Investing PART 8: “Pump up the volume.”

Yes, a little rap.

Now we can pump up the volume since previous postings have made us armed and dangerous. So, let’s look at another, and more sensible, discussion of asset allocation (i.e., rebalancing, to use the terminology I’ve been using). BARONS had an interesting interview dated Friday, December 31, 2010, “The Charms of Cash” by Lawrence C. Strauss. It’s worth reading to reinforce things you already know and for the challenge of finding practices you can and should avoid. Looking at both the plusses and minuses results in some interesting guidelines and a conclusion that is very different from the interviewee’s.

First a plus, let’s look at some sage wisdom that the interview brings out. Note that the theme of the interview is let cash build up when their isn’t an attractive investment. If you read the discussion of cash in PART 4 of this series you may have noted agreement with the theme of cash as an alternative to bad investments.

However, there’s a minus associated with this wisdom; let’s call it a caveat. PART 7 had the statement “The deadly flaw in EVERY discussion of rebalancing and market timing that I’ve seen hinges on the interpretation of the statement that rebalancing should reflect current conditions. They all focus on the wrong current conditions, namely market conditions. What is far more important is your condition.” Addressing YOUR conditions introduces two problems.

It is hard to over emphasize the first caveat. There is a minimum level of cash you should always have available. That minimum is determined by your cash flow requirements. Thus, cash would build from there if you can’t find attractive investments. Personal financial advisors stress having a rainy day fund. It applies equally to an investment portfolio and a household. (See PART 3 for a discussion).

The second caveat harkens back to “Wall Street Doesn’t Run the World.” That posting stressed that investment options for an individual aren’t constrained the way money managers are constrained. That’s true of timing and the range of investments an individual can make. In the interview, the interviewee is limited to considering three asset classes: stocks, bonds, and cash. You’re not.

He doesn’t consider non-public businesses. Despite recent news about Facebook, they’re not an option for many investment managers. Commodities are available in multiple forms. Real estate in the form of equity in your home is one of the most widely-distributed assets. There is little doubt many Americans were, and probably still are, under invested in real estate equity in their home. Similarly, it isn’t clear whether he includes REITs when he says stocks. Options can be used to hedge risk and make money.

Finally, just to add an investment that people don’t often think about, in the discussion of the flash crash, “The day the computers panicked PART 3,” I mention placing purchase orders at below current market prices. Specifically, the statement was “The …technique is a buy order with a price limit that is “good until canceled.” One has to remember the order has been placed and treat it as money spent.” One could argue that the technique implies letting cash build up, but I view this as a way to deploy capital and deploying capital is investing. So, bottom line he may have to let cash build up. You shouldn’t have to.

Now let’s get back to another bit of sage wisdom in the article. This time it’s a little more subtle than the cash issue. In response to one of the questions the interviewee starts his answer with: “In absolute return-oriented portfolios…” Remember in the discussion of “quilt chart” in PART 1, the references aren’t to relative returns. They are to positive returns. Getting a positive return should always be the objective. Not a positive return on every asset class, but on the total portfolio. That is going to require a broad range of assets, and it may not be possible to determine what the return is using mark-to-market accounting. Non-public assets can’t always be marked-to-market. (For further discussion see “Angels, entrepreneurs, and diversification: PART 2”).

There is a point that is even more important than re-highlighting asset classes beyond stocks, bonds and cash. Seeking a positive return contradicts the argument for cash. Cash is a sterile asset. At best it’s a shelter and a bad one. If you’re an investor, cash is, in a way, an admission of failure or at least an admission that looking for additional options is too much work.

It’s worth noting that for most people for most of their life an almost risk free real estate investment option exists. It arrives each month in the form of a mortgage payment request. They can increase their equity with an extra payment. It doesn’t matter whether the house price goes up or down. The additional payment builds equity. You own more real estate than if you didn’t make the payment. Further, you don’t know what you’ll get for your house until you sell it. So, the excuse that there aren’t any investment opportunities is nonsense.

There is another point where the interviewee highlights yet another item that is worth stressing. He makes the point “People, if they could just be a little bit more patient, would do a lot better by buying and holding cheap assets and waiting for the market to come around.” The implications of that simple statement deliver a double whammy.

First, the discussion of different types of asset presented above can make investing sound very complicated. Goodness sakes, we’re talking stocks, bonds, non-public businesses, mutual funds, options, real estate, and good-until-cancelled stock orders. Do we all need to become rocket scientists, too?

If it were that complicated, I certainly wouldn’t try it. It would be a rare investor who could claim to be too confident of their valuations across all these asset classes. However, it would be equally unusual for someone comfortable with one of these asset classes to be helpless when it comes to the other. Remember the goal is to make a positive return (i.e., absolute return) not beating every market (i.e., alpha). So, perfect timing in each market is less important than being in the right asset classes most of the time.

Put another way in modern portfolio terms, make sure you have the asset mix that puts you on the right risk-return frontier. Sure, others may get a higher return by taking more risk. If you want to aspire to higher returns, you can make larger reallocation changes (i.e., make bigger timing bets) or change the asset mix toward more volatile potentially higher return assets. By contrast if you use returns through the cycle and target a specific rate of return, you can be pretty sure of achieving the target return.

There are powerful simplifying strategies. Previous postings have discussed diversification across time. My observation is that what the interviewee alludes to is more than just inpatience; it’s an inability to grasp the power of diversification across time and a tremendous level of insecurity.

For those who want more current music, Katy Perry in “Teenage Dream” says: “And don't ever look back, Don't ever look back.” Now, I’m pretty sure she isn’t talking about investing. However, it has it’s applicability as investment advice. Once you discard the anchor of the past, the issue becomes what should your reference point be. Well, it is not the present except at the very moment when you sell. At all other times, it’s when you plan to sell. Inpatience is irrelevant until when you plan to sell. So, is mark-to-market accounting.

To illustrate with an approximation of a teenage dream, consider a young investor planning to retire some day. For the retirement portfolio, does it matter what the portfolio is worth over the next 20-25 years? Not a bit. So, a major simplifying strategy is for the investor to buy whatever he or she thinks will be worth the most 20-25 years from now. That just doesn’t change that much.

The other advantage of thinking out 10, 20 or 30 years is that it eliminates the nonsense of over confidence. It forces you to confront the uncertainty that is inherent in reality. It encourages you to think about asset mix as a hedging strategy since only a rare fool thinks he or she knows what the world will look like in 10, 20, or 30 years. The only thing you can truly know about the future is that you have to plan for it. If you don’t, you still get what you planned for: namely nothing.

I said simplifying strategies, so you have every right to expect more than one. I already mentioned another one in connection with cash. Specifically, targeting a value rather than a portion of the portfolio works fairly well. The dollar value of the target depends on personal circumstances. For example, a guideline like stocks can’t exceed X times my cash flow requirement can make sense. (Note: technically I’m using stocks as a proxy for assets with a given risk profile, especially volatility. It would be an estimated probability of default with bonds). Another guideline more appropriate as you approach or are in retirement would be a ratio of cash flow from the asset to your living expenses.

Interestingly, these types of guidelines have a tendency to indirectly result in fairly good market timing without having to call market turns. Adjustments will occur less frequently than if you try to time the market, but rates of return aren’t savaged. Besides, it will all make sense to you, which helps.

One more simplifying strategy. This one flies in the face of a lot of financial planning advice that ignores the “you” in your portfolio. Many advisers say treat all your investments as one big portfolio. That makes sense from the portfolio’s perspective. The portfolio has only one objective. I would venture a guess you have multiple objectives.

Don’t be afraid to segment into multiple portfolios for different objectives. There is no need to plan for 10 or more years for all of your portfolio, and it’s equally silly to plan your entire life based on what you think will happen over the next few months.

There’s another nice thing about segmenting your portfolio and setting dollar targets. Once you have cash and are on track in your retirement portfolio that’s good for 10, 20, or 30 years, new investment options can be considered. Previously, I mentioned options. Well options are out for a portfolio constructed based on forecasts of the value in ten years. They inherently involve a forecast of shorter run timing (i.e., when the level is achieved). Usually, with options, the forecast has to be right within no more than a 3 year horizon and even less for most options. (Technically they also involve an implicit forecast of volatility and interest rates). They’re an investment field of their own, but also useful when hedging.

One still has to review the overall portfolio from the perspective of balancing the different objectives. Most importantly, once your cash cushion is in place, make sure you aren’t neglecting objectives.