Aaii austin 2013


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  • As this is my first presentation to this group, I’m going to wander through a series of slides and topics that provide an overview of how I have come to look at investing. We will begin with a handful of high-level descriptive formulas and work our way down to specific strategies that reflect these rather uncertain times.
  • For much of this rally from 2009 we have felt like we were having to navigate a veritable quicksand of underlying forces. 2012 brought a rather normal year in retrospect. There was a general positive trend, a typical -10% correction, and, in the end, a successful double-digit return. Despite the markets rather benign year, the myriad fears and concerns out in the world have kept mutual fund and hedge fund managers on the sidelines, leading them to underperform their benchmarks (such as the S&P 500) by the most since 1937. Only 10% of mutual fund managers have beaten their benchmarks over a two-year span – a testimony to how difficult the market environment has been.
  • So we’re all struggling against the current here. Here’s how one hedge fund manager put it last year.
  • Let’s begin by looking at some starting points.
  • We value assets with this formula. Cash flows which come from dividends, expected capital appreciation, corporate earnings, all the money generation goodness in the numerator. We discount that goodness with risk. The market reflects risk everyday through interest rates, in broad strokes, pushing that number up or down as the individual riskiness of the asset dictates. The wonder of finance is that I will raise and lower that risk using different assumptions than you will. It’s the intersection of all those varying assumptions and viewpoints that makes a market. This formula is very important these days because central banks are proactively trying to drive risk down in an effort to pump up asset values. In simple terms, that is all the central banks of the world are trying to do. If they can convince investors that market risk is reduced, money flows into riskier assets, investors make more money, take more chances, and stimulate more growth.
  • This is a slightly different way to think about markets but with just a reworking of the same idea. Markets are the intersection of these three inputs. We usually expect that fundamentals: corporate earnings, economic growth, etc. are the primary force behind the market. That’s true to a degree, but it’s limited. Liquidity is just the amount of money flowing into or available to stocks. This is where the monetary policy of the Federal Reserve plays a role, which has certainly been nominally trying to prop up stocks. The real money gets made when investor sentiment turns upward and people get excited about stocks. That’s what we really want, and what the Fed has been trying to influence. Excitement causes P/E ratios to expand and the compounding effect of investors paying more per dollar of corporate earnings at the same time that earnings are growing pushes stocks sharply higher.
  • With corporate earnings at record levels, certainly the fundamental part of the equation is doing its part. The Fed has been supplying the liquidity piece in their effort to juice sentiment by reducing interest rates and perceived risk. These two things should be driving investor sentiment and stocks well higher. And by some measures, notably the VIX volatility measure, investors would seem to be rather content. However, as stocks have been rallying over the past 3.5 years, investors have been pulling money OUT of stocks and pouring that money INTO bonds, despite record low bond yields. Thus, investor sentiment is a far cry from where it could be. And that’s the missing piece of the rally puzzle at this point and the piece that really kicks the market into a higher gear. I’d note that one of the reasons investment folks are pretty excited about this month is a surge of money INTO equity funds for the first time in quite awhile. We don’t know if that’s a new trend. If it is, this rally will have some legs.
  • There are any number of reasons why investor sentiment remains in the dumps. I’d argue that regardless of what’s going on in the world today, this decline in sentiment is simply a normal course of events; a reaction to an overly enthusiastic bull market period that culminated in the internet and tech stock bubble of the late 1990s. Sentiment went too high then, and it’s likely to overshoot on the downside going forward.
  • When we look back over decades of stock market history, we find that this slack attitude toward stocks is nothing new. Investors go through these regular cycles of bullishness and bearishness. .These long, secular cycles last for a good while – 15-20 years, typically. During a bullish cycle, a buy and hold strategy wins the day as stocks rarely suffer any notable yearly loss – though they certainly have bad days and months. However, during the bearish secular cycle, markets really swim upstream, struggling to hold on to gains.
  • The defining characteristic of these secular cycles is investor sentiment; again, emotion is the key component of investing. The fever pitch of the late 1990s marked the latter stage of the most recent secular bull market. We have been living since early 2000 through a secular bear market. Markets will have a few good years, followed by some heart-breaking declines. The net effect is rather little progress. The investor sentiment can be fairly easily seen in what’s called a PE 10 ratio. The PE 10 ratio divides stock prices by a 10-year rolling average of earnings. This smooths out earnings over the regular economic cycle, leaving us with a clearer view of investor behavior/sentiment. This ratio has consistently found its way under 10 at the end of these long secular bear periods. Today, we sit at around 20, roughly half of the ratio at its all-time high in the late 1990s, and about twice where we need to get to in achieving a bottom that coincides with history.
  • The reason why understanding these secular market cycles is important is that the market acts so differently. in these two environments. During a secular bull market, we cannot go wrong sticking with stocks. 96% of the time we are having decent years with most of those winning years being solidly double-digit. Thus, buy and hold is a decent strategy through secular bull periods. In secular bear markets, however, markets gyrate a whole lot more, sometimes dealing us quite negative returns, other times, quite good returns. The watchword during these times is flexibility and paying attention.
  • Investors have had a tough time during this rally because of the persistence of sharp declines in the market. This chart is really telling for the secular bull/bear concept. The bars show the annual return of the broad stock market. The dots below show the maximum drop or drawdown in that year. Throughout the 1980s and 1990s secular bull market, the declines experienced during the year were typical 10% or less corrections. There were only a couple of exceptions, both of which felt like major crashes given how benign markets were acting. We enter a secular bear market in 2000 and see what happens – the market becomes a whole lot more volatile, with declines routinely greater than 10%. This choppiness destroys investor confidence and pushing money to the sidelines.
  • A couple of pictures show these secular market cycles over time. The lines at the bottom show the PE 10 ratio and how it trends up or down to drive the expansion or contraction of stock prices. You can see that we’ve come down a good bit since the peak. Recent stock price action has pushed the ratio back upward, however.
  • This is Fidelity’s view of same chart, simply showing the periods of flattish returns followed by extended periods of very good returns. Fidelity argues that we are quite near the end of this secular period, so they are trying to get people to hang in there for better times ahead.
  • Here’s a more detailed look at their view. They are believing that we’ve seen most of the major swings and are in for an extended period of choppy markets as seen on the right side of this chart. This chart shows the average trajectory of bearish market cycles, looking at many countries over multiple decades. They are considering the 2008 market crash as the beginning of this downward sub-cycle. Note that they think we could have as much as 3-4 more years of choppy sideways markets with a nearly 40% trading range. That’s plenty wide to make and lose lots of money!
  • Another way to examine how far we have left to go in this secular bear market is to look at the average PE ratio contraction. This chart just shows the % change /decline in PE ratios as they contract through a bearish cycle. Compared to the average of past cycles, our current secular bear market is generally tracking the path downward. We are marching pretty close to the average here. However, I’d point out that the starting point of the current secular bear market, in terms of PE ratio, was far higher than normal. Will that mean we fall further than average? The bottom line is that investor sentiment is a serious drag on stock values these days and that is unlikely to markedly improve anytime soon.
  • So we do not expect a big upward swing in PE ratios to take place during this bearish sentiment phase. Let’s shift gears a little bit and take a look at some of the things causing all that investor angst right now. The big one has been an all-too-fresh memory of 2008. Investors still see contagion everywhere they look. The current rally has been, in large part, a relief rally on the view that the contagion has been lessened or eliminated. If contagion and finance are not as bad as we thought, that leaves us with the underlying economics. Europe’s recession may be modest in depth. China appears to be coming OUT of their shift downward., which could bring recovery to emerging markets ending an 18-month cyclical bear market period for those markets. U.S. growth, while sub-par, is still better than other large “developed” economies.
  • Here’s a quick look at global growth trends and projections. We see that U.S. growth, while not exciting, is the best among the large developed economies. The “emerging” economies, have seen growth declining. They’ve been injecting lots of stimulus in the hopes of returning to an upward slope . JP Morgan, at least, expects them to succeed. If so, this bodes well for emerging market stocks.
  • Keeping a lid on growth in the “mature” economies has been a period of global deleveraging. At the highest level, we have a global debt problem that is unwinding. The effects of this elevated debt were captured most notably in a book by professors Reinhart and Rogoff. They looked at the experience of many countries over a long period of time. In general, they found that once the debt exceeds 90% of the nation’s GDP, economic growth really suffers – underperforming by 1%, on average, for many years as government investment is diminished and bond investors become concerned. The western world is wrestling with this problem right now. The U.S. sits with debt in excess of 70% of GDP in debt, still somewhat away from the tipping point here, but uncomfortably close. A good chunk of Europe along with Japan are all beyond this 90% number, which limits their ability to expand in turn limiting global economic growth. With Europe largely acting as one, Germany must send money to Southern Europe to cope with the debt thus limiting one of the world’s top 3 economies.
  • While some people like to equate the U.S. with Greece or Argentina of the laste 1990s, there are enormous differences that lessen the immediate impacts when compared with those scenarios. The U.S , as the global standard currency, has unique advantages other countries do not. Lack of understanding these advantages leads to erroneous assumptions about the timing of negative events – such as debt-induced higher interest rates, etc. This misunderstanding of the facts of global finance has been one of the primary causes of poor investment performance, it seems to me. Thus, global debt and the resulting deleveraging cycle are a serious hurdle to global economic growth, and one that should pervade for awhile to come. Still, the U.S. is a long way from a crisis brought on by this, if only because the alternatives/competitors are in even worse shape.
  • The corporate earnings piece of our fundamental input has been very good – with the S&P 500 generating over $100 in per share earnings this year. Corporate earnings are at record highs. But growth is slowing as global economies face myriad headwinds. The margin gains driving early growth in earnings have all been used up leaving revenue gains as the only source of earnings growth. Thus, 2013 looks like a sluggish year for earnings gains.
  • This slide shows how a bubble in private debt leads to a bubble in public/gov’t debt. The private deleveraging process has obvious implications for private economic investment. The gov’t tries to cover the slack, thus building public debt. Which is in turn worked off as the economy heals, tax revenues rise, and the need for gov’t support diminishes. We are following this path and are in between the light and dark blue phases.
  • This is what the surge in private debt looked like building up to the financial crisis. You can see how government debt (green line) picked up the slack from the falling private debt (from households and financial companies).
  • The federal debt is still very high, of course. The chart on the right puts federal spending and income in the context of GDP. Thus, as GDP plunged in 2008, spending as a % spiked upward. We see the gaping deficit caused by a decade of shrinking revenue while spending spiked. As the economy has recovered, spending as a % has been decreasing. With the recent changes in tax policy and further recovery in the economy, we should see further reductions in this income-spending gap. The deficit that fuels the debt has been shrinking and is expected to drop to 4% of GDP over the next couple of years.
  • I brought this slide forward from last fall as we now know some of the results and can check them against these projections. This slide from PIMCO provides detail of the fairly common assumption among investment folks that the election impact will be minimal on the overall magnitude of the budget actions. We know now that the tax impact was quite similar to what PIMCO at least expected. The spending changes are still yet to come.
  • Stepping back from all of this we have no shortage of uncertainty. That is keeping our PE ratio/sentiment piece of the equation relatively low despite the Fed’s efforts to make stocks more attractive.. Going forward, the global economy continues to work through a series of big issues. One of the challenges we have as investors is deciphering how much of this is already priced into stocks. None of these issues is new or unknown to the broad investment public.
  • This month at least investors appear to have diminished their concerns about the bottom two items, feeling that the “tail risk” as we call it has decreased substantially. Chinese economic data has been improving. The fear of a U.S. fiscal cliff has gone away. And markets already embraced the notion that contagion risk from Europe and the possible breakup of the Euro had become a non-issue. I’d say some of those worries still exist – Europe certainly is not out of the woods yet - and will return to the forefront at some point.
  • When we build an investment strategy we have a short list of questions to ask ourself. It’s really important to understand yourself and be honest about what you can handle with investments. Use this to guide what strategy works best for you. If we can master the emotional part of investing, we have a much greater chance of success. For most people, the emotions are triggered by market and stock volatility. If we can reduce this volatility, we in turn reduce the likelihood of our having an emotional reaction that leads to a poor investment decision. We’re going to survey in the next few slides some investment strategies built around reducing volatility. .
  • We talk about volatility as equaling risk because it’s that volatility that creates our mental view of gains and losses and drives us to actions and reactions.
  • Based on studies of individual investors, most of us can identify with not one, but both of these individuals. We buy high, after hearing news reports, friend testimonials, et al. telling us of great riches being made, riches that we are missing out on. It feels “safe” to invest during these times. We dive in headlong not realizing the bulk of the market gain has passed. The market inevitably rolls over, heads sharply downward, and starts to feel dangerous. We eventually get tired of seeing our balance falling month after month and throw in the towel just before or after the bottom. The market comes roaring back upward without us in it. If we can overcome these emotional reactions to the market, primarily through building a portfolio that minimizes the volatility, we have a better chance of succeeding.
  • So, imagine how those guys would fare in this sort of environment. This is the last secular bear period from the mid-1960s through 1981, A nightmare for investors. A market that wrings out their emotions with the volatility. And back then, almost no tools were available for individual investors to protect their portfolios, and you’re running almost every trade through an expensive broker. There’s not much you can do. As a reaction to that, some folks tried to figure out different ways to invest.
  • Harry Browne was one of those people. The secular bear market had clearly left scars on him as you can see from his quote in bold. So, he created the Permanent Portfolio – an uncorrelated group of assets that will lessen the volatility and generate decent returns.
  • This is what Harry did. He got off to a bad start and his timing was poor also. For in 1982 a new secular BULL market got underway and all the volatility and lack of return Harry was trying to protect against went away. Markets got better. And his new fund was built for the bear market, not the bull.
  • Looking over the past 20 years, however, we see that despite falling way behind during the 1990s bull market, the Permanent Portfolio was immune to the 2000-2002 market crash and suffered relatively little in the 2008 financial crisis. Now, over this 20-year period, the fund has rewarded those who stuck with it. It’s made good on its low-volatility design while delivering solid returns.
  • In the shorter-term, since the 2009 rally began, the fund has continued to do well, though it’s been flat for the past year.
  • Also coming out of the 1960s and 70s secular bear market was a study showing that investing in lower volatility stocks actually rewarded investors far more than academic theory would suggest. Academic theory argues that investors should be compensated for taking on greater risk. If taking less risk still delivers equal returns, however, what does that mean? It means it’s a good investment!
  • The S&P Low Volatility Index underperforms during strong secular bull periods, and it’s not immune to the market forces that caused the 2008 financial crisis crash. Still, for stock investors, this index offers a smoother ride and will approach market performance much of the time.
  • The index is regularly rebalanced to the sectors that are exhibiting the least amount of volatility. Utilities routinely comprise about 20% of the index. However, we can see that financials became a heavy part of the index only to be whittled down as volatility in that sector increased. Currently, healthcare and consumer staples, along with utilities account for the bulk of the index allocation.
  • Recent variations on this pursuit of low volatility have been to manage volatility and risk as the primary objective. Another approach to managing volatility which is a bit more sophisticated is to set a volatility target and let the allocation to equities float as volatility in the market rises and falls. If market volatility rises above a deviation of 15%, then you automatically reduce your equity exposure. You can measure this ratio daily-weekly or monthly as you like. And of course, there’s an ETF for that – this one offered by Direxion Funds.
  • Here’s a pictorial view of how this might work, reducing your equity exposure as market volatility increases.
  • Finally, returning to our simple approach from last year. I spoke then of simple timing mechanisms to give your portfolio a “tactical” approach, minimizing your exposure to market downsides which allows you to build more wealth over time. This chart shows how that works – going to cash when timing indicators, such as a simple moving average approach, tell you to exit the market.
  • We can expand on this simple timing approach by combining some of the ideas we’ve covered. We can essentially buy and hold a low-volatility “core” portfolio using some of the possibilities we’ve covered here – stocks and/or bonds. When the market is healthy, in an upswing, with low volatility, we press the pedal down a bit by adding some higher performance positions. As volatility increases and/or our timing indicators flash red, we reduce these higher performance positions. You see that this approach is ALL about reading the market. There really isn’t any stock analysis required. It’s a rather low-maintenance investment approach which can be accomplished by just following a few indicators – e.g. market volatility, simple price movement, moving averages, etc.
  • Here’s a more visual view of one of the ways we approach this. We have a low-volatility fund for investing in global bonds (PIGLX) along with a high-yield bond fund (VWEHX) as our core positions. You can see these positions generally march upward with the only real pause being the 2008 financial crisis. And we saw before that there were any number of indicators which could help us avoid most of that. We then manage the Emerging Market and Nasdaq 100 positions using our more short-term timing indicators. We have to be more diligent with these positions because they can drop so quickly and sharply – inflicting serious damage on our portfolio; the type of damage we are doing everything to prevent!
  • Here’s the performance of such a portfolio. You could also buy and hold more defensive market sectors such as healthcare and consumer staples, or a low-volatility ETF – anything that has a volatility profile that’s substantially less than the market. We focus on the Nasdaq 100 and emerging markets as our high-performance sectors. You can also incorporate energy and other more cyclical sectors – really anything that has a good amount of performance to offer and which you can fairly easily time.
  • And some metrics associated with this approach. We receive less of the return when the market is going up, which we expect, but endure far less drawdown when the market is falling. The net effect is far better returns with half the volatility and a fraction of the drawdowns.
  • More incremental ways to modify your portfolio during uncertain times – downshifting in steps. There are any number of ways to do this. The list shown here is just one way to reduce risk incrementally.
  • Though we’ve spent much of today talking about stock market trends and investing, I wanted to say at least a few words about income investing. These days, the Fed has increasingly been trying to push investors to view stocks and similar higher risk investments – e.g. MLPs, utilities, dividend stocks – as a better place to put money than regular bonds. The Fed has made us actively consider the relative risk of being more aggressive . For example, by purchasing high-yield bonds instead of triple-AAA corporate bonds, by purchasing municipal bonds instead of U.S. Treasury bonds. They have tried to decrease the absolute risk of those investments by making money so cheap for corporations and municipalities that the risk of default goes way down. We’ve seen that in the high yield bond area where defaults are almost non-existent, well below historical averages, because the interest payments are so much lower than typical and the market so hungry for refinancing their debt. But as rates start to tick upward, and they must at some point, managing duration becomes the key. Basically, duration is just a quick way to see what our price risk is with the bonds. If the duration is 10, then our bond/bond portfolio/fund will drop by -10% in price for every +1% increase in yield. Yields go from 3% to 4%, we lose -10% in price. If the duration is only 2, then we only lose -2% for that same move in yields. It’s important to pay attention to that when buying bond ETFs, or whatever fixed income instrument you’re buying. Also, you want to understand that spreads tell the tale of risk in the market. If the spreads are at historic lows, as they were in the summer of 2007, it means investors are underpricing risk relative to history.
  • I think most people would put us in the lower left corner – low inflation that is likely to rise going forward. This has traditionally been a positive period for equities as well as commodities. Bonds should return to providing little more than their coupon.
  • Shifting back to the big picture of where the market is. I’ll leave you with an optimistic slide from Fidelity. Here, Fidelity outlines some of the positive potential drivers of a higher stock market in the future. Both Fidelity and JP Morgan have been rather bullish this year in spite of all the noise and angst surrounding us. It’s been a good call.
  • This graphic returns us to our thesis that emotions and our ability to build a strategy that fits well with our emotional makeup is the key to long-term investment success. I find this graphic to be so true. There’s this chasing our tail aspect to the left side of the graphic – the one that depicts the individual investor who’s always seeking the hot trade.
  • From my experience working with everyone from students who are new to investing to clients of all backgrounds and approaches to very successful investors, this is the key. Find out your investor “personality” and get a strategy that fits.
  • Aaii austin 2013

    1. 1. INVESTING IN UNCERTAIN MARKETS Don Lansing AAII Austin “Chapter” Meeting January 28, 2013
    3. 3. Be LONG insanity and SHORT common sense - @parhedgeDON LANSING (DONL@STEDWARDS.EDU) 3
    4. 4. Part 1: Valuing AssetsDON LANSING (DONL@STEDWARDS.EDU) 4
    5. 5. At the highest level, we value assets with this formula: Cash Flow / Risk = Asset ValueLess Risk = Higher Asset ValueCentral Banks’ objective: Reduce perceived risk in order to push up asset values  which makes consumers feel more free to spend  which drives up economic growth. DON LANSING (DONL@STEDWARDS.EDU) 5
    6. 6. WHAT DRIVES MARKET PRICES?• Fundamentals  Economic Cycle; Corporate Earnings (S&P 500 at $100/share in earnings)• Investor Sentiment  Enthusiasm drives P/E ratios for stocks; Yield spreads for bonds• Liquidity  Availability of capital; money flow; Fed policy can influence this (HAS influenced this!)DON LANSING (DONL@STEDWARDS.EDU) 6
    7. 7. WHAT DRIVES MARKET PRICES?• Fundamentals  Economic Cycle; Corporate Earnings (S&P 500 at $100/share in earnings)• Investor Sentiment  Enthusiasm drives P/E ratios for stocks; Yield spreads for bonds• Liquidity  Availability of capital; money flow; Fed policy can influence this (HAS influenced this!)DON LANSING (DONL@STEDWARDS.EDU) 7
    8. 8. Corporate Earnings x PE Ratio = Market PricesDON LANSING (DONL@STEDWARDS.EDU) 8
    9. 9. Part 2: Emotions Drive MarketsDON LANSING (DONL@STEDWARDS.EDU) 9
    10. 10. MARKET CYCLES• Most stocks follow the market• Markets move in broad cycles driven by a combination of fundamentals and sentiment • SECULAR cycles last 15-20 years, typically • Sub-cycles last 2-3 years, typically• Secular cycles peak when investor sentiment (good or bad) reaches a “fever pitch” pushing prices well beyond norms.• Sub-cycles change more on events/fundamentals – e.g. perceived economic expansion/recession DON LANSING (DONL@STEDWARDS.EDU) 10
    11. 11. SECULAR MARKET CYCLES• Secular bull cycle – i.e. 1982-2000 for stocks • Investment rarely loses money • Pricing reaches very high levels • P/E ratios for stocks are a good general barometer• Secular bear cycle – i.e. 2000-today for stocks • Investment struggles to deliver real return • P/E ratios gradually slope downward to under 10DON LANSING (DONL@STEDWARDS.EDU) 11
    14. 14. 14
    18. 18. Part 3: The FundamentalsDON LANSING (DONL@STEDWARDS.EDU) 18
    19. 19. MARKET CYCLES – CAUSES OF INVESTOR ANGST• Global finance and economics becoming increasingly intertwined • Increased systematic risk  notion of “contagion”• Domestic cycle influenced by global cycle, but still distinct • Europe in recession • China Slowdown  falling commodity demand  weakness in Brazil, Australia, Russia, other Emerging Markets • These areas have been in a clear bear market • Are they truly turning the corner? • U.S. growth sluggish but best of neighborhood DON LANSING (DONL@STEDWARDS.EDU) 19
    21. 21. THE IMPACT OF GLOBAL DEBT• Living in Reinhart/Rogoff World: • Research by Reinhart/Rogoff widely sited for concerns about U.S. debt • Studied financial situation of 44 countries over two centuries • Found that debt to GDP >90% was a tipping point • Led to reduction in growth of -1% for years on end (20+ years) • Why? High debt limits government’s ability to invest • Resources go to pay down/support debt • Interest rates spike as markets demand more compensation DON LANSING (DONL@STEDWARDS.EDU) 21
    22. 22. THE IMPACT OF GLOBAL DEBT• Is the U.S. different? • Yes – for now. • Almost unlimited ability to borrow, and very cheaply! • Current interest cost is at the same level as 1991 • Dollar as Reserve currency and related Treasury bond market provide important “buffer” – size of markets without peer • Debt has been transferred from private to public – lowers net interest expense in the “system” • Debt cycle is following a “typical” path of previous bubbles – reason for optimism DON LANSING (DONL@STEDWARDS.EDU) 22
    28. 28. Corporate Earnings x PE Ratio = Market PricesBULLS:•PE Ratios are cheap, especially with interest rates so low.•The worst has passed and the future is brighter than the past.BEARS:•The global economy is buried under the weight of debt•Deleveraging (reducing the debt) cycle will keep earnings and investorsentiment down•Eurozone workouts and China slowdown are big known risks.•U.S. budget issues and related debt are a big potential risk. DON LANSING (DONL@STEDWARDS.EDU) 28
    29. 29. Corporate Earnings x PE Ratio = Market PricesBULLS:•PE Ratios are cheap, especially with interest rates so low.•The worst has passed and the future is brighter than the past.BEARS:•The global economy is buried under the weight of debt•Deleveraging (reducing the debt) cycle will keep earnings and investorsentiment down•Eurozone workouts and China slowdown are big known risks.•U.S. budget issues and related debt are a big potential risk. DON LANSING (DONL@STEDWARDS.EDU) 29
    30. 30. Part 4: Building a StrategyDON LANSING (DONL@STEDWARDS.EDU) 30
    31. 31. BUILDING AN INVESTMENT STRATEGY• Objectives • Long-term (retirement) vs Short-term (project)• Personality Profile • Knowledge • Maintenance • Stomach (Ability to Handle Volatility)DON LANSING (DONL@STEDWARDS.EDU) 31
    32. 32. DISCUSSION OF RISK• What is risk?  A result that is different than expected – investors focus on worse than expected. • Volatility is the enemy of successful investing (though it also creates opportunities) • Deviation is dangerous because it pushes emotional buttons in individual investors  makes them anxious, induces fear, … • Deviation from account peak – what we call “drawdown” – is a key focus • Investors emotionally “own” an asset value • Thus, the goal is to minimize drawdown and hold on to the bulk of gains offered 32
    34. 34. 2-3 Years Up; 1-2 years DownDON LANSING (DONL@STEDWARDS.EDU) 34
    35. 35. DEALING WITH UNCERTAINTY:PERMANENT PORTFOLIO• Established in 1982, in an era of stagnant economic growth and rampant inflation, Permanent Portfolio seeks to provide a sound structure and disciplined approach to asset allocation. The Fund was born in an environment where investors didnt know where to turn. Regardless of what an investor did, they were losing money. Harry Browne, one of the founders of the fund stated, "Its easy to think you know what the future holds, but the future invariably contradicts our expectations. Over and over again we are proven wrong when we bet too much on our expectations. Uncertainty is a fact of life." No one can accurately predict the future.DON LANSING (DONL@STEDWARDS.EDU) 35
    36. 36. DEALING WITH UNCERTAINTY:PERMANENT PORTFOLIO• Solution: Invest in 4 uncorrelated asset classes • Precious metals, cash, stocks, U.S. Treasury bonds• Fund (PRPFX) got off to a bad start, losing over -10% in its second year• Has since lost money only 3 times in almost 30 years• Expanded charter to include non-U.S. stocks and real estateDON LANSING (DONL@STEDWARDS.EDU) 36
    39. 39. DEALING WITH UNCERTAINTY:LOW VOLATILITY INVESTING• Another reaction to secular bear market ending in 1982• Study shows that buying and holding low-volatility stocks = market return with 2/3 the volatility.• Calls into question fundamental tenet of investing research • One is compensated more for taking more risk• Recent: S&P creates a low-volatility index  SPLVDON LANSING (DONL@STEDWARDS.EDU) 39
    42. 42. DEALING WITH UNCERTAINTY:SETTING VOLATILITY TARGETS• Rather than focus on return, focus on measuring and adjusting portfolio based on market volatility• Set target volatility – example 15%• Divided Volatility Target by S&P Volatility• Result sets % allocated to equities • As market volatility increases, equity allocation decreases• Ex: 15% / 20% = ¾ = 75% equity allocationDON LANSING (DONL@STEDWARDS.EDU) 42
    45. 45. DEALING WITH UNCERTAINTY:PORTFOLIO CONSTRUCTION – COMBINING IDEAS• Carry a low-volatility core portfolio • Can be low-volatility stocks and/or bonds • Bonds can be adjusted for risk target – e.g. HY• “Allow” allocation to higher performance/volatility pieces when applicable • When market trending up – own higher-beta pieces • Market volatility increases – cut high-beta positionsDON LANSING (DONL@STEDWARDS.EDU) 45
    48. 48. Avoid the bad times. Keep vol low.DON LANSING (DONL@STEDWARDS.EDU) 48
    49. 49. Part 5: Managing your StrategyDON LANSING (DONL@STEDWARDS.EDU) 49
    50. 50. DOWN/UPSHIFTING A PORTFOLIO• We can take half-steps in making our portfolio more or less risky in small steps• Reduce our risk by adding more yield • Move from stock index position to 1. High yield stock ETF (DVY/SDY or HDV) Decreasing Risk 2. Preferred stock ETF (PFF/PGX/PGF) • Note: mostly financial companies 1. Hybrid yield ETF (PCEF/INKM) 2. High yield bonds (HYG/JNK, VWEHX) 3. Corporate bonds (LQD)DON LANSING (DONL@STEDWARDS.EDU) 50
    51. 51. MANAGING INCOME PORTFOLIOS• Relative versus Absolute Risk• Importance of Duration • +1% move in interest rates = -D% move in bond price• Managing spreads instead of rates • Spread = Difference between rate of bond & Treasury rate • Higher the spread, the more compensation being demanded • Lower spreads = nearer to end of cycleDON LANSING (DONL@STEDWARDS.EDU) 51
    55. 55. Becoming a successful investor is largely about learning what triggers emotions that bring harm to your portfolio; then developing/embracing a strategy that avoids the negative triggers.DON LANSING (DONL@STEDWARDS.EDU) 55