I think it was George Bernard Shaw, the Irish playwright and 1925 winner of the Nobel prize for literature, who once said that people who do not know the laws of probability were not fit to run for government. I don’t think he was alluding to any special mathematical ability. Rather, I believe he felt it was of utmost importance that any person charged with the responsibility of looking after the resources of a country should be astute enough to make well calculated guesses in a world of uncertainty. This is equally applicable in the world of financial planning.
Larry Swedroe, in his book “Rational Investing in Irrational Times,” tells of a statistics professor who begins each year’s class by asking each student to write down the sequence of ones and zeros for a series of 100 imaginary coin tosses. One student, however, is chosen to flip a real coin and chart the outcome. The professor then leaves the room and returns in 15 minutes with the outcomes waiting for her on her desk.
She tells the class that she will identify the one real coin toss out of the thirty submitted with just one guess. With great persistence she amazes the class by getting it correct. How does she perform this seemingly magical act? She knows that the report with the longest consecutive streak of H (heads) or T (tails) is highly likely to be the result of the real flip. The reason is that, when presented with a question like which of the following sequences is more likely to occur, HHHHHTTTTT or HTHTHTHTHT, despite the fact that statistics show that both sequences are equally likely to occur, the majority of people select the latter "more random” outcome.
Jack Bogle, founder of the Vanguard Group and a legend of the late twentieth century, once remarked: "After nearly 50 years in this business, I do not know of anybody who has done it [market timing] successfully and consistently. I don't even know anybody who knows anybody who has done it successfully and consistently."
In spite of such comments, timing still rears its ugly head in what some professional managers call tactical asset allocation, which is encouraged perhaps by occasional winning streaks similar to the coin toss experiment above. Or it may be because it meets the approval of clients who perceive the adviser who is tactical or active in his approach to be doing “more work” and therefore more deserving of his adviser fee.
Back to Basics
A normal distribution is a frequency chart that shows how often each value along the x-axis occurs. If a series of returns has a normal distribution, it makes it possible for us to make statements such as there is a 95% probability that our portfolio return of, say, X%, is contained within plus and minus Y%.
A probability distribution that is normal is a random distribution. This is because there is 50% chance that an event will occur on either side of the mean. Advisers have to be careful though when making statements using the laws of probability. A probability of 90% does not mean an event will occur 9 times in the next 10 trials. Probability is a long term concept and to ignore this fact is to commit the same error in thinking as in the coin toss experiment above.
In the 2 probability distributions below, the blue bars are the actual occurences while the red bars are randomly generated from a distribution with the same mean and standard deviation. Can you decide if the historical return (normalized by subtracting the mean) performance for The Coca Cola Company (NYSE:KO) and the Dow Jones Industrial Average are near normal? The two graphs are courtesy of the expertGTC3 Portfolio Optimization system.
Timing the Market
According to an influential study conducted by money managers Gary Brinson, Brian Singer and consultant Gil Beebower over a ten year period from 1974 to 1983, dubbed the Brinson Study, stock selection and market timing do not matter nearly as much as how you mix the building blocks of your investment portfolio. Asset allocation accounts for more than 90% of the variance of the returns on your investment, as the Study revealed, with the specific stocks you choose and market timing accounting for the rest.
Doing a rigorous evaluation of Brinson’s Study is beyond the scope of this article but not many people know that the Study was not so much to put forth asset allocation as to discourage market timing and stock picking. You see, the Brinson Study had a more interesting result than the fact that asset allocation explained over 90% of investment return. The Study showed that market timing and stock picking actually decreased portfolio return by 1.1%. Effectively, you actively allocate to the detriment of your portfolio performance.
In other words, the key to a winning investment strategy is not so much to choose the right investment or to decide on the best time to buy or sell but to choose the right asset mix and then to stick to it.
To help your client achieve his life goals, you’ve looked at his personal balance sheet, computed his investible income, and insured against the unthinkable. His investible income will then be used to achieve his life goals after you have ascertained his tolerance for risk.
Consider these 10 stocks that, according to Yahoo Finance, Warren Buffett has invested in: American Express (NYSE:AXP), ConocoPhillips (NYSE:COP), Johnson & Johnson (NYSE:JNJ), Kraft Foods (KFT), Procter & Gamble (NYSE:PG), Coca Cola (KO), USBanCorp (NYSE:USB), Walmart Stores (NYSE:WMT), Wells Fargo (NYSE:WFC), and Wesco Financial (NYSEMKT:WSC). If we had a portfolio that invested an equal amount in each of these ten stocks, the volatility over the years for this portfolio would reduce as shown in this figure.
While the correct holding period may theoretically be forever, the good news is you don’t have to hold on forever to achieve a good reduction in volatility. In fact, it is evident from the graph above that the incremental benefits of time diversification taper off the longer you hold.
What's clear, however, is that even though volatility plus the effect of compounding long term annualized returns make it hard to get an exact fix on how much you will (or will not) have in the future, you help your client to achieve his life goals by letting time diversify away a portion of his portfolio risk.
Passive vs. Active
Volatility is what stands between your client achieving his life goals both in terms of the amount he needs and the time it takes to achieve that amount. Along the way, the possibility of a large loss can devastate his retirement goal.
Consider a 5-year investment that promises a 10% annual return. If you lose 30% of your capital at the end of the first year, you will need about 24% return every year for the next 4 years to achieve what you had originally hoped to achieve in that 5 year time frame.
Reducing the possibility of a large loss depends on whether you can reduce the volatility of your portfolio. Start by finding assets with acceptable risk-return ratios. Make sure they are well-diversified as a group or if you have the technology, optimize so that you can get the best mean return for the least risk.
Adjust your client’s expectations so that his risk profile matches with the amount of risk that his portfolio contains. Finally, rebalance his portfolio so that it keeps true to its original optimal mix.
Whether you rebalance once a year or more frequently, monitoring the portfolio so that it keeps to the assumptions of normality or near-normality is a constant activity. So while the tactical (active) manager is trying to time the market or select the next best investment, the strategic (passive) manager is constantly making sure his client’s portfolio is coursing towards its long term goal.
There is perhaps no closer analogy to strategic asset allocation than the sport of sailing. The sailor who wants to arrive at his destination does not wait for a gust (timing) from behind to drive him to his destination. Instead, he sails directly into the wind coming in front of him by tacking left and right (rebalancing) till he gets to his destination.
Buying or selling so that the proportion invested in each asset is restored to its optimal value ensures that you do not take on more risk than you had originally intended when you first sat down to design your client’s portfolio. By unloading an asset class that has enjoyed a nice rise, you managed to sell high, although not necessarily at the highest high. Similarly, buying into a declining market will ensure you own sufficient amounts to boost your overall portfolio return when the investment ultimately recovers.
It is unfortunate that the word “passive” is used to describe a strategic asset allocation plan. The word conveys the image that nothing is really being done along the way and this could not be further from the truth.
This article outlines an introduction to a theoretically sound way of portfolio planning that is based on the two pillars of investing: diversification and a long term view.
But while your plan should be built on these 2 pillars, understanding the assumptions underlying this methodology and knowing what to do about them in situations where these assumptions have been violated is also important for its successful implementation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.