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Travis Morien
Compass Financial Planners Pty Ltd
travis@travismorien.com
http://www.travismorien.com
Before viewing this
presentation:
B would die
out through
lack of takers!
When two investments appear to offer identical risk, investors will prefer to
buy the higher returning one. If the market is peopled by reasonably well
informed investors, there simply won’t be any high returning low risk
investments left and nobody will buy high risk assets with a low expected
return.
Risk and return continued
In a portfolio construction context “risk” is usually
measured with some sort of measure of price volatility.
There are other risks of course that need to be taken
into account.
Inflation risk is a major problem with the more
“conservative” asset classes such as fixed interest and
cash. Many pensioners find to their horror that they
can no longer live off their savings, despite the
conservatism of their strategy, simply because their
returns weren’t high enough to maintain the portfolio’s
real value after inflation, costs and withdrawals.
It is necessary for all but the most short term oriented
investors to consider at least some exposure to growth
assets like shares and property, just to fight inflation.
Major asset classes: shares
Shares are part interests in businesses. How good a return
you get on your share depends to a large extent on the
fundamental business developments of the company itself
and on the price you paid for the share.
Averaged out over many companies, shares as an asset class
tend to respond to interest rates and the economy.
Although in the last few years many markets have fallen
substantially, shares are still the highest performing asset
class over the long term and by far the most tax efficient.
Shares generally go up in price over the long term because
businesses don’t pay out 100% of their profits as dividends,
they keep some to grow the value of the business itself.
Over the long term, shares have beaten inflation by about
6%pa.
Major asset classes: property
There are many types of property to invest in, each are
different.
The highest income yield comes generally from commercial
and industrial property, which often pay the owner as much
as 10%pa in rent alone.
Residential property is an asset class that has really been
booming over the last few years, but rental yields are now
alarmingly bad by historical standards meaning that investors
are highly reliant on capital growth.
Over the longer term you can expect property to grow in
capital value at about the same rate as inflation (because the
salaries with which we have to pay the mortgages only grow
with inflation – there eventually comes a limit when growth
above inflation just can’t be sustained), though local supply
and demand issues mean actual returns could be higher or
lower over a particular period of time.
Major asset classes: fixed interest
A “fixed interest” investment is a debt that can be bought and
sold.
The borrowers are usually governments and companies. A
typical fixed interest investment pays a regular “coupon”
(interest payment) and will repay the principle on maturity.
Some fixed interest securities have a maturity of several
decades, others are shorter term.
The actual price of a fixed interest investment will fluctuate in
response to many things, most particularly interest rates. If
general interest rates fall, the price of a long term fixed interest
security will usually rise such that the “yield to maturity” is
similar to those of other investments with a similar risk. On the
other hand, if interest rates rise, fixed interest investments fall.
A typical fixed interest portfolio is yielding less than 5% right
now, though falling interest rates over the last decade have
helped bonds to deliver very strong performance which included
a growth component.
Major asset classes: cash
“Cash” may mean currency, but in an investment context
cash is just a really short term highly liquid fixed interest
investment.
Longer term fixed interest investments are usually called
“bonds”, shorter term fixed interest investments may be
called “notes” and really short term ones are often called
“bills”.
Cash management trusts usually invest in a portfolio of high
quality short term fixed interest investments. Because of the
short maturity, these fixed interest investments aren’t as
sensitive to interest rate changes and thus don’t have a great
deal of capital volatility.
Many cash investments are returning about 4% at the
moment.
Other asset classes
Shares, property, bonds and cash are the major asset
classes, but there are many others to choose from.
Hedge funds are sometimes called a distinct asset class as
they pursue unconventional strategies that give them
performance very different to the asset classes that they
invest in.
“Private equity” is basically a shares investment, but in
companies not listed on a stock exchange.
Agribusinesses are agricultural investments in things like
tree farms and vineyards.
Some people also consider commodities like gold to be an
asset class of its own, and many people consider
collectibles, race horses and fine wines to be useful
alternative investment asset classes.
The point of portfolio construction
A portfolio is often more than the sum of its parts.
Because not all asset classes perform the same way
over the short term, a portfolio of many asset classes
usually offers a superior overall relationship between
risk and return to any single asset.
A portfolio consisting only of shares would have done
badly in the last few years since the US market crashed,
but property and bonds have performed very well. This
is quite typical, more “defensive” asset classes often do
well when equities are falling.
A diversified portfolio has a reasonable long term growth
rate because over time all asset classes offer a positive
return, but being invested across different asset classes
smooths out returns and offers a more predictable
growth rate.
The last twenty years have seen very good returns for
all major asset classes, well in excess of inflation, but
the risk and return are highly variable.
S&P/ASX500
Index A$
MSCI World
Index A$
Percent Return
1000
UBS Comp
Bond A$
500
UBS 90 Day
Bank Bill A$
Aust CPI
Index A$
0
12/84 5/87 10/89 3/92 8/94 1/97 6/99 11/01 4/04
Risk
Inefficient portfolios below efficient frontier
Efficient vs. inefficient portfolios
It is impossible to predict in advance
which portfolios will be the most
efficient as this would require knowing
in advance asset class performance and
correlations.
A portfolio that has been diversified
into a variety of asset classes should be
close to efficient over the longer term,
provided it is rebalanced regularly.
Rebalancing
Rebalancing a portfolio is the process of
adjusting a portfolio to bring it back to its
original asset allocation.
Since assets perform differently at different
times, the portfolio is likely to drift from
your desired asset allocation.
Failure to rebalance means that a portfolio
can change risk profile over time and may
no longer be appropriate.
A simple rule of portfolio construction
If you have two assets with roughly equal
expected returns, putting 50% into each
is a way to hedge one’s bets (and spread
the risk) without compromising expected
return. The lower the correlation of those
assets, the more the risk will be reduced
while not reducing expected returns at all.
Actually, this holds true with a greater
number of investments as well. For
example, if you have five equally
attractive assets you could invest one fifth
in each.
Since 1982 Australian shares (ASX500 index), international
shares (MSCI world index) and property securities (ASX300 listed
property index) have had roughly the same return…
GROWTH OF DOLLAR
30
25 S&P/ASX500
Index A$
Value of Dollar
20
15 MSCI World
Index A$
10
5
ASX 300 Prop
Index A$
0
12/81 9/84 6/87 3/90 12/92 9/95 6/98 3/01 12/03
GROWTH OF DOLLAR
30
S&P/ASX500
25 Index A$
20
Value of Dollar
MSCI World
Index A$
15
One third in
each
0
12/81 9/84 6/87 3/90 12/92 9/95 6/98 3/01 12/03
100
Global L
Gross A
10
Global large companies 14.98%pa
Global S
Gross A
1
12/74 7/78 2/82 9/85 4/89 11/92 6/96 1/00 8/03 3/07
Annualised return
25.0%
global large caps indexes is 10
20.0%
quite low. 15.0%
10.0%
9
Despite the high volatility of 7.5%
5.0%
2.5%
emerging markets, their low 8 0.0%
portfolio can actually reduce 4.24 4.26 4.28 4.3 4.32 4.34
18
14
Anualised return %
0
0 1 2 3 4 5 6 7
Monthly std deviation %
Obviously some asset classes have been more
efficient than others over this time frame, but
which asset classes will be best over the next
10 years is another matter entirely.
Australian value stocks for example continued
to provide strong gains over the last few years
as the rest of the stock market, especially
international stocks, did poorly. In 2003,
Australian small caps rose 40% (nearly twice
what large companies returned) despite
underperforming over the previous decade.
There really is no way to forecast which assets
are going to outperform, although that doesn’t
stop people from trying!
Adding conservative assets
So far we’ve only shown what happens when
growth assets of the various flavours of shares
and property are added together.
Although we can substantially improve on
large cap growth share portfolios in terms of
risk and return there are limits to how
conservative a portfolio of growth assets can
be, to push the efficient frontier more toward
lower risks the income asset classes (bonds,
cash, mortgages) will need to be added.
We have to accept that over the longer term
this will probably cost the investor money due
to a lower expected return, but the risk
reduction potential is tremendous and this
may be more suitable for conservative
investors.
Half the risk doesn’t mean half the
return!
Risk to reward ratios get more favourable for
conservative portfolios.
Putting half a share portfolio into cash will
basically halve the risk, but since cash doesn’t
return 0% you won’t halve the return.
If you gear a portfolio though you do double your
risk (if you use 50% leverage), but because you
have to pay interest on the loan you won’t double
your return.
Conservative portfolios therefore can greatly
reduce risk without necessarily having the same
amount of reduction in the return. This can be
seen on the efficient frontier, which is usually
curved instead of straight.
A property of efficient frontiers is that the left side of the chart is
usually a lot steeper than the right side. Addition of even a small
amount of cash to a share portfolio (here we have used the ASX500
All Ordinaries share index from January 1980 to January 2004) can
significantly reduce volatility with very little impact on returns and the
addition of a small amount of shares to a cash portfolio can
significantly increase returns without increasing volatility much.
13
30% 20% 10% 0%
12 40%
50%
60%
All cash 70% All shares
11 80%
90%
100%
10
9
0 1 2 3 4 5 6
Monthly std deviation %
Part Three
$200,000
$180,000
$160,000
$140,000
$120,000
$100,000
$80,000
$60,000
$40,000
$20,000
$0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
8% 10%
Choosing a level of risk vs. return
“Risk profiling” is a tricky business that
depends on the time horizon, risk
tolerance and return requirements of
an investor.
As a financial planner I spend a lot of
time working on this with clients, but it
is a complex area and it is outside the
scope of this presentation.
Some model portfolios with different
levels of risk and their risk/return
profiles are shown on the next few
slides.
Three dimensional approach to risk profiling
Most advisors discuss risk tolerance in terms
of potential volatility only, often using short
multi-choice questionnaires. In my opinion,
this is inadequate and doesn’t really address
the client’s needs. I think there are actually
three dimensions to risk profiling:
1. Time frame – when is the money required?
2. Volatility tolerance – how much volatility?
3. Conventionality – given the different cycles
of value and small cap shares and that they
may underperform large growth companies
for extended periods of time, how much of a
value and small cap tilt is acceptable?
Example model
High growth Growth Balanced Low growth Conservative
portfolios
Growth assets 100.00% 85.00% 70.00% 55.00% 30.00%
14.50%
14.00% High growth
Growth
Annualised return
13.50%
Balanced
13.00%
Low growth
12.50%
12.00% Conservative
11.50%
0.00% 1.00% 2.00% 3.00% 4.00%
Monthly standard deviation
February 1985 to December 2003, monthly distribution of returns:
Note the higher peak and narrow spread of the conservative portfolio compared
to the higher risk portfolios, but note also that the riskier portfolios peak further
to the right showing that on average they have had better returns.
80
Number of occurences
70
60
50
40
30
20
10
0
30.00%
M a x im u m d ra w d o w n
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
J a n -8 5
J a n -8 6
J a n -8 7
J a n -8 8
J a n -8 9
J a n -9 0
J a n -9 1
J a n -9 2
J a n -9 3
J a n -9 4
J a n -9 5
J a n -9 6
J a n -9 7
J a n -9 8
J a n -9 9
J a n -0 0
J a n -0 1
J a n -0 2
J a n -0 3
High Growth Growth Balanced
Low growth Conservative
Compared to the individual asset classes, the historical drawdown of the
diversified “High Growth” portfolio was much less. Individual growth
assets have tended to have up to twice the downside risk.
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Jan-82
Jan-86
Jan-87
Jan-89
Jan-91
Jan-94
Jan-96
Jan-99
Jan-01
Jan-02
Jan-03
Jan-83
Jan-84
Jan-85
Jan-88
Jan-90
Jan-92
Jan-93
Jan-95
Jan-97
Jan-98
Jan-00
Australian shares Global shares Property securities High Growth
Typical downside risk as measured
by maximum drawdown
A “High Growth” model portfolio would have lost about 25% in
the crash of October 1987 and by the bottom of the next
largest three subsequent bear markets (September 90,
January 95, February 03), losses were about 12%.
Every 15% of allocation to income assets reduced the average
magnitude of the drawdown at the bottom of each significant
bear market by an average of about 15% (not surprisingly!) at
a cost of about 0.5%pa in annualised returns.
It is also worth noting that the drawdown periods tended to
last slightly longer in the aggressive portfolios as it took more
time to make up the greater losses.
Bear in mind the inferior tax efficiency of the conservative
portfolios, so for taxable investors the gap between each
portfolio would be slightly greater.
Designing a portfolio – risk tolerance
First, determine the time frame of the investment.
Examining data from model portfolios and adding
on a margin of safety, decide how much downside
risk over that time frame that you can accept.
Remember, the consequence of risk is more
important than the probability of risk. Risk
should be assessed in terms of how much damage
it would do to your ability to pay for something
you need at some time in the future. Don’t get
too obsessed about daily, weekly, monthly or even
annual volatility if your investment horizon is 20
or 30 years!
Of course if your investment horizon is quite short
term, you probably should be obsessed about
short term volatility!
Designing a portfolio – value vs.
growth
Value stocks and small companies tend to
outperform large cap growth companies over the
longer term but they do have risks of their own.
Value stocks outperformed by a huge margin
during the “bear market” of the last few years, in
fact Australian value stocks even outperformed
property trusts during a time which is generally
remembered as a property boom.
The trouble though is that during the “tech boom”
of the late 1990s, value stocks lagged by a large
margin. We know with hindsight this was a bubble,
and most of those gains were lost, but this wasn’t
that easy to spot at the time. The newspapers
were all touting the “new economy”, and value
investors seemed like they were obsolete. As a
dimension to risk profiling, this one is about how
willing you are to ignore underperformance and the
prognostications of pundits.
Designing a portfolio – value vs.
growth
Personally I am happy to have a very strong tilt
toward value stocks, but not everyone feels that way.
The numbers for value vs. growth strongly favour
value for more than half a century in the US and
many foreign markets where data is available, the
track record of value is impressive.
But how many years will you persist with value
investing if it underperforms the general market?
One year? Five years? Ten years? How do you know
there isn’t really a “new paradigm” and markets
haven’t really changed?
Most people prefer to hedge their bets, allocating
some but not all of their portfolio to value stocks,
buying growth stocks and having a “balanced”
exposure. This may not be the highest returning
strategy for the very long term, but it seems more
conservative for most people.
Is value more risky than
growth?
Many academics argue that the outperformance of value
stocks vs. growth stocks is a “risk premium”, i.e. that
investors are merely being rewarded for taking on more risk.
Others who don’t believe in the “efficient market hypothesis”
think that the outperformance of value is caused be
systematic errors made by analysts who overestimate the
future profits of “growth stocks” and underestimate the future
profits of “value stocks”, this would be an “inefficiency”, an
opportunity to earn a higher return without higher risk.
Various people have put forward various theories about the
extra risk of value, but one of the most obvious troubles with
the value = risky theory is that value based portfolios tend to
be less volatile, not more, in fact “growth” portfolios, which
have lower returns, can be much more volatile.
This debate has gone on for years and will continue to go on
for years more, to some people the idea of a “free lunch” in
value stocks is theoretically impossible, so they hypothesise
new forms of risk.
Citigroup BMI value and growth indexes,
July 1989 to Jan 2004 (Australian
shares)
Although the value index in this example outperformed the growth index
by more than 3%pa, if there is much extra risk in value stocks then it
doesn’t show in the volatility or drawdown figures.
Longer term in the US: Fama and French large value vs. large growth
indexes January 1926 to December 2003. Again, if there is extra risk it
isn’t obvious in the drawdown figures. Value outperformed growth by
more than 2%pa over the entire period but this didn’t translate into
meaningfully greater downside risk. Value was marginally more volatile
though, 7.45% per month vs. 5.48%.
Risk of value stocks
The main reason why many academics say value
stocks are more risky is because in theory they
would have to be more risky for the efficient
markets hypothesis to remain valid. Many
explanations are given, but some tend to be almost
metaphysical, claiming that the risk can’t be
measured but is there somehow and somewhere.
Interestingly, prior to academics discovering the
“value premium”, nobody claimed value stocks
were more risky, this claim was made by efficient
market supporters only after the higher returns
were proven.
It is an interesting issue, but from a personal
investor’s point of view it is a question of whether
the value premium is likely to persist for ever and
whether they are willing to tolerate periods of
underperformance where growth does better than
value.
Value vs. growth
In the late 1990s, growth stocks outperformed value
stocks. If you had switched out of value and into
growth following that period of outperformance you
would have been hurt badly by the bear market that
followed, where value stocks outperformed growth
by a big margin.
Growth stocks often outperform in rising markets,
especially in the latest stages of bull markets when
most people invest the most money. Typically, value
stocks offer more consistent performance.
If you can’t tolerate underperforming the market or
don’t want to bet on a value premium continuing,
stick with normal large cap “blue chip” shares.
Strongly tilted value and small cap portfolios aren’t
suitable for everyone.
Conclusions
Asset allocation is an overlooked and
underrated field of investment, but studies
show it is more influential on the behaviour of a
portfolio than stock selection or market timing,
more importantly you can exercise more
control over asset allocation whereas the
others are often a matter of luck.
Used properly, asset allocation is the major risk
management tool in an investor’s arsenal, but
it can also be a source of higher returns.
Asset allocation can be a complex area with
many fine points that are often overlooked and
is particularly important for pension portfolios.
Recommended reading
•Common Sense on Mutual Funds by John Bogle
•The Intelligent Asset Allocator by William Bernstein
•The Four Pillars of Investing by William Bernstein
•A Random Walk Down Wall Street by Burton G. Malkiel
•The Intelligent Investor by Benjamin Graham
•Contrarian Investment Strategies: The Next Generation by David Dreman
•Against the Gods: The Remarkable Story of Risk by Peter Bernstein
•John Neff on Investing by John Neff
Web sites of interest
http://www.stanford.edu/~wfsharpe/art/active/active.htm
http://www.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm
http://marriottschool.byu.edu/emp/srt/passive.html
http://www.diehards.org/
http://www.investorsolutions.com/ArticleShow.cfm?
Link=art_It_Dont_Get_Much_Worse_Than_This.cfm
http://www.investorhome.com/cherry.htm
http://library.dfaus.com/faqs/
http://library.dfaus.com/articles/dimensions_stock_returns_2002/
http://www.indexfunds.com/
http://faculty.haas.berkeley.edu/odean/
http://www.efficientfrontier.com/
http://www.tweedy.com/library_docs/papers.html
http://www.travismorien.com
Disclaimer:
Information contained herein has been obtained from sources
believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not
be considered investment advice or an offer of any security for
sale. Investors should seek the advice of their own qualified
advisor before investing in any securities.
Please note that returns quoted in this article are based on historical
performance of indexes, not actual products. Real world products
(index funds) are available to track the majority of indexes quoted
in this presentation, but returns will be affected by fees and taxes.
Past returns are not a reliable indicator of future returns.