Asset Allocation

Asset allocation is an effective method of diversification. It refers to the strategy of dividing your total investment portfolio among various asset classes. Here are five basic models, portrayed in an article of Shauna Carther (Biography) for http://www.investopedia.com/.

The Future of Life-Cycle Saving and Investing

The Future of Life-Cycle Saving and Investing

Life-cycle finance is the branch of finance that affects everybody. The Research Foundation of CFA Institute teamed with Boston University and the Federal Reserve Bank of Boston to present a conference exploring the frontiers of life-cycle finance. Insights from such leading thinkers as Paul Samuelson, Robert Merton, and Zvi Bodie are captured in these proceedings of the conference.

The Second Edition (February 2008), with additional comment, is now available (online only) on the web site of CFA Institute.

The Future of Life-Cycle Saving and Investing, Second Edition (Full PDF)
Zvi Bodie, Dennis McLeavey, CFA, and Laurence B. Siegel
Research Foundation Publications, The Future of Life-Cycle Saving and Investing, Second Edition(February 2008): 1-183.
Abstract Full Text PDF(1975K) Linked PDF(2000K)

Investment Strategies Against Inflation

Inflation and especialy elevated inflation could seriously undermine investment returns. Therefore efficient tactics against it need to be developed in order to prevent or at least dampen the defects of inflation. Here I will name several broad strategies that could be of help:

1. Avoid broad portfolio diversification
2. Stay long energy, materials and industrials against shorts in all other sectors
3. Stay liquid to buy depressed financial assets
   
4. Own actual and/or implied interest rate and equity volatility
5. Short bonds with fixed rate against stock
   
6. Own some floating-rate bonds
   
7. Own some gold
8. Own inflation protected bonds if available

It might be surprising for some but inflation at a small pace is usually much preferred over deflation. Why? Well, the best reason I could come up with is that in a deflation environment people start losing their jobs. With product and services getting cheaper, investment and expansion is much tougher.

Benjamin Graham's Investment Screening

Ever wondered how Benjamin Graham used to screen for investment picks?

Here is his list:

1. PE of the stock has to be less than the inverse of the yield on AAA corporate bonds.
2. PE of the stock has to be less than 40% of the average PE over the last 5 years.
3. Dividend yield has to be more than two-thirds of the AAA corporate bond yield.
4. Price has to be less than two-thirds of book value.
5. Price has to be less than two-thirds of net current assets.
6. Debt-Equity Ratio (Book Value) has to be less than one.
7. Current assets have to be more than twice current liabilities.
8. Debt to be less than twice current assets.
9. Historical growth in EPS (over last 10 years) has to be over 7%.
10. No more than two years of negative earnings over the previous ten years.

Although Modern Portfolio Theory teaches that it is generally impossible for any individual to outwit the market, Graham's approach retains a widespread and dedicated following. Graham’s best claim to fame comes from the success of the students who took his classes at Columbia University. Among them were investors like

Charlie Munger and Warren Buffett.

Have in mind though that Graham's criteria can lead you to stocks that are value traps, meaning the shares are cheap for good reason and unlikely to appreciate. Screens are a good place to start, but it is common sense not to buy without doing your own research.

Managing Your Own Portfolio

Need a piece of advice on personal portfolio management?

Here is an insightful memo from Arthur Zeikel
to his daughter on Managing Your Own Portfolio.

Arthur is a 20-Year Veteran of Merrill Lynch Asset Management, now retired. He is father of three and grandfather of four and one of the most respected US leaders in asset management. Arthur is also member of the Editorial Board of the Financial Analysts Journal where the memo has been published in the March-April edition in 1994. Now this piece of advice is available on the web site of CFA Institute in their Private Wealth Corner.

Here is an excerpt to let you sense the style of Arthur:

Act.
Make decisions. No amount of informafion can remove all
uncertainty. Have confidence in your moves. Better to be approximately right
than precisely wrong.
Take the long view.
Don't panic under short-term transitory developments. Stick to your plan. Prevent emotion from overtaking reason. Market timing generally doesn't work. Recognize the rhythm of events.
Remember the value of common sense.
No system works all of the time. History is a guide, not atemplate.

Download the letter here.

Creating Your Investment Policy Statement II

Part II – Practice

Although each Investment Policy Statement (IPS) is very personal, it bears certain features which are nicely summed up in the Morningstar’s Investment Policy Worksheet (pdf). This document is only two pages long but full of vital questions that each investor should address.

The worksheet’s leading section is called Executive Summary and serves as an overview of your current situation and what you expect from your portfolio. Oncce filled in, it is advisable to update it whenever you rebalance your portfolio.

The next two sections ask you to state your objectives and put in plain language your investment philosophy. The last two sections refer to your investment selection criteria and monitoring procedures.

The worksheet is an excellent start for constructing your IPS although it does not address critical issues like liquidity and reconciliation of your ability and willingness to take risk. See Part I for more clues on that. Another feature that also could be elaborated is the list of available asset classes briefed into the Executive Summary. The lack of commodities and no split of bonds into government and corporate strike at first glance but here the illustrative nature of the Worksheet seems much more important.

Creating Your Investment Policy Statement I

Part I – Theoretical approach

The Investment Policy Statement (IPS) is your investment strategy in writing and helps you commit to a disciplined investment plan. It is an instrument to face your future financial goals today.

A well-constructed IPS is thought to address at least the following areas:

>your financial goals and desired/required return
>your willingness and ability to take risk
>your relevant investment constraints

It should usually set guidelines for constructing and monitoring a portfolio that can be expected to best meet your goals while remaining in compliance with any relevant constraints.

Stating your financial goal is not an easy task, but it a building block for your IPS. After all why bother to write a statement if this is not included. Each goal/goals should be detailed and accompanied by a possible way to meet it. Return objectives, which focus on rates that increase your current wealth or future savings, should always be addressed with the risk-return trade-off in mind. Increasing return increases risk or vice versa. The stated return objective will be useless if it does not take into account all relevant portfolio constraints.

Overall risk tolerance is a function of both your ability to take risk and willingness to take risk. Your ability can be expressed in numbers. Your willingness, however, involves a more subjective assessment. Reconciling both is a right step toward the proper portfolio.

The following matrix illustrates the reconciliation process:

In case you fall into the problem area, you should reconsider your options and address the mismatch early. Otherwise improper positioning will mean only future trouble.

Few portfolios have no investment constraints. Usually your portfolio constraints generally will fall into one of the following categories:

-Liquidity
-Time horizon
-Taxes
-Legal / regulatory environment
-Unique circumstances

Liquidity may range from very important to not applicable. You would not want to liquidate your portfolio in a depressed market in order to meet liquidity needs. Therefore good planning of portfolio liquidity may prove paramount for returns.

As for the time horizon, each portfolio could have several time horizons and this should be addressed in the IPS.