Tag Archive | modern portfolio theory

Even Advisors are promoting better Risk Management – Down Markets Matter!

SmartStops comment:  We couldn’t agree more!  It is exactly why we brought this service to the marketplace.



Look at the money protected by SmartStops recently on AAPL, CMG, NFLX etc.

Nowhere to Run: The Correlation Bubble

SmartStops Comment:: Indeed, Beta and correlation approaches are not enough to manage risk in today’s markets. However we have somewhere for you to run – to intelligent self-adjusting risk methodologies that the SmartStops optimization engine offers.

Originally published at Seeking Alpha: http://seekingalpha.com/article/815851-nowhere-to-run-the-correlation-bubble

Fundamental analysis of “buy and hold” companies is a quaint, Warren Buffetish notion that probably works in the long term. But as Keynes said, in the long term we’re all dead. The big risk in today’s über-correlated markets is systemic shock. One can practice due diligence on a company and buy at a reasonable valuation, but if global markets collapse the next day and don’t recover for years, one has paid a lot in opportunity cost. In other words, tail risk is not reflected in fundamental analysis.

Fundamental analysis is valuable so long as the basic fabric of capital markets remains intact. In an insane world (where U.S. Treasuries and German Bunds are considered “risk-free”, of infinite rehypothecation, where MF Global’s John Corzine walks off with $200M segregated assets, of the London Whale, LIBOR, Goldman’s muppets, regulatory capture of SEC and Fed, U.S. / China animosity and the dollar’s loss of world reserve status) it’s unlikely that business-as-usual will continue without a disruptive bout of creative destruction.

Precisely when and how it will occur is anyone’s guess, but, unfortunately, old school techniques like cross-asset class and regional diversification have lost their glimmer. Just as socioeconomic disparity is partitioning the globe into lords and serfs, so too has the market been divided into polarized castes of highly correlated risk-on assets and (scarce few) risk-off havens.

Position Sizing: Key to Maximizing Returns

In a time when market volatility and equity preservation is of utmost importance, determining the correct number of shares to buy, or “position sizing”, is key to maximizing returns and minimizing risk.

The common investor generally doesn’t spend much time thinking about how many shares to buy or how significant of a position to take.  Instead, most investors use a common methodology of trading the same number of shares each time, which usually translates to a specific dollar amount.  Other, more sophisticated investors, opt to allocate a certain percentage of their portfolio value to a specific position. Following this train of thought, a new position in a portfolio of $100,000 would transcribe either a $10,000, or 10%, investment or a usual position of 50 shares.

Although these methods may work for some, using the volatility of a specific portfolio is likely to be the most effective decision tool.  Measuring a portfolio’s overall volatility enables an investor to decide on what percentage of that portfolio he is willing to risk losing on the new position.  This methodology is better explained through the following example. Read More…

Rethinking Modern Portfolio Theory

Are we all doing it wrong — or is the theory in need of updating and repair?

I think MPT died 30 years ago,” says Jeffrey Saut, chief investment strategist at Raymond James. “If the theory were correct, Warren Buffett, Peter Lynch and Paul Tudor Jones wouldn’t have their track records.” He says that although 60% of Lynch’s trades resulted in losses, he could manage downside risk precisely because he wasn’t tied to a strategic asset allocation. “Asset allocation-and just about any other model-works in a bull market,” Saut scoffs. “But the driver of returns in a bear or range-bound market is stock selection and risk management.”

By Joan Warner
February 1, 2010

So far, no other single method has knocked the Modern Portfolio Theory off its perch as a coherent way of structuring portfolios and pricing assets. But more and more practitioners believe the theory doesn’t deal adequately with today’s world.

Poor Harry Markowitz. Every time investors get whipped in the financial markets, they take it out on his Modern Portfolio Theory (MPT).

Never mind that the groundbreaking concept has governed investment discipline for more than 40 years and that Markowitz won a Nobel Prize for it in 1990. Its central tenet-that diversification mitigates portfolio risk-seemed to collapse in 2008 when the bear market left no asset class unmauled. Only Treasuries provided a haven, and according to MPT, Treasuries don’t even count. They’re just the risk-free baseline at the bottom of the return axis. If you had furious clients asking what the hell happened to your age-appropriate asset allocation strategy, you weren’t alone.

Investors don’t kick Markowitz only when they’re down. MPT also came under gleeful attack during the technology boom of the late 1990s, when “risk” was a dirty word. What sense does it make to diversify out of an asset class that’s returning 30%? Plenty, of course-but try telling clients to keep a little money in cash during a raging bull market.

Why does MPT look so good on paper, yet fail so spectacularly every few years?

Read More…

Know when to Hold ‘em, Know when to Fold ‘em

SmartStops comment:   Its why this service was brought to fruition.  Follow SmartStops and you can be protected before you lose it all. 

Unprecedented Monthly Volume Sell-Off Suggests Now’s the Time to Take Shelter – published at Minyanville by Kevin A. Tuttle

Do not concern yourself if the market goes up today, tomorrow, or a month from now. The risk of entering is not worth the reward.

Over the weekend I had the pleasure of speaking with a very prominent European money manager – overseeing hundreds of billions – about the “across-the-pond” financial crisis unwind and looming hazard of a potential domino-effect coming to fruition. Without rehashing the entire conversation, the consensus is not “if,” it’s “when” will the developing pressure finally blow. He actually went so far as to say it could truly begin unraveling within the next few weeks considering the catalysts currently in play.

The intent of providing the conversation synopsis is not for sake of fear, but understanding the potential ramifications. About three years ago, in one of my firm’s quarterly reports, we opined on a unique situation in regard to the GDP measurements of Global Nations. It stated the unprecedented growth statistics from the 56 nations tracked. “History is currently being made in the sense that all the globally tracked economic growth nations (56), every one… 100%…, are showing expansion.” This lead to my next comment… “If the economic cycle pendulum swings in both directions what would happen if the inverse occurred?” Are 2011/2012 the years we are about to find out? Maybe that’s somewhat extreme, but yet… is it possible?

We at my firm do not pretend to be intelligent enough to figure out all the nuances, catalysts, causes and reasons why the markets could fall apart; we’ll leave it to the team of economists and officials to attempt to sort that out. What we do instead is try to determine when the storm is coming and how to take shelter, which brings me to my point: Now is the time. Take shelter! Do not concern yourself if the market goes up today, tomorrow or a month from now. Clarity is key! Would you sail your boat into rocky waters with a potential hurricane looming because of your love of sailing? Is the risk worth the reward? For some, maybe; but for most, probably not.

S&P 500 Index

Since the “2011 Channel of Indecision” broke on August 4, the seas have picked up dramatically and have begun swallowing ships. The markets have never seen this type of monthly volume sell-off – 47% above average (unprecedented), as seen in the monthly chart above. As Kenny Rogers put it so eloquently… “Know when to hold em’ and know when to fold em’, know when to walk away, know when to run!”

PIMCO’s El-Erian Warns U.S. Rating at Risk, Even With Debt Ceiling Deal

SmartStops comment:  Investing in today’s 21st century markets demands dynamic, intelligent risk management.  Economic impacts to governmental policies and published economic numbers are fluid.  No longer is it sufficient to just allocate amongst your holdings based on beta. 

originally published  by AdvisorOne, by Melanie Waddell

July 25, 2011

As negotiations on a debt-ceiling deal broke down again over the weekend and leaders of both parties now plan to unveil their own debt ceiling plans, Mohamed El-Erian, co-CEO of PIMCO—the world’s largest bond fund manager—is warning that even with a debit limit deal in hand, the United States’ AAA rating is still at risk

El-Erian (left) said in a blog posting for The Huffington Post that while he believed the nation’s leadership would “stumble into a short-term compromise over the next few days—one that raises the debt ceiling and avoids a debt default” more importantly such a plan “leaves the AAA rating extremely vulnerable and does little to lift the damaging clouds hanging over the U.S. economy.”

A debt deal, he said, “will come down to the wire,” however, “the resolution will likely be temporary, and the damage will be real and long-lasting—both of which render an already worrisome situation even more difficult going forward. Indeed, by illustrating so vividly to the whole world what is ailing America, the weekend’s political theatrics should make us all worry even more about the world’s largest economy.”

El-Erian went on to say that America’s “already-fragile economic psyche and its global standing have taken a material hit. Forget about ‘animal spirits’ for now.” Instead, he wrote, “worry even more about an economy that is already having tremendous difficulty sustaining an acceptable growth momentum, and that already suffers from an unemployment crisis that is increasingly protracted in nature. Analysts will now scramble to again revise down their projections for growth, and up those for unemployment.”

Second, he warned. “The debt and deficit issues that are at the root of the debt ceiling drama are, unfortunately, a small part of a much larger set of structural impediments to employment, investment and wealth creation.” The housing sector is still languishing, he continued, “credit intermediation is uneven, infrastructure investment is lagging, job skill mismatches are increasing, and income and wealth inequalities are worsening.”

Read More…

The Myth of Diversification

SmartStops recently found this article based on a study which shows some of the fallacy that diversification from modern portfolio theory , MPT, is the only way to manage risk and thus lead to higher returns.     Their definition of risk for this study did use the standard deviation from mpt.   Our hope is that the industry realizes that even that computational methodology is lacking the sophistication that the smartstops optimization engine was built upon.   You can read some of our own studies here.  

 Their conclusion:

The takeaway from this article should be to note that it doesn’t take broad asset class diversification to adequately achieve one’s investment goals with a reasonable level of reward versus risk. So all of you lazy Lisas and Larrys out there can sleep easier knowing that your nest egg needn’t be diversified among more than the two carefully selected asset classes discussed above for you to realize your desired long-term return at minimum risk.

published originally at:  http://www.stockmarketcookbook.com/index.php

The Myth of Diversification

July 14, 2011 at 3:48 pm

Everyone assumes that broad asset class diversification in an investment portfolio is advantageous. The major benefit is to reduce the risk associated with events that can trigger a decline in any one asset class. By holding a variety of asset classes that are mostly uncorrelated with one another, the investor hopes to avoid those catastrophic occurrences that completely wipes out years of gains such as what happened during the credit crisis of 2008. Further, diversification makes financial planning more reliable and predictable by reducing the variations in portfolio performance from year to year.

Simply put, diversification is a sound investment practice.

But exactly how much risk reduction, in actual numbers, is obtained through application of this philosophy? That was the question I was pondering and was wondering if, indeed, asset class diversification is all that it’s cracked up to be.

Let’s find out.

[Disclaimer: First of all, nothing that follows is an attempt to challenge the precept of broad diversification as an indispensable investment tool, so don't get scared. Consider this analysis to be an exercise in quantitatively determining the relevance of just how much risk can be reduced by adding more asset classes to one's portfolio.]

Read More…

Avoid Financial Disasters with Trailing Stops

By Chuck LeBeau, SmartStops.net Director of Analytics  (originally published Jan. 2009)

In less than a year six widely held financial stocks (Fannie Mae (FNM)’ Freddie Mac (FRE), Lehman Brothers (LEH),

American International Group (AIG), Washington Mutual (WM) and Bear Stearns (BSC) have cost Buy and Hold investors more than $840 billion dollars.  That’s billions more than the controversial government bailout that has the entire country up in arms.  If we add in the losses in the rest of the market we are talking about recent losses measured in trillions of dollars.  (I’m certain that many of the Lehman and Bear Stearns account executives advised their clients that the best way to invest was to Buy and Hold.)

Think of all the retirement funds and college tuition money that has been needlessly lost in these few months.  It’s a very sad scenario for average investors who are not Wall Street tycoons.  However the saddest part is that the investors who lost all these billions and trillions of dollars could have avoided this disaster by simply using some logical form of trailing exit to protect their investments.

Buy and Hold is not only the riskiest possible strategy it doesn’t qualify to be called a strategy.  Buy and Hold is actually the absence of any intelligent exit strategy and is mostly adopted by default.   Read More…

Elevating Risk Management

We couldn’t agree with some of the commentary from this article in  Financial Advisor Magazine.  Its why we created SmartStops.   

The broader message is that indexing is moving past the standard beta carve-ups, such as small- vs. large-cap equities and value vs. growth stocks. A new era of factor-based indexing is dawning… Among the catalysts for the new indices is the growing use of factor models, says Rolf Agather, director of index research at Russell. “As investors become more sophisticated, they’re using risk factor models to have a better understanding of their risk exposures.”   Elevating risk management to a high priority, in other words, is the new new thing.   “Many investors are realizing that using a traditional framework built around countries, sectors or styles doesn’t always provide the insights for appropriately managing risk,” he explained in an e-mail. “Investors are looking for new ways to manage their risks more directly.”

Beyond One Beta

A key motivation for targeting multiple risk factors in portfolio design is recognizing the limits of using just one.

The broad market beta does the heavy lifting for explaining the link between risk and return, according to the capital asset pricing model (CAPM). (CAPM is Robert Merton’s invention) .   But if CAPM worked as promised, one beta would suffice for explaining risk and return. More exposure to market beta would bring higher return; less exposure would mean lower return.

CAPM’s embedded message: Don’t waste your time with factors other than market beta. It’s an elegant story, and it simplifies portfolio design and management—if it works.  But it doesn’t, at least not completely

Even if you have the stomach for sitting tight over ten or 20 years, the risk and return story isn’t as simple as CAPM suggests. Decades of empirical research show that there are other risk factors beyond market beta driving performance. In fact, the risk-return story is teeming with factor narratives. The concept of one dominant beta isn’t dead, but it’s no longer alone.

As President Obama said, the stock market needs to be under a watchful eye

President Obama made this statement in his inaugural address.  For the latest on what’s happening read below.  SmartStops is proud to be a member of the GlobalRisk Community.    Of course , we at SmartStops think regulation can only achieve so much, and hope that our intelligent risk management approach can be an alternative “watchful eye” helping increase protection for all investors, traders and professional advisors.

This was originally published on the GlobalRisk Community website.

 DFA Reform: With 30% of rules in place will regulators be ready to prevent another financial crisis.

Report by Marijana Curguz – GlobalRisk community’s participant at the conference

With House Committee passing a slew of rules on May 4, 2011 to postpone the implementation of derivatives section of the DFA by 18 months, Seila Bair’s decision to leave the FDIC on July 8, Geithner’s warning of a financial crisis if the legal debt limit is not raised, many are wondering if the U.S. economy is heading back into recession and will regulators be ready to prevent it.
These and other concerns were the main focus of the Regulatory Risk conference held in New York on May 9-10, 2011.  The organizer, Marcus Evans, brought together leading industry Experts and a keynote speaker Carlo V. di Florio, Head of SEC Office of Compliance Inspections and Examination,  to evaluate critical Regulatory Reforms: the Dodd-Frank Act, Basel III, housing finance reforms and KYC/CIP that are drastically altering the landscape of the financial world as we know it.
Florio underlined SEC need for a big budget boost to keep up with the fast-growing markets and carry out new duties they were tasked by the DFA.  SEC was handed lion’s share of work to implement DFA that requires it to write nearly 100 new rules for Wall Street by summer, manage systemic risk, oversee the $600 trillion derivatives market, regulate the unregulated (PE, HF, Credit Rating Agencies, ABS) and catch the next Bernard Madoff, and secure greater transparency and liquidity.
Read More…


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