ColemanInvestingBlog: January 2010

Saturday, January 23, 2010

why the model portfolio is overweigted to small caps

Once one has chosen which stocks to include in a portfolio, there are many ways to decide how much of each to include relative to the whole (i.e. the weighting of each stock). The three most common methods are as follows:

1. Market Capitalization. Each company has a market value of it's total equity, which is simply the number of its shares multiplied by the price of each share. Most stock indexes are set up such that the portion of the index allocated to each stock corresponds to that company's market cap relative to the total market cap of all the companies in the index. If one wishes to construct a portfolio that will closely mimic the performance of the index (e.g. S&P 500), then the stock allocations in the portfolio will also have to be based on market cap weightings.

For instance, one first adds up the market cap of all the companies in the portfolio (say this total is $100 billion). Then, each individual company's market cap is divided by that total in order to calculate the portion of the portfolio that should be allocated to each individual stock. So if a particular stock's market cap is $5 billion, then 5% of the portfolio would be allocated to that stock ($5 billion / $100 billion = 5%).

Some benefits to this approach are that it's simple to compute and one's portfolio will not significantly under-perform the chosen stock index. A drawback is that the portfolio performance will be most heavily influenced by the performance of the few stocks with the largest market caps. For instance, the top 10 companies in the S&P 500 account for roughly 20% of the total market cap of all the companies in the S&P 500. So, even if a portfolio holds all 500 stocks in the S&P 500, but the portfolio is weighted according to market cap, then 20% of the portfolio's performance will depend on the performance of those 10 largest companies.

2. Equal Weighting. The simplest method - the weight of each stock equals 1 / (# of stocks in the portfolio). So if one's portfolio holds 100 stocks, then each stock is ascribed a 1% weighting in the portfolio. If 200 stocks, then each stock is ascribed 0.5% weighting, etc.

A benefit to this approach is that one's individual stock risk is reduced. No need to worry about waking up one morning to find that the largest company in your portfolio has been falsifying their accounting statements, is declaring bankruptcy, and your portfolio just lost a large part of it's total value. The drawback is that, in comparison to the index, one's portfolio will be more allocated to smaller companies (i.e. 'small caps'). Therefore there will be times when one's portfolio will outperform the index and there will be times when the portfolio will under-perform the index, the latter of which, because we're all evolved with a sensitivity to relative status, will cause one to feel like a failure and question one's own convictions with respect to investing strategy. Aside from the emotional distress (assuming one isn't mentally immunized against it), these feelings might cause permanent under-performance if one capitulates and switches the portfolio to market cap weightings just before the small cap stocks subsequently outperform large-caps because of (think: Wizard of Oz voice) Reversion to the Mean.

Just FYI, historically speaking, in the long-term, small caps have outperformed large caps, but I don't believe this will necessarily always be the case (it's probably just a historical quirk). Better bet is that over long periods of time, large and small caps will realize equal performance.

3. Mean-Variance Optimization. Theoretically, this method should provide for the best performance. Essentially it attempts to weight stocks in the portfolio according to (i) how the price movements of each stock correlate with price movements of the other stocks and (ii) the expected long-term appreciation of each stock, the net result of which should provide for maximum investment returns for any chosen level of stability in the portfolio value (i.e. how much the value of the portfolio bounces around and gives you heartburn). Unfortunately, this method doesn't outperform the simple method of Equal Weighting. Personally, I think that's because the calculated stock weightings according to Mean-Variance Optimization are extremely sensitive to the assumed volatility and expected return of each stock. Since it's impossible to predict the actual returns of each individual stock, it's a matter of garbage in, garbage out.

Side Note: I do think that on average, the volatility of individual stocks tends not to change drastically over time (at least relative to the volatility of stocks in general). So a variation of this mathematically oriented methodology can be useful if one wishes to simply minimize portfolio volatility, or even dial in a certain level of portfolio volatility.

Conclusion. The stocks in the model portfolio were initially weighted by first grouping the stocks into economic sectors. Each sector was allocated somewhat according to Market Capitalization. For instance, the Vanguard Total World Stock Index (ticker: VT, which is one of our benchmarks) has about 14% of its portfolio allocated to companies making consumer goods, so therefore I allocated roughly 14% of the hypothetical money in the model portfolio to consumer goods companies. Now, for various reasons the sector weightings of the model portfolio don't exactly match up to all the sector weightings of VT (mainly because I did not want to include oil companies or banks), but the point is that the sector weightings of the benchmark were indeed a consideration when establishing the sector weightings of the model portfolio.

Lastly, within each sector, the individual stocks were Equal Weighted because (i) I don't want to have a significant allocation to any individual stock and bear the idiosyncratic risk and (ii) I don't want to do the data gathering and mathematics associated with mean-variance optimization when it doesn't work anyway.

You may have noticed I said this is how the model portfolio was initially allocated. Over time, as certain stocks have outperformed others, the weights necessarily drift. Next week, perhaps we'll cover re-balancing and the pros and cons thereof. Then, since re-balancing will provide a nice segue to market-timing, I think we may switch gears from talking about what to buy/sell and begin talking about when to buy/sell, which (especially in the short-term) is a much more important determinant of portfolio performance.

Sunday, January 17, 2010

the only investment guide you will ever need

Folks, I truly believe this is the best book you can buy on the subject of investing. There is a nice summary review here. Do yourself a favor and read the first 59 pages for free here. Then buy the paperback for about $10 at Amazon.

Saturday, January 16, 2010

beta

Assuming one's portfolio is well diversified such that the unexpected misfortune of one company is generally offset by the unexpected good fortunes of another company, then the changes in overall portfolio value are generally related to the overall economy. This is because all companies' fortunes are somewhat related to the economy (in the short-run) and when the economy suffers, almost all the companies' business prospects face a headwind. Although when this happens, there will always be a few companies that perform well in spite of the economy, due to some random circumstance, but there is no way of knowing ahead of time which companies will do so.

Beta is simply a measure of how much the portfolio value correlates with the overall stock market, which in turn reflects market participants' expectations for the overall economy. For instance if your portfolio beta is 2.0 and the stock market appreciates 10% one month, then statistically speaking based on historical performance, your portfolio value is likely to increase 20%. If your portfolio beta is 0.5, then your portfolio value is likely to increase only 5%. So what? Well, if the economy is sucking wind and you're therefore at greater risk of financial distress in your own life (job loss, etc), that is the worst possible time for your portfolio (savings) to lose value. So, if one chooses to invest money in stocks that they can't stand to be without for at least 10 years (even during a stretch of unemployment) - which no competent financial professional would ever advise - one should at least avoid constructing a portfolio that will compound the problem by being overly sensitive to the economy.

Now, conventional financial theory asserts that if all investors view the world as outlined in the preceeding paragraph (i.e. all investors are rational), then they will be less attracted to stocks that are overly sensitive to the overall stock market / economy. This collective aversion to 'high beta' stocks, will cause those stocks to fetch lower prices, even if these more volatile companies' future business prospects are equal to the business prospects of 'low beta' stocks/companies. And if one pays less now for a high beta stock (vs a low beta stock) and that high beta stock nevertheless achieves average long-term profit growth equal to the low beta stock, then the investor will end up with a higher investment return (because in the long run, stock price appreciation tracks the company's profit growth).

Sounds great, right? If one can do without their savings for a long enough time period to ride out economic cycles, then one can collect a premium investment return by purchasing high beta stocks and constructing a portfolio with a high average beta! Trouble is, it doesn't work because investors are not 'rational' in the sense outlined above. Rather, people are more concerned with keeping up with the Joneses when the stock market is appreciating than they are with protecting themselves from a declining portfolio value when the economy inevitably falters (after all, it's not so bad to lose money so long as their friends are also losing money). Therefore, investors pay no heed to a stock's beta when deciding whether or not the stock price is attractive. If anything, an investor will pay more for a stock with a high beta, based on a presumption the overall stock market is going to rise and the high beta stock will therefore outperform (which of course it likely will in the short-run, if the investor's prognostication for the overall stock market proves correct). Wouldn't that same investor be fearful of underperformance if the overall stock market declines? Nah, Mr. or Ms. Investor wouldn't buy stocks at all if they thought the overall stock market was about to decline.

So where does that leave us? Why does our model portfolio contain stocks with low betas such that the average portfolio beta is only .79 (as measured against the S&P 500)? It gets back to 'addition by subtraction'. If investors are overpaying for high beta stocks, which represent companies whose profit growth will ON AVERAGE IN THE LONG RUN (the best caveat EVER!)not be any better than low beta stocks, then those high beta stocks will provide a lower long-term return (again, because long-term stock prices track profit growth). Obviously, we want to avoid owning stocks that will underperform due to this factor.

For more on the dynamic outlined above, I highly recommend a new book by Eric Falkenstein called Finding Alpha (which is where I learned about this - thank you, Mr. Falkenstein). I would say the book is a little advanced for anyone not previously acquainted with finance, but it's so full of knowledge and well written, I think anyone who has in fact had an introductory class in finance (or read up on basic finanical theory themselves) would be able to learn something from this book even without understanding each and every page. But I recommend first watching the free videos before deciding whether or not to spend money on the book.

Monday, January 11, 2010

Sunday, January 10, 2010

Addition by Subtraction

I rarely feel highly confident that a particular sector of the economy is going to outperform the rest. More often, I have a view that a particular sector will underperform (call me a pessimist if you like). Therefore, my method of portfolio construction begins with selecting a large number of stocks that will both limit exposure to the travails of any individual company (i.e. idiosyncratic risk) while providing exposure to the various sectors of the global economy, with sector weightings in line with those of the global stock market. Then I simply cut out or reduce the weights of any particular sectors I feel will underperform. For example, in looking at the model portfolio holdings listed in the posts below, you may have noticed an absence of (think: Al Gore voice) banks and 'big oil' companies.

I see banks as leveraged plays on bond holdings and I don't think highly of the risk/return profile of bonds (100% potential loss with minimal potential gains in the context of an uncertain world: see Black Swan). As for Big Oil, my view isn't predicated on the price of oil per se (in fact I think the price of oil could easily rise very high, very fast), but is based on the idea that oil companies' costs (of extracting the oil) will rise even faster than their revenues (the price of oil) because over time it will require more and more energy/money to lift the same amount of hydrocarbons out of the ground per year and I don't see this dynamic being continually offset by improved extraction methods/technology.

Another phrase to describe this approach is 'enhanced indexing' - where the indexing is accomplished by first mimicking the sector weights of the overall market and the enhancement is accomplished by removing those sectors that are anticipated to underperform.

I think perhaps next week we might cover why our model portfolio is 'overweighted' to small cap stocks, rather than large caps, and why I favor that portfolio composition. Or perhaps we could cover a metric known as 'beta' and why the average beta of the stocks in our portfolio is purposefully low.

Saturday, January 2, 2010

Benchmark

When evaluating investment performance, it's often helpful to compare the results to some kind of benchmark. Otherwise it can be tough to know if your investment decisions are adding or subtracting value. It's important that the potential investments that comprise the benchmark are inclusive of the investments you will be selecting for your portfolio. Otherwise, you could 'go outside' your benchmark to make investments and the comparison would not be as relevant. For instance, if my benchmark were say the Dow and I go purchase a bunch of brazilian stocks, then my results may exceed those of the Dow Jones Industrial Index, but the comparison would be irrelevant because the risk profile of my investments would be nothing like the risk profile of the stocks comprising the Dow.

Since I think it's beneficial to be as diversified as possible, I don't want to limit my 'investment universe' and will be amenable to purchasing stocks with any geographic, market cap, or sector characteristics. Therefore we need a benchmark that is similarly unlimited. To that end, I like the following:

Ticker: ACWI - This is an Exchange Traded Fund (ETF) that seeks to mimic the performance of the MSCI All Country World Index, which is designed to measure the combined equity market performance of developed and emerging markets countries, and was developed by MSCI Inc. as an equity benchmark for global stock performance. This is a passive benchmark, meaning the manager does not attempt to buy and sell various investments in an attempt to 'beat the market'.

Ticker: VT - This is an ETF that seeks to mimic the performance of the FTSE All-World Index, which includes approximately 2,900 stocks of companies located in 47 countries, including both developed and emerging markets, and was developed by Vanguard as an equity benchmark for global stock performance. This ETF is also passively managed.

Ticker: FWWFX - This is a Mutual Fund that seeks growth of capital (invests in growth stocks). The fund's equity investments may include established companies and new or small-capitalization companies. Although it may invest anywhere in the world, the fund mainly purchases securities of issuers in developed countries in North America, the Pacific Basin, and Europe. The fund may invest in debt securities of any rating. It may also invest in closed-end investment companies. This mutual fund is actively managed.

Lastly, although I don't consider it an appropriate benchmark, I've included a graph of the watch / model portfolio vs. the S&P 500 index, which contains 500 of the largest companies in the U.S., just because a lot of people are U.S. centric in their investing mindset and would want to know where we stand vis-a-vis this metric.