Portfolio Development and Investment Choice

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Portfolio Development and Investment Choice

• Part II

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Pure Risk Models

• Capital Asset Pricing Model
• Arbitrage Pricing Model
• Both models depend on
• Market efficiency
• Stable Beta coefficients
• But fail to accurately predict returns

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Expected Return Factor Model

• Research identifies factors that explain and
  predict relative stock returns
• Factor magnitudes will differ from one stock to
  another
• Individual stock factor exposures are measured as
  the number of standard deviations (?) away from
  the average factor magnitudes

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Expected Return Factor Model

• Individual stock factor exposures are multiplied
  by the historically determined expected factor
  return payoffs
• Now we sum payoff weighted exposures to get
  expected return of the individual stock relative
  to the average stock

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Expected Return Factor Research

• The Five Factor Families
• Technical factors
• Measures of cheapness
• Measures of profitability
• Risk Factors
• Liquidity factors

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Factors with the Largest Payoffs

• Technical factors
• Momentum (1, 2, 6 and 12 month excess return)
• Trading volume trend
• Trading volume/market capitalization
• Dividend payout ratio

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Factors with the Largest Payoffs

• Cheapness factors
• Earnings to price ratio
• Cash flow to price ratio
• Profitability factors
• Return to equity
• Return to assets
• Risk factors
• Cash flow/price variability

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Research Results

• 3,500 US stocks were formed into deciles of 350
  stocks
• Deciles were ranked by total expected return
• Line of Best Fit going through plot points for
  each decile has a slope of 3.2
• 20 year avg. annual return range (79-99)
• Best Decile 36 annual average return
• Worst Decile 2 annual average return

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Logarithm of Cumulative Decile Performance
Source Haugen. The Inefficient Stock Market,
page 53
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Decile Scatter Plot 1980-1999
Source Haugen. The Inefficient Stock Market,
page 52
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Research Results

• Return prediction accuracy and the decile range
  of returns increases when we move from large
  companies to small companies
• Factor Return Payoffs
• European markets do not exhibit high level of
  same factor payoff correlation
• Canada and US exhibit high level of same factor
  payoff correlation

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Research Results Return to Risk Analysis

• Best decile stocks
• Higher expected return
• Lower volatility risk
• Worst decile stocks
• Lower expected return
• Higher volatility risk

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Expected Return Factor Research Conclusion

• Pure risk models do not predict returns as well
  as payoff weighted factor models
• Stock market pricing is inefficient
• Research results challenge long held beliefs
  about a positive return to risk trade-off across
  all stock

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Market Inefficiency

• The results of advanced statistical analysis
• The probability distribution of stock market
  returns is not normal but negatively skewed
• The market is not a random walk
• Return to risk analysis based on assumptions of
  market efficiency and linear CAPM and APT models
  are seriously flawed

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Chaos versus Order

• A fractal time series separates a pure random
  time series from a deterministic system which can
  be disturbed by random events
• The Hurst exponent (H) measures how random a time
  series is
• H ? 0 totally random (jagged)
• H ? 1 totally deterministic (smooth)

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Fractal Noise Observations
H 0.72
H 0.90
Source Peters. Chaos and Order in the Capital
Markets, page 68
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Fractal NoiseCumulative Observations
H 0.72
H 0.90
Source Peters. Chaos and Order in the Capital
Markets, page 69
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Hurst Coefficients and Average Cycle Length

Source Peters. Chaos and Order in the Capital
Markets, page 90
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Market Inefficiency

• Standard and Poors 500 Index
• Can model the motion of this index with as little
  as three dynamic variables
• Typical market cycle is 42 months
• World equity markets
• Are partially chaotic non-linear dynamic systems
• The expected return or volatility risk cannot be
  described by linear risk or factor models

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Behavioral Economics

• 1. Flawed mental accounting
• 2. Loss aversion
• 3. Decision paralysis
• 4. Money illusion
• 5. Confirmation bias
• 6. Overconfidence
• 7. Lemming effect

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1. Flawed Mental Accounting

• No financial control
• Have trouble saving
• Keep credit card balances
• Credit increases impulsive spending
• RSP not invested for growth
• Spend windfalls

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2. Misguided Risk Aversion

• Prefer bonds over stock
• Sell winning investments
• Keep losers
• Sell stock at bottom of market cycle

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3. Decision Paralysis

• Afraid of being wrong
• Self abuse over bad choices
• Prefer trial periods from sellers
• Procrastinate

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4. Money Illusion

• Invest in last years hottest fund
• Pay too much for insurance
• Ignore commission and fund MERs
• Unaware of compounding
• Inconsistent risk taking behavior

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5. Confirmation bias

• Impulsive investment decision maker
• Anchored to bad ideas
• Oblivious to opportunity loss
• Accept seller pricing without question

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6. Overconfidence

• Every selection is a winner
• Winners compensate for losers
• Unrealistic return expectations
• Active and impatient trader
• Sell a house without an agent
• Unaware of return on investments

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7. Lemming Effect

• Constantly switching funds
• Act on hot tips
• Influenced by the media
• Buy at top and sell at bottom
• Decisions based on opinions
• Band wagon investing

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Long Run Investing

• Develop realistic return expectations
• Diversified equity funds will dominate bonds in a
  long run growth portfolio
• Minimize expense ratios and transaction costs
• Invest up to one third of a long run growth
  portfolio in small and medium sized firms
• Maintain balance over the cycle

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Long Run Investing

• Favor global sector-based funds over global
  country-based funds
• Growth and value stock performance will be
  counter cyclical
• Money needed in the next 5 years should not go
  into the stock market
• Be a contrarian, run against the herd
• Watch the interest rate trend

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Total Real Returns
Source Siegel. Stocks for the Long Run, page 11
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Stocks Outperform Bonds and T-Bills
Source Siegel. Stocks for the Long Run, page 28
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Stocks versus BondsRisk Return Trade-off
Source Siegel. Stocks for the Long Run, page 37
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Lessons from HistoryWarren Buffet
Source Buffet. Investors Guide 2002, Fortune.
Dec 10, 2001,
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Lessons from HistoryWarren Buffet

• 1964-1981 rapid economic growth but
• Rising interest rates and inflation
• Profit as a share of GNP falls to 4
• Loss of confidence in the US economy
• 1981-1998 slower economic growth but
• Falling interest rates and disinflation
• Profit as a share of GNP rises to 6.5
• Confidence in the US economy soars

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20th CenturyWarren Buffet

• 3 major bull markets
• Covering 44 years
• The Dow Jones gained 11,000 points
• 3 periods of stagnation
• Covering 56 years
• US made significant economic progress during
  these years
• Dow Jones lost 292 points

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Lessons from HistoryWarren Buffet

• Past experience cannot be used to predict future
  performance
• If we do not learn from past errors we are doomed
  to repeat the same mistakes
• Investors buy less stock when prices are at
  bargain levels and buy more stock when prices are
  too high

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Lessons from HistoryWarren Buffet

• Short run price trends are unpredictable
• 5. Incorrect stock values are always corrected in
  the long run
• 6. History tells us
• Stocks will outperform bonds in the long run
• Profits rarely exceed 6.5 of the GNP
• Market value of all traded shares has
  historically been 70-80 of GNP

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The 90s BubbleWarren Buffet

• In March 2000 the market value of all US shares
  hit 190 of GNP.
• Insufficient profits and dividends to support
  stock prices
• All the signs of a bubble were present
• Warnings were issued but few listened

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The FutureWarren Buffet

• Stock market returns to normalize over the 1st
  decade of the 21st century
• Major index returns with dividends included and
  2 inflation assumed will average 7, not the
  16 average return over the 1990s
• Selecting good value in any sector is critical to
  achieving returns above 7

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Irrational Exuberance

• The stock market is inefficient
• Market volatility far exceeds what could be
  explained by a rational response to events
• Market volatility will include both error and
  price driven volatility
• By every measure the stock market was overvalued
  in the late 90s

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Confluence of Factors

• The promise of the Internet
• The triumph of capitalism over communism
• Pro-business political culture
• Capital gains tax cut
• Weak performance of real estate and bonds turns
  investor focus to equity
• Baby boom demographics increase flow into growth
  investments

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Confluence of Factors

• Media promotion of investor success
• Analyst research corrupted by the competition for
  lucrative IPOs
• Equity exposure in pension plans
• Popularity of stock options
• Decline of inflation and interest rates

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Confluence of Factors

• Day trading
• Overconfidence of investors exploited by
  unethical brokers
• Investors turn into speculators
• Speculators turn into gamblers

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Fund Portfolio Strategyfrom Spectrum Investments

• Know what stocks you hold in your mutual funds
  portfolios
• Avoid highly correlated funds with identical
  sector and stock exposure
• Differentiate benign and harmful volatility
• Balance your portfolio with a mix that includes
  money market, fixed income and equity

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Successful Portfolio Strategyfrom Spectrum
Investments

• Use your RSP foreign content limits
• Aim for 40 international diversification
• Rebalance to original intended mix if your
  portfolio mix deviates widely
• You cant guess the cycle, ride it out
• Do not redeem poorly performing mutual funds too
  hastily
• Invest enough to succeed with a realistic minimum
  acceptable return

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Contribution to ReturnSelection vs. Asset
Allocation
Selection10-20
Allocation80-90
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Total Wealth Portfolio

• Human Capital Wealth
• Life income return to education
• Job loss and disability risk
• Property Wealth
• Real estate
• Collectibles
• Financial Asset Wealth
• Debt
• Equity

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Financial Asset Allocation

• Money Market
• Bonds or debentures
• Index linked funds, notes and GICs
• 4. Income or partnership trust units
• 5. Large cap growth or value stocks
• 6. Small and medium cap value stock
• 7. Derivatives

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Portfolio Returns

• Bear market Mar 2000 to Oct 2002
• Is the market heading for higher ground or
  treading water around 10,000?
• What if interest rates trend higher?
• Do we face a period of market stagnation in North
  America?
• Flight to income equity, real estate and
  international financial markets?

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The Flight to Real Estate
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Real Estate Bubble?

• Price to imputed rent ratios running well above
  long run averages in the major US urban markets
• Record home equity financing is funding consumer
  spending
• Deficits and a weak dollar spell higher interest
  rates in 2005
• Higher property taxes and energy costs

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Financial Product Innovations

• Index Linked Notes and GICs
• Real Return Bonds
• Income Trust Units
• Partnership Units
• Debt-Equity Hybrids
• Deconstructed Equity Securities
• Deconstructed Debt Securities

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Futures Index Linked Notes

• What are the effects of adding managed futures to
  a diversified equity portfolio
• Higher returns with less risk

Source BDC. Managed Future Notes Series N-7
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Managed Futures

• Better performance than Canadian equity
• Portfolio diversification benefits
• 7-year rolling average performance

Source BDC. Managed Future Notes Series N-7
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Real Return Bonds

• Have recently outperformed traditional bonds and
  Canadian equity
• Federal government issues pay a fixed real return
  coupon of 4.25
• General price index inflation adds to principal
  value of the bond each year

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Units

• Index Participation Units
• Real Estate Investment Trust Units
• Partnership Units
• Royalty Trust Units
• Income Trust Units

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Index Participation Units

• i Series on the TSX
• Bonds
• Indexes
• Sectors
• NASDAQ QQQs
• Dow Jones Diamonds
• SP Spiders
• AMEX Worldwide Equity Benchmarks

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Income Trusts

• Trust or partnership equity units
• Flow through fully taxable dividends
• Time limited tax shelters
• Volatility, income default or deferral risk
  varies widely
• Unit holder liability not clarified

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Debt-Equity Hybrids

• Canadian Originated Preferred Securities
• 25-99 year term subordinated debentures
• Subordinated to all other issued debt but ranks
  ahead of other preferred shares
• High interest yield which can be deferred up to 5
  years at managements discretion
• Trade on the stock exchange

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Deconstructed Equity Securities

• Common shares are divided into
• Dividend equity share
• Receive dividends
• Priced like bonds
• Maturity value based on capital share
• Redeemable
• Capital share
• Capital gain potential but no dividend

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Deconstructed Debt Securities

• Federal and provincial bonds are divided into
• Coupon Strips
• Sold at discounted value
• Fixed compounded interest income payable at
  maturity
• Interest taxed on accrual
• Zero Coupon Principal
• Deep discount to maturity value
• Deferred capital income to maturity

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CONCLUSION

• Risk of underperformance in North American equity
  markets due to
• Deficits and debt accumulation
• Declining US dollar and flight of capital risk
• Higher future interest rates
• Solution?
• Wider asset allocation needed
• Internationalization
• New financial products

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Risk can be your friend