Portfolio Building: Risks, Not Risk

While at our last denominational meeting, I made the offer to the pastors of my denomination that if they needed investment advice, they could contact me for advice. Out of eighty or so pastors that that could have asked for advice, one e-mailed me. (The pastors and elders did elect me to the pension board, to help manage the relationships with the defined contribution fund managers. I’ll do my best for them.) The pastor is young-ish, with a wife and six kids. He had 60% invested in a broad bond fund which had a high exposure to investment grade corporates and high yield (and AAA CMBS), and 40% in a stable value fund. This is a redacted version of what I wrote to him:

You’ve been playing it conservatively. At this point conservative is good. If I were not tardy in responding to you (my apologies), I might have suggested taking a little more risk at the time when you wrote.

This is the way that I view asset allocation: look at the risk factors in the investment markets, and look at the funding needs of the person or institution that owns the assets. (I.e., so what are we saving for?)

Most people don’t save enough. The $4000 per year is good, but most people need to put more of a buffer aside than that, whether in IRAs (for retirement) or in a taxable account (for emergencies, future coollege aid to children, etc.) You have six little liabilities that may need some help starting out as they reach adulthood. Consider saving more.

Now for the risk factors:

• Equities — somewhat overvalued at present. (US and foreign)
• Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
• Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties. There will be more defaults, both in commercial and residential.
• Yield Curve — Steep. It is reasonable to lend long, so long as inflation does not take off.
• Inflation — Low, but future inflation is probably underestimated.
• Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
• Commodities — the global economy is not running that hot now. There will be pressures on resources in the future, but that seems to be a way off.
• Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

What this leads me to is this: I don’t know all of the bond and stock funds you can use at present, though I will after the next pension board meeting. The bond fund you are using was a great play over the last 9 months, but is probably overvalued now. If there is a more conservative bond fund, you might want to shift some funds there. If not, use the fixed fund. I don’t think we have an international bond fund, or an inflation protected fund available, but if we do I would add some there.

On a pullback in the stock markets, I would look to add some stock into the mix. I would add some with the market 10% lower, and would add considerably with the market 30% lower. If there are international stock funds, I would use them 30/70 with US funds.

Consider this a start of a discussion. I’m not bullish on much right now. This is a time to preserve capital, not make returns. Let me know what you think, and sorry for being so slow to get back to you.

If I were talking to an institutional investor, I would have added illiquidity as a risk factor, which I think is fairly priced right now. I might have also added that I would be bullish on GSE-sponsored mortgage bonds and carefully selected CMBS.

Aside from that, I was pleasantly surprised in Barron’s to see Mark Taborsky of Pimco thinking about asset allocation the way I do. There is no generic risk. There are many risks. Are you getting fair compensation for the risks that you are taking? If not, invest in other risks, or if there are few risks worth taking, invest in cash, TIPS, or foreign fixed income.

Modern Portfolio Theory has done everyone a gross disservice. It is not as if we can predict the future, but the use of historical values for average returns, standard deviations, and correlations lead us astray. These figures are not stable in the intermediate term. The past is not prologue, and unlike what Sallie Krawchecksaid in Barron’s, asset allocation is not a free lunch. With so many people following strategic asset allocation, assets have separated into two groups, safe and risky.

To this end, it is better to think in terms of risk factors rather than some generic formulation of risk. Ask yourself, am I getting paid to bear this risk? Look to the risks that offer the best compensation, and avoid those that offer little or negative compensation.

Comments

[CautiousInv...:]

I collect many thoughts and ideas and am prone to fail to note the source; these notes on MPT align with my thoughts and received wisdom but are not my words:

So what assumptions and fundamentals does Modern Portfolio Theory rely on? There are ten of them which are particular doozies. The following are key concepts around which MPT has been constructed:


-There are no transaction costs in buying and selling securities.

-There is no brokerage, no spread between bidding and asking prices. You pay no taxes of any kind and only "risk" plays a part in determining which securities an investor will buy.

-An investor can take any position of any size in any security he wishes. No one can move the market and liquidity is infinite. You can buy a trillion dollars worth of stock in a small speculative mining stock or buy one cent worth of Berkshire Hathaway. Nothing stops you from taking positions of any size in any security.

-The investor does not consider taxes when making investment decisions, and is indifferent to receiving dividends or capital gains.
Investors are rational and risk adverse. They are completely aware of all risk entailed in an investment and will take positions based on a determination of risk, demanding a higher return for accepting greater volatility.

-Investors, as a group, look at risk-return relationships over the same time horizon. A short term speculator and a long term investor have exactly the same motivations, time horizon and profit target. Regardless of who you are, you will always give an investment the same amount of time to work out and volatility will be your only concern.

-Investors, as a group, have similar views on how they measure risk. All investors have the same information and will buy or sell based on an identical assessment of the investment and all expect the same thing from the investment. A seller will be motivated to sell only because another security has a level of volatility corresponding to their desired return. A buyer will make a purchase because this security has a level of risk corresponding to the return that he wants.

-Investors seek to control risk only by the diversification of their holdings.

-All assets, including human capital, can be bought and sold on the market.

-Investors can lend or borrow at the 91-day T-bill rate - the risk-free rate - and can also sell short without restriction.

-Politics and investor psychology have no effect on the markets.

Oct 04 11:20 AM

[Juandoc.:]

The market is and continue to be unpredictable,in my very limited
understanding it was made that way every theory to predict will be good some times and wrong others; seniors like me have to live and die with it..

Oct 04 01:04 PM

[untrusting ...:]

Good summary, Most small investors would probably be well served if they undertook this type of approach.


On Oct 04 09:15 AM CaptainJJack wrote:

> As Benjamin Graham was constantly preaching, nobody can PREDICT the
> market or the future course of an investment, but it is possible
> to VALUE the market or stock. Buffet has said the same thing, many
> times.
>
> The problem arises when human psychology gets involved. We know that
> dopamine is released as we see our stock values rise, and we know
> that the amygdala fires up the "flight or fight' response when the
> market "plunges".
>
> EVERYONE feels these, even Buffet -- just as everyone feels their
> heart race when someone yells "fire".
>
> The key is to find, somehow, the discipline to overcome YOURSELF,
> and here Graham was pretty pessimistic.
>
> He saw two classes of investors: defensive and "aggressive". He believed
> that 80+% of the population should be in the defensive category,
> and his portfolio weighting was 50/50 equities/fixed.
>
> He suggested that most part-time "investors" manage their portfolio
> to this ratio so that they had something to do that at least did
> no harm.
>
> The aggressive investor is not a risk taker, he is a FULL time investor
> willing to spend FULL time researching investments and reviewing
> his/her own portfolio, but even then, not to think about doing this
> until the investor was sure that he understood his own weaknesses
> (for example, by far my biggest weakness was to sell bonds and buy
> stocks last March -- I could not do it until April)
>
> But the good news is that with a 50/50 split, based on my experience
> and based on everything I've looked at, you get better than 80% of
> the long term stock market return with 50% the risk.
>
> The biggest problem with taking a defensive approach is that it aspires
> to mediocrity; you always do "OK", but, by design, you never outperform.
>
>
> Finally, he suggested that you could vary the ratios, but ONLY sell
> when the market has gotten too expensive, primarily characterized
> by a flood of IPOs of what he called "secondary" companies (.i.e.
> companies with poor earnings but good stories to tell -- think internet
> stocks in 1999).
>
> Or when the market was oversold, often characterized by great companies
> selling at unheard of low Price to Book ratios with some selling
> at or below the cash they held on their books (think last March).
>
>
> Even then, he cautioned to never let the ratios get more than 75/25
> in either direction.

Oct 04 04:30 PM

[change is t...:]

David,

There, is an old saw about advice: wise men don't need it, and fools won't take it. The worst thing about an advisor that one overly relies upon, is when he (or she) is not available...then one will doubt one's own judgement, give up too eaisly or stay too long.

While I am not saying anyone offers anything but fundamentally sound advice, the best advice I ever had was to teach myself and not be afraid to make mistakes. I now consider mistakes my tuition in the school of hard knocks.

The greatest risk is trusting in someone or something that you do not really understand. While you may or may not be successful listening to someone else...you may wish to tell your pastor to be sure if he relys on you or anyone else and does not understand what you are saying......he is stepping out on faith.

Oct 04 09:32 PM

[Clint007:]

On Oct 04 07:57 PM bobbybutte wrote:

> Warren Buffett the only man who has made over 100 billion dollars
> investing KNOWS this so is anyone really smarter?
> If they were so smart how come Buffett is so rich.ahahaa
======================...

Well, have a good look here: "Gold Versus Warren Buffett" www.dailymarkets.com/s.../

Oct 04 11:13 PM

[Moon Kil Woong:]

As with all market trading systems, once the mainstream takes a theory and applies it people start looking for ways to take advantage of the common assumptions. In this case, the best way to break it is to try to find informational assymetry (if you can't find it make it), essentially become unethical and try fixing the market or find a way to modify a business so the future bears no resemblance to the past, sell statistical lies (let's make 50 mutual funds, take the best performing one and sell people on it's outperformance or the one with the lowest statistical risk profile even though the same guy made all 50 of them most of which underperformed), etc.

The simple fact is that the presumption of market risk being absolutely correlated to the past has been a great misperception people have used to sucker grannies and everyone else into buying securities that have a lot more risk than say the 2-5 year graphic they show you when they sell a product (nowadays they use 20 year performance, imagine that).

Although historic risk can be quantified in a single number the risks associated with investment are numerous and have not changed century after century. If you don't consider management risk, cash flow risk, market dynamics, macro-economic risk, etc. and only look at earnings assumptions and stock volatility you are getting blindsighted even if you win today. Why? Probably because you are taking a lot more risk than you are getting paid off for.

In reality, even most fund manager exhibit a gross lack of due dilligence when it comes to their investment patterns. You should know quite a lot about the company, management, macroeconomics, and the field that you are investing in because risk, in all it's forms has a way of catching up to you if you aren't aware of it.

Don't believe your financial advisor if they tell you this they know everything about the risk profile. You pretty much can't lose. And X is the absolute risk you are taken unless it's fully hedged with no counterparty risk (in which you might ask why you aren't just in cash then). Investing isn't as simple as it looks.

Personally I feel standard historic risk is a good guide to tell you if you underestimated the risk of a given investment. But it is a terrible indicator to determine if an investment is a low risk. Many stable companies have a good solid low risk right up to when they don't. AIG and Enron are great examples. If you thought you bought a stable insurance company or utility with historically low risk profiles and exceptional returns how wrong you would have been.

Management can always make risk shoot through the roof.

Oct 05 04:09 AM

[Living4Divi...:]

Because it was developed in the late 1960s and early 1970s, MPT is fairly old. Here are my defenses and criticisms of MPT:

Defense:
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. The goal of MPT is to maximize return and minimize risk. By diversifying a portfolio with (hopefully) weakly correlated asset classes - one can minimize risk. MPT does accomplish volatility reduction. Critics of MPT seem to think that MPT is bad, because MPT fails to eliminate risk. MPT never claimed that risk (volatility) can be eliminated.

Criticism:
One shortcoming in the MPT model, is that "RISK" is defined as the standard deviation of return. By combining different assets whose returns are not correlated, MPT can and does reduce volatility. However, volatility is not the only risk. Loss of purchasing power is a great risk. MPT is flawed in that it considers the US T-Bill as the risk-free asset.

More Criticisms:
MPT also assumes that investors are rational and markets are efficient. There is growing evidence that investors are not rational and markets are not efficient.

Criticism:
These include the fact that financial returns do not follow a Gaussian distribution and that correlations between asset classes are not fixed but can vary depending on external events (especially in crises).

Summary:
MPT is flawed because it is based on several faulty assumptions. Despite its many severe flaws, at least MPT does achieve some level of diversification. The old adage goes "if you want to keep the dog, you have to put up with the fleas."

MPT has alot of fleas. I keep the parts of MPT that still work. (The fact that a diversified portfolio of assets will lower volatility). But, I discard many of MPT's assumptions.

Oct 05 10:34 AM

[Living4Divi...:]

(Revision to third to last paragraph:)
1. MPT is also flawed because, despite MPT's claims, financial returns DO NOT follow a Gaussian distribution. ..and..
2. The math in MPT makes the assumption that correlations between asset classes are fixed. This is a bad assumption, because correlations are NOT fixed. Correlations vary heavily. Correlations tend to get closer to "1" (1= perfectly correlated) in crises.

Oct 05 10:53 AM

[Plant the s...:]

The main drawback is the assumption of past returns, standard deviations and correlations to estimate the future for each asset class.
I think using the past averages and adjusting to information available and investor thinking will still work. This can be done either using the risk factors as suggested in the article, variety of macro, micro and industry information to adjust the expected future.

Oct 05 04:43 PM

[robert.b.fe...:]

All investors are not the same which is only one of many flaws in MBT. When you think about it those who rely on a CFP to do their investing for them aren't really investors at all. They rely on an investor to do it for them. For example some folks get into their 401K at work and never look at the components leaving the default investments in place ignoring the e-mails advising them to do some thing. Others examine the choices available and based on research or data provided make selections and then leave things on auto pilot indefinitely. Nothing is really wrong with either approach and in most cases they will build their savings very slowly which is better than no savings or cash in the mattress. Others actively manage their 401K and contribute to an IRA which usually has an advisor to coach them (or bamboozle them). However using an advisor means you must understand what is being discussed and proffered as advice. Insufficient understanding of the advisors lexicon invariably leads to mallallocation of resources. This brings us to another flaw in MBT the fact that markets are not always efficient or even rational and not all advisors have their clientèle's best interests at heart (Madeoff). As has been pointed out here before the market can remain irrational longer than you can remain solvent. There are good and bad points to most investment theories and philosophies and one size does not fit all; but nothing replaces due diligence on the part of the investor and a good understanding of the positions you take, why you take them and what your expectations are.

Oct 05 05:42 PM

[mikezq:]

Totally agree! In addition, MPT may not suitable for all investors, and certainly not suitable for traders most of time. When it comes to personal investment, the only one investors should rely on is himself: do some homeworks and develope investing strategy that fits in personal financial needs and that best fits in his risk tolerance etc. Experts, analysts, or economists won't do any good for the investors.


On Oct 04 08:56 AM User 353732 wrote:

> 1. MPT is a theory based on a set of highly specific assumptions:
> it is not a universal truth. MPT has been willfully abused by Wall
> St to fleece investors and tragically misapplied by retail investors
> whose knowledge of mathematical finance is rudimentary.
> -----As a theory MPT makes a foundational reliance on free, fair,
> smoothly adjusting and highly informed markets: there are no such
> financial or commodity markets in the US or anywhere in the West
> today
> .........As a mathematical construct, MPT relies of several, very
> specific and binding assumptions about information flow, ethical
> behavior, symmetry of knowledge and execution capacity etc: almost
> none of these assumptions are valid in the US in 2009
> ------As a prescription, MPT depends on observed patterns and relationships
> that prevailed for a specific time in specific markets: MPT is not
> a law of investing for all seasons and all risk profiles and all
> utility functions. As the patterns change and the seasons pass, MPT
> diverges ,often dangerously, from prevailing reality
>
> 2. Investment advice, these days, should be viewed as an aide to
> thinking and organizing observed behavior,NOT as a guide to robotic
> action. In my view, investors are better served by developing, over
> several weeks and after serious study, an interdependent view of
> the world and then designing an investment strategy and action plan
> based on this view of the world.

Oct 05 06:01 PM

[ff4444:]

I would like to make one comment in defense of MPT, then I will tear it apart and suggest something better.

In Defense: if most people put a variety of assets into an mean-variance optimizer and chose a modest portfolio such as 9% or 10% 20 year compound return - they would have less "risk" than their current portfolio.

Major problem: mean-variance optimal portfolios always end up being riskier than people and institutions expect because of flaws built into MPT.

Flaw #1: Average period returns for assets are used instead of compound returns. (For high volatility assets the average return is substantially higher in value than the compound return. This means that MPT based portfolios put too much weight into volatile assets.)

Flaw #2: MPT falsely equates standard deviation of returns with “risk”.

Flaw #3: MPT thinks that correlation matrices have predictive value – but they don't at all!

Flaw #4: Optimizing for the most return per unit risk, means that MVO portfolios are over-weight asset classes that have had a recent un-sustainable run up in price and are due for a correction.

The Solution: If people or institutions are currently using buy-and-hold type portfolios developed under the auspices of MPT, they should re-allocate to find the portfolio with the same return but lowest historic losses possible. This approach is called RiskCog. I have found that this simple metric has better predictive power than statistical-variance based theories. Here is an article that compares the performance of two MPT type portfolios to the RiskCog equivalents: www.riskcog.com/mean_v...

Oct 05 06:33 PM

[David Van K...:]

Dumb question or not?...What is "risk"?

Most of the comments above criticize MPT for equating risk with standard deviation of returns. Elsewhere, I have seen definitions cirticized because they equated risk with volatility.

But none of the comments offered their own definition of "risk." (Sorry if someone did and I missed it.) So, what is your definition of "risk"? And how do you determine if you are being "paid sufficiently for the level of risk you are assuming"?

It's like Sklansky on poker: The optimum play is the play you would make if you knew what cards you opponent was holding. But you don't. In investing, you don't know what the future is. It may follow historical anaogs, but it may not. There may be black swan events (I hate that term, but everybody uses it these days). Yet how can you base assessments of "risk" or "being sufficiently paid" on anything but historical data, knowing that you wll be wrong a certain percentage of the time, which percentage is itself indeterminable?

So, what's your definition of "risk"?

Oct 05 06:56 PM

[TLassen:]

It's the regressive fallacy, the belief we can construct probability (expected return or risk) from empirical data. To conclude the market comes with a 16 standard deviation based on only what we have observed historically will "lead us astray"

Nicolas Taleb, in his book Black Swan, describes in detail his views on taking the concept of normal distribution in gaming situations and applying it to real life, such as in the Market. The rules in gaming situations are defined, they don't change, so mathematics can be used to construct probability, statistics are used to validate the math behind the expected probability.

In life, there are no defined rules, those rules may exist are subject to change at any given time, thus there is no math that can construct probability. Given the absence of structure we have no choice but to turn to empirical observed data only.

I agree with the author, experienced investors should look to manage their risk factors.

David Merkel wrote:
"Modern Portfolio Theory has done everyone a gross disservice. It is not as if we can predict the future, but the use of historical values for average returns, standard deviations, and correlations lead us astray. These figures are not stable in the intermediate term. The past is not prologue, and unlike what Sallie Krawchecksaid in Barron’s, asset allocation is not a free lunch. With so many people following strategic asset allocation, assets have separated into two groups, safe and risky"

Oct 05 07:38 PM

[ff4444:]

On Oct 05 06:56 PM David Van Knapp wrote:
> Dumb question or not?...What is "risk"?

Hi David, for me risk means being sorry that I made a particular investment at some indefinite time in the future.

Oct 05 08:28 PM

[ValidFi:]

PIMCO's Global Multi-Asset fund PGMAX recently reduced their equity exposure. see: www.validfi.com/LTISys...

Oct 05 09:42 PM

[Living4Divi...:]

Good point ! For example, bonds have done very well (nearly equal to stocks) over past 28 years. I am sure that the MVO heavily overweights bonds due to recent performance.

But rather than attacking or blaming MPT for this shortcoming, perhaps the fault lies at the person using the MVO. They use too short of a time period of data.

As well, the fault lies in the MVO itself. These are tricky beasts that operate under the "Garbage in garbage out" principle. A properly tamed MVO can give good results.

On Oct 05 06:33 PM ff4444 wrote:
>
> Flaw #4: Optimizing for the most return per unit risk, means that
> MVO portfolios are over-weight asset classes that have had a recent
> un-sustainable run up in price and are due for a correction.
>

Oct 06 08:59 AM

[GotLife:]

During an Investment course at Univ of Chicago in 1997, the 40ish PHD professor was extolling the virtue of MPT, suggesting a 50/50 allocation in Index funds was the only rational approach to investing. A classmate, who was attending the MBA program only for entertainment, had just closed on another acquisition that was to net close to $10M over a two year period. He would challenge Mr. PHD constantly. Who do you think the class believed?

MPT appeals because, like "trite phrase investing" (In it for the long haul, America has always recovered), it comforts the procrastinator, the ignorant and the static system advocate. How about the poor sap that began MPT investing in March 2004 and needed to exit March 2009? Right, they violated the "long term" principle. What a load....

Oct 06 10:29 AM

[robert.b.fe...:]

I submit that risk is a variable that is calculated differently by investors VS traders and then by the individual style of each. I hold relatively low risk stocks like Met Life (MET) and Principle Financial Group (PFG) because they are low risk long term plays. Does that mean they have no risk? Certainly not just look how far off of their highs they fell. I also hold Pimco Total Returns Fund (PTTDX) for the same reasons. This position is even less of a risk factor than the blue chips but some risk is inherint in even the stodgiest positions in the market. I also hold extremely risky positions like Dry Ships (DRYS) and Hana Biosciences (HNAB). These are short term speculative plays whch may pay off big but may very well go bust resulting in a total loss. Each investor/trader must determine their own level of risk tollerance and take positions accordingly. Those who wish to take speculative positions must understand the risks they are undertaking as opposed to the potential rewards.

Oct 06 03:45 PM

[ValidFi:]

I absolutely agree that MVO is just a mathematical tool that was overused/over promoted for marketing and (UChicago's) religious purpose. It is how to properly use it matters.

For example, on top of MVO, Black and Litterman have proposed a method to incorporate investor's outlook/estimate. Furthermore, in a simplistic manner, one could opt to use other ways to estimate covariances instead of getting that from recent history.

It is also important that as a TOOL, one could apply MVO to a set of time series objects instead of just those traditional static assets. An example would be to use various strategies (on asset classes) such as long/short etc. as the inputs.

Budgeting risk factors could be the first pre-processing step to tilt the MVO. Moreover, an overall and weights on individual assets could be capped to limit the 'fat tail' risk. A post processing step could be added to limit such overall exposure.

Anyway, if you are a practitioner, you choose tools handy smartly to handle the problems, not blindly trusting the output, let alone treating such MPT as the godsend. No wonder Buffett once criticized the EMT(Efficient Market Theory) academics, for that I quoted his Berkshire Hathaway's 2007 annual shareholder letter here:

"And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter’s performance and what it meant for the school’s cherished theory.

Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.

Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was “right” (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat.

Maybe it was a good thing for his investors that Walter didn’t go to college. "


On Oct 06 08:59 AM Living4Dividends wrote:

>
>
> Good point ! For example, bonds have done very well (nearly equal
> to stocks) over past 28 years. I am sure that the MVO heavily overweights
> bonds due to recent performance.
>
> But rather than attacking or blaming MPT for this shortcoming, perhaps
> the fault lies at the person using the MVO. They use too short of
> a time period of data.
>
> As well, the fault lies in the MVO itself. These are tricky beasts
> that operate under the "Garbage in garbage out" principle. A properly
> tamed MVO can give good results.
>
> On Oct 05 06:33 PM ff4444 wrote:

Oct 06 07:31 PM