What is Financial Portfolio “DI-WORSIFICATION”

Versus Di-Versification

BUSINESS MANAGEMENT: The term “diworsification” was coined by legendary investor Peter Lynch in his book, One up on Wall Street, to describe the over-expansion of a company into new growth projects and businesses they do not fully understand and which do not align with the company’s core competencies.

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PORTFOLIO MANAGEMENT: The term diworsification has since grown to also refer to over-diversifying an investment portfolio in such a way that it reduces the overall risk-return characteristics.

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RELATED: https://medicalexecutivepost.com/2021/05/29/modern-portfolio-theory-and-asset-correlation-not-allocation/

MORE: https://medicalexecutivepost.com/2014/11/12/the-negative-short-term-implications-of-diversification/

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PODCAST: Why Bitcoin is a “Once-in-a-Species” Asset Class

In this episode, DWealthMuse host, Dara Albright, and guest Jeff Ross, CIO of Vailshire Capital Management, discuss why bitcoin may just be that once-in-a-species asset class that saves the planet from economic and, yes, even environmental ruin.

This episode is loaded with so many great insights including:

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  • Why Jeff believes bitcoin’s investment risk has evaporated;
  • How bitcoin fits into Warren Buffet’s investment thesis;
  • Two characteristics bitcoin skeptics share: a lack of understanding and deep ties to the traditional banking system;
  • Why bitcoin is a dishonest politician’s worst nightmare;
  • Why every modern retirement portfolio should have bitcoin exposure;
  • Why regulatory scrutiny may be turning away from bitcoin and heading straight towards ethereum and altcoins;
  • How bitcoin could solve the world’s energy problems;
  • Why we may be nearing the end of the Keynesian economic experiment;
  • How bitcoin forces an honest unit of accounting by governments;
  • Why fiat is destined to self-destruct while bitcoin is designed to appreciate in time;
  • Whether bitcoin can reach a new all-time high by Jeff’s August 29th birthday and cross 100,000 by Dara’s December 24th birthday?

PODCAST: https://dwealthmuse.podbean.com/e/episode25bitcoinbulls/

Your comments are appreciated.

THANK YOU

****

Modern Portfolio Theory and Asset Allocation [Not Correlation]

THE CORRELATION HOT TOPIC

ACADEMIC C.V. | DAVID EDWARD MARCINKO

By Dr. David Edward Marcinko MBA CMP©

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Modern Portfolio Theory approaches investing by examining the complete market and the full economy. MPT places a great emphasis on the correlation between investments. 

DEFINITION:

Correlation is a measure of how frequently one event tends to happen when another event happens. High positive correlation means two events usually happen together – high SAT scores and getting through college for instance. High negative correlation means two events tend not to happen together – high SATs and a poor grade record.

No correlation means the two events are independent of one another. In statistical terms two events that are perfectly correlated have a “correlation coefficient” of 1; two events that are perfectly negatively correlated have a correlation coefficient of -1; and two events that have zero correlation have a coefficient of 0.

Correlation has been used over the past twenty years by institutions and financial advisors to assemble portfolios of moderate risk.  In calculating correlation, a statistician would examine the possibility of two events happening together, namely:

  • If the probability of A happening is 1/X;
  • And the probability of B happening is 1/Y; then
  • The probability of A and B happening together is (1/X) times (1/Y), or 1/(X times Y).

There are several laws of correlation including;

  1. Combining assets with a perfect positive correlation offers no reduction in portfolio risk.  These two assets will simply move in tandem with each other.
  2. Combining assets with zero correlation (statistically independent) reduces the risk of the portfolio.  If more assets with uncorrelated returns are added to the portfolio, significant risk reduction can be achieved.
  3. Combing assets with a perfect negative correlation could eliminate risk entirely.   This is the principle with “hedging strategies”.  These strategies are discussed later in the book.

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BUT – CORRELATION IS NOT CAUSATION

https://medicalexecutivepost.com/2021/02/05/correlation-is-not-causation/

In the real world, negative correlations are very rare 

Most assets maintain a positive correlation with each other.  The goal of a prudent investor is to assemble a portfolio that contains uncorrelated assets.  When a portfolio contains assets that possess low correlations, the upward movement of one asset class will help offset the downward movement of another.  This is especially important when economic and market conditions change.

As a result, including assets in your portfolio that are not highly correlated will reduce the overall volatility (as measured by standard deviation) and may also increase long-term investment returns. This is the primary argument for including dissimilar asset classes in your portfolio. Keep in mind that this type of diversification does not guarantee you will avoid a loss.  It simply minimizes the chance of loss. 

In the table provided by Ibbotson, the average correlation between the five major asset classes is displayed. The lowest correlation is between the U.S. Treasury Bonds and the EAFE (international stocks).  The highest correlation is between the S&P 500 and the EAFE; 0.77 or 77 percent. This signifies a prominent level of correlation that has grown even larger during this decade.   Low correlations within the table appear most with U.S. Treasury Bills.

Historical Correlation of Asset Classes

Benchmark                             1          2          3         4         5         6            

1 U.S. Treasury Bill                  1.00    

2 U.S. Bonds                          0.73     1.00    

3 S&P 500                               0.03     0.34     1.00    

4 Commodities                         0.15     0.04     0.08      1.00      

5 International Stocks              -0.13    -0.31    0.77      0.14    1.00       

6 Real Estate                           0.11      0.43    0.81     -0.02    0.66     1.00

Table Source: Ibbotson 1980-2012

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Are Financial Asset Classes like a Box of Valentine Chocolates in 2021?

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On Valentine’s Day Diversification

By Rick Kahler MS CFP® ChFC CCIM  www.KahlerFinancial.com

Rick Kahler CFPWith displays of Valentine candy in every store, February is the perfect time to talk about chocolate. A creative financial planner might even steal Forrest Gump’s analogy and say, “Diversification is like a box of chocolates.”

Except that it isn’t.

True, a box of chocolates might have a lot of variety. Cream centers. Caramels. Nougats. Nuts. Dark chocolate. Milk chocolate. Truffles. Yet it’s all still chocolate.

Retirement Savings

Buying that box would be like investing your retirement savings in a variety of US stocks. Even if you had a dozen different companies, they would all be the same basic category of investment, or asset class.

For example, suppose you gave your true love a slightly more diversified Valentine gift made up of chocolates, Girl Scout cookies, baklava, and apple pie. That would compare to investing in different types of stocks like US, international, or emerging markets. But, everything would still be dessert.

Wiser Physician-Investors

You would be a wiser doctor-investor if you took your true love out for dinner and had a meat course, a salad, vegetables, bread, dessert, and wine. Now you’d start to see real diversification.

In addition to US, international, and emerging market stocks (all dessert), you might have some other asset classes like US and international bonds (meat), real estate (bread), cash (salad), commodities (veggies), and absolute return strategies (wine).

***

box

***

Long Term Growth Generator

This kind of asset class diversification is the best investment strategy for long-term growth. My preference is eight or nine different classes. For many clients, I recommend a mix of US and international stocks and bonds, real estate investment trusts, a commodities index fund, market neutral funds like merger arbitrage and managed futures, junk bonds, and Treasury Inflation Protected Securities (TIPS).

Market Fluctuations

Fluctuations in the market will tend to affect the various securities within a given asset class in the same way. Most US stocks, for example, would generally move up or down at the same times. So, owning shares of several different stocks wouldn’t protect you against changes in the market. When a portfolio is well-diversified, the volatility is reduced even during times when the markets are moving strongly up or down.

When I talk about investing in a variety of asset classes, I don’t mean owning stocks, real estate, gold, or other assets directly. For individual investors, mutual funds are a much better choice. Occasionally, someone will ask me, “But why should I have everything in mutual funds? That isn’t diversified, is it?”

Mutual Funds

Mutual funds are not an asset class. A mutual fund isn’t like a type of food; it’s like the plate you put the food on. A single plate might hold one food item or servings from several different food groups. More specifically, mutual funds are pools of money invested by managers. One fund might invest in real estate investment trusts (REITS). Another might have international stocks chosen for their high returns. Still others invest in a diversified mix of asset classes. The mutual fund is just the container that holds the investments.

heart[Courtesy GE Healthcare]

Annuities

Annuities and IRAs aren’t asset classes, either, but are also examples of different types of containers that hold investments. If you use your IRA to purchase an annuity, all you’re doing is stacking one plate on top of another. It doesn’t give you another asset class, it just costs you more for the second plate.

Assessment

Having a box of chocolates for dinner might seem more appealing in the short term than eating a balanced meal. Investing in the “get-rich-now” flavor of the month might seem tempting, too. Yet in the long run, asset class diversification is the best way to make sure you have a healthy investment diet.

***

February 14th, 2021

***

Conclusion

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***

  Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners(TM)* 8

Should a diversified investment portfolio produce the same return as US stocks?

 On unrealistic expectations

By Rick Kahler CFP®

I have a complaint. The pot pie at one of my favorite restaurants doesn’t taste like a pot roast. I keep complaining, but nothing changes. I am thinking I may need to find a new restaurant because their cooking skills are just not living up to my expectations.

Or maybe I need to adjust my expectations. How can I expect a pot pie—a savory pastry with a mixture of potatoes, vegetables, and beef chunks—to taste like a beef pot roast? Even though beef is an ingredient in a pot pie, no reasonable diner would expect the two meals to taste the same.

Investing

But, that same reasonable diner might be perfectly comfortable expecting that their diversified investment portfolio should produce the same return as US stocks. This is just as unrealistic as it is to expect pot pie and pot roast to produce the same taste.

A diversified portfolio has a variety of investments in it, just as a pot pie has a variety of ingredients in it. A pot pie provides a complete meal with a nice balance of grain, veggies, and protein with a tasty blend of spices. A pot roast provides just one component of a balanced meal, a heavy dose of protein.

Likewise, a diversified portfolio is a meal in itself. A particular recipe that I like has the equivalent of a flour crust made of high quality bonds, high yield bonds, and Treasury Inflation Protected Securities. Stuffed inside is a delicious blend of real estate investment trusts, international stocks, US stocks, emerging market stocks, commodities, all flavored with managed futures, a long/short fund, and a put/write investment strategy.

The flavor of the diversified portfolio is completely different from an investment of just US stocks. Yet investors regularly try to compare the two.

EXAMPLE:

A few months ago, a reader wanted to know why her small account with a well-known brokerage house was doing three times better than her IRA managed by a fee-only advisor. She was thinking she should put all her IRA money with the brokerage firm.

Following up revealed the ingredients in her IRA: 30% was in a global mix of 1,100 high quality bonds, 300 high yield bonds, and 20 TIPS. The remaining 70% was in a global mix of 12,000 US, international and emerging market companies of all sizes, 300 real estate investment trusts, 21 commodities, a long/short fund with hundreds of positions, and a smattering of other investment strategies.

The small brokerage account had just one ingredient: 31 large US stocks.

Over the previous 15 months, the globally diversified portfolio had returned 9% and the 31 US stocks had returned 21%. Of course, the US stocks in her diversified portfolio had also returned 21%, but just like the chunks of beef in a pot pie, they only made up part of the mix, in this case 17%. So, comparing the diversified pot pie of her IRA return to the single-ingredient pot roast of her brokerage account was not valid.

Over the past nine years nothing has done better among major asset classes than US stocks. Any diversified portfolio will have underperformed them. That phenomenon will inevitably end. The time will come, sooner or later, when US stocks will be one of the worst performers of the decade.

***

***

Assessment

Just as a diversified portfolio will often garner smaller returns when US stocks rise, it will also have substantially higher returns when US stocks crash. At that time, those with diversified portfolios will be thankful that they stayed the course. And millions of other investors will be wishing they had ordered pot pie instead of pot roast.

Conclusion

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Contact: MarcinkoAdvisors@msn.com

***

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***

The [Negative] Short-Term Implications of Investment Portfolio Diversification

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Delving Deeper into Asset Allocation

By Lon Jefferies MBA CFP® CMP®

Lon JeffriesAsset allocation is one of the key factors contributing to long-term investment success.

When designing a portfolio that represents their risk tolerance, investors should be aware that a portfolio that is 50% stocks is likely to obtain approximately half of the gain when the market advances but suffer only half the loss when the market declines.

This general principle frequently holds true over extended investing cycles, but can waiver during shorter holding periods.

Case Model

For example, a fairly typical physician client of mine who has a 50% stock, 50% bond portfolio has obtained a return of 4.62% over the last 12 months, while the S&P 500 has obtained a return of 14.31% over the same time period (as of 10/30/14).

An investor expecting to obtain half the return of the index would anticipate a return of 7.15%, and by this measuring stick, has underperformed the market by over 2.50% during the last year.

What caused this differential?

Answer

The issue resides in how we define “the market.” In this example, we use the S&P 500 index as a measure for how the market as a whole is performing. As you may know, the S&P 500 (and the Dow Jones Industrial Average, for that matter) consists solely of large company U.S. stocks.

Of course, a diversified portfolio owns a mixture of large, mid, and small cap U.S. stocks, as well as international and emerging market equities. Consequently, comparing the performance of a basket of only large cap stocks to the performance of a diversified portfolio made up of a variety of different asset classes isn’t an apples-to-apples comparison.

***

Stock_Market

***

Frequently, the diversified portfolio will outperform the non-diversified large cap index because several of the components of the diversified portfolio will obtain higher returns than those achieved by large cap holdings.

However, the past 12 months has been a case where a diversified portfolio underperformed the large cap index because large cap stocks were the best performing asset class over the time period. In fact, over the last twelve months, there has been a direct correlation between company size and stock performance (as of 10/30/14):

  • Large Cap Stocks (S&P 500): 14.92%
  • Mid Cap Stocks (Russell Mid Cap): 11.08%
  • Small Cap Stocks (Russell 2000): 4.45%
  • International Stocks (Dow Jones Developed Markets): -1.05%
  • Emerging Market Stocks (iShares MSCI Emerging Markets): -1.04%

Since large cap stocks were the best performing element of a diversified portfolio over the last 12 months, in retrospect, an investor would have obtained a superior return by owning only large cap stocks during the period as opposed to owning a diversified mix of different equities. Does this mean owning only large cap stocks rather than a diversified portfolio is the best investment approach going forward? Of course not.

Year after year, we don’t know which asset category will provide the best return and a diversified portfolio ensures we have exposure to each year’s big winner. Additionally, although large caps were this year’s winner, they could easily be next year’s big loser, and a diversified portfolio ensures we don’t have all our investment eggs in one basket.

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Assessment

Don’t be overly concerned if your diversified portfolio is underperforming a non-diversified benchmark over a short period of time. As always, long-term results should be more heavily weighted than short-term swings, and having a diversified portfolio is likely to maximize the probability of coming out ahead over an extended period.

Conclusion

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Is it Fire Drill Time for Physician Investors?

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Catastrophes and “Black Swans” Happen

An ME-P Special Report

By Lon Jeffereis MBA CFP® CMP®

Lon JeffriesHistory tells us that over a long enough time span catastrophes are likely to occur. Fires, flooding, earthquakes – none can be prevented and all can be potentially devastating. While these events can’t always be avoided, we can prepare for these “black swans.”

Running practice fire drills enables us to act appropriately during misfortune while maintaining emergency food storage ensures we won’t starve when tragedy strikes.

Just as physical calamity can turn lives upside down, financial upheaval can lead to an unrecoverable loss. Fortunately, we have the ability to prepare for financial uncertainty in the same way we prepare for other exposures. As the current bull market is now both the fourth longest in history (64 months) and the fourth largest (+192% gain), now would be a perfect time to ensure you are prepared for the next market pullback.

Run a Portfolio Fire Drill

You can run a fire drill for your portfolio by understanding the loss potential of your holdings. It is critical to recognize that the amount of volatility your portfolio will experience in declining market environments is dependent on your asset allocation – how much of your account is invested in stocks vs. bonds. The larger the percentage of stocks in a portfolio, the more the portfolio’s value will increase during bull markets but decrease when the market declines. Let’s look at the historical performance and risk levels of a range of diversified stock-to-bond ratios:

Asset Allocation – Risk & Return (1970-2013)

***

Portfolio Allocation Average Annual Return Large Loss 08′
100% Stocks 10.85% -39%
80% Stocks20% Bonds 10.33% -30%
60% Stocks40% Bonds 9.99% -20%
50% Stocks50% Bonds 9.76% -15%
40% Stocks60% Bonds 9.49% -11%
20% Stocks80% Bonds 8.85% -4%

 ***

After determining the asset allocation of your portfolio, ask yourself how you would respond to another market correction like we experienced in 2008. For this exercise, considering loss in dollar terms is particularly productive. For instance, if 80% of your portfolio is invested in stocks, you might be able to convince yourself that you could sustain a 30% loss. However, supposing you have $500k invested, a 30% loss would mean your portfolio is suddenly depleted to $350k — $150k of hard earned money just evaporated. To many, the thought of losing $150k is more uncomfortable than the thought of a 30% loss.

Next, picture every media outlet sending warnings day after day about how the market is only going to get worse. Imagine yourself checking what the markets are doing multiple times a day and constantly being disappointed that it is another day of losses.

Lastly, visualize your occasional friend, neighbor or family member bragging about how he got out of the market before the collapse and telling you how you are a fool for not doing so.

***

Accidents Happen

[Accidents Happen]

How would you respond in such an environment? Would you have a hard time sleeping or digesting your food? It’s critical to be honest with yourself. If you would stray from your long-term investment strategy by selling after a market drop and waiting for the market to recover, your current portfolio may be too aggressive. If so, scale back the assertiveness of your portfolio by reducing your stock exposure now because selling stocks during a market decline is the last thing you want to do.

Sound financial planning suggests individuals should scale back the assertiveness of their portfolio as they approach retirement. While a young worker with 30 years until retirement can afford to be aggressive and has time to recover if a large loss in suffered, a person who is closer to retirement can’t afford to endure a significant loss right before the invested funds are needed to cover life expenses.

Maintain an Emergency Financial Storage

As stocks and bonds are the long-term portion of your investment portfolio, cash equivalents are your tool for dealing with short-term spending needs. Before even investing, everyone should have an emergency reserve holding enough cash to cover three to six months of expenses. These funds should only be tapped in the event of a job loss or a medical emergency.

Be Prepared

Additionally, investors who are taking withdrawals from their portfolio in order to meet cash flow needs should also have the equivalent of two years of necessary withdrawals in cash at all times. These funds should be used to cover living expenses during the next market correction. Having this emergency financial storage will prevent you from having to take withdrawals in a down market and allow your portfolio time to recover.

Assessment

No one knows when the next bear market will come. However, just like winter follows every fall, market corrections will ultimately come after every bull market.  Preparing for such a financial downturn will ensure you act appropriately when the time comes and prevent financial catastrophe.

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Conclusion

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What is Tactical Portfolio Management?

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Re-Thinking Strategic Allocation

[By Dr. David Edward Marcinko MBA]

Dr. David E. Marcinko MBAMany successful physician investors, retirement account managers or endowment fund administrators will establish a “strategic” allocation policy that is intended to guide long-term (greater than one-year) investment decisions.

Thinking Long Term?

This strategic allocation reflects the endowment’s thinking regarding the existence of perceived fundamental shifts in the market. Most endowments will also establish a target range or band for each asset class. The day-to-day managers then have the flexibility to make tactical decisions for a given class so long as they stay within the target range.

Terms

The term “tactical” when used in the context of investment strategy refers to the investor or manager’s ability to take advantage of short-term (under one year) market anomalies such as pricing discrepancies between different sectors or across different styles.

Assessment

Historically, tactical decisions with respect to asset allocation were derided as “market timing.” However, market timing implies moving outside of the target ranges whereas tactical decision making simply addresses the opportunistic deployment of funds within the asset class target range.

So, what do you think?

Online MD investor

Conclusion

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Are We Over-Optimizing Portfolio Asset Classes?

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Too Many Other Asset Classes?

[By Dr. David Edward Marcinko MBA CMP™]Dr. David E. Marcinko MBA

Some financial analysts believe that the focus on asset classes may have gone too far as physicians and other investors have sought to “over optimize” their portfolios.

In fact, colleague David Loeper, CEO of Wealthcare Capital Management, explained this concept as follows:

“Where things have really got off track has been the insistence on breaking asset classes into sub-classes by style, market capitalization, etc. The unpredictability of all the inputs into our optimizers, even over long periods of time, has been ignored. We have attempted to take efficient portfolios of stocks, bonds and cash and make them even more efficient by breaking the unpredictable asset classes into even less predictable sub-classes. This has all been done into the pursuit of “efficiency” as the proposal was validated by the Brinson & Beebower study, which purports to find that over 90% of the investment return variance is explained by asset allocation. The risk that you produce inefficient portfolios INCREASES if you increase the number of “asset classes” for which you must forecast not only the risk and returns but also each asset class’ correlation to the others.”

Assessment

If true, and I think it is a valid point, the results of the optimizer and your resulting portfolio’s efficiency is based on the accuracy of the inputs and NOT THE NUMBER OF THE INPUTS.

Stock_Market

Or, is this like the TNTC situation in cell cultures and microbiology [Too Numerous To Count].Certified Medical Planner  Conclusion

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Learn the “Right” Investing Lessons from 2013

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Understanding the Recency Effect

Lon JeffriesBy Lon Jefferies MBA CFP® www.NetWorthAdvice.com

The year 2013 was viewed as a very positive one by most investors; especially physician-investors.

The S&P 500 index (measuring large cap U.S. stocks) was up 32.39% for the year.

However, the reality is most other asset categories didn’t come close to keeping up with the pace set by U.S. equities.

For instance:

  • Foreign Stocks (IEFA): 22.46%
  • Emerging Markets (IEMG): -2.77%
  • Real Estate (IYR): 1.16%
  • US Government Bonds (IEF): -6.09%
  • US TIPS (TIP): -8.49%
  • Corporate Bonds (LQD): -2.00%
  • International Bonds (IGOV): -1.37%
  • Emerging Market Bonds (LEMB): -6.73%
  • Commodities (DJP): -11.12%
  • Gold (GLD): -28.33%

In Hindsight

In retrospect, the way to maximize your gain last year would have been to hold a completely undiversified portfolio consisting of nothing but U.S. stocks. The danger going forward is to learn the wrong lesson from 2013. Investors always have the temptation to fall prey to the Recency Effect, continuing and exaggerating the behaviors that worked in the recent past believing the environment we’ve just been through will be permanent.

The Long-Term Benefits of Diversification

Many will abandon their investment strategy because it didn’t give them the absolute best result last year, failing to recognize the long-term benefit of diversification. I’d argue that a better perspective is to remind yourself that the definition of diversification is that you always dislike a portion of your portfolio.

Always Laggards

Even in the most widely prosperous market environment, a truly diversified portfolio will have an element or two that lags the market. In fact, if at any time a portion of your portfolio isn’t generating negative returns, you should be concerned about a lack of diversification in your investment strategy.

Allocate Assets Now

Now is an ideal time to review your asset allocation and remind yourself why we diversify. Modifying your allocation with a focus on what happened in 2013 would be similar to guessing a coin flip will land on tails because it did on the previous flip.

Stock Market

Assessment

The correct lesson to take from 2013 is that over time, a well-diversified portfolio is capable of producing sufficient returns to help you reach your investment goals while minimizing risk.

Conclusion

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Capital Market Expectations, Asset Allocation and Safe Portfolio Withdrawal Rates

By Staff Reporters

From: Munich Personal RePEc Archive [MPRA]

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Economist Wade Donald Pfau has just finished a new article called, “Capital Market Expectations, Asset Allocation, and Safe Withdrawal.

Abstract

Most retirement withdrawal rate studies are either based on historical data or use a particular assumption about portfolio returns unique to the study in question.

But, financial advisors and planners may have their own capital market expectations for future returns from stocks, bonds, and other assets they deem suitable for their clients’ portfolios. These uniquely personal expectations may or may not bear resemblance to those used for making retirement withdrawal rate guidelines. The objective here is to provide a general framework for thinking about how to estimate sustainable withdrawal rates and appropriate asset allocations for clients based on one’s capital market expectations, as well as other inputs about the client including the planning horizon, tolerance for exhausting wealth, and personal concerns about holding riskier assets.

The study also tests the sensitivity of various assumptions for the recommended withdrawal rates and asset allocations, and finds that these assumptions are very important. Another common feature of existing studies is to focus on an optimal asset allocation, which is expected either to minimize the probability of failure for a given withdrawal rate, or to maximize the withdrawal rate for a given probability of failure. Retirement withdrawal rate studies are known in this regard for lending support to stock allocations in excess of 50 percent.

Assessment

This study shows that usually there are a wide range of asset allocations which can be expected to perform nearly as well as the optimal allocation, and that lower stock allocations are indeed justifiable in many cases.

Link: MPRA_paper_32973

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NOTE: Wade Donald Pfau is an Associate Professor of Economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan. His PhD in economics was from Princeton University.

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Thinking Beyond Portfolio Asset Allocation

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Don’t Forget Your Spending Policy – Doctors

By Dr. David Edward Marcinko MBA CMP™

www.CertifiedMedicalPlanner.com

[Publisher-in-Chief]

If you are economically literate – or read the ME-P regularly – you may be tired of hearing the familiar saw, “the single most important determinant of investment results over time is asset allocation.”

But, as most of us realize, this glosses over critical obstacles to building personal wealth—taxes, inflation, and spending policy. A doctor’s spending policy itself is as critical as asset allocation in preserving wealth, as well as for all investors who understand the trade-offs: there are both allocation and spending strategies that stand to preserve wealth and insulate against excessive equity risk at the same time.

Income versus Security

In proving his point a decade ago, the author—Roger Hertog in “Income Versus Security”— traced the growth of a $1 million portfolio during the period of 1960–1994. He showed that while an all-stock portfolio would have experienced a compound growth rate of 10.1%, an all-bond portfolio of 7.4%, and an all T-bill portfolio of 6.1%, these growth rates dropped to 8%, 5%, and 3.7%, respectively, after taxes and conservative transaction costs. When further reduced by inflation, they dropped to 3.1%, 0.2%, and -1%, respectively. Stocks still nearly tripled in real value after taxes.

Next, Hertog factored in spending. He showed that the greater the equity exposure, the more likely investors will preserve or increase their levels of real spending and wealth. Also, he demonstrated how a spending policy of a fixed percentage of the portfolio; or of spending all the income is ill-suited to estate building. He arrived at an optimum allocation of 60% stocks and 40% bonds with a policy of spending all stock dividends but only spending interest to the extent it exceeds inflation. This latter spending policy adjusts for the fact that in – unlike today but perhaps again in the near future – an inflationary environment a portion of bond interest is a return of principal. This type of asset allocation and spending policy resulted in the greatest amount of growth over the years and gained on inflation. Hertog contends that the 60/40 allocation provides an appealing combination of growth and protection.

IOW: It gives investors a milder ride.

Assessment

Over the 35-year period studied, a 60/40 mix returned almost as much as the all-stock portfolio both before taxes and after taxes and achieved some 75% of its real after-tax growth. Also, the portfolio’s worst year was only half as bad as the all-stock portfolio. Hertog believed that balancing with bonds softened the downside. But – what about the “flash-crash” of 2008-09?

Note: “Income Versus Security: Do You Have To Choose?” Roger Hertog, Trust & Estates, March 1997, pp. 44–62, Intertec Publishing Corporation.

Conclusion

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Musings on a Famous Portfolio Asset Allocation Study

Some Critics Claim Brinson, Hood, and Beebower Conclusions Wrong

[By Dr. David Edward Marcinko MBA CMP™]

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Frequently, we hear the axiom that asset allocation is the most important investment decision, explaining 93.6% of portfolio returns. The presumption has been that once the risk tolerance and time horizon have been established, investing is simply a matter of implementing a fixed mix of stocks, bonds, and cash using mutual funds selected for this purpose. This axiom is based on a famous study by Brinson, Hood, and Beebower (BHB) published in the Financial Analysts Journal in July/August 1986. It is the stuff of most modern business school and graduate students in economics and finance.

Enter the Critics

One critic claims that BHB’s conclusions and the interpretation of their conclusions are wrong, stating that because of several methodological problems, BHB needed to make certain assumptions for their analysis to go forward. They assumed that the average asset-class weights for the 10-year period studied are the same as the actual normal policy weights; that investments in foreign stocks, real estate, private placements, and venture capital can be proxied by a mix of stocks, bonds, and cash; and that the benchmarks for stocks, bonds, and cash against which fund performance was measured are appropriate. The author believes that each of these assumptions can lead to a faulty measurement of success or failure at market timing and stock selection.

The Jahnke Study

William Jahnke claims that BHB erred in their focus on explaining the variation of quarterly portfolio returns rather than portfolio returns over the 10-year period studied. According to the study, asset allocation policy explains only a small fraction of the range of 10-year portfolio returns earned by the pension funds reported in the study. The author concluded that this discrepancy is caused by the effect of compounding returns. He adds that BHB were wrong to use variance of quarterly returns rather than the standard deviation. Use of standard deviation would reduce the often cited 93.6% to about 79%. Moreover, BHB did not consider the cost of investing, such as operating expenses, management fees, brokerage commissions, and other trading costs, which are more significant for individual investors than for the pension plans studied. Jahnke claims that excessive costs can reduce wealth accumulation by 50%.

Note: (“The Asset Allocation Hoax,” William W. Jahnke, Journal of Financial Planning, February 1997, Institute of Certified Financial Planners [303] 759-4900).

Assessment

Finally, the author takes issue with establishing long-term fixed asset class weights. Asset allocation should be a dynamic process. Higher equity return expectations should in turn produce larger equity allocations, other things being equal.

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Conclusion

Are doctors different than the average investor noted in this essay?

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How Equity-Based Securities Affect a Physician’s Total Financial Plan

Equity Securities Provide a Portfolio Growth Engine

By Dr. David Edward Marcinko MBA, CMP™

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[Editor-in-Chief]

Equity securities provide growth. Theoretically, the amount of growth potential in an equity security is infinite. A stock’s price appreciation possibilities have no limit. However, a stock’s price can also go to zero and an investor can lose the entire amount invested. Therefore, while stocks contribute long-term growth to a portfolio, they also add risk.

Stock Diversification is Key

Diversification is the best defense against risk, so only a portion of every portfolio should be in stocks. Other investments—fixed income securities; cash equivalents that can be used to take advantage of opportunities or for emergencies; real estate; and even commodities (precious metals, for instance, or securities of companies whose businesses are commodity-based)—should all be considered by the responsible physician-investor or financial advisor as components of a well-rounded, balanced portfolio.

And So is Portfolio Diversification

The stock portfolio itself should also be diversified. Diversify among all types of equity securities such as some large capitalization stocks, some small capitalization stocks, some utilities, some cyclical stocks, some value stocks, some growth stocks, and some defensive stocks. Because it is difficult to adequately diversify an equity portfolio with a small amount of money, consider mutual funds or ETFs for some doctors or financial advisory clients. At least this is the philosophy of our Certified Medical Planner™ [CMP] online educational program.  

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Assessment

Always remember that, because the equity component of the portfolio can be expected to provide more than its proportionate share of the risk of a portfolio, it must be constantly monitored. Also remember that every physician-investor as a different level of risk tolerance, and some may be able to handle ownership of only the most solid and stable equity investments.

Conclusion

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The Asset Allocation Decision for Physician Investors

A Historical Perspective for all Lay and Medical Professionals

By Manning & Napier, Inc.

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Introduction

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To a large extent, your investment objectives are driven by your investment time horizon and the needs for cash that may arise from now until then.  Once these objectives have been set, you must decide how to allocate assets in pursuit of your goals.  Establishing the appropriate asset allocation for your portfolio is widely considered the most important factor in determining whether or not you meet your investment objectives.  In fact, academic studies have determined that more than 90% of a portfolio’s return can be attributed to the asset allocation decision.  The following will provide a historical perspective on the risks which need to be balanced when making the asset allocation decision, and the resulting implications regarding the way this important decision is made by investors today.

The Balance between Growth and Preservation of Capital

The asset allocation decision (i.e., identifying an appropriate mix between different types of investments, such as stocks, bonds and cash) is the primary tool available to manage risk for your portfolio.  The goal of any asset allocation should be to provide a level of diversification for the portfolio, while also balancing the goals of growth and preservation of capital required to meet your objectives.

How do investment professionals make asset allocation decisions?  One way is a passive approach, in which a set mix of stocks, bonds and cash is maintained based on a historical risk/return tradeoff.  The alternative is an active approach, in which the expected tradeoff between risk and return for the asset classes is based upon the current market and economic environment.

Can any single mix of stocks, bonds and cash achieve your needs in every market environment that may arise over your investment time frame?  If such a mix exists, then it is reasonable for you to maintain that particular passive asset allocation.  On the other hand, if no single mix exists that will certainly meet your objectives over your time frame, and then some judgment must be made regarding the best mix for you on a forward-looking basis.  This case implies that some form of active decision making is required when determining your portfolio’s asset allocation.  To answer this question, let’s consider the historical tradeoff between the pursuit of growth and the need to preserve capital over various investment time frames.

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The Need for Growth

Our first conclusion is that you have to be willing to commit a majority of your assets to stocks to pursue capital growth, but even an equity-oriented portfolio is not guaranteed to meet your growth goals over a long-term time period.  To provide some historical perspective using Ibbotson data, a mix of 50% stocks and 50% bonds provided an 8.9% annualized return from 1926-1998, but failed to surpass what many consider to be a modest return of 8.0% in approximately 49% of the rolling ten and twenty year periods over this time.  In fact, a portfolio of 100% stocks provided an 11.2% annualized return, but failed to surpass 8.0% in almost 1 of every 3 ten-year periods and more than 1 of every 4 twenty-year periods.

This data also reflects the difficulty through history of consistently achieving an 8.0% rate even with an aggressive mix of stocks and bonds.  In this time of high flying stock markets, it is important to keep in mind that taking more risk is no guarantee of higher returns.  However, what is clear from this data is the importance of allowing a manager the flexibility to achieve meaningful exposure to stocks in attractive market environments to pursue the goal of long-term capital growth.

The Need for Capital Preservation

Of course, there is a clear risk of long-term declines in an equity-oriented investment approach, especially for a portfolio dealing with interim cash needs (e.g., a defined benefit plan with ongoing benefit payments, a defined contribution plan with participants having different dates until retirement, or an endowment with ongoing withdrawal needs).  An illustration of the sustained losses that may result from heavy allocations to stocks is the fact that 1 of every 4 one year periods and 1 of every 10 five-year periods resulted in a loss for a portfolio of 100% stocks.  Even the 50% stock and 50% bond portfolio has seen losses in almost 1 of every 5 one-year periods and more than 1 of every 25 five-year periods over the past 73 years of available data.  Thus, it is clear that no single mix of investments is likely to meet all of the needs for a portfolio in every market environment.

The Need for Active Management of Risk

The analysis to this point has discussed the need to balance long-term growth and preservation of capital, and it has summarized the tradeoff between these conflicting goals.  There remains, however, an important issue regarding the appropriate stock exposure for you in the current environment.  Even though returns over the long-term may have been strong for an all-stock portfolio, your returns will be very much dependent on the market conditions at the start of the investment period.

To set up this discussion, consider the risk of failing to achieve a target return of 5%, 8% or 10% in the S&P 500 over the last 44 years.

FAILURE RATES OF TARGET RETURNS IN STOCKS [1955-1998]

 

   1 Year  3 Years  5 Years  10 Years
 % Periods with Less Than a 5% Return:   32%   15%   17%   13%
 % Periods with Less Than an 8% Return   38%   29%   27%   32%
 % Periods with Less Than a 10% Return   41%   41%   41%   44%

 

Taking the risk of failing to achieve your return goals one step further, does this risk increase with an expensive stock market?  Looking at several different stock valuation measures, the U.S. stock market is currently at historically extreme levels.  As an example, the S&P Industrials price-to-sales ratio was 2.0 at the end of 1998.  High valuation measures are often associated with periods of high volatility in stocks, and a price-to-sales ratio greater than 1.0 (i.e., ½ of current level) has historically been considered high.

FAILURE OF STOCKS TO MEET GOALS WHEN S&P INDUSTRIALS PRICE-TO-SALES RATIO IS GREATER THAN 1.0 [1955-1998]

 

   1 Year  3 Years  5 Years  10 Years
 % Periods with Less Than a 5% Return:   42%   26%   24%   45%
 % Periods with Less Than an 8% Return   47%   55%   55%   79%
 % Periods with Less Than a 10% Return   49%   71%   71%   97%

 

Understanding the Data

The data in the table above indicates that high market valuations significantly increase the risk of failing to achieve even moderate return goals.  In all, there were 50 quarters from 1955 to 1998 in which the S&P Industrials price-to-sales ratio was over the 1.0.  During these periods, strong returns were possible, but less likely to be sustained than when there are less optimistic valuations in the market.  While this does not mean that a major correction or bear market will necessarily occur, the risk of failing to meet your goals is clearly higher than average based upon this data.  Because the market is a discounting mechanism, the positive economic environment we see today may become over discounted, resulting in moderate returns until fundamentals catch up with the optimism.

Assessment

Clearly, history tells us that no single mix of assets may provide both long-term capital growth and stability of market values in all market and economic conditions.  Far too often, investment professionals take a passive approach to asset allocation, relying on past average returns and correlations to determine asset allocation without a full understanding of the long periods of time in history over which there are significant deviations from long-term averages. This data confirms that a more active approach to asset allocation based on the risk faced in today’s market and economic environment is key to lowering the risk to your portfolio failing to meet its investment objectives.

Conclusion

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Hospital Capital Formation, Harry Markowitz and Modern Portfolio Theory

Strategic Risk Considerations for Physician-Executives and Healthcare CXOs

[By Calvin W. Wiese; MBA, CPA, CMA]

To most all financial advisors, wealth managers and stock-brokers, the work of Harry Markowitz and Modern Portfolio Theory [MPT] is not usually discussed in terms of hospital capital formation. But, perhaps it should!

Capital Investments Create Risk

Capital investments create risk. Risk is the uncertainty of future events. When hospitals make capital investments, they commit to costs that affect future periods. Those costs are known and relatively fixed. What are unknown are the benefits to be realized by those capital investments.

Defining Risk

For capital investments, risk is the certainty of future costs coupled with the uncertainty of future benefits. In some cases, while the future benefits are uncertain, there is a high degree of certainty that the benefits will exceed the costs. In these cases, risk can be very low. Risk may be better defined as the degree to which the uncertainty of unknown benefits will exceed the known and committed costs.

Asset Burdens and Benefits

When capital assets are purchased, both the burdens and the benefits of ownership are transferred to the owner. The burdens are primarily the costs associated with acquisition and installation. The benefits are primarily the revenues generated by operating the capital assets. Risk of ownership is created to the degree that the benefits are uncertain.

Understanding Risk

Hospital managers need to be skilled at putting hospital assets at risk. Without clear knowledge and understanding of the benefits and the burdens, hospitals can quickly find themselves at unacceptably high levels of risk. Risk must be continually assessed and evaluated in order to successfully put hospital assets at risk. Hospitals require many varied capital investments; their capital investments represent a risk portfolio. An effective combination of risky assets can often create risk that is less than the sum of the risk of each asset.

Modern Portfolio Theory

Of course, financial managers have know this for years as a basic principle of Modern Portfolio Theory (MPT), first introduced by Harry Markowitz, PhD, with the paper “Portfolio Selection,” which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller, PhD, and William Sharpe, PhD, for what has become a broad theory for securities asset selection; and hospital assets may be viewed as little different.

Prior to Markowitz’s work, investors focused on assessing the rewards and risks of individual securities in constructing a portfolio. Standard advice was to identify those that offered the best opportunities for gain with the least risk and then construct a portfolio from them. Following this advice, a hospital administrator might conclude that a positron emission tomography (PET) scanning machine offered good risk-reward characteristics, and pursue a strategy to compile a network of them in a given geographic area. Intuitively, this would be foolish. Markowitz formalized this intuition.

Detailing the mathematics of diversity, he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios of securities, or capital assets that each individually has attractive risk-reward characteristics. In a nutshell, just as investors should select portfolios not individual securities, so hospital administrators should select a wide spectrum of radiology services, not merely machines.

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Assessment

Savvy hospital managers will mitigate ownership risk by constructing their portfolio of risky assets in a manner that lowers overall risk

Conclusion

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When to Change Portfolio Managers

Some Considerations for Medical Professionalsfp-book

By Clifton N. McIntire, Jr.; CIMA, CFP®

By Lisa Ellen McIntire; CIMA, CFP®

Sometimes even the best made physician financial plans just don’t work out. And, despite extensive time and energy spent on due diligence before hiring an investment or portfolio manager, it becomes evident that you must change managers.

Some Thoughts for Doctors

Here are a few thoughts when considering a portfolio manager change:

  • You should have initially hired the manager with a long-term relationship in mind. Realizing that styles go in and out of favor, we were not simply buying last quarter’s best numbers; in 2009.
  • Market statistics often mask “real” performance of money managers, both good and bad. The S&P 500’s 2007 performance can be attributed to a few very large companies.
  • Generally, a full market cycle would be required to assess money manager performance. Having said that, what could happen that would warrant changing managers? Here is a brief list:
  1. Style Drift: You have a growth manager and when growth stocks turn down, you begin to see the purchase of “value” stocks.
  2. Not Sticking to Previously Established Disciplines: If the process is to sell if the price declines 20 percent down from the original buy range and now they are holding because, “This time, it is different.”
  3. Personnel Changes: New analysts are hired with a different philosophy. Recent transactions seem 180 degrees off course.
  4. Principals Leave: Like professional sports figures, good money managers are in demand and sometimes change firms. The replacement may be a 29-year-old MBA with little experience.
  5. The Firm is Sold: This may be good new if it broadens ownership and helps retain good people.  Look for long-term incentive driven “staying” bonus plans.
  6. Loss of Major Accounts: Reduced revenues may force cut backs in personnel and services. Attention may shift from portfolio management to marketing.

Assessment

Finally, sometimes it is just not working. Misjudgments in asset allocation and poor stock selection over a reasonable period of time can be reason enough to change managers.

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Conclusion

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Take the Hospital Endowment Fund Management Challenge!

Calling all Financial Advisors – Are You CMP™ Worthy?

By Staff ReportersBecome a CMP

After conducting a comprehensive fundraising program, the Hoowa Medical Center received initial gifts of $50 million to establish an endowment. Its status as the community’s only trauma center and neonatal intensive care unit causes it to provide substantial amounts of unreimbursed care every year. This phenomenon, together with the declining reimbursements and an estimated 6% increase in operating costs, leaves the Center with a budgeted cash shortfall of $4 million next fiscal year. Although the new endowment’s funds are available to cover such operating shortfalls, the donors also expect their gifts to provide perpetual support for a leading-edge medical institution.

The Treasurer

Bill, the Center’s treasurer, has been appointed to supervise the day-to-day operations of the endowment. One of his initial successes was convincing his investment committee to retain a consultant who specializes in managing endowment investments. The consultant has recommended a portfolio that is expected to generate long-term investment returns of approximately 10%. The allocation reflects the consultant’s belief that endowments should generally have long-term investment horizons. This belief results in an allocation that has a significant equity bias. Achieving the anticipated long-term rate of returns would allow the endowment to transfer sufficient funds to the operating accounts to cover the next year’s anticipated deficit. However, this portfolio allocation carries risk of principal loss as well as risk that the returns will be positive but somewhat less than anticipated. In fact, Bill’s analysis suggests that the allocation could easily generate a return ranging from a 5% loss to a 25% gain over the following year.

The Committee

Although the committee authorized Bill to hire the consultant, he knows that he will have some difficulty selling the allocation recommendation to his committee members. In particular, he has two polarizing committee members around whom other committee members tend to organize into factions. John, a wealthy benefactor whose substantial inheritances allow him to support pet causes such as the Center, believes that a more conservative allocation that allows the endowment to preserve principal is the wisest course. Although such a portfolio would likely generate a lower long-term return, John believes that this approach more closely represents the donors’ goal that the endowment provide a reliable and lasting source of support to the Center. For this committee faction, Bill hopes to use MVO to illustrate the ability of diversification to minimize overall portfolio risk while simultaneously increasing returns. He also plans to share the results of the MCS stress testing he performed suggesting that the alternative allocation desired by these “conservative” members of his committee would likely cause the endowment to run out of money within 20 to 25 years.

The Polarizer

Another polarizing figure on Bill’s committee is Marcie, an entrepreneur who took enormous risks but succeeded in taking her software company public in a transaction that netted her millions. She and other like-minded committee members enthusiastically subscribe to the “long-term” mantra and believe that the endowment can afford the 8% payout ratio necessary to fund next year’s projected deficit. Marcie believes that the excess of the anticipated long-term rate of return over the next year’s operating deficit still provides some cushion against temporary market declines. Bill is certain that Marcie will focus on the upside performance potential. Marcie will also argue that, in any event, additional alternative investments could be used as necessary to increase the portfolio’s long-term rate of return. Bill has prepared a comparative analysis of payout policies illustrating the potential impact of portfolio fluctuations on the sustainability of future payout levels. Bill is also concerned that Marcie and her supporters may not fully understand some of the trade-offs inherent in certain of the alternative investment vehicles to which they desire to increase the allocated funds.

Key Issues:

1. Given the factors described in the case study (anticipated long-term investment return, anticipated inflation rate, and operating deficit) how should Bill recommend compromise with respect to maximum sustainable payout rates?

2. How should Bill incorporate the following items into his risk management strategy?

a. educating the committee regarding types of risk affecting individual investments, classes, and the entire portfolio;

b. measuring risk and volatility;

c. provisions for periodic portfolio rebalancing;

d. using tactical asset allocation; and,

e. developing and implementing a contingency plan.

3) What additional steps should Bill take to form a group consensus regarding the appropriate level of endowment investment risk?

4) What additional elements should Bill add to his presentation to target the concerns of the “conservative” and “aggressive” committee members, respectively?

Assessment

And so, financial advisors, planners and wealth managers; are you up to answering this challenge? We dare you to respond! Visit: www.CertifiedMedicalPlanner.com

Conclusion

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Asset Allocation Methods for Physician-Investors

What’s Old … is New Again?

By Dr. David Edward Marcinko; MBA, CMP™

Publisher-in-Chiefdem23

Asset allocation policies, incorporating the risk/return fundamental equation, have traditionally been classified under the following approaches: Principal Stability and Income, Income, Income-Oriented, Balanced, Growth, and Aggressive Growth.

Traditional Concepts

In all forms of traditional asset allocation and diversification policy approaches, the physician-investor is presumed to diversify within the chosen asset class in order to reduce the potential for specific or unsystematic risk.

Principal stability and income approach

Objective: Income, liquidity, and stability of principal.

Investment: Shorter-term fixed income securities with a large concentration in money market exposure to enhance liquidity and price stability. Accounts tend to maintain cash equivalent reserve balance of 30–50% of the portfolio.

Income approach

Objective: Maximum income.

Investment: 100% fixed income exposure.

Income portfolios arise from the traditional notion that an investor should spend only income and reinvest capital gains. Sometimes this is a legal requirement, as in a trust that has an income beneficiary distinct from the principal beneficiary.

Income-oriented approach

Objective: Income and some capital growth.

Investment: Accounts tend to maintain 15–35% in equity investments; balance of investment in fixed income.

Income and growth approach

Objective: Capital growth and income using a balanced approach to limit volatility.

Investment:  Accounts tend to maintain 45–65% equity exposure; balance of investment in fixed income.

Income and growth portfolio policies generally refer to both the fixed income and equity portions of the portfolios. Because of the income bias, the overall stock portion of the portfolio will usually have a dividend yield greater than the market yield. This method allows the portfolio manager to invest in some no- or low-dividend yielding issues.

Growth approach

Objective: Capital growth with income as a secondary objective.

Investment: Accounts tend to maintain between 65%–85% equity exposure; balance of investment in fixed income, usually cash reserves.

Aggressive growth approach

Objective: Long-term capital growth.

Investment: Accounts maintain 100% equity exposure. Exposure to variety of equity types normal (small capitalization, international, emerging markets, etc).

fp-book15

Assessment Of course, the above is much more accurate during stable economic times, than it is today; don’t you think? Are newer concepts required today … or is past … prologue.

Link: https://healthcarefinancials.wordpress.com/2008/10/25/new-wave-thoughts-on-investing/

Conclusion

And so, your thoughts and comments on this Medical Executive-Post are appreciated.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com  or Bio: www.stpub.com/pubs/authors/MARCINKO.htm

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Asset Allocation Portfolio Decisions

A Historical Perspective for Physicians

[By Jeffery S. Coons; PhD, CFP®]

Managing Principal-Manning & Napier Advisors, Inc

Dr. Jeff Coons

To a large extent, your investment objectives are driven by your investment time horizon and the needs for cash that may arise from now until then. Once these objectives have been set, you must decide how to allocate assets in pursuit of your goals.

Establishing the appropriate asset allocation for a physician’s [any investor] portfolio is widely considered the most important factor in determining whether or not you meet your investment objectives. In fact, academic studies have determined that more than 90% of a portfolio’s return can be attributed to the asset allocation decision.

The following will provide a historical perspective on the risks which need to be balanced when making the asset allocation decision, and the resulting implications regarding the way this important decision is made by investors today.

Growth versus Capital Preservation Balance

The asset allocation decision (i.e., identifying an appropriate mix between different types of investments, such as stocks, bonds and cash) is the primary tool available to manage risk for your portfolio.  The goal of any asset allocation should be to provide a level of diversification for the portfolio, while also balancing the goals of growth and preservation of capital required to meet your objectives.

Allocation Decisions

How do investment professionals make asset allocation decisions? 

One way is a passive approach, in which a set mix of stocks, bonds and cash is maintained based on a historical risk/return tradeoff.  The alternative is an active approach, in which the expected tradeoff between risk and return for the asset classes is based upon the current market and economic environment.

Can any single mix of stocks, bonds and cash achieve your needs in every market environment that may arise over your investment time frame? If such a mix exists, then it is reasonable for you to maintain that particular passive asset allocation. 

On the other hand, if no single mix exists that will certainly meet your objectives over your time frame then some judgment must be made regarding the best mix for you on a forward-looking basis. This case implies that some form of active decision making is required when determining your portfolio’s asset allocation.  To answer this question, let’s consider the historical tradeoff between the pursuit of growth and the need to preserve capital over various investment time frames.

The Need for Growth

Our first conclusion is that you have to be willing to commit a majority of your assets to stocks to pursue capital growth, but even an equity-oriented portfolio is not guaranteed to meet your growth goals over a long-term time period. 

To provide some historical perspective using Ibbotson data, a mix of 50% stocks and 50% bonds provided an 8.9% annualized return from 1926-1998, but failed to surpass what many consider to be a modest return of 8.0% in approximately 49% of the rolling ten and twenty year periods over this time.  In fact, a portfolio of 100% stocks provided an 11.2% annualized return, but failed to surpass 8.0% in almost 1 of every 3 ten-year periods and more than 1 of every 4 twenty-year periods.

This data also reflects the difficulty through history of consistently achieving an 8.0% rate even with an aggressive mix of stocks and bonds.  In this time of high flying stock markets, it is important to keep in mind that taking more risk is no guarantee of higher returns.  However, what is clear from this data is the importance of allowing a manager the flexibility to achieve meaningful exposure to stocks in attractive market environments to pursue the goal of long-term capital growth.

The Need for Capital Preservation

Of course, there is a clear risk of long-term declines in an equity-oriented investment approach, especially for a portfolio dealing with interim cash needs (e.g., a defined benefit plan with ongoing benefit payments, a defined contribution plan with participants having different dates until retirement, or an endowment with ongoing withdrawal needs).

An illustration of the sustained losses that may result from heavy allocations to stocks is the fact that 1 of every 4 one year periods and 1 of every 10 five-year periods resulted in a loss for a portfolio of 100% stocks.  Even the 50% stock and 50% bond portfolio has seen losses in almost 1 of every 5 one-year periods and more than 1 of every 25 five-year periods over the past 73 years of available data.  Thus, it is clear that no single mix of investments is likely to meet all of the needs for a portfolio in every market environment.

The Need for Active Management of Risk

The analysis to this point has discussed the need to balance long-term growth and preservation of capital, and it has summarized the tradeoff between these conflicting goals. There remains, however, an important issue regarding the appropriate stock exposure for you in the current  environment.  Even though returns over the long-term may have been strong for an all-stock portfolio, your returns will be very much dependent on the market conditions at the start of the investment period.

To set up this discussion, consider the risk of failing to achieve a target return of 5%, 8% or 10% in the S&P 500 over the last 44 years.

 

           FAILURE RATES OF TARGET RETURNS

               IN STOCKS [1955-1998]

 

 

 

 

1 Year

 

3 Years

 

5 Years

 

10 Years

 

% Periods with Less Than a 5% Return:

 

 

32%

 

 

15%

 

 

17%

 

 

13%

 

% Periods with Less Than an 8% Return

 

 

38%

 

 

29%

 

 

27%

 

 

32%

 

% Periods with Less Than a 10% Return

 

 

41%

 

 

41%

 

 

41%

 

 

44%

 

Taking the risk of failing to achieve your return goals one step further, does this risk increase with an expensive stock market?  Looking at several different stock valuation measures, the U.S. stock market is currently at historically extreme levels.  As an example, the S&P Industrials price-to-sales ratio was 2.0 at the end of 1998.  High valuation measures are often associated with periods of high volatility in stocks, and a price-to-sales ratio greater than 1.0 (i.e., ½ of current level) has historically been considered high.

 

FAILURE OF STOCKS TO MEET GOALS WHEN S&P INDUSTRIALS PRICE-TO-SALES RATIO IS GREATER THAN 1.0 [1955-1998]

 

 

 

 

1 Year

 

3 Years

 

5 Years

 

10 Years

 

% Periods with Less Than a 5% Return:

 

 

42%

 

 

26%

 

 

24%

 

 

45%

 

% Periods with Less Than an 8% Return

 

 

47%

 

 

55%

 

 

55%

 

 

79%

 

% Periods with Less Than a 10% Return

 

 

49%

 

 

71%

 

 

71%

 

 

97%

 

The data in the table above indicates that high market valuations significantly increase the risk of failing to achieve even moderate return goals.  In all, there were 50 quarters from 1955 to 1998 in which the S&P Industrials price-to-sales ratio was over the 1.0.  During these periods, strong returns were possible, but less likely to be sustained than when there are less optimistic valuations in the market. 

While this does not mean that a major correction or bear market will necessarily occur, the risk of failing to meet your goals is clearly higher than average based upon this data.  Because the market is a discounting mechanism, the positive economic environment we see today may become over discounted, resulting in moderate returns until fundamentals catch up with the optimism.

Assessment

Clearly, history tells us that no single mix of assets may provide both long-term capital growth and stability of market values in all market and economic conditions.

Far too often, physician investors and investment professionals take a passive approach to asset allocation, relying on past average returns and correlations to determine asset allocation without a full understanding of the long periods of time in history over which there are significant deviations from long-term averages.

Conclusion

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