If you believe in using passive indexes to capture exposure to various asset classes (as I do) then the security you use to track that index becomes very important. Its ability to track that index with very little error becomes paramount in making forward looking models, portfolio construction, etc. If I pick an ETF and plug a certain risk/reward profile (based on the historical index performance) into my software to see how it meshes with the rest of the portfolio then I would like to believe that going forward, the least of my worries is whether or not the ETF actually tracks the index it is supposed to.

Well index tracking error is always a possibility with ETFs. Witness the recent troubles of the DBA ETF with purchasing the same futures contracts as the index it tracks. In short, the Commodity Futures Trading Commission sets position limits on certain futures contracts. The recent commodity explosion and subsequent boom in the DBA ETF caused the DBA to bump up against those limits. They have started having to purchase futures contracts that are not the same as the ones in the actual index. This could ultimately lead to tracking error.

Not that a few basis points here or there is anything to worry about BUT anything more than that might be. I suppose tracking error could work in one’s favor as well but my complaint here is that I want to eliminate as many uncertainties as possible. I don’t want unintended portfolio consequences (volatility and what not) because an ETF had some major index tracking error.

Enter the realm of the ETN. One of the major benefits of ETNs from my perspective is the lack of tracking error. The tracking error responsibility is transferred to the issuer. You are buying a Note from them and they are agreeing to pay you the index return (minus fees of course) at the valuation date of the Note. There will be zero tracking error on your end. I am not quite sure how most of the ETN issuers cover their note liabilities but, if for some reason, the securities they are using to match that index somehow have tracking error, then that is their problem, not yours. They still have to pay you the agreed upon index factor at the valuation date of the note.

ETNs are not without their own flaws. There are uncertainties surrounding tax issues, possible default risk of issuers, and several other possible negatives in the space. From an index tracking error point of view however, the ETN structure certainly has a dominant position over ETFs that have to actually purchase securities to replicate the index they track.

Look, I am by no means an expert on the economics of commodities or commodity prices. I have used commodities as a diversifying tool in my personal accounts and in client accounts for about 3 years. More often than not, these positions amount to no more than 5% of the funds. During that time span I have soaked up as much information as I could about commodities and their potential place in a portfolio. It is with great interest that I read the story on HardAssetInvestor.com entitled, “Great Commodities Debate”.

Without going into a complicated discussion about the differing sides of the argument here, let me give a quick summary. On the one had we have those (like Rick Ferri) who believe that the long run rate of return on commodities is no better than inflation and that adding them to a portfolio serves no purpose other than to reduce volatility (some would argue that this is worthwhile in its own right). On the other hand we have those (like Larry Swedroe) who believe that a strategy of using Collateralized Commodity Futures (CCFs) contracts does indeed provide meaningful returns.

So where do I fall? Well, as of this moment I am leaning towards the Swedroe side of the fence (by way of using Commodity ETFs and ETNs) for several reasons. Granted, my reasoning here is that of an outsider so please leave a comment if the logic seems misguided or implausible.

I will not argue with the fact that commodity prices (spot prices) have a historic return rate near the inflation rate. That seems obvious and plausible enough for me given my limited knowledge of competitive markets theory and the past history of commodity production. My line of reasoning here sort of presents a scenario for why that “might” be different going forward.

Before you go bashing me and throwing me under the proverbial bus with the rest of the “this time it’s different” crowd, let me state that I am a dyed-in-the-wool “reversion to the mean” kind of guy so this is a bit out of character for me. And so we begin…

The reason that a “commodity” or any other product that has been commoditized would only produce the long run inflation rate of return is born by economic theory. Basically, anytime there are no differentiating features between products, producers are left to compete on price alone. Prices will always devolve towards the marginal cost of production in this scenario. Therefore, as the cost of production rises with inflation, the commodity product will simply have a long term return that is somewhere near that rate of inflation. Now, one would think that this line of thinking precludes competition or price cycles entirely but it does not.

When it comes to hard assets like grains or metals, there are really no differentiating factors. Certainly, there are differing “grades” but each of those grades is a different product, used for different things. In the past, apparently supply was not a long term issue. Producers could produce various commodities and supply them to buyers and basically satiate any needs they had. As with any market there were periods of excess supply and excess demand, either hastening or delaying the price competition down to the cost of production. There were also firms who entered and left the market because they either could not make a profit or because they were not as efficient as other producers and couldn’t match their prices. All of this leads to relatively normal economic cycles who’s average effect ultimately ends up being spot prices that were near the rate of inflation. One need look no further than some of the U.S. farm subsidies for proof of how this price competition worked. Some U.S. farmers obviously could not charge enough for some of their crops to warrant continuing on. The U.S. government then decided to subsidize them in an effort to keep them producing (this is probably a national security thing I believe).

Now, most of the reasoning above relies on the assumption that supply was the dominating factor in the supply/demand balance in the past. There were only very brief moments when supply issues caused prices to rise. Here, it is important to note that renewable commodities (the agricultural ones that can be planted every year) and depletable commodities (like oil or some of the metals and ores that are mined) have differing economic forces at work. Obviously, as depletable commodities become more scarce, the cost to discover and produce them will rise more rapidly.

Does anyone believe for a moment that the current and future demand for commodities is going to look anything like the past? The U.S. and the rest of the developing world pretty much had its run of the mill in the 20th century. We could afford to pay as much as we needed to to satiate our need for commodities. There were really no competitors for those resources and our relatively small population (300 million in the US, 700 million in Europe, and throw in another 100 million in other developed areas) made it possible to supply us with just about all we could demand. Now fast forward to the 21st century.

The proliferation and dissemination of technology in the last 20 years has meant that the rest of the world is now developing at a rapid pace. There are billions of people around the world whose economies are now becoming integrated into the global business world. This is allowing them to produce real wealth and increase their standards of living exponentially. Now, I don’t pretend for a minute that the entire world is going to look like the U.S. in 5 years. What I do believe is that in 20 or 30 years this planet will look vastly different from a quality of living standpoint. Improving quality of living requires resources and commodities. The demand is going to be there whether we like it or not.

I am sure that there will be further technological advances in the methods of production and distribution of commodities that aid in keeping prices down. There will also be substitutions that affect things (when one commodity that is more plentiful can be substituted for another that is more scarce). In my opinion, however, the demand for commodities is going to far outweigh any supply improvements and we are going to see rising prices. We could see rising prices simply because of energy related factors. I won’t get into the debate over peak oil here but there is no doubt that oil related price issues spill into just about every other type of commodity price. Producing crops takes oil (for machines and distribution) and fertilizer (which is derived from oil based products and natural gas). It also takes water which is becoming more scarce. When the costs of production go up, the baseline price will also go up.

That’s sort of a long winded way of saying that I personally do not believe the future commodity price landscape will look much like the past. There are rare occasions when I believe that fundamental changes are afoot and this is one of them. Will there be periods of negative returns in the coming years? Certainly. Will the markets be volatile? Certainly. Will global recessions have a negative impact? Yes. Can I predict the future? No. Given all that, I don’t think it’s that difficult to see that the demand profile will be different going forward than it has been in the past. I think the prices of depletable items like oil and metals will probably be more drastically affected than some of the agricultural products but everything “should” perform better than inflation. I am not removing all my commodity exposure simply because the future “might” look like the past.

Of course, this is not a suggestion to rush out and buy commodities. They have had a mad parabolic dash in the last few months. This discussion is merely an idea about a possible course commodities could take in the long run.

I suppose it was only a matter of time. After all, the PGA Tour is run by the players. The now infamous Made Cut, Did Not Finish Rule (MDF for those of you who happened to see it on a scoreboard) has been revised.

See my previous post for the details of the rule. Previously, if more than 78 players qualified for the “low 70 and ties” cut, then the tour would back up a stroke and take the next lowest group of players nearest to 70. Under the new rule, if more than 78 players make the cut on Friday, they will all get to play on Saturday BUT there will also be a cut after Saturday’s round, again taking the low 70 plus ties. This should mitigate some of the issues the players were griping about and I personally believe it is a good rule change. It will create a little extra drama on Saturday for some of these guys.

The proliferation of commodity ETFs and commodity ETNs has a lot of people scratching their heads. It’s tough to keep track of all of the various commodities that some of these securities have exposure to. I thought I would create a few handy, dandy spreadsheets so you can compare exactly which ETF/ETNs have exposure to what.

Before I start listing these I want to start out with a few caveats. First, most of these indexes change regularly. I got the most up-to-date info I could from fund websites and prospectuses but if the difference between 3% and 4% in soybean oil is going to matter to your allocation then by all means, PLEASE go to the websites and get the most recent data. The stuff I have compiled is just to give you a glimpse of how these things compare to one another.

In addition, I decided to consolidate exposure in some areas because I figured the average investor really didn’t care all that much about the different grades of sugar, or whether a fund held Kansas Wheat or Chicago Wheat futures. If you’re sophisticated enough to know that there are several different types of crude oil (West Texas, Brent, Light Sweet, etc.) and it matters which one you are holding then please do your own due diligence and go find which is which on the fund’s website. I decided to combine all such exposures here to maintain my own sanity.

One final note. “Exposure” can mean a number of different things. ETFs are obviously either holding the actual commodity (as in the case of a couple of Gold ETFs) or have exposure to them via futures contracts. ETNs don’t typically own anything, neither the physical commodity nor futures contracts. They are simply “notes” that promise to pay you the return of a given commodity index in the future. Please be aware that very few of these assets actually own a physical commodity.

Broad Based Commodity ETFs / Commodity ETNs

By “broad based” I mean funds that have at least some exposure to the three main classes of commodities including; Energy, Metals, Agriculture.

Energy ETFs / Energy ETNs

The following funds limit themselves to “energy” exposure by way of Crude Oil, Natural Gas, Gasoline, Heating Oil, and Gasoil.

In addition to the above broader energy funds, the following list of ETFs/ETNs provide 100% exposure to Crude Oil:
OIL (ETN), DBO (ETF), UCR (ETF), DCR (ETF), USL (ETF), USO (ETF)

You also have two with 100% exposure to Natural Gas:
GAZ (ETN), UNG (ETF)

As of 2-26-2008 there is another Victoria Bay ETF trading that is 100% Gasoline:
UGA (ETF)

Agriculture ETFs / Agriculture ETNs

The following funds limit themselves to “agriculture” exposure. I won’t list every ag commodity (see the chart) but these obvioulsy have exposure to the major ag products; soybeans, wheat, sugar, cotton, coffee, corn, etc.

As far as I know there aren’t currently any ETFs / ETNs that provide 100% exposure to any ag products. The most focused is the COW ETN which holds 62% Cattle and 38% Lean Hogs.

Metals ETFs / Metals ETNs

The following funds limit themselves to “metals” exposure. I didn’t separate them into Precious vs Base Metals because quite honestly there aren’t that many. If your looking for some exposure to gold, silver, aluminum, copper, zinc, lead, tin, platinum, or palladium then these are your boys.

The metals space has a few funds with 100% exposure. If you want 100% Gold then look to; GLD (ETF), DGL (ETF), IAU (ETF).

100% Copper = JJC (ETN)
100% Nickel = JJN (ETN)
100% Silver = SLV (ETF), DBS (ETF)
80% Gold / 20% Silver = DBP (ETF)

That about does it for this addition of “under the hood”. There are some other ways to gain “pseudo” commodity exposure, like the CUT (Timber ETF), but those actually provide exposure to companies that have exposure to commodities (another layer!) I will discuss those in another post in the future.

Since becoming a financial planner I have become acutely aware of the confusion in the general public’s mind when I say, “I am a financial planner.” Terms like “financial advisor”, “investment advisor”, “financial planner” and others are really thrown around by lots of people interchangeably and I think that ultimately confuses people. One of the problems lies in the genericalness (yes this is a word!) of the term “financial advisor.”

Just about anyone can and does call themselves a financial advisor these days. Anyone who comes within a country mile of anything to do with your money probably has used the term financial advisor. This might include insurance salespeople, mortgage brokers, accountants, estate attorneys, and even those friendly folks at the bank who help you open a checking account. While I have no problem with that, it does make it difficult to explain one’s business when compared to such people. Many people hear “financial planner” and mistakenly lump that in with all the other financial advisors that they’ve come across in their lifetimes. The truth is, financial planners provide a comprehensive service that none of the aforementioned roles provide. I want to take just a few paragraphs to talk about what financial planning is and how it might be of benefit to you.

First off, I would like to explain that as a CERTIFIED FINANCIAL PLANNER™ professional, I have had to meet some very strenuous requirements. Those requirements included 2 years of graduate school studying nothing but the technical aspects of each area of financial planning, as well as passing a 10 hour long exam that only 50-60% pass on the first try. Once that was complete I had to have 3 years of experience within the field, actually practicing all or parts of the planning process before I could call myself a CFP®. Now, I am not trying to boast by outlining that, I am simply trying to show you that there is a serious level of knowledge, commitment, and time that has gone into referring to myself as a “financial planner”.

So to the original point…what is financial planning? Well, as I am sure you are aware by now, your financial life can become very complicated very quickly. The financial planner is there to sort through all that complexity, provide some insight and education, simplify your financial life, and help you create a plan to accomplish all your goals as well as mitigate any risks you might have.

The financial planning process starts with real heart to heart discussions about your goals, aspirations, dreams, fears, and worries. Once those things have been laid on the table a plan can be put into place that will help you achieve goals, put your dreams within reach, and assuage some of your fears.

Of course, you can’t get to where you want to be without knowing where you are. So the next step in the process involves a “discovery” phase. This is where you dig through your file cabinets and get out all those statements you never open. This is where you get out copies of all your insurance policies, wills, powers of attorney, company benefit plans, and statements from every financial account that you have. This can be a tedious process if your financial life has become disorganized but the process of simplification always starts with a little pain!

Once your financial planner has all of these bits of information they will look at them in a holistic manner and examine how all the pieces of your financial jigsaw puzzle fit together. That’s when the real planning begins. The following areas are just a few of the more common areas the planner might look at. There are certainly others in more complicated situations.

• Retirement Planning
• Education Planning
• Investment Management
• Estate Planning
• Risk Management & Insurance
• Cash Flow Analysis
• Tax Strategies
• Employer Benefits
• Charitable Giving Plans
• Small Business Financial Issues

Things like Retirement Planning and Education Planning obviously involve forecasting future needs and coming up with an Investing plan that will help you to meet those needs. Some of the other items are designed to help you better situate your finances for the present by planning for any number of potential risks like medical issues, death, or legal action against you.

The financial planner will ultimately help you establish a plan that gives you the best chance of reaching your goals while simultaneously allowing you to sleep at night knowing that some of the risk factors have been mitigated. The plan itself will help to simplify your financial life and provide you a sort of peace of mind in knowing that you have everything organized and under control. This seems to especially be true for families and small business owners.

The financial planner doesn’t just provide the plan and then send you on your way. Most planners will help you with the implementation of the plan and a common practice is to actually manage your investments for you. Of course, with this sort of ongoing relationship, the planner can help you to monitor the progress of the plan and how you are moving towards your goals. Adjustments can be made as necessary or as the transitions of your life dictate. The most benefit really comes from a lifelong relationship with your planner. They will know you on a personal level and know the ins and outs of your financial picture and be able to provide you with advice when you need it most.

I hope that sheds a little light on exactly what financial planning truly is. It’s more holistic than some of the “pieces” that individual professionals might help with. One last point I would like to make involves the question, “who needs financial planning?” Most people are under the mistaken impression that financial planning is only for the super-rich or high net worth. While they will certainly benefit from someone with vast technical knowledge who can handle the complexities of their situation, there are lots of middle class (i.e. middle income) people who could benefit as well.

If you are someone who has a disorganized financial life, no savings plan, no direction, no established goals, are confused by your 401k plan, don’t know what types or how much insurance to buy, don’t have a will, and have no clue what to invest in, then I think financial planning would be good for you. Heck, it would be worth it if only a couple of those apply to you. There are financial planners out there that are eager to work with good people, without regard to their level of savings or current net worth. Go find one and do yourself a favor…simplify your finances!

First off, a hat tip to Mebane Faber over at World Beta for providing the links to this Vanguard “We Believe” Series. The links below are to 4-6 page PDFs that Vanguard produced. Each of them starts with “Vanguard’s Investment Philosophy…We Believe”. I thought I would list them all here and then throw my own two cents in beside them. You might like to see how these compare to my Portfolio Management Best Practices.

Vanguard’s Investment Philosophy

We Believe #1

Investing is for meeting long-term goals; saving is for meeting
short-term goals.

No argument from me on this one. I completely agree.

We Believe #2

Broad diversification, with exposure to all parts of the stock and
bond markets, reduces risk.

Once again I agree. I would also add assets other than stocks and bonds. Real estate, commodities, currencies, etc. I might even throw in a few “strategies” that are equity related but nonetheless are designed to do certain things and provide diversification (buy write strategies, inverse index funds, etc.) It all depends on the asset classes behavior related to the other asset classes.

We Believe #3

An investor’s most important decision is selecting the mix of assets to be
held in a portfolio, not selecting the individual investments themselves.

I agree with this one to a degree but the oft quoted research about asset allocation accounting for 90% of the returns of a portfolio are misleading in my opinion. A little known paper done in 2002 by Mark Kritzman of Windham Capital Management and Sebastien Page of State Street Associates calls into question many of the conclusions drawn from the original study and presents some findings that make me skeptical about this piece of oft cited “common sense”.

We Believe #4

Consistently outperforming the financial markets is extremely difficult.

My ideas about this one would take several thousand words to convey. I will try to keep it short here and post on this again in the future. A market (i.e. the S&P 500) has a specific risk/return profile (which Vanguard agrees with given #9 below). By creating a portfolio that includes that market, and other non/low-correlated assets, it is indeed possible to consistently produce better risk adjusted returns than “the market”. I believe that Jon Bogle’s premise is that exposure to a given asset class is better gained by indexing than by picking stocks within that class. With that, I tend to agree. I don’t believe he thinks for a second that the combination of various asset classes together (as long as they are indexed) cannot outperform a single market index consistently. I’ll have more on this in the future.

We Believe #5

Minimizing cost is vital for long-term investment success.

This is one of my most passionate beliefs about investing. I have written about fees and minimizing fees in a number of places on this site. You can see all of them be checking out the Climb Finance Fees tag page. There’s another small bit about it on my Portfolio Management Best Practices page.

We Believe #6

Investors should know how each investment fits into their plans
and why they own that particular asset.

I agree with this. Too many times I see people buying securities without any real clue how their return profile will interact with the rest of the portfolio to increase or decrease the risk/reward outlook. One should pay special attention not only to the fundamentals of the investment in a vacuum but also the interaction and correlation of the investment with their other holdings.

We Believe #7

Risk has many dimensions, and investors should weigh “shortfall risk”—the
possibility that a portfolio will fail to meet longer-term financial goals—against
“market risk,” or the chance that returns will fluctuate.

Funny that this is one of the principles. I wrote an article about this earlier in the week entitled, “What is Risk? Not Reaching One’s Goals”. Obviously I agree with the sentiment pointed out here.

We Believe #8

Market-timing and performance-chasing are losing strategies.

Not really sure why this one is separate from #4. They seem to dissuade the same action. I think the term “market timing” is used in so many different ways so as to make it irrelevant. Most people think of market timing as either day trading or trading in other very small time frames. The question I have is, isn’t waiting for a security to reach a price below what you believe to be its fundamental value market timing? It is, and if so then we must call Warren Buffet and all the great value investors of our time market timers. In that sense, I think long term valuation related “timing” is acceptable to me. Day trading, swing trading, momentum trading, or technical trading are not really acceptable to me. As for chasing performance, I definitely agree that this is a bad idea. I have seen the reversion to the mean specter show its face on too many occasions.

We Believe #9

An investor should not expect future long-term returns to be significantly
higher or lower than long-term historical returns for various asset classes
and subclasses.

This is one that I agree with, again to a degree, but I have my teeth gritted and am kind of nodding with a little doubt. I think that when creating forward looking models we should indeed be mindful of the historical returns of asset classes and potential for a “reversion to the mean”. However, I don’t want to entirely dismiss the possibility that the risk/return profiles of certain asset classes might fundamentally change in the future. One such example that comes to mind is commodities. Historically, commodity prices have only risen with inflation. In my opinion (and after lots of hours of research) I do not think that this is necessarily going to hold true into the future as billions of people around the world, having become a little wealthier with an improved global economy, start demanding more food and resources and competing for them.

So, it looks like I have a lot of principles in common with Mr. Bogle and the folks at Vanguard. Most of these principles are solid and wise. Except for my noted skepticism about some of them and the outright disagreement with #4, I’d say we are pretty much on the same page. I’d say most people would benefit from adhering to these investing principles.

Okay tax rebate fans, the news you’ve all been waiting for is official. President Bush signed the tax rebate (and other economic stimuli) bill yesterday. I wanted to do a quick and dirty post with some of the basic information on this plan. There are a lot of details but hopefully this will help you have an idea of what to expect. (As usual, don’t rely on my ability to decipher government info as a means of creating an expectation for yourself. Circumstances will differ and I may have misread/misunderstood parts of the bill.)

• Checks will probably (the IRS has not determined exactly when yet) not be mailed out until mid-May at the earliest, possibly later if you file for a return extension.
• The info the government uses to determine your eligibility for the rebates will be based on your 2007 tax return (the one you file by April 15th, 2008).
• The first step for you will be to look at your “Net Tax Liability”. This can be found on line 46 (page 2) of your form 1040. This IS NOT how much you might owe for 2007, this is the amount that you actually are liable for before taking into consideration what payments you made.
• You will also need to know your adjusted gross income (AGI). This can be found on line 37 of form 1040.

Let’s start with the rebate for parents with children. You will get $300 per child as long as they are under age 17. I cannot find and have not seen any phaseout rules for this rebate so I am assuming that everyone with a Net Tax Liability who has children will get to take advantage of this. I reserve the right to change this assumption if I am proven wrong (horrible cya disclaimer).

Now, as for the normal tax rebate. That is split into 1) single filers (single) and 2) married filers (married) filing jointly.

First, let’s discuss those people who have NO Net Tax Liability. As long as they had at least $3000 in earned income from wages, social security, or veterans disability benefits then they will get the minimum rebate - $300 single, $600 married.

For everyone else that did have a Net Tax Liability, here are the rules as I understand them. The maximum rebate is $600 single, $1200 married. The minimum rebate is $300 single, $600 married (assuming you have $3000 in earned income per above paragraph).

The way you determine how much you get is to look at your Net Tax Liability. If that amount is greater than the maximum listed above then you will get the maximum. If it less than the minimum listed above then you will get the minimum. If it falls anywhere in between then you will get the exact amount of your Net Tax Liability. For example, if Joey Toolbag has a Net Tax Liability of $450 and he files single, he would get a rebate of $450. If his NTL was $4200 he would get only $600. If his NTL was $150 he would still get the $300 minimum. Got it? Good, let’s move on to phaseout rules.

As the government is fond of doing, they have once again put phaseout rules on the rebates for higher income families. These phaseout ranges are $75k-$87K for singles and $150-$174K for marrieds. Your rebate will be phased out $50 for each $1000 in AGI that your AGI exceeds the bottom figures above. As an example, Bob and Sue have an AGI of $165K, and a NTL of $14,000, meaning they “are eligible for” the maximum $1200 tax rebate. However, they would only get a tax rebate of $450. AGI of 165k-150k = 15K. (15K/1000) x $50 = $750. $1200-$750 = $450.

I know some of you are quick so I assume you see that by the time you reach the upper end of these ranges your tax rebate will be ZERO. Single filers having an AGI over $87k and married filers having an AGI over $174k will get nothing from this part of the tax rebate plan.

The last point I want to make here is that these rebates will have to be reported on your 2008 tax returns (filed next year-probably as a tax credit) so expect to have that to deal with in the future.

Here is a more detailed article entitled “Tax Rebates Winner and Losers” provided by bankrate.com on Yahoo! Finance.

I was wondering how long it would take for the players to fight back on the new MDF (Made Cut, Did Not Finish) Rule.

Looks like the players want to settle on a compromise. If there are more than 78 players after the 36 hole cut, then have a 2nd cut after 54 holes. From the Golf.com article:

A tour official said on Wednesday that the 16-man Players Advisory Council, which met this week at Riviera Country Club, wants to return to the traditional 36-hole cut of the top 70 and ties. If that results in more than 78 players, another cut on Saturday to the top 70 and ties would help reduce the field for the final round.

I, for one, didn’t ever quite understand the rationale behind the MDF rule to begin with. I mean, I understand wanting to limit the number of guys who play on the weekend from a logistics standpoint, but is the new rule really making that much of a difference? Eliminating 15 players from weekend play is 5 groups of 3, or about 50 minutes of tee times. Is that so much to ask just for all this hassle?

I say let em play. I’d much rather be cheering for some of my favorites to climb the leaderboard and the money list on Saturday and Sunday than to sit around and anguish over seeing their name with a big MDF next to it. Boring.

The term “risk” is frequently batted around in financial circles as if it were some concrete, well-defined concept in the minds of anyone who happens to hear it. The truth is, there are as many definitions of risk and abstract mental constructs of risk as there are people. In the financial world we like to use words like “standard deviation” or “volatility” or “terminal wealth dispersion” to measure risk. In reality, those terms mean very little to a client (or individual investor as it were).

I have some very smart clients, clients who know how to ask lots of the right financial questions. No matter how many times I try to explain the concept of standard deviation as a measure of risk, they still have a difficult time grasping it without some hard core, real life examples. “What does a 15% standard deviation mean? Give me an example.”

I would like to thank Roy Diliberto for writing an article: Measuring True Risk (sorry cannot find link to article on the fa-mag.com website) in this month’s Financial Advisor magazine addressing this very issue. While I have always sort of considered his point in my own consultations, I never fully reached clarity on how to describe it until now. The truth is, most people will have a better understanding of risk if risk is defined as the probability of reaching (or not reaching) one’s goals. Forget about all the statistical measures we use to calculate “volatility” and how we quantify those things. The article refers to portfolio ups and downs as “fluctuations”, something that seems a little easier to understand for most people. Let us Certified Financial Planners and Investment Advisors worry about the mathematical stuff. The every day investor should be concerned with how fluctuations in his portfolio increase or decrease his chance of reaching his goals. Nothing more, nothing less. Is the pain of the fluctuation greater or less than the pain of knowing you might not reach your goals if you don’t increase your equity exposure?

To illustrate my point a little further I decided to do a little example using my trusty monte carlo simulator (Quantext Portfolio Planner). What I did is pretty simple. I plugged in a very basic all ETF portfolio; 15% TIP, 10% AGG, 5% TLT, 5% DJP, 5% ICF, 40% SPY, 10% EFA, 5% EEM, 5% XLU (for those interested the projected avg. return and std. deviation for this portfolio was 8.11%/9.75%). This looks like some lazy portfolio you might find on any number of sites nowadays. I also assumed 1) the portfolio weights would remain stable (i.e. not be rebalanced, this is not true but is simple enough to illustrate my point), 2) the investors would continue contributing $15k per year until their retirement (inflated each year with inflation), and 3) they would have a draw rate of 4.5% in retirement with a $60k/year (today’s dollars, also inflated in retirement) minimum draw.

What I wanted to do was show how a sudden 25% decrease in portfolio value would have different effects on 1) a 35 year old with 30 years to retirement and 2) a 55 year old with 10 years to retirement. By “effect” I mean how it changed the likelihood of them running out of money before a certain age. In these concrete examples you can really see how “risk” is better defined in terms of reaching goals.

I started the 35 yo off with a portfolio of $200k. He has a 10% chance of running out of money at age 93 but his 20th percentile puts him up to 100. What this means is that in all the monte carlo simulations that were run, this person, given the assumptions above, only ran out of money 10% of the time by age 93. 80% of the time he made it past 100.

BAM , some big shock happens and the market (and his portfolio value) drops 25% immediately (that’s right, immediately, for shock value). He now has only $150k to start with. How does that affect his chances of running out of money? He now runs out of money 10% of the time by age 88, 15% by age 92, 20% by age 96, and fully makes it past 100 in 75% of the simulations. That is not a very drastic change in his chance of success, certainly not something that couldn’t be overcome by a little common sense investing/rebalancing along the way. Presented in this light the 35 yo should not be intimidated by a 25% bear market at all.

Now on to our 55 yo. He is a little further along in life and has saved a bit more money. Let’s say $850K, which gives him the same 10% chance of running out of money at age 93 as the 35 yo (also an 80% chance of making it past 100). So what happens to this guy’s chances if he suddenly gets hit with a 25% smackdown in his portfolio value? He now runs out of money 10% of the time by age 84, 20% by age 89, and only makes it to 100 about 55% of the time. These are probably somewhat more meaningful changes to this person.

Now, the great unwashed might immediately assume that this means the older investor should be more conservative and guard against that 25% downdraft with more vigor. After all a shock like that would significantly decrease his chances of success. People typically get more conservative by increasing bond exposure and decreasing equity exposure. So let’s take all the bond positions in the portfolio (TIP, AGG, TLT) and double their weights. We’ll half all the other weights except SPY which will be at 25% instead of 40%.

At first glance this seems to be a good move, the 10% chance of failure moves up to age 85. The kicker is in the longer term ages. This more conservative portfolio now only gives the investor a 50% chance of making it past age 94. Yikes! There is indeed an inflection point (as I discussed in my article Optimal Withdrawal Rates for Retirement Accounts) where becoming more conservative decreases one’s chances in the long run. Of course, this is a direct function of how long one expects to live. Being more conservative might be wise if you believe (I will let you determine the factors that make you assess your life expectancy) you will live only to age 85. Being more aggressive might be necessary if you believe you will live longer than that and need your portfolio to remain in a growth stage for longer.

These examples are certainly hardwired and do not take into consideration a number of variables but I think they serve to illustrate the point I was trying to make. Sometimes it’s easier to look at risk in terms of achieving one’s goals than it is to try and apply some abstract mathematical construct to it. A 10% Standard Deviation? Huh? How about, “dude, if you don’t get more aggressive here you have a 25% chance of running out of money before you turn 88.” That seems to hit home a little more to me.

You know what never ceases to amaze me? The number of “how to invest during a recession” or “where to put your money in a bear market” articles that come out AFTER a recession or bear market has started. Yes, I am in the camp who believe 1) a recession has already started and 2) a bear market has already started. Whether or not I am correct makes no difference. The aim of portfolio defense is to have your money go down less than the market when it tanks. I don’t think it’s too late to implement some defensive strategies (it never is) but the fact that the S&P 500 is down about 15% since early October should give you pause when considering some of the advice in these articles. After all, what’s the point of blitzing when your opponent has already blown past you?

One of the most common bits of advice I see is to “make sure you have plenty of international exposure to diversify”. The reasoning is something like “if the US goes into a recession then other parts of the world should do fine.” While this idea of “decoupling” may seem nice and logical, the reality of the situation is a little different. During times of market turmoil fear and uncertainty (i.e. behavioral issues) dominate the investing world. Rational behavior, valuations, and capital distribution give way to the sprint away from risk and into “safe havens”. It doesn’t matter one bit what the economies actually do, or even what the economists believe they will do. What matters are the collective psyches of the people investing in those countries and their collective beliefs about how uncertain those prospects for decoupling are. Sure, decoupling would be nice, but am I really willing to risk significant sums of capital on that belief?

When the US market is in trouble and there are global financial issues in play people become very fearful of possible systemic shocks that would bring down world market indexes. Most investors (both individuals and institutions) rightfully decide that the preservation of capital is of paramount importance. So they run from risk, no matter what “might” happen in the future. The riskiest assets in a portfolio are sold down to fund safer (i.e. cash, CDs, treasuries, etc.) investments. So the idea of decoupling really doesn’t matter a great deal. It will matter when the market settles down a bit and people start putting money back to work BUT when everyone is fearful of further declines, the risk plays a bigger part in the decision than the potential reward.

So does international diversification really provide a lot of value when US markets are declining? Well, to give you an idea I ran a few tests. I used the EFA, EEM, ADRE, DLS (Wisdomtree Intl Small Cap Divs) and threw in the ^DJC commodity index and XLU (utilities) as comparisons. I first checked Beta, R^2, and Correlation to the S&P 500 for the 3 year period ended 9/30/2007. I then compared that to the same figures for 10/1/2007 to 1/31/2008. The results are in the table below:

What you can see from these numbers is that during the recent down slide, both the R^2 and Correlations of the broader international ETFs increased. What this means is that both the developed and emerging markets were tanking lock, stock, and barrel right alongside the S&P 500. The riskier emerging markets had almost a 1.0 correlation during this period. This is proof positive that in times of turmoil people will run from the riskier assets. Having exposure to developed markets provided a little diversification but probably not as much as one would hope for. Many of these broad market international funds have exposure to multinational companies from those areas. One would expect these companies to decline in value if their were issues with the global economy. Check out the DLS, small cap intl fund though. Small caps are more confined to local economic issues than to global ones, therefore, one would expect them to act differently. The data shows that they did. The problem is that even though the small caps were uncorrelated with the S&P 500 during this time, they tanked more on a percentage basis (see chart at Yahoo Finance) than any of the other options on the list.

The bottom line here, once again, is that people will run from the riskiest assets the fastest when they are scared. It is also interesting to note that the US utilities ETF (XLU), a notorious “safe haven”, went down the least and performed well as a diversification tool. Sometimes, it pays to look right in your back yard for good defensive strategies.

Of course, coming up with a defensive strategy should happen when everything looks rosy and no one is fearful. Now that most everyone is fearful and scared its time to start making plans for the future. I am making a list of the portfolio changes I would like to make to become more offensive when the situation dictates. How about you? Are you preparing your playbook?