Tag Archives: seeking

4 Things To Understand About Your Portfolio’s Margin Of Safety

By Ronald Delegge Does your portfolio have a margin of safety? I ask that question because the total U.S. stock market (NYSEARCA: SCHB ) has been rocky over the past few weeks and now has a year-to-date (YTD) loss of -1.23%. And since most investors underperform the stock market and the index ETFs tied to it, it’s fair to assume many people have much worse performance. The concept “margin of safety” was originally developed in the 1930s by Benjamin Graham and David Dodd, the founders of modern day value investing. Unlike today’s faceless generation of “roboadvisors” that have never experienced a bear market, let alone survived one, Graham and Dodd lived through the Great Depression so they understood the importance of investing with safety. Although their idea was applied to selecting individual stocks at undervalued prices, Dodd and Graham’s principles about safety are applicable to anyone with a portfolio of investments that owns not just stocks (NYSEARCA: VT ), but bonds (NYSEARCA: JNK ), real estate (NYSEARCA: VNQ ), and even commodities (NYSEARCA: GSG ). Here are four things all individual investors need to understand about their portfolio’s margin of safety: Installing a margin of safety within your portfolio should always happen before a negative event In my online course, “Build, Grow, and Protect Your Money: A Step-by-Step Guide,” I teach how the prudent investor does not wait for a market crash or another adverse global event to build a margin of safety within their investment portfolio. Rather, your portfolio’s margin of safety – just like an insurance policy – is purchased ahead of the accident or crisis in order to protect your capital. Investing money without a margin of safety, whether done deliberately or out of plain ignorance, is negligent. Building an architecturally sound investment portfolio doesn’t happen by chance All structurally strong and healthy portfolios have three crucial parts: 1) the portfolio’s core, 2) the portfolio’s non-core, and 3) the portfolio’s “margin of safety.” (See image below) Each of these containers within your portfolio will complement each other by deliberating holding non-overlapping assets. “I’m a long-term investor” or “the stock market always bounces back” is not prudent risk management Some people have deceived themselves into believing their IRA, 401(k), or other investments require no margin of safety. This group of individuals generally believes they are too wealthy, too experienced, and too smart to have a margin of safety inside their portfolio. It’s a paradox too, because this same group that invests without a margin of safety (or insurance), has insurance (or margin of safety) on their automobiles, homes, and lives. Somewhere along the line, this group of people lacks the same prudent sense to protect their financial assets. Investing in gold and bonds is not appropriate for your portfolio’s margin of safety Many people along with certain financial advisors make the rookie mistake of believing that assets like bonds (NYSEARCA: BND ) or gold (NYSEARCA: GLD ) can be used for a portfolio’s margin of safety. Why is this approach fundamentally wrong? Because both bonds and precious metals – just like stocks and real estate – are subject to daily fluctuations and can lose market value. For example, anybody that bought gold at its height in mid-2011 is now down over 42% and should know from first hand experience that gold is an inappropriate tool for margin of safety money. In conclusion, implementing your portfolio’s margin of safety should happen when market conditions are favorable, not when it’s raining cannonballs. And if you’re caught in the unfortunate situation where you failed to implement a margin of safety during good times and market conditions have deteriorated, the next most logical moment to implement your margin of safety is immediately. Disclosure: None Original Post

The Limits Of Risky Asset Diversification

Do you want to reduce the volatility of your asset portfolio? I have the solution for you. Buy bonds and hold some cash. Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. Those buying stocks stuck to well-financed “blue chip” companies. The diversification from investor behavior is largely gone (the liability side of correlation). Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets. But beyond that, hold dry powder. Think of cash, which doesn’t earn much or lose much. Think of some longer high quality bonds that do well when things are bad, like long treasuries. Photo Credit: Baynham Goredema . When things are crowded, how much freedom to move do you have? Stock diversification is overrated. Alternatives are more overrated. High quality bonds are underrated. This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best. First, I don’t like infographics or video. I want to learn things quickly. Give me well-written text to read. A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs. Here’s the problem. Do you want to reduce the volatility of your asset portfolio? I have the solution for you. Buy bonds and hold some cash. And some say to me, “Wait, I want my money to work hard. Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?” In a word the answer is “no,” though some will tell you otherwise. Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. Those buying stocks stuck to well-financed “blue chip” companies. Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include: Growth stocks Midcap stocks (value & growth) Small cap stocks (value & growth) REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.) Developed International stocks (of all kinds) Emerging Market stocks Frontier Market stocks And more… And initially, it worked. There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers. Now, was there no diversification left? Not much. The diversification from investor behavior is largely gone (the liability side of correlation). Different sectors of the global economy don’t move in perfect lockstep, so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them. How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally? Why do I hear crickets? Hmm… Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought: Timberland Real Estate Private Equity Collateralized debt obligations of many flavors Junk bonds Distressed Debt Merger Arbitrage Convertible Arbitrage Other types of arbitrage Commodities Off-the-beaten track bonds and derivatives, both long and short And more… one that stunned me during the last bubble was leverage nonprime commercial paper. Well guess what? Much the same thing happened here has happened with non-“blue chip” stocks. Initially, it worked. There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers. Now, was there no diversification left? Some, but less. Not everyone was willing to do all of these. The diversification from investor behavior was reduced (the liability side of correlation). These don’t move in perfect lockstep, so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). Yes, there are some that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short. Many of those blew up last time. How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally? Why do I hear crickets again? Hmm… That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point. Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets. But beyond that, hold dry powder. Think of cash, which doesn’t earn much or lose much. Think of some longer high quality bonds that do well when things are bad, like long treasuries. Remember, the reward for taking business risk in general varies over time. Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%). This isn’t a call to go nuts and sell all of your risky asset positions. That requires more knowledge than I will ever have. But it does mean having some dry powder. The amount is up to you as you evaluate your time horizon and your opportunities. Choose wisely. As for me, about 20-30% of my total assets are safe, but I have been a risk-taker most of my life. Again, choose wisely. PS – if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification. You will have to wait for those ideas to be forgotten. Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

How To Find The Best Style Mutual Funds: Q4’15

Summary The large number of mutual funds hurts investors more than it helps as too many options become paralyzing. Performance of a mutual funds holdings are equal to the performance of a mutual fund. Our coverage of mutual funds leverages the diligence we do on each stock by rating mutual funds based on the aggregated ratings of their holdings. Finding the best mutual funds is an increasingly difficult task in a world with so many to choose from. How can you pick with so many choices available? Don’t Trust Mutual Fund Labels There are at least 806 different Large Cap Value mutual funds and at least 5514 mutual funds across all styles. Do investors need 459+ choices on average per style? How different can the mutual funds be? Those 806 Large Cap Value mutual funds are very different. With anywhere from 15 to 735 holdings, many of these Large Cap Value mutual funds have drastically different portfolios, creating drastically different investment implications. The same is true for the mutual funds in any other style, as each offers a very different mix of good and bad stocks. Large Cap Value ranks first for stock selection. Small Cap Blend ranks last. Details on the Best & Worst mutual funds in each style are here . A Recipe for Paralysis By Analysis We firmly believe mutual funds for a given style should not all be that different. We think the large number of Large Cap Value (or any other) style mutual funds hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many mutual funds. Analyzing mutual funds, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each mutual fund. As stated above, that can be as many as 735 stocks, and sometimes even more, for one mutual fund. Any investor worth his salt recognizes that analyzing the holdings of a mutual fund is critical to finding the best mutual fund. Figure 1 shows our top rated mutual fund for each style. Figure 1: The Best Mutual Fund in Each Style (click to enlarge) Sources: New Constructs, LLC and company filings How To Avoid “The Danger Within” Why do you need to know the holdings of mutual funds before you buy? You need to be sure you do not buy a fund that might blow up. Buying a fund without analyzing its holdings is like buying a stock without analyzing its business and finances. No matter how cheap, if it holds bad stocks, the mutual fund’s performance will be bad. Don’t just take my word for it, see what Barron’s says on this matter. PERFORMANCE OF FUND’S HOLDINGS = PERFORMANCE OF FUND If Only Investors Could Find Funds Rated by Their Holdings… The Calvert Social Investment Fund: Calvert Large Cap Core Portfolio (MUTF: CMIIX ) is the top-rated Large Cap Blend mutual fund and the overall top-rated fund of the 5514 style mutual funds that we cover. The mutual funds in Figure 1 all receive an Attractive-or-better rating. However, with so few assets in some, it is clear investors haven’t identified these quality funds. Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.