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Tom Mongan, CFA
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Tom Mongan, CFA, retired several years ago after 40+ years in the banking and securities industries. Prior to retirement he served as an executive officer of a major bank, focusing on trust and investment management. Following retirement he was a contract analyst with Argus Research in New York... More
  • A Defensive Strategy for the Nonprofessional Investor 0 comments
    Dec 15, 2011 11:38 AM

    Daytime cable TV offers a constant stream of financial news.  It may be useful information for someone, but if you are a non-professional investor, even a conscientious one, do you think there is anything there that the pros don’t already know?  Can your trade equal theirs for efficiency in cost and time of execution?  The low-cost trade commercials would have you think so, but what are the odds?

    A guest editorial in the January/February 2011 issue of The Financial Analysts Journal offers some information that can influence the way we invest.  The author, Mark Krutzman, CFA, is president of Windham Capital Management and a senior lecturer at MIT.  Along with colleague Yuanshen Li, he has conducted statistical studies of security prices.  His comments on diversification and market efficiency are enlightening.

    Misunderstanding Diversification

    When most of us think of diversification, it usually amounts to some variation of “Don’t put all of your eggs in one basket.”  That can mean holding multiple stocks and bonds.  Professional managers usually hold at least 30 and often 100 or more.  We diversify the industries we hold, even the countries.  We also check correlation tables to see how asset classes interact.

    All of these steps are important, but we are still subject to the limits of averages and correlations.  Averages are snapshots.  They have useful but limited value.  Krutzman uses an example of someone selecting clothes for a trip to Boston where the average annual temperature is 51 degrees.  Given the severity of Boston winters, you can see the risk of relying on averages. 

    Correlations describe how different measures relate to each other.  A perfect correlation between two items is 1; both items react exactly the same way to an external influence.  A correlation of 0 means there is no correlation.   A perfect negative correlation is -1; when one goes up, the other goes down by the same amount.  There are countless measurements between +1 and -1, and investors looking for diversification look for a blend of securities and asset classes to minimize the market volatility.

    This seems logical, but why did this not protect us when the market collapsed in 2008?  Krutzman says that one correlation figure only tells part of the story.  As an example, he shows that in a rising market the correlation between U.S. stocks and foreign stocks was -17%.  That suggests reasonable diversification.  But when the markets collapsed, the correlation was +76%, virtually no protection whatsoever.  Appropriate allocation can change with the investment cycle.  One conclusion is that investors should not be complacent with conventional wisdom on diversification. 

    Why be satisfied with average performance?

    The message that I see repeatedly is that any of us can outperform the market with the right tools.  Really?  The numbers don’t show this.   Krutzman writes about the efficiency of markets.  In investment theory the stock market is highly efficient, and he agrees.  The information flow is instantaneous, which does not leave much room for superior performance. 

    The performance figures are intimidating.    Krutzman cites Standard & Poor’s data to show that from 2005 to 2009, 61% of large cap funds in the U.S. failed to outperform their benchmark.   The underperformance rate for small cap funds was 67% and for international equities, 89%.  In fact, none of the 10 major asset class averages came close to meeting their benchmarks. 

    Krutzman takes it a step further by adjusting the positive returns for manager expenses and luck.  Less than 1% showed management results that were better than chance, only 12 of the 2076 mutual funds that they studied.  Even worse, there was no way to predict which 12 would make the list.  If by average performance we mean the well-known market benchmarks like the S & P 500, average might not be so bad. 

    Don’t give up

    Despite market efficiency, many managers get superior results.  Knowing this and given the stakes, many of us are inspired to try.  By mixing index funds, ETFs and selected mutual funds, the nonprofessional investor can create a portfolio of stocks, bonds, real estate and commodities.  The results can outstrip inflation and provide a comfortable retirement that is both affordable and safe. 

    For those who are uncomfortable doing this alone, there are managers who can help design a portfolio to the investor’s specific goals.  As long as you know the risks, there is no reason that you cannot participate.

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