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Last Week Showed Us What A Black Swan Panic Looks Like

This past week had the largest recorded percentage loss for the averages, for the first trading week of any year, going back to when George Washington was President. I have been warning about the markets being overvalued for sometime now and preparing for it for years. What triggered this sell-off was actually a Black Swan event (A Black Swan event is an event in human history that was unprecedented and unexpected at the point in time that it occurred), where North Korea supposedly exploded a Hydrogen Bomb. A Hydrogen Bomb is multiple times more powerful than the bombs that were dropped on Hiroshima and Nagasaki at the end of World War II, so North Korea has definitely gotten the world’s attention. What will happen next is anyone’s guess, but it’s not looking good based on investors’ reaction. This past Friday, we had a strong jobs report that should have made the markets go up, but instead of buying the dips, investors were selling the rips. Remember that we operate in a world and stock market where we cannot control events or how millions of investors will trade on any given day, but when the panic button was hit this week, our 79% cash position is what saved us. Why 79% in cash? Well simply because our Friedrich Algorithm is not finding much for us to buy these days. To demonstrate what I mean here are the real-time results of the Dow Jones 30 Index vs. what an investor would have seen in 2010 using the same stocks. Green means that each stock’s Wall Street Price is selling below its Main Street Price and Red means just the opposite or that the stock is overvalued according to Friedrich. Click to enlarge So with just using simple common sense and logic, one sees that in 2010 most of the list, according to Friedrich , was a bargain and in 2016, stocks in the Dow Jones Index above are way overvalued. Therefore, when most stocks in the Dow Jones 30 Index are overvalued, it does not take much for them to go down, but a Black Swan event like North Korea claiming to having set off a hydrogen bomb really panicked investors. This folks is what a Black Swan Panic looks like. (Percentage loss from December 31, 2015 close) Click to enlarge What happens next is anyone’s guess, but it seems that if one wants to practice “Capital Appreciation through Capital Preservation,” they better get busy and go through their portfolios with a fine tooth comb.

The Challenges And Pitfalls Of Measuring Factor Exposures

Factor-based investing has grown significantly in the years since Eugene Fama and Kenneth French first published (1992) their groundbreaking research on the “three-factor model” to explain the return of stocks. Now, a growing number of investors view their portfolios as “collections of various risk-factor exposures,” including risks to particular asset classes and specific “styles,” such as value, size and momentum. Investors reasonably expect to be rewarded for taking on these various types of risk. Understanding the source of returns has also made it difficult for investment managers to pass off factor-based returns as “alpha” – i.e., something that they (the manager) should be paid for having produced. But in order for investors to be sure they’re not overpaying for factor-based returns falsely portrayed as alpha, they must first be able to measure their exposures to the various risk factors – and this is trickier than one might expect. In a recent white paper from AQR , Ronen Israel and Adrienne Ross consider the challenges associated with measuring factor exposures. The authors draw a distinction between academic and practitioner models, favoring the latter for being more practical to implement. Factor Analysis When conducting factor analysis, investors should ask themselves two questions: Exactly what factors am I using? Are they the same as those I’m getting in my portfolio? The answers to those questions can significantly affect alpha and beta estimates. Factor design is also important and can lead to major discrepancies, too. When comparing alphas and betas across managers, investors should make sure they’re using factors being captured by both portfolios – otherwise, they risk overpaying for inappropriately attributed alpha. For portfolios with more than one risk factor, multivariate statistical models are most appropriate. Mr. Israel and Ms. Ross caution investors to consider t-stats – measurements of statistical significance – and not just betas, especially when comparing portfolios with different volatilities. Decomposing Returns Mr. Israel and Ms. Ross examine a hypothetical long-only stock portfolio designed to capture returns from value, momentum, and size style premia . The portfolio was designed with a 50/50 weight on value (book-to-price) and momentum (12-month trailing returns), entirely within the small-cap universe. From January 1980 through December 2014, the hypothetical portfolio would have returned an annualized 13.8% above the return on cash. Mr. Israel and Ms. Ross start with one factor – equity market risk – and build from there. First, a value factor is added (“HML”), and then momentum (“UMD”) and finally size (“SMB”). The HML, UMD, and SMB abbreviations refer to “common academic” definitions: HML (high-minus low) – Long/short value methodology; long high-value stocks/short low-value stocks; UMD (up minus down) – Long/short momentum methodology; long the stocks up the most/short the stocks down the most; and SMB (small minus big) – Long/short “size” strategy; long small stocks/short big stocks. As you can see, when only considering a single factor (“the market”) in Model 1, it appeared that the portfolio generated nearly half of its returns from manager alpha. But as more factors are accounted for, it became clear that alpha-generation was actually much smaller. As an investor, you shouldn’t have to pay active-manager fees for factor exposures presented as alpha.

The Simplest And Most Effective Way To Build Your Own Investment Portfolio

Across the entire landscape right now, I believe Meb Faber has done more than anyone to bring some of the most important developments in asset management to individual investors. He has recently published a number of books that distill some of the secrets of the top investors in the world into easy-to-understand concepts that can be applied by even the most finance-phobic. The book referenced above, “Global Asset Allocation,” really tackles two major mistakes investors regularly make. First, most investors fall prey to “home country bias.” Because U.S. stocks are highly overvalued currently, based on their own history and against almost every other equity market on the planet, this is a real problem especially relevant to today’s markets. Second, while they may be well-diversified within certain asset classes most individual investors are not nearly well-diversified enough across multiple asset classes. This serves to create unneeded volatility in portfolios over the course of longer-term cycles. And unneeded volatility just makes it that much harder to stick to your plan when sticking to your plan may be single most important thing you can do. To demonstrate the value of greater diversification, I built the simple ETF allocation shown below based on the concepts in Meb’s book. I also compared it to the typical 60/40 portfolio along with one invested entire in U.S. stocks. Click to enlarge Charts via PortfolioBacktester.com Below are the backtested returns since 1973 (the first date PortfolioBacktester.com makes available). Notice that the returns are fairly comparable across all three but the more diversified portfolio (#1) greatly reduced your “worst year” and “maximum drawdown” when compared to the other two. Not bad, eh? Click to enlarge Charts via PortfolioBacktester.com Now this is not in any way designed to be specific advice. These are, however, terrific tools for individual investors to use in designing a portfolio allocation that suits their own unique goals and risk tolerance. Combine this with commission-free ETFs at places like Schwab, Vanguard and Fidelity and it amounts to an incredibly low cost and effective way to build your own investment portfolio and in a way that the greatest minds in the business would approve of. Many thanks to Meb for putting this all together. It’s very exciting to me to see that individual investors now have these sorts of tools, knowledge and opportunities that were previously only available to institutional investors. If you’re interested in learning more about this stuff, buy Meb’s latest book and you’ll get “Global Asset Allocation,” among others, for free.