Investment Policy

In 1986, there was a study published by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower called Determination of Portfolio Performance. There study followed 91 pension funds to dissect where portfolio performance is derived.  They divided up plan returns into three components: asset allocation policy, active asset allocation, and security selection.   There research came back that, based on the pension funds that they researched, investment policy dictated, on average 91.5% of the variation in quarterly plan returns.

Whose portfolio is equivalent to a pension fund???  I think I hear birds chirping.

With that being said, a new study has come out published by Roger Ibbotson, James X. Xiong, Thomas M. idzorek, and Peng Chen titled, Asset Allocation and Investment Strategy are Equally Important. This study concluded that the majority of any portfolio’s returns is attributable purely to the beta – the movement of the markets.  According to the study as much as 70% of returns are from a portfolio’s beta.

Wow.  Whoope-ta-doo!  That really answers all the questions out there about how to invest.  I think we can all breathe a sigh of relief now that we have that information at our fingertips.

Unfortunately, we all have to live in the real world where our portfolios are structured like pension funds and investment decisions have an impact on our lives.  Of course, if you look at the performance of many pension funds maybe it is a good thing that individual investors don’t HAVE to invest like them.

Strategy?

I had a good question last week about www.statpro.com – which is a portfolio analytics software that will help you determine the amount of risk in your portfolio.

I don’t know anything about the service or software so I can’t say whether it is good or bad (and even if I could that should be some what irrelevant because it might be bad the way that I would use it and good the way that you would use it).  With that being said, if you are going to use a software to evaluate the risk in your portfolio, then you better completely understand how they measure risk.  What are the parameters that they use, how were the developed, have they been stressed tested under “extreme conditions”, why is their system better than others?  Then you take that information and, just as you would with an investment, you analyze it to determine if it is worthless or valuable.  Because at the end of the day, don’t think that the U.S. banks weren’t using metrics to determine the risk in their capital structure.  They had extremely intelligent people using math that few people care to learn to make sure that they didn’t make any stupid mistakes…. Well, we all know that they made a bunch of stupid mistakes and they all drove off the same cliff – just at different speeds (AIG did it in a Ferrari while Morgan Stanley appeared to have done it alongside Fred Flintstone).

Let’s talk about reducing risk in your portfolio using more traditional measures.  One of the main sources of risk in managing your independent portfolio is listening to so many different sources without having a system or process to put it all into an overarching view.

Charlie Munger, who is Warren Buffett’s business partner, has spoken extensively about having a system of checklist to guide you in your process – whatever it may be.   Mr. Munger has been quoted as saying,  “No wise pilot, no matter how great his talent and experience, fails to use his checklist.”   I think this is a key to building a portfolio that has less risk.  As I mentioned recently, I think that developing your own process and having your own checklist is one of the most important factors in reducing risk.

Think about what would happen if you don’t have a system or process in helping you evaluate an investment idea or theme.  If you don’t have a system or process and you simply read a bunch of investment newsletters, listen to CNBC, or sort through the ideas on investment forums then you are going to make some investment decisions based on someone else’s opinion – which is obviously an enormous error and introduces a huge amount of risk into your portfolio.

On the other hand, if you develop your own process then you can take into account a piece of information as it pertains to your process, internalize it and then make an informed decision about how you incorporate it into your portfolio.   Of course, this goes to the next best way to reduce risk in your portfolio – knowledge.

Mr. Munger has also said, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time — none, zero.”  That sums it up pretty well.  In order to be good at the game of investing, you have to immerse yourself in information that will grow your knowledge about your style and challenge it at the same time.  A process or system that doesn’t get challenged regularly will almost certainly fail.  You have to learn and understand the opposing view of why you could be wrong.  It might only serve to strengthen your resolve or it might help you incorporate a new idea or step into your process.

So I guess what I am saying is that feel free to use tools and resources to check the risk in your portfolio, but at the end of the day, if you are self managing your portfolio, there are two excellent ways to reduce risk right at your fingertips: develop and refine your checklist/process and increase your knowledge about your process.  Don’t trust the next guy just because he has built a fancy mathematical model that no one else understands because if he uses bad assumptions in his model then he gets bad data out and that is a risk that you don’t want to take.

Portfolio holdings

I was thinking about the number of individual stocks that people hold in there portfolio this afternoon. If I have to 50 stocks in my portfolio then it is likely that on average no one position makes up more than 2 percent of my account.

The great news about that, and the one often qouted in the financial media, is if anyone stock goes bankrupt then I only lose 2 percent of my holdings. That sounds like great news but it also means that if any one stock doubles in my account then I have only made 2 percent. If I don’t lose much if I am wrong and don’t gain much if I am right then what is my motivation to spend a lot of time researching any one stock. Under this scenario, my risk/reward is so muted that I can be content with average. As a matter of fact, I woulds argue that you HAVE to be content with average.

For those people that don’t have the time or the energy to put into research then you should be content with average because if you put in limited research and effort you will be lucky if you “get” average. But for those that have the time and financial understanding of companies you need to ask yourself if you are in the game to be average.

Risk?

I’m in the middle of reading a book on Financial Statement Analysis and the authors have decided to take a moment to define “investment theory and financial statement analysis”.

The book leaped right into the debate by defining the beta coefficient theory as, “total risk associated with an investment is comprised of two elements: systematic risk, the risk attributed to prevailing market movements, and unsystematic risk, the risk unique to a specific security.”

We all know where this leads us  – right down the path of referring to beta as the definition of systematic risk.  Where a security with a beta of 1 moves perfectly in line with that of the “market” and a security with a beta of 1.5 moves 50% more than the market (for example if the “market” was UP by 1% in a given day then a security with a beta of 1.5 would be up 1.5% on that given day and on a day when the “market” was DOWN 1% this security would be down by 1.5%).

The theory says that you want to hold a diversified portfolio to eliminate unsystematic risk away (remember that this is the risk unique to a specific security).  In other words, you don’t know the next company that has a “BP oil spill” type of event so by holding a bunch of companies in your portfolio you reduce the impact that this type of thing would have on your overall net worth.

For many investors, this is the absolute right thing to do.  Hold a diversified portfolio because you don’t have the time to do the research necessary to hold just a few select companies.  However, for those investors who are interested in spending the time necessary to research companies I would argue that you want to hold as few securities as possible to try to eliminate ‘systematic risk’.

If you know your companies inside and out, why do you want to deal with “market risk”.  You want to eliminate “market risk” because it is erratic and unpredictable.  If you have good knowledge of your companies, then you know the risk that are involved and are willing to accept them because you believe, based on your due diligence, that the management team is able to deal with them.  Diversifying to the point that you have market risk means that you have now introduced an unknown risk to your portfolio – something that you can’t control.

This is what I want in my portfolio of individual stocks – less systematic risk and more unsystematic risk.  I want to be rewarded or penalized for my hard work so I will continue to own very few stocks in my portfolio.

An interesting comment

I was reading John Mauldin’s Outside the Box this morning and was interested in a piece of the article.  For those of you who are reading my post (anyone???) who don’t know John Mauldin, he is a brilliant individual who has written several books including one of my favorites, Bulls Eye Investing.  In addition, John has a weekly newsletter that he sends out – free of charge – to anyone that wants to sign up.   I would recommend signing up if you are interested at his website – www.johnmauldin.com.

This week in Outside The Box, he reproduced an article by Michael Lewitt who recently published a book, the Death of Capital.  In it he wrote:

“Capital is not a thing or a category; capital is a living breathing phenomenon.  Capital is an expression of the human relationships that generate economic  value.  Just as these relationships that generate economic value.  The most important attribute of capital as it functions in the real world is that it is a relationship; as such as it has the capacity to change form.  This is often described as its liquidity function.  Capital is also a human construct; it is not something found in nature or subject to scientific laws, despite the misguided attempts of today’s rocket scientists to claim that is possesses such qualities.  Most importantly, capital is unstable.  If capital were better understood for what it is, it could be better managed and regulated.”

I think that is a pretty powerful statement.  As investors, we are always looking at the return on capital but how do we define capital.  The general definition of capital would be the financial resources available for use.  When evaluating a company, you have to question whether or not the managers understand CAPITAL and how it impacts their business.  Capital isn’t just the buildings, inventories, equipment and other assets that make up the balance sheet they are the relationships that drive a business, the brand that the business has created, and the people that go in every day to make it work.

When evaluating a business, it’s going to be important to determine if the manager and/or executive team is getting the most out of that part of the capital.  Part of that is going to come through in the numbers because a company that is leveraging that part of its ‘balance sheet’ should definitely going to be getting a good return on its physical assets.  Nonetheless, I enjoyed Michael Lewitt’s thoughts on the topic and wanted to share it with you.