk estimate is incorrect. It also means that risk is not where the inexperienced investor thinks it is.
Suppose, for example, the inexperienced investor sees headlines saying "ABC Company Announces New Product!" and decides he wants to capitalize on this knowledge. But examination of the price history will show that the stock price will have reacted within seconds or minutes of the announcement as the new data are "priced in". Therefore, the "edge" the inexperienced investor thinks he is getting has already been largely removed - and what he thinks is a low-risk "sure thing" is, in fact, anything but because the success of the new product has already been anticipated in the price. Similarly, negative news is priced in very quickly - and the stock the inexperienced investor thinks is high risk may, in fact, not be, because the price has already adjusted to reflect that risk.
This leads to the Efficient Market Hypothesis, or EMH. An excellent description of EMH can be found in the book "A Random Walk Down Wall Street", by Burton G. Malkiel. EMH has several forms, but basically says that the fair price for a security is whatever it is currently selling for. Many studies have been performed on EMH; several market inefficiencies have been identified, but they tend to disappear when they become widely known. For most people, EMH should be regarded as "approximately true": the market price might not be perfectly correct, but the work and costs associated with identifying extra returns (or extra risk) aren't worth it when reasonable results can be obtained fairly simply by rebalancing (see below) and/or overweighting value or small-cap stocks.
Some investors may be tempted to see if they themselves can obtain extra returns. If such an investor thinks the consensus overestimates the risk, the security is underpriced and he should buy. If he thinks the risk is underestimated, the security is overpriced and he should sell. This leads to contrarian investing - doing what everybody else doesn't. Contrarian investing is related to value investing, since the type of stocks a contrarian buys are often "value stocks" - that is, they have lower-than-average prices as determined by certain financial ratios.
Unfortunately, it is much easier to describe contrarian behaviour than it is to successfully achieve it, since those who think they are going against the consensus often have misjudged where it lies. One analogy is to the swings of a pendulum: as market sentiment responds to current trends, it tends to either overreact or underreact. The 2000 NASDAQ bubble was a classic overreaction (and selling opportunity), and was followed by an underreaction (and buying opportunity). But the time to go against a pendulum's movement is just before it is at the end of its swing; if you do so in the middle, you get clobbered.
An individual can not know whether he will be a successful contrarian investor until he tries it. Trying it will almost certainly result in mistakes - and mistakes cost money. Since that cost will be incurred early in an investor's career, it will have a high compounded value - with no guarantee that the tuition fee will result in any increase in skill. As stated earlier, for most people a reasonable rebalancing strategy, possibly combined with value- or small-cap overweighting, is a good alternative.
Individual Securities and Risk
If the investor purchases a particular security - say, stock in JKL Mining Limited or a bond issued by MNO Corporation - he exposes himself to the risk that something untoward may happen to that particular company.This risk is in excess of that associated with the "market risk" associated with the type of security, and is referred to by academics as unsystematic risk. The risk associated with the broad market or index is referred to as the systematic risk of that market or index.
As an example of systematic risk, consider holding a portfolio of stocks or funds that trade on U.S. stock markets. The value of all such securities will be affected by (amongst other things) the US-Canadian dollar exchange rate, which therefore represents a systematic risk. Effective diversification will require the purchase of securities that are not priced in U.S. dollars.
Unsystematic risk can be reduced by holding a large number of securities, either by direct purchase or via a fund of some type. Systematic risk, on the other hand, can not be removed by holding additional securities in the same market or sector, and must be controlled by adding components from other sectors.
There is some argument over how many individual securities are necessary in a portfolio to reduce unsystematic risk. Although some American studies have concluded that as many as fifty stocks may be necessary, the transaction fees associated with such a large number of purchases are too great to render such an approach practical for the individual investor. In my opinion, the amount of portfolio risk added with an individual security should be considered as a function of its portfolio weighting: including 50 individual securities in a component with a portfolio weighting of only 5% would mean that the average weighting was only 0.1%, and the reduction in portfolio risk in going from 25 securities at a 0.2% weighting to 50 securities at a 0.1% weighting would not be worth the additional cost.
One rule of thumb is to keep individual securities at weightings of between 1 and 5% of a portfolio (unless they have a guarantee, such as Government of Canada bonds.) This range provides a reasonable balance between risk and costs.
Investors should continue to manage portfolio risk on an ongoing basis by setting ranges for portfolio components, and reducing components back to the target level (rebalancing) when they exceed a trigger point. Conversely, when components drop to a lower threshold, additional amounts are purchased. This type of rebalancing forces the manager to buy low and sell high. The discipline associated with rebalancing protects the investor against valuation extremes such as the technology bubble of the year 2000.
In some circumstances, rebalancing may improve portfolio returns. This is because of the principle of mean reversion, which states that a period of above-average returns in one asset class is often followed by a period of below-average returns. Mean reversion can be observed by examining the pattern of yearly returns in The Callan Periodic Table of Investment Returns .
Some investors prefer to rebalance at fixed intervals. According to this study by William Bernstein, return increases slightly as the time between rebalancing is increased. Monthly rebalancing is too frequent, but there is little difference between quarterly and annual rebalancing. Rebalancing every four years gives only a slight increase in return, but also increases portfolio risk. Another approach is to rebalance when the nominal ranges of the portfolio components are exceeded. It is important to set the threshold points high enough that rebalancing is infrequent, thus minimizing tax and transaction costs. Example thresholds are ±25% relative, -33%/+50% relative, or ±5% absolute/±25% relative.
Extra costs, particularly taxes, should be carefully considered before rebalancing; this may mean that sales are performed in an RRSP if rebalancing is done frequently. However, switches between entities trading in US dollars in an RRSP may incur a US-to-Canadian dollar conversion fee at some brokerages even if the switch is done in one day. Check with your brokerage before making a switch.
The amount of foreign diversification that a portfolio should hold is a subject on which there is considerable disagreement. One principle that investors can consider is to match the currency of assets to the currency of obligations. A retiree who intends to spend several months wintering in the U.S. may want a significant portion of his cash flow in U.S. dollars. This can be accomplished by using U.S. equities and bonds or by holding U.S.-dollar denominated bonds or U.S.-dollar preferred shares issued by Canadian institutions. A retiree who wants to travel extensively in Europe may wish to hold Euro-denominated bonds. Individuals who wish to spend most of their time in Canada may want to maximize their cash flow in Canadian dollars, since most of their expenses will be made in Canadian dollars. In that case, their foreign content will be utilized for diversification and risk management, rather than cash flow.
For Canadian investors, a useful starting point for asset allocation is often one of the three Financial Post Indexes (FPX Indexes) designed by Richard Croft and Eric Kirzner. These indexes use exchange-traded funds (ETFs), which are baskets of stocks that can be bought and sold on a stock exchange, for its equity components. Many investors will consider the FPX Balanced to be the most useful model. The FPX Balanced contains 25% Canadian equity; 10% U.S. Equity; 15% foreign equity; 40% bonds; and 10% cash. Because different (and better) equity ETFs are now available, a simpler portfolio with better US and foreign equity coverage can now be designed. I will give details in later sections covering US and foreign equity investing.
One vital question in asset allocation is the size of future returns that can be expected. Jeremy Siegel, author of "Stocks for the Long Run", is a leading proponent of the theory that superior returns can be obtained with equities. But many authors are concerned about current high equity valuations, particularly of U.S. large-cap stocks, and predict lower returns going forward.A highly-respected market watcher, Jack Bogle, made the following comment in this speech:
"...it seems sensible for both investment professionals and investors themselves to plan for an era of lower financial market returns. Not 18% for stocks, but perhaps 4% to 8%. Not 10% for bonds, but perhaps 5% to 7%. Not 7% for the money markets, but perhaps 3% or 4%."
An even more pessimistic observation was given by columnist Scott Burns of the Dallas News. Burns referred to a recent paper by Robert D. Arnott and Peter L. Bernstein, which contains this quote:
"The current risk premium [for stocks over bonds] is approximately zero, and a sensible expectation for the future real return on both stocks and bonds is 2 to 4 percent, far lower than the actuarial assumptions on which most investors are basing their planning and spending." [My explanation.]
Since those articles were written, stock markets have continued to drop [and later recovered]. In this speech on Oct. 22, 2002, Jack Bogle suggests that stock market returns may be 8-9% before inflation and expenses, with bond returns of 3-5%. Unfortunately, further increases since that date suggest that the Oct. 22 estimate is optimistic.
Because of the wide fluctuations in stock market valuations in the last few years, it is clear that future growth forecasts are very difficult and subject to continual revision. Nevertheless, single-digit growth rates, rather than double-digit growth rates, remain a reasonable estimate.
Real-return bonds will likely return about 4-6% (i.e. inflation will be at about 2% - the centre of the Bank of Canada target band). Although most equities may only return about 6% before inflation, emerging market equities may return slightly more - say 8-9% - but with substantially higher risk, and should represent only a small component of most portfolios. A balanced portfolio will therefore return at most about 6-7% (4-5% after inflation), and diversification will primarily act to reduce volatility, rather than to enhance returns.
Many investors may find the prospect of such low returns disappointing. Nevertheless, it is better to reduce expectations (and expenses), and to plan for low returns, than it is to plan for high returns and be unable to meet future commitments.
Finally, with such low returns going forward, it will be more important than ever for investors to control costs.