The Permanent Portfolio, Investing, Finance and Random Thoughts.
Posts tagged risk
Trading Against Pros
0Doing some research recently I’ve found that almost 9 out of 10 of the trades on any given day on Wall Street are between professionals, not individuals. Think about that for a second. When you go to make a trade, 9 out of 10 times you are doing it against someone that does it for a living. And not just a living, but paid really big bucks to do it and has a tremendous amount of resources behind them. This includes mutual funds, pension funds, hedge funds, professional speculators, investment banks, etc.
But it gets even better. If 9 out of 10 trades are between professionals that means that most of the trades pros do are between each other. Now that’s interesting to consider. That means the average you see in the investing products on Wall Street represents the best that the pros on Wall Street can do in any single year.
Often I read about an investing strategy or trading method that claims to beat the broad market indices. That’s a pretty bold claim. I have to wonder if the sellers of these ideas are aware of the reality of trading on Wall Street. To think that you’re going to teach an individual investor to go up against a highly skilled pro and win. It’s kind of like telling an amateur golfer they are going to turn into Tiger Woods if they just buy the right golf club. It’s a fun thing to think about, but just not very realistic.
Even much vaunted hedge funds, the supposed masters of secret Wall Street strategies, often bomb. If they can’t do it, what chance does an individual have?
THERE’S yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.
Basic stock market index funds generally aspire to nothing more than matching the returns of a market benchmark. So in a miserable year for stocks, index funds may not look very appealing. But it turns out that, after fees and taxes, it is the extremely rare actively managed fund or hedge fund that does better than a simple index fund.
That, at least, is the finding of a new study by Mark Kritzman, president and chief executive of Windham Capital Management of Boston. He presented his results in the Feb. 1 issue of Economics & Portfolio Strategy, a newsletter for institutional investors published by Peter L. Bernstein Inc.
The Index Fund Wins Again, Mark Hulbert February 21, 2009
http://www.nytimes.com/2009/02/22/your-money/stocks-and-bonds/22stra.html
I’ve been to financial firms on Wall St. in the past and had a chance to see some of their trading operations. These firms are trying everything possible to make a buck off each other. They are highly competitive and highly compensated if they manage to do it. Many use cutting edge hardware, algorithms and trading techniques trying to sniff out every last penny of advantage. There are actually magazines for the field (http://www.automatedtrader.net) discussing advanced applications in areas of High Frequency Trading and other esoteric topics.
These firms are looking for every possible edge to gain. And the harder they look, the more efficient the markets become. It is almost impossible to get an information edge, and therefore consistent excess profits, over anyone else at those levels. This is why, despite their best efforts, many funds cannot beat the market average once you subtract the costs from what they do.
You cannot compete against Wall Street with a home computer and technical analysis charts. The NSA would have a hard time competing against some of the computing power these firms have.
Sitting back and letting these people slice each other to pieces on trading is the best strategy. A Permanent Portfolio using a simple stock index fund let’s you do just that. You cannot compete against Wall Street with a home computer and technical analysis charts. The NSA would have a hard time competing against some of the computing power these firms have. This is why trading against the pros is a losing proposition on all fronts. Not only are you not likely to beat them, but they can’t even beat the simple market average themselves.
Conclusion?
Just own index funds where appropriate for your Permanent Portfolio. Don’t waste time and money trying to compete against those that aren’t even competitive against market averages.
Reminder: You can sign up for the announcement list for the upcoming Permanent Portfolio Book here.
Stop Looking at Your Portfolio So Frequently
In response to concerns about the Permanent Portfolio having a bit of a down month over at the forum I posted the following:
I have been running this portfolio for almost five years now. I sleep so much better vs. my older index stock/bond portfolio I cannot put it into words. It has taken me through the 2007 real estate bubble, the 2008 real estate crash, the 2009 stock market recovery, the 2010 “double dip” recession (which was a banner year for stocks BTW), and now the 2011 Quantitative Easing Part III and Euro panic. It has done these things with a stability that I never had before I started using it. If I owned another portfolio over all of this I would have given up a long time ago.
I strongly encourage people not to track their portfolio values over days or weeks. If you can stomach not checking but only once a month that is an OK start. If you can check once a quarter that is great. If you can do it once or twice a year that is fabulous. But emotionally most investors just can’t stomach looking at things frequently. There are powerful psychological reasons why this happens. So, I recommend we just accept it and don’t fall victim to them. The best way to do this is to not look at things too often. Simple!
You will go nuts checking portfolio values frequently. If you don’t go nuts because you think you are losing money, then just wait until your neighbors are bragging about their +20% gains some year at the company Christmas Party. That will drive you insane with jealousy if you maintain a short-term attitude (but of course they never brag about the negative years they have, do they?).
I am perfectly happy with my boring and low volatility 9-10% average returns the portfolio has had through the years. This really is a remarkable thing when you look at what other portfolios put their owners through to get the same results. The Permanent Portfolio is still positive year to date where many stock/bond portfolios are probably well into negative territory by now.
The Permanent Portfolio is not a magic elixir that eliminates all short-term losses, but I haven’t found anything that works better so I’m going to stick to the plan. Part of that plan is not checking the portfolio constantly!
2010-11-04 – Asset Volatility and Risk
1 year ago
In this episode I discuss the four asset classes of the Permanent Portfolio and volatility. I also discuss risk in investing and the need to not look at assets in isolation in your portfolio.
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Gold Ownership in an Investment Portfolio
1 year ago
On some investment forums the idea of the Permanent Portfolio is very strange. After all, it holds gold and everybody knows that gold is a net zero real return asset (e.g. it matches inflation historically and that’s it). Or they say it’s in a “bubble” and it’s going to pop. Fair enough. But that still doesn’t mean an investor can’t use the asset intelligently in a balanced portfolio with stocks and bonds.
Speaking for myself I will say this: I don’t own gold in a portfolio because I want to. I own gold because I have to.
The reason I have to is because of the way modern central banking and paper currencies work. I am not hoping gold goes up in value because it represents a market outlook that is bad for the currency and performance of assets invested in that currency (like stocks and bonds). Yet I have to live in the world I have, not the world I want. In the world I have currency debasement is just part of what happens so I choose not to put 100% of my life savings in paper currencies. It would be great if stocks and bonds could go up forever without worry from sudden high inflation and other market problems. But that’s just not how things work in reality.
I don’t understand the controversy when an investor knowingly decides that they are willing to put 25% of their wealth in an asset that historically (as critics point out) has largely been impervious to monetary shenanigans. Critics will go on about needing to devote 100% of their wealth to “growth” assets but history, indeed even recent history, has shown that sometimes these assets like stocks and bonds can do especially bad for extended periods. Not only do we have the 2000s as a recent example, but the decade of the 1970s had very bad inflation which was not good for the markets then either.
So an investor decides to look at the history of the markets and reasons that the “stocks and bonds are all you need” mantra falls flat under some economic conditions. This is not exactly breaking news to anyone that has spent any kind of time looking at the data. The reality is that a stock and bond portfolio alone has had dismal returns for decade+ periods and holding some kind of hard asset in a portfolio was not a bad idea during these times. Theory or not, these are just the facts.
A common criticism is that a portfolio that holds stocks, bonds, cash and gold shouldn’t work because of the assets it holds. Yet if you look at the data, including empirical data, it does work. Not only has it managed to weather some terrible storms in the market with very low draw down, but it has posted gains that may not be barn burners but are OK for people that are looking for moderate returns and lower risk.
Even if gold were to drop to $0 tomorrow morning it would represent a loss of -25% to the portfolio as that wedge became worthless. Barring the very unlikely nature of this happening, compare it to the -40% losses that stock investors took in 2008. Even a “balanced” stock and bond portfolio took a -25-30% loss that year. Yet somehow those kind of losses are acceptable to critics because it’s a “growth” asset. That’s not the kind of “growth” I want.
Therefore holding gold in a portfolio is not a big deal if you are rebalancing it and holding it in combination with stocks, bonds and cash. It doesn’t matter if one of the assets is in a “bubble” because investors will be rebalancing out of it into the laggards. Damage is limited by the design of the allocation and the assets it holds.
The reason the Permanent Portfolio holds four assets in 25% allocations is to work as a firewall against serious damage during market swings. Even if one asset does especially bad one year with, say, a 50% drop that would be a -12.5% loss to the portfolio. This is not great, but also not a life destroying event. That also assumes that no other asset in the portfolio rises by another amount to offset the losses.
The data on the portfolio is extensive and, most importantly, empirically tested. It is not theory. Basically the complaints about it amount to this: “It can’t work because my theories say it shouldn’t!”
Fine. But if the empirical data is showing one conclusion and the theories say another outcome should happen then what does that mean? Is the empirical data wrong or the theories?
What if you’re wrong?
Have you ever noticed how confident people are with their predictions on the investing markets? So many seem to be so sure about so much that is so uncertain. Their favorite pet asset (stocks, bonds, gold, commodities, etc.) just have to go up because, well, they own it and they are never wrong about these things. Besides, losing money stinks and if we just think good thoughts then losing money doesn’t happen, right?
What if you’re wrong?
That’s the question I always ask myself about an investment decision. It’s not that a lack of confidence is a good thing. It’s just that overconfidence can mask bad investment decisions that can be truly painful. The problem comes up not only in investments we may pick ourselves, but also in following the latest guru’s advice because they sound, well, confident in what they are saying.
Before I make an investment decision I always want to know what the worst scenario is in case the deal blows up or goes sideways in unexpected ways. What are the risks? How much can I lose? Are the gains worth the potential pitfalls? I think it is important to recognize that a worst case scenario can happen in any investment and realistically plan for it.
This way of thinking really helps temper investing. Maybe instead of putting 90% of your life savings into that hot new stock your brother-in-law told you about you’ll cap it at 5% instead. Sure, perhaps this new investment is going to later show you having 500% profits in two years. But then again it could sink by 50%. Think about the consequences if you’re wrong.
If you invest long enough you’re going to be wrong eventually about the markets. When it happens, don’t let it be something that wrecks your life savings. Stay diversified and not too confident in any one investment. It’s a good way to avoid bad things.
