Wednesday, June 10, 2009

A common sense guide to investing

Apologies for the lack of posting but I've been back home for the past couple of weeks. As you can imagine, in this economy being a "finance" guy in a group of "non-finance" people typically elicits a number of questions, but one that surprisingly came up over and over again was "What do I do?" (i.e. how should I invest). The buy-and-hold model has ruined many people and individual investors seem completely lost now that the standard go-to plan has clearly failed to meet the most basic of objectives: capital preservation in times of need. Demographically, this is an unmitigated disaster as baby boomers are going to start retiring in a few years en masse and the long-term assumptions built into their carefully crafted investment plans have been torn down by massive drawdowns in their IRA NAVs. This post is meant be an introductory answer to the "Now what do I do" question that many retail investors are asking. As members of the financial community, I'm sure many of us have faced this question in various forms from friends and family so if you can think of anyone who could use an answer to this question, forward them to this post and hopefully this will provide a solid framework that individual investors can use and tailor to their own needs. As always, feedback is welcome.


If you are reading this, you are probably asking yourself what to do with your IRA/529s/investment accounts in various forms. The financial planning industry has grown massively and in direct correlation with the massive influx of retail investors into the equity market and this army of CFPs has spread the gospel for years: "invest in stocks and bonds 60/40, equities will return 9% in the long-term, don't try to time the market" etc. However the past year has demolished most of these notions and even the few individual investors who did well, seem adrift and shaken in their investment beliefs. The purpose of this post is not to answer why the old paradigm failed but instead to guide you going forward.

Many of these ideas are not particularly new or innovative (though there are some twists in here that we haven't seen anywhere else) but we hope this provides you with two things; 1) an easily digestable and common sense approach to new financial concepts that will improve your portfolio and 2) an imperative to become more financially educated. I designed this to be helpful to a reasonably wide range of individual investors - from completely passive investors who park their money in Treasuries every year to relatively sophisticated individuals, who may do their own equity research and be comfortable with basic finance.


Individuals will have vastly different goals for their portfolio based on personal situations, risk tolerance, income, income potential, financial literacy, etc. However, most portfolios should have a few goals in common (in order of importance):

1) Limit significant drawdowns

This should be the single biggest goal of your portfolio. The reason for this is that one large and unexpected drawdown can erase years of painstaking research and carefully disciplined portfolio management. For example, a 40% drawdown (which is what many investors suffered in 2008) requires a 66% appreciation just to get back to where you started. This question should be in the back of your mind at all times and should be the first question you ask when you evaluate a new investment opportunity (both in the context of the investment and your overall portfolio). Numerous interviews and conversations with the world's top money managers have confirmed that the most common question that they constantly ask themselves is "How much can I lose on this?"

Large drawdowns have been the death blow to many of the world's most famous hedge funds and they will be to your portfolio as well.

2) Ensure an appropriate level of volatility for the time horizon

As an individual, you are investing for a purpose - to save for retirement, buy a car, pay for school, etc. In the simplest terms, you have $X and you need $Y in Z years. However, you are taking an unnecessary risk if you have an excessively volatile portfolio right up till the point that you need the money.

For example, if you have $90 and you need a $100 next year to pay college tuition for your daughter, would you bet $25 on a coin flip? Making sure your portfolio is appropriately tuned to the right level of volatility for your time horizon is critical.

3) Provide a rate of return sufficient to meet your goal

The most carefully constructed, well-designed portfolio is useless (or at least, not as useful as it could be) if it does not give you enough money to do whatever you're saving for.

The goals and the ordering of them provides some insights:
- Do not reach for return at the expense of drawdown risk or time-inappropriate volatility
- Set a target and back-solve for the return; don't do it the other way around
- There are very few stock picks/trade ideas that are appropriate for every investor
- Constantly sanity check to see if your investment plan and assumptions make sense- remember, there is no free lunch. A huge reason for the MBS crisis was demand for MBSs to begin with; investors thought they could get high yield returns at high grade risk. The risk never went away, it was just expressed in a different way.


Within five minutes of learning about finance, you are sure to hear the phrases "alpha" and "beta". If you've never heard of those terms, don't worry - we want to define/redefine those terms for you. Every time you make a choice, that's alpha; your choice is either "positive alpha" or "negative alpha". Every time you put your money at risk, that's beta; beta is the compensation you receive for putting your money on the line.

For traditional investing, a good analogy would be a reverse casino; basically, all the games are in the players' favor. You can first choose your game and then you can play it. A higher risk game is like picking a riskier asset class; you can win a lot more than your usual blackjack game but you also should expect your losses to be greater. As you can guess, a high risk game would be high beta. Once you're playing, the better you play the game, the more money you'll earn than the next guy. This is your alpha. Some games have a lot of variation in alpha; a good player can expect to make significantly more in blackjack or poker while even the best roulette player is unlikely to earn much more than the next guy. Additionally, in practice, high beta games are likely to return more on average than low beta games (albeit with more volatility). The reason for this is investors don't like volatility and need to be compensated with additional returns to make up for the sleepless nights.

Most individual investors have long been told that they can only play two games in this casino; equities and bonds. This is for two practical reasons; 1) those two games are the easiest for individuals to get involved with and 2) they typically will provide enough return to satisfy the needs of most investors. While this is sufficient to address goal 3 and with some jiggering can also suffice for goal 2, this leaves our biggest goal (goal 1) completely unaddressed. However those two reasons are no longer sufficient. With a lot of the newer products and some research/legwork, an individual investor can invest in other asset classes. Additionally, the US equity market is in line to recover into a secular bear market (translation: don't expect the returns we've seen since 1982). As a result, the returns may not be sufficiently in line with what you've come to expect. Ok, so our current two games don't satisfy our goals for our portfolio. What do we do? Before we answer that question, let's explore two topics.


Diversification is probably one of the most misunderstood concepts in finance; I say this because how else can it be explained that so many people have taken the 60/40 stock/bond split to constitute diversification? Diversification is one of the few exceptions to the free lunch rule - unless you are a high-octane investor, with a ridiculous track record of years of high performance, you want to be diversified. The definition I want you to use for diversification is: the less that any single bad event of any kind can affect your portfolio, the more diversified you are. It's patently simple at face value but the 60/40 stock/bond split fails that very basic test. A stock market crash would cripple that portfolio because the hit to the equity side would completely overwhelm any offsetting gains for the bonds. To put some numbers on it, a 60/40 stock/bond portfolio is going to have 80-90% of it's performance determined by the stock market (exact percentage depends on time frame and calculation methods).

Remember goal 1 from above - if it all it takes is a stock market crash (which typically happens every few years in some form) are you really diversified and are you positioned to avoid the huge drawdowns?


Leverage is a close second in the "most misunderstood concepts in finance" competition. Like guns, laptops or radiation, leverage is ultimately a tool that can used for good or bad, purposely or on accident. Leverage is the use of borrowed money to increase return. Practically, leverage increases the risk and the return for any asset while de-leverage decreases the risk and return for any asset. The academic term for this is "risk parity" and what that functionally means is that if any asset has higher risk and return than any other asset class, it is probably levered up in some way. For example, stocks are a leveraged asset class because companies typically borrow money to fund expansion and investment. There are other factors that determine an asset class' risk/return profile other than leverage. For example, top VC firms will typically outperform public equities on a risk-adjusted basis because VC is a much more illiquid asset class with hurdles to investment - technically, the risk is just being expressed in a different way (liquidity risk in addition to the typical volatility risk).

However, when used with a firm and careful hand leverage is extremely powerful because it allows you fine-tune asset classes to your risk/return preference. By being able to craft your portfolio with leverage, you can now use many other asset classes that may have previously been too volatile or not high-yielding enough. This in turn can lead to diversification. For example, even if you wanted to stick to a pure stock/bond mix as before, you could use leverage to craft your portfolio to have the same notional exposure with less exposure to a stock market crash. Of course, once you add in more and more asset classes you will see correspondingly better returns for the same amount of risk (or conversely, less risk for the same amount of returns).

Some caveats about leverage: fully understand the instrument you are using to lever your position. For example, options are a great way to leverage equities but many beginner options traders get absolutely hammered by theta (time decay). The good news is it doesn't take a lot of time - a few hours talking to a knowledgeable financial advisor or reading should be enough to understand the risks and how to control them. Additionally, I would advise you to stick to using leverage solely as a portfolio management tool and not as a returns generator in itself. Sticking with the options example, don't start selling options or day-trading options; create a plan and use options to help you achieve it.

Tying it all together

Ultimately, the beta of equities is not going to be enough to provide you with the returns you need. That is why you used to look for mutual funds instead of just buying the S&P index. However, the mindset shift we want you to have is this: the additional alpha you need to add to your returns does not have to come from trying to beat the stock market. There are thousands of full-time equity research analysts and hedge fund analysts who are trying to generate alpha in the stock and bond markets. If you think you can beat them by putting in a few hours every other weekend, you have to be a truly exceptional investor. Additionally, given the distribution of traditional alpha returns, it isn't the top 50% beating the bottom 50% by making better picks. In reality, it is more like the top 10% beating the bottom 90%.

So ask yourself: are you in the top 10% of all equity investors?

By redefining alpha as we have above, I hope you will see that you don't need to try and beat your head against the wall by paying mutual fund fees and financial advisor commissions and still getting below market returns. There are numerous studies that show that individual investors typically buy high and sell low. Instead of trying to generate alpha by stock-picking, you should consider generating alpha by using leverage appropriately and investing in a wider variety of asset classes. Additionally, you can also generate alpha by a number of other ways you may have not considered before. There are a few books out there that expand on this topic.

A more general method I would suggest would be to construct a framework that accomplishes two goals: 1) it covers most bad things that can affect your portfolio and 2) consists of variables that you can understand and would feel comfortable having a view on. For example, as an introductory framework I would suggest one consisting of {growth, liquidity, inflation and volatility}. Map out a grid of high and low states for the 4 variables and then map the asset classes you can invest in to each cell. (Note: volatility refers to the volatility of the unlevered asset class, not the returns of the asset class in high volatility - this variable is used to accomplish goal 2 from above).

Using this as a quick guide, you can develop a basic view on the economy and allocate slightly more to the asset classes that you think will perform better in your world view. Tactical asset allocation works because many of the players in the macro picture (central banks, governments, etc.) are not profit maximizers and so if you think an inevitable macro trend is going to emerge you may as well protect yourself. To clarify, this is different from being a macro investor - macro investors seek to play offense; that is to jump on macro trends before they are priced in by the market. Your goal is to play defense - you want to protect your portfolio from say, inflation, and though inflation expectations may be priced in to bond prices, you may still want to allocate accordingly.


First, start reading. Read about the different asset classes, how you can leverage them, different derivatives you can use, some of the books out there on tactical asset allocation, etc. Once you move to this new way of investing, you are going to probably spend less time on aggregate than you were before but there is an up front investment in terms of time. Use what available resources you have from a financial savvy friend or relative to your financial advisor. Once you have internalized many of the concepts, start developing your own views and frameworks.

For example, you could construct a framework based solely on types of risks that may hurt you. You could view your income stream itself as an asset (for example, a type of bond) and think about the risks that would imply; having your life savings in the stock of the company that hires you (i.e. provides your income stream asset) exposes your net worth to a ridiculous amount of risk from one source. If the employees at Enron and Bear Stearns had thought in that way, they undoubtedly would have been better off financially. The possibilities are endless.

Become proficient with Excel. This shouldn't take more than a couple of hours but will allow you to conduct most, if not all, of the analysis you need to do. Remember, there are many, many practical considerations as well; tax implications, restrictions on individuals investing in certain derivatives, family planning, analysis on correlations, leverage analysis, etc. The more independent you are, the less you will need to rely on CNBC or your financial advisor for interpretation.

I hope this has been helpful. Please read the FAQs if you have any questions.


Nothing in this post can be construed as specific investment advice to buy or sell certain securities. We are not registered advisors and you should consult with your financial, legal and tax advisors before doing anything.


I don't understand what X term means?

Finance has its own language and it is necessary to get into the habit of looking up terms. Much like reading Thucydides in his original Greek, you are going to need that financial dictionary by your side while you go through this stuff. If all else fails, you can use the Google function "define: x" as a search term.

Your definition of alpha and beta doesn't match what I heard from XYZ/learned in school/read online?

That's because the traditional definitions tend to be a little narrow. The definition we have certainly wouldn't work for an institutional but for our purposes, I think it does the job.

I'm just a small-time investor, how can I possibly start investing in all these complicated derivatives/assets?

Ask someone! You can trade equity options, bonds and international equities on ETrade, it's not too hard for an individual to open up a mini-futures or FX account, and derivatives in general are moving to a more retail-friendly basis.

Why do all this reading and research? Why not just buy the leveraged ETFs?

There is enough material here for a longer post but in short, the leveraged ETFs (and even many of the unleveraged commodity ETFs) are a bad idea. If you don't believe me track the returns of USO, DXO and crude oil on Google finance. If you really want to invest in ETFs, it may not be a bad idea but first you should read extensively about futures and then read the offering document of the ETF to see how it expresses its position in the relevant underlying. For example, if USO is buying the near-month contract in a severely contangoed oil market (like we are in now), the gains in the spot will never compensate for the roll yield.

I have a question that is not in the FAQs and that cannot be answered through a few minutes of research?

Post it in the comments; collaborative learning is a great benefit of this blog.
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