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Tag Archives: Modern Portfolio Theory

How to Become a Successful Long-Term Investor – Part 2 of 3 – Understanding and Reducing Risk

25 Wednesday Sep 2019

Posted by wmosconi in asset allocation, behavioral finance, Consumer Finance, Education, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Geometric Returns, historical returns, Individual Investing, individual investors, investing, investing advice, investing tips, investment advice, investments, math, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, standard deviation, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, volatility

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academia, academics, behavioral finance, finance, financial, historical stock returns, invest, investing, investments, math, mathematics, Modern Portfolio Theory, MPT, performance, portfolio, portfolio management, S&P 500, S&P 500 historical returns, S&P 500 Index, standard deviation, statistics, stock market, stock returns, stocks, success, uncertainty

Another extremely important part of being a long-term investor is to understand the concept of risk.  Financial professionals define risk in a number of different ways, and we will examine some of those definitions.  The overarching goal is to look at risk from the standpoint of the volatility or dispersion of stock market returns.  Diversification of various investments in your portfolio is normally the way that most financial professionals discuss ways to manage the inevitable fluctuations in one’s investment portfolio.  However, there is another more intuitive way to reduce risk which will be the topic of this second part of this examination into becoming a successful long-term investor.

The first part of this series on long-term investing was a look back at the historical returns of the S&P 500 Index (including the reinvestment of dividends).  The S&P 500 Index will again be the proxy used to view the concept of risk.  If you have not had a chance to read the first part of the series, I would urge you to follow the link provided below.  Note that it is not a prerequisite to follow along with the discussion to come, but it would be helpful to better understand the exploration of risk in this article.

The link to part one of becoming a successful long-term investor is:

https://latticeworkwealth.com/2019/09/23/successful-long-term-investing/

But now we will turn our attention to risk.  Risk can be a kind of difficult or opaque concept that is discussed by financial professionals.  Most individual investors have a tough time following along.  Sometimes there is a lot of math and statistics included with the overview.  Although this information is helpful, we need to build up to that aspect.  However, there will be no detailed calculations utilized in this article that might muddy the waters further.  I believe it helps to take a graphical approach and then build up to what some individual investors consider the harder aspects of grasping risk.

Risk related to investing in stocks can be defined differently, but the general idea is that stocks do not go up or down in a straight line.  As discussed in depth in part one, the annual return of the S&P 500 Index jumps around by a large margin.  Most individual investors are surprised at seeing the wide variation.  Ultimately, the long-term historical average of the S&P 500 Index from 1957 to 2018 is 9.8%.  But rarely does the average annual return end up being anywhere near that number.

The first way I would like to look at risk within the context of long-term investing is to go back to our use of “buckets” of returns.  If you have not already read part one, I used “buckets” with ranges of 5% to see where stock returns fit in.  As it relates to risk, we are only going to look at the “bucket” that includes the historical average 7% to 12% and then either side of that “bucket” (2% to 7% and 12% to 17%).  Additionally, we will look at yearly stock returns and then annualized stock returns for three years, five years, and ten years.  Here is our first graph:

Returns on Either Side of Historical Average

The main takeaway from viewing this graph is that, as the length of time increases, more stock market returns for the S&P 500 Index group around the historical average for the index of 9.8%.  Remember that part one covered the useful information that, even though the historical average to be expected from investing in stocks is 9.8%, individual investors need to know that it can take long periods of time to see that historical average.  In fact, if we look only at one-year increments, approximately 33.9% of stock returns will fall into the range of 2% to 17%.    Or, if we use our yearly equivalent, stock market returns will only fall within that range 1 out of every 3 years.  When individual investors see this graph for the first time, they are usually shocked and somewhat nervous about investing in stocks.

The important thing to keep in mind is that as the length of time examined increased many more stock returns fall into this range.  The numbers are 65.0%, 67.1%, and 81.1%, for three years, five years, and ten years, respectively.  Converting those numbers to yearly equivalents we have about 6-7 years out of ten for three years and five years.  And, as one would intuitively suspect, the longest timeframe of ten years will have stock returns falling into the 2% to 17% range roughly 8 in every 10 years.  Now that still means that 20% to 35% of long-term returns fall outside of that range when considering all those time periods.  But I believe that it is certainly much more palatable for individual investors than looking at investing through the lens of only one-year increments.

Another aspect of risk is what would be termed downside protection.  Most individual investors are considered to be risk averse.  This term is just a fancy way of saying that the vast majority of investors need a lot more expected positive returns to compensate them for the prospect of losing large sums of money.  Essentially an easier way to look at this term is that most individual investors have asymmetric risk tolerances.  All that this means in general is that a 10% loss is much more painful than the pleasure of a 10% gain in the minds of most investors.  Think about yourself in these terms.  What would you consider the offset to be equal when it comes to losing and earning money in the stock market?  Would you need the prospect of a 15% positive return (or 20%, 25% and so forth) to offset the possibility of losing 10% of your money in any one year?  Let’s look at the breakdown of the number of years that investors will experience a loss.  To be consistent with my first post, I am going to use the “bucket” of -3% to 2% and work down from there.  Here is the graph:

Returns Less than 2%

There are 61 years of stock market returns from the S&P 500 Index for the period 1957 to 2018.  If we look at the category of 1 year, stock market returns were 2% or less 38.7% of the time (17 years out of 61 years).  However, if we move to five-year and ten-year annualized returns, there were no observations in the -3% to -8%, -8% to -13%, or less than -13% “buckets”.  When looking at losing money by investing in the stock market, a long-term focus and investment strategy will balance out very negative return years and your portfolio is less likely to be worth significantly less after five or ten years.  Of course, there are no guarantees and perfect foresight is something that we do not have.  However, I believe that looking carefully at the historical data shows why it is important to not be so discouraged by years when the stock market goes down and even stays down for longer than just one year.  Hopefully these figures do provide you with more fortitude to resist the instinct to sell stocks when the stock market takes a deep decline if your investment horizon and financial goals are many, many years out into the future.

The final concept I would like to cover is standard deviation.  The term standard deviation comes up more often than not either in discussions with financial professionals during client meetings or is used a lot in the financial media.  There are many times when even the professionals use the term and explain things incorrectly, but we will save that conversation for another post.  Standard deviation is a statistical term that really is a measure of how far away stock market returns are from the mean (i.e. the average).  It is a concept related to volatility or dispersion.  So, the higher the number is, the more likely it is that stock market returns will have a wide range of returns in any given year.  Let’s first take a look at a graph to put things into context.  Here it is:

Standard Deviation

The chart is striking in terms of how much the standard deviation decreases as the time period increases.  A couple things to note.  First, I do not want to confuse you with a great deal of math or statistical jargon and calculations.  My point is not to obscure the main idea.  Second, the 25-year and 50-year numbers are just included only to cover the entire period of 1957 to 2018 for the S&P 500 Index.  These periods of time are not of much use to individual investors to consider their tolerance for risk and the right investments to include in their portfolios.  And, as one of the most famous economists of the 20th century, John Maynard Keynes, quipped:  “In the long run, we are all dead”.  My only point is that discussion of how the stock market has performed over 25 years or longer is just not relevant to how most individuals think.  It is nice to know but not very useful from a practical perspective.

The main item of interest from the graph above of standard deviation is that you can “lower” the risk of your portfolio just by lengthening your time horizon to make investment decisions on buying or selling stock.  For example, the standard deviation goes down 46.9% (to 8.95% from 16.87%) between one-year returns and three-year annualized returns.  Why do I use “lower”?  Well, the risk of your portfolio will stay constant over time and focusing on longer periods of time will not decrease the volatility per se.  However, most financial professionals tell their clients to not worry about day-to-day fluctuations in the stock market.  Plus, most Financial Advisors tell their clients to not get too upset when reviewing quarterly brokerage statements.  This advice is very good indeed.  However, I urge you to lengthen the period of your concern about volatility in further out into time.  My general guideline to the individuals that I assist in building financial portfolios, setting a unique risk tolerance, and planning for financial goals is to view even one year as short term akin to examining your quarterly brokerage statement.

Why?  If you are in what is termed the “wealth accumulation” stage of life (e.g. saving for retirement), what occurs on a yearly basis is of no concern in the grand scheme of things.  The better investment strategy is to consider three years as short term, five years as medium term, and ten years as the long term.  I think that even retirees can benefit with this type of shift.  Now please do not get me wrong.  I am not advising that anyone make absolutely no changes to his/her investment portfolio for one-year increments.  Rather, annual returns in the stock market vary so widely that it can lead you astray from building a long-term investing strategy that you can stick to when stock market returns inevitably decline (sometimes precipitously and by a large margin).  Note that all the academic theories, especially Modern Portfolio Theory (MPT), were built using an assumption of a one-year holding period for stocks (also bonds, cash, and other investments).  Most individual investors do not fall into the one-year holding period.  Therefore, it does not make much sense to overly focus on such a short time period.

Of course, the next thought and/or comment that comes up is “what if the stock market is too high and I should sell to avoid the downturn?”.  I will not deny that this instinct is very real and will never go away for individual investors.  In fact, a good deal of financial media television coverage and news publications are devoted to advising people on this very topic every single day.   It is termed “market timing”.  In the third and last article in this series on becoming a successful long-term investor, I am going to examine “market timing” with the same stock market data from the S&P 500 Index.  You will clearly see why trying to time the market and buy/sell or sell/buy at the right time is extremely difficult to do (despite what the financial pundits might have you believe given the daily commentary).

Before You Take Any Investment Advice, Consider the Source – Version 2.0

18 Wednesday Sep 2019

Posted by wmosconi in asset allocation, Average Returns, behavioral finance, bonds, Charlie Munger, confirmation bias, Consumer Finance, emerging markets, Fama, finance, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Geometric Returns, Individual Investing, individual investors, interest rates, Internet Bubble, investing, investing advice, investing, investments, stocks, bonds, asset allocation, portfolio, investment advice, investments, Markowitz, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, risk tolerance, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Uncategorized, Valuation, volatility, Warren Buffett

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academics, anchoring, behavioral economics, behavioral finance, Ben Graham, Bill Ruane, Capital Asset Pricing Model, CAPM, Charlie Munger, cognitive bias, Common Stocks and Uncommon Profits, David Dodd, economics, economy, Efficient Market Hypothesis, EMT, finance, invest, investing, investments, mathematics, Modern Portfolio Theory, MPT, performance, Phil Fisher, portfolio, portfolio management, Security Analysis, stocks, uncertainty, Warren Buffett

I originally wrote about this topic five years ago.  However, I think that it may even be more relevant today.  You may have heard about behavioral finance/economics and how cognitive biases plagued individual investors when making financial and investing decisions especially during volatility times in the financial markets.

Sometimes an overlooked topic is the fact that whomever provides you with financial advice will invariably be affected by those same biases.  Yes, even the professionals cannot escape them.  One of the most prevalent and insidious cognitive biases is called “anchoring”.

In layman’s terms, “anchoring” describes the tendency of people to form a particular belief and then stick with it unless there is an incredible amount of evidence to the contrary.  It is just part of human nature; we generally do not want to admit that we were mistaken or flat out wrong.

Now when I am talking about considering the source, I am not referring to the person’s qualifications such as having a Chartered Financial Analyst (CFA), Certified Financial Planner (CFP), or Chartered Market Technician (CMT) designation.  I am referring to the person’s investing paradigm. 

For the most part, financial professionals are influenced greatly by the time period in which they first start out in the financial services industry.  The first several of years have an outsized impact on their investing recommendations throughout the rest of their careers. 

I will give you an example in life, and then I will talk about Warren Buffett and even myself.  Take special note that I am including myself in this “anchoring” cognitive bias within the context of investing.

There have been many studies that show that the kind of music you listen to most during your teen years becomes your preferred type of music.  For example, there are many people in their early 40’s that love 80’s rock.  They would prefer to listen to that over any type of new music.  My parents are in their seventies now, and they love to listen to Peter, Paul, & Mary, the Beach Boys, Neil Diamond, Motown, and lots of one-hit wonders from the 50’s and 60’s. 

Think about your own taste in music.  Does this ring a bell?  Most people fall into this category, and it is almost subconscious.  You like a certain genre of music best, and it sticks with you.  Did you have a family member that was really into music and had a collection of records?  Sometimes you get introduced to music at an even younger age, and you are drawn to it.  You listened to it during your formative years.  The same goes for investing in a rather similar way.

If we take a look at Warren Buffett, he was definitely influenced by the time period in which he started learning about investing seriously.  Buffett read Security Analysis by Benjamin Graham and David Dodd, and he knew right away that he wanted to go to Columbia to get his MS in Economics.  The themes in the book seemed to resonate with him.  I have heard stories that the value investing class with Ben Graham and Warren Buffett was really a conversation between the two of them.  The rest of the classmates just sat back and enjoyed the “show”. 

Warren Buffett also learned a lot from a lesser known gentleman, Phil Fisher.  Phil Fisher wrote the classic treatise on “scuttlebutt” called Common Stocks and Uncommon Profits.  “Scuttlebutt” is essentially trying to gain every last piece of information you can about a company prior to investing.  This technique includes, not only speaking to management and reading annual reports, but talking to competitors, suppliers, current employees, past employees, and several other sources.

Warren Buffett remarked in the past that he was “15% Fisher and 85% Graham” in terms of his investing style.  Most experts on the career of Buffett would say that the percentage has shifted toward Fisher quite a bit, especially with the massive size of Berkshire Hathaway now.

I did not pick Warren Buffett because of his long-term track record of stellar performance.  I only picked him because many individuals are familiar with Warren Buffett.  Warren started out working for Graham in the early 50’s after he graduated from Columbia in 1951.  If you look back at this time in history, the stock market had finally gained back its losses from the great crash of October 1929.  The baby boom was in full swing, and the US economy was on overdrive in terms of growth.  The Securities and Exchange Commission (SEC) was set up back in 1933 after the crash once an investigation was done regarding the causes of this debacle. 

There were two important promulgations from the SEC in 1934 and 1940 that were issued in order to ensure that company information was available to the public and not fraudulent.  Well, there were still scams, but they were harder to pull off.  (As an aside, the Investment Advisor Act of 1940 did not stop Bernie Madoff from stealing billions of dollars several years ago).  Buffett and Graham (and Graham’s partner, Newman) loved to get their hands on any piece of information they could.  In fact, Buffett used to read entire books on every single public company. 

During that time period, information was so disjointed and hard to get.  However, it was now available to the public and professional investors who could do much more thorough analyses.  The financial markets had far more inefficiencies back then. 

This time period was before the dawn of Modern Portfolio Theory (MPT), the Capital Asset Pricing Model (CAPM), and the Efficient Market Hypothesis (EMT).  Thus, there was a great deal of opportunities for individuals like Buffett who soaked up all the information he could find.

Buffett started his own investment partnership in the mid 50’s.  It was essentially a hedge fund in most respects.  Without getting into too much of the details, Buffett was able to earn 20% more on average than the Down Jones Average annually until 1969.  The stock market at this time seemed to be overpriced in his estimation, so Buffett disbanded the partnership.  He referred his partners to Bill Ruane of the famed Sequoia Fund.  Bill was a former classmate of Warren, and he amassed quite a record himself.

So if we look at Buffett’s beginning career, he saw how doing your homework really paid off.  In fact, there are even stories that Ben Graham would use examples in his lectures about companies he was going to buy.  After class let out, all the students rushed to call, or see directly, their stock brokers to buy the companies Graham presented on. 

Buffett learned from Graham the importance of valuing a company based upon verifiable evidence and not market sentiment.  Fisher’s lessons showed him the benefit of accumulating information from different sources in order to truly understand a business prior to investing.  These formative years are still with Buffett. 

Now Charlie Munger, Buffett’s Vice Chairman at Berkshire Hathaway, has been an influence as well.  What is little known is that they grew up together in Omaha, Nebraska, and they were able to meet during this same time period.  This introduction to investing left an indelible mark on Warren Buffett that permeates his investing career today.

Obviously I am no Warren Buffett, but I started investing in mutual funds at age 13 in November 1987.  What got me so interested in the stock market?  Obviously Black Monday on October 19, 1987 really caught my attention.  It was not really the crash that really piqued my interest though.  My father told me that the market drop of 508 points on that day was an overreaction (down over 20% amazed me).  I did not know much about stocks, but it seemed to me like the world was ending.  At least that was how the nightly news portrayed things.  My father said watch the market over the next several days. 

To my absolute amazement, the Dow Jones Industrial Average (DJIA) went up almost 290 points in the next two trading sessions.  Wow!  This turn of events was really weird to me.  How could stocks move around in value so greatly?

I thought that all the big money investors in the stock market really knew what they were doing.  However, most everyone was caught by surprise by Black Monday.  The other interesting thing for me was that 1987 turned out to be a positive year for the DJIA.  If you want to get your friend’s attention, you can ask them what the return of the DJIA was for 1987 (positive return) and 1988 (negative return).  Most people will get it wrong.

Well, these events left a mark on me.  When I learned more about investing and was exposed to Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMT), I really did not think it was true given my start in investing back in the latter portion of 1987.  How could the value of the entire U.S. economy be worth 20% less after one day of trading? 

Now, the stock market is normally efficient and stock prices are correct, but I knew that there were inflection points in the stock market where rationality was thrown out the door.  Therefore, when I learned about Mr. Market and the vicissitudes and vagaries of the stock market from Ben Graham’s books, I liked that metaphor and way to characterize volatility in the stock market. 

For better or worse, I really do not care for the academic, ivory tower analysis of behavior in the stock market.  I cling more to focus investing, value investing, and seeing the financial markets as complex adaptive systems.  I would fall into the camp of Warren Buffett and the great hedge fund investor, George Soros.  Both men have said that they would never be able to pass the Chartered Financial Analyst (CFA) exam. 

The CFA is now the standard designation for all portfolio managers of stocks and bonds.  I tried studying for it, but a lot of it made little sense to me.  I guess that is why I think it is funny when Buffett says he wants to gift money to universities to install permanent chairs in business schools to teach Modern Portfolio Theory forever.

Most of the financial professionals you meet will range in age from twenties to sixties.  You should always ask them when they started investing or their career as a Financial Advisor.  Here are the ten major events that will cover those individuals:

  • The 1973-1974 severe bear market;
  • The Death of Equities article from Business Week magazine in 1979;
  • Black Monday in October 1987;
  • The Bond Bubble Bursting in 1994;
  • The Asian Contagion and Long Term Capital Management (LTCM) incidents in 1997-1998;
  • The Barron’s article in December 1999 that questioned the relevance of the Oracle of Omaha, Warren Buffett;
  • The Bursting of the Internet Bubble in April 2001;
  • The Financial Crisis and ensuing Great Recession of 2008-2009;
  • The “Lost Decade” of Returns from the S&P 500 from 2001-2010 when stocks averaged approximately 2% annually.
  • Managing Money is Easy. Look at my investing record over the past 10 years (2009-2018).  Note that the annualized return of the S&P 500 index over that period was 13.13%.

These major inflection points in the financial markets will have a great effect on your financial professional’s recommendations for investment portfolio allocation.  In fact, I met a Financial Advisor that tells his clients that they can expect to earn 12% annually from stocks over the long term.  He uses this return for modeling how much clients need to invest for retirement.  He was introduced to investing around 1996 which is when the stock market went gangbusters. 

I know another Financial Advisor that tells his clients to never put more than 50% of their money in common stocks.  He tells this to all of his clients, even if they are in their thirties and have 30+ years until retirement.  He started advising clients in 2007, and he lost a great many clients in 2008.  Therefore, he wants to have limited downside risk for two reasons. 

First, he has seen how much the stock market can drop in one year.  Second, this gentleman wants to ensure that his clients do not close accounts and flee to other financial professionals because the stocks in their portfolio go down 30-40% in a single year.

The importance today of the long, extended bull market of the past 10 years is extremely important to take into account for all individual investors.  A recent stretch of 13.13% annualized stock returns makes it seem that investing systematically over the long term is the correct investment strategy.  I would not disagree with that thought. 

However, Financial Advisors with 10 years of experience or less will only tell clients what they would do hypothetically in the event of a major market decline in the stock and bond markets.  Hypotheticals and backtesting are all well and good. 

But it has been my experience, that there is no substitute for actually investing during periods of extreme volatility and major stock market declines (20% or more).  For example, what was the best stock investment strategy right after the Internet Bubble implosion in terms of the asset class?  The best performing asset class for the next decade was to have a larger than normal allocation to emerging market stocks (think Ticker Symbol EEM or VWO).  Do you think that your Financial Advisor would have the stomach to recommend this investment to you after seeing the NASDAQ index fall by over 50%?

As you can see, the start of anyone’s investing career has an impact on their outlook for the financial markets and how to set up a portfolio properly.  I am not saying that any of this advice is “wrong” per se. 

My only point is that you need to probe your Financial Advisor a little bit to understand the framework he/she is working with.  Thus, you can refer to the aforementioned list of ten major events in the history of the financial markets.  These events really shape the investment paradigm of all of us.  And, of course, I will admit that I am no different.

With that being said, most investment strategies recommended by Financial Advisors are borne out of those individuals first few years with the financial markets.  Some financial professionals are more bullish than others.  Others focus on downside risk and limiting volatility in investment portfolios.  Still others utilize complicated mathematics to build investment portfolios that are optimized. 

Therefore, you need to understand your risk tolerance and financial goals very well.  You have your own personal experience with the market.  If your Financial Advisor is somewhat myopic and focused on the past repeating itself in the same way over and over, you need to be careful. 

History does repeat itself, but the repeating events will be caused by much different factors in most cases.  Unfortunately, the financial markets and market participants are always adapting to changing investment strategies, global economic GDP growth, interest rates, geopolitical events, stock price volatility, and a whole host of other things. 

You can learn from the past, but I urge you not to be “stuck” in the past with your Financial Advisor’s “anchoring” cognitive bias at the expense of setting up an investment portfolio that will allow you to reach your financial goals and match your risk tolerance.

Free Book – A New Paradigm for Investing on 50 year-old Investment Advice Available on Amazon.com

13 Wednesday May 2015

Posted by wmosconi in academia, academics, alpha, asset allocation, beta, books, college finance, finance, finance books, finance theory, financial planning, Free Book Promotion, Individual Investing, investing, investing books, investment advice, investments, Modern Portfolio Theory, MPT, personal finance, risk, stock market, stocks, volatility

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I have decided to make my recently published book FREE for several days, May 13, 2015 through May 17, 2015 (it normally retails for $4.99).  The book is another installment in my A New Paradigm for Investing series.  In this particular book, I focus on the use of Modern Portfolio Theory (MPT) as the primary tool by Financial Advisors to recommend portfolio allocations.  The theory is over 50 years old, and most of its assumptions have been shown to be less and less useful.  I explore the reasons why in my text.  I have tried to write in such a manner that you do not need a degree in mathematics or statistics to understand its contents.  Moreover, you do not need to know about the intricacies of MPT in order to follow my logic.  You would find the same information in a college textbook but in a condensed format here.  It actually is quite surprising how little Financial Advisors know about MPT in general and how the ideas apply to individual investors.

Note that this book is available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Amazon.com Prime Members can borrow the book for FREE as well. I have provided a link below to make it easier.   My email address is latticeworkwealth@gmail.com should you have any questions/comments/feedback.

The book is:

  • A New Paradigm for Investing: Is Your Financial Advisor Creating Your Portfolio with a 50 Year-Old Theory?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00FQQ0CKG/ref=sr_1_1?s=books&ie=UTF8&qid=1381520643&sr=1-1&keywords=a+New+paradigm+for+investing+by+William+Nelson

I would like to thank my international viewers as well of my blog that can be found at https://latticeworkwealth.com/.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would strongly recommend following for their content and insight):

Followers on @NelsonThought:

  • The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts
  • The Wall Street Journal Central Banks @WSJCentralBanks – Coverage of the Federal Reserve and other international central banks by @WSJ reporters
  • The Royce Funds @RoyceFunds – Small Cap value investing asset manager
  • Research Magazine @Research_Mag – Latest industry information for wirehouses and ETFs
  • Barron’s Online @BarronsOnline – Weekly financial news magazine of Dow Jones
  • Cleveland Fed Research @ClevFedResearch
  • Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal
  • Muriel Siebert & Co. @SiebertCo
  • Roger Wohlner, CFP® @rwohlner – Fee-only Financial Planner for individuals
  • Ed Moldaver @emoldaver – #1 ranked Financial Advisor in New Jersey by Barron’s 2012
  • Muni Credit @MuniCredit – Noted municipal credit arbiter
  • Berni Xiong (shUNG) @BerniXiong – Author, writing coach, and national speaker

Followers on @LatticeworkWlth:

  • Tracy Alloway @tracyalloway – US Financial Correspondent at Financial Times
  • Vanguard FA @Vanguard_FA – Vanguard’s ETF research and education
  • EU External Action @eu_eeas – Latest news from the European External Action Service (EEAS)
  • Charlie Wells @charliewwells – Reporter and Editor at The Wall Street Journal
  • Sri Jegarajah @CNBCSri – CNBC anchor and correspondent for CNBC World
  • Jesse Colombo @TheBubbleBubble – Columnist at Forbes
  • Alastair Winter @AlastairWinter – Chief Economist at Daniel Stewart & Company
  • Investment Advisor @InvestAdvMag – Financial magazine for Financial Advisors
  • Gary Oneil @GaryONeil2 – Noted expert in creating brands for start-ups
  • MJ Gottlieb @MJGottlieb – Co-Founder of hustlebranding.com
  • Bob Burg @BobBurg – Bestselling author of business books
  • Phil Gerbyshak @PhilGerbyshak – Expert in the use of social media for sales

A New Paradigm for Investing on 50 year-old Investment Advice Available on Amazon.com

01 Saturday Mar 2014

Posted by wmosconi in asset allocation, beta, business, Consumer Finance, Education, Fama, finance, financial planning, Free Book Promotion, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, Markowitz, math, Modern Portfolio Theory, MPT, passive investing, personal finance, portfolio, risk, Sharpe, sigma, statistics, stock prices, stocks, volatility

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Amazon.com, business, economics, education, FA, finance, Financial Advisors, free books, individual investing, investing, investment advice, investments, mathematics, Modern Portfolio Theory, MPT, personal finance, statistics

I have decided to make my recently published book FREE for today only, March 1, 2014(it normally retails for $4.99).  The book is another installment in my A New Paradigm for Investing series.  In this particular book, I focus on the use of Modern Portfolio Theory (MPT) as the primary tool by Financial Advisors to recommend portfolio allocations.  The theory is over 50 years old, and most of its assumptions have been shown to be less and less useful.  I explore the reasons why in my text.  I have tried to write in such a manner that you do not need a degree in mathematics or statistics to understand its contents.  Moreover, you do not need to know about the intricacies of MPT in order to follow my logic.  You would find the same information in a college textbook but in a condensed format here.  It actually is quite surprising how little Financial Advisors know about MPT in general and how the ideas apply to individual investors.

Note that this book is available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Amazon.com Prime Members can borrow the book for FREE as well. I have provided a link below to make it easier.   My email address is latticeworkwealth@gmail.com should you have any questions/comments/feedback.

The book is:

1)      A New Paradigm for Investing:  Is Your Financial Advisor Creating Your Portfolio with a 50 Year-Old Theory?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00FQQ0CKG/ref=sr_1_1?s=books&ie=UTF8&qid=1381520643&sr=1-1&keywords=a+New+paradigm+for+investing+by+William+Nelson

I would like to thank my international viewers as well of my blog that can be found at https://latticeworkwealth.com/.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would strongly recommend following for their content and insight):

Followers on @NelsonThought:

–  The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts

–  Institutional Investor @iimag

–  The Royce Funds @RoyceFunds – Small Cap value investing asset manager

–  Research Magazine @Research_Mag – Latest industry information for wirehouses and ETFs

–  Barron’s Online @BarronsOnline – Weekly financial news magazine of Dow Jones

–  Cleveland Fed Research @ClevFedResearch

–  Euromoney.com @Euromoney

–  Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal

–  Muriel Siebert & Co. @SiebertCo

–  Roger Wohlner, CFP® @rwohlner

–  Ed Moldaver @emoldaver

–  Sylvia Maxfield @sylviamaxfield – Dean of the Providence College of Business

–  The Shut Up Show @theshutupshow

–  Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

–  Tracy Alloway @tracyalloway – US Financial Correspondent at Financial Times

–  Vanguard FA @Vanguard_FA – Vanguard’s ETF research and education

–  EU External Action @eu_eeas – Latest news from the European External Action Service (EEAS)

–  Direxion Alts @DirexionAlts

–  Charlie Wells @charliewwells – Editor at The Wall Street Journal

–  Jesse Colombo @TheBubbleBubble – Columnist at Forbes

–  Alastair Winter @AlastairWinter – Chief Economist at Daniel Stewart & Company

–  AbsoluteVerification @GIPStips

–  Investment Advisor @InvestAdvMag

–  Gary Oneil @GaryONeil2

–  MJ Gottlieb @MJGottlieb

–  Bob Burg @BobBurg

–  TheMichaelBrown @TheMichaelBrown

–  Phil Gerbyshak @PhilGerbyshak

– MuniCredit @MuniCredit

A New Paradigm for Investing: Can Your Financial Advisor Answer These Questions?

01 Wednesday Jan 2014

Posted by wmosconi in asset allocation, bonds, business, Consumer Finance, Education, Fed Taper, Fed Tapering, Federal Reserve, finance, financial advisor fees, financial planning, Individual Investing, investing, investment advisory fees, investments, math, Modern Portfolio Theory, MPT, Nobel Prize in Economics, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, Suitability, volatility

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Amazon book deals, asset allocation, books, business, education, finance, Financial Advisors, financial planning, individual investing, investing, investment advsiory fees, Modern Portfolio Theory, MPT, reasonable investment advisory fees, retirement

Greetings to all my loyal readers of this blog.  How would you like to start off the New Year of 2014 by reevaluating your investment portfolio and how you get investment advice?  This book on Amazon.com is available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Please feel free to check out the titles below.  I have provided links to make it easier.   My email address is latticeworkwealth@gmail.com.

The link to the book is as follows:

A New Paradigm for Investing:  Can Your Financial Advisor Answer These Questions?

 

http://www.amazon.com/New-Paradigm-Investing-Financial-Questions-ebook/dp/B00F3BDTHW/ref=sr_1_3?s=books&ie=UTF8&qid=1388595896&sr=1-3&keywords=a+new+paradigm+for+investing+by+william+nelson

The book listed is normally $9.99 but available but I am offering it for a lower price over the course of the next week.  For most of the day today, the book is $3.99 which is 60% off.  The price of the book will be gradually increasing during the course of that period.

I would like to thank my international viewers as well.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

 The Wall Street Journal Wealth Report @WSJwealthreport – #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Chloe Cho – @chloecnbc – CNBC Asia Anchor for Capital Connection show

Pedro da Costa @pdacosta – Central banking and economics reporter at The Wall Street Journal

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield – Dean of the Providence College of Business

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells – Editor at The Wall Street Journal

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

A New Paradigm for Investing on 50 year-old Investment Advice Available on Amazon.com

03 Tuesday Dec 2013

Posted by wmosconi in alpha, asset allocation, Bernanke, beta, bonds, business, Consumer Finance, Education, Fama, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial advisor fees, financial planning, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, Markowitz, math, Modern Portfolio Theory, MPT, Nobel Prize, Nobel Prize in Economics, portfolio, rising interest rate environment, rising interest rates, risk, Schiller, Sharpe, sigma, statistics, stock prices, stocks, volatility, Yellen

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alpha, asset allocation, Bernanke, beta, bonds, business, consumer finance, economics, education, Fama, Fed, Fed taper, Fed Tapering, Federal Reserve, finance, investing, investments, math, Modern Portfolio Theory, MPT, Nobel Prize, Nobel Prize in Economics, personal finance, portfolio, portfolio management, Schiller, Shiller, statistics, stocks, volatility, Yellen

I am happy to announce that I have published another book on Amazon.com.  I have decided to make it FREE for the rest of the week through Saturday, December 7th (it normally retails for $4.99).  The book is another installment in my A New Paradigm for Investing series.  In this particular book, I focus on the use of Modern Portfolio Theory (MPT) as the primary tool by Financial Advisors to recommend portfolio allocations.  The theory is over 50 years old, and most of its assumptions have been shown to be less and less useful.  I explore the reasons why in my text.  I have tried to write in such a manner that you do not need a degree in mathematics or statistics to understand its contents.  Futhermore, you do not need to know about the intricacies of MPT in order to follow my logic.  You would find the same information in a college textbook but in a condensed format.

Note that this book is available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Amazon.com prime members can borrow the book for FREE. I have provided a link below to make it easier.   My email address is latticeworkwealth@gmail.com should you have any questions/comments/feedback.

The book is:

1)      A New Paradigm for Investing:  Is Your Financial Advisor Creating Your Portfolio with a 50 Year-Old Theory?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00FQQ0CKG/ref=sr_1_1?s=books&ie=UTF8&qid=1381520643&sr=1-1&keywords=a+New+paradigm+for+investing+by+William+Nelson

I would like to thank my international viewers as well.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

The Wealth Report @wsjexperts – Wall Street Journal #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Pedro da Costa @pdacosta

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

A New Paradigm for Investing Available on Amazon.com

11 Friday Oct 2013

Posted by wmosconi in asset allocation, Bernanke, bonds, business, Charlie Munger, Consumer Finance, Education, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, GIPS, GIPS2013, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, Modern Portfolio Theory, MPT, NailedIt, NASDAQ, personal finance, portfolio, risk, statistics, stock prices, stocks, volatility, Warren Buffett, Yellen

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academia, academics, asset allocation, Ben Graham, Bernanke, bloomberg, bonds, BRK, BRK.A, BRK.B, BRK/A, BRK/B, Buffett, cnbc, cnbcfastmoney, cnbcworld, consumer finance, David Dodd, economics, economy, Fed, Fed taper, Federal Reserve, finance, financial advice, Govtshutdown, individual investing, investing, investments, Jim Cramer, madmoney, math, mathematics, MBT, Modern Portfolio Theory, personal finance, portfolio, retirement, Shutdown, statistics, stocks, value investing, Warren Buffett, Yellen

I am happy to announce that I have published another book on Amazon.com.  The book is another installment in my A New Paradigm for Investing series.  In this particular book, I focus on the use of Modern Portfolio Theory (MPT) as the primary tool by Financial Advisors to recommend portfolio allocations.  The theory is over 50 years old, and most of its assumptions have been shown to be less and less useful.  I explore the reasons why in my text.  I have tried to write in such a manner that you do not need a degree in mathematics or statistics to understand its contents.  Futhermore, you do not need to know about the intricacies of MPT in order to follow my logic.  You would find the same information in a college textbook but in a condensed format.

Note that this book is available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Amazon.com prime members can borrow the book for FREE. I have provided a link below to make it easier.   My email address is latticeworkwealth@gmail.com should you have any questions/comments/feedback.

The book is:

1)      A New Paradigm for Investing:  Is Your Financial Advisor Creating Your Portfolio with a 50 Year-Old Theory?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00FQQ0CKG/ref=sr_1_1?s=books&ie=UTF8&qid=1381520643&sr=1-1&keywords=a+New+paradigm+for+investing+by+William+Nelson

I would like to thank my international viewers as well.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

The Wealth Report @wsjexperts – #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Pedro da Costa @pdacosta

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

How Risky Are Stocks? Do You Understand Volatility? Part 2 of 2

20 Friday Sep 2013

Posted by wmosconi in asset allocation, bonds, business, Charlie Munger, Education, finance, financial planning, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, personal finance, portfolio, risk, statistics, stock prices, stocks, volatility, Warren Buffett

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asset allocation, bonds, business, Charlie Munger, education, Fed taper, finance, financial planning, investing, investments, long term investing, mathematics, Modern Portfolio Theory, MPT, portfolio, retirement, risk, statistics, stocks, Warren Buffett

In the first part of this discussion, I talked at length regarding the volatility of stock prices.  Most investors are fearful of stock prices jumping all around for seemingly random or unknown reasons.  Many times extreme volatility can be explained.  Other times different news sources will attribute these fluctuations to totally different or even opposite reasons.  No wonder it is frustrating for individual investors.  Now traders and speculators need volatility to make money.  Additionally, Wall Street trading desks generate purchase and sale orders if stock prices are constantly in flux.  However, if you have a longer timeframe for holding the underlying components of your portfolio, it is quite easy to get hung up in this daily “circus”.  It is hard to have what I term “intestinal fortitude”, which is a fancy way to say guts, in the face of this environment of information overload.

Most financial professionals will construct a portfolio and recommend purchases/sales based upon Modern Portfolio Theory (MPT).  If you have heard the terms beta, alpha, r-squared, and tracking error, you are already familiar with MPT.  I will not get into the history behind the construction of MPT, but it started over 50 years ago.  Harry Markowitz is credited with creating the outline of the theory, and there has been a plethora of academic work done since then by some of the greatest academicians of all time.  With that being said, coming up with an academic theory and applying it to the real world are two different stories.  In brief, MPT talks about how to create a portfolio on the efficient frontier which maximizes return and minimizes risk (where risk is defined as the volatility of stock prices).  The portfolio consists of a combination of the risk free asset (Treasury debt) and an additional percentage of stocks.  However, there are a number of assumptions which underlie the theory.  In order to get the mathematics to work, a number of simplifying assumptions need to be made.  Otherwise, the calculations are so difficult that only a handful of mathematicians and statisticians would be able to understand the theory.  For some background information on the issue of stock price volatility, I encourage you to reread the first part of this article:  https://latticeworkwealth.com/2013/09/08/how-risky-are-stocks-do-you-understand-volatility-part-1-of-2/.

Let’s take a look at the six key underlying assumptions of MPT as described by Dr. John C. Hull who is the Maple Financial Group Chair in Derivatives and Risk Management at the Joseph L. Rotman School of Management, University of Toronto in his book entitled Risk Management and Financial Institutions Third Edition.  As an aside, most students with an MBA in Finance or MS in Financial Engineering will recognize Dr. Hull’s name from his book on Options, Futures, and Other Derivatives, which is a standard text in most programs:  http://www.amazon.com/Options-Futures-Derivatives-DerivaGem-Package/dp/0132777428/ref=sr_1_1?ie=UTF8&qid=1379691849&sr=8-1&keywords=john+hull+options+futures+and+other+derivatives+9th .  Dr. Hull lays out the assumptions on pages 10-11 of the aforementioned book.  They are as follows:

1)       Investors only care about the expected returns and the standard deviation of their portfolios assuming the standard normal distribution (bell curve).  He admits that many academics and practitioners believe that the expected returns of stock prices are non-normal and exhibit skewness and excess kurtosis.  Without giving a formal definition of the two, suffice it to say that skewness depicts whether or not more observations are above or below the average.  Kurtosis is simply whether or not there are observations than the simple bell curve would not predict.  Investors are more concerned with extreme negative returns above and beyond what the bell curve would predict;

2)      The second assumption is that stock price changes are not correlated to each other.  However, think about the industry factors that affect Apple and Samsung.  It is likely to be that global demand for smartphones will affect both these stocks in similar ways;

3)      The time horizon for all investors is one period which is typical one calendar year;

4)      All investors can borrow and lend at the same risk free interest rate;

5)      All investors are taxed at the same rate in all locations;

6)      All investors make the same calculations about the estimated expected returns, standard deviations, and correlations between returns for all investments available to investors.

We can clearly see that these assumptions severely limit the practical application of MPT to constructing a portfolio of investments that will provide a satisfactory rate of return given ones risk tolerance and financial goals.  Why are these assumptions made?  Well, I can assure you that even with these assumptions the math gets quite complicated.  For example, ask your Financial Advisor how William Sharpe proved that you can eliminate the covariance between stocks in order to come up with portfolios that lie on the efficient frontier to “simplify” Markowitz’s original theory.  Note this is just one “easy” part of coming up with the expected return of a portfolio composed of percentages of the risk free asset and all stocks.  If your Financial Advisor can explain that concept to you, you need not read any further.  I would be quite impressed and listen more to what he/she says.  If not, I would urge you to continue reading.

If some or all of the six assumptions do not apply to you, why would you want a portfolio custom made for you that uses a 50 year-old theory?  Personally, I do not know either.  So let’s proceed with how it relates to individual investors.  I will concentrate on investors in or near retirement or saving for retirement in my discussion below.

If your time horizon is longer than one year, you can make some modifications to MPT in order to fit your financial goals, risk aversion, and timeframe.  How?  Well, if you are an individual investor, you can choose to see the world in a different manner when it comes to investing.  The day-to-day and even quarterly fluctuations of stock prices should not concern you too much.  Yes, I realize it is easier said than done.  However, you can choose to make tactical and strategic decisions about the composition of your portfolio.  Most financial professionals would tell you to invest for the long term anyway, right?  Well, tactical decisions should be made in the context of an annual review of your portfolio.  Strategic decisions should be made with an outlook on the next five years or so.  This is probably what you have heard anyway.  Here is the twist though:  if you look at the stock price fluctuations of the S&P 500 index over the last 50 years, there will be some scary results.  If we take the period April 1, 1957 through June 28, 2013 and use MPT statistics, you can expect that 1 out of every 10 quarters your quarterly return from the S&P 500 index will be less than -11.5% or greater than 15.1%.  Note the returns are based upon quarterly fluctuations.  You can expect to experience a return in any given quarter which is less than -11.5% every 5 years or so.  Given your risk tolerance, how would you feel if your portfolio lost this amount in a single quarter?  Most investors, especially retirees, would have a difficult time accepting this volatility in expect returns.  Should you sell all your stocks at this point?  Well, I try never to give portfolio advice, but, if you are fearful of losing more than 10% of your money investors in stocks, I think you should strongly reconsider your risk tolerance.  That negative return is any given quarterly window is not too extraordinary in the real world.

I talked about the standard deviation of stocks on an annual basis at great length in the first part of this article.  How can we use the same statistical techniques to look at a portfolio over the long term?  Your Financial Advisor is used to speaking with you once a quarter and at the end of the year to review the performance of your portfolio.  What if you are wondering what you should do over the next five years? If you are 43 years old, why should you worry about daily stock price returns in 2014?  You should think about stock price returns but not to the extent of watching the stock market every single day, month, or quarter to try to glean magical insight into the future direction of stock prices.  I have been investing in the stock market since 1987, and the history of the stock market is littered with incorrect predictions about the stock market.  In fact, it can be dangerous to listen to some of the market prognosticators of “gloom and doom”.  For example, if you hear that you should buy gold because the entire financial system is going to collapse, I would ask you to perform a thought experiment.  If the financial system breaks down such that we are bartering for goods with gold and silver coins, ask yourself how long that money will last.   How long will it be until there is a scene out of NBC’s television show Revolution?  If there is an armed gang of thugs roaming the streets, I am pretty sure that your coins will not be in your possession for very long.  Note that is my personal opinion, but, if you construct your portfolio based upon extreme scenarios, you have to perform extreme scenarios to “stress” your portfolio.  I think it is a better use of time to think about uncertainty as being an ongoing component of investing.  There will never be 100% certainty about economic and financial events.

We can use the same statistics invoked by the academicians who created MPT to our advantage if the time horizon is extended to five year increments.  For example, over the time period 1961-2010, the average annual return for stocks in the S&P 500 index over each five-year period was 9.7% per year.  Now the minimum and maximum annual returns for each five-year increment were 0.5% (2001-2005) and 18.2% (1996-2000), respectively.  Now please observe that the annual returns of 1973, 1974, 1987 (as shown in part 1 of 2 was actually positive), 2001, and 2008 are included in that time series.  How does this occur?  The extreme increases and decreases of stock returns are smoothed out over a long period of time.  We had the Internet Bubble in 2001 which was preceded by the period of time in the late 1990’s which former Federal Reserve Chairman, Alan Greenspan termed irrational exuberance (note that this term was coined by him in December 1996; please refer to this link for Greenspan’s famous speech:  http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm).  The fluctuation of stocks over a particular year can be quite volatile and can persist for much longer than expected by top-notch economists and asset managers.  However, if you look at these observed returns, you come up with much smoother results.  Your financial professional encourages you to invest for the long term, so why don’t you look at the expected returns over the long term for stocks when creating your portfolio?  If you are making tactical (medium term) and strategic (long term) changes to your portfolio, doesn’t it make sense to ignore the daily changes in stock prices?  To me, these are rhetorical questions.  Given the financial advice you receive or information you receive from the financial media now, does it sound like they consider these questions to be rhetorical?

The last point I will leave you with is a brief look at the annual returns you might expect over any five-year holding period in stocks.  Looking at the ten observations of five-year annual returns between 1961-2010 for the S&P 500 index, you can expect that 1 year in every 100 your five-year annual return will be outside -5.9% and 25.2%.  Therefore, every 200 years, there should be a five-year annual return less than -5.9% which is otherwise thought of as downside risk.  The worst five-year annual return for stocks since 1931 was 1936-1940 in which the average annual return was a bit less than -0.5%.  The five-year annual return for stocks between 1931-1935 was 2.2% which incorporated the height of the Great Depression.  Therefore, I would argue that you are thinking about investing as a long-term exercise in helping you reach your financial goals, stocks may be less risky than you think.  Or at the very least, you should ask your Financial Advisor why they do not use annual and five-year annualized (geometric basis of course) expected returns for stocks when recommending how you should position your portfolio.  It is a valid question if you are a long-term investor.  Note that I did not even include diversification in this discussion.  Since you are able to choose small cap stocks, international stocks, high yield bonds, and real estate, you can look at an individual portfolio in an even more positive light.

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