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To TIPS or not to TIPS – The Treasury Inflation Protected Securities (TIPS)

Saturday, June 5th, 2010

Treasury Inflation Protected Securities (known as TIPS), are inflation indexed bonds issued by the US Government. But what do they really offer you as an investor and how exactly do they work???

First of all, there’s a lot of angst regarding future inflationary expectations.  After all – it’s a normal concern with the government deficit exploding to unfathomable proportions on a minute by minute basis (not to mention interest rates overall are at historically low levels, and when rates revert to the statistical mean inflation is a likely counterpart to that occurrence).

TIPS can be purchased direct from the US government through the treasury, a bank, broker or dealer – or most preferably through a low cost index fund such as DFA Inflation Protected Securities.  Individual TIPS are purchased according to an auction process, where you can either accept whatever yield is determined at the auction or set a minimum yield you’re willing to accept (in which case you may or may not end up purchasing the TIPS if your yield expectations aren’t met).

TIPS come in 5, 10, and 30 year maturities and are bought in increments of $100. The return of principal AND ongoing interest payments depend on the TIPS principal value adjustment for the consumer price index (the CPI which is the most commonly used measure of inflation).  The coupon payment however, is a constant and stays the same for the life of the security.

With the underlying TIPS unit value fluctuating based on the CPI, each coupon payment interest rate fluctuates (fixed dollar payment divided by a fluctuating par value equals a floating interest rate).  So while the principal value fluctuates, the interest rate is fixed. This is how the holder is protected from inflationary pressures.  If inflation goes up, the underlying par value increases along with it.

As with the majority of US Government debt obligations, TIPS pay their coupon semi-annually.  The index for measuring the inflation rate is the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics (BLS).

In what situations would TIPS be a viable option for your investment portfolio? Consider for example you feel inflation will rise over the next five years.  If you were to invest in a portfolio of TIPS, as inflation occurs the principal value of the TIPS rises to compensate you for the inflationary pressure.  Your coupon payment remains the same, but your TIPS principal investment is worth more.

Now let’s look at the opposite of inflation – deflationary pressures.  Should deflation occur, your principal value would drop.  TIPS do have a backstop for deflation however.  The TIPS maturity value payment is the greater of $100 per TIPS unit, or the adjusted current value at that time.

Treasury auctions vary by security type and date, and it’s challenging to find relevant samples for different types of issue.  However here’s some real life examples of TIPS and regular 5 year treasury notes for comparison.

In a recent TIPS auction on April 26th, 2010, 5 year TIPS were priced at 99.767648 (or $99.77 per $100 par value TIPS security) with a rate of .50%.  On the same day, the 5 year treasury note yield was sitting right at 2.6%.  In this case, the regular 5 year treasury note is yielding roughly 5 times as much as the 5 year TIPS.  Seems like a lot to give up for some inflation protection doesn’t it?  The wide disparity in yield is primarily due to investor expectations of inflationary pressure (investors are willing to accept a lower interest rate for the inflation protection).

There is an upside however.  Let’s look at a similar 5 year TIPS security issued last year on 4/15/2009.  It was issued at $100.11 for each $100 TIPS and a rate of 1.25%.  At the same time the normal 5 year treasury note yield was at 1.71% – not nearly the spread of the first noted TIPS example.  That same treasury note issue today (June 5th, 2010) is indexed at 1.02858 or each TIPS is worth $102.86.

A 5 year treasury note issued on April 30, 2009 (as close as possible to the last TIPS example) priced at 99.691687 ($996.91 per $1,000 maturity par value) and yielded 1.875%.  Today through TD Ameritrade where I custody client assets, that same 5 year note is priced at 101.188 ($1,011.88 per $1,000 maturity par value).

The roughly one year old 5 year treasury note has earned a return of the coupon payment (two payments at $9.375 each plus some accrued interest which we’re discounting for this example), plus an increase in principal of $14.97 which equates to a 3.37% return.  For comparison, the closest issued TIPS issue from April 15, 2009 has garnered a return of two coupon payments (I’m using 10 TIPS to bring this example to parity with the $1,000 par value treasury note) of $6.25, and experienced an increase in value of $27.48 for a comparative return of 3.99%.  In this example the TIPS outperforms the treasury note by a reasonable margin.

Granted, these examples aren’t perfect, but they’re close enough for illustrative purposes on TIPS calculations and values compared to treasury note calculations and values.

There are downsides to TIPS however – one being taxes.  Should the principal value rise with inflation in a given year you’re taxed on the growth (which is NOT distributed, it’s only on paper) as if it were income. This creates somewhat of a phantom income tax – you don’t actually receive the money, but you’re taxed as if you did!  The upside of this is you establish a new basis in the security and won’t be taxed on it again, and in fact if deflation occurs may have a loss to put on your tax return.  Of course, don’t take my word for it – please consult your tax advisor.

In addition to the tax issue, there’s also political risk associated with the US Government (the rules can change – after all the rules change all the time!) in addition to the fact that the government calculates the CPI (who’s to say they’ve got their calculations right!).

While TIPS are great for some investors, they’re not right for everyone, and certainly not right for an entire (or even a majority of) portfolio.  However, should inflation pick up from these historically low levels over the next five years, the TIPS should comparatively do just fine compared to the regular 5 year treasury notes.

With all of the TIPS calculations noted above, still one of the best ways to hedge inflation is with a diversified portfolio of passive investment assets such as Dimensional Fund Advisors (DFA Funds), and other exchange traded funds (ETF’s).  Red Rock Wealth Management portfolios provide a substantial amount of NON-dollar denominated assets.  The portfolio philosophy invests in over 8,000 stocks in over 40 countries.  In addition, many US based companies hold non-dollar assets as well, and the Red Rock Wealth Management portfolio philosophy also holds other tangible assets the government can’t “print” – such as gold, oil, and timber.

Consider adding TIPS to your portfolio for a component of inflation protection, just make sure you fully understand all of the positive AND negative aspects of TIPS!

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Is There Alpha In Norway? Manager Added Value vs. Passive Investing

Friday, March 26th, 2010

Alpha is the ability for an investment manager – for example a mutual fund manager – to add value over and above what the index alone can do performance-wise.  As a passive investment manager and financial advisor, I don’t believe in Alpha.  In fact, if anything, investment fund managers DETRACT from portfolio performance on average by a substantial amount.  Passive investing simply means we’ll accept the broad market returns rather than trying to “beat” or “time” the markets, which statistically speaking can’t be done with any consistency or reliability.

Here’s Weston’s Article:

Is There Alpha in Norway?

Norwegians have a well-deserved reputation for sound stewardship of their substantial oil wealth, and based on a recent study, they may become further noted for making a significant contribution to the active vs. passive investment debate.

Funded by severance taxes and income from a 67% ownership stake in energy giant Statoil, a government-run petroleum fund (now known as the Government Pension Fund — Global) was first capitalized in 1996 and has become one of the world’s largest sovereign wealth funds, with over NOK 2.5 trillion in assets ($430 billion) as of September 30, 2009. The value of the fund exceeds NOK 1 million per Norwegian household, and the government has given a great deal of thought to the best way to manage this store of wealth for future generations.

The Norwegian Ministry of Finance determines the general investment strategy as well as ethical guidelines for “promoting good governance and safeguarding environmental and social concerns.” Norges Bank Investment Management, an affiliate of the Norwegian central bank, carries out the investment mandate using a combination of internal staff and external active money managers. Equity investments were first authorized in 1998, and the current asset allocation target is 60% equity (diversified across 46 countries) and 40% fixed income.

The fund is an unusually sophisticated market participant. With no current distribution requirements and a time horizon measured in generations, the fund is the quintessential patient investor, and with its ample resources, it can afford to hire the best and brightest managers the world has to offer. The fund devotes considerable effort to the process of hiring external money managers, seeking out not just successful organizations but specific individuals within those organizations with desirable characteristics. Combined with the traditional Scandinavian virtues of thrift and thoughtful analysis, the fund appears well-positioned to achieve its ambition, as described by the Ministry of Finance, “to be the best managed fund in the world.”

Following a disappointing performance in both absolute and relative terms in 2008 (the fund fell 23.3% for the year, trailing its benchmark by 337 basis points) the Ministry of Finance engaged an international team of experts to “evaluate the experiences in active management in Norges Bank.” The resulting 220-page report by Andrew Ang (Columbia Business School), William N. Goetzmann (Yale School of Management), and Stephen M. Schaefer (London Business School) provides an unusually detailed examination of an institution’s investment experience for more than eleven years, and the Ministry of Finance deserves credit for encouraging such a detailed independent investigation.

The conclusion? The authors’ “key finding” is that despite having an internal staff of 249 and hiring hundreds of external money managers, “to a first approximation, the Fund is actually not an actively managed portfolio” (Ang, Goetzmann, and Schafer 2009). Echoing an earlier performance study by Brinson, Hood, and Beebower (1986), they find that the Fund’s results are almost entirely explained by exposure to systematic risk factors rather than active management bets. “By far the most important influence on the performance of the Fund”, the authors say, “is the choice of benchmark. This accounts for over 99% of the total variance of the Fund’s returns so the contribution of active returns to the overall Fund performance has been small. However, a significant fraction of even the small component of total Fund returns represented by active returns is explained by exposure to a limited number of common factors. The overall behavior of the Fund is therefore very similar to an index fund with a small overlay of exposures to systematic factors such as credit, value-growth, liquidity, volatility, etc.”

Based on their finding that the average active return from January 1998 to September 2009 was statistically indistinguishable from zero, the authors suggest that the fund could benefit by targeting various risk factors more explicitly and taking advantage of the fund’s unusually long time horizon to earn appropriate returns as compensation for risks that other investors might be unable or unwilling to bear.

Norges Bank Investment Management has responded with a defense of their approach, and it remains to be seen if the report precipitates any significant changes in the overall strategy. Regardless of what the Ministry of Finance decides to do, the exercise provides a compelling illustration of the challenge facing investors in seeking to outperform markets, and, if nothing else, we now have a new standard by which such efforts should be evaluated and impressive documentation that “structure explains performance.”

Andrew Ang, William N. Goetzmann, and Stephen M. Schafer, “Evaluation of Active Management of the Norwegian Government Pension Fund — Global,” (research paper, December 2009).

Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance,”, Financial Analysts Journal, 42, no. 4 (July/August 1986): 39-44.

The research paper “Evaluation of Active Management of the Norwegian Government Pension Fund — Global” is available at The Norwegian Ministry of Finance website www.regjeringen.no (accessed February 22, 2010).

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Income Investing For Total Return In A Low Interest Rate Environment

Monday, March 8th, 2010

With the lowest interest rates in decades, many investors are now coming to the harsh realization that re-investing their fixed income securities as they mature means a substantial reduction in investment return (the interest rate earned from a specific debt security).  Rates just aren’t where they were even a couple years back, and if you’re relying solely on fixed income to retire on (which isn’t a recommended strategy) it’s disappointing at best – and financially devastating at worst.  Financially devastating – primarily because you either have to suffer with a dramatically reduced retirement income, OR extend out your fixed income maturities to pick up a bit of yield (a VERY risky and in my opinion poor strategy in this low interest rate environment).

Even worse – these low rates lead many retirees to search for higher yield. There is no free lunch… higher yields mean higher risk to your principal AND/OR if it’s in the form of an annuity can completely lock up your funds in high commission-based insurance products (not that all annuities are bad, for example they’re perfect for a spendthrift who can’t control their own financial plan).  Chasing yield is a mistake, but many retirees incorrectly think it’s a low risk strategy to bolster their retirement income.

So just what is a retiree to do in this low interest rate environment?  Invest for total return through a diversified and balanced portfolio. The fact is, most investors think they need bonds and other fixed income investments to live off of the interest during retirement.  That’s just not the case and really couldn’t be further from the truth.  Retirees can benefit from a diversified blend of income sources.

Just what do I mean by a diversified blend of income sources?  Most certainly the fixed income component is a must.  Your portfolio needs bonds to produce interest and reduce your personal investment volatility and risk.  That’s a given.  How much to allocate to fixed income in your portfolio is a factor of your financial risk tolerance for portfolio volatility to a point, but it’s also a factor of how much income you need!

Many retirees don’t fully understand the planning factors that go into a retirement lifetime.  Some investors think a portfolio allocation is solely based of some risk tolerance profiling questionnaire – that may be the case for PART of your investment portfolio planning.  But it’s also based on your current and projected financial income needs.

For example, some clients need to be coached and educated on the financial costs of having too much fixed income.  Too much fixed income will lower your overall long term investment returns, putting your retirement nest egg at risk.  Not necessarily loss of principal, but loss of effective principal due to a reduction in purchasing power from inflationary pressures.  Let’s face it, a stamp is 44 cents today.  Stamps were 3 cents in the great depression, and it takes well over $16 today to buy what $1 did in 1933!  If you’re not keeping pace with inflation, you’re falling behind financially.

Yet other investors need consultation and education on reducing their equity exposure because it’s not needed to achieve their retirement income goals.  Many clients have conservative retirement budgets, and live off less income from their portfolio than they could.  In this case, it may not make sense to allocate a greater portion of a portfolio to equities for growth – as it’s not financially necessary!

There is FAR MORE than simply a risk tolerance profile to consider when creating an investment portfolio suited to your specific financial needs, goals and risk tolerance!

Assuming you fall somewhere in the middle of an extremely conservative all income producing fixed income portfolio and an all equity aggressive growth portfolio – you’ll experience “income investing for total return”. Income doesn’t need to be generated solely from portfolio interest.  Rather you can experience longer term higher returns to help offset inflationary pressures, as well as a solid current income through a diversified portfolio of equity, fixed income, and alternative investment assets.

Total return income investing means your income will be derived from interest payments, dividend payments, capital gains and other distributions (such as return of principal for example).  The key is to consider ALL sources of distributions and income that your portfolio generates when creating your investment portfolio allocation.  Focus more on total return, rather and interest income!

To be successful at income investing for total return however, you must be absolutely prepared for the inevitable market downturns. The worst possible time to liquidate portfolio assets to create cash flows for your retirement income is in a bad market environment – such as the one in 2008 and early 2009.  There is no catch-up for liquidating principal investments at lower levels during retirement.  The fact is, in retirement you’re not typically adding to your investment portfolio, you’re utilizing it for income.  Selling shares of anything at lower prices can’t be recovered from.

An effective and well-constructed retirement plan is far more important than the investments you choose to allocate the plan with. Missing something simple like leaving enough reserves in short term fixed income investments and money market type instruments means more of your balanced portfolio is at risk for liquidation at lower values if the market turns sour again.  It’s pretty clear – have enough liquidity on hand to cover a reasonable amount of monthly income cash flows or risk your portfolio to the whims of the capital markets!

I typically recommend anywhere from 9 months to 1 year of income on hand and accessible in money markets or highly liquid high quality ultra short duration fixed income funds or securities.  This depends on the client, on their plan, and on their personal risk tolerance of course.  There is no clear cut answer for the masses in retirement.  But enough liquidity to help you weather a typical 12 to 18 month bear market is a great starting point, after which the amount becomes a factor of how aggressive or conservative the remainder of your portfolio balance is, and your personal risk tolerance.

Managing income investing for total return in a bear market presents it’s own challenges.  It brings on a whole new set of decisions, for example when to re-balance your portfolio and does it make sense to shorten the amount of cash reserves in order to maintain your core long term retirement strategy.  These decisions should be monitored and managed closely with your financial advisor.

If you’re a fixed income investor, think carefully before you choose to chase yield.  Think even more carefully before you choose to extend your bond or CD maturities.  And most importantly think carefully before locking up any of your retirement in an annuity.  While annuities may be right for some investors, they’re typically not highly efficient retirement planning vehicles.  I’m sure that assessment will draw substantial criticism from the ranks of those in insurance sales – but I’m not paid commissions to sell investment products – I’m compensated to develop a sound retirement income strategy for those who need it!

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Deposit $25,000 or more, 1.50% APY CD available

Wednesday, February 10th, 2010

Through TD Ameritrade Institutional (Red Rock Wealth Management’s custodian of preference) you now have the opportunity to get a great rate of 1.50% Annual Percentage Yield (APY) – and FDIC protection up to $250,000 with a new deposit of $25,000 or more with a 3-month High Yield CD.

Did you know the average American holds 10.8 jobs in their lifetime? You do not have to leave your retirement savings behind; consider offering a high yield CD as part of a Rollover IRA for their retirement assets.

Of course – this is only ONE small part of a long term diversified investment plan. If you’ve ever wanted to work with Red Rock Wealth Management, now’s the time! TD Ameritrade is offering this very attractive CD rate for a three month deposit while we work through your planning, retirement, and financial issues in greater detail on the way to creating and implementing a successful diversified and risk-managed investment strategy for the LONG term!

Access to this special offer CD is available for a limited time only and will expire 2/26/10. Special 3-month CD rate of 1.50% APY was current as of 01/20/10 and is subject to change without prior notice.

If you’re stuck in .50% bank rate CD’s, or just plain don’t know what to do in this volatile market environment – consider this a great opportunity to pick up some extra yield while beginning a relationship with Red Rock Wealth Management!

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Welcome to 2010!

Thursday, January 28th, 2010

After a wild couple of years and an amazing 2nd, 3rd, and 4th quarter of 2009 – we’re finally in 2010. This alone seems like a milestone achievement of epic proportions considering where we were not more than a couple years ago.

2008 was nothing more than wealth destruction at it’s finest, in more ways than one. Real estate values plummeted, equity markets sank, jobless numbers rose, GDP shrank, the dollar became weak, and commodities were highly volatile to put it mildly! 2008 marks a year of despair and discontent.

2009 started off the same, people continued to make the wrong decisions at the wrong time. Average investor mentality prompted selling at what we look back now as the bottom. I know, there were investors who couldn’t remain grounded in their financial plans. Fear took over, greed was long gone, and a return of principal was all they wanted even if it meant abysmal interest rates and locking in paper losses. That proved to be an incredibly detrimental decision for the masses of individual investors throughout the world who made similar decisions.

What proved to work, which has proved to work time and time again for decades, is staying grounded in a solid plan. Those with near term cash needs separated in conservative money market and CD type of investments were able to weather the storm. In fact those same clients were able to re-balance their portfolios on the way down into first quarter 2009, and subsequently later at much higher levels later in 2009. For investors who stayed focused on their plans – the gains were tremendous as portions of equity positions were bought at depressed levels, and subsequently portions were sold later in 2009 at higher levels. All along, maintaining enough cash and CD investments to cover near term cash liquidity needs.

A bad year(s) coupled with bad decision making can lead to a lifetime of lost net wealth…

After nearly 15 years as a financial advisor (March 15 marks my 15th year since starting with then “Dean Witter Reynolds” and subsequently “Morgan Stanley” – as an advisor) 2009 will go down in the history of my career as one of the most successful advising experiences ever. In the grand scheme of things – I will always look back on the focus and fortitude it took my clients to endure the most difficult and challenging period for net wealth volatility since the decade of the great depression.

The trust clients placed in the process and long term focus I provided them is unequivocally my Firm’s most valuable asset.

That leads me to today, WELCOME TO 2010!!! Remember, we are investors, not speculators. We implement and manage focused and concise plans to achieve goals over long periods of time while reducing risk and volatility to a level each client is comfortable with. We CAN NOT predict the market movements, we DON’T try to manipulate investments to take advantage of “what we think will happen”. Truth is, no one knows.

Here’s the hook though, as Americans IT IS IN OUR BLOOD to think we know better, to think we can predict what investments or managers or assets will outperform. We ARE the greatest nation on the planet, if this drive to always outperform WASN’T in our persona – we wouldn’t be the greatest nation on the planet!

So, I propose to you NOT to try and guess where the markets are going. DON’T let fear and greed lead your investment decision making. ABSOLUTELY NEVER deviate from a solid long term plan UNLESS your financial situation changes. TURN OFF THE NEWS and the “talking heads”. For every analyst who says we’re going down, there’s another saying we’re going up. They don’t know anymore than you or I do.

What we DO KNOW HOWEVER, is that in the context of a well thought out longer term financial and investment plan (as you all know I share the mantra 5 years, 5 years, 5 years with many of my Fee-Only advisor counterparts), the strategies of minimizing costs, taxes, and turnover, consistently re-balancing at opportune times, monitoring your financial situation for adjustments to your longer term plan, updating your financial plan regularly, and staying focused on what works IS THE BEST WAY TO ACHIEVE FINANCIAL SUCCESS!

So prepare for a drop in your account values, prepare for another rocky year. I don’t know where we go from here, up, down, or sideways. I do know that we have a strategy in place based on you and your financial needs that is solid (if you question that statement to the slightest degree call me IMMEDIATELY so we can review your plan in person together AS SOON AS POSSIBLE!).

Now that you’ve had a chance to review your year end performance reports, please contact me at 702-987-1607 or greg@redrockwealth.com if there have been any changes to your financial situation I should be aware of OR if you have any questions we haven’t covered in your financial and investment management reviews.

Welcome to 2010!!! A year I hope to be filled with peace and financial prosperity!!!

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FDIC Insured Money Market Option

Wednesday, October 21st, 2009

TD Ameritrade is now offering an FDIC insured money market option which is yielding (albeit abysmally low!) a substantial amount MORE than the US Government money market option (which most Red Rock Wealth Management clients have). For this reason I’m moving all client money market options into the FDIC Insured Money Market account.

The FDIC Insured Money Market is a sweep fund, meaning money automatically flows in and out of the fund to earn maximum interest by keeping your money working for you.

It’s a good option to have and all clients will be taking advantage of it. You may notice some changes on your statements referencing this fact, please don’t hesitate to call or schedule a meeting to review.

Greg

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Active Mutual Fund Managers Report Card

Monday, October 19th, 2009

Report Card for Active Managers

Morningstar recently announced the introduction of a new “Box Score” report analyzing the performance of actively managed US equity mutual fund managers. Morningstar’s analysis starts with a universe of 22,000 US equity funds and prunes the list by aggregating multiple share classes and eliminating exchange-traded funds, sector funds, bear market funds, long/short funds, and lifecycle funds. They also exclude funds deemed to have a “passive-like” investment approach, specifically citing Dimensional strategies. All funds available for purchase at the beginning of any particular time period under review are included, so the results are free of survivor bias. Morningstar compares results to their own stock indexes, which seek to capture the returns of the nine distinct Morningstar style boxes (large cap growth, mid cap value, etc.), and evaluates performance by calculating both Jensen’s alpha and a more comprehensive Fama/French alpha.

The report is similar to the SPIVA report (Standard & Poor’s Indices versus Active Funds Scorecard), which compares actively managed funds to various S&P and Barclays indices in US equity, international equity, and fixed income markets. S&P uses the CRSP Survivor-Bias-Free US Mutual Fund Database, and, like the Box Score report, is published semiannually.

Although we found the Morningstar report rather light on documentation, both reports are useful in providing a regularly updated analysis that quantifies the challenge facing investors seeking to identify winning money managers.

A few nuggets from recent reports:

  • Morningstar finds that 41% of actively managed funds outperformed their respective indexes for the three-year period ending June 30, 2009, using a measure of Jensen’s alpha. But Morningstar notes that “once the Fama/French factors are taken into account, active managers’ outperformance relative to the indexes falls materially.” By the latter measure, only 37% of managers outperformed, and average alpha was negative in all nine style categories.
  • S&P reports that only 31% of large cap core funds for the five-year period ending June 30, 2009 outperformed the S&P 500 Index. Results were even less favorable for non-US markets, where 13% of international funds and 10% of emerging markets funds outperformed their respective benchmarks. We often hear that non-US stock markets exhibit greater pricing errors than the US, supposedly offering a target-rich environment for clever stock pickers. The numbers suggest this is wishful thinking.
  • Fixed income markets were no less challenging: for the same five-year period, Standard & Poor’s found that 22% of intermediate government funds were outperformers, and the number dropped to 11% for high-yield bond funds and only 2% for mortgage-backed securities funds.
  • The fund attrition rate is significant: S&P reports that 27% of the 2,154 US equity funds in existence five years ago have merged or liquidated as of June 30, 2009. For reasons unclear to us, the number jumps to 39% for large cap blend funds, the worst among all style categories. Morningstar reports that 10% of small growth funds have disappeared in just the first six months of 2009.

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    Investment Portfolio Risk – Systematic vs. Specific Risk

    Wednesday, June 17th, 2009

    Most individual investors (and unfortunately many financial advisors) haphazardly throw together bits and pieces of stocks, bonds, mutual funds and annuity products in an attempt to diversify their financial holdings and reduce investment risk. Incorrectly they assume that “more” holdings is automatically “better”, when in fact more may mean little more than a false sense of security.

    In the context of creating a truly diversified investment portfolio, there are two primary types of risk associated with individual investment securities – specific risk and systematic risk. The creation of an “efficient investment portfolio” is based on several factors, including eliminating all “specific risk” or “non-systematic risk” (also called diversifiable, unique, unsystematic or idiosyncratic risk).

    Specific risk is a completely unnecessary risk. Most investment portfolios are exposed specific risk, yet most investors aren’t compensated with corresponding investment return because of the nature of specific risk.

    Specific risk is the risk associated with individual investment securities. It’s unnecessary because it can be diversified away by adding more similar securities to the portfolio. The more securities added (similar in nature), the more the specific risk of an investment is reduced until you reach a point of diminishing returns (where added securities have no added risk reducing effect).

    If you own shares of IBM, there is specific risk associated with that security. It fluctuates in value based on its own set of business circumstances like profitability, financial strength, product innovations and future prospects. IBM also fluctuates in value based on how its market sector (a grouping of other large technology companies) is performing.

    If you owned 10 large technology companies, you’d begin to diversify away the specific risk associated with IBM. If you diversified into enough positions (many experts say 15 to 20 at a minimum), you would have an “asset class”.

    An asset class is a group of similar securities – for example large companies, small companies or international companies. Asset classes do not have specific risk as it has been effectively eliminated through diversification. An asset class does however have “systematic risk”.

    Systematic risk is the risk associated with an entire asset class once all specific risk has been eliminated. It cannot be diversified away (with the exception of long/short strategies which is beyond the scope of this article). Each asset class has it’s own systematic risk that one must endure to achieve the expected long-term returns of the asset class.

    Each asset class has a historical “correlation” to another asset class, meaning some investment securities perform differently at different periods in our economic cycle. For example, in 2008 commodities like gold and oil fluctuated wildly both up and down in value. United States equity holdings floundered through the third quarter, then sank dramatically in the fourth quarter as commodities stabilized. Treasury bond prices tended to trend upward throughout the year as interest rates came down.

    These are excellent examples of “non-correlation”. Asset class investments performed good or bad relative to each other, and although most asset classes ended lower in value in 2008, there were varying degrees of investment loss for each asset class. Consequently a well diversified portfolio including multiple asset classes and bond holdings performed better on average than their 100% equity counterparts.

    To create a truly diversified investment portfolio, an investor must first remove all unnecessary (specific) risk associated with their investment holdings. This means ONLY accepting the systematic risk associated with an investment, and embracing it as a means to an end.

    To further reduce portfolio risk through diversification, an investor must combine several asset class investments with non-correlative qualities in a portfolio balanced to the investors desired risk tolerance. This concept is based on Modern Portfolio Theory – or an effectively proportioned mix of non-correlative asset class investments. Modern Portfolio Theory serves as an industry wide accepted model for rational investment portfolio decision making.

    Generally speaking, a minimum of 6 asset classes could be combined into a statistically significant diversified portfolio. 6 asset classes each holding 20 securities (minimum) makes for a LONG portfolio statement from your custodian! That’s 120 securities in your portfolio, and it’s quite unnecessary with the advent of no-load mutual funds and exchange traded funds. You could hold 120 positions and monitor them – fumbling around a re-balancing program, or hold 6 positions (8 to 12 is more preferable) making re-balancing your diversified portfolio allocation much simpler, and invariably more precise.

    Once the specific risk is removed and non-correlative asset classes are combined into a balanced portfolio, an investors desired long term return level should in theory be purely correlated with each unit of risk they’re willing to accept. When only systematic risk remains, and full diversification among several asset class investments has been accomplished – the saying “the greater the risk, the greater the reward!” should hypothetically hold true over long periods of time.

    So before beginning any investment program, consider carefully the types of risk you’re exposing your portfolio to. There’s no need to take unnecessary risks with your investments. It is your financial future after all!

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    Treasury Investment vs. Equity (Stock) Investment – Surprising Information You Must See!

    Wednesday, June 10th, 2009

    Here’s a quick 7 minute video produced by Dimensional Fund Advisors on the REAL risks of treasury bills vs. the risk for equity investment. It’s a piece every investor should see and understand, as the risks to purchasing power are increased dramatically with a heavy allocation to (what people mostly consider) “safe” investments like treasury bonds.

    Here’s the video:
    http://www.dfaus.com/library/videos/retireme/

    Surprisingly enough – the WORST 10 year period for stocks is NOT AS BAD as the WORST 10 year period for stocks and a balanced portfolio somewhere in the middle has the best risk/reward characteristics!

    OF COURSE, the main caveat is we’re assuming “equities” or “stocks” are a DIVERSIFIED BASKET of those securities – NOT individual stock positions, which brings in another realm of portfolio risk.

    Greg

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    Your Mutual Funds & Lending Securities

    Monday, June 1st, 2009

    It’s a little known fact that MANY mutual funds practice securities lending. Securities lending entails taking portfolio holdings, loaning them to another firm, and collecting interest on that loan.

    Why would anyone want to borrow securities? Simple – traders sometimes sell the market short – called “short selling”. Short selling is borrowing a stock or bond, selling it at current market prices, then buying it back at “hopefully” lower prices. Short selling is a trading strategy – NOT a long term investment strategy!

    What you probably also don’t know is that Dimensional Funds DOES in fact lend out securities and collects interest in order to benefit the portfolio performance by the amount of interest earned on the securities loan.

    Another article by Weston Wellington at DFA Funds details some recent commentary by Wall Street Journal author Jason Zweig:

    In a recent article, Wall Street Journal columnist Jason Zweig takes a look at securities lending practices among various mutual funds and finds, in some cases, cause for concern. “Securities lending is sensible and beneficial in the right hands,” he observes, “but can wreak havoc when it is done wrong.” Last year’s turbulent fixed income market led to problems in unexpected places such as money market funds or short-term “enhanced cash” strategies, and a number of lending programs experienced losses associated with reinvestment of collateral backing the securities on loan.

    Zweig’s principal gripe is that some fund sponsors keep a portion of the lending revenue even though loaned securities belong to fund shareholders and they bear the risk associated with such activities. He notes approvingly that T. Rowe Price Group and Vanguard Group “rebate all securities-lending income (net of expenses) back to the funds that generated it.” Although not mentioned in the article, Dimensional funds likewise receive 100% of any net lending revenue.

    Zweig’s article suggests that fund investors and their advisors should pay close attention to securities lending practices, the allocation of revenue, and the financial incentives for those providing lending services to the fund.

    A description of Dimensional securities lending practices appears on page 80 of the DFA IDG/DIG prospectus dated February 28, 2009, and a related risk discussion appears on page 16. A table on page 36 shows net lending revenue for the fiscal year ending October 31, 2008 for twenty-seven funds, with the funds earning a total of $182,252,000. The resulting performance enhancement among these twenty-seven funds for the fiscal year ranged from 0.04% for US Large Company Portfolio to 0.66% for Japanese Small Company Portfolio.

    Dimensional’s Research group is preparing a more detailed review of securities lending programs, including a discussion of recent problems. Look for it on our website in the near future.

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