Lowell Herr's  Instablog

A few days I came across an article on the psychology of investing over on the Portfolioist blog. The article is written by Daniel R. Solin, author of "The Smartest Portfolio You'll Ever Own." Readers will recall that I analyzed some of the portfolios from the Solin book here on ITA Wealth Management. When I read articles of how our brains can get in the way of successful investing, I am reminded of the Dunning-Kruger Effect. Read the first few paragraphs and see if you don't agree.

Education is one of my key points to successful investing and that takes effort. While "The Golden Rule of Investing" involves the discipline of saving, education is right up there as one of the most important aspects of investing. Look over my Top Ten Investment Books and begin your investment education. Those interested in an amplified version of the Solin article will find it in Chapter 4, "The Enemy in the Mirror" of William J. Bernstein's excellent book, "The Investor's Manifesto." Fans of Bernstein know he is a strong advocate of using index funds to populate portfolios.

Saving, reading, asset allocation, discipline, patience, etc., are all about preparing for the financial aspects of retirement. I am already in that stage of life, but this blog is written for those a long way from retirement as well as for retirees. If I had my druthers, I would prefer to capture very young investors to this blog as time is crucial to successful retirement planning. Look up the Goofus and Gallant examples for further clarification.

When I gave financial talks at the school where I taught, I don't recall a lecture session where anyone in their twenties showed up. I assume they thought retirement was too far into the future. However, the lecture hall or classroom was filled with 50 and 60 year old folks - and some were in a panic as a result of not saving early in life.

In the original Sortino Ratio">Sortino Ratio where we have S = (R - T)/DR, the T equaled MAR or Minimum Acceptable Return. Sortino dropped that term for his trademark term Desired Target Return (DTR). Think of T as Retirement Target Return (RTR). The more one saves, the lower the value of T. What we need to do is construct a retirement portfolio where the R value or the Internal Rate of Return (IRR) for the portfolio exceeds the RTR. The RTR percentage depends on many factors, including life expectancy, life style, retirement contributions, pension, social security income, retirement income from other sources, inheritance, and unexpected expenses. Many of these factors are not known, particularly for those where retirement is far in the future.

Built into the Quantext Portfolio Planner is a Monte Carlo calculator to help us determine what annual saving is required in order to lower the probability of running out of money during the retirement years. From time to time I show these calculations as they are associated with the various portfolios tracked on this blog.

One of our major goals is to come up with a portfolio where the Internal Rate of Return (IRR) of the portfolio (represented by R in the Sortino Ratio equation) exceeds the T value or what one may call the Retirement Target Return. We want to accomplish this goal while keeping the portfolio risk as low as possible.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

How do I see the week ahead and what is the strategy for ITA investors?  While not trying to frighten anyone, I am approaching this next week with great caution for two reasons. 

1. The "Super Committee" is deadlocked and unless this changes over the next few days several things are likely to occur. 

• Automatic cuts will go into effect, but not until 2013.  You might know that Congress would put off the problem as long as possible. 
• The cuts will go into effect, but Congress, with their incredible wisdom, will vote to remove the automatic cuts they voted for in the first place.

Either of these scenarios will have a negative impact on the financial rating of the U.S. resulting in higher interest rates and a dip in our markets.  While it is unpopular, taxes need to be raised, and that includes everyone.

2. The second reason for extreme caution is the growing problem in Europe.  France is now becoming part of the problem, and they are one of the larger economies. And the problem is spreading.  It is no longer just the PIIGS, but now we are seeing problems with the FINS.  Spain gets counted twice.

What paths are available to investors considering the uncertain climate ahead?  Below are several possible suggestions.

First, hedge the portfolio.  I am beginning to purchase shares in SDS, an ultra-short ETF on the S&P 500.  Long-time ITA readers recall when we put on SDS positions in the past.  Here is how the SDS is designed to work.  If the S&P 500 goes up one point, the SDS will go down about 2 points.  It is not a perfect hedge, but it is a close approximation.  If the S&P 500 declines by 1 point, the SDS will rise approximately 2 points.  Generally, I will hedge a portfolio in the 5% to 10% range. 

The second suggestion is to kick the ITA Risk Reduction model into action.  This is not easy to do with a complex portfolio with numerous holdings.  With the Maxwell, Euclid, and Madison portfolios I've reduced the number of holdings while continuing to spread investments all over the globe.

When I looked at StockCharts this morning, VTI, IWN, IGE, VEU, VWO, VNQ, and RWX were all priced under their respective 195-Day Exponential Moving Averages (EMAs).  Investors should be in cash according to the ITARR model.  We have a few days until the end of the month at which time I will examine the situation closely.  The coming weeks are ones where closer attention needs to be give to the portfolios.

Over the past 10 to 20 years is was not unusual to watch portfolios experience two and three sigma moves over a few months if the standard deviation of the portfolio was something around 15%.  Market volatility continues to frighten the average investor who constructed a portfolio with an expected standard deviation of 12% to 15%.  Is there a way to tamp down market volatility?

Benoit Mandelbrot and Richard L. Hudson write the following in their book, "The (Mis)Behavior of Markets."  "From 1916 to 2003, the daily index movements of the Dow Jones Industrial Average do not spread out on graph paper like a simple bell curve.  The far edges flare too high: too many big changes. Theory suggests that over that time, there should be fifty-eight days when the Dow moved more than 3.4 percent; in fact, there were 1,001.  Theory predicts six days of index swings beyond 4.5 percent: in fact, there were 366.  And index swings of more than 7 percent should come once every 300,000 years; in fact, the twentieth century saw forty-eight such days. Truly a calamitous era that insists on flaunting all predictions. Or, perhaps our assumptions are wrong."

While it is up to the investor to build an uncertainty resistant portfolio, we could use some outside help.  I posit two solutions to reducing market volatility.  1) Attach a percentage "trading tax" on every transaction held for less than 30 days.  2)  Where trades once required 1/8 of a point break points on trades, move the current penny divisions back up to five cent or ten cent break points.

The cry of lack of liquidity is bound to erupt.  However, is it really necessary for large firms to move their computers closer to the NYSE so as to gain nanosecond advantages over the competition.  The "trading tax," if sufficiently large, could slow the skimming process that now occurs and encourage long-term investing.  Is this likely to happen?  Not a chance, but at least it is a point for discussion.

I throw these ideas out for readers to punch holes in them. Have at it and add your own ideas for tempering market volatility.



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.