Planning Your Portfolio – All successful investors use heuristics to shape their strategic decisions, but it’s wrong to assume they are always correct.
Wikipedia defines heuristics as “experienced-based techniques for problem solving.” However, it rightly warns that the solution they provide “is not guaranteed to be optimal,” merely “good enough for a given set of goals.”
In a new book,* William Bernstein examines some investment heuristics and exposes their flaws:
Buy low and sell high
Trouble is, even the most experienced investors find it psychologically difficult to buy when prices have plunged (Wall Street fell 90 per cent from 1929 to 1932), and especially if they’re continuing to fall. If you plan to buy after the market has bottomed, how do you know when that has happened?
Another problem is that fund managers have much less cash to invest then, because many of their clients have fled the stock market for the relative safety of bank deposits. At the very point when future returns are going to be excellent.
Rebalance portfolio assets periodically
Trouble is, this can mean shifting capital into assets that are in a long-term downtrend. Bernstein gives as an example a portfolio split 50/50 between US and Japanese equities, with annual rebalancing. Over the period 1990 to 2009, you would have earned an average of 3.64 per cent. But if you had avoided all rebalancing – no buying of declining Japanese stocks – your return would have averaged 5.16 per cent.
Trouble is, the fundamentals on which you base your asset purchases can change. For example, it used to make sense to buy commodities futures and hold them to maturity to harvest an automatic return called “roll yield.” But as investors piled in, the roll yield disappeared.
Also, commonsense logic can be wrong. For example, emerging markets can seem appetizing because of high economic growth. But that doesn’t mean the shares go up, as investors in China have discovered. Others find ways to reap the benefits.
Your portfolio will, from time to time, get hammered by negative returns. And some of them can be severe, such as the 90 per cent fall in US shares over the 1929-32 period, loss of half their value in the wake of the sub-prime crisis, or the 20 per cent drop on Wall Street on a single day in October 1987.
But those are “almost always short-term events” followed by recovery. The major risk is long-term failure to accumulate enough capital to finance your consumption needs after you retire, when it’s too late to rectify shortage or replace losses.
The four dangers are:
- Severe, prolonged inflation of the sort that effectively wipes out fixed-income investments and can also drive down shares.
- Economic depressions that produce the opposite pattern, devastating equities while leaving intact the highest-quality fixed-income investments.
- The political risk of government confiscation and/or catastrophic taxation, “which is more common than we might like to admit, even in developed nations.”
- Most fearsome of all, but fortunately the rarest – the financial devastation that is a consequence of war.
“You can’t protect yourself completely against all these scourges,” but you can “design your portfolio with these real-world possibilities in mind.”
Short-term risk is the propensity of an investment to produce bad returns in bad times. Bernstein says it is best measured by standard deviation.
My problem with this is that measures of standard deviation don’t reflect and warn you against the occasional catastrophic risk – a defect I wrote about in On Target issue dated June 29, 2013, on “black swan risks and your defences.” Even Bernstein admits that the Wall Street collapse on October 19, 1987, was a minus 20 standard deviation – the odds against that happening were extreme, “about the same odds of your winning the next Olympic decathlon.”
Here are some other interesting points from his book:
- The problem with types of shares that have the potential to deliver high returns during crises, especially inflationary ones, such as those of companies mining precious metals, is that over the long term they deliver the lowest returns of all among equity classes.
Nevertheless, because they aren’t correlated with other shares, having some of them is “highly desirable” in a stock-market collapse. Over the period 1964 to 2012 the portfolio of US equities with the lowest short-term risk – least average standard deviation – would have been one containing 15 per cent precious metal companies and 85 per cent S&P 500 stocks.
Bernstein recommends some holding of precious metal and other resource stocks “as a bulwark against inflation, which financial history shows to be the most salient macroeconomic risk facing the investor in a fiat money world.”
copyright: Martin Spring of OnTarget
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