Pertinent Questions

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I met recently with a group of business students.  Not surprisingly, we talked mostly about their careers and how they could best position themselves for the jobs they covet.  Four questions came up that belong in this blog.

  1. How does one secure a good track record managing equities?

There are a number of ways to manage stocks: some lean toward value, some toward growth, some are purely quantitative, some rely exclusively on human judgment, and some blend these elements.

For growth, the aim is to ferret out companies that are growing rapidly or, better yet, are about to experience a growth spurt. You buy their stock to enjoy the price increases that emerge from the growing market enthusiasm about the firm’s success.  You must always remain on top of the firm’s prospects and its stock price, because there will come a time when the market’s enthusiasm for the company outstrips reality, at which point, even if the company continues to do well, its stock price will languish or fall.  You must have the insight to recognize this moment and sell quickly –– boldly –– and put the money to work elsewhere before suffering the losses, absolute or relative to the other buys you could make.  Your insight must distinguish between a fundamental turn and the inevitable pauses that occur even as a stock climbs.  Therefore, growth management styles involve much trading –– turnover, in financial jargon.

Quantitative techniques have limited value for the growth approach.  You could devise a computer-based algorithm to identify fast-growing companies from a universe of stocks and perhaps even to assess whether the stock prices have kept up with that rapid growth.  Otherwise the effort involves a lot of research about why the company is growing fast and judgment about management, competition, and product offerings to determine whether that growth will last.  For those who have the skill and diligence, it can be very rewarding.

Quantitative techniques can have a larger role in the value approach.  The object here is to find stocks where the market has pegged the firm’s stock price beneath the company’s fundamental value.  The presumption is that at some point the market will wake up to its pricing mistake and price the stock upward accordingly.  This approach might lead to buying slow-growing, unexciting companies the market has neglected.  It might also involve a fast-growing firm for which the market has yet to wake up to its potential.  All sorts of computer-based algorithms can test for such valuation mistakes in the market. When I managed money professionally, I used one that assessed the earnings prospects of hundreds of companies, using what is called an earnings discount model to estimate the price they should sell at –– what in market jargon is called a fair value price.  That algorithm then compared the fair-value estimate to the actual market price and ranked stocks from those with the largest positive gap between fair value and the actual price –– the undervalued stocks –– to the smallest or negative gap (the over-valued stocks). In building a diversified portfolio, I would focus my research and analysis on those the algorithm identified as most attractively priced.

Whichever approach you take, you must stick with it over time.  The market can overlook value and fail to respond to growth for longer than you might feel comfortable with.  One is never always right, but if there is worth in the approach, it will only tell in the long run.  If you cannot stay the course for at least five years, you do not belong in stocks.  Choose bonds or bank deposits.

  1. If you were to become a professional portfolio manager and had a need to make your mark in less than a year, what approach would you use then?

The best approach then is to pray for luck. Luck is always a big part of investment success, but if you must make your mark in stocks in less than a year, luck is all you have.

  1. What about Bitcoin or some other cyber-currency? Do you think it would be good to have a global currency?

There was a time when the world did have one: gold. It worked for a long time, but it could not do so today for a number of reasons.  In theory, a substitute for traditional, nationally based currencies has appeal.  Bitcoin and other cyber-currencies have, however, failed in this regard.  They don’t have the stability that, among other things, is essential in a successful currency.  Cyber-currencies values have swung wildly relative to all major currencies (dollars, euros, yen, yuan etc.) and, most importantly, against goods and services in general. To take the place of dollars or any other currency, cyber-currencies must show more stability than these currencies do, not less.

  1. If you cannot buy a cyber-currency, what can you do if you expect dollar inflation?

You don’t need a global currency to protect yourself from dollar inflation, though a viable one would be convenient.  You can buy real estate, art –– things that hold real value when the dollar is losing value.  If you want an asset that gets priced every day, then buy gold or commodities.  Their prices swing up and down but they usually keep up with general prices levels, especially when inflation is a problem. Copper or zinc will work, too. They have in the past.




Tailoring a Portfolio

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This post and the next two are devoted to constructing an investment portfolio.  This first post takes up broad divisions – the mix of cash, stocks, and bonds — what professional investors refer to as asset allocation. The next post will focus on the portfolio’s bond assets and the third will discuss its stock assets.

Typically, a broker’s portfolio report begins with the overall amounts you have in cash, in stocks, and in bonds.  The report then gets into intricate detail, listing all the bonds, who issued each, the original “coupon” rate as a percent of the bond’s face amount, and its maturity date.  (See this earlier post for an explanation of these terms.) The broker’s report will probably also show how much you paid for each bond, its current value, and perhaps the interest payments you earned from it since the last report.  A comparable listing of the stocks in your portfolio will show the name of the issuing corporation, the number of shares you own, what you paid for them, their current value, and possibly dividend payments since the last report.

While these reports are useful to brokers, bankers, and accountants, portfolio managers look at holdings more broadly to consider how they can achieve two key objectives for you:

  1. Good diversification: An effort to avoid having too many eggs, meaning dollars, in one basket, that is too many of one security or type of security. If you could always pick the best, you would not need to diversify.  But perfect foresight is impossible, so spreading your wealth among different types of stocks and bonds will protect the portfolio from setbacks by ensuring that its different parts respond to events in different ways.  Such diversification of exposure allows your portfolio to secure the most gain with the least amount of risk.
  2. Serving the specific goals of the investor: Are your portfolio’s assets meant to provide retirement income?  To buy a vacation home? Or to pay for a newborn child’s college education? These and other long-term objectives will determine what sorts of stocks and bonds your portfolio should hold and how it should mix the types of securities to get the greatest prospective return for the least risk.

So think of the stocks and bonds in the portfolio not necessarily as individual holdings but rather as the best possible representatives of the sort of security that serves these basic aims.

There is no perfect mix.  Your right combination will depend heavily on your particular circumstances and preferences — what many in the investment business term your life-cycle/life-style situation.  Some people cope better than others with risk and occasional loses.  Those more suited to a riskier life style feel comfortable reaching for gains in a more volatile portfolio.  The mix you choose should also reflect where you are in your life cycle.  Young people investing for retirement, for example, will not need the money for years, so they can take more risk to earn greater returns than can older investors who are approaching the end of their working lives and have less opportunity to make up for an investment loss or time to wait for a market rebound after a setback.

Portfolios need to reflect such differences.  Young people, who will not need the money for years, particularly risk-takers, may want few or no bonds in their portfolios. They may want to concentrate on stocks, particularly smaller, less established stocks, because these, though more volatile than other investments, tend over time to gain more than bonds and more conservative stocks.  To be sure, stocks generally and particularly those of less established companies may suffer severe occasional reverses.  But as a group they eventually always come back.  An investor with a long time horizon can count on that recovery.  Someone older, with less opportunity to wait out a temporary setback, may want more bonds and stable, dividend-paying stocks. Retirees, who are already living off investment income, may also prefer bonds and dividend-paying stocks because they also tend to generate more immediate income than less established stocks.

There are many ways to combine stocks and bonds to meet portfolio goals. The aim is to learn their characteristics and create a good investment fit for your critical needs.  The next post will explain the role of bonds and the one following will do the same with stocks.