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I am passionate about learning and teaching as I learn, which I also believe will help me learn at a faster rate than if I kept the info to myself.
  • Value Weighted Index With Multiple Asset Classes 0 comments
    May 23, 2011 1:55 PM | about stocks: TLT, DBC, SPY, UUP, UDN, FXC, FXA, FXY

    How Sophisticated Of An Investor Are You?
    An unsophisticated investor is over diversified in stocks and pays high fees and simply buys mutual funds. This may (if dollar cost averaging is used and fees are low) may still be superior to savers who may lose money due to inflation. There may be sophistication within the particular mutual fund, but unless the mutual fund investor has done his or her research, This is not something this class of investor has decided himself or herself.
    A move slightly above is putting money in the SPY. This investor knows that 80% of mutual fund owners fail to beat the S&P, and figures, "why not just invest in the S&P"?
    As you move up in sophistication, perhaps you are able to make stock decisions yourself, and make more intelligent ones. The more sophisticated investor may own SPY to invest in stocks, an ETF such as TLT to invest in treasury bond ETFs, an ETF such as DBC to get exposure to commodities, and also a combination of currency ETFs.
    A sophisticated investor is sophisticated because money flows from one asset class to another, and sometimes back again. The sophisticated investor is able to capture inflation through commodities and stocks, and deflation through bonds and currency ETFs. But as certain markets begin to increase, the sophisticated investor can rebalance his or her portfolio to match the outlook.

    A basic way to accomplish this would be to equally weight the portfolio.
    25% Cash/Currency
    25% Bonds/fixed income
    25% Commodities
    25% Stocks
    This investor either doesn't have an educated guess where the money will flow enough to make a decision or believe the conditions are such that there is an equal probability of money flowing into any of these asset classes. It's also possible that there's a slight bias towards inflation but due to margin of error, the investor chose to own additional currency.

    If movements in commodities are high, and after a few months the portfolio looks like this:
    25% Cash/Currency
    25% Bonds/fixed income
    35% Commodities
    15% Stocks
    Then to put the portfolio back in balance, enough commodities would be sold to use the cash to purchase stocks so that everything is even at 25% again, or at least close to it. You don't need to make changes if it's within a small amount.
    Even though this style represents sophistication, it is primarily looking to take advantage of other people's speculation. If they move too aggressively in one direction or another, you re able to sell or buy to rebalance and you profit from volitility.

    This method is known as Multiple Asset Class Investing. There are a few seeking alpha posts on the subjects. There are also a few posts on about value weighted index funds, and multiple class investing, and finally an example of how you can essentially create your own value weighted index multiple class index fund using ETFs and other instruments.

    A more sophisticated way to look at this would be to value weight this multiple class investment strategy. So you might recognize what historically is priced cheaper, stocks or commodities? Where you do you see the movement in asset classes flowing? Additionally, if you believe you have an edge in a particular area, you may want to focus more resources there as you will better be able to recognize individual opportunities. If you are a good commodity investor and recognize certain shortages in resources, and skew your investments in that area, and recognize mispricings, you may allocate more areas to commodities, even if you aren't sure where the money will flow. You position yourself to capture a larger percentage of the move. So now you might start with
    25% Cash/Currency
    25% Bonds/fixed income
    35% Commodities
    15% Stocks
    Recognizing commodities are undervalued, but rather than owning DBC, perhaps you bet more heavily on solar and natural gas.Regardless, once commodities starts to gain it might look like this
    25% Cash/Currency
    20% Bonds/fixed income
    45% Commodities
    10% Stocks

    Now you might reassess the situation and say you no longer want to bet heavily on comodities. It might be a more gradual process before that happens, but rather than reallocate capital to
    25% Cash/Currency
    25% Bonds/fixed income
    35% Commodities
    15% Stocks
    This allocation as you had before, you might instead say "stocks are now undervalued and commodities are maybe fairly or even overvalued" and instead do this:
    25% Cash/Currency
    20% Bonds/fixed income
    17.5% Commodities
    37.5% Stocks

    In general, such an allocation also would be indiciative of your estimated probability of each asset class doing well, with cash and currency and bonds being more of a deflationary hedge and covers the event that you are wrong in addition to the possibility of a more deflationary, disinflationary, forced selling environment, or flight to quality.

    The next step in sophistication would be hedging. That would be shorting overvalued individual sectors wtihin a broad asset class or perhaps an industry within a sector or even an individual name while buying an area that is undervalued. The same type of rebalancing would occur, and reassessment occasionally as well. To reach this level of sophistication you have to also have knowledge of shorting and you also must include actual cash in your "cash/currency" rather than all currency ETFs. You will have to be able to manage the increased risks and in addition, as you become more sophisticated, you need to have more money, or have a greater edge as otherwise the fees will become too expenses to rebalance more and more names where smaller percentage differences may also be rebalanced. This not only takes a lot of knowledge and understanding, but would probably require actual training. Although paper trading may not be the same, managing a theoretical portfolio that involves hedging is a much needed step before you can climb to this level of sophistication, and you should also consider training and participating in the other areas before you continue in that direction.

    One step beyond that would be using the same strategies only with LEAP options which also requires even more training and experience of the other areas. This would allow leverage on those gains. There is even more sophistication such as futures trading, options strategies that involve both selling and buying calls as well as puts, and doing so at different strike prices at different expiration dates. As you enter into this level, you really have to know a lot more to be successful and avoid making mistakes that may be more difficult to recognize.

    Being the most sophisticated investor isn't always the end goal even though it will allow more opportunities. Buffett ultimately became a stock buyer through limited partnerships, raising other people's money to invest in stocks, the area he understood how to identify value the most, and although there are rare instances when he bought insurance companies to use floats, sold derrivatives to gain extra capital to use to invest in, replaced his investments with bonds, went to cash and sold all his investments returning the money to his partners, and at one point even owned a lot of silver. However, the large majority of his success was gained through buying stocks, and doing so in a way that provided him with increasing leverage as he became more comfortable with managing more money. It was only as he did well that he considered other areas of opportunities. Buffett is not only an investor, but a businessman who took courses on speaking, and had to actually grow under the mentorship of graham to understand limited partnerships, and raising capital, and ultimately had to take Birkshire Hathaway public before he could see that kind of success.

    I believe being able to value weight your portfolio as Joel Greenblatt talks about will provide an advantage, but to be able to do so across multiple asset classes will provide an even greater advantage, especially if you work hard to develop your skills in each asset class and develop your sophistication as an investor.

    Disclosure: I am long SPY, TLT, DBC.

    Stocks: TLT, DBC, SPY, UUP, UDN, FXC, FXA, FXY
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