the know-nothing investor

…money doesn't grow on trees, you know?

Month: January, 2015

10.MUST-HAVE ASSETS – PART I

It was on the first days of 2013 when I started to think what kind of assets should be in the portfolio and in what percentage. Because I wanted to delay paying profit taxes for how much I could, I knew that what I decided it would be for all the investment period. I tried to be cautious.

If I gathered 100 years of market data and I assume only mean reversion, probably I would not end up with all type of asset classes. But no one know what the future will bring, so for the long run I thought it would be extremely important to cover all asset classes.

I like to divide asset classes in two major groups:

  • Non-equities shares
  • Equities shares

Those two groups have different correlations and therefore a well structured portfolio must have both. Because of negative correlation between groups, normally when stock markets are going up the other group tend to go in opposite direction and vice-versa. Of course this doesn’t work all the time and there are always exceptions that we must be aware, for instance because 2008 markets crash was due to the sub-prime, real estate was also severed hit.

First group can be subdivide as described below.

Non-equities shares

Bonds

In first group we have government and corporate bonds and normally they represent a fixed income to our portfolio.  Their yield depends on the investment period and the risk of getting payed. So government bond pay less than corporate, because countries are less likely to go bankrupt. Between countries there are also differences, countries with economic and political stability will pay less because they represent minor risk to your money (although at this moment Spain and Italy are paying less than US, which is odd). Long-term maturities bonds (15 to 30 years) pay more than intermediate (3 to 10 years) and short-term ones (less than 3 years).

There is also another type of government bond that is an inflation-protected security aka TIPs. This security is very interesting because your fixed income will be inflation free and we should be aware of what inflation could do to our rate of return.

Bonds also represent a negative correlation with shares. If shares are in a turmoil investors will look for safety instead of returns and that means going for bonds. In uncertain times you need to have bonds from countries which are reliable and dictate external police (this means being the world’s biggest military superpower) and that is USA…USA…USA.

Bonds are a must have in any portfolio. They are ice when things start to heat.

Gold

My precious…the shining metal has intrinsic value since ever and will have in future, because it’s rare, is used in the industry and some say that countries can go back again to gold standard (China and Russia are among those, be careful USA). Pundits also say owning it is good way to have protection against inflation, especially in these times of central bank planning, where burning currency is the main agenda. Nevertheless, Barry Ritholtz point out that “In real, inflation-adjusted terms, gold is unchanged since the early 1980s — the last peak in gold.”  and it doesn’t give any kind of dividend, which might discourage some investor of having it.

But in uncertain times is where investors also put their money as it seen after 2008 markets collapse. Adding to this all the speculation around reintroducing gold standard by some of the world strongest economies, makes gold a must have in any future proof portfolio.

Commodities

In this category it fits a world of raw materials and essential commodities for everyday life, such as crude, oil, gas, gold, copper, zinc, wheat, corn, timber to name a few. When inflation is high, commodities are a good hedge to protect your money, because commodities prices also tend to rise and there are few assets that can handle high inflation. But we haven’t seen inflation in recent year and as Cullen Roche affirms commodities are not an investment, it’s basically short-term speculation, in fact he arguments that commodities at real prices are in bear market for at least 130 years and it is probably best to own commodities equities producers (CEP) instead. So why should I include commodities? Simply because I real can predict the future and as LTCM (portuguese multi-asset expert nickname not the fund) said to me once “Isn’t because you have commodities that your portfolio will underperform”. And why not to choose a CEP ETF instead? Because as we will see later I will be exposed to that equities in shares assets.

In my humble opinion commodities must be in multi-asset portfolio, with time I will have enough data to understand if commodities are being my weakest link but for now it makes sense to have it. No one know really how commodities will perform in the future, where earth’s population is still growing and the need for food and raw materials will for sure increase.

REIT

Real Estate Investment Trust (REIT) is an asset that trades like a stock in the exchanges and invest in real estate. Who has never dream of owning an hotel or a condominium, through reit you can and revenues will come from renting or interests of lending money for mortgages to real estate owners.

In Portugal investing in real estate is everyone dream, but dealing with tenants must be a nightmare. I would rather put 150k in a REIT, but probably no bank would give me a loan for that.

If this is no-brainer investment for sure that it has its place in multi-assets portfolio. At least in mine has.

 


 

Although these assets are different from stocks, most of them are extreme volatile and shouldn’t be purchase if money will be needed in short time. These type of assets should be considered for an intermediate to long-term investment period.

Negative correlation with stocks is quite different of low volatility and therefore is important to understand that depending of the assets you choose you can still have real big drawdowns. The difference lies in the fact if you had only stocks it would be a massacre.

At this time I knew that an important part of my portfolio’s allocation would go to bonds, gold, commodities and REIT.

1.FOOLED BY NUMBERS

When you start to understand the game you become more sceptical about people constantly bragging about their methods and rate of returns. Sometimes they don’t even need to show their return numbers to have a lot of followers that don’t question those figures or their incongruencies and if there are better ways to participate in the markets.

This year I decided to honour those “two digit figures” braggers by becoming one of them and saying to you, few fellow followers, that through my magnificient method and outstanding capabilities in 2014 I achieved 48.58% rate of returns.

Wait…wait…that number was achieved because I’m counting with new add money for buying assets purpose. Although it is a true number, because my portfolio value grew that much, it was due to add money from my savings.

This is a fair observation. I’m really bragging, but those number are unrealistic.

So looking for the NAV in my broker account, in 2014, my returns were still impressive with an increase of 17.16% .

Wait…wait…that number is only achieved because my main currency is in EUR and my assets are in USD. This pair’s valuation was great for dollar assets and only because of that I achieved so great returns. For me, that use euros in my daily life it was a great value increase. Nevertheless, I’m a naturally bragging again.

Well I only have two more number left for my 2014’s rate of returns, but those are just ok and they are not to great to brag about. The first one was the total return of my portfolio in USD, which was 4.92% and if I consider new entries over the year I’ll end up with a rate of return of 4.36%, which is still better than the average of active investors.

So don’t let you fool by numbers and braggers. All that rate of returns are true in someway, you can pick your favorite or just ignore my returns and focus on yours.

What I can say is, I’m glad with my 2014‘s results, after all my portfolio’s value more than recovered the losses of short-term madness.

9.GOING FOR LONG TERM

My days as a trend follower were over. Even if I tried to make money out of the markets as a trader, probably trend following would not be the best way to do it, specially in the post-crisis of 2008.

It was time to have statistical data on my side and this meant to have a geographic diversified multi asset portfolio with periodic rebalancing for a very long time. The truth is that long-term investor in the long run will beat the majority of short-term traders (here and here). But how long is it to invest in a long term basis? For me I thought about my retirement so I decided to invest for a period never less than 30 years.

I had quit trying to get rich in two or three years, instead it would take me 30 years but at least I wouldn’t get broke in the process.

Nevertheless, 2012 had taught me two lessons that needed to be quickly addressed to achieve good performance in the markets:

  • Brokerage costs were a substantial part of my losses.
  • Every Time I had a profitable trade I would pay 28% of it in profit taxes.

In 2013 I changed to an international broker, based in US, which guarantees minimum fees and on profit taxes I decided that my portfolio would only buy and for rebalance purpose I would only use fresh money instead of selling winners to buy loosers. At first it will be easy, after my portfolio gets bigger in value it will get more complicated, but I’ll use dividends money and if needed I will sell. But is like that old saying “dying and paying taxes later the better” and with this simple tax planning it will allowed me to legally escape paying taxes for a long time.

The last thing to decide was what kind of financial instruments I would use to make my long term portfolio and here I quickly restrain my option to two: exchange tradable funds (ETF) or mutual funds.

Based on my conviction on having a portfolio with lower expense ratio as I could, I opted for ETFs.  Although ETFs don’t seek alpha their associated costs are cheaper than those in mutual funds. ETFs only purpose is to track an index, a commodity or a bundle of assets, so they don’t have active management like mutual funds. Besides all cost associated with buying, selling and owning shares, in mutual funds you also need to pay the people that actually run the fund. They can be quite good and excel the performance of whatever benchmark they are following but then you also need to excel and choose the right ones. If you don’t choose a correct amount of right ones probably you will end annihilating any alpha possibility. On the other hand, if I failed as a stock picker why I should I be good at picking mutual funds?  Past performance are not a good indicator of future returns and If you don’t choose the right ones or the management teams start to have worst performances you will need to turnover your portfolio and that will erode your portfolio’s value in taxes and other fees associated.

But how are the performance of those management professionals, that year after year try to beat the market, creating in your portfolio an extra-value? Not great, especially in the long run as you can read here in this great article of Rick Ferri. To resume it, I just want to mention this paragraph: “Maintaining consistently high performance is so difficult for fund managers that less than half (10% to 20%) of the top quartile funds were even able to stay in the top half over the next five years. Approximately 30% to 40% of funds in each category finished in the top half after accounting for funds that go out of business, merged with another fund or changed style categories.”. Of course this tend to get worse as time passes by.

So I realized I could done the same amount of harm to my money as professional and I decided for ETFs.