It's All About Risk!

[Mysto]

Hi - I'm new here and I am curious about efforts to better control risk in portfolios.

I was "lucky" to have a windfall in 1999 - Not being too sophisticated on stocks I invested and then watched as the market crashed and burned. I knew to "ride it out" and I held on for 2001 and 2002. Finally with my accounts decimated I withdrew and of course missed all the upside.

Now I am getting ready to retire ( a little early) and I have been doing my home work. I agree with asset allocation models and MPT to a large extent. I found a great portfolio model in the book "Work Less, Live More" by Bob Clyatt. His model shows a 9.5 % return and during the "bad years" barely saw a ripple. So I took some Vanguard fund examples - plugged them in and tried it. My portfolio took a bath (historically). Is his portfolio wrong? Does anyone have some example models with low risk that should earn better than a CD or am I just searching for the holy grail? (looking for 7-8% and a calm stomach)

 

[Nords]

Does anyone have some example models with low risk that should earn better than a CD or am I just searching for the holy grail? (looking for 7-8% and a calm stomach)

Welcome to the board, Mysto.

When most people say "risk", they mean "volatility." But there's also the risk of being concentrated too much in a single stock, holding too much in a single sector, of not diversifying across different types of assets, of not beating inflation, and of having to withdraw from a portfolio before it recovers. If you focus on eliminating volatility, one of the other risks is going to sneak up and bite you right in the assets.

Take a look in the back of William Berstein's "The Four Pillars of Investing". The front discusses the risk(volatility)/reward curve and asset allocation, while the back presents different portfolios for different investor's needs & temperaments.

 

[Mysto]

Thanks for the welcome. It already seems like I know many of you after reading so many past posts.

Of course you are right. I am talking about volatility. (Actually my real concern is DR - Can't find any models on this) My real problem is two fold.

First - I'm looking for models that have gone a little further in trying to add non-correlation to the mix in an attempt to limit the DR. Bob Clyatt's portfolio included assets not normally part of most models.

Secondly - I'm finding that most of the model's results they get through their back testing will not hold up to reality. I can't invest in actual indexs (or is it indices) When I try out real funds I usually find that the volatility is greater and the results often worse than the models.

I'm just wondering if there are any models that try to work on DR and if there are some models with results based on real funds that have better risk control (I am trying to avoid DFA as I really don't want the advisor add on)

Thanks for the book recommendation. I have read Intelligent Asset Allocator, I'll pick up Four Pillars today.

I know that all of this is a result of my getting killed in the market and the fact that I am considering increasing my exposure should give all of you pause. (Perhaps you should all short what ever I get into)
:

 

[unclemick]

What does DR stand for My brain isn't working this morning.

 

[Mysto]

Sorry - DR is downside risk. The argument is that investors don't care about volatility - Let it go up as much as it wants. What we really care about is when it goes negative. So attempts have been made in some modeling to apply DR theory - limit the downside risks while allowing the upside potential. In theory you should get greater returns and still get hurt less in down markets.

 

[brewer12345]

Mysto, I think that you are getting drowned in the sea of details. Backtesting any suggested portfolio is sensitive to exact replication of the suggested portfolio, the time period you look at it over, and accurately accounting for both fund distributions and rebalancing. For example, did you look at fund prices or total return? In some cases, distributions made a BIG difference in the Clyatt reference portfolio.

I would not get too hung up on all of this. What you need is a widely diversified portfolio with exposure to many asset classes. I think the Clyatt portfolio is a good starting point, although I think that A) it is improbably to get some of the exposures (VC?), and B) I have zero interest in dealing with a DFA "gatekeeper". If I were you, Iwould draw up a portfolio allocation that included as many asset classes as feasible, nvest the money, and go enjoy life. If you insist on fretting about bad stuff happening, spend some money on cheap, out of the money index/ETF pus as a hedge in the first couple of years in retirement. Chances are, it'll be wasted money, but if that is the cost of sleeping at night, it may offer you a good value.

 

[ERD50]

In theory you should get greater returns and still get hurt less in down markets.

Mysto - I think you will have a hard time realizing this. In general, if you take steps to limit your downside risk, it is done at a cost to your upside. That might be appropriate for many of us.

But to expect to get greater upside and less downside is the Holy Grail - let us know if you find it.


That said, I've actually been doing pretty well with some of my portfolio in covered calls and/or selling cash covered puts (basically the same thing). I've had above market returns with less volatility - but that is measured over the past 14 months - I have no idea if I can do it over a longer term, and it is a fair amount of work.

-ERD50

 

[Nords]

I have read Intelligent Asset Allocator.

Hunh, I'll be darned. Counting Bernstein and his editor, that makes four of us.

If you've read IAA then you don't need to read Four Pillars from the beginning. Your worst enemy right now is "paralysis by analysis". Skip to the part of Four Pillars that has the sample portfolios, pick one that you're comfortable with, implement it with low-cost funds like Vanguard, Fidelity indexes, or ETFs, and get on with your life.

Seriously, if we hadn't made our portfolio allocations after reading Four Pillars and before reading IAA, I'd be curled up in a fetal ball in the corner speed-dialing Alan Greenspan. My pessimistic demeanor would make Greg look like the love child of Jim Cramer & Abby Joseph Cohen.

You want 7-8% APY over the next 20 years, then stocks & diversification will get you there.

If you want 7-8% per annum with no downside, then I doubt it exists. We'd have to pay a lot of money to find an insurer for that annuity contract.

 

[Mysto]

Thanks to all for the replies.
I may have let my query drift a bit. How about this way - efficient markets or not - I do not believe that all passive portfolios have the same return at the same basic asset mix level. Using different types of vehicles (i.e. index funds - etfs) - variance from the real indices - operational costs - etc. all will effect the actual performance of a passive portfolio.

Sooooo (he says with hat in hand) any thoughts on better allocation models and actual funds or is the consensus that I should stick with those in Four Pillars and Vanguard as best I can.

BTW - I am sure that some of you are right. I can analize anything until it breaks ( I can prove I don't exist) and I said I read Intelligent Asset Allocator - I didn't say I understood it <g>

Again - thanks to all of you for a great board and helpful advice.

 

[Nords]

... or is the consensus that I should stick with those in Four Pillars and Vanguard as best I can.

Yup.

If that really bugs you, then set 10% of your portfolio aside in a separate brokerage account. Make sure you can sell short & trade options in it. Then get a copy of Nicolas Darvas' "How I Made $2M in the Stock Market" and run wild.

Whatever you do, don't just sit there until AFTER you've implemented your asset allocation. "If you choose not to decide, you still have made a choice." And it'll be a bad one.

 

[whitestick]

That said, I've actually been doing pretty well with some of my portfolio in covered calls and/or selling cash covered puts (basically the same thing). I've had above market returns with less volatility - but that is measured over the past 14 months - I have no idea if I can do it over a longer term, and it is a fair amount of work.

-ERD50

I have been enjoying the same type of results by essentially doing the same - covered calls and cash covered puts, and like you wondering if long term would produce the same. Sometimes the results have been so consistently good, and reading all the posts about asset allocations et.al. makes me wonder if I'm doing something wrong. At least I'm doing it with only a portion of my total assets, till I become more convinced of the consistency. Are you short terming your options - month by month or two months max, or do you go for the year or longer stretch?

 

[ERD50]

... At least I'm doing it with only a portion of my total assets, till I become more convinced of the consistency. Are you short terming your options - month by month or two months max, or do you go for the year or longer stretch?

whitestick - it's good to get some feedback on this, I don't see too much interest in the approach in general. Sounds like we're on the same page. I put ~ 40% of my portfolio into this method, and probably won't go much beyond that, but the results do tempt me to go a bit deeper. It's providing better gains and less volatility that anything else that I see out there - again, unknown if I can do it consistently, but so-far-so-good.

I diversify that across 10-12 stocks, and try to get no more than two in the same sector. One month contracts only (highest premium/time rate). For me, the real work is identifying the stocks to use. I try to find stocks with enough volatility to pay a 2%-4% premium and give me ~ 6%-10% downside protection for the month. I sell at a strike price ~ 5% below the stock price. But I also want to avoid stocks with earnings reports in that time frame or other known events that could drop the stock more than 10%. Sometimes, I think I should go ahead and include those stocks, that the higher premium, on average, should overcome the occasional large drop. But I fear that the likely volatility increase might make me feel uncomfortable.

So I spend hours scouring the tables. I'm using optionmonitor.com to do some sorting - they provide some nice screening tools w/o a 'get rich quick' hype approach.

I'd be interested in hearing the details of your approach.

-ERD50

 

[whitestick]

whitestick - it's good to get some feedback on this, I don't see too much interest in the approach in general. ...
So I spend hours scouring the tables. I'm using optionmonitor.com to do some sorting - they provide some nice screening tools w/o a 'get rich quick' hype approach.

I'd be interested in hearing the details of your approach.

-ERD50

Sorry, been away, or i would have responded earlier. I took the Kim Snider "the method" course, in which she describes a lot of the formulas and pick details that she has worked out to keep me from having to spend the hours of time scouring the tables. I plug in some parameters per her process in PowerOptions tool set, request the month I am interested in, and it provides me the top stock options meeting my criteria, which the ones that you describe could be factored in as well. I just pick the top ones, make my choices on OptionXpress, and go back to bora-bora for the rest of the month. That can be the hardest point, since we all like to tweak things - something about the testostorene influence I think. She talks about a consistent 14% to 16% annualized average with investment grade bond risk. I tweak for a bit higher risk, and get mid 30's to mid 40s %, so far at least.
I usually trade on month by month, and occasionally roll over to the next month, if I can pick up better income. I'm usually selling 1 strike over price for current month, depeding on what my costs are. That way, if the options expire worthless, I can do it all over again the next month, and not tie up all of the available money.
Does that sound like your activity?

 

[Cb]

Mysto, have a look at this site:

http://easyallocator.com/login.aspx?page=/calculator.aspx

I think it's a slick little tool, and allows you overweight all the recent favorite assett classes...

Cb

 

[Gone4Good]

I'm looking for models that have gone a little further in trying to add non-correlation to the mix in an attempt to limit the DR. 

I think a lot of us here are probably experiencing seriously diminishing returns as we try to add asset classes to improve diversification and limit DR.  I'd wager that many back tested models overstate the diversification benefits of various asset classes.  It is my belief that once asset classes are made easily accessible to the retail masses they will start trading similar to other retail investment products (i.e. historically non-correlated assets will become more highly correlated).  Diversification has its benefits . . . but it has its limits too.

An additional way of approaching "downside risk" is by managing both the size and flexibility of your withdrawal rate.  If you start with an initial WR of 3.5%, instead of 4%, your portfolio can suffer a 12.5% decline in value before your WR increases back to the suggested 4% "safe" range.  If your initial withdrawal rate also includes 10% spending that is highly discretionary, your portfolio can decline 21% before your withdrawals hit the 4% area.