Jan 27 2009
Jan 27 2009
What are the projections for a portfolio of ten stocks culled from the “Creme List” and priced to buy. Click on this video for more information.
As mentioned in the “movie,” this portfolio does not have the diversification as a 20 stock portfolio, nor is the projected annual return and projected annual risk factor as well situated.
Lowell Herr
Photograph: Ken Appel photograph on the northern shore of Ireland – outside of Belfast.
Jan 27 2009
Yesterday, I posted detailed information on the Passive Portfolio and how it experienced a three sigma event in 2008. This morning I will take a similar look at the AEM Portfolio. On 12/31/2007, the portfolio value was $101,631 and by 12/31/2008 it had dropped to $67,689 or a 33.4% (-33.4%) loss. That is a larger loss than experienced by the Passive Portfolio (PP), likely due to the Strategic Asset Allocation (SAA) plan. Note that the AEM portfolio is not skewed toward value. The SAA plan is described below.
Just a note to readers to let them know this portfolio is “outperforming” the VTSMX benchmark by 0.1% point as of 1/23/2009. This is an annualized figure and the portfolio has been in operation for a little over two years. Call it a statistical dead heat.
I looked at the Quantext Portfolio Planner (QPP) data back on 12/31/2007 and the projected return at that time was 8.5% with a projected standard deviation (SD) of 17.3%. This SD is quite high, particularly in light of the projected return. Now contrast the 8.5%/17.3% ratio with the historical performance for the prior three years. The historic ratio was 9.0%/9.8% or nearly one. The warning flag, had I been using this software in 12/31/2007, was waving as the projected return of 8.5% was slightly lower than the 9.0% historical return. Further, the very high projected SD was not a good omen.
I think we already see this 33.4% loss is a three sigma event, but let’s walk through the math. A projected return of 8.5% in 12/31/2007 with a SD of 17.3% gives us a one sigma event of 8.5 +/- 17.3 or 8.5 + 17.3 = 25.8% on the high side and 8.5 – 17.3 = -8.8% on the down side. Since we lost 33.4%, it sure was more than a one sigma event. Let’s go for a two sigma event.
For the two sigma event, we need to double the SD from 17.3% to 34.6%. On the upside we would expect 8.5% + 34.6% or 43.1%. These advances do happen and that would have been a happy problem. On the downside we expect 8.5% – 34.6% or -26.1%. Since we lost 33.4% we can see this loss throws us into the three sigma range.
Just to review a bit, I grabbed the following from Wikipedia. “The central limit theorem says that the distribution of a sum of many independent, identically distributed random variables tends towards the normal distribution. If a data distribution is approximately normal then about 68% (68.27%) of the values are within 1 standard deviation of the mean (mathematically, ? ± ?, where ? is the arithmetic mean), about 95% (95.45%) of the values are within two standard deviations (? ± 2?), and about 99.7% (99.73%) lie within 3 standard deviations (? ± 3?). This is known as the 68-95-99.7 rule, or the empirical rule.”
Once more, armed with the data above, one can see how unusual it is for a portfolio, such as the AEM, to experience a drop in value in excess of 30%. With the AEM Portfolio structured as it was, we were prepared for a 8.8% (SD value) loss approximately 32% of the time, but it was highly unlikely we would experience a 33.4% loss.
Where are we this morning and what are the forward looking projections? Using data from 1/23/2006 through 1/23/2009, the projected annual return is 9.5% while the projected annual SD is a high, 19.8%. We prefer this ratio to be closer to one vs. a value of over two as we see in this situation. The historical returns for this portfolio over the same period was -12.3% with an annualized SD value of 18.95%. Since the projected future return is higher than the historical return, probability is on our side. However, one needs to remember that these are projections and probability calculations. In these poor economic times, it is not difficult to imagine another one sigma event to the downside. We just don’t know what will happen.
One more measurement of concern with the AEM Portfolio is the Diversification Metric. It is a rather low 27%, indicating the portfolio is not well diversified.
Lowell Herr
Photograph: Harbor at Dubrovnik, Croatia
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