Objective of an Investor Rational investor wants to maximize returns with a given amount of risk Basis of “Modern Portfolio Theory”
Modern Portfolio Theory LowHigh Expected Risk The optimal allocation is the combination of stocks, bonds, and cash that maximizes expected return for any level of expected risk The Efficient Frontier Expected Return High Low Inefficient Portfolio Less Risk with Same Return Same Risk with Greater Return Efficient Frontier: Key principle behind portfolio management Optimal Allocation
Investment Risks Event Risk (can’t control) economic, social and political events Market Risk (can control) Security Selection Concentration Asset Allocation – Cash, Bonds, Stocks (sector, geography), Real Assets Inflation (rising prices – can’t control) Taxes (dependant on source of income) Human Nature (can control)
Factors Affecting Risk Tolerance Time horizon Ability to handle market volatility Aggressiveness of goals Different type of goals –Compartmentalizing
Types of Assets Cash –T-Bills/GIC Fixed Income –Bonds Equities/Real Assets –Canadian Equities –US Equities –International Equities –Commodities –Real Estate
Long Term Diversification Annual Returns for Decade Ending February 2009 US Stocks (-1%) International Stocks (1%) Real Estate (7%) Natural Resources (7%) Rebalance on a regular basis
Did Diversification Work During the Crisis? What Worked? –Cash/T-bills –Bonds What Kind of Worked? –Gold/Precious Metals –Real Estate What Didn’t Work? –International Diversification
Why didn’t it work as well as hoped? In times of crisis only two things matter Risk and Safety Investors were fleeing risk into safety
Asset Allocation Conclusion In times of crisis allocation between cash, bonds and equities is most important Over the long term (5 years+) allocation between and rebalancing of multiple asset classes is very important
We have seen the enemy……..and he is us! The Pogo Papers
Human Nature Morningstar Survey –Looked at all 17 categories of securities they follow –In all 17 the time weighted returns are higher than the dollar weighted returns Top 10 Internet Funds 1997-2002 –Time Weighted average 1.5%/year –Dollar weighted -72% Tax Bill was 24% due to turnover
Human Nature Over Confidence –82% of students consider themselves better than average drivers –Men are more overconfident than women in areas like finance –Overconfidence leads to too much trading and higher fees as well as taking too much risk
Human Nature Pride and Regret (Get-Evenitis) –Selling winners too early and losers too late - Investors are 50% more likely to sell a winner than a loser Would I buy this stock if I didn't own it?
Human Nature Considering the Past –People tend to use a past outcome as a factor in evaluating a current risky situation –People take a larger risk after large gains and less risk after loses –However sometimes after losing money some investors will "double down" to get even
Human Nature Mental Accounting –Viewing investments on an individual basis as opposed to part of the whole.
Human Nature Representativeness and Familiarity –Canadians owning mostly Canadian stocks –Residents of Atlanta owning lots of Coke –Employees owning a high percentage of their company's stock. –Over 50% of the time an investor becomes interested in a stock because another person mentions it
Human Nature Social Interaction and Investing –Herding or social proof –Buying Nortel because everyone else owns it. Emotion and Investing –Compared the daily return in 26 stock exchanges around the world to the weather in the 26 exchanges. –When they annualized the difference between the sunniest and worst days the difference was 24.6%
Human Nature Conclusion Investors need to work hard to be rational!!
Reduce Risk of Large Losses Making mistakes early can hurt you in the long run Invest $100,000 Investment drops 20% to $ 80,000 You need to earn 25% to break even again $80,000 X 1.25% = $100,000
Probability of Reaching Goals Uncertain <75% A confidence level below 75% means that there is too high of a chance you may not achieve your goals. Adjustments need to be made to your goals, your allocation or your investments Sacrifice >90% A confidence level above 90% indicates that you are needlessly sacrificing your financial goals. You could take less investment risk, achieve larger or more goals and still maintain confidence in your financial future. Confidence & Comfort (in “balance”) A confidence level between 75% and 90% should give you confidence that your goals can be met. This reading indicates a set of goals that is manageable and avoids unnecessary investment risk. You may find at some future date minor changes may be suggested, but they are likely to be small, easily manageable and exposed well in advance through ongoing monitoring. This analysis simultaneously evaluates your goals, your investment allocation and your assets to determine how confident you can be that your goals will be met. The Wealthcare process subjects your goals and investment strategy to this sophisticated ‘stress testing’ process which simulates 1000 market environments, both good and bad. Your Confidence or Comfort is the percentage of the 1000 simulations that achieve your goals. For example, if you achieved all of your goals or more in 830 of 1000 tests your
Achieving Your Goals $3,000,000 $1,800,000 $200,000 54 55 56 57 58 59 60 61 Age Your Portfolio Monitoring Your Progress… As financial markets, financial goals and priorities change, we monitor your progress on an ongoing basis. The Wealthcare process identifies in advance the future portfolio values needed to maintain balance between confidence and undue sacrifice. This monitoring process enables us to track where your current portfolio falls so we can alert you of potential problems, or help you achieve additional goals you may have. Additionally, this dynamic process recognizes that throughout your life, goals and priorities change. In such cases we will design new recommendations for you.
Financial/Life Planning Estate Planning Risk Planning Tax Planning Business Planning Retirement Planning Life Planning
Financial/Life Planning Conclusion –Having a well thought out plan is essential in order to reach your goals and get the most out of your life –Even the best plans need to be updated on a regular basis
Questions? By Matthew Lekushoff Financial Advisor Matthew.firstname.lastname@example.org www.matthewlekushoff.com
Recommended Readings Extraordinary Popular Delusions and the Madness of Crowds –Charles Mackay Influence and the Psychology of Persuasion –Robert Cialdini Seeking Wisdom – From Darwin to Munger –Peter Bevelin The Importance of Muliti-Class Investing (White Paper) –Roger Gibson