Simple Pound

After I came across the model portfolio that was to become my “blueprint”, I ordered the book in which the author originally published this idea. The foreword of “All About Asset Allocation” was written by William Bernstein, himself author of “The Intelligent Asset Allocator” and I thought I’d share a short excerpt with you because it gives some valuable insights as to why asset allocation is so important.

“In the fall of 1929, Alfred Cowles III had an ordinary, if rather large, problem. Ordinary because, like many other Americans, he had been badly hurt by the recent stock market crash. And large because, not only was he the heir to the Chicago Tribune fortune, but he also managed it.

A highly intelligent young man, he took his charge seriously, consuming as much written analysis from the nation’s brokerage houses, insurance firms, and financial commentators as he could. Alas, it was in vain; none of them warned him of the impending crash. How could the country’s brightest financial stars have been so uniformly wrong?

Cowles’s response to the catastrophic stock market decline that wiped out nearly 90 percent of the stock market’s value over the next three years, and the Great Depression that it ignited, has thundered through the financial markets to this very day. Modern investors ignore the lessons learned by Cowles, and those who followed in his footsteps, at their own peril.

For what Cowles and his followers did was nothing less than remove finance from the realm of ignorance and superstition and place it on scientific footing. With the help of the nation’s foremost economists, he founded the Econometric Society, and along with the legendary Benjamin Graham, who had been similarly affected by the 1929 crash, he began to collect and analyze financial data in the most detailed and thoroughgoing way possible. In effect, he, and those who had followed him in the seven decades since, took investing away from the astrologers and the charlatans and gave it to the astronomers and physicists. (This is, in some cases, quite literally true: many of the finest minds of modern finance began their careers in the physical sciences.)

Unfortunately, when you pick up a financial magazine, watch CNBC, or call your broker, you’ve just traveled back to the pre-1929 era. In fact, you’ve just accomplished the financial equivalent of betting the farm on the daily horoscope or of taking a rare cancer to a doctor whose main source of recent medical knowledge is USA Today.

Like most intellectual revolutions, the modern science of investing is highly counterintuitive. Do you think that it is possible, through careful securities research, to reliably select market-beating portfolios? Wrong: the data show that although many investors do so, in almost all cases this is purely the result of the randomness of the markets - in simple terms, dumb luck. People have also gotten fabulously rich buying lottery tickets; they have also gotten off scot-free without ever wearing a seatbelt. That does not make either activity a good idea. Do you think that by choosing a portfolio of only a few stocks that you hope will score big, you are maximizing your chances of becoming wealthy? Indeed you are, but by doing so, you are also maximizing your chances of a retirement of cat food cuisine. And make no mistake about it: the object of this particular game is not to get rich - it’s to not get poor.

All About Asset Allocation will bring you back into the modern era with a comprehensive, yet readable exposition of how to apply to your investment portfolio what seven decades of financial research have taught us about investing.

Building an asset allocation is much like putting up a skyscraper. You will need blueprints - what asset classes to buy, which ones to skip, and how much of each to use. You will also need the construction materials - which building blocks to buy and who to buy them from. Rick Ferri provides you both of these, in spades.

Unfortunately, in building your financial skyscraper, there is one thing that neither Rick nor I nor any other financial expert can do for you, which is to provide you with the nerve to stick to those blueprints when you find yourself 30 stories up in the naked girders in a howling wind. But with All About Asset Allocation by your side, you’ll know that you’re executing a sound design, using the best materials, and wearing the best safety rope that money can buy.”

I can’t wait to start reading the book…

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After I talked about the principle of asset allocation the other day, I also promised to share what I think will work best for me in the future. This model portfolio was proposed by Richard Ferri, author of the book “All About Asset Allocation”. It is one of the two models he outlined for young investors and I am told that his book contains further examples for people in mid-life, early retirement and late retirement.

The “Early Saver” is based on a 70 : 30 distribution between stocks and bonds, which seems rather conservative for young people at first, but bonds in themselves aren’t necessarily only dull and boring.

Since the book is ultimately targeted at a US-American audience, the original classification reads “Total US Stock Market” instead of what I simply called “Domestic Stocks“, i.e. equities from companies within your country of residence - so in my case UK companies. This accounts for around 40% of the portfolio.

A further 20% is dedicated to “International Stocks“, which covers anything from China or India to the US or Australia, but also European equities (which don’t seem quite so international to me). And the final 10 percent of the stocks section is taken up by REITs, which are an American investment security that somehow replicate the property market. Since I am not aware of anything similar in the UK, and with the current state of the property market in which I don’t really want to get my fingers burnt, I will probably extend my international stocks section to 30%.

The remaining 30% of the model portfolio are taken up by intermediate term bonds, i.e. debt securities with a maturity of less than 10 years (but at least 1). This part of the portfolio will guarantee a regular income stream which - if re-invested - can build up significantly over time.

Up to here, there’s no real rocket science in the portfolio, but Ferri breaks it down further, and there lies the real reason of why I like this particular portfolio: diversity!

The breakdown of the stocks section is as follows (percentages are in terms of the whole portfolio - i.e. 25% means a quarter of all money invested as opposed to 25% of all money in stocks; notice how the following numbers add up to 70%, not 100%).

• Domestic mid- to large-cap stocks (25%): these are the “blue chips”, the established companies that don’t give you massive growth, but stability and regular dividends
• Domestic small-cap (10%): smaller companies with a market capitalisation of less than, say, 300 million; these companies - if well researched (!) - provide capital gains through a steady growth that mature stocks can’t provide
• Domestic micro-cap (5%): penny stocks - shares bought literally for a few pennies that can give you phenomenal growth, but are also rather risky
• Property (10%): as explained earlier, I will probably put these 10% towards European stocks or any specialist sector that might be under-represented in the portfolio
• Pacific stocks (5%): corporations that have their country of origin in the Asia-Pacific regions, e.g. Japan, Taiwan or Korea
• European stocks (5%): since I feel I know a fair amount about European (especially German) companies I will probably end up investing more than 5% in European equity
• International small-cap (5%): companies with a low market capitalisation outside the UK
• Emerging Markets (5%): this is a particular exiting market sector, covering economies that are just at the brink of becoming (fully) industrialised and whose companies therefore show excellent growth potential (remember the Indian stock index!?!)

And finally, a more precise break-down of the bonds section of the portfolio that shows that bonds don’t necessarily have to be all old-school and boring, but can bear some pretty substantial risk and thus returns

10% of the portfolio is tied up in high yield bonds, which are also called junk bonds because the companies generally have a low(er) credit rating and thus have to pay higher premiums in order to get loans. A further 10% (or a third of the bonds section) is categorised as intermediate term bonds, which is a fairly general classification as this section only needs to fulfill the maturity requirements (i.e. more than a year but less than 10 years maturity). These will generally pay a lower coupon rate than the junk bonds, but also have a lower risk of defaulting and are thus part of the “safe haven” of the portfolio.

The final 10% in the model portfolio is broken down into 5% for emerging market bonds and 5% into inflation-linked bonds. Here we essentially have two extremes in that the emerging market bonds are clearly the most risky of debt securities to rely on (and thus yield the highest returns) while inflation-linked bonds pay a premium that is only marginally higher than the current rate of inflation. Here the goal is clearly capital preservation.

So this is how the overall portfolio would look:

If you can’t get enough of asset allocation and model portfolios I suggest you start reading here and move on to here.

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While we are all eagerly waiting for some progress in the Brennan vs NatWest case, a first court order filed in Birmingham established the lawfulness of overdraft fees.

The claimant was suing his bank Lloyds TSB over £2,545 of unauthorised overdraft fees, which he claimed were illegal contractual penalties. The judge concluded:

“Having held that the charges complained of are not charges for breach of contract but part of the price of the services provided by the bank…he has not satisfied me that he has any ground in law for recovering from the bank the amount of any charges which he has paid to it.”

Even though this ruling comes from a District Court and is thus not binding on any other court, it might adversely affect the number of bank charges claims that are successfully settled before the first hearing.

Read the BBC story here.

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Along with diversification, asset allocation is probably one of the topics that gets an investor talking for a looong time. In simple terms, asset allocation is the brains behind diversification in that it examines how to diversify your portfolio to get the best (overall) return given your attitude to risk. It is based on modern portfolio theory and certainly seems to require a lot of Maths to come up with the following, relatively simple graph:

Even though I do find this quite interesting, none of the mathematical background is required to find a diversification method that suits your needs. In fact, there is no such thing as an ideal way of arranging your portfolio, because it all depends on your individual circumstances, your goals and your age. While young, you can stomach a high percentage of stocks because you have plenty of time to sit out a dip in the market, while someone who has 3 years left till retirement should really opt for a safer portfolio with a higher percentage of bonds…

You can find plenty of sample portfolios on the web (and in books…) which are adjusted towards different risk attitudes. Especially if you don’t have much experience, these models are a good way of starting out and can be adjusted over time as you learn and gain more familiarity with the different options available.

Generally, investors can be classified as conservative, moderately conservative, defensive, balanced, moderately aggressive and aggressive with the proportion of stocks (vs. bonds) increasing as you go along. There is no test to determine which group you belong to, but it is something you need to find out for yourself. Read here to get a brief overview of each category together with a sample portfolio (which may or may not work for you, but should give you a reasonably good idea of the proportions involved).

I have been shopping around a little myself and the portfolio that looks most attractive to me is taken from the book “All about Asset Allocation” by Richard Ferri. So far I’ve only read a summary online, but I’m contemplating to get the book myself - not only to read more about the model portfolio but also to extend my knowledge of the different asset classes.

More about Ferri’s portfolio for young investors soon…

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How much money do you spend a year on books? That figure should exclude any academic textbooks you might require as a student, but with the average paperback novel priced between £7 and £10 it is probably still a respectable amount - at least if you find the time to read regularly.

As I’m slowly getting ready to move to London in June, I have started a massive de-cluttering project, simply to reduce the number of boxes I will have to carry. I have looked at every single CD, DVD and book in my room and asked myself whether I will really need it. Quite unsurprisingly it wasn’t very difficult to discard all of my textbooks from last year as well as the majority of the remaining Computer Science textbooks in my shelf. The only academic textbooks I’m keeping are those that might prove useful at work.

What I’ve discovered in the process is that I had about 10 novels in my shelf that wouldn’t even sell for £0.01 on Amazon anymore - despite being in excellent condition! That’s when “Read it - Swap it” came back to mind, which is a website I had come across during the time I was revising for exams and against my usual inclination for any sort of procrastination I left it till later to explore it further.

So what is it? The website basically acts as a market place where people can swap their old books against other people’s old books. In order to participate you must sign-up and list all the books you’d be willing to swap with someone else. Anyone interested in one of your books can offer you a “swap”. When that happens, you will get an email with a link to the other person’s book list and if you come across something that might interest you, you can agree to swap (there is no obligation to…). Once a swap is agreed, both parties post the book to the other’s address and you get to read a new book while simultaneously getting rid of extra clutter in your home!

Signing up is free and all you pay for the “new” book is the postage of your “old” book, but since your swapping partner is doing the same, you’re essentially even. The library currently contains well over 100,000 books and if everyone spreads the word this number can be increased even further (*hint*)! I have certainly added all my books and within less than 24 hours had already 2 people interested in them (even though I didn’t particularly like theirs…).

Go and check it out yourself!

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J.D. @ Get Rich Slowly stumbled upon a video produced by Coronet Instructional Films in 1948, which introduces its audience to the concepts of budgeting and saving for larger purchases.

It takes about 10 minutes to watch, but it’s quite funny and certainly worth the time…

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