Managing Your Investment Portfolio For Dummies - UK, UK Edition E-Book

David Stevenson

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch
• Veröffentlichungsjahr: 2013

Seitenzahl: 610

Beschreibung

Achieve positive returns on your investments, in any market With Managing Your Investment Portfolio FD you can build and manage a portfolio of investments that's flexible enough to provide positive returns, no matter what the market is doing. Inside you'll find a wealth of strategies and techniques to help you take your investments to the next level. Lean to track and predict volatility; hedge your exposure by going long and short; use strategies like arbitrage, relative value and pairs trading; and dip into distressed assets, options, derivatives, spread betting and much more. Techniques and strategies covered include: * Tracking and predicting volatility, and making short-term gains on very volatile markets * Hedging exposure and going long and short * Arbitrage (taking advantage of price differences between markets) * Pairs trading * Relative value strategies * Distressed assets (things written off by the mainstream that may have long-term value) * Earnings surprises (looking for companies delivering better earnings than predicted by analysts) * Options and derivatives * Macro trading (looking at key indicators for economic cycles)

Leseprobe

Managing Your Investment Portfolio For Dummies®

Published by: John Wiley & Sons, Ltd.,The Atrium, Southern Gate, Chichester, www.wiley.com

This edition first published 2013

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ISBN 978-1-118-45709-2 (pbk), ISBN 978-1-118-45713-9 (ebk), ISBN 978-1-118-45711-5 (ebk), ISBN 978-1-118-45712-2 (ebk)

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Managing Your Investment Portfolio For Dummies®

Visit www.dummies.com/cheatsheet/creativethinkinguk to view this book's cheat sheet.

Table of Contents

Introduction

About This Book

What You’re Not to Read

Conventions Used in This Book

Foolish Assumptions

How This Book Is Organised

Part I: It’s All about Portfolios

Part II: Picking the Strategies for You

Part III: Thinking and Acting Like a Hedgie: Simple Strategies You Can Employ Yourself

Part IV: Delving Into More Specialist Techniques (with a Little Help)

Part V: Tools of the Trade: Useful Instruments

Part VI: The Part of Tens

Icons Used in This Book

Where to Go from Here

Part I: It’s All about Portfolios

Chapter 1: Introducing Great Opportunities for Advanced Investors

Building a Balanced Portfolio

Thinking about asset classes

Diving into a world of choice

Diversifying Your Investments

Mixing and matching different betas: Correlation

Deciding how much diversification is enough

Going global

Investing in University Endowment Funds

Considering the university endowment model

Integrating endowment model principles in your own portfolio

Loving Your Hedge-Fund Manager

Chapter 2: Assessing Risk: Deciding What Kind of Investor You Are

A Tale of Two Trade-Offs

Balancing risk and return

Balancing risk and age: Lifecycle investing

Changing investment strategies throughout life: The glidepath

Delving Deeper into Risk

Discovering the different risks

Assessing your preferred risk level

Matching Horses for Courses: Choosing the Right Investment for You

Operating as a low-risk, cautious investor

Choosing products for the middle-of-the-road investor

Being an adventurous investor

Encountering More Advanced Portfolio Thinking

Thinking about absolute returns

Deciding whether hedging or shorting are for you

Investigating alternative assets and strategies

Understanding the cycles

Considering gearing up

Knowing your own and other people’s limitations

Part II: Picking the Strategies for You

Chapter 3: Grasping Basic Hedge-Fund Strategies

Introducing the Hedge-Fund Concept (and a Bit of Hedge-Fund History)

Treating Companies as Couples: Pairs Trading

Putting pairs trading to work for you

Assessing the pros and cons of pairs trading

Comprehending Covered Call Writing

Understanding options

Discovering how covered calls work

Weighing up trading strategies for writing calls

Following the Shareholder Activist Strategy

Profiting from shareholder activism

Finding suitable ‘at risk’ candidates

Meeting Merger Arbitrage

Observing the process in practice

Considering the risks of merger arbitrage

Encountering the Earnings Surprise Strategy

Locating earnings estimates

Finding the biggest opportunity

Seeking out surprise stocks

Chapter 4: Dealing with Volatility and Economic Cycles

Forever Blowing (Economic) Bubbles

Bubbling up from trends

Analysing the life of a bubble

Using Technical Analysis

Spotting the trend

Meeting moving averages

Beholding the Bollinger bands

Bringing the Relative Strength Index into play

Playing with Volatility

Accepting the reality of volatility: It constantly changes!

Measuring volatility

Making (or losing!) money from volatility: Key trends and tactics

Understanding the Importance of Economic Cycles

Examining three economic rates that matter

Reaching up for the growth cycle

Recognising the importance of the business cycle

Giving credit to the corporate credit default cycle

Bringing cycles together: Asset allocation cycle

Choosing an approach to follow

Chapter 5: Digging Deeper into Alternative Assets: Commodities and Currencies

Thinking about Alternative Investments

Considering Commodities as an Investment

Introducing the world of commodities

Examining spot prices versus the futures index

Making money from commodities

Sifting through the different commodity indices

Meeting a few methods for investing in commodities

Accepting the risks of commodity investing

Keeping Current: Investing in Currencies

Introducing the products and structures

Swotting up on FX basics

Making money from FX markets

Deciding on hedge-fund strategies for FX markets

Selecting strategies for success

Discovering the downsides of currency trading

Chapter 6: Assessing the Hedge-Fund Industry: Don’t Believe the Hype

Investing in Hedge Funds: Better than Gambling?

Understanding the efficiency of markets

Working with the reality of efficient markets

Getting to Grips with Hedge-Fund Costs

Considering hedge-fund charges

Accepting that these extra costs matter

Describing the Charges against the Hedge-Fund Industry

Over-charging and being over-paid

Looking at the financial figures

Assessing other arguments against

Defending the Hedge-Fund Industry

Favouring the best managers

Arguing for hedge funds

Part III: Thinking and Acting Like a Hedgie: Simple Strategies You Can Employ Yourself

Chapter 7: Selling What You Don’t Own: Short Selling

Introducing the Art of Short Selling

Defining short selling

Carrying out the short-selling process

Looking for a company’s downside

Knowing the Risks of Short Selling

Locating a Shorting Target

Spotting the signs

Introducing the net short

Using short interest as a key measure

Considering the sad case of Pursuit Dynamics

Entering the World of Active Extension Funds

Meeting active extension portfolios in practice

Enjoying the benefits for the private investor

Understanding the dangers of active extension funds

Discovering another Short-Selling Option: Exchange-Traded Funds

Chapter 8: Understanding Arbitrage: Big Name, Simple Idea

Introducing Arbitrage: Pricing Models and Arbitrage Options

Getting all mathematical

Meeting some different types of arbitrage

Viewing a typical example of an arbitrage opportunity

Assessing the risks

Investigating Convertible Arbitrage

Profiting from convertibles

Assessing the strategy’s recent performance

Finding the opportunities

Being aware of the risks of convertible arbitrage

Getting Up to Speed with High-Frequency Trading

Appraising the brave new world of computerised trading

Discovering different HFT strategies

Stating the argument for HFT

Setting out the objections

Predicting that new regulations are on their way

Chapter 9: Weighing Up Growth Versus Value Investing

Understanding the Key Measures

Cultivating an Interest in Growth Investing

Defining growth-investing basics

Focusing on profits

Following the profits

Getting practical with a growth screen

Searching for the elusive tenbagger

Entering the World of Value Investors

Using value as the key criterion

Looking at value investor loves

Value investing in practice

Reading the value bible according to Tweedy, Browne

Using the balance sheet for real value

Considering the risks of value investing

Minding the GARP: The Best of Both Investment Worlds

Getting to know GARP

Remaining sceptical

Desiring sustainable growth

Finding out-of-favour sectors

Focusing on smaller companies

Getting some Zweig appeal

Performing tonight: Joel Greenblatt and the Magic Numbers

Hearing the gospel according to Buffett

Chapter 10: Gearing up to Use Leverage

Understanding Investment Leverage

Leveraging: The theory

Leveraging: The practice

Considering the types and forms of leveraging

Buying on margin

Appreciating the Risks

Determining leverage risk

Asking the question: Isn’t gearing up risky?

Thinking Seriously about Leverage

Perusing what works over the long term

Making leverage work for you

Remembering to hold some cash

Chapter 11: Stepping into Structured Investments

Introducing Structured Products

Investigating investments with a defined return

Using bear and bull accelerators to gear up your returns

Examining the Components of Structured Products

Discovering the call option

Enjoying the downside: The put option

Getting insurance: The zero coupon bond

Understanding the Structured Products You Invest In

Timing your purchase for structured investments

Mixing and matching for maximum impact

Buying and selling structured investments

Chapter 12: Benefitting from Shareholder Activism

Discovering the Activist Basics

Evolving activism over time

Organising activist campaigns

Using the hedge-fund advantages

Examining who benefits from activism

Selecting Target Companies

Watching out for activist quarry

Knowing when to get out

Monitoring Master Activists in Action

Waging war by letter: Dan Loeb

Meeting a turnaround specialist: Edward Bramson

Targeting Investment Trusts

Anticipating the Future of Shareholder Activism

Part IV: Delving Into More Specialist Techniques (with a Little Help)

Chapter 13: Advanced Investing in Commodities: Sharks and Rocket Scientists

Understanding the Importance of Contango and Backwardation Switches

Playing the Commodity Markets: The New Big Macro

Cornering a commodity market

Making money from commodity trends

Examining Other Commodity-Trade Opportunities

Oiling your profits: Brent versus WTI

Using price differences: Crack spread

Trending Big – When Appropriate

Tracing the emergence of trend-seeking hedge funds

Analysing a trend in action

Reviewing the Remorseless Rise of Commodity Trading Advisors

Encountering CTAs

Remaining disciplined for success

Discussing whether CTA funds work in practice

Catching a successful CTA in action: Winton Capital

Spotting the wrong kind of markets for CTAs

Chapter 14: Investing in Emerging-Market Equities and Currencies

Investigating Emerging Markets

Identifying EMs for your investment

Looking at hedge funds and EM

Joining an expanding space

Remembering the risks of an EM-focused strategy

Playing Emerging Markets in Alternative Ways: Special Situations

Converting Your Money: Emerging Markets and Currency Trading

Introducing the Balassa–Samuelson theory

Carrying on trading

Getting down to fundamentals: Purchasing-power parity

Chapter 15: Investing Macro Style: Seeing the Big Picture

Checking out Macro-Economic Basics

Thinking about the impact on investments

Using macro risk to consider your investments: The Investor Dashboard

Understanding the Importance of Bonds

Bonding with bond basics

Seeing the risks for bond investors

Emerging from the shadows: Developing-nation bonds

Measuring the Risk of Bond Default

Determining credit risk

Insuring with CDSs

Making use of bond correlation

Meeting Macro Hedge Funds

Judging macro investing’s success as a strategy

Watching macro investing in action

Introducing the major players and their investments

Describing recent macro hedge-fund trades

Copying macro hedge-fund trades

Part V: Tools of the Trade: Useful Instruments

Chapter 16: Following Indices: Exchange-Traded Funds and Other Trackers

Entering the World of Exchange-Traded Funds

Tracking indices

Considering physical replication trackers

Seeking synthetic trackers

Knowing the risks

Getting in on the action

Answering queries: An ETF FAQ

Introducing Other Trackers – ETFs and Beyond

Trusting in units

Noting ETNs

Investing in commodities

Thinking about tax for total returns

Searching for value stocks: Fundamental trackers

Taking an active approach to managing indices

Putting Other Tracker Structures to Work: Geared Derivatives

Using covered warrants

Powering up for turbos

Multiplying returns with leveraged trackers

Chewing Over Traded Options

Putting and calling options

Accepting that options can be complicated

Seeing the basic option terms in practice

Appreciating the pretty options chain

Pricing options

Being in the money (or not)

Understanding the contracts behind options

Chapter 17: Taking a Punt on the Financial Markets

Introducing Spread-Bet Basics

Understanding how a spread bet works

Meeting the concept of margin

Working a long/buy trade

Trying a short/sell trade

Making money on the way down as well as on the way up

Spread Betting in Action

Placing your bets, please

Perusing some practical issues

Working out your time frame and strategy

Dealing with the downsides

Taking advantage of spread-betting benefits

Remembering the disadvantages

Going Another Route: Contract for Difference

Following an example CFD long trade

Appreciating the advantages of CFDs

Knowing the risks

Considering interest

Part VI: The Part of Tens

Chapter 18: Ten Top Tips to Protect Your Stash

Welcoming Cash as Your Friend

Hedging, Hedging, Hedging

Remembering that Bonds Can Be Risky

Valuing Your Dividends

Recognising that Covered Calls Are for Everyone

Employing Defensive Autocalls

Loving the Blue Chips

Handling Currency Risk

Avoiding Too Much Focus on Income

Protecting Yourself if You’re a Risk-Taker

Chapter 19: Ten Hedge-Fund Style Techniques to Grow Your Wealth

Making Bigger, More Focused Bets

Using Leverage Smartly

Shorting Poor Value

Investing Bottom Up

Looking for New Sources of Beta

Avoiding Fraudsters and Scams

Keeping Costs Low

Understanding That Hedge-Fund Replication Can Work

Staying Away From Ideas That Look Too Popular

Being Careful about Fund of Funds

About the Author

Cheat Sheet

Introduction

Investment can be a scary business, with all those self-proclaimed masters of the universe wielding ultimate control over your pension and long-term savings pot. They’re a worrying bunch and their ability to wreak havoc on the global financial markets and livelihoods worries more than just the Occupy Wall Street mob. Plus, the media doesn’t help this sense of foreboding with (scaremongering) stories about unseen powers taking control of people’s financial futures: global financial crises, big blowouts and meltdowns hog the headlines, scaring the wits out of even the smartest private investor.

But here’s the good news: investing can be a rewarding pursuit . . . honest! As a humble private investor you can take control of your financial future, make profits and control the downside risks by leaving behind that fear of big scary markets. Smart, sophisticated investors like yourself can and do build successful and robust investment portfolios, full of ideas that help sustain year-on-year profits.

In this book I show you the route to becoming a more proficient, advanced investor, helping you figure out how to build a well-rounded, thought-through investment plan: in other words, a strong, diversified portfolio of financial assets. My central insight – a call to action if you like – is that private investors need to think a little bit more like the hedge funds of this world. Don’t worry, I’m not implying that you sell the family hatchback and invest in a hedge-fund manager style Porsche. I mean that the hedge-fund community is full of smart people with useful information to pass on to you. Their ideas about obtaining absolute returns in all market conditions, controlling the downside, managing risks and understanding trends are simply good, old-fashioned commonsense.

I hope that this book acts as your guide to this advanced form of investing. It brazenly swipes ideas from the hedge-fund masters, acknowledges their failings and weaknesses, and attempts to put the best ideas in a practical context that you can use within your portfolio on a daily basis.

About This Book

Plenty of books about investing promise a magic formula. These get-rich-quick manuals offer some allegedly quick formula or special set of measures that instantly illuminates the darkest corners of the global investment world. Read those instant-promise books if you like, but you may as well just visit the horse races! Instead, I encourage you to be disciplined, careful, cautious and to think like a professional hedge-fund manager. This book doesn’t promise to make you rich overnight, but it may help preserve some of your hard-earned wealth by helping you to think intelligently about the downsides of investing and the need to stay disciplined when looking for the upside.

This book may even encourage you to introduce new strategies that painstakingly produce relatively steady profits on a regular basis. After all, that’s what some of the most successful investors in the world do – many of them hedge-fund managers. They concentrate on getting the small things right, on absolutely making sure that a simple investment insight works like clockwork on a regular basis. They grind out small, regular, steady profits by making sure that they don’t have too much at risk in the frightening financial markets. Despite their reputations, hedge-fund managers are frequently cautious, careful types.

This book reveals some of their tried-and-trusted techniques and ideas. It talks about hedging your downside, using options to produce an income from volatile markets and working out which company or share constitutes ‘good value’. In sum, this book is about preserving capital and having modest aspirations for making steady positive returns over the long term.

What You’re Not to Read

I heard a rumour that not all readers read every page of every book that they buy. This shocking revelation doesn’t leave me in despair, though. I realise that you’re a busy person and that every once in a while a more entertaining activity may present itself while you’re reading this book.

To help manage this painful neglect (!), this book is designed so that you can just dip in and out; I even highlight certain sections that you don’t have to read. Sidebars (those grey boxes of text), for instance, give you a more in-depth look at a certain topic, but aren’t essential to you understanding the rest of the book. Feel free to read or skip them. Similarly, you can a pass over the text that appears besides the Technical Stuff icons if you prefer. This technical material is interesting and may get you ahead of the pack, but you can still come away with everything you need without reading this text. Honestly, I won’t be offended if you quietly skip over them and read the ‘best’ bits!

Conventions Used in This Book

I do my best to make this book as easy-to-read and pain-free as possible. For starters, I make use of the following conventions:

Italic type indicates new terms that I define nearby.

Monofont is used for web addresses. The Internet bring lots of facts and figures easily to hand, and so I direct you to many useful websites.

The shaded grey boxes of text are filled with interesting but not essential information.

In general examples that require a gender, I use female in odd-numbered chapters and male in even-numbered chapters.

Foolish Assumptions

I assume a few things about you as follows (sorry for being presumptuous!):

You’re a relatively advanced, smart investor who has a portfolio with lots of different working aspects in it.

You’re already invested in shares and bonds and willing to experiment by looking at more adventurous investment ideas and asset classes (new investment categories).

You’re suspicious of the pointy-head types that you regularly see on TV pontificating about the secrets of their own success. Like all good cynical investors you sneakily concede that they may have some insights that you can learn from. But you want to check their ideas against the strategies outlined in this book and work out for yourself what’s bravado and what’s truly insightful.

You’re ready to think about investing in a new way that involves minimising your downside risk, riding the volatility of markets (to your advantage) and being modest about your investment aspirations. Gains of 4X5 per cent annually, year on year, without big losses, are more appealing to you than one fantastic year of amazing 50 per cent gains and then a following painful year of 70 per cent losses.

How This Book Is Organised

The information is laid out in a straightforward format. The six logical parts contain self-contained chapters that any investor interested in shares can follow easily.

Part I: It’s All about Portfolios

The two chapters in this part are all about the basics. Chapter 1 explains why a diversified portfolio is so important and Chapter 2 shows you how your own attitude towards risk needs to influence the investments you plan to stuff in your portfolio. In particular, watch out for the idea of adjusting your mix of assets based on your long-term savings goals . . . and your age!

Part II: Picking the Strategies for You

Hedge funds contain some of the smartest people on the planet, who spend their time figuring out how the markets work and what investors have to do to maximise their upside and minimise their downside. This clutch of chapters digs deep into hedge-fund land, looking in Chapter 3 at core techniques and strategies and in Chapter 4 at how real world economies affect markets and why volatility matters. Chapter 5 covers the vital role that alternative assets, such as commodities and currencies, play in building a diversified portfolio, and Chapter 6 contains a warning that hedge funds can be expensive and not always rewarding to you. Buyer beware!

Part III: Thinking and Acting Like a Hedgie: Simple Strategies You Can Employ Yourself

Ask professional hedge-fund managers what exactly they do, and how, and you’re likely to hear procrastination and general ‘clouding of the air’: ‘it’s far too difficult to explain to an outsider like you’ is the common, general thrust of the response. But working out how hedge funds run their investment process isn’t nightmarish or incredibly complicated, although the subject does have its more arcane and technical bits involving super computers that defy simple explanations.

But most hedge-fund investors don’t rely on complex algorithms. They use fairly straightforward, easy-to-understand techniques that advanced investors can copy, as I describe in this part. Chapter 7 dishes the dirt on the longing to go short (as opposed to getting caught short trying to go long!), Chapter 8 discusses arbitrage (using price differences to profit) and Chapter 9 investigates the competing merits of value versus growth investing. In Chapter 10, I introduce you to using leverage (borrowing to invest) to increase your returns, in Chapter 11 to structured investments and in Chapter 12 to the mysterious art of shaking things up via shareholder activism.

Part IV: Delving Into More Specialist Techniques (with a Little Help)

In this part, I put some of the strategic thinking to the test in the real world of specialist investing.

Chapter 13 describes investing in commodities from gold to oil, Chapter 14 dips into the emerging markets of the developing world and Chapter 15 takes in the big economic picture with macro-investing.

Part V: Tools of the Trade: Useful Instruments

Hedge-fund investors are discerning about the instruments (the funds, options and betting products) they buy to make money on the markets. These sophisticated financial buyers have educated the marketplace and encouraged a huge wave of innovation, helping to fuel the rise of exchange-traded funds (the subject of Chapter 16) and spread betting on the direction of the markets, which I describe in Chapter 17.

In the right hands, backed up by sensible strategies, these innovative financial products and structures can make a huge difference, but you absolutely need to know when and how to use these products.

Part VI: The Part of Tens

This part is the For Dummies hallmark – the Part of Tens. These chapters give you a crash course in wealth preservation (Chapter 18) and a primer on strategies for making money that have withstood the test of time (Chapter 19).

Icons Used in This Book

To help you navigate your way around this book, I use the following icons to highlight certain types of text.

This icon flags a particular bit of practical advice that may give you an edge over other investors.

I use this icon to remind you to stash this information in your memory, whether you’re new to investing or an old pro.

Pay special attention to this icon, because the advice can prevent headaches, heartbreaks and financial woes.

Throughout this book I aim to avoid technical text or jargon where possible, but sometimes such bits and pieces can help. This icon indicates more involved or complicated information, such as equations and background material, that you can skip if you want to without any harm coming to your investing!

I place this icon besides detailed descriptions of specific investment approaches. Often this text comprises a simple imagined scenario that walks you through a strategy easily and clearly.

Where to Go from Here

You can read this book in whatever way and in any order you like. If you want to get straight down to business, flip to the three top-ten chapters in Part V for immediate tips and follow the cross-references to whatever chapter grabs your fancy.

If you want the basics, be conventional and start with Parts I and II. They set out the ground rules for a more sophisticated kind of investing. Parts III and IV contain a wide variety of different strategies and not everything is going to light your particular fire, but if you read the first few chapters you’re more likely to know what kind of investor you are and what’s going to work for you.

After reading a few chapters, you’ll feel a little more confident about testing out new ideas and advanced strategies and I hope become a smarter, more sophisticated investor who understands how to gear up your returns and minimise your downside.

Happy reading and I wish you a stable and profitable investment future.

Part I

It’s All about Portfolios

For Dummies can help you get started with lots of subjects. Visit www.dummies.com to learn more and do more with For Dummies.

In this part . . .

Understand the value of creating a well-balanced investment portfolio and how to protect your money.

Learn about university endowments and hedge-funds and assess whether these are good investment options for you.

Examine your risk/return trade-off and select the investments that are right for you.

Further develop your portfolio by considering more sophisticated investment strategies.

Chapter 1

Introducing Great Opportunities for Advanced Investors

In This Chapter

Realising that creating a portfolio is the foundation

Understanding that diversifying is key

Thinking long term with a university endowment

Taking lessons from hedge funds

Most investors follow a similar path when they start out: they invest, make mistakes and lose money, but they learn lessons from the process. With the passage of time, they develop a sensible, balanced style of investment that works for them, somewhere on the spectrum from ultra conservative to wildly adventurous.

In this introductory chapter on investment ideas for serious investors, I describe some techniques, stress the importance of creating a well-diversified portfolio, focus on university endowments in particular because of these investment funds’ proven ability to deliver outstanding returns in difficult markets, and say briefly why you can learn from hedge-fund best practice.

Investing is all about building a diversified portfolio full of different ideas, strategies and asset classes (commodities, bonds, shares and so on).

Building a Balanced Portfolio

The basic building block for any investor is the humble portfolio, a long list of assets held within your stock-broking or investing account.

I hope that you’re not invested in just one asset class to the exclusion of everything else, such as being invested in only one share or bond. If you are, I’m going to do everything in my power to convince you to do otherwise! The reason? Because you reduce risk when you diversify your portfolio.

Thinking about asset classes

Portfolio thinking starts with the idea of diversification, which means including different asset classes (bonds, stocks, commodities) within one portfolio.

An asset class is a broad grouping of investment opportunities that share a number of key characteristics. All government bonds, for instance, are largely similar in structure, as are stocks or shares – ditto for commodities. These asset classes represent broad buckets (groups) of opportunities available to you as an investor. Of course, thousands of different individual shares, bonds and investment products exist within each bucket, some of which are worth your consideration, but most of which you need to avoid with a lengthy barge pole.

Diving into a world of choice

The huge variety of asset classes and their contents means that investment life extends beyond a few big individual blue chip shares (names such as Apple or Google, BP or Exxon) or lending money to Uncle Sam through the massive US bond programme.

You have a world of choice available and I suggest that you make sure that your list of potential opportunities is long, even if your actual investment actions are relatively uncomplicated and succinct.

The key to investment success is to juggle these different buckets that comprise different asset classes in a sensible and intelligent fashion, which entails thinking long and hard about diversification. Luckily academics have done much of the heavy lifting for you and they’ve come up with some smart ideas about how you build a diversified portfolio of assets.

Dozens and dozens of different asset classes exist, but in essence you need to start with the three main groups:

Bonds: Includes everything from lower-risk government securities to higher-risk corporate bonds issued by so-called risky companies.

Equities: Includes stocks and shares. But within this simple definition is a world of different national markets (the US is the largest, followed by the UK, Europe and Japan), regional markets and even global markets (a composite of all the national markets). In addition, certain equity-based asset classes cut across these definitions to focus on particular sectors (energy companies, for instance) as well as themes such as value versus growth investing (the subject of Chapter 9).

Alternative assets: Indicates the huge range of investment ideas that don’t quite fit in the bonds and equity buckets, from hedge funds dabbling in esoteric commodity strategies (of the sort I discuss in Chapter 13) to forestry funds.

The sensible, diversified investor looks to invest in the full range of assets. No matter what your style, at the very least you need to consider investing in items from all three broad asset classes.

Diversifying Your Investments

Many investors intrinsically understand the concept of not putting all your eggs in one basket and probably practise a primitive form of diversification. Academic economists have taken this commonsense notion and turned it into the noble idea of modern portfolio theory.

I’m not going to bore you to death with a lengthy exposition of the ins and outs of this very specialised academic field. Suffice to say that most investors have three building blocks that comprise their total return:

Risk-free return: Usually the rate of return you get from cash.

Return from beta: The return you get above the risk-free rate of return from holding an asset class such as shares or a market. So if the risk-free rate of return is 2 per cent and you buy a tracker for the UK FTSE All Share index that gives you 8 per cent per year, your beta is 6 per cent.

Return from alpha: The value added by a financial manager that’s derived by the person moving away from the beta. Most managers aren’t very good at adding this alpha, but they continue to charge you extra in terms of fees regardless!

Be careful with the distinction between beta and alpha, especially as regards fund managers. After a good year in which the market’s overall value has greatly increased, you see many fund managers trumpeting their own individual success. This blatant mis-marketing frequently confuses the beta of a market (the overall return from investing in a market) with the alpha skills of the fund manager (that is, what special thing the person did that resulted in the higher return).

With alpha, look for consistent outperformance by a fund manager, not just one year’s good result followed by endless average performances.

Mixing and matching different betas: Correlation

The concept of diversification means that lots of different kinds of markets and assets (bonds mixed with shares and, say, an alternative asset such as commodities) can give you lots of different betas, and if you’re lucky those different betas don’t move as one; that is, they aren’t correlated as they jump up and down in value. Thus if equities go down bonds may rise in value along with, say, commodities such as gold. Mixing different betas therefore gives you added benefits and improves returns.

Correlation is a key term that you hear bandied about in the discussion on portfolios and it’s connected to how two different asset classes move in relationship with each other:

Positive correlation: If two different asset classes have a positive correlation of 1, they move as one. When one goes up, the other goes up as well. Similarly, when one goes down, so does the other.

Uncorrelated: If two different asset classes are uncorrelated (have a correlation of zero), no relationship exists and they move independently of each other.

Negative correlation: If the different asset classes have a negative correlation, one moves up as the other moves down.

In an ideal situation your diversified portfolio has some assets that are positively correlated with each other (perhaps emerging-market stocks and developed-world stocks, which I discuss in Chapter 14), some uncorrelated (commodities and bonds) and some negatively correlated (bonds and shares; I cover this relationship in the discussion on volatility and economic cycles in Chapters 4 and 15). The key is to mix asset classes with different correlations.

Be careful about putting in your portfolio lots of diversified assets that are very closely correlated with each other. For instance, watch out for lots of apparently diversified assets that all go up or down as one because they have the same sensitivity and therefore increase your risk.

Consider a portfolio made up of Chinese shares, mining company shares quoted on the London stock market and bonds issued by large Canadian banks. On paper, you seem to have a great deal of diversification within this portfolio, but in reality Chinese shares and UK-based mining shares tend to move in a similar way because in effect you’re buying into the global business cycle and its effect on industrial production in China. And guess which country has a heavy exposure to mining and whose banks have lent substantial amounts of money to the mining sector? That’s right . . . Canada and its banks. The bottom line is to think intelligently about diversification to ensure that your portfolio not only includes different asset classes but also includes a balance between positively, negatively and uncorrelated assets.

Combining assets and betas

Economists are so smitten with the idea of diversification – some call it the diversification premium – that they suggest it’s the one free lunch left in investing. Although in recent years even that seems to come at a rather hefty price as markets begin to move as one during periods of stress.

The prime mover in the academic field of diversification analysis was economist Harry Markowitz, who showed how investors can combine different asset classes and betas without increasing risk.

Later economists and analysts have taken Markowitz’s ideas and fleshed them out. The fund manager at Yale University’s endowment fund David Swensen, for instance, spent decades running hugely diversified portfolios investing in everything from forests to private equity funds and hedge funds. I discuss some of his accumulated learning in the later section ‘Investing in University Endowment Funds’.

Thinking like an asset allocator

In 1986, three leading academics looked at what really contributes towards the performance of a portfolio. These three wise men were called Brinson, Singer and Beebower, and in a seminal paper they looked at fund managers’ market-timing skills, their ability to pick shares and their ability to diversify assets. They studied just under 100 of the largest pension plans in the US over a ten-year period, with portfolio sizes reaching to US$3 billion.

They discovered that a massive 91 per cent of investment return was explainable by careful use of diversification and the use of varying asset classes and markets over time. In fact, the study found that traditional and often much trumpeted active fund-management skills such as timing (making decisions to buy and sell based on predictions of future market prices) and stock picking (selecting stocks based on a set of criteria assumed to indicate the stock’s growing value) produced negativereturns over time after adjustments for risk.

The bottom line? Don’t bother picking individual shares or trying to time the market, just allocate across different asset classes in an intelligent, diversified manner.

Including alternative assets in your portfolio

Including alternative assets, such as currencies and commodities, in a well-balanced portfolio can improve returns (flip to Chapter 5 for all about alternative-asset investing). A study by research firm Ibbotson Associates discovered that the average improvement in returns from these uncorrelated assets was worth 1.33 per cent per year. The company also found that asset allocation and active diversification accounted for 81.4 per cent of the monthly variation in balanced return funds.

Deciding how much diversification is enough

Accepting that diversification is a good thing is great, but then you need to apply this piece of wisdom within your portfolio.

Back in September 2005, US analysts Paul Merriman and Richard Buck attempted to resolve the question of how to go about building ‘one portfolio for life’. Using the database of Dimensional Fund Advisers, the researchers looked at returns between 1955 and 2004, a 50-year period that included lots of bear (downwards), bull (upwards) and sideways tracking markets. They looked at three potential portfolios, each of which produced dramatically different results:

Option 1 – S&P 500 tracker: Annual return of 10.9 per cent.

Option 2 – 60 per cent in the S&P 500 Index and 40 per cent in five-year Treasury notes: Annual return of 9.6 per cent.

Option 3 – As option 2 but with the equity split four ways between US-based large-capitalised stocks, large-cap value stocks, small-cap stocks and small-cap value stocks: Best annual return by far. ‘Over the 50 years in our study,’ Merriman and Buck report, ‘this diversified 60/40 portfolio produced a return of 11.4 per cent, with a maximum drawdown (loss) of 25 per cent.’

Putting a figure on the benefits

Diversification can work wonders if done properly, especially if you’re willing to stack up your portfolio with different types of asset classes. One US-based financial thinker called Geoff Considine has even gone so far as to put a number on the value of the diversification premium: 2–2.5 per cent per year.

No fixed rules apply to how many different asset classes to put in your portfolio, but certainly consider having some shares, some bonds and some alternative assets (especially hedge funds and hedge-fund strategies). If you’re a cautious investor, focus on bonds; if you’re more adventurous, put more money into shares.

Going global

Merriman and Bucks’s original analysis (in the preceding section) looked only at US investments, but they suspected that benefits come from investing internationally as well.

Therefore, they looked at year-by-year returns from 1970 to 2004 for an investor using diversified option 3 but where the 60 per cent equity segment was split: 50 per cent into US-based stocks of varying sizes (large-cap stocks, large-cap value stocks, small-cap stocks and small-cap value stocks) and 50 per cent into international stocks (split five ways, to include large-cap stocks, large-cap value stocks, small-cap stocks, small-cap value stocks and stocks in emerging markets).

Returns increased by more than 40-fold! So the more you diversify internationally, the greater your potential returns.

Investing in University Endowment Funds

The research into diversification outlined in the earlier section ‘Diversifying Your Investments’ produces three simple but compelling recommendations:

Think global.

Think across different asset classes.

Mix and match different options such as bonds and shares in varying combinations.

Seems simple enough, but in the real world you’re faced with a massive and baffling array of options. What do you do when confronted by thousands of different investment strategies, ideas and products? Step forward the subject of this section – a rather unconventional source of wisdom for advanced investors called university investment endowment funds, which have an open-ended, long-term commitment to provide funding for institutions that are in many cases hundreds of years old.

Considering the university endowment model

Perhaps the single most successful investment model of the last decade, university-based investment funds have pioneered a raft of new strategies that continue to deliver exceptional returns in incredibly difficult markets. Leading institutions such as the Yale University endowment – managed by the charismatic US investor David Swenson – have developed a very distinctive approach that focuses on the extensive use of alternative assets as well as on the use of hard assets (think of oil and natural gas, gold and other precious metals, and real estate and farmland – assets that have intrinsic value) that may protect these august institutions against the ravages of future inflationary pressures.

The long-term focus of university endowments, however, doesn’t mean that they don’t also need to derive a generous income in the here and now – cost inflation at large US- and UK-based institutions (think institutions such as Oxford and Cambridge) is unrelenting and a limit applies to what governments or students can afford to pay through fees.

This focus on protection against inflation has made the large endowments keen to invest in hard assets that have inflationary protection – Yale, for instance, is a major investor in New Zealand forestry plantations while the large UK universities such as Cambridge own extensive agricultural land banks.

University endowments are also determined to keep costs to the minimum, running their own in-house investment advisory units and hiring expert, outside managers only at low rates for limited periods of time.

I emphasise this powerful lesson throughout this book: keep costs to a minimum and don’t let professional money managers rip you off with the promise of lots of extra returns!

Traditionally this focus on cost-effective, inflation-plus returns would have prompted these large institutions to focus on high-yielding mainstream shares. After all, shares are the only asset class in the last 100 years to consistently deliver real returns over a few per cent per year after net costs. Yet the endowments at Harvard and Yale have developed portfolios that look very different. Their portfolios are phenomenally diversified, with all manner of alternative assets including land, forestry, private equity and hedge funds, and a surprisingly small amount of direct equity exposure.

This explicit focus on a diversified portfolio of very differing asset classes delivered remarkable returns (see Table 1-1). The top five endowments in the US (with assets for each endowment of more than US$10 billion) returned 9.7 per cent per year for the last ten years to the end of June 2011. This is 5.1 per cent greater than the returns of a traditional US 60 per cent equity/40 per cent bond portfolio for a private investor, which returned just 4.6 per cent annually. (I describe these 60/40 portfolios in the earlier section ‘Deciding how much diversification is enough’.)

Table 1-1 Ten-Year Returns by Endowment Fund Size to June 2011

Portfolio

10-year Annualised Return as Percentage

Alternative Assets as Percentage of Total

Typical US equity (60%)/bond (40%) portfolio

4.6

0

Average US endowment

5.6

53

Top-5 endowment funds with assets under management of more than US$10 billion

9.7

69

Harvard and Yale (the super-endowments)

9.8

69

Source: Frontier Investment Management – more details at http://www.frontierim.com/asset-allocation-driving-returns-research.aspx

Seeking alternatives

At the core of the endowment model is a relatively simple idea: diversifying your range of asset classes beyond the conventional shares and bonds. Many US endowment fund managers have devised a strategy that involves buying not only US stocks, but also a wide range of bonds, lots and lots of foreign stocks, plus a heavy dose of alternative assets that aren’t highly correlated with the stock market (see Chapter 5 for details).

Whereas ordinary investors with a standard 60/40 split of assets (shares and bonds) have almost no exposure to alternatives, the big endowments invest a huge proportion of their funds in these alternative assets, which include everything from private equity to hedge funds. Table 1-2 shows the major asset classes in the largest university endowment funds. Notice the heavy exposure to hedge funds, private equity, real estate and commodities – most ordinary investors probably struggle to have more than a few per cent of their portfolio in each or all of these alternatives, but the endowments typically hold the majority of their assets in these alternatives.

Table 1-2 Top 20 US Endowment Funds by Assets

Asset Class

Proportion of Fund (%)

Private equity

20

Global equities

21

Hedge funds

22

Global bonds

10

Commodities

9

Real estate

10

Emerging equities

6

Source: Frontier Investment Management and various US University Annual Reports

Digging a bit deeper into the model’s core investment ideas

These huge funds have adopted a number of core investing ideas:

Diversify, diversify and diversify! The institutions have lots and lots of alternatives in their portfolios.

Maintain an absolute global focus with a major shift away from local currency assets into developed-world markets. Not one of the major US or UK endowments invests more than 50 per cent of its assets in local currency assets (check out Chapter 5 for all about currencies).

Keep bond investments (and especially gilts) to a very low level.

Invest heavily in hard assets that provide protection against inflation – that means investing in land, residential and commercial property, and energy-based assets.

Hold a diversified portfolio, avoid attempts at market timing and fine-tune allocations at extreme valuations.

Use outside managers for all but the most routine or indexed investments. This outside manager must be expert in diversifying complex portfolios and using highly sophisticated investment strategies, areas of expertise that may be beyond the purview of in-house university staff cash managers.

University endowment funds use only those outside fund managers who add ‘value’ – called alpha in the trade, as I explain in the earlier section ‘Diversifying Your Investments’ – and make sure that you pick the very best.

Hold relatively low levels of cash with a standard range between 5–10 per cent.

Remembering that the endowment model doesn’t always work

The radical approach to investing embodied by the endowment model has been phenomenally successful but it doesn’t make money in all markets, especially when absolutely everything, except perceived safe assets such as gilts, start tumbling in price.

In 2008, for instance, many of the large US endowments saw their funds crash in value. The median decline in return for all endowments to 30 June 2009 was 19 per cent, against a loss of 26.2 per cent for the S&P 500 over the same period. The super-big endowments lost even more money, with Harvard and Yale experiencing 27 per cent and 25 per cent respective declines. (Note: Different from an average, a median is the middle value of a series of values arranged in an order of magnitude.)

The problem is the nature of illiquid assets; that is, assets that can’t be easily or immediately sold, like property, collectibles and, in some cases, giant blocks of stock. Many alternative assets end up investing in strategies and ideas that are relatively illiquid. The big endowments are major investors in illiquid ideas because they can afford to be patient. Similarly, pension funds are willing to invest in more illiquid assets because they don’t need to be able to access their funds in a matter of a few days. Private investors can also afford to be patient and invest in illiquid assets, especially if they have a very long-term plan and are willing to ignore day-to-day or month-to-month changes in price.

Illiquid assets can be very dangerous when investors are scared witless and want to keep their money safe in so-called liquid assets such as cash. During panics, illiquid assets are sometimes hit badly in price and then take many months to recover after confidence is restored.

Getting back in the game

The dark days of 2008 are now a relatively dim and distant memory for these large endowments – their recent performance has been exceptional, with Harvard and Yale notching up returns of more than 15 per cent in 2011. Table 1-3 shows that Harvard now has over US$30 billion in assets in its endowment compared to Yale with US$19 billion, although the University of Texas System produced the best results in 2011, with a gain of 22 per cent on its endowment.

In addition, this return to superior performance didn’t involve any particular change to what these large funds invest in. Table 1-4 shows that the largest and most successful funds (those over US$1 billion) continue to pump huge amounts of money into alternative assets including hedge funds and private equity funds. The smaller funds (those under US$25 million) tended to leave the largest allocation of their investment money in more traditional assets.

Integrating endowment model principles in your own portfolio

The recent return to form for large endowment funds tells you an important fact – over the long term, the endowment model delivers exceptional returns in a relatively stable manner. They do so by using the following techniques:

Use alternatives: Think out of the box and don’t stick just to the standard 60/40 per cent equity/bond mix that I describe earlier in ‘Deciding how much diversification is enough’.

Get the best managers: Make sure that you hunt down the very best managers if you’re going to pay for expert advice; otherwise keep things simple, cut costs and use index-tracking funds (including the exchange-traded funds that I cover in Chapter 16).

Be adventurous and think global: For example, if you’re based in the UK don’t be overly focused on your home country and sterling.

Think real assets: Ensure that you have some inflation proofing inside your portfolio by investing in hard assets, like metals, land, and energy sources – assets that tend to be negatively correlated to stocks and bonds (refer to the earlier section ‘Mixing and matching different betas: Correlation’.

Although in theory you can apply these principles to any portfolio, no matter how big or small, the truth is that large endowments have huge advantages over mere mortals. For this reason many experts concede that the big endowment funds run strategies that average private investors can’t easily copy.

For instance, many successful fund managers only accept money from outfits such as super-big endowments, because those funds are large, stable and for the long term. Some successful fund managers, especially in the private equity space, have also closed their offerings to new money, effectively locking out all but a tiny part of the market. But endowment enthusiasts don’t think that you and I should give up, as the next three sections reveal.

David Swenson and Yale

David Swenson of Yale endowment fame (see the earlier section ‘Considering the university endowment model’) reckons that if you don’t have access to his amazing panel of top return-producing fund managers, you shouldn’t try to pick individual stocks or pay anyone to do it for you. He’s a tireless critic of the mainstream for-profit mutual-fund industry.

Instead, he advocates that private investors should use low-cost index funds as one way of building a diversified portfolio. In his bestselling book Unconventional Success: A Fundamental Approach to Personal Investment (and later revisions), Swenson maps out a ‘well-diversified, equity-oriented portfolio’ for private investors.

His current advice is that you create a single portfolio consisting of passive, index-tracking funds that invest in the following:

Domestic (US/UK) stock funds: 30 per cent

Real estate investment trusts: 15 per cent

US (or UK) Treasury bonds: 15 per cent

US (or UK) Treasury inflation-protected securities: 15 per cent

Foreign developed-market stock funds (such as the EU, Japan, Australia): 15 per cent

Emerging-market stock funds (Brazil, Russia, India, China, Taiwan, South Korea and the rest of the developing world): 10 per cent

Mike Azlen and Frontier

Other experts have their own endowment-based portfolio mixes. For instance, UK investor Mike Azlen, based at fund manager Frontier, runs low-cost multi-asset class portfolios that draw on the best ideas of university endowments (see Table 1-5). These varying-risk-based portfolios comprise passively managed funds at a cost of less than 1 per cent per year. In particular Azlen’s funds mirror many of the same asset allocations used by Harvard and Yale universities.

Table 1-5 Endowment Index Portfolio: 2011 Asset Allocation

Asset Class

Proportion of Fund (%)

Private equity

27

Commodities

13

Global equities

13

Global bonds

10

Real estate

13

Hedge funds

8

Managed futures or CTA hedge funds

8

Emerging-markets equities

6

Emerging-markets bonds

Under 2

Source: Frontier Investment Management

Mebane Faber and Cambrian IM

US-based fund manager and investment writer Mebane Faber – chief investment officer at Cambrian IM – is a fan of the diversified endowment model.

In a recent book with Eric Richardson, The Ivy Portfolio (as in the Ivy League of top US universities), Faber outlines what he thinks a private investor’s portfolio may look like, with all the building blocks comprised of cheap, low-cost passive tracking funds, such as ETFs (which I discuss in Chapter 16):

Domestic (US/UK) stocks: 20 per cent

Foreign (non US or UK) stocks: 20 per cent

Bonds: 20 per cent

Real estate: 20 per cent

Commodities: 20 per cent

Loving Your Hedge-Fund Manager

Preserving your capital is a vital aspect of any investment strategy. Your accumulated long-term savings are the product of many years of hard work and yet they can be destroyed in a matter of weeks, by forces entirely beyond your control. You can always look to earn more or less, but your nest egg or pension fund has to last you for the rest of your life. If that money goes, you have to work a whole lot harder to rebuild your stash of capital, or accept that your twilight years may be blighted by poverty and low levels of income. (For immediate tips on protecting your wealth, visit Chapter 18.)

This gloomy way of thinking leads many investors to a central insight: preservation of capital is a primary consideration. Just as endowments (see the earlier section ‘Investing in University Endowment Funds’) have to keep funding lecturers’ fees and maintaining grand libraries, so you have to keep paying out for your retirement costs.

The idea of capital preservation has found a willing audience within the hedge-fund community. Many of the best professional money managers have built successful careers around the idea of absolute returns (making money whether markets rise or fall; see Chapter 2 for more). Of course, cynical observers can easily denigrate successful hedge-fund managers as money vampires looking to impoverish investors through Ponzi schemes, excessive costs and duff trading strategies (I examine hedge-fund criticisms in Chapter 6).

Ponzi schemes are fraudulent investment schemes in which higher-than-average returns are promised to investors and then paid using the investors’ own money. Named after Charles Ponzi who gained notoriety using the scheme in the 1920s, Ponzi schemes reemerge regularly. Recent schemes involve Nicholas Levene, who bilked investors of £32 million, and Bernie Madoff, whose massive Ponzi scheme cost investors billions of dollars.

But good hedge-fund managers are some of the best managers in existence today and many have concluded that private investors like you take too much risk with your accumulated savings. (Turn to Chapter 3 for a discussion on basic hedge-fund techniques and Chapter 2 for help deciding on the correct level of investment risk for you.) They suggest that you focus on preserving your capital and then look to grind out a steady, positive return no matter which direction the financial markets are going in.

These managers think that you should be aiming for a steady 4–10 per cent per year return, year in, year out. They believe that you need to be brave, sometimes adventurous, and look to all manner of different asset classes and investment strategies including controversial practices such as:

Shorting: Selling what you don’t own (see Chapter 7).

Arbitrage: Buying and selling an asset at the same time to make a profit from the price difference (check out Chapter 8).

Leverage: Borrowing other people’s money to invest (if that sounds good, turn to Chapter 10).

Structured instruments: Employing a simple risk/return trade-off that creates a series of options to increase your payout (mosey over to Chapter 11) for more.

Shareholder activism: Pressuring a firm’s managers and Board to increase the value of the company’s shares (race to Chapter 12 when you’re feeling ‘active’!).

Spread betting: Betting on the movements of financial markets (gamblers need to head to Chapter 17).

The core investment mantra of hedge-fund managers is: if you’re willing to diversify ideas and strategies, you’re better able to produce an absolute return in all markets. The big university endowments certainly believe this sales pitch and many of the world’s wealthiest investors have also bought into this strategy – and so can you.

Chapter 2

Assessing Risk: Deciding What Kind of Investor You Are

In This Chapter

Clarifying what’s important to you

Getting a grip on your risk/return trade-off

Achieving what you want from your portfolio

Looking at advanced portfolio strategies

Being successful at anything in life involves knowing yourself well, and building an investment portfolio is no different. To invest wisely and profitably you need to assess your strengths and weaknesses and your current circumstances. Plus, having clear goals and strategies in mind as to what you’re seeking from your portfolio now and in the future stands you in good stead, because investing requires understanding and balancing trade-offs, most obviously ones involving risk.

In this chapter I help you decide on the kind of investor you are by taking a look at two trade-offs that are central to building a successful portfolio, examining your investment priorities and tolerance for risk so that you can choose the investments that are right for you, and offering information about more-sophisticated investment strategies and principles you’ll want to consider as you manage your portfolio.

A Tale of Two Trade-Offs

In the best of all possible worlds (apologies to Dickens and Voltaire fans for mixing literary references), there’d be no trade-offs, and you wouldn’t have to compromise on one good thing to receive the benefits of another good thing. Alas, when portfolio planning in the real world, consider trade-offs you must. Specifically, you must think about the trade-off between risk and return and the trade-off between risk and your age.

Knowing how these two trade-offs work in reality is certainly crucial to investment success, but also your views on them helps you discover the sort of investor you are or want to become:

The trade-off between what returns you can expect versus the risks you’re going to take: