ITA Wealth Management

If 2008 taught us one lesson it is that portfolio risk is just as important as the attention we give to portfolio return.  In the following analysis I want to examine some of the risk details of the Passive Portfolio (PP).  At the end of 2007, this portfolio had a value of $234,160 and by the end of 2008, one year later, the value dropped to $162,513 or a negative return of 30.6% (-30.6%).  Were we prepared for such a drop and if so, how unusual was this likely to happen?  Those are a few of the questions we want to analyze as we take a careful look at this portfolio.

While the PP continues to outperform the VTSMX benchmark by approximately 3% points annually over an eight-year span, for many years the portfolio bested the benchmark by 8% points on an annual basis.  Here is the asset allocation plan for the passive portfolio.

• Large-Cap Value = 14%
• Mid-Cap Value = 15%
• Small-Cap Value = 13%
• Large-Cap Growth = 13%
• Mid-Cap Growth = 13%
• Small-Cap Growth = 5%
• International = 15%
• Emerging Markets = 7%
• REITs = 5%
• Cash = 0%

The asset allocation percentages were not altered during the year and the portfolio did not require any rebalancing.  Cash was added and a few ETFs were purchased throughout the year.  Overall, there was a minimum of activity within this portfolio during 2008.

Back on 12/31/2007, a Quantext Portfolio Planning (QPP) analysis showed this portfolio to have a projected return of 8.3% with a standard deviation of 17.3%.  Looking back, this was a rather high SD when measured against the projected return.  Within one standard deviation or a one sigma event, the portfolio would range from a high of (8.3% + 17.3%) or 25.6% to a low of (8.3% – 17.3%) negative 9.0% (-9.0%).  However, the portfolio dropped -30.6% during 2008.

A two sigma event would see the range of variance expand from the average to include 95% of the data.  The standard deviation must be doubled.  We now have a two standard deviation or two sigma event.  The range of outcomes for the two sigma event would be 8.3% plus or minus 2 x 17.3% or from 8.3% + 34.6% to 8.3% – 34.6%.  Now a two sigma event captures 95% of the outcomes so the two sigma range is from 42.9% on the upside to -26.3% on the downside.  Once more, remember the Passive Portfolio dropped more than 26.3%.  Therefore, what happened to this portfolio in 2008 was a three sigma event.  A three sigma event includes 99% of the outcomes.  Actually, it is 99.73% of all events, so you gain an appreciation of how unusual it was for a drop of -30.6% to occur.

The question we should have been asking ourselves a year ago is the following.  How much risk are we capable of handling?  Is a three sigma event acceptable?  If not, what do we need to do to make sure this does not happen again?  I will be posting, for Premium subscribers, a flag that was waving had I been using the QPP software a year ago.  Is the Passive Portfolio positioned properly for today’s market and what about the other six portfolios?

Lowell Herr

Photograph: Tibetan farmers just outside of Lhasa, Tibet

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