Monthly Archives: September 2013

Life Imitates Art

One of the few regrets I have in life is never attending a performance of Kabuki.  I did see a Noh play once, and it was as slow and as confusing as people said it would be.  I think its pace and complexity was by design.  Kabuki, as I as understand it, is perhaps more interesting, but maybe just as confusing.

For the uninitiated, Kabuki is a form of classical Japanese theatre in which elaborately costumed male performers use stylized movements, dances, and songs in order to enact tragedies and comedies.

What this has to do with the current state of affairs in the United States will be left to the imagination of the reader.

That is all…

What’s in a Number?

As I worked on my graduate degree at Columbia, I would often stop and silently thank my high school math teachers for the solid foundation they gave me in numbers.  My finance and stats classes didn’t use “hard-core” math (as some would call it), but understanding derivatives, distributions and derivations came in very handy.  Even now, I find myself using a lot of the math I learned in high school.

Everywhere we turn we are surrounded by numbers.  In most cases, the number you see means exactly what you think it does.  The $5 price on your morning cup of fancy java means you need to give the barista a five-spot.  The vast majority of numbers we think about each day – the interest rate you pay on your mortgage, the speed limit on a highway, your blood pressure, your weight (!?), and so on – all tend to mean exactly what we think they do.  However, this normal and rational experience with numbers tends to unravel when we consider the capital markets and investing.

Sure, a lot of the numbers we see in the investment world (interest rates, stock prices, economic figures, etc.) sort of mean what we think they do, but many of them are much more complicated than casual consideration can ascertain.  Take the S&P 500 index for example.  In reality, there is no such physical entity as the S&P 500 index.  It is a fanciful construct consisting of the share prices of 500 different and independent companies.  So the number you see quoted for this index is not so much one number (although it is daily presented as such), but the net result of all investors’ opinions (reflected through daily buying and selling) of all 500 of the underlying stocks.  The one number we see in the price quote of the S&P 500 is literally the sum of millions of daily decisions by investors of all sorts. Every other index could be viewed in a similar fashion.

Then we come to forecasts, predictions and price targets.  There is something deep inside us that craves certainty and order.  The grand irony here is that the more complex a system is, the more we want a simple, whole-number answer.  This innate desire for a simple number to describe a complex function (the capital markets for example) I believe drives market strategists and equity analysts to derive and publish price targets and forecasts.  Yet, when a strategist “predicts” the market to be at some level by year end or when an analyst publishes a single number price target, they know without a shadow of a doubt, in my opinion, that their published numbers represent a midpoint in some, possibly wide, range.  As a former strategist and analyst, I know this to be true.

Professional investors understand this and use analysts’ price targets with a grain of salt.  To them, the price target is a measure of an analyst’s enthusiasm for a stock and little else.  But, a published number can get the individual investor into trouble.  Too often, I will hear someone get excited about a stock because “some analyst has a price target up 30% (or whatever) from the current price.”  You can almost see the gears turning inside this person’s head figuring out how to spend this almost certain 30% (or whatever) windfall.  Individual investors should think like a professional, and consider any forecasted number they see with a big grain of salt.  In a like fashion, one should never make an investment based on a price target or a market forecast.

In my own work with equities, I am constantly analyzing companies and trying to determine a “fair value” or price target, if you will, for a given stock.  For me to say with any degree of certainty that the stock will definitely reach my target is way too arrogant for my understanding of the capital markets.  I understand that my price target can be influenced by many factors – the company’s earnings growth, interest rates, the economy and sentiment about all of the above.  When fundamentals change, I often need to reassess my targets and my opinions about each stock I follow.  It is quite complicated, but I am aided in my efforts by my training during decades of experience as a professional investor.

Bottom line – to be a better investor one should learn to view simple one-number forecasts with a skeptical eye.

The Merits of Balance and Rebalance

My Uncle Roy loved to tell (and retell) the following joke:  “Two birds were sitting on a fence.  One was named ‘Pete;’ the other ‘Re-Pete.’  ‘Pete’ flew away.  Who was left?”  We’d answer “Re-Pete (repeat).”  Then he would say, “Two birds were sitting on a fence…”  And so on and on as long as we would answer him.  Even now I have to chuckle at that one.

I am a firm believer in the benefits of repetition.  I truly appreciate when the people I respect take the time to remind me of best practices, be they health habits, exercise, interpersonal relationships, communication styles, and yes, even basic investment principles.

I think most people understand at some level the basic investment notions of diversification, risk management, valuation and so forth.  And yet, I often see otherwise highly-intelligent people with less-than-highly intelligent portfolios.  Sometimes the portfolio is simply unfocused – a smattering of well-known names, probably selected due to the company’s high profile, attractive products or good standing in the corporate world.  Sometimes the portfolio will be focused on one single idea, such as high-dividend-yield stocks, energy stocks or the biggest names from one overseas country.  Sometimes I meet the hyper-indexed portfolio, put together by someone who thinks 1) the market is efficient and 2) outperforming the market is impossible (both of which are subject to debate).  Where one broad index fund might be sufficient, the hyper-indexer will own 20 – “just to be safe.”  Sometimes, I meet a portfolio with a handful of stocks, one of which represents about 60% of the total. This investor may think the portfolio is diversified (Hey, I own 7 stocks!), but this kind of portfolio may be the riskiest of all the sub-optimal portfolios I see.

For the most part, these kinds of portfolios are underbalanced, undermanaged, and under-diversified, characteristics that often lead to underperformance and can undermine one’s long-term financial plans.

In order to be truly balanced, a portfolio needs a number of key elements.  First is a fixed asset allocation.  Many will debate this point with me, but I think asset allocation should be based on a person’s risk tolerance, not on how he or she feels about the markets.  One’s asset allocation may vary over a lifetime, as core risk tolerance changes, but it should not be changed during a market cycle.  The second key element is adequate diversification.  A mutual fund portfolio with as few as 8 funds may offer sufficient diversification.  An individual equity portfolio should have at least 30 names to reduce non-systemic risk.  Owning a whole lot more than 30 names rarely provides additional meaningful risk reduction.  The third element of a portfolio in balance is some kind of rebalancing regime.  For example, when one asset class becomes a higher percentage of one’s portfolio than the target allocation calls for, one should sell a portion of it, and put the proceeds into the other assets classes.  In an individual stock portfolio, when one stock becomes much larger (through outperformance – yay!) than others in the portfolio, what should one do?  A disciplined rebalancing routine would have one sell a portion of that stock and deploy the profits elsewhere among existing stocks or even into new names.

This rebalancing may seem a bit contrary to some of the old “rules of thumb” we hear sometimes about investing, such as “let your winners run,” or “cut losses on your losers.”  In my view, there are so many such “rules” that following all of them would be nearly impossible.  Sometimes they might apply to short-term traders, but not to long-term investors.  Following the guidelines I’ve suggested will more often result in “buying low and selling high,” something we can all agree is a good thing.

But what about all those capital gains generated by “selling high?”  Well, as my good friend Scott Bush often would say, “No one ever went bankrupt by paying capital gains taxes!”  The good news with realization of capital gains is that you are making money!  The better news is that the U.S. IRS taxes long-term capital gains at a lower rate than ordinary income.  As painful as paying capital gains taxes may be (I would argue this is less pain than losing money!), not rebalancing will often lead to a portfolio that is less balanced, and hence potentially much riskier than the investor would like.

To paraphrase an old saying, “The market giveth and the market taketh away…”  Sometimes it’s wise to take profits when the market offers them to us.