Plan your menu, and don't count on the supermarket's daily specials.
Recently, I came across an article about Laszlo
Birinyi, founder and president of Birinyi Associates, a stock market
research and money management firm. Birinyi is well known for his
market predictions and commentary, but most importantly for his "ticker
tape analysis." He doesn't pay attention to corporate or economic
fundamentals; he looks at money flow and investor psychology. Birinyi's
theory is that there is a positive correlation between money flows and
share-price performance on the path of a stock. He compares himself to
a cook who visits the market each day to see what's fresh before he
makes dinner. If you subscribe to his newsletter, on a daily, weekly or
monthly basis, he will tell you what to buy.
Now, I started thinking about Birinyi's analogy of
cooks and investors. When I was a kid, we didn't have a lot of money,
so our forays to the grocery store were a weekly event, but always with
a carefully crafted shopping list in hand. The idea was to buy all you
needed for the week without overspending your budget. A quick trip to
the store mid-week was a demonstration that you failed to plan well.
You would work harder on the list for the following week. It wasn't a
bad way to live; we had nutritious food and mom would mix up the dinner
fare so we didn't have tuna noodle casserole every Friday.
In the 1950s when I was a kid, investing was largely
based on a conventional buy-and-hold strategy. If you had the money to
invest, you bought blue-chip companies and held them forever or until
you needed the money for some other purpose. Like the weekly trips to
the grocery store, you had a list of stocks that were good buys and
that you knew would last. Stocks went up; stocks went down, but you
stayed the course on the notion that you owned quality companies that
were going to be around when your children's children wanted to buy a
house.
Somewhere in the late '80s, big companies began to
falter, and we realized that we couldn't depend on our earlier
investing experiences. We needed to pay closer attention to what we own
and why we own it. In the early 1990s, IBM dropped about 41% over a
six-month period. I remember reading about a guy who worked for IBM. He
was three years short of retirement and all his holdings, including his
retirement funds, were in IBM stock. He'd walk down the street every
day, pointing to the house that he wanted to buy for his retirement
years, telling everyone in earshot that this was the house he was
supposed to retire to; this was the house he will never get to live in.
So, by 1993 we figured out that blue chips alone are
not guaranteed and that overconcentration can leave you stranded.
That's pretty surprising, since Harry Markowitz won the Nobel Prize in
1952 for the notion that diversification in a portfolio can reduce
risk. Yet, here we are in 2005, not having learned much about
investment strategies, and challenging Modern Portfolio Theory because
our experiences in recent years don't seem to prove that
diversification is working.
We may be too narrow in our challenge of MPT. If you
believe that our job as wealth managers is to help our clients get
where they want to go, you must also believe that we must have
dependable tools and techniques to get them there. Some tenets of MPT
are irrefutable: putting together poorly correlated, risky investments
can result in a safer portfolio. As I see it, the MPT process itself is
what's important. (Fig. 1) What method any of us uses to divvy up the
portfolio, or what projections we all utilize for the return
expectations, can and will vary.
Initially, we all need to start with some basis for
expected return. In our practice we start with the risk-free rate, and
then use the Ibbotsen building-block approach to estimate
forward-looking returns for different asset classes and styles. We then
develop forward-looking expectations for correlations and standard
deviations. Once the expected returns, volatility and correlation are
in place, we run an unconstrained optimization to determine the
efficient frontier.
Since clients can seldom buy-in to a totally
unconstrained portfolio (for example, 35% in emerging markets) we apply
our "client-friendly" overlay to determine a practical, rather than a
theoretical, portfolio. Our final step is to compare the unconstrained
portfolio with the constrained portfolio to determine how inefficient
our "client-friendly" portfolio will be. We're convinced that the most
efficient portfolio is useless if our client can't live with it. In
theory there is no difference between practice and theory; in practice,
there is.
Not every client will expect, or want, to have
a surprise meal every evening. Imagine coming home to pickled pigs ears
because they were fresh at the market today! Most people find great
comfort in consistency, and enjoy the aspects of planning their
meals. While a gourmet chef may plan his dinners with whatever is
freshly available in the market every day, few people will want to live
with the whims of that market. (I don't like salmon even when it's in
season.) While my clients would love to follow the latest hot stock tip
of the last ten minutes, realistically they can't live with the
inherent volatility that is likely to result, nor can they afford to
risk their retirement on it.
Clients take comfort in a disciplined investment
process. They take comfort in the planning that is the framework for
our advice. Our job is to integrate the concepts of investment theory,
including MPT, along with knowledge and an understanding of our
client's dreams, goals and issues, and with their risk tolerance.
So, next time your client wants to invest in the
latest hot tip, ask him if he'd like a pickled pig's ear for dinner.
Deena Katz is president of Evensky & Katz Wealth Management in Coral Gables, Fla.