September 11, 2012
The Death of a Nobel Prize Winning Idea
The Investment View from Prescott, Arizona
The Modern Portfolio Theory (MPT) was first proposed in 1960 and was awarded the Nobel Prize for Economics in 1990. MPT is also the foundation of Certified Financial Planner (CFP) studies and testing. I know because I held the CFP designation for a dozen years.
One of the reasons I gave up being a CFP is that the CFP Board of Standards had their head in the sand and refused to pull it out. I believe that investment strategies that recognize rather than ignore the realities of the marketplace should be given consideration in the financial planning process. They should be viewed as another form of diversification along with allocations to stocks, bond, commodities, etc. This point of view is in sharp contrast to the CFP Board.
In 2002 I wrote them a letter objecting to the fact that only 3 of 1850 topics in their approved curriculum were remotely related to active management of investments. Their polite reply was “We think 3 are sufficient.”
These days I am getting some heavy weight validation of my position, a recent one from Arun Muralidhar. He is the former head of investment research for the World Bank, a former managing director at J.P. Morgan Investment Management and the head of AlphaEngine Global Investment Solutions LLC, a company he started. An economist trained at the Sloan School of Management at the Massachusetts Institute of Technology, Mr. Muralidhar has the credibility to make you take notice when he says something. He argues that Modern Portfolio Theory is doing a disservice to investors.
“The foundation of the MPT investing model is to construct an optimal portfolio based on the investor’s objectives. As the market moves, the portfolio allocations are re-balanced to get it back to its optimal state. For example, a portfolio with 60% stocks and 40% bonds will become over-weighted in stocks if stock prices increase. To prevent drift away from the target allocations, the adviser re-balances by selling stocks and investing the proceeds in more bonds.
The benefit of this process is that it’s simple, transparent and easy to execute. However, a static re-balancing process does not work well. It’s like tying the rudder on your ship in place and ignoring the winds and currents that you experience, Mr. Muralidhar said.
The solution is for advisers to focus on using optimal investment strategies rather than maintaining fixed portfolios, he said. These strategies involve managing allocations more actively, based on market conditions. (Exactly what we do at Hepburn Capital)
People say this sounds like market timing. But the fact is that doing nothing is market timing and being in cash is market timing, Mr. Muralidhar said. You have two choices — either be intelligent about market timing, or don’t be.
And don’t expect the principles of Modern Portfolio Theory to save you.”
Give a person a fish and you feed them for a day.
Teach a person to use the Internet and they won’t bother you
for weeks, months, maybe years.
Mark Your Calendar
I have been asked to once again teach Advanced Investment Analysis at Yavapai College this semester. I first began teaching at Yavapai in 1990, and really enjoy it.
In the class we will be discussing how to use charts and graphs to analyze investments. The class will be held from 1-4 p.m. on the following two Thursdays, October 4th and 11th. This class is a fun way to introduce your friends to my work, so consider inviting a friend or two and make this a social occasion as well as an educational one.
Call the college at 717-7755 to register for class #FA12-127 and get the classroom number. Tuition, payable to Yavapai College, is $65.
A Slice of Life
Have you noticed a drop in the email Viagra and Cialis ads? There is good news on the spam front. Internet hardware giant Cisco Systems reported a 75% drop in spam over the past year.
The drop is attributed to the shutting down of internet drug sellers in Russia and Armenia who would pay commissions to anyone who could generate an order, a process that spawned a worldwide army of independent spammers.
The next big challenge is for anti-virus companies to figure out the many “botnet”, short for robot network, operations that have infected millions of computers which then produce spam after a remote command and sometimes even automatically.
If you have ever received a funny looking email from someone you know with a link to a website that you did not recognize, this is a favorite technique for spammers to insert programming that can take control of your computer – a virus.
Ways to protect yourself from this type of malware include:
1. Never ever click on a link sent to by someone you don’t recognize.
2. Don’t open emails from friends with no subject or text and only a link. Their address book has probably been hacked. If you want to be sure, simply email the friend back and ask “is this legit?”
3. Keep your Windows operating system updated.
4. Use anti-virus software and keep it updated, too.
Then cross your fingers.
How’s the Market Doing?
The stock market flattened out toward the end of August, as a confluence of forces descended upon it. Late August is notorious for final vacations before school starts and institutional traders, the ones that move markets, are real people needing vacations, too. So trading often slows down at that time of year.
The other influence is one I mentioned in my last two newsletters and that was the overhead resistance stock prices find at earlier highs. Because the stock market was approaching the high point it enjoyed in early April, the stock market was struggling as people who had bought near the previous high could finally sell without taking a loss. This is a normal process and one that can be expected to generate a wave of selling which will hold back prices, and it did.
Until Thursday, that is, when we had one of the bigger up days of the year, finally breaking through the overhead resistance which for the S&P 500 Index** was at 1419. With that hurdle out of the way, perhaps the market can continue its recent run-up. The breakout was a good sign.
Economically we are getting mixed signals, with shipping and key manufacturing indicators slipping while the real estate industry is finally showing signs of life.
And China may bring the next big round of problems as manufacturing slows due to weak markets in Europe and here, and as the Chinese real estate bubble deflates in a big way. The Chinese stock market has been going down for almost two years, and is now back to 2007 levels. Stocks are a leading economic indicator, and Chinese stocks did not participate in this summer’s stock rally, so no economic upturn is in the works yet over there. China announced a $150 billion economic stimulus plan last week, so they are clearly fighting a slump, too.
If you think it is interesting watching US authorities deal with a few hundred Occupy Wall Streeters, think how much heart burn the Chinese government will be having dealing with millions of unemployed peasants facing rising food prices.
“May you live in interesting times”, says the Chinese curse.
Will is going to be in Scottsdale on Thursday, September 20th. If you would like to meet with him, please call the office for an appointment. (928) 778-4000
What’s Going On In Your Portfolio?
We seemed to have turned a corner after making some strategy changes in mid-August that have us back in tune with the markets and once again making money.
Both of my main strategies seemed to deviate from their successful long term track records last year about the time the government began the latest economic stimulus plan, called Operation Twist. I’m guessing that whenever things would get bad in the financial markets, a time in which I normally would move to cash or buy a hedging investment – one that went up when the markets went down – the Fed would throw a few more buckets of money into the economy, turning around the financial markets and making our move unprofitable.
We don’t have to fully understand why something is happening, only that it is happening so we can react to it. This is one of those times.
Our Growth strategy* is fully invested, primarily in retail, biotech and real estate – using individual stocks in larger accounts and mutual funds in smaller accounts. This combination has been outperforming the major indexes most of the time on both good days and bad, which is what we are after. Your patience with this portfolio is paying off.
August was also a turnaround month for Flexible Income* portfolios with a small gain being recorded. All investments owned in Flex Income* accounts are showing profits as of this writing on September 9th, and in addition they all throw off nice dividends.
Our Floating Rate bond funds and high yield municipal funds have been held since late last year and continue to perform well. Newer holdings in high yield bond funds and total return bond funds are providing stable to rising share prices plus dividends averaging almost 5%.
With both Growth* and Income* strategies doing well, Adaptive Growth* and Adaptive Balance* strategies, blends of the two are also doing well.
Our Municipal Income* strategy continues to be the best performer for the year, and is one reason why we have a good chunk of munis in our Flexible Income* strategy.
Geography for Retirees
I occasionally provide content for Kiplinger’s magazine, and this item is from their website, www.kiplinger.com
Our Spotlight Strategy
With our Flexible Income Strategy we strive to provide high total return consistent with Capital Preservation.
Your money will be invested in bond or currency funds, including precious metals that may be used as currencies and equity-income investments whose price trend is up. If the price cycles down, holdings are replaced with new investments that are going up. Repeat as needed. Growth stocks are not used. For more information please click: [Flexible Income]
If you would like a current copy of our SEC Form ADV, Part 2, it is on our website at hepburncapital.com/form-adv.html
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable; however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.