jmorace

The Nature of Risk

Great piece Geoff. I think you make a tremendous amount of sense here with this approach. But, I'm not sure how realistic your underlying assumption is--that an individual buy and hold a stock with a time horizon of infinity. This begs the question of why the particular selection was made for that stock in the first place.

To pick an individual equity implies a process of selection -- so even if everyone's selection process is different, some reasoning has occurred involving fundamental, technical, random or combination of reasoning schemes. But hand in hand with that selection has to be a system of rules as to how to mange these individual selections.

I see it breaking down into two areas: First, a change in the investment reasoning and second a robust system of cash management. So, if an individual equity is selected for a fundamental (or technical or combination of) reason(s), and one of those reason changes, the equity should be sold. (Note this is completely different than liquidating an asset class.)

In terms of cash management, it’s interesting to note that if a stock declines 50% it takes a 100% gain on it to get you back to zero, which is pretty hard (if not impossible) to do. So the stock should be sold well before it gets this damaged. If s/he has a coherent system of selling (and buying) rules in place, the individual equity holder will not have to confront this ugly situation. Which also precludes having a total loss (for the former owner, since they've already sold), even if the stock goes bankrupt.

That said, I do think running the stocks through the qpp program can be a useful screen to use in addition to other selection rules.

best,

JMorace

More Thoughts on Mohamed El-Erian's 'When Markets Collide'

"the banks are making it harder for leveraged speculators to speculate." Seems true "This is volatility." I don't think so as there are well capitalized shorts and short selllers can move prices. "This makes assets cheap for investors with available cash and gives them an incentive to inject liquidity back in..." no. not so.....

Sorry to disagree with you Goeff but there is no incentive to jump back in because these declines feed on themselves. Sales push asset prices down forcing assets to be marked to market forcing more asset sales to meet capitalization requirements.....

The only possible way out is a Minsky moment.... which seems to be at hand! (RE: Paulson and Freddie and Fannie this weekend.) It is our first this cycle. Minsky moment, that is. May it be the only one we need. We will see if it is enough.

Check out the literature on Japan and their real estate bubble if you want to see how long this can take when its handeled badly. Of course as a percentage of gdp, this real estate bubble seems to be a bit smaller than monseter the land of the rising sun created, so maybe we'll get out of it sooner.......and can happily return to our inflationary modeling. I hope so.

More Thoughts on Mohamed El-Erian's 'When Markets Collide'

dlaw's liquidity comment is interesting. It seems to me all of modern portfolio theory is predicated on the assumption of an ever expanding amount of money which inevitably pushes up the price of something. So, Central banks pump liquidity into the system and a bull market(or bubble) forms. Even when the bubble bursts, the next effect on wealth is that it has increased in the system as a whole. And so a portfolio allocation method like QPP makes intuitive sense. It’s trying to capture the sweet spots where the next expansion will happen.

But here we are in a situation where 'liquidity' is contracting in spite of central bank action (or error in the case of the ECB.) All the institutions are delevering. El Erian discusses this. Of course it becomes a vicious cycle. And it is a key question for the moment. What happens to the QPP modeler in a deflationary environment when prices of all assets go down? Granted these periods are rare, but that's because the central banks have inflated each and every asset (financial or hard) they can, now there are none left to expand. Maybe they can get them to expand again. But it is just as likely that they will fail in this effort So we must think through the possibility of asset prices deflation on our portfolios.

Sounds crazy, I know but deflation is not a rare thing. It’s rare just in our lifetimes. The thirties, post panic of 1907, civil war period. There are many other examples. So it can happen, and it is a not a ’black swan’ and how do we model for this possibility now?

More Thoughts on Mohamed El-Erian's 'When Markets Collide'

dlaw's liquidity comment is interesting. It seems to me all of modern portfolio theory is predicated on the assumption of an ever expanding amount of money which inevitably pushes up the price of something. So, Central banks pump liquidity into the system and a bull market(or bubble) forms. Even when the bubble bursts, the next effect on wealth is that it has increased in the system as a whole. And so a portfolio allocation method like QPP makes intuitive sense. It’s trying to capture the sweet spots where the next expansion will happen.

But here we are in a situation where 'liquidity' is contracting in spite of central bank action (or error in the case of the ECB.) All the institutions are delevering. El Erian discusses this. Of course it becomes a vicious cycle. And it is a key question for the moment. What happens to the QPP modeler in a deflationary environment when prices of all assets go down? Granted these periods are rare, but that's because the central banks have inflated each and every asset (financial or hard) they can, now there are none left to expand. Maybe they can get them to expand again. But it is just as likely that they will fail in this effort So we must think through the possibility of asset prices deflation on our portfolios.

Sounds crazy, I know but deflation is not a rare thing. It’s rare just in our lifetimes. The thirties, post panic of 1907, civil war period. There are many other examples. So it can happen, and it is a not a ’black swan’ and how do we model for this possibility now?

Defining a Set of Core Asset Classes

Hi Geoff,

I great, helpful article. Thank you for it.

I have a question about core asset classes. I see that you have used the DJ Utilities index as a surrogate for what El-Erian terms as the infrastructure asset class allocation. What other etfs do you see as adequate surrogates? Would railroads or natural gas pipelines count? Should this infrastructure investment be international or domestic etc.

A second question: I notice that pimco has a bond fund that invests in emerging market debt denominated in local currencies. Would participation in this constitute a different asset class or would it be a subset of the bond portion of the portfolio?

Thank you,

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