ITA Wealth Management

Premium Content readers have access to the spreadsheet that tracks the Jane Portfolio (was GLW Portfolio), a small portfolio under construction.  Today, JNJ was added to this portfolio, one of three slots open for individual stocks.  The core holdings will come from a variety of ETFs so we have a well balanced portfolio.  The Dashboard inside the SS gives a clear picture of the target percentages and the current positions.

Here is a “movie” of the initial asset allocation plan.  Note the improvements in this portfolio asset allocation plan vs. the sample portfolio offered earlier in the day.  These portfolio plans are normally reserved for Premium readers, but I wanted to give readers here on the free side a taste of how we go about planning and building a portfolio.

Note the importance placed on asset allocation.  The core ETFs cover the “Big Six” equity asset classes.  In addition, we have bonds, commodities, REITs, developed international, and emerging markets as part of the overall plan.  In this AA plan, Brazil and Malaysia will be included in the emerging market asset class.  In future AA plans, there will be some adjustments in emerging markets as we do not want to overweight that class.

For more information on Asset Allocation, move over to the right-hand edge of the page and under Categories, click on Asset Allocation (AA).  This is such an important concept in investing, one should read as much as possible on the research surrounding AA.

Lowell Herr

Photograph:  Amsterdam, The Netherlands

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Over on the Premium Content side of this blog, I provide analysis and information on several active portfolios.  One such portfolio is the Passive Portfolio (PP), in operation for eight years.  In the following “movie” you will see the ETFs used to populate this portfolio and the target percentages for each asset class.

When this portfolio was launched back on 11/30/2000, analytical tools were not available for the small investor.  At least none that I could afford.  With help from QPP, I now realize the PP is anything but a well diversified portfolio.  Even though the investments are spread all over the world, the diversification metric (DM) is only 9%.  We prefer to see this value over 40% and higher.

The analysis indicates the portfolio should outperform the S&P 500 by approximately 2% annually.  This is what has happened over the last eight years as the IRR for the PP is -0.6% while the VTSMX benchmark lagged at -2.6%.  Outperforming the S&P 500 by two percentage points over eight years is to be commended.  All the transaction details for PP are available on a SS if one is a Premium member.

How to increase diversification, increase projected return, and reduce projected risk is the work for a portfolio contractor.  That is what we are trying to design with the seven active portfolios.

Lowell Herr

Photograph:  Amsterdam, The Netherlands - typical canal scene

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Investors with cash available after tax selling are now looking for ways to put that cash to use.  Link to this “movie” to view one example of how an investor might restructure their portfolio.

Even if this is not a market bottom, long-term investors need to rethink the asset allocation of their portfolios.  The model shown in the “movie” is one of several portfolios tracked within Premium Content.  Currently, this particularly portfolio carries over 50% in cash and that is one reason for laying out a plan for future investments.

This morning, VOE and VNQ were added to this portfolio.  Additional limit orders are placed for different asset classes.

Lowell Herr

Photograph:  Halloween in Bratislava, Slovakia

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One of several portfolio tracked over on the Premium Content side of the blog is one we title, Passive Portfolio or PP for short.  This portfolio has operated since December 2000.  As of November 28, 2008, PP dipped into negative territory for the first time as measured by month end statements.  The IRR was -0.23% while the VTSMX benchmark for the same period was -3.61%.  The past three months ripped up this portfolio.  The Return/Risk ratio was still a remarkable 0.73.  As you will recall, any value over zero is commendable.  The 0.73 value is an excellent number and is due to the portfolio outperforming the benchmark with relatively low risk.

The details of this portfolio are contained in the PP.xls spreadsheet available through links provided on the Premium side of the blog.  The portfolio is constructed using ETFs from Barclay.  When PP was first started, Vanguard did not offer ETFs.  Over time we picked up a few of Vanguard’s offerings, but the timing has been anything but stellar.

Lowell Herr

Photograph: Bratislava, Slovakia

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In this “movie” I divided the portfolio into eleven different asset classes.  The reason for using only eleven is to match the same number of sectors used in the prior post. Note that the projected annual return increased, the standard deviation decreased, and the diversification metric increased. When the portfolio is diversified across asset classes rather than sectors, all three important metrics move in the preferred direction.

Another important lesson to take home is that one can improve on each of these portfolios by not investing equal amounts in each ETF.  Using the Quantext Portfolio Planning software, one can make tactical moves so as to increase projected return while reducing risk.  These tactical asset allocation decisions will be shown over the next few weeks in Premium Content.

Lowell Herr

Photograph: View of the Rhine River from atop the Marksburg Castle.  As one can see, it was a dreary day.

Asset Allocation refers to the diversification or the allocation of investments within a portfolio across asset classes or market sectors.  I favor diversification across a minimum of 10 asset classes vs. using market sectors as I think it provides for superior diversification.  For example, one could allocate various percentages of their assets to each of the following asset classes: Large-Cap Growth, Mid-Cap Growth, Small-Cap Growth, Large-Cap Value, Mid-Cap Value, Small-Cap Value, REITs, International (developed) Markets, Emerging Markets, Bonds, Commodities, etc.  Academic studies show that, on average, over 90 percent of the variability of a portfolio’s performance over time is solely attributable to the portfolio’s asset allocation.  This comes out of the Brinson et. al. papers.  That material has been moved over to the Premium Content side of this blog.  Further, on average about 100% of the level of a portfolio’s total return is due to asset allocation.  These results come from the Ibbotson & Kaplan research.  Different research papers answer different questions. Therefore, the asset allocation decision is by far the most important in the financial planning process and it should be the first plank in your portfolio construction plan.  Here at ITA Wealth Management, we consider asset allocation to be fundamental in the investing process.

Lowell Herr

Photograph:  Image is found just above the entrance to the Benedictine Abbey at Melk, Germany

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For long-term investors, now is a good time to check the asset allocation mix of your portfolio.  If you have five to ten years to go before you need any of your investments, stick with your plan.  Continue to save as much as you can as early as you can.  Save on a weekly or monthly basis rather than investing a chunk once a year.  In other words, save from every paycheck.

Check to see if your asset class percentages are within the target limits.  If not, begin to add to the asset classes that are below target by the greatest percentage.  This is an excellent practice for those adding to the portfolio on a regular basis.

There are situations when it is time to change the asset allocation plan.

• Has your aversion to risk changed?  Is your risk tolerance not as high as you imagined?  If so, you may want to move some assets into more conservative vehicles.  Here is a first approach.  Go back and retake the Risk Capacity survey on the IFA web site.  You may find your risk number is lower now that we are in a bear market.
• Will you need living money within the next five years?  If so, you may want to readjust the asset allocation of the portfolio.
• Using the Quantext Portfolio Planner, you find that you will not need all the money you have saved.  For those who have yet to use QPP, there is a section of the program that takes your assumptions and runs a projection of how long your money will last.  Given this information, you may wish to alter your asset allocation.  The QPP is a great aid in helping with this future planning.

This has definitely been a severe bear market so investors may not have as much stomach for risk as they thought they had when the market was rising. Don’t be too quick to change your asset allocations.  In other words, don’t “go conservative” unless you have good reasons for doing so.

Photograph:  Lighthouse on Kauai, Hawaii

I am investigating software that will aid in the development of portfolio asset allocation, reduction of risk, and give some insight into what asset classes to emphasize in the coming year.  Look for more information beginning sometime around the middle of November.  There is a high probability a new portfolio will be launched using these additional asset allocation tools. Specific details will be made available to Premium Content subscribers.

I just finished building a spreadsheet using the asset allocation targets of the Passive Portfolio.  The projected return is 11.8% with a standard deviation of 8.75%.  The S & P 500 is projected to return 8.3% with a standard deviation of 15%.  While I don’t expect to see anything close to an 11.8% return next year, I do like the fact that the SD is lower than the S & P 500 due to broad diversification.

Lowell Herr

Photograph: Venice, Italy

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Do you have the stomach to stay with equity investments or are you fleeing to CD’s, treasury bills, or cash?  For those who do not need the money over the next three to five years, I recommend sticking with your asset allocation plan. Take dividends and other available cash and begin to shore up asset classes that are under target.  I would not be in a hurry to do this as the broad market is likely to be in a “funk” for another year.  Examine the StockCharts for asset classes of interest and carefully pick your buy-in points.

The current “rescue” plan does not adequately do the job.  One economist I respect said the bill that was voted down in the House was superior to the bill passed in the Senate.  One can only hope that additional spending measures will be placed on the back burner until the financial conditions of the country are turned in another direction.

The various portfolios are being upgraded over on Premium Content.  The youngest portfolio, Scrappy, was the latest to be updated and it is outperforming the VTSMX benchmark by over 40%.  We do not pay much attention to these numbers other than to look for trends.  Keep in mind that the younger the portfolio the more the Internal Rate of Return numbers will change from day to day.

The AA-Mosaic and Mosaic2 are also current so take a look at those spreadsheets.  Thus far, only the Mosaic2 portfolio is lagging the VTSMX benchmark.

Lowell Herr

Photograph: Shanghai, China

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The oldest portfolio built around asset allocation continues to perform much better than the VTSMX benchmark.  As of 9/26/08, the Passive Portfolio (PP) has an IRR of 5.1% over the past seven plus years.  During that same period, the VTSMX benchmark has a positive IRR value of 1.9%.  Keep in mind that this period spans one of the worst bear markets in history and the recover has been modest at best.

All the details for the PP are available to Premium Content clients.  One can download the portfolio and view all the transactions since 12/01/2000.

Lowell Herr

Photograph:  What is better than a cup of coffee in the woods in Central Oregon?

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