Investment Articles

Choosing an asset allocation, or the mix of stocks, bonds and cash in a portfolio, is the most important decision that you’ll face as an investor. A study by Ibbotson Associates concluded that asset allocation decisions determine about 100 percent of investment performance for those who follow a low-cost, long-term investing strategy. Similarly, according to a Dalbar and Associates study, many investors underperform the market because they deviate from their asset allocation plan during market downturns. Investors who want to maximize their long-term investment returns must develop a risk-appropriate asset allocation plan that they can stick with in good times and bad.

Asset Allocation Step 1: Evaluate Your Risk Profile

A reliable, long-term asset allocation plan starts with a thorough understanding of your risk profile. It’s helpful to think of your risk profile in two parts: your risk capacity, or the degree of portfolio volatility that you can absorb financially, and your risk attitude, or your emotional tolerance for risk.

Risk capacity is influenced by factors like income and net worth, but its largest determinant is time horizon. Early in life, when retirement is far off, your future earning potential can be thought of as a sizable bond, allowing you to allocate the majority of your retirement portfolio to more volatile equity investments. As you grow older and your future earning potential decreases, it’s important to replace those bond-like expected earnings with a higher percentage of bonds in your portfolio. By the time you retire, most of your investments should be in bonds in order to provide a reliable, low-volatility source of income.

Risk attitude is more difficult to quantify than risk capacity, especially for first-time investors who haven’t experienced difficult market conditions. Many investors make the mistake of failing to understand their risk attitude until a market downturn occurs. This usually leads to selling equity investments at the worst time (the bottom of the market), only to miss out on a subsequent market rebound. To help avoid this phenomenon, investors can use resources like risk questionnaires and historical performance charts to help find a stock/bond mix with an emotionally acceptable level of volatility. These tools are far from perfect, however, so when in doubt, it’s best to err on the side of conservatism.

Generally speaking, your most conservative risk dimension (capacity or attitude) should determine your portfolio’s equity/bond split. For example, if you have the risk capacity to handle a portfolio of 80% equities, but can only stomach the volatility of a 70% equity portfolio, you should choose the more conservative allocation. Developing a plan that you can stick with in good times and bad is much more important than maximizing your expected return.

Asset Allocation Step 2: Break Down Equities and Bonds

Once you’ve settled on a risk-appropriate stock/bond mix, you can think about subdividing the equity and fixed income portions of your portfolio. The key to this part of the asset allocation process is finding a suitable tradeoff between simplicity and maximum expected return.

Modern Portfolio Theory tells us that by adding volatile asset classes that don’t move in lockstep with the rest of our investments, we can increase our portfolio’s risk-adjusted return. Based on that principle, consider adding international stocks and Real Estate Investment Trusts (REITs) to your equity portfolio. Companies outside of the US represent more than half of the value of global equity markets, and investors have historically been compensated for the risks that accompany international investing. Likewise, REITs offer a great diversification benefit and give investors unique exposure to the commercial real estate market.

Within your US and international stock allocation, you may also want to boost your exposure to small company and value investments, as investors have historically been compensated for the risks inherent in these investing styles. If you’re not familiar with the arguments for overweighting these equity segments, however, you should probably steer clear of them in favor of simplicity.

To expand your fixed income allocation beyond a broad sampling of the US Bond Market, consider adding Treasury Inflation-Protected Securities (TIPS) and municipal bonds. TIPS are unique because, unlike traditional bonds, their principal and interest payments adjust with inflation, so they offer a government-guaranteed rate of return above inflation when held to maturity. Municipal bonds are appropriate for investors in high tax brackets with taxable investment accounts, as the interest from these bonds is generally tax-exempt in the issuing state and at the federal level.

Portfolios can be sliced and diced in any number of ways, but a more complex portfolio is not necessarily a better one. Wise investors understand that their investing success will largely be determined by their ability to stick with their asset allocation plan, and for that reason, they err on the side of simplicity.

Asset Allocation Step 3: Implement Your Plan

Once you’ve broken down your portfolio into target percentages, all that remains is to implement your asset allocation plan. With literally thousands of funds to choose from, it’s best to narrow down the field by focusing on one factor that you can control: investing costs.

First, you can minimize the impact of many fees, expenses and taxes by investing in low-cost index funds and ETFs. If your workplace retirement account has limited choices, simply pick the lowest cost funds that fill a position in your asset allocation plan. Secondly, pay close attention to all applicable fees and commissions prior to doing business with a brokerage firm or mutual fund company. IRAs and other investment accounts are extremely portable, so there’s no good reason to stick with a high-commission broker. Finally, maximize your portfolio’s after-tax returns by placing tax-inefficient asset classes (e.g., REITs, Bonds) in tax-sheltered accounts.

Once you’ve settled on specific investment choices, help yourself stay on track by formally documenting your asset allocation plan in an Investment Policy Statement (IPS). This document provides an organized framework for recording your investing goals, philosophy and target allocation so that you can help yourself resist the temptation to stray from your long-term strategy. The ideal time to draft an IPS is while the rationale for your asset allocation decision is fresh in your mind.

Conclusion

More than any other factor, your ability to develop and implement a risk-appropriate asset allocation plan will determine your investing success. By thoroughly evaluating your investing risk profile, choosing an appropriate level of portfolio complexity, and picking low-cost investments, you’ve taken a giant step toward your long-term investment goals.

George Watkins is President of West Wind Wealth Management, an independent, SEC-registered investment advisory firm that specializes in index fund and ETF portfolios. A former nuclear-trained Naval Officer, George has a BS in Economics from Duke University and an MBA from Harvard Business School. To receive a free asset allocation recommendation or a personalized portfolio recommendation for as little as $19, visit http://www.invest-it-yourself.com.

Choosing an asset allocation, or the mix of stocks, bonds and cash in a portfolio, is the most important decision that you’ll face as an investor. A study by Ibbotson Associates concluded that asset allocation decisions determine about 100 percent of investment performance for those who follow a low-cost, long-term investing strategy. Similarly, according to a Dalbar and Associates study, many investors underperform the market because they deviate from their asset allocation plan during market downturns. Investors who want to maximize their long-term investment returns must develop a risk-appropriate asset allocation plan that they can stick with in good times and bad.

Asset Allocation Step 1: Evaluate Your Risk Profile

A reliable, long-term asset allocation plan starts with a thorough understanding of your risk profile. It’s helpful to think of your risk profile in two parts: your risk capacity, or the degree of portfolio volatility that you can absorb financially, and your risk attitude, or your emotional tolerance for risk.

Risk capacity is influenced by factors like income and net worth, but its largest determinant is time horizon. Early in life, when retirement is far off, your future earning potential can be thought of as a sizable bond, allowing you to allocate the majority of your retirement portfolio to more volatile equity investments. As you grow older and your future earning potential decreases, it’s important to replace those bond-like expected earnings with a higher percentage of bonds in your portfolio. By the time you retire, most of your investments should be in bonds in order to provide a reliable, low-volatility source of income.

Risk attitude is more difficult to quantify than risk capacity, especially for first-time investors who haven’t experienced difficult market conditions. Many investors make the mistake of failing to understand their risk attitude until a market downturn occurs. This usually leads to selling equity investments at the worst time (the bottom of the market), only to miss out on a subsequent market rebound. To help avoid this phenomenon, investors can use resources like risk questionnaires and historical performance charts to help find a stock/bond mix with an emotionally acceptable level of volatility. These tools are far from perfect, however, so when in doubt, it’s best to err on the side of conservatism.

Generally speaking, your most conservative risk dimension (capacity or attitude) should determine your portfolio’s equity/bond split. For example, if you have the risk capacity to handle a portfolio of 80% equities, but can only stomach the volatility of a 70% equity portfolio, you should choose the more conservative allocation. Developing a plan that you can stick with in good times and bad is much more important than maximizing your expected return.

Asset Allocation Step 2: Break Down Equities and Bonds

Once you’ve settled on a risk-appropriate stock/bond mix, you can think about subdividing the equity and fixed income portions of your portfolio. The key to this part of the asset allocation process is finding a suitable tradeoff between simplicity and maximum expected return.

Modern Portfolio Theory tells us that by adding volatile asset classes that don’t move in lockstep with the rest of our investments, we can increase our portfolio’s risk-adjusted return. Based on that principle, consider adding international stocks and Real Estate Investment Trusts (REITs) to your equity portfolio. Companies outside of the US represent more than half of the value of global equity markets, and investors have historically been compensated for the risks that accompany international investing. Likewise, REITs offer a great diversification benefit and give investors unique exposure to the commercial real estate market.

Within your US and international stock allocation, you may also want to boost your exposure to small company and value investments, as investors have historically been compensated for the risks inherent in these investing styles. If you’re not familiar with the arguments for overweighting these equity segments, however, you should probably steer clear of them in favor of simplicity.

To expand your fixed income allocation beyond a broad sampling of the US Bond Market, consider adding Treasury Inflation-Protected Securities (TIPS) and municipal bonds. TIPS are unique because, unlike traditional bonds, their principal and interest payments adjust with inflation, so they offer a government-guaranteed rate of return above inflation when held to maturity. Municipal bonds are appropriate for investors in high tax brackets with taxable investment accounts, as the interest from these bonds is generally tax-exempt in the issuing state and at the federal level.

Portfolios can be sliced and diced in any number of ways, but a more complex portfolio is not necessarily a better one. Wise investors understand that their investing success will largely be determined by their ability to stick with their asset allocation plan, and for that reason, they err on the side of simplicity.

Asset Allocation Step 3: Implement Your Plan

Once you’ve broken down your portfolio into target percentages, all that remains is to implement your asset allocation plan. With literally thousands of funds to choose from, it’s best to narrow down the field by focusing on one factor that you can control: investing costs.

First, you can minimize the impact of many fees, expenses and taxes by investing in low-cost index funds and ETFs. If your workplace retirement account has limited choices, simply pick the lowest cost funds that fill a position in your asset allocation plan. Secondly, pay close attention to all applicable fees and commissions prior to doing business with a brokerage firm or mutual fund company. IRAs and other investment accounts are extremely portable, so there’s no good reason to stick with a high-commission broker. Finally, maximize your portfolio’s after-tax returns by placing tax-inefficient asset classes (e.g., REITs, Bonds) in tax-sheltered accounts.

Once you’ve settled on specific investment choices, help yourself stay on track by formally documenting your asset allocation plan in an Investment Policy Statement (IPS). This document provides an organized framework for recording your investing goals, philosophy and target allocation so that you can help yourself resist the temptation to stray from your long-term strategy. The ideal time to draft an IPS is while the rationale for your asset allocation decision is fresh in your mind.

Conclusion

More than any other factor, your ability to develop and implement a risk-appropriate asset allocation plan will determine your investing success. By thoroughly evaluating your investing risk profile, choosing an appropriate level of portfolio complexity, and picking low-cost investments, you’ve taken a giant step toward your long-term investment goals.

George Watkins is President of West Wind Wealth Management, an independent, SEC-registered investment advisory firm that specializes in index fund and ETF portfolios. A former nuclear-trained Naval Officer, George has a BS in Economics from Duke University and an MBA from Harvard Business School. To receive a free asset allocation recommendation or a personalized portfolio recommendation for as little as $19, visit http://www.invest-it-yourself.com.

Our image of a canny investor might be clad in pinstripe, testosterone- fuelled and a ruthless risk-taker. Yet he is in serious danger of being outperformed by those of a more feminine persuasion.

One of the largest studies of investment activity, carried out at the University of California in 2001, showed that men traded 45% more often than women. Yet their average risk-adjusted returns were 1.4% less. Another large survey by DigitalLook found that women’s portfolios grew by 3% more than the FTSE in the year ended 31st July 2004, while men’s lagged 1% behind.

Since then the evidence for female supremacy in the investment markets has been steadily mounting. Now psychologists can identify the character traits that make up a winning investor. They’re also pinpointing those traits that explain why more men end up counting their losses in the markets.

What are those attributes that put one a cut-above the other? Women’s better investment performance may be down to the simple fact that they are:
More cautiousWomen’s portfolios are more balanced and diverse. They also choose more low risk, less faddy, options.
Less competitiveWomen invest less of their ego in a deal. They’re less motivated to prove their financial prowess to others or to be in it for the thrill.
More consistentWomen have been shown to back a less volatile portfolio than men. They’re also better at tuning out the ‘information’ that others may over-react to and riding out the ups and downs of the markets.
More patientThey engage in less fund hopping, trade less frequently and hold investments for longer. Those that trade most frequently earn the lowest returns, studies by Barber and Odean (2000) and Carhart (1997) have found. This is true of both individuals and mutual funds.
Better researchersAlthough women on the whole are less experienced investors than men, they will research more thoroughly and be less swayed by the herd.

Sure, these aspects of the female psyche also make women more conservative investors than men. And so they may not reap the stratospheric profits (or make the mega losses) that men do. But, by investing in funds that are consistently good over time women’s net returns are higher. And isn’t that what counts in the end?

Of course, many men have what it takes to make them top-notch investors. But their winning traits may not be the customarily masculine ones. The truly top male investors may be more in touch with their feminine side than we’d think.

Apart from a lack of estrogen and fewer handbags, what else accounts for the winner-loser divide? There are three key psychological traits that, when it comes to making the savviest investment decisions, can trip men up every time.

These are:
Attitude to riskMen are less risk averse than women and will back portfolios that are more uncertain. They’re more likely to put all their eggs in one basket instead of opting for a safer, more diverse portfolio. Men’s higher earnings and greater net worth also makes it easier for them to take greater risks than women. A US study by Wang in 1994 also showed that women are more likely to be offered safer options than men, by advisors who expect them to be risk-averse.
OverconfidenceOverconfidence is consistently found in more men than women, research shows. And this is especially true in male-dominated arenas such as finance. They overestimate the returns their investments will bring and the certainty of the return. They also have a misjudged overconfidence in the accuracy of their own knowledge and over-rate their own ability. In a Gallup study, both men and women expected their portfolios to outperform the market but men expected theirs to outperform it by a greater margin.
The herd instinctConstantly monitoring the market can fuel men’s over-activity and cause them to act irrationally. Men are more likely to get drawn into financial follow-my-leader games and information cascades. They also fall foul of being too well informed, instead of tuning out the endless stream of news and financial information and sticking to an annual portfolio review.

Despite women having more of the innate skills that could earn them the best returns, still lamentably few of them are in the game. Male investors outnumber females by eight to one, and a mere 3% of hedge funds are headed by a woman. Simonne Gnessen, who owns Wise Monkey Financial Coaching and has a predominantly female clientele, says women could do with borrowing some of that male over-confidence. “Many women have exactly what it takes to reach dizzy financial heights,” she commented, “the only thing holding them back is knowing that they have it and acting on it.”

Professor Karen Pine is a renowned researcher in Developmental Psychology as well as being a popular women’s writer. Currently she is Professor of Developmental Psychology at the University of Hertfordshire. Professor Pine’s research has been published extensively in international academic journals and presented at conferences worldwide. Women’s issues have always been at the heart of Karen’s interests and her wide-ranging research includes non-verbal communication, money management and body image. She has featured regularly in the media, on television programmes such as Channel 4 News and Richard and Judy and in news media from the Independent in the UK to the Sydney Morning Herald in Australia.

http://www.karenpine.com
http://sheconomics.com

As a man, I find myself asking myself often, “What is going on in this world?” Is it me or is there a concerted effort, or should I say a case of “trying too hard” to marginalize men in society. Now don’t get me wrong, I am all for “women rights,” only when women will decide to seek harmony with men. However, “gender equality” should not come at the expense of the rights of men.

That is why it humors me to no end at this current attempt by the feminist propaganda machine to not only blame men for the current economic landscape, but to proclaim, by way of a certain articles (see below), that women are better investors than men. Much of what is written suggests that men need to “step aside” and let women take over the reins of the decisions involving the investment portfolio. Without rehashing much of what was written in these articles, here is a summary of the main points:

• Men overall traded stocks 45% more frequently than women.
• Single men traded stocks 67% more frequently than single women.
• Women overall earned annual risk-adjusted returns that were 1.0% greater than men.
• Single women earned annual risk-adjusted returns that were 1.4% greater than single men.
• The major problem men have is ego.

While I don’t necessarily disagree with the stats, providing there was no number “massaging,” I do disagree with the conclusion that women are better investors and that men are somehow gender inferior to women in this area; This where I call it a case of “creating something that wasn’t there.” Now that we live in a society that fosters in women false empowerment and discourages constructive criticism, it is time to start exposing the truth. I don’t mind pimping out my investment portfolio to my women friends if I saw a clear advantage but I am going to share my 5 reasons why women are hardly any better investors despite the numbers that appear to the contrary.

Reason One: Women have a safety net

When have you ever seen the majority of the homeless in America made up of women? When have you ever heard of the majority of divorce settlements falling in favor of men? When have you ever seen a continuous stream of women losing custody over their children to their fathers? When have you ever seen domestic disputes where the majority of time women were arrested? I could go on and on, but this will suffice.

I went into left field to say that women, despite their “come up,” have a “safety net” provided for them by society. Forget the propaganda of women “struggling to make it to the top.” Women are achieving such because they are in a place where they can’t fail (which by the way was created for them by men). Men can complain or women may not want to acknowledge it, but that is reality.

So if you knew you couldn’t fail, then how do you think your investment performance would fare? If there is little to no risk to your world collapsing, then you can afford to sit back and hold your investments longer and trade them as little. While men are accused of being over confident in their trading, the numbers also imply that women generally do well because of conditions that they did not create.

As for men, there is no comparison. A man can spend his life toiling to create a respectable fortune and a suitable life, make one miscalculation, whether its marrying the wrong woman, gets fired, or the business goes defunct, and he is likely to do a free fall to the bottom. Because of this, it is the reason why men have the tendency to take more risk. We are not wired to take risk, but rather we must take chances in the real face of uncertainty to create a probable certainty.

Reason Two: Women posses no inherent added value

It is a disservice to both men and women to suggest that women possess some “super power” that men are lacking. This argument is based on the results that women out performed men by a measly 1 to 1.3%. I say measly because if it were the case that there was some inherent added value within the biological and gender make up of women, then why does this power eke out only less than 5%. That’s like calling the “man of steel” Superman but he can only lift 5 more pounds than the strongest body builder. The argument sounds a bit stretched.

When you look at the annual performance number combined with the 45 and 67% over trading statistics, it speaks volumes not to any power women may have, but rather to the mistakes that men make in the financial markets. The numbers really suggest men need a better framework for trading successfully. If you look at the numbers again, all men have to do is ever so slightly improve their trading by just a little, and men easily dwarf the trading performance of women. It is as simple as that.

On another note about the so called “gender superiority” women supposedly have when it comes to investing in the financial markets, my question is, if this is true, then why aren’t more women in droves coming in to take advantage of their “inborn super powers?” Women have for years taken on jobs and careers that were nontraditional and “worked hard to get to the top” of their professions, why wouldn’t they do something that supposedly comes “naturally” for them? As the rapper Jay-Z would say, “One of us ain’t playin’ right, but I’ll let you tell it.”

Furthermore, the collective of articles points out the reason why women make better investors is due to them having higher emotional intelligence than men. On the surface this is true because women are systemically tied to their emotions, so it obviously make sense. The more you use something the more intelligent you become in that area. This is so apparent but I have to ask, what does this have to do with the price of tea in China? If you look in the annals of giants in the investing or trading arena, how come you never hear any of these great men mentioning that they relied on their emotions to invest successfully? That is like me asking women, if they are so attuned to their emotions or their intuition, how come many of them fail to use their innate power to “feel” the difference between a good man and a loser. This brings me to the next reason.

Reason Three: Women have no long-term perspective

Last time I check, the divorce rate hovered around 50-70%. What is more interesting is that 60-70% of those divorces are initiated by women. Maybe I am missing something here but can anybody explain to me how I am supposed to believe they can pick and hold the right stocks for the long term, but lack discernment in their choice of men and lack the long-term perspective to stick with their relationships. I am just saying…

Reason Four: Women are masters of pride

Another argument for the idea that men need to “sit down” and let women take over is that men have too much ego. On this point, I definitely agree with this one. Men tend to put a little too much stock in what little they know, especially when it comes to investment selection. I know because I use to carry on with this tone managing my portfolio to my demise. But to suggest that men are “wired” this way or that women are not in possession of any flaw is ludicrous.

What women may lack in ego, they more than make up in pride. Here is a quick exercise. Count on your hands the number of times you ever heard a woman admit to a mistake or admitted that she was wrong? If you get the range of numbers I get then you clearly see that although a man will overcompensate on his expertise, women will avoid humiliation to the point of denial rather than admit that they made an error in their investment decisions. So it equals out. Are you finding it hard to believe that women are somehow “getting over” on men by using their “superior strength” in the financial markets?

Reason Five: Women don’t take rejection to well

You ever wonder why in spite of the changes in society with women moving up in the world, most women still hold (when it suits them) these beliefs that men are still supposed to pay for dinner, pursue them, and whatever else works for them in their favor. I quickly assess that the real reason is that women use this as a way of keeping power to overcompensate for their fear of rejection. After all, I just mentioned that women are the masters of pride. I will share an incident with you that will help bring home this point.

I remember years ago, I was at this bar with a couple of my partners. We were talking about whatever when we noticed that this particular woman sitting at the bar whispering amongst her girlfriends while looking in the direction of one of my friends. Eventually, she gets up and starts heading over in our direction and starts to have a conversation with him. Instead of us butting in, we proceeded to eat at our food while “ear hustling.”

Apparently, she was trying to engage him in a conversation about whether he had a girlfriend and what not. What made me start snickering was that his nonverbal language hinted to his disinterest. While she was making every attempt to close the deal, he finally told her that he was neither interested nor looking for a relationship at this time, since he just got out of relationship. Once she got the picture, she went back to the bar.

But then she started crying. I mean literally crying with her head down on the bar. It was so bad that her girls gathered around to console her. For obvious reasons, we and the few men who were privileged to see this were laughing hysterically. It was shocking enough that we witnessed the very few times a woman actually approaching a man, but to see a woman get rejected was kind of funny in a weird kind of way. Now she knows what men go through every day.

I bring up this story to make this point: Most women never put themselves in positions of great risk or danger. Consequently, when they encounter these situations, they are not trained to deal with them. So how all of sudden they are now better investors than men when the essence of the financial markets is risk, and I now need to turn over my investment decisions over to them. Miss me with this.

As I said earlier, most men under perform in the financial markets due to a lack of understanding or not having an optimal mindset for the markets. It really has nothing to do with gender as much as it has to do with social engineering. The secret to improving performance in the financial markets is to understand that what goes on in the markets is a microcosm of what goes on in society. Deflect the way society tries to influence you as a man, and you will begin to improve your performance in the markets.

Resources

http://www.women24.com/Content/Wellness/BodyAndSpirit/2502/c28a5f25e4eb47eebb6a376e49ad013d/24-03-2009-09-36/Why_women_are_better_investors

http://www.advancingwomen.com/more-money/why-women-make-better-investors-than-men.html

Henry “Solomon” Billingslea, Jr. is a financial trader, and the author of Pimping Wall Street, The Player’s Guide To Trading The Markets Vol. I. He offers a Free Trading Mentoring Program where he gives free coaching and free capital to get build a solid trading portfolio.

Any discussion on risk-adjusted performance measures must start with the grandfather of all risk measures the Sharpe Ratio or Reward to Variability which divides the excess return of a portfolio in excess of the risk free rate by its standard deviation or variability.

Most risk measures are best described graphically, a measure of return in the vertical axis and a measure of risk in the horizontal axis.

Ideally if investors are risk averse they should be looking for high return and low variability of return, in other words in the top left-hand quadrant of the graph. The Sharpe ratio simply measures the gradient of the line from the risk free rate (the natural starting point for any investor) to the combined return and risk of each portfolio, the steeper the gradient, the higher the Sharpe ratio the better the combined performance of risk and return.

Funds are ranked in order of preference with the Sharpe ratio but it is difficult to judge the extent of relative performance. M2; first proposed by Leah Modigliani and her grandfather Professor Franco Modigliani (1997) offers an alternative risk-adjusted return using the Sharpe ratio of the portfolio but calculated at the risk of the benchmark thus allowing direct comparison.

Investment statistics can either be grouped as Sharpe type combining risk and return in a ratio, risk adjusted returns such as M2 or descriptive statistics which are neither good nor bad but provide information about the pattern of returns of the portfolio manager. The first moment of a return series is the mean, the second moment is the variance, the third moment is skewness and the fourth moment kurtosis. Kurtosis measures the weight of returns in the tails or the peakedness of a return distribution. Investors should prefer high average returns, lower variance or standard deviation, positive skewness and lower kurtosis. The adjusted Sharpe ratio suggested by Pezier (2006) explicitly rewards positive skewness and low kurtosis (below 3, the kurtosis of a normal distribution) in its calculation and thus potentially removes one of the possible criticisms of the Sharpe ratio.

The regression statistics b (or systematic risk), r (correlation) and R2 are descriptive statistics. Jensen’s alpha is often misquoted as the portfolio manager’s excess return above the benchmark, more accurately it the excess return adjusted for systematic risk.

Treynor ratio or Reward to Volatility is similar to Sharpe ratio, the numerator (or vertical axis graphically speaking) is identical but in the denominator (horizontal axis) instead of total risk we have systematic risk or volatility as calculated by beta. Although well known the Treynor ratio is less useful precisely because it ignores specific risk.

The appraisal ratio first suggested by Treynor & Black (1973) is similar in concept to the Sharpe ratio but using Jensen’s alpha, excess return adjusted for systematic risk in the numerator, divided by specific risk not total risk in the denominator.This measures the systematic risk adjusted reward for each unit of specific risk taken.

In the same way that absolute return and absolute risk are combined in Sharpe ratio excess return and tracking error (the standard deviation of excess return) are combined in the information ratio, although given the need of an appropriate benchmark less useful for hedge funds.

The Sharpe, appraisal, Treynor and information ratios are familiar measures used by the industry for decades. More recently hedge funds have encouraged the use of further risk measures designed to accommodate the risk concerns of different types of investors. These measures can be categorised as based on normal measures of risk, regression, higher or lower partial moments, drawdown or value at risk (VaR).

Predominately hedge fund management styles are designed to be asymmetric in their return patterns. If successful this leads to variability of returns on the upside but not on the downside. Investors are less concerned with variability on the upside but of course are extremely concerned about variability on the downside. This leads to an extended family of risk-adjusted measures reflecting the downside risk tolerances of investors seeking absolute not relative returns.

Standard deviation and the symmetrical normal distribution are the foundations of Modern Portfolio Theory. Post-modern Portfolio Theory recognises that investors prefer upside risk rather than downside risk and utilises semi-standard deviation.

Downside risk measures the variability of underperformance below a minimum target rate. Theminimum target rate could be the risk free rate, the benchmark or any other fixed threshold required by the client. All positive returns are included as zero in the calculation of downside risk or semi-standard deviation.Downside potential is simply the average of returns below target, upside potential the average of returns above target.

In their article “A Universal Performance Measure” (2002) Shadwick & Keating suggest a gain-loss ratio, Omega (W) that captures the information in the higher moments of a return distribution implicitly adjusting for both skewness and kurtosis; dividing upside potential by downside potential.

A natural extension of the Sharpe and Omega is suggested by Sortino (1991) which uses downside risk in the denominator. Total risk has simply been replaced by downside risk, portfolio managers will not be penalised for upside variability but will be penalised for variability below the minimum target return.

The upside potential ratio suggested by Sortino, Van de Meer & Platinga (1999) can also be used to rank portfolio performance and combines upside potential with downside risk. Even “Prospect Theory” the fact that investors dislike losses far greater than they like gains can be built into a Sharpe like measure in the form of the Prospect ratio.

If value at risk is your preferred measure of risk then, of course, there is a Sharpe type measure that replaces standard deviation with VaR in the denominator; called reward to VaR. VaR does not provide any information about the shape of the tail or the expected size of loss beyond the confidence level. In this sense it is a very unsatisfactory risk measure; of more interest is conditional VaR otherwise know as expected shortfall, mean expected loss, tail VaR or tail loss which takes into account the shape of the tail. Historical simulation methods which make no assumptions of normality are particularly suitable for calculating conditional VaR. The conditional Sharpe ratio replaces VaR with conditional VaR.

Perhaps the simplest measure of risk in a return series from an absolute return investor’s perspective, wishing to avoid losses, is any continuous losing return period or drawdown. The average drawdown is the average continuous negative return over an investment period, three years being a typical period of measurement for comparison purposes.

The maximum draw down not to be confused with the largest individual draw down is the maximum potential loss over a specific time period, typically three years. Maximum draw down represents the maximum loss an investor can suffer in the fund buying at the highest point and selling at lowest.The Calmar ratio is a Sharpe type measure that uses maximum draw down rather than standard deviation to reflect the investor’s risk. In the context of hedge fund performance it is easy to understand why investor’s might prefer the maximum possible loss from peak to valley as an appropriate measure of risk.

The Sterling ratio replaces the maximum draw down in the Calmar ratio with the average largest draw downs.

Similar measures including the Pain ratio and the Ulcer Performance ratio incorporate the duration and depth of draw downs since the previous high water mark. The range of combined risk and return measures available for hedge fund investors is almost limitless.

With so many similar ratios the natural question to ask is “which is the best measure to use?” In fact Eling & Schuhmacher (2006) have published an article “Does the Choice of Performance Measure Influence the Evaluation of Hedge Funds” which concludes that most of these measures are all highly correlated and do not lead to significantly different rankings. Both the question and their article to some degree miss the point, risk like beauty is in the eye of the beholder, the investor most decide ex-ante which measures of return and risk best reflect their preferences and choose the combined ratio which reflects those preferences. One, and only one, of the above ratios are most likely to reflect the preferences of the investor. Care should also be taken to ensure hedge funds are not hiding volatility by using smoothed valuations. Consistent valuation criteria must by applied each month, although Global Investment Performance Standards (GIPS) do not require that specific risk measures are used they do require documented policies and procedures for valuations consistently applied and are therefore valuable and a source of comfort for any potential investors.

Read the full 13 pages article at:
http://www.statpro.com/resources/whitepapers/how_sharp_is_the_sharpe_ratio.aspx

Carl is also the author of “Practical Portfolio Performance Measurement & Attribution” part of the Wiley Finance Series, numerous articles and papers and editor of “Advanced Portfolio Attribution Analysis”

Most investors do not realize, but as a private investor managing his own money, he has got an immense advantage over a fund manager due to factors he may not even be aware of.

Sure it will take up some of your free time but it will probably be one of the most awarding activities you can invest your time in.

We have all worked hard for the money we have saved and it would only be prudent to invest in in the best way possible.

With public pension systems crumbling around the world because of aging populations, making the most of your savings had gotten much more important.

Below are the advantage I have come up with. If you come up with any others please send me a short note.

1. You can wait
As a private investor you can wait for attractive investment opportunities to present themselves. If you cannot find anything attractive you can stay in cash.

Fund managers do not have this luxury. They have to invest in whatever their investment area is irrespective of valuation.

Holding cash in the fund management world is known as career risk as the fund manager runs the risk of falling behind his peers or his benchmark. The larger the cash position the higher the career risk.

The best example of career risk I have read is value fund managers losing their jobs because they refused to buy internet shares during the internet bubble.

2. You can invest anywhere and everywhere
As a private investor you can invest in any type of asset in any country that offers an attractive risk return trade-off, be it corporate bonds, equities, options, real estate etc.

Fund managers have to stay within the fund’s investment area. Additionally complying with regulations, even further limits their investment choices.

You can argue that you can change to a fund in another investment area but that is also actively managing your money.

3. You can invest in any size
This is similar to the investing anywhere and everywhere as you have the freedom of investing in small or large companies whatever is most attractively priced.

I was recently astounded when I heard of a value fund manager that had to invest in companies that have a high weighting in a particular share index because he had institutional investors (read large investors) that would withdraw their funds should his performance deviate too much from the market.

This is ludicrous, why invest with a value manager if you really want market index performance? You want a value manager to do what he does best, search for undervalued companies.

4. You have no benchmark
As a private investor I only have one goal in mind, to grow my investment portfolio each year irrespective of what the market does.

I do not consider it a good year if I have lost 25% while the market has lost 40%.

I am sure your goal is the same.

Fund managers only have one goal, beating his benchmark irrespective of absolute return. I cannot remember how many times I have heard a fund manager say that he has to remain fully invested in his investment area as that is what his investors expect of him.

Just think of what happened to investors in technology funds as the internet bubble deflated.

5. You can focus and ignore
Studying, understanding and applying what has worked in investing is all you need to do to be wildly successful as a private investor.

You can only focus on a few things and ignore the market noise, you only have to spend relatively little time to be successful.

Fund managers have to have an opinion on a lot of different investment areas because they have to appear competent in company and client meetings. It is tough for them to have to say I do not know.

I do not watch financial television, its complete rubbish and a waste of time. Mainly yo-yo news i.e. what went up and down.

I have my investment criteria, I look for companies that falls within it and I study only that. The rest does not interest me and that saves a lot of time.

6. No conflict of interest
This is a big one. You only have your best interests at heart. In other words all your decisions are in your best interest.

Fund managers have to think of keeping their jobs, increasing their assets under management and keeping clients happy.

All this means is that their investment performance is not the most important thing on their minds.

Also fund managers in companies what also offer investment banking services may be pressurised to buy securities of investment banking clients irrespective of investment attractiveness.

7. You can have a long view
According to a study by the New York Stock Exchange the average holding period of shares held by investors have declined from five to six years in the 1950’s to 11 months.

It is unlikely that a company with problems, as undervalued investment inevitably have, can sort them out in such a short period of time.

As a private investor you can follow the company over many years and realize the gains when the company gets revalued by the market.

This may be the largest competitive advantage you have. The ability to look at a company solely on valuation and keep it as long as it is undervalued.

8. No peer pressure
Accept if you discuss your investment with friends or family you will have no peer pressure to buy or sell any investments.

I have gotten to the point that I am reluctant to discuss my investments because the response I get is either, “never heard of it” or “what, you must be mad, don’t you read the newspaper?”

Fund managers have a different problem. The funds they manage get compared to benchmark indices and other funds, including the individual fund holdings. Should you stand out in any way invites questions. Should the performance be worse than the peer group or benchmark career risk increases.

If you manage your own money you have none of these problems.

9. You decide
You make the final decision after you have done the analysis. You may be wrong but at least you make the calls either way.

A lot of funds are managed where committees decide what is bought and sold. Apart from the problems of group-think investment committees are staffed with people throughout the organization with different investment approaches, not all of which has shown good historical results.

Furthermore it may be difficult to tell your boss that his investment idea stinks if you have your bonus evaluation later that day.

This leads to suboptimal and sometimes completely dysfunctional decision making.

10. You can concentrate
If you find a really compelling idea you can choose to invest as large a part of your capital as you feel comfortable with.

With 80% of non-market risk diversified away with as few as 15 positions you can determine what your optimal number of investments are.

Mine is 30 as I feel comfortable with the weighting of each position in my portfolio and I can easily keep track of the investments.

When I see funds with 100 or more investments my first thoughts are that they must not have much conviction in any of their ideas.

Also with so many positions you may as well buy the market itself through an inexpensive exchange traded fund.

11. You control the costs
Controlling costs and fees, or the friction of investing, is a very important part of part of realizing superior long term results.

Using a discount broker I can buy and sell most shares for around 1% brokerage. If I hold a position for three years that equates to 0.33% per year plus a 0.25% custody fee.

That is a lot lower than funds that charge 1% to 1.5% per year on top of a 5% initial fee and other expenses.

Calculated over a period of 20 to 30 years keeping costs low makes a huge difference.

12. Down years are more bearable
This goes along with the point on making your own decisions.

Should you have a bad year at least you know you made the decisions, can learn from your mistakes and make adjustments to your investment strategy.

13. You can be fully invested
Should you find a large number of attractive investments you can be fully invested and remain so even if the markets declined and you are still convinced of the investment case of each investment.

With a fund manager this is unfortunately not the case. When markets fall they are bound to get redemptions. In order meet the redemptions they must either have cash available or sell investments.

But when markets are falling liquidity drops as well. That means that because investments have to be sold liquid investments are sold first. This selling pressure puts pressure on share prices leading the markets to fall further thus triggering more redemptions. You get the picture.

Some fund managers plan for such eventualities be keeping a certain amount of liquid investments or by keeping at least a small amount of cash on hand.

This as mentioned in one of the points above leads to suboptimal investments not necessarily the managers best ideas.

Luckily as a private investor you do not have this problem.

I always keep a cash reserve of one years living expenses aside to ensure that I do not have any pressure to sell investments should the market decline unexpectedly.

Also a large cash reserve gives me the peace of mind and opportunity to focus on investing for the long term.

There are of course a few funds where the drawbacks mentioned below do not apply but they are in the minority. The large bulk of fund management companies are focused on growing the amount of money they manage, where maximizing the returns to investors come a distant last.

Tim du Toit is the editor of EuroShareLab. The purpose EuroShareLab is to share knowledge and ideas gained in over 20 years of investing experience and continuous learning to help other independent investors on their investment journey.

Visit us at http://www.eurosharelab.com browse through past content and sign up for our free weekly newsletter. Do something for your financial future today.

The bursting of the asset bubble amidst a tsunami of financial problems and the economic recession has already erased more than four years of wealth created by world’s households and corporations. However, the precipitous drop in wealth is unlikely to end anytime soon. Now there is something else to worry about: deflation. Emerging deflation in general consumer prices will likely exacerbate the current economic and financial problems and will lead to the extended, albeit somewhat less severe losses in asset values and therefore in general wealth.

Institutions such as the Central Bank, the IMF, and our own banks such as AIB have all painted gloomy growth, or rather contraction, forecasts for Ireland. A central point is that Ireland’s recovery is heavily dependent on global economic recovery, and so somewhat out of our control.

Deflationary pressures have already slashed values of various asset classes, especially in the property market. However, these pressures will be sustained as the world’s economies enter into a cycle of falling prices of consumer goods and services. Given that deflation negatively affects household income, corporate profits, asset values, and the overall economic growth, it will be necessary to show prudence when making investment decisions in the current market. In fact, for deflation, there is only one right investment choice: preserving capital.

In deflationary times, the overall investment strategy should be focused on the preservation of wealth rather than on the creation of wealth. Moreover, the goal is to concentrate holdings in safe assets rather that to diversify them across sectors and markets. This conservative approach means steering away from equities, commodities, and high-yield fixed income securities, even from traditionally conservative investments such as property and managed funds, and focusing on safe liquid investments, such as cash and bonds, which do not necessarily produce high returns.

In fact, deflationary times give true meaning to the cliche cash is king. This is so because, by definition, deflation means that the value of your money increases as the price of goods and services declines. There are also other liquid (cash-like) investment instruments, such as certificates of deposit and money market funds, which would preserve your wealth from losses propped up by deflation.

Bonds are also an option. However, investing in bonds when deflation is coupled by financial distresses and the possibility of an extended economic downturn warrants caution in respect to bond issuer creditworthiness. The likelihood of default on certain types of government securities (particularly municipal bonds) and corporate bonds is heightened in the current situation in which corporate bankruptcies, especially in some sectors such as auto industry, are rising. Therefore, one should be very selective when opting for bonds, particularly corporate bonds, making sure that securities with the lowest probability of default are selected. Treasury bonds are the safest investment choice.

Certain undervalued equities may also offer some long-term value. For those who maintain investment positions in equities with a long-term perspective, sectors that could offer some relative security from the generally declining stock market include infrastructure construction-related sectors, consumer staples, healthcare, and utilities such as electric power companies.

However, with this investment strategy one may view deflation as an economic process that reduces opportunities to maximize wealth creation. Quite the contrary! Conservative investment choices in deflationary times preserve wealth from losses and secure capital for the time when high-return opportunities re-emerge. In fact, deflations are the precursors of investment opportunities that will follow it. These opportunities, when identified properly, may offer substantial long-term returns that will assure optimal long-term investment performance. Still, while the coming deflation may not last long, it will take a while before the economy charges ahead again. It will be necessary to clean some of the excesses accumulated during the largest asset bubble in the economic history of the modern world before good investment opportunities sprout again.

This cleansing process is where the National Asset Management Agency (NAMA) needs to make the correct decisions, on behalf of the Irish taxpayer, in order to maximise long-term sustainable growth. Here’s hoping…

http://rhinoxoo.com

Mark Twain said “There are three kinds of lies: lies, damned lies, and statistics.” His point was that through the judicious selection of data, statistics can be manipulated to prove just about any point a person wants to make. If this is true (and I wouldn’t want to argue with Mark Twain), investment performance falls firmly into the same category.

Timing the Market vs. Time In the Market

Arguments for and against the loosely-defined “market timing” is an area that takes the most liberties when it comes to quoting investment performance numbers. The most common case for a buy-and-hold strategy is that pulling money out of the market could cause an investor to miss a big market day. A quick search on Google reveals a long list of websites and articles that follow this general theme: If you had invested $10,000 at such and such a date and kept it invested, you could now retire early and send your kids and grandkids to Harvard. But if you missed the [10 best months/best month each year/5 best days each month/etc/etc], your investment would now be practically worthless. Obviously, Time In the Market is better than trying to Time the Market.

Standard & Poor’s Financial Library contains a chart that is often used in web articles to prove the case against market timing. The chart, titled “The Effect of Staying Invested vs. Missing Top Performance Days, 1997 to 2006″, shows the result of investing $10,000 and staying invested over 10 years, compared to missing the best 5, 10, 15, …, 30 days of the market. A buy-and-hold approach results in the investment growing to $22,451. Missing the best 30 days over that 10 year period results in the investment shrinking to $6,921. The conclusion stated on the chart, as well as most articles that use the chart, is that “missing the market’s top-performing days can prove costly.” Duh. Now let’s apply a little logic.

If your market timing system is so bad that it only misses the best days in the market, then a buy-and-hold approach is clearly the way to go. However, if a case can be made based on something as ridiculous as missing ONLY the 30 best days over 10 years, then it seems there would be an equal chance of missing only the 30 worst days. What happens in that case? Well, if you invested the same $10,000 and happened to miss only the 30 worst days (also clearly ridiculous), your investment would have grown to $69,879. Clearly, Timing the Market is much better than Time-In-the-Market. Both data points are hogwash, but only one of them tends to be used in what masquerades as a serious argument.

Historical Return Of the Stock Market is X%

Now let’s take a look at another way historical performance is often misused. The superior long-term performance (or lack of performance) of stocks is often used to justify portfolio allocations, indexing, actively-managed mutual funds, etc. After all, U.S. stocks have returned an average of 10.3% per year. Or they have been flat for over 4 decades when adjusted for inflation and excluding dividends. Or they have underperformed bonds. All of these statements are true in the right context and with enough disclosure. The long-term performance of stocks is a wonderful and dangerous tool because there are so many degrees of freedom with which to play. If I want a good long-term number, I can start my performance analysis in 1908 and end it in 2007. However, if I start in 1929 and end in 2008, I get a very different (and much worse) number. Going back to using stock performance to justify the buy-and-hold argument, the DJIA has had a couple of periods that work very well to support buy-and-hold. From 1943 to 1962, the DJIA had an average return of about 8.2%, and from 1982 to 2000 the return was around 12.9%. However, 1900-1943 (2.3% annual return), 1962-1982 (2.4% per year), and 1996 to 2009 (0%) didn’t work out so well, and could all be used to argue the exact opposite point. I recently saw a chart of the DJIA adjusted for inflation and excluding dividends. When looking at the market this way, the market is currently at about the same level it was in 1966. Even more interesting was that you could draw a straight line on the chart between 1929 and 1992. This data could be used to justify market timing, or a bond portfolio, or real estate investing…you name it. Many may argue that you can’t disregard dividends, and that the definition of inflation is up for interpretation, but however we massage the data, it can still be used to justify practically any argument…just like statistics.

How Should Performance Be Used?

The only data we have to go on is past performance, so obviously we shouldn’t throw out the data just because it can be easily manipulated. However, an awareness that data can be selectively chosen to justify our own biases is important, especially since this can be done subconsciously. In severe bear markets, it is easy to point back to the latest bull market and convince ourselves that things will quickly get back to “normal” if we just hang on a little longer. If normal is defined as consistent 10.3% returns, there are long periods in the market that don’t support this. Another thing to keep in mind is that it is just as easy to use the most recent market performance to justify the newest investing fad as it is to ignore recent market data in order to argue that traditional investing ideas will always work. U.S. and world economies evolve, and just because a strategy would have worked over the last 80 years does not mean it will work over the next 20. The key thing is to maintain a good dose of skepticism whenever performance data is used to justify an argument, and always ask “does this make sense”. Ignoring the best market performance days but including the worst days to “prove” a point should raise some red flags, and would certainly make Mark Twain think twice.

Jerry Verseput is Certified Financial Planner and Registered Investment Advisor in El Dorado Hills, CA. More information can be found at http://www.veripax.net