A New-Age Investment Philosophy
Potential Return and Volatility
At the most basic level, we're looking for two things out of our investment portfolios: (1) high returns and (2) low volatility. The goal of any investment strategy is to maximize investment returns while minimizing the fluctuations of the portfolio's overall value. In an ideal world, our portfolio returns would look something like the chart below:
This straight line increase in the value of our portfolio is created by earning a 10% return every year without fail. This is ideal because we know what the value of our portfolio will be at any point in the future. So, if I want to have $100,000 available at retirement, I'll now exactly how much I need to invest every year to get to $100,000 at retirement. Unfortunately, this isn't a reality. Investments fluctuate in value on a daily, weekly, monthly and annual basis. I would argue that no investment, not even government bonds, provides a certainty of real return (more on this later - for now, real return is the return we receive after inflation of the money supply is taken into account). So, we're left with charts of the value of our investment portfolio looking more like the chart below:
In the real world, we're not sure what the value of our portfolios will be in 3 months, 1 year, 5 years, etc. This characteristic of our portfolios is magnified by holding more volatile investments and reduced by holding less volatile investments. Generally, investments are more volatile the less certain their future value is. For example, a government bond issued by a G20 nation has a relatively certain future value because the market has a high level of confidence that the government that issued it will pay you the interest and principal payments as outlined in the bond contract until the bond matures. On the other end of the spectrum, the value of a share issued by an upstart biotechnology company whose entire future is based on a new drug that has yet to be approved by the U.S. Federal Drug Administration will be more volatile because the market is unsure of the future value of the Company. There is generally a pretty strong relationship between the potential return provided by an investment and its volatility. So, each one of us has to decide where the appropriate trade-off between return and volatility is for us personally. This is a combination of our time horizon to retirement, our personal tolerance for volatility and our investment preferences (e.g. someone may want to invest in green energy for personal or ethical reasons). This website will outline 5 investor profiles along the return/volatility continuum.
The Principle of Diversification and its Weaknesses
Most investment books and investment advisors base much of their advice on the principle of diversification. Diversification is a simple principle that most people intuitively understand. It`s commonly referred to in popular english as "not putting all of one's eggs into one basket". The idea is that you should hold a number of different investments so that you're investment returns and the future value of your retirement portfolio are not tied to just one or a few investments. For example, if I only held IBM stock in my investment portfolio and a technological revolution came along tomorrow that crushed IBM and led IBM on a quick path to bankruptcy, my stock would fall quickly and my retirement savings would dissapear. So, diversifying into various investments is clearly a smart thing, and in general leads to lower volatility for our portfolios. But, there are two common misunderstandings when it comes to diversification:
Correlations between investment returns are not static and in reality change frequently. The principle of diversification is based on the concept of correlations between investment returns. That is if, based on historical data, IBM stock moves up in price when Wal-Mart stock moves down in price, and I believe this relationship will hold in the future, buying both IBM and Wal-Mart stock will provide diversification to my portfolio because their prices don't move together (hence the value of my portfolio is less volatile). Now, I don't want them to move exaclty the opposite in price so that I don't earn any positive return over time. What I want is for both of them to have a positive expected return and still move in different ways to offset each other so that over time I have a positive return but less volatility. The problem is, the correlation between IBM and Wal-Mart that I established using historical data may not hold in the future, and in fact is unlikely to hold. So, I think I'm getting diversification but I'm not, and when a major market event happens that crushes the price of IBM stock, it may also crush the price of Wal-Mart stock and I'm left exactly where I would have been without Wal-Mart. What's important to know is that correlations are much more persistent on an asset class level, and to a lesser extent on a sector level, than on an individual stock or bond level. That is, the correlation between the stock and bond markets or the correlation between the general Information Technology ("IT") sector and the general Retail sector is more stable than the correlation between IBM and Wal-Mart stocks. But, just like we saw in the financial crisis of late 2008, large market events tend to take all sectors of the equity market down in price, not just a few sectors. So, we shouldn't be overly dependent on the correlation between equity (stock) sectors, and are much better off diversifying by owning various asset classes (i.e. stocks, bonds, commodities, etc.).
Diversification isn't a function of the number of securities in a porftolio. Too often I've seen investment advisors telling their clients the way to obtain more diversification is to purchase more stocks and bonds different from the ones that the investor already owns. While this is generally true, it misses the point and leads to poor investment decisions. For example, a huge company like IBM is already diversified to an extent. That's because IBM has multiple business units providing different products and services in various geographies around the world. IBM is diversified across product lines, across the Information Technology supply chain (the chain of product or service flows throughout an industry) and across geographies. So, owning IBM is just like owning a collection of mid-sized businesses in the IT sector. The main difference is that IBM's creditors (banks and bondholders) generally have recourse to the entire entity, so if one business unit performs poorly the other business units have to pay off the debt, but otherwise it's already diversified. On the other hand, a small business that owns three fashion jeans stores located in Seattle is not diversified. It's concentrated in one type of product, in one segment of the supply chain and in one geographic location. The point here is to keep in mind that we don't need to own a bunch of investments to be diversified. What's important is that we own the right mix of investments.
Correlations Beyond our Investment Porftolios
When you're managing your wealth for retirement, you need to take more than just the contents of your investment portfolio into account. Since our goal is to manage our total wealth available at retirement, we need to expand our focus beyond our investment portfolios to include our other assets and income streams as well. Let me explain. We discussed the volatility of our portfolios in the first section of this page, and I mentioned how the correlations between investments plays a role in the second section. Well, our other assets and income streams also have correlations with our investment porftolios. So, to reduce the volatility of our total wealth, we need to consider the nature and value of our other assets and income streams when selecting investments for our portfolio. This commonly shows up in two ways for most people:
Your net equity in your real estate holdings. Most people saving for retirement own a house and have a mortgage on that house. The net equity on that house represents an investment in an asset class that's part of their overall wealth holdings. If your net real estate equity is worth $200,000, your investment portfolio is worth $100,000 and your other net assets (after all debts) are worth $50,000, you have a significant portion your total wealth invested in real estate (whether your principle residence or apartments you rent out, etc). So, you'd want to minimize your investments in real estate investment trusts (REITs) and select your RRSP investments to properly round out your total asset holdings. Further, you'd want to consider the correlations between the value of your real estate assets and your investment portfolio. This isn't an issue for most Canadians, but if prosperity in the neighbourhood, city or region you live in is driven by one or two industries, you'll want to reduce your exposure to these industries in your investment portfolio so that the value of your total wealth isn't overly exposed to the one or two industries. A Calgarian should hold a smaller proportion of oil & gas investments in her portfolio than someone in Quebec because the value of her real estate holdings is already highly exposed to the success of the oil & gas industry.
You and your spouse's income. Picking right back up where we left off with the Calgary oil & gas example, a couple that work in the oil & gas industry, so that their income levels are directly dependent on the success of the industry, should have a smaller proportion of oil & gas investments in their portfolio than a couple that work in the forestry industry. But the income effect goes beyond just industry exposure. Someone with a highly volatile income should offset the effect this has on her total wealth by reducing the volatility in her investment portfolio. Using two extreme cases for an example, on the one hand a business executive in the oil & gas industry that earns 50% of her total annual compensation as variable bonus pay has a volatile income and is dependent on the success of the oil & gas sector. On the other hand, a high-school teacher that lives in Vancouver and earns 0% of her total annual compensation as variable bonus pay and earns a steady income with raises based on increases in the cost of living has a very non-volatile income and very little exposure to the oil & gas sector. Both should adjust the mix of investments in their retirement portfolios to manage the volatility of their overall wealth, not just the volatility of the value of their investment portfolios.
Natural Forces at Play in the Economy
Almost by definition, it is easier for a small company to grow than it is for a large company. Most of the products and services that will be consumed in the future will be produced by companies that are small and growing today or not yet even established. For example, Google was founded in 1996, went public in 2004, was added to the S&P 500 Index in March 2006 and is now the 15th largest company in the index. Point being, we wouldn't even have been able to purchase Google stock 10 years ago, but it is now one of the largest companies in the world. Examples like this are abundant. The natural forces at play in the world's economies mean that small companies collectively are almost assured to grow faster than large companies over the long-term. This is not just due to innovation, but agility, the ability to adapt to change and new, more efficient methods of organization and management. Similarly, large industries tend to grow slower than smaller industries. While oil & gas is a key sector in Canada, it isn't likely to grow as quickly as other sectors in Canada, such as Consumer Discretionary or Information Technology (see here for S&P's homepage for the S&P/TSX Composite Index). We have to be careful with this concept though, because a large company and/or large industry can continue to grow quickly for extended periods of time before they do slow. Many people even thought Google's growth would have slowed much quicker than it has. In any case, the natural forces at play in the economy, combined with my belief in reversion to the mean (discussed as Rule #4 on my home page), form the basis for two of my most basic investment strategies: (1) equal weighting large, mid-size and small companies in a portfolio and rebalancing periodically and (2) equal weighting sectors and rebalancing periodically as opposed to investing according to the market cap and sector weights of the major indices. These natural forces also apply to the global economy as a whole. Emerging and developing economies will naturally experience higher growth rates than developed economies because they have a much more significant potential for development. For example, IT companies serving a country that has yet to roll out IT infrastructure to the extent that North America has will naturally experience faster sales growth than a company serving a country where most IT infrastructure has already been rolled out. Even just the sheer force of a large and fast-growig population entering the labour force of an industrializing nation can be very powerful and create rapid economic growth. Most of the non-developed world is agressively pursuing development to improve their population's standard of living, as can be seen in the rapid growth of the BRIC countries (Brazil, Russia, India and China). These countries will continue to drive much of the world's population and economic growth moving forward, and will provide the opportunity for higher investment returns as well.
Unnatural Forces at Play in the Economy
Modern, 'western', capitalist economies all operate with a core element of central planning known as a central bank. The central bank's role is effectively to manage the nation's supply of money (in its most basic form as dollar bills, but also including various forms of currency not in circulation as well). It does this through various tools it has at its disposal, including the regulation of some key interest rates charged to major banks and the purchase and sale of various govnerment bonds from/to financial institutions. Most central banks state that their aim is to manage their nation's inflation rate to remain within a target zone, but in reality the cental bank is also there to encourage economic growth and manage the financial system through a crisis such as that which occured globally in late 2008. Before we had central banks, many civilizations used gold as the primary form of currency. However, as economies developed, 'banks', or stores of gold, began issuing notes backed by the gold they had in storage. In those times, most of the gold held in the 'banks' was owned by the king. When the king owed other people or institutions money for performing a service for him or selling him a good, he'd pay them with the notes issued by the bank that were backed by a stated quantity of gold. Kings soon realized that they could reduce the quantity of gold that backed the note, but still pay people with the same amount of notes, so that they king was effectively paying people less for their goods and services. People didn't like this, and some historians believe this was a key factor in the decline of royal power and the rise of an aristocratic elite in many countries. There are great historic accounts of the gold standard and management of the money supply around the world, especially in the U.S., but without getting into the details I'll just say that the U.S. went through many dramatic revisions to the way the money supply was managed before the establishment of the U.S. Federal Reserve Bank in 1914. The gold standard lasted in one form or another until the 1970s and is now completely abolished. With a gold standard in place the way to debase (reduce the value of) the currency was to reduce the quantity of gold that backed a given note. But now, without a gold standard, central banks around the world can effectively just print more money when they want to. This is exactly what happened in late 2008 and throughout 2009 as the U.S. Federal Reserve and other central banks 'printed' more money to maintain the liquidity of the major finanical institutions around the world. When central banks increase the supply of money, they reduce the value of money, so that each $1 bill is worth less than it was before. The effects of this reduction in purchasing power aren't seen immediately, especially during a financial crisis and its aftermath when asset prices are generally still falling or flat and banks are not increasing their lending to businesses and consumers. However, the effects do show up when the economy stabilizes and starts to grow again. We call a reduction in the purchasing power of a dollar 'inflation'. Inflation may show up in various ways. High income earners and/or those with significant wealth, such as business executives, wall street investment bankers/traders and those with significant investment and business holdings tend to be the first and primary beneficiaries of inflation because they first and foremost experience the impacts of the increased liquidity (i.e. money supply) in the system. For example, from mid 2006 to the end of 2008, the U.S. Federal Reserve Bank dropped one of the key interest rates charged to major banks from 5.25% to 0.0%. During this time, most of the benchmark rates used by banks on personal and commercial loans did not decline by the same amount, so the banks automatically earned a higher 'spread' or profit margin on their loans without changing anything. Further, the banks had access to capital at an extremely low interest rate during a time when global stock markets had one of their best years ever. This meant the banks were able to borrow at an extremely low interest rate and invest in stocks and other investments that were rising in price very quickly, so they made a very high profit margin on this activity. This is why many major North American banks reported very high profit levels in the 2nd, 3rd and 4th quarters of 2009. Effectively, the Federal Reserve Bank controls the cost of the banks' primary input: money. No other industry has the cost of their primary input regulated like this by the government (although some industries have the cost of their products or outputs regulated by the government). In the last economic cycle (2003-2008), inflation didn't really show up in the consumer price index ("CPI") basket of goods, which is the primary measure of consumer inflation used by most governments. However, the inflation showed up in various other ways, including the increase in real estate prices around the world, increases in the prices of luxury goods and increases in the prices of commodities. It is difficult to distinguish between a price rise caused by the demand/supply interactions for a good or service and a price rise caused by general inflation in the system, but my belief is that a significant portion of the price rise of the items I mentioned above was caused by inflation. Once inflation is in the sytem, it is virtually impossible to get it out, and it has the effect of continously leading us on boom/bust cycles. Inflation has very important implications for the structure of our porftolios, and will play a role in the investment recommendations I make on my website.
Constantine Hatzipanayis has been involved in finance and investments ever since attending a Bachelors of Commerce program at a Canadian university. He is now a CFA charterholder and MBA graduate as well. His education and experience have fostered his belief that most North Americans are 'ripped off' by their investment managers, who add little value at a significant cost, so he'd like to help Canadians and Americans alike better invest for their retirements.� Visit his website at www.investyourrrsp.com.
Orignal From: A New-Age Investment Philosophy
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