This book lives up to its intention as an introduction to the basics of money and investing. It begins with the history of the monetary system in the United States and elsewhere, explains stocks, stock exchanges, the market and its cycles, bonds, mutual funds, and futures and options.
Full of charts, tables, and graphics, it provides illustrations and examples of concepts and financial processes, such as what happens during a purchase of stock on the New York Stock Exchange. Additionally, it shows correlations--the cause and effect relationship between weak and strong dollars on international stock purchases.
The book offered investment strategies, using options. As the authors stated:
"You can use options conservatively to increase your income or to limit your risk.
The most popular income-producing strategy is selling covered calls. You write call options on a share-for-share basis against stocks you own. If someone exercises the calls, you meet your obligation to sell by handing over your stocks. The goals of covered calls are to provide some protection if the stock price falls, establish a selling price above the current market price or increase your income in a sideways market, when prices move up and down within a very small range.
Writing cash-secured puts is another income-oriented approach. You sell a put for each 100 shares of stock an investor is willing to buy at a special price. Then, as security, you invest an equivalent amount in U.S. Treasury bills or a money market account. If the put is exercised, you liquidate that investment and use the cash to buy the stock"(pp. 144-145).
I plan to read more recent editions of this book, to make a comparison of the information they contain. Stay tuned!
Morris, K. M. & V. B. Morris. (1999). The Wall Street Journal Guide to Understanding Money and Investing. New York: Lightbulb Press, Inc. and Dow Jones & Co., Inc.
Friday, November 27, 2009
Tuesday, November 3, 2009
Time-Driven Activity-Based Costing
Kaplan, R. S. & Anderson, S. R. (2007). Time-driven Activity-Based Costing : A simpler and more Powerful Path to Higher Profits. Boston, MA: Harvard Business School Press.
Robert Kaplan, best known for his work on the Balanced Scorecard, and Steven R. Anderson wrote this book to demonstrate how enterprise resource planning (ERP) systems enable companies to assess at the transaction level the time consumed in steps of processes. Specifically, time-driven activity-based costing measured the "cost and profitability of producing and delivering their products and services, and managing their customer relationships" (p. xi).
The Balanced Scorecard, equally as necessary for companies to evaluate their progress, reveals how companies create value for employees, shareholders, customers, and investors.
If a company realized a low total-cost strategy, activity-based costing enables managers to accurately measure the costs of significant processes. If a company has not gaged the profitability of their customers, activity-based costing provides insight into that information. According to the authors, customer profitability influences other customer metrics, "such as satisfaction, retention, and growth, to signal that customer relationships are desirable only if these relationships generate increased profits" (p. xii).
Traditional standard cost system employed three cost factors--labor, materials, and overhead. With increased automation, the authors argued that allocations of costs under this system became distorted. Activity-based costing corrected these distortions "by tracing these indirect and support costs first to the activities performed by the organization's shared resources, and then assigning the activity costs down to orders, products, and customers on the basis of the quantity of each organizational activity consumed" (p. 5).
Anderson improved on the activity-based costing model with the 'time-driven activity-based costing' (TDABC). Finding the data gathering to support the conventional model "time-consuming . . . costly . . . subjective . . . . difficult to validate . . . local . . . not easily updated . . . theoretically incorrect when it ignored the potential for unused capacity" (p. 7), TDABC modified the conventional system "by eliminating the need to interview and survey employees for allocating resource costs to activities before driving them down to cost objects (orders, products, and customers).
Time-driven activity based costing involves a two step process. The first, "the TDABC model calculates the cost of supplying resource capacity . . . personnel, supervision, occupancy, equipment and technology" (p. 8). "It divides this total cost by the capacity--the time available from the employees actually performing the work--of the department to obtain the capacity cost rate" (p. 8). The second step, "TDABC uses the capacity cost rate to drive departmental resource costs to cost objects by estimating the demand for resource capacity . . . that each cost object requires"(p. 8).
PRACTICAL APPLICATION
Capacity cost rate = Cost of capacity supplied
----------------------------------------------
Practical capacity of resources supplied
Capacity cost rate = $567,000
------------------------------------------------
630,000 minutes = $0.90 per minute
TDABC estimates of customer related activities:
Process customer orders : 8 minutes
Handle customer inquiries: 44 minutes
Perform credit check: 50 minutes
TDABC COST DRIVERS
-------------------------------------------------------------------------
Activity Unit time (minutes) Rates (at $0.90/minute)
----------------------------------------------------------------------------------------
Process customer order 8 $ 7.20
Handle customer inquiry 44 $39.60
Perform credit check 50 $45.00
Used capacity
Unused capacity (8.2)
As a tool for future decision making, the TDABC allows managers to develop trends of data over time. Modifications to the tool occur from new activities, for example, changes in time due to more complicated or custom processes, changes in cost rates, due to automation or increased efficiencies, such as the implementation of quality programs. Therefore, the system adapts to changes in circumstances.
To estimate processing time, the first principal of TDABC, enterprise resource planning systems aid companies in accumulating data, such as cubic meters, kilograms, gigabytes, and bauds. Global positioning systems and radio frequency identification devices facilitate accumulating data. Having detailed and complete business process diagrams simplifies calculating time estimates. The author argued that the granularity at the transaction level provided greater accuracy for users of TDABC. Recommending steps for implementation, the authors suggested the following: "begin with the most costly processes . . . define the scope of the process . . . determine the key drivers of time . . . use readily available driver variables . . . start simple . . . engage operational personnel to help build and validate the model" (p. 36).
The second principal, aggregating the cost of capacity supplied, consolidates all department costs--"the compensation of frontline employees and their supervisors; occupancy, technology, and other equipment costs; and the costs of corporate staff functions that support the work performed" (p. 41). How companies determine these costs vary depending on the nature of the business and the degree of specificity desired. For example, equipment costs can apply historical, replacement costs, or the "opportunity cost of the investment in the equipment"(p. 43). The second part of this equation, practical capacity, "can be estimated somewhat arbitrarily or studied analytically. The arbitrary approach assumes that practical capacity is a specified percentage, say, 80 or 85 percent, of theoretical capacity" (p. 52). Similarly, equipment might register 15 to 20 percent downtime. Enterprise resource planning systems might record actual repair time, startups, downtime, vacation and sick time for equipment and employees. Although actual costs from accounting systems supply readily available numbers, some firms elect to use budgeted, normalized costs.
The remainder of the book covered the implementation of TDABC and some case studies, of organizations as diverse as an historical black university (HBU), for-profit companies, and not-for profit organizations. The authors address the transformation of customers from unprofitable to profitable with the TDABC system. They end the book by responding to frequently asked questions.
Robert Kaplan, best known for his work on the Balanced Scorecard, and Steven R. Anderson wrote this book to demonstrate how enterprise resource planning (ERP) systems enable companies to assess at the transaction level the time consumed in steps of processes. Specifically, time-driven activity-based costing measured the "cost and profitability of producing and delivering their products and services, and managing their customer relationships" (p. xi).
The Balanced Scorecard, equally as necessary for companies to evaluate their progress, reveals how companies create value for employees, shareholders, customers, and investors.
If a company realized a low total-cost strategy, activity-based costing enables managers to accurately measure the costs of significant processes. If a company has not gaged the profitability of their customers, activity-based costing provides insight into that information. According to the authors, customer profitability influences other customer metrics, "such as satisfaction, retention, and growth, to signal that customer relationships are desirable only if these relationships generate increased profits" (p. xii).
Traditional standard cost system employed three cost factors--labor, materials, and overhead. With increased automation, the authors argued that allocations of costs under this system became distorted. Activity-based costing corrected these distortions "by tracing these indirect and support costs first to the activities performed by the organization's shared resources, and then assigning the activity costs down to orders, products, and customers on the basis of the quantity of each organizational activity consumed" (p. 5).
Anderson improved on the activity-based costing model with the 'time-driven activity-based costing' (TDABC). Finding the data gathering to support the conventional model "time-consuming . . . costly . . . subjective . . . . difficult to validate . . . local . . . not easily updated . . . theoretically incorrect when it ignored the potential for unused capacity" (p. 7), TDABC modified the conventional system "by eliminating the need to interview and survey employees for allocating resource costs to activities before driving them down to cost objects (orders, products, and customers).
Time-driven activity based costing involves a two step process. The first, "the TDABC model calculates the cost of supplying resource capacity . . . personnel, supervision, occupancy, equipment and technology" (p. 8). "It divides this total cost by the capacity--the time available from the employees actually performing the work--of the department to obtain the capacity cost rate" (p. 8). The second step, "TDABC uses the capacity cost rate to drive departmental resource costs to cost objects by estimating the demand for resource capacity . . . that each cost object requires"(p. 8).
PRACTICAL APPLICATION
Capacity cost rate = Cost of capacity supplied
----------------------------------------------
Practical capacity of resources supplied
Capacity cost rate = $567,000
------------------------------------------------
630,000 minutes = $0.90 per minute
TDABC estimates of customer related activities:
Process customer orders : 8 minutes
Handle customer inquiries: 44 minutes
Perform credit check: 50 minutes
TDABC COST DRIVERS
-------------------------------------------------------------------------
Activity Unit time (minutes) Rates (at $0.90/minute)
----------------------------------------------------------------------------------------
Process customer order 8 $ 7.20
Handle customer inquiry 44 $39.60
Perform credit check 50 $45.00
Used capacity
Unused capacity (8.2)
As a tool for future decision making, the TDABC allows managers to develop trends of data over time. Modifications to the tool occur from new activities, for example, changes in time due to more complicated or custom processes, changes in cost rates, due to automation or increased efficiencies, such as the implementation of quality programs. Therefore, the system adapts to changes in circumstances.
To estimate processing time, the first principal of TDABC, enterprise resource planning systems aid companies in accumulating data, such as cubic meters, kilograms, gigabytes, and bauds. Global positioning systems and radio frequency identification devices facilitate accumulating data. Having detailed and complete business process diagrams simplifies calculating time estimates. The author argued that the granularity at the transaction level provided greater accuracy for users of TDABC. Recommending steps for implementation, the authors suggested the following: "begin with the most costly processes . . . define the scope of the process . . . determine the key drivers of time . . . use readily available driver variables . . . start simple . . . engage operational personnel to help build and validate the model" (p. 36).
The second principal, aggregating the cost of capacity supplied, consolidates all department costs--"the compensation of frontline employees and their supervisors; occupancy, technology, and other equipment costs; and the costs of corporate staff functions that support the work performed" (p. 41). How companies determine these costs vary depending on the nature of the business and the degree of specificity desired. For example, equipment costs can apply historical, replacement costs, or the "opportunity cost of the investment in the equipment"(p. 43). The second part of this equation, practical capacity, "can be estimated somewhat arbitrarily or studied analytically. The arbitrary approach assumes that practical capacity is a specified percentage, say, 80 or 85 percent, of theoretical capacity" (p. 52). Similarly, equipment might register 15 to 20 percent downtime. Enterprise resource planning systems might record actual repair time, startups, downtime, vacation and sick time for equipment and employees. Although actual costs from accounting systems supply readily available numbers, some firms elect to use budgeted, normalized costs.
The remainder of the book covered the implementation of TDABC and some case studies, of organizations as diverse as an historical black university (HBU), for-profit companies, and not-for profit organizations. The authors address the transformation of customers from unprofitable to profitable with the TDABC system. They end the book by responding to frequently asked questions.
Monday, October 26, 2009
Carlson, R. C.(2005). The new rules of retirement: Strategies for a secure future. New York: John Wiley & Sons.
In creating a retirement plan, the author recommends that each individual starts with "an estimate of monthly or annual spending in the first year in retirement. After that the length of retirement must be estimated. Then the spending estimate should be adjusted for inflation over the length of retirement. Finally, an estimated investment return is used to estimate how much money should be accumulated at the start of retirement" (p. 27).
The author suggested certain steps to ensure a more accurate forecast: "count on inflation . . . key issue is which inflation rate to use . . . don't underestimate longevity . . . don't overlook all possible income sources . . . make more than one estimate . . . check the numbers regularly" (p. 39).
Although the book covers other topics, such as social security, trusts, and IRAs, I will reserve them for future postings.
Monday, October 5, 2009
Kiyosaki: Rich Dad's Prophecy 2002
In typical Kiyosaki fashion, he prognosticated an impending financial collapse and wrote this book to explain how investor's can avoid the disaster. In the Introduction, he claimed that the book had six basic messages: "to remind all of us to be vigilant . . . about the flaw of ERISA . . . to see the world today with a true financial perspective . . . to ask yourself if you're truly ready for the future . . . to offer some ideas on what you can do to prepare for the biggest stock market crash in history . . . to let you know that you may have up to the year 2010 to become prepared . . . to let you know that you will probably be better off financially, if you actively prepare" (pp. 6-7).
ERISA, according to the author, caused employees with 401(k), 403(b), and other plans to plot their own financial future and rely on the vagaries of the stock market, fluctuating from business cycles. ERISA resulted in the change from DB plans, defined benefit, to DC, defined contribution, plans. The first, defined benefit plans, specified the amount an employee would receive from the length of employment and the term of service. Although not related to a company and regulated by the government, social security conforms to the definition of a defined benefit plan. In contrast, the DC plan returns to employees the amount of contributions, if any, that they have made to the plan. Companies can switch from DB to DC plans, forcing retirees to adjust to the transition. Many workers have not made contributions to their DC plans and, therefore, face a lifetime of employment.
The second lesson, that of the flaws of ERISA, applied to the requirements of the law. It mandates that participants begin making withdrawals to their accounts at the age of seventy, a mass divestiture of funds, which will depress the stock market. Another flaw concerns the source of education of investors--the financial community itself. Kiyosaki concluded that "financial education today is really a sales pitch" (p. 63). The final flaw entails the tax penalties that retirees will incur from early withdrawals from a 401(k). "Portfolio income is primarily from capital gains, which is typically the type of income you will earn from investments. The maximum capital gains rate for investments held for one year is 20 percent. The rate decreases to 18 percent for investments held for five or more years . . . If you hold your investments outside of a 401(k), the tax rate on gains would be 18 percent-20 percent. If, however, you hold these same investments inside a 401(k), . . that withdrawn income is ordinary income, taxed at the highest rate. That means a 401(k) plan doubles your tax rate from the capital gains rate (18-20 percent) to the ordinary tax rate (38 percent).
The author predicted that when retirees start to divest their assets, according to the plan, they will panic and transfer their wealth into cash, with a subsequent decline in the stock market. As an antidote to the impending crisis, Kiyosaki offered his prescription for the future.
He used the Noah's ark analogy in describing a plan of "taking control of the ark" (p. 145). The plan contained three elements, cash flow, leverage, and control. To understand how how his cash flowed, Kiyosaki completed a financial statement every month. He suggested that before a person invests or starts a business, he or she develop and review their financial statement. He recommended that every person, who seeks control of their ark, (1) compile and analyze his or her financial statement, "find a bookkeeper or accountant . . . make an appointment with an accountant or bookkeeper to review your financial statements to make sure you have completed them properly . . . analyze where you are today and what changes you need to make in your investing habits" (p. 153).
Kiyosaki based his system on accounting, which began with four quadrants of E (employee), B (big business), S (self-employed or small business owner), and I (investor). These designations divided the four ways people make money. To educate individuals in each of the quadrants, Kiyosaki illustrated the two fundamental statements of accounting, the income statement and the balance sheet. Contrary to most accounting principles, Kiyosaki defined financial terms as follows: "Assets cash flow money into the income column . . . Liabilities cash flow money into and out of the expense column" (p. 176). He offered this lesson, "the relationship of cash flow between an income statement and a balance sheet that tells if something is an asset or a liability" (p. 176). Therefore, what a person perceives as an asset can become a liability.
Similar to the distinction between assets and liabilities, Kiyosaki distinguished good debt from bad and good interest from bad. Good debt created wealth; bad debt purchased a car. Good interest generates tax-free income; bad interest penalizes the individual with taxable interest.
Businesses start small and grow large. Kiyosaki invests in PREPs (private real estate partnerships, a private partnership that is formed to buy a large real estate investment, such as a storage warehouse) and in triple net lease real estate ("triple net means that in addition to their lease payment, the tenant pays for the maintenance of the building, the insurance, the taxes, and structural repairs"). Kiyosaki warned that these investments necessitate large down payments and do not provide a commission for brokers, who seldom recommend them.
Kiyosaki urged readers, who sincerely want to control their ark to do the following:
"Challenge yourself to find a minimum of five hours a week to devote to building your ark . . .
"Visit a real estate broker to inquire about investment properties. Spend dinner one night a week discussing new business ideas. Attend franchise shows in your area. Attend local seminars on real estate, building businesses, or investing in the stock market. Decide which asset class you want to start with: business, real estate, or investing in stocks and/or options" (p. 226).
Vigilance means constant attentiveness. An attentive person remains true to his or her word; he or she will "keep an open mind and . . . ears tuned for change . . . learn to read financial statements . . . use technology . . . watch for bigness . . . watch for changes in the laws . . . watch for inflation . . . pay close attention to government's handling of its social programs (pp. 224-226).
To build the ark, perform the following tasks:
Grow your own company
Name your business
Begin to seek funding sources
Search for outside advisers
Select your business entity and form it
Obtain any necessary licenses and permits
Set up a relationship with you banker
Protect proprietary information
Write a business plan
Select your location
Form your service procedures
Plan ahead for bookkeeping, accounting, and office systems
Decide on pricing strategies
Determine employee needs
Prepare your marketing plan
Seek insurance coverage
Address legal issues
Fine-tune your cash flow budget
Set up your office
Hire employees
Announce your business
Buy a company
Buy a franchise
Join network marketing
Entry cost is low and there are training programs to help you succeed. The companies are typically based on direct sales with home-business opportunities
Invest in Small Real Estate Properties
Kiyosaki suggests that investors strategize to become rich, according to his definition of rich, protect themselves from extreme market gyrations and crashes, and diversity. For adequate leadership, he instructed investors to have a team of advisers, to meet with them regularly, to ask questions and make decisions, to learn from mistakes. As to areas for meaningful self-advancements, Kiyosaki advised investors to "Invest some time finding the long- and short-term reasons why you want to learn something . . . Invest sometime in learning the technical knowledge required to achieve your goals . . . invest some time learning via real-life trial and error" (pp. 263-264). "Stock options investing . . . sales and sales training . . . real estate investing . . . building a business . . . raising capital" (p. 265).
ERISA, according to the author, caused employees with 401(k), 403(b), and other plans to plot their own financial future and rely on the vagaries of the stock market, fluctuating from business cycles. ERISA resulted in the change from DB plans, defined benefit, to DC, defined contribution, plans. The first, defined benefit plans, specified the amount an employee would receive from the length of employment and the term of service. Although not related to a company and regulated by the government, social security conforms to the definition of a defined benefit plan. In contrast, the DC plan returns to employees the amount of contributions, if any, that they have made to the plan. Companies can switch from DB to DC plans, forcing retirees to adjust to the transition. Many workers have not made contributions to their DC plans and, therefore, face a lifetime of employment.
The second lesson, that of the flaws of ERISA, applied to the requirements of the law. It mandates that participants begin making withdrawals to their accounts at the age of seventy, a mass divestiture of funds, which will depress the stock market. Another flaw concerns the source of education of investors--the financial community itself. Kiyosaki concluded that "financial education today is really a sales pitch" (p. 63). The final flaw entails the tax penalties that retirees will incur from early withdrawals from a 401(k). "Portfolio income is primarily from capital gains, which is typically the type of income you will earn from investments. The maximum capital gains rate for investments held for one year is 20 percent. The rate decreases to 18 percent for investments held for five or more years . . . If you hold your investments outside of a 401(k), the tax rate on gains would be 18 percent-20 percent. If, however, you hold these same investments inside a 401(k), . . that withdrawn income is ordinary income, taxed at the highest rate. That means a 401(k) plan doubles your tax rate from the capital gains rate (18-20 percent) to the ordinary tax rate (38 percent).
The author predicted that when retirees start to divest their assets, according to the plan, they will panic and transfer their wealth into cash, with a subsequent decline in the stock market. As an antidote to the impending crisis, Kiyosaki offered his prescription for the future.
He used the Noah's ark analogy in describing a plan of "taking control of the ark" (p. 145). The plan contained three elements, cash flow, leverage, and control. To understand how how his cash flowed, Kiyosaki completed a financial statement every month. He suggested that before a person invests or starts a business, he or she develop and review their financial statement. He recommended that every person, who seeks control of their ark, (1) compile and analyze his or her financial statement, "find a bookkeeper or accountant . . . make an appointment with an accountant or bookkeeper to review your financial statements to make sure you have completed them properly . . . analyze where you are today and what changes you need to make in your investing habits" (p. 153).
Kiyosaki based his system on accounting, which began with four quadrants of E (employee), B (big business), S (self-employed or small business owner), and I (investor). These designations divided the four ways people make money. To educate individuals in each of the quadrants, Kiyosaki illustrated the two fundamental statements of accounting, the income statement and the balance sheet. Contrary to most accounting principles, Kiyosaki defined financial terms as follows: "Assets cash flow money into the income column . . . Liabilities cash flow money into and out of the expense column" (p. 176). He offered this lesson, "the relationship of cash flow between an income statement and a balance sheet that tells if something is an asset or a liability" (p. 176). Therefore, what a person perceives as an asset can become a liability.
Similar to the distinction between assets and liabilities, Kiyosaki distinguished good debt from bad and good interest from bad. Good debt created wealth; bad debt purchased a car. Good interest generates tax-free income; bad interest penalizes the individual with taxable interest.
Businesses start small and grow large. Kiyosaki invests in PREPs (private real estate partnerships, a private partnership that is formed to buy a large real estate investment, such as a storage warehouse) and in triple net lease real estate ("triple net means that in addition to their lease payment, the tenant pays for the maintenance of the building, the insurance, the taxes, and structural repairs"). Kiyosaki warned that these investments necessitate large down payments and do not provide a commission for brokers, who seldom recommend them.
Kiyosaki urged readers, who sincerely want to control their ark to do the following:
"Challenge yourself to find a minimum of five hours a week to devote to building your ark . . .
"Visit a real estate broker to inquire about investment properties. Spend dinner one night a week discussing new business ideas. Attend franchise shows in your area. Attend local seminars on real estate, building businesses, or investing in the stock market. Decide which asset class you want to start with: business, real estate, or investing in stocks and/or options" (p. 226).
Vigilance means constant attentiveness. An attentive person remains true to his or her word; he or she will "keep an open mind and . . . ears tuned for change . . . learn to read financial statements . . . use technology . . . watch for bigness . . . watch for changes in the laws . . . watch for inflation . . . pay close attention to government's handling of its social programs (pp. 224-226).
To build the ark, perform the following tasks:
Grow your own company
Name your business
Begin to seek funding sources
Search for outside advisers
Select your business entity and form it
Obtain any necessary licenses and permits
Set up a relationship with you banker
Protect proprietary information
Write a business plan
Select your location
Form your service procedures
Plan ahead for bookkeeping, accounting, and office systems
Decide on pricing strategies
Determine employee needs
Prepare your marketing plan
Seek insurance coverage
Address legal issues
Fine-tune your cash flow budget
Set up your office
Hire employees
Announce your business
Buy a company
Buy a franchise
Join network marketing
Entry cost is low and there are training programs to help you succeed. The companies are typically based on direct sales with home-business opportunities
Invest in Small Real Estate Properties
Kiyosaki suggests that investors strategize to become rich, according to his definition of rich, protect themselves from extreme market gyrations and crashes, and diversity. For adequate leadership, he instructed investors to have a team of advisers, to meet with them regularly, to ask questions and make decisions, to learn from mistakes. As to areas for meaningful self-advancements, Kiyosaki advised investors to "Invest some time finding the long- and short-term reasons why you want to learn something . . . Invest sometime in learning the technical knowledge required to achieve your goals . . . invest some time learning via real-life trial and error" (pp. 263-264). "Stock options investing . . . sales and sales training . . . real estate investing . . . building a business . . . raising capital" (p. 265).
Monday, June 1, 2009
Ken Fisher: The Ten Roads to Riches
Ken Fisher wrote a lively 'how to' book on getting rich. Unlike most books, which present only one formula, Ken offers ten: "manage other people's money, marry rich, be a sidekick, be an athlete or entertainer, become a CEO, invest in real estate, enter the legal field, start a business, invent income, and save and invest wisely" (p. xiii). No matter which route you choose, note the list of books on page 120 on selling yourself, a fundamental skill for any path.
If you find yourself in a leadership position, Fisher urged readers to lead from the front, acting in ways that followers can emulate--working the hours that they work, flying the class that they fly (coach or business), and working as a team. If you occupy the middle class with a average job and salary, Fisher recommends that you save and invest in stock, in up times and down. With compound interest and stock growth, you will increase wealth.
Recommended reading
How to win friends and influence people, Dale Carnegie
You'll see it when you believe it. Wayne Dyer
The psychology of selling, Brian Tracy
The difference maker, John Maxwell
Confidence, by Roseabeth Kanter
See you at the Top, Zig Ziglar
Spin Selling, Neil Rackham
Fisher, K. (2009). The ten roads to riches: The ways the wealthy got there (And how you can too!). Hoboken, NJ: John Wiley & Sons.
If you find yourself in a leadership position, Fisher urged readers to lead from the front, acting in ways that followers can emulate--working the hours that they work, flying the class that they fly (coach or business), and working as a team. If you occupy the middle class with a average job and salary, Fisher recommends that you save and invest in stock, in up times and down. With compound interest and stock growth, you will increase wealth.
Recommended reading
How to win friends and influence people, Dale Carnegie
You'll see it when you believe it. Wayne Dyer
The psychology of selling, Brian Tracy
The difference maker, John Maxwell
Confidence, by Roseabeth Kanter
See you at the Top, Zig Ziglar
Spin Selling, Neil Rackham
Fisher, K. (2009). The ten roads to riches: The ways the wealthy got there (And how you can too!). Hoboken, NJ: John Wiley & Sons.
Saturday, April 25, 2009
Thomsett, M. C.: Annual Reports 101
Thomsett begins his book on annual reports with the question, Transparency, fact or fiction? Acknowledging that annual reports serve a duel purpose of communicating federally mandated financial information and acting for a company as a public relations tool, it rests with the reader to separate the functions, legal, financial, and marketing. Likewise, readers of annuals reports tend to fall into multiple groups, the lay investor and the financially savvy accountants, company executives, and federal regulators.
To verify the validity of the financial information, the reader can apply tests of "capital strength, profitability, and growth potential--whether these key factors are highlighted in the material that the company choose to show you or not" (p. 2). Therefore, the author answers his initial question with an emphatic 'no'. By educating the reader on basic accounting principles, focusing on the subtleties of the annual report footnotes and its organization, and explaining the manipulations of auditors, the author attempts to increase of transparency of these compliance documents.
Annual reports represent the final stage of a three-step accounting process, bookkeeping, decision making, and reporting. Thomsett concentrated on three reports, the balance sheet, summary of operations (income statement), and the statement of cash flows.
Three areas of financial statements, working capital, capitalization, and profitability, employ ratios.
"1. Working capital
The current ratio compares current assets and liabilities
The quick assets ratio is similar to the current ratio, but without inventory
Inventory turnover compares inventory and direct costs.
2. Capitalization
The debt ratio shows the sources from which operations are funded
3. Profitability
Gross margin compares gross profit to revenues
Expense level is a study of expenses as a percentage of revenue.
Net return compare earning to revenue" (p. 55).
"In addition to the ratio in thee three classification, you can learn a lot by checking dividend yield and the consitency of dividend paid over time, the well known P/E ratio, and some technical indicator, such a the 52-week price range and a review of the trading range" (p. 55).
The working capital ratio indicates the size of a company's pool of cash, its liquidity needed in order to function--pay debts, meet payroll, buy inventory, expand.
Formula Current assets
Current liabilities = x to y
"A general standard for the current ratio is 2 to 1. A company is considered to be in good shape if its current ratio is 2 to 1 or better" (p. 56).
The quick asset ratio, a variation of the current ratio, excludes inventory. "The general standard defining a 'good' level for the quick asset ratio is 1 to 1. So if the quick assets are equal to or higher than the total current liabilities, that is acceptable" (p. 58).
Another dimension of working capital, inventory turnovers, reflects an average based on average inventory levels.
Formula Direct costs of goods sold
Average Inventory = Turns
"There is no single standard for an 'acceptable' number of turns. However, by studying a corporation's inventory turnover over time, you can spot trends . . . in the best of all worlds, turnover would remain steady even when revenues grow substantially. However, there is a tendency for turnover to slow down with greater volume" (p. 60).
"Captialization is simply the funding of a company. It comes from two general sources. Equity is provided by investors, who expect dividends and stock price appreciation. Debt comes from lenders, who expect periodic interest payments and repayment of the amount loaned" (p. 61).
Formula long-term debt to equity ratio
Long-term debt
Long-term debt + stockholders' equity = long-term debt to equity ratio
"Outcomes are not always what they seem. It is possible to conclude that working capital is healthy without realizing that the ratio has been created by growth in long-term debt. Invariable, apparent trends have to be confirmed by also checking other, related trends.
Profitability
Formula Gross Margin Gross profit
Revenues = Gross Margin
"Gross margin becomes meaningful only if and when an established level changes . . . it should remain constant" (pp. 65-66).
Formula Expense level Expenses
Revenues = Expense level
Formula Net operating profit
Revenue = Net return
Formula Earnings per Share Net operating Profit
Total shares outstanding = EPS
Formula Dividend Yield Dividend paid
Share price = Dividend yield
"Dividend yield is meaningful only in relation to the price you pay for stock. After that, changes in the yield don't affect you.
Formula P/E ratio Share price
EPS = P/E
"The P/E ratio can be very unreliable unless it users current information for both sides of the equation" (p. 71).
To verify the validity of the financial information, the reader can apply tests of "capital strength, profitability, and growth potential--whether these key factors are highlighted in the material that the company choose to show you or not" (p. 2). Therefore, the author answers his initial question with an emphatic 'no'. By educating the reader on basic accounting principles, focusing on the subtleties of the annual report footnotes and its organization, and explaining the manipulations of auditors, the author attempts to increase of transparency of these compliance documents.
Annual reports represent the final stage of a three-step accounting process, bookkeeping, decision making, and reporting. Thomsett concentrated on three reports, the balance sheet, summary of operations (income statement), and the statement of cash flows.
Three areas of financial statements, working capital, capitalization, and profitability, employ ratios.
"1. Working capital
The current ratio compares current assets and liabilities
The quick assets ratio is similar to the current ratio, but without inventory
Inventory turnover compares inventory and direct costs.
2. Capitalization
The debt ratio shows the sources from which operations are funded
3. Profitability
Gross margin compares gross profit to revenues
Expense level is a study of expenses as a percentage of revenue.
Net return compare earning to revenue" (p. 55).
"In addition to the ratio in thee three classification, you can learn a lot by checking dividend yield and the consitency of dividend paid over time, the well known P/E ratio, and some technical indicator, such a the 52-week price range and a review of the trading range" (p. 55).
The working capital ratio indicates the size of a company's pool of cash, its liquidity needed in order to function--pay debts, meet payroll, buy inventory, expand.
Formula Current assets
Current liabilities = x to y
"A general standard for the current ratio is 2 to 1. A company is considered to be in good shape if its current ratio is 2 to 1 or better" (p. 56).
The quick asset ratio, a variation of the current ratio, excludes inventory. "The general standard defining a 'good' level for the quick asset ratio is 1 to 1. So if the quick assets are equal to or higher than the total current liabilities, that is acceptable" (p. 58).
Another dimension of working capital, inventory turnovers, reflects an average based on average inventory levels.
Formula Direct costs of goods sold
Average Inventory = Turns
"There is no single standard for an 'acceptable' number of turns. However, by studying a corporation's inventory turnover over time, you can spot trends . . . in the best of all worlds, turnover would remain steady even when revenues grow substantially. However, there is a tendency for turnover to slow down with greater volume" (p. 60).
"Captialization is simply the funding of a company. It comes from two general sources. Equity is provided by investors, who expect dividends and stock price appreciation. Debt comes from lenders, who expect periodic interest payments and repayment of the amount loaned" (p. 61).
Formula long-term debt to equity ratio
Long-term debt
Long-term debt + stockholders' equity = long-term debt to equity ratio
"Outcomes are not always what they seem. It is possible to conclude that working capital is healthy without realizing that the ratio has been created by growth in long-term debt. Invariable, apparent trends have to be confirmed by also checking other, related trends.
Profitability
Formula Gross Margin Gross profit
Revenues = Gross Margin
"Gross margin becomes meaningful only if and when an established level changes . . . it should remain constant" (pp. 65-66).
Formula Expense level Expenses
Revenues = Expense level
Formula Net operating profit
Revenue = Net return
Formula Earnings per Share Net operating Profit
Total shares outstanding = EPS
Formula Dividend Yield Dividend paid
Share price = Dividend yield
"Dividend yield is meaningful only in relation to the price you pay for stock. After that, changes in the yield don't affect you.
Formula P/E ratio Share price
EPS = P/E
"The P/E ratio can be very unreliable unless it users current information for both sides of the equation" (p. 71).
Technical Indicators
Thomsett defined fundamental and technical indicators as follows, "the financial, also called fundamental, indicators include revenues, earnings, capitalization, and dividends declared and paid . . . the nonfinancial, also called technical, indicators include high and low stock prices during the year and the year-end stock price per share" (p. 72). In his 'Key point' box, the author made the following point, "the 52-week high/low can mislead you and cause you to reach an inaccurate conclusion. You should also review a 52-week price chart to spot the trend within that trading range"m (p. 73). He listed these reasons to question the technical indicator, the trading range might include a nonrecurring spike . . . the price might be showing an upward trend . . . the price might be showing a downward trend . . . volatility in price might make it impossible to spot a trend" (p. 73).
Friday, March 13, 2009
The first 90 days: Critical success strategies for New Leaders at all levels
Michael Watkins provided a road map for new managers who lead organizations in transition, explained the types of transitions firms undergo, and detailed the actions mangers should take to maximize the initial phase of the process. Eight challenges face managers in this context. He or she should "promote yourself . . .accelerate your learning . . . match strategy to situation . . . negotiate success . . . achieve alignment . . . build your team . . . create coalitions" (p. 212).
Watkins, M. (2003). The first 90 days: Critical success strategies for new leaders at all levels. Boston, MA: Harvard Business School Press.
Watkins, M. (2003). The first 90 days: Critical success strategies for new leaders at all levels. Boston, MA: Harvard Business School Press.
Thursday, March 5, 2009
Robert Shiller. The subprime solution : How today's global financial crisis happened, and what to do about it
After describing the history of all types of bubbles, Shiller proposed a number of solutions of three general types to alleviate future bubbles, information technology, market-based instruments, and risk-management institutions. Among the technology solutions, Shiller elucidated the capabilities of mathematical finance, which exposed the nuances of risk management. This capability demonstrated how both sides of a contractual relationship can win, a critical aspect of agency theory. Agency theory "explains how to motivate agents to behave as much as possible in the interest of all parties to a transaction" (p. 188). Shiller promoted information technology to achieve a number of goals: "comprehensive financial advice . . . financial product safety commission . . . standardized default-option financial plan . . . improve the disclosure of information . . . improve financial databases . . .new system of economic units of measurement" (pp. 121-148). The units of measurement that Shiller and other devised "would be defined for many common economic values including income, profits, and wages. But the greatest importance would be new units of measurement for inflation . . . an inflation-indexed unit of account" (p.141).
Of the market solutions, Shiller formulated new markets that would address risk. To minimize real estate risk, the source of the 2008 bubble, Shiller suggested a single-family home-price futures market, to short real estate without selling a home. Chicago Mercantile Exchange (CME) currently has such markets, which "have been predicting large declines in home prices in the United States almost since the markets' inception in May 2006" (p. 152). Other markets Shiller mentioned included "markets for long-term claims on incomes--individual incomes, incomes by occupation, incomes by region, and national incomes" (p. 154). These markets would reflect "livelihood risk" (p. 154). "Markets for occupational incomes--such as futures, forwards, swaps, and exchange-traded notes--will ultimately make it possible for people to hedge their life income risks" (p. 154). Shiller advanced another financial instrument, a "perpetual debt that pays a share of GDP as dividend" (p. 154). Dividends would fluctuate based on the economic growth or contraction of a country. Shiller argued that "in economic slowdown, the government would find that the burden of interest on the national debt would, in effect, fall below expectations. It would thus have more resources available to deal with the crisis" (p. 155-156).
Among the risk-management institutions, Shiller listed continuous-workout mortgages, home equity insurance, and livelihood insurance. With demographic data to establish criteria, issuers could minimize the possibility of individual abuse and manipulation.
Shiller, R. J. (2008). The Subprime solution: How today's global financial crisis happened, and what to do about it. Princeton, NJ: Princeton University Press.
Of the market solutions, Shiller formulated new markets that would address risk. To minimize real estate risk, the source of the 2008 bubble, Shiller suggested a single-family home-price futures market, to short real estate without selling a home. Chicago Mercantile Exchange (CME) currently has such markets, which "have been predicting large declines in home prices in the United States almost since the markets' inception in May 2006" (p. 152). Other markets Shiller mentioned included "markets for long-term claims on incomes--individual incomes, incomes by occupation, incomes by region, and national incomes" (p. 154). These markets would reflect "livelihood risk" (p. 154). "Markets for occupational incomes--such as futures, forwards, swaps, and exchange-traded notes--will ultimately make it possible for people to hedge their life income risks" (p. 154). Shiller advanced another financial instrument, a "perpetual debt that pays a share of GDP as dividend" (p. 154). Dividends would fluctuate based on the economic growth or contraction of a country. Shiller argued that "in economic slowdown, the government would find that the burden of interest on the national debt would, in effect, fall below expectations. It would thus have more resources available to deal with the crisis" (p. 155-156).
Among the risk-management institutions, Shiller listed continuous-workout mortgages, home equity insurance, and livelihood insurance. With demographic data to establish criteria, issuers could minimize the possibility of individual abuse and manipulation.
Shiller, R. J. (2008). The Subprime solution: How today's global financial crisis happened, and what to do about it. Princeton, NJ: Princeton University Press.
Saturday, February 28, 2009
Ellis. Winning the Loser's Game: Timeless Strategies for Successful Investing
Ellis established the basic premise that institutional investors cannot beat the market, for they compose the market. He differentiated a winner's game from a loser's, "in a winner's game the outcome is determined by the correct actions of the winner. In a loser's game, the outcome is determined by the mistakes made by the loser" (pp. 4-5). Ellis ascribed the reason for losing to the institutional investors, "they are the most important part of the problem" (p. 8). Ellis continued by asserting, "active investing is at the margin always a negative-sum game. Changing investments among investors would by itself be a zero-sum game, but costs such as commissions, expenses, and market impact must be deducted. Net result: a negative-sum game" (p. 9).
Ellis interjected an optimistic note, in this rather bleak picture, that "every investor can be a winner. All we need to do to be long-term winners is to reorient ourselves and concentrate on realistic long-term goal setting, sound policies to achieve our goals, and the requisite self-discipline, patience, and fortitude required for persistent implementation" (p. 10).
Ellis identified four strategies investors employ in their attempt to beat the market: "1. Market timing 2. Selection of specific stocks or groups of stocks 3. changes in portfolio structure or strategy 4. An insightful, long-term investment concept or philosophy" (p. 11). None of these proved to create a winning option, according to Ellis. He proposed the alternative of index funds, which had the advantages of "higher returns . . . lower fees . . . lower operating costs . . . lower taxes . . . lower risk of errors or blunders . . . lower anxiety about errors or blunders" (pp. 30-31).
Regarding the congruence between investment goals and strategy, Ellis observed a paradox. He saw a discrepancy between an investment manager's short-term actions and an investor's long-term objectives. He urged investors to have their advisor accomplish four tasks when seeking investment advice: "(1) understanding the client's real needs, (2) defining realistic investment objectives that can meet the client's realistic needs, (3) establishing the right asset mix for each portfolio, and (4) developing well-reasoned, sensible investment policies" (p. 43) that match objectives, strategy, and adherence to the strategy. Observing these principles improve the potential of portfolio performance, "policies that position the portfolio to benefit from riding with the main long-term forces in the market" (p. 43).
Six Questions
Ellis enunciated six questions each investor should ask an investment manager.
"First, what are the real risks of an adverse outcome, particularly in the short run . . .
Second, what are the probable emotional reactions of clients to an adverse experience? . . .
Third, how knowledgeable are you about investments and the vagaries of financial markets? . . . Fourth, what other capital or income resources does the client have and how important is the particular portfolio to the client's overall financial position? . . . Fifth, are there any legal restrictions on investment policy? . . . Sixth, are there any unanticipated consequences of interim fluctuations in portfolio value that might affect policy" (pp. 46-47).
Benign Neglect
The two factors that influence investment performance include time and risk. Ellis described time as the "Archimedes lever in investing" (p. 55). He continued, "the trade-off between risk and reward is driven by one key factor: time" (p. 55). These two factors determine the ratio of fixed income investment and equity investment. Risk entails three elements: "the real risk-free rate of return . . . a premium over the risk-free rate of return to offset the expected erosion of purchasing power caused by inflation . . . a premium over the inflation-adjusted risk-free rate of return to compensate investors for accepting market risk" (pp. 67-68). Furthermore, Ellis explained four types of risk: "price . . . interest rate risk . . . business risk " (pp. 67-68). The forth type of risk, market risk, "market risk pervades all investment. It can be increased by selecting volatile securities or by using leverage, and it can be decreased by selecting securities with low volatility or by keeping part of a portfolio in cash equivalents. But it cannot be avoided or eliminated. It is always there. Therefore, it must be managed" (p. 68). Two actions add a degree of control: "deciding deliberately what level of market risk to establish as the portfolio's basic policy and (holding to the chosen level of market risk" (p. 73).
Ellis stressed the advantage of index funds: "Such a fund provides a convenient and inexpensive way to invest in equities, with the riskiness of particular market segments and specific issues diversified away" (p. 70).
Writing an investment policy
Defining an investment policy, Ellis considered the fundamental task of the investor. An investment policy “is to establish useful guidelines for investing that are genuinely appropriate to the realities both of your own investment objectives and of the realities of the investment markets. These are the internal and external realms of investing, and investment policy must be designed to work well in both realms” (p. 89). The policy articulates the investor’s risk tolerance, objectives, and the equities that fit with the risk and objectives. The investment advisor explains the external factors, the markets and economic realities that affect the investor’s goals. “Investment policy is the explicit linkage between your long-term investment objectives and the daily work of your investment manager” (p. 90), stated Ellis. He recommended that the investor have the policy in writing.
Ellis elaborated on three policy facets: “the level of market risk to be taken . . . whether the level of risk is to be sustained or varied as markets change . . . whether individual stock risk or group risk is to be taken or avoided and the incremental rate of return which such risks, when taken, are expected to produce in the portfolio” (p. 90). If an investment advisor differentiates himself from the general market, that is an index fund, the investor needs to understand how he differs. Ellis stipulated how an advisor might differ: “by betting heavily on a few stocks, by favoring a particular stock market sector, or by investing heavily in cash if he thinks stocks are overpriced” (p. 90). Furthermore, understanding his execution, “whether continually as part of a long-term strategy or occasionally as a short-time tactic . . . and, most important, why he is confident that he will achieve favorable incremental results by taking these actions” (p. 91). With this insight, an investor can assess the advisor’s competence.
Ellis offered five standards by which an investor can evaluate an investment policy:
“1. Is the policy carefully designed to meet your real needs and objectives?
2. Is the policy written so clearly and explicitly that a competent stranger could manage the portfolio and conform to your intentions?
3. Would you have been able to sustain a commitment to the policies during the most troubling capital markets that have actually been experienced over the past 50 years—when conventional wisdom was surely most opposed?
4. Would the investor or professional investment manager have been able to maintain fidelity to the policy over the same periods despite intense daily pressure?
5. Would the policy, if implemented, have achieved your objectives?” (pp. 94-95).
Performance measurement, chapter 14 of Ellis’ work, has two basic principles—that the market, similar to any statistical phenomenon, tends to conform to the regression to the mean” (p. 97). The second principle stipulated that an investor should compare the portfolio with those of the same type—small cap with small cap and growth with growth.
Ellis reiterated the need to measure long-term results to determine true success.
Managing Managers
Ellis described how knowledgeable investors manage their advisors. The investor should attend to formulating an investment policy, internally and externally, in keeping with his or her decision-making process. Internal and external understanding constitutes the first and second steps of the process. Third, find a manager to execute your plan. Fourth, stick to the plan regardless of external realities. To maintain the relationship, Ellis suggested quarterly or semiannual meetings with an agenda, all documents. Ellis continued, “each meeting should begin with a careful review of the investment manager’s mission—the agreed-upon investment policies of the portfolio through which the manager is expected to accomplish the mutually intended long-term objective—to see if any modification in either objective or policy is appropriate” (p. 116). If not, reaffirm the policy document. “Discussion of specific portfolio operations—purchases and sales of specific securities—should be on an exception basis and should be brief” (p. 116). “The balance of the meeting time, usually another half hour, can best be devoted to a thoughtful and detailed discussion of almost any topic of importance to both the client and the manager as a way to increase shared understanding” (p. 117).
At least once a year the main topic should be a candid review—led by the client—of the client’s overall financial situation and the context in which the investment portfolio fits” (p. 117).
A written summary of perhaps three to five pages should be prepared and distributed after each meeting and kept for future reference. One suggestion would be to have alternating meetings summarized by the client and the investment manager” (pp. 117-118).
Questions an investor should ask for an actively managed portfolio include: “which managers will outperform the market for many years into the future? . . . can you identify the future’s favored few today? . . . will you make the right decisions and take action at the right time? . . . if you do select a superior manager, will that manager stay superior or will the assets managed grow? . . . (p. 120).
Among the rights of a client investor, according to Ellis, the investor “can select specialist managers skilled in each of the several different kinds of investing wanted . . . clients can diversity against the risk of one manager’s investment concept being out of tune with the overall market” (p. 122). Instead of many managers to diversity and reduce risk, Ellis pointed to index funds as a means to accomplish the same end.
The various decision-making sections of a portfolio entail equity mix, active versus passive management, advisor choice, portfolio policy and alternations. Emphasis on section 1, equity mix, increase the odds of success in comparison to portfolio alternations, section five.
Individual Investor’s 10 Commandments
1. “Don’t speculate
2. Save
3. Don’t do anything in investing primarily for “tax reasons”
4. Don’t think of your home as an investment
5. Never do commodities
6. Stockbrokers . . .their job is not to make money for you . . . their job is to make money from you
7. Don’t invest in new or “interesting” investments
8. Don’t invest in bonds because you’ve heard that bonds are conservative or for safety
9. Write out your long term goals
10. Don’t trust your emotions” (pp. 141-142)
Concentrate your investment in index funds for 401(k) plans.
Questions to Ask to Plan for the Future
“During retirement, how much income do I want to have each year in addition to Social Security and my employer’s pension benefit? . . . How many years will I be I retirement? What spending rule am I ready to live with and live by? . . . How much capital will I need to provide amply for retirement? . . . After insurance, what capital will I need—inflation-adjusted—to cover full health care for my spouse and myself? . . . How much capital do I want to pass on to each member of my family? . . . How much capital do I wish to direct to my philanthropic priorities?” (p. 156).
“Average returns for each type of investment have been approximately as follows:
Stocks 4 1/2 percent
Bonds 1 1/2 percent
T-bills 1 ¼ percent
Steps to Develop a Strategy
“Ask representatives of three organizations this question in writing: ‘Over the past 20 years, the stock market’s average annual total return has been X percent. Starting at the stock market’s present level, what average annual rate of return from today’s market level would your firm expect over the next 20 years? Next question: Over the next 1-, 5-, and 20-year periods, what rate of inflation do you expect?” (p. 157). When you have their answers, take the average of their answers. You’ll now have two crucial estimates of the future: The nominal rate of return for the stock market and the amount you will have to adjust nominal returns to estimate the real (inflation-adjusted) rates of return.
Any funds that will stay invested for 10 years or longer should be in stocks
Any funds that will be invested for less than two to three years should be in “cash” or money market instruments
“Prepare a complete inventory of your investment assets, including the following:
Investment in stocks and bonds
Equity in your home
Assets in any retirement plans"
Ellis' Suggested Reading List (pp. 174-175)
Berkshire Hathaway Annual Reports
The IntelligentInvestor by Benjamin Graham
Bogle on Investing, Jack Bogle
Pioneering Portfolio Management, David Swensen
Why SmartPeople Make Big Money Mistake--and How to Correct Them, Gary Belsky and Thomas Gilovich
The Crowd, Gustave LeBon
The Only Investment Book You'll Ever Need, Andrew Tobias
A RandomWalk down Wall Street
An Investor's Anthology
Wealthy and Wise, Claude Rosenberg
Ellis, C. D. (2002). Winning the loser's game: Timeless strategies for successful investing. NewYork: McGraw-Hill.
Ellis interjected an optimistic note, in this rather bleak picture, that "every investor can be a winner. All we need to do to be long-term winners is to reorient ourselves and concentrate on realistic long-term goal setting, sound policies to achieve our goals, and the requisite self-discipline, patience, and fortitude required for persistent implementation" (p. 10).
Ellis identified four strategies investors employ in their attempt to beat the market: "1. Market timing 2. Selection of specific stocks or groups of stocks 3. changes in portfolio structure or strategy 4. An insightful, long-term investment concept or philosophy" (p. 11). None of these proved to create a winning option, according to Ellis. He proposed the alternative of index funds, which had the advantages of "higher returns . . . lower fees . . . lower operating costs . . . lower taxes . . . lower risk of errors or blunders . . . lower anxiety about errors or blunders" (pp. 30-31).
Regarding the congruence between investment goals and strategy, Ellis observed a paradox. He saw a discrepancy between an investment manager's short-term actions and an investor's long-term objectives. He urged investors to have their advisor accomplish four tasks when seeking investment advice: "(1) understanding the client's real needs, (2) defining realistic investment objectives that can meet the client's realistic needs, (3) establishing the right asset mix for each portfolio, and (4) developing well-reasoned, sensible investment policies" (p. 43) that match objectives, strategy, and adherence to the strategy. Observing these principles improve the potential of portfolio performance, "policies that position the portfolio to benefit from riding with the main long-term forces in the market" (p. 43).
Six Questions
Ellis enunciated six questions each investor should ask an investment manager.
"First, what are the real risks of an adverse outcome, particularly in the short run . . .
Second, what are the probable emotional reactions of clients to an adverse experience? . . .
Third, how knowledgeable are you about investments and the vagaries of financial markets? . . . Fourth, what other capital or income resources does the client have and how important is the particular portfolio to the client's overall financial position? . . . Fifth, are there any legal restrictions on investment policy? . . . Sixth, are there any unanticipated consequences of interim fluctuations in portfolio value that might affect policy" (pp. 46-47).
Benign Neglect
The two factors that influence investment performance include time and risk. Ellis described time as the "Archimedes lever in investing" (p. 55). He continued, "the trade-off between risk and reward is driven by one key factor: time" (p. 55). These two factors determine the ratio of fixed income investment and equity investment. Risk entails three elements: "the real risk-free rate of return . . . a premium over the risk-free rate of return to offset the expected erosion of purchasing power caused by inflation . . . a premium over the inflation-adjusted risk-free rate of return to compensate investors for accepting market risk" (pp. 67-68). Furthermore, Ellis explained four types of risk: "price . . . interest rate risk . . . business risk " (pp. 67-68). The forth type of risk, market risk, "market risk pervades all investment. It can be increased by selecting volatile securities or by using leverage, and it can be decreased by selecting securities with low volatility or by keeping part of a portfolio in cash equivalents. But it cannot be avoided or eliminated. It is always there. Therefore, it must be managed" (p. 68). Two actions add a degree of control: "deciding deliberately what level of market risk to establish as the portfolio's basic policy and (holding to the chosen level of market risk" (p. 73).
Ellis stressed the advantage of index funds: "Such a fund provides a convenient and inexpensive way to invest in equities, with the riskiness of particular market segments and specific issues diversified away" (p. 70).
Writing an investment policy
Defining an investment policy, Ellis considered the fundamental task of the investor. An investment policy “is to establish useful guidelines for investing that are genuinely appropriate to the realities both of your own investment objectives and of the realities of the investment markets. These are the internal and external realms of investing, and investment policy must be designed to work well in both realms” (p. 89). The policy articulates the investor’s risk tolerance, objectives, and the equities that fit with the risk and objectives. The investment advisor explains the external factors, the markets and economic realities that affect the investor’s goals. “Investment policy is the explicit linkage between your long-term investment objectives and the daily work of your investment manager” (p. 90), stated Ellis. He recommended that the investor have the policy in writing.
Ellis elaborated on three policy facets: “the level of market risk to be taken . . . whether the level of risk is to be sustained or varied as markets change . . . whether individual stock risk or group risk is to be taken or avoided and the incremental rate of return which such risks, when taken, are expected to produce in the portfolio” (p. 90). If an investment advisor differentiates himself from the general market, that is an index fund, the investor needs to understand how he differs. Ellis stipulated how an advisor might differ: “by betting heavily on a few stocks, by favoring a particular stock market sector, or by investing heavily in cash if he thinks stocks are overpriced” (p. 90). Furthermore, understanding his execution, “whether continually as part of a long-term strategy or occasionally as a short-time tactic . . . and, most important, why he is confident that he will achieve favorable incremental results by taking these actions” (p. 91). With this insight, an investor can assess the advisor’s competence.
Ellis offered five standards by which an investor can evaluate an investment policy:
“1. Is the policy carefully designed to meet your real needs and objectives?
2. Is the policy written so clearly and explicitly that a competent stranger could manage the portfolio and conform to your intentions?
3. Would you have been able to sustain a commitment to the policies during the most troubling capital markets that have actually been experienced over the past 50 years—when conventional wisdom was surely most opposed?
4. Would the investor or professional investment manager have been able to maintain fidelity to the policy over the same periods despite intense daily pressure?
5. Would the policy, if implemented, have achieved your objectives?” (pp. 94-95).
Performance measurement, chapter 14 of Ellis’ work, has two basic principles—that the market, similar to any statistical phenomenon, tends to conform to the regression to the mean” (p. 97). The second principle stipulated that an investor should compare the portfolio with those of the same type—small cap with small cap and growth with growth.
Ellis reiterated the need to measure long-term results to determine true success.
Managing Managers
Ellis described how knowledgeable investors manage their advisors. The investor should attend to formulating an investment policy, internally and externally, in keeping with his or her decision-making process. Internal and external understanding constitutes the first and second steps of the process. Third, find a manager to execute your plan. Fourth, stick to the plan regardless of external realities. To maintain the relationship, Ellis suggested quarterly or semiannual meetings with an agenda, all documents. Ellis continued, “each meeting should begin with a careful review of the investment manager’s mission—the agreed-upon investment policies of the portfolio through which the manager is expected to accomplish the mutually intended long-term objective—to see if any modification in either objective or policy is appropriate” (p. 116). If not, reaffirm the policy document. “Discussion of specific portfolio operations—purchases and sales of specific securities—should be on an exception basis and should be brief” (p. 116). “The balance of the meeting time, usually another half hour, can best be devoted to a thoughtful and detailed discussion of almost any topic of importance to both the client and the manager as a way to increase shared understanding” (p. 117).
At least once a year the main topic should be a candid review—led by the client—of the client’s overall financial situation and the context in which the investment portfolio fits” (p. 117).
A written summary of perhaps three to five pages should be prepared and distributed after each meeting and kept for future reference. One suggestion would be to have alternating meetings summarized by the client and the investment manager” (pp. 117-118).
Questions an investor should ask for an actively managed portfolio include: “which managers will outperform the market for many years into the future? . . . can you identify the future’s favored few today? . . . will you make the right decisions and take action at the right time? . . . if you do select a superior manager, will that manager stay superior or will the assets managed grow? . . . (p. 120).
Among the rights of a client investor, according to Ellis, the investor “can select specialist managers skilled in each of the several different kinds of investing wanted . . . clients can diversity against the risk of one manager’s investment concept being out of tune with the overall market” (p. 122). Instead of many managers to diversity and reduce risk, Ellis pointed to index funds as a means to accomplish the same end.
The various decision-making sections of a portfolio entail equity mix, active versus passive management, advisor choice, portfolio policy and alternations. Emphasis on section 1, equity mix, increase the odds of success in comparison to portfolio alternations, section five.
Individual Investor’s 10 Commandments
1. “Don’t speculate
2. Save
3. Don’t do anything in investing primarily for “tax reasons”
4. Don’t think of your home as an investment
5. Never do commodities
6. Stockbrokers . . .their job is not to make money for you . . . their job is to make money from you
7. Don’t invest in new or “interesting” investments
8. Don’t invest in bonds because you’ve heard that bonds are conservative or for safety
9. Write out your long term goals
10. Don’t trust your emotions” (pp. 141-142)
Concentrate your investment in index funds for 401(k) plans.
Questions to Ask to Plan for the Future
“During retirement, how much income do I want to have each year in addition to Social Security and my employer’s pension benefit? . . . How many years will I be I retirement? What spending rule am I ready to live with and live by? . . . How much capital will I need to provide amply for retirement? . . . After insurance, what capital will I need—inflation-adjusted—to cover full health care for my spouse and myself? . . . How much capital do I want to pass on to each member of my family? . . . How much capital do I wish to direct to my philanthropic priorities?” (p. 156).
“Average returns for each type of investment have been approximately as follows:
Stocks 4 1/2 percent
Bonds 1 1/2 percent
T-bills 1 ¼ percent
Steps to Develop a Strategy
“Ask representatives of three organizations this question in writing: ‘Over the past 20 years, the stock market’s average annual total return has been X percent. Starting at the stock market’s present level, what average annual rate of return from today’s market level would your firm expect over the next 20 years? Next question: Over the next 1-, 5-, and 20-year periods, what rate of inflation do you expect?” (p. 157). When you have their answers, take the average of their answers. You’ll now have two crucial estimates of the future: The nominal rate of return for the stock market and the amount you will have to adjust nominal returns to estimate the real (inflation-adjusted) rates of return.
Any funds that will stay invested for 10 years or longer should be in stocks
Any funds that will be invested for less than two to three years should be in “cash” or money market instruments
“Prepare a complete inventory of your investment assets, including the following:
Investment in stocks and bonds
Equity in your home
Assets in any retirement plans"
Ellis' Suggested Reading List (pp. 174-175)
Berkshire Hathaway Annual Reports
The IntelligentInvestor by Benjamin Graham
Bogle on Investing, Jack Bogle
Pioneering Portfolio Management, David Swensen
Why SmartPeople Make Big Money Mistake--and How to Correct Them, Gary Belsky and Thomas Gilovich
The Crowd, Gustave LeBon
The Only Investment Book You'll Ever Need, Andrew Tobias
A RandomWalk down Wall Street
An Investor's Anthology
Wealthy and Wise, Claude Rosenberg
Ellis, C. D. (2002). Winning the loser's game: Timeless strategies for successful investing. NewYork: McGraw-Hill.
Thursday, February 26, 2009
Antoine van Agtmael: The Emerging Market Century
An excellent book stated Swensen about the transformation of third-world makets to emerging markets.
van Agtmael, A. (2007). The emerging markets century: How a new breed of world-class companies is overtaking the world. New York: Free Press.
A banker and investment manager, van Agtmael worked at Bankers Trust with companies in Iran, South Korea, Japan, Thailand, and other Asian countries. One lesson Agtmael learned from his travels, he summarized as "foreign investors would be better off hedging their bets by investing in a basket of markets in developing nations as opposed to a single one" (p. 3). The idea of portfolio investing in emerging markets continued as the unifying theme of the book and the belief that these economies will dominate the economic future.
The author reiterated reports from Goldman Sachs, projecting the growth of emerging markets, the BRICs (Brazil, Russia, India, and China). Agtmael wrote that these countries "will overtake the several largest industrialized countries, the G7 (United States, Japan, Germany, France, UK, Italy, and Canada) by 2040. With globalization as the stage on which the developed and emerging markets compete, emerging market companies have proved the ability to compete, export, and produce on a global level.
Agtmael discerned these stages of emerging market development: "wave 1 foreign direct investment in overseas plants, wave 2 outsourcing and offshoring, wave 3 peer-to-peer emerging world class competitors" (p. 19). From his experiences, he extracted nine lessons. "'Unbundle' an industry by taking advantage of 'legacy thinking' to create opportunities for newcomers; vertically integrate the supply chain by building on related expertise; be a chameleon; turn the outsourcing model upside down; follow a south-south strategy(stay local); solve the zip code problem by going global; use a veil of anonymity by aspiring to be the largest company no one has ever heard of; translate the classic Chinese Sun Tzu war strategy into focusing on a niche ignored by market leaders; offer cheap brainpower instead of cheap brawn power" (pp. 50-55). He examined a number of emerging markets that illustrated each of these attributes.
van Agtmael, A. (2007). The emerging markets century: How a new breed of world-class companies is overtaking the world. New York: Free Press.
A banker and investment manager, van Agtmael worked at Bankers Trust with companies in Iran, South Korea, Japan, Thailand, and other Asian countries. One lesson Agtmael learned from his travels, he summarized as "foreign investors would be better off hedging their bets by investing in a basket of markets in developing nations as opposed to a single one" (p. 3). The idea of portfolio investing in emerging markets continued as the unifying theme of the book and the belief that these economies will dominate the economic future.
The author reiterated reports from Goldman Sachs, projecting the growth of emerging markets, the BRICs (Brazil, Russia, India, and China). Agtmael wrote that these countries "will overtake the several largest industrialized countries, the G7 (United States, Japan, Germany, France, UK, Italy, and Canada) by 2040. With globalization as the stage on which the developed and emerging markets compete, emerging market companies have proved the ability to compete, export, and produce on a global level.
Agtmael discerned these stages of emerging market development: "wave 1 foreign direct investment in overseas plants, wave 2 outsourcing and offshoring, wave 3 peer-to-peer emerging world class competitors" (p. 19). From his experiences, he extracted nine lessons. "'Unbundle' an industry by taking advantage of 'legacy thinking' to create opportunities for newcomers; vertically integrate the supply chain by building on related expertise; be a chameleon; turn the outsourcing model upside down; follow a south-south strategy(stay local); solve the zip code problem by going global; use a veil of anonymity by aspiring to be the largest company no one has ever heard of; translate the classic Chinese Sun Tzu war strategy into focusing on a niche ignored by market leaders; offer cheap brainpower instead of cheap brawn power" (pp. 50-55). He examined a number of emerging markets that illustrated each of these attributes.
Friday, February 20, 2009
Swensen: Pioneering portfolio management
The subtitle of Swensen's latest book, Pioneering portfolio management: An unconventional approach to institutional investment, appears directed to organizations. However, the introduction indicated that it applied to organizations and individual who have the time and skill to manage actively a portfolio. Swenson has observed that most individuals do not dedicate the time and learning required for active management. He recommended that they use passive investment methods, such as index funds that follow the S&P 500, the Russell 3000, or others.
Consistent with active portfolio management, the book stressed three themes. The first addressed "taking action within the context of an analytically rigorous framework, implemented with discipline and undergirded with thorough analysis of specific opportunities" (p. 4). The second theme, agency issues, confronted the personal, internal, and external forces which inhibit portfolio managers from adhering to their fiduciary responsibilities--from fee chasing to purchasing assets of companies that compromise investor interests. The last theme, active management challenges focused on the two variables of active management, market timing and security selecting, to realize rewarding pricing for assets.
In explaining the investment goals of Yale University, Swensen articulated the need for sustainability. He quoted Tobin, "the trustees of an endowed institution are the guardians of the future against the claims of the present" (p. 25). To achieve this goal, Swensen defined his investment philosophy, "by choosing to place asset allocation at the center of the investment process, investors ground the decision-making framework on the stable foundation of long-term policy actions . . . expressing an equity bias and maintaining appropriate diversification provide the foundation for building strong investment portfolios" (p. 52).
Swensen also specified Yale endowment’s spending philosophy. Sustainability requirements result from the balance of preserving the endowment and funding operations. Specifically, “Yale’s policy relates current year spending both to the previous level of spending from endowment and to the previous endowment market value. Under Yale’s rule spending for a given year equals 80 percent of spending in the previous year plus 20 percent of the long-term spending rate applied to the endowment’s market level at the previous fiscal year end” (p. 29). The older the endowment value the smaller the weight given to that value, ensuring less volatility and allowing greater risk. “Target spending rates sit at the center of fiscal discipline”, stated Swensen (p. 37).
Portfolio managers classify asset classes in a variety of ways. Swensen designated the groups noting the "broad sweeping differences in fundamental character" Debt versus equity, domestic versus foreign, inflation sensitive versus deflation sensitive, private versus public, liquid versus illiquid" (p. 101). Furthermore, Swensen described the type of economic environment in which each of the classes performed best.
"Under normal circumstances, bond returns exhibit high positive correlation to stock returns When interest rates fall, bond prices rise as a result of the inverse relationship between prices and yields. When interest rates decline, stock prices tend to rise as investors subject future earnings streams to lower discount rates. Strong positive correlations between stocks and bonds in normal environments produce little diversifying power. In the case of unanticipated inflation, bonds suffer. Inflationary price increases erode purchasing power of fixed nominal bond payments, causing investors to push bond prices down. While inflation may have negative short-term consequences for stocks, in the long run stocks react positively to inflation. With unexpected inflation, the long-term correlation between stocks and bonds prove to be low, providing substantial diversification to the portfolio. In a deflationary environment stocks perform poorly as economic woes cause earnings to suffer. In contrast, bonds generate handsome returns since fixed payments appear increasingly attractive as rice levels decline. During periods of deflation, low or negative correlations between stocks and bonds provides strong diversification" (p. 117-118).
In the context of the economic factors that influence asset allocation, the investor must decide on a portfolio. Yale identified the following two goals: "preservation of purchasing power and provision of substantial, sustainable support for operations" (p. 122). Given these goals, Yale defined its "'spending trauma' as a 10 percent reduction in real endowment distributions over five years" (p. 122). The responsibility rested on the portfolio manager "in selecting the portfolio best suited to satisfy, to the extent possible, both goals" (p. 123).
Having established portfolio management philosophies, goals, objectives, and investment and spending targets, the Yale team undergoes iterative portfolio simulations to verify performance. "Returns for each asset class, based on assumed returns, risks, and correlations and drawn from the specified distributions, determine portfolio returns for the initial period. The spending rule dictates the amount withdrawn from endowment, leaving the residual to be invested in the second period. After rebalancing the portfolio to long-term policy weights, repeating the return level for the subsequent year. The process continues, creating a time series of spending and endowment values" (p. 123). The team had multiple criteria for judging portfolio performance: failure to meet the team's goals and failure to realize both goals in equal weights. The exercises of simulations "encourage investors to create well-diversified portfolios" (p. 127), containing larger domestic equity classes, smaller reliance on bonds, and the inclusion of "private assets, including venture capital, leveraged buyouts, real estate, timber, and oil and gas" (p. 127). This exhibits a strategy geared to higher returns with less risk than the less-diversified endowments, the 'free lunch'.
In his chapter on portfolio management, Swensen emphasized, that the "fundamental objective of portfolio management is faithful implementation of long-term asset allocation targets" (p. 130). He continued, "If investors allow actual portfolio holdings to differ materially from asset class targets, the resulting portfolio fails to reflect the risk and return preferences determined by the asset allocation process" (p. 130).
After establishing asset allocation targets, Swensen contends that “risk control requires regular rebalancing to policy targets” (p. 132). A contrarian mindset lies at the heart of a rebalancing philosophy. Rebalancing requires discipline. An investor’s frequency of rebalancing ranges from daily, monthly, quarterly, or annually. “Since rebalancing requires sale of assets experiencing relative price strength and purchase of assets experiencing relative price weakness, the immediacy of continuous rebalancing causes managers to sell what others are buying and buy what others are selling, thereby providing liquidity to the market . . . To the extent that markets exhibit excess volatility, continuous rebalancing generates excess returns” (p. 134-135).
On consequences of active management, Swensen reiterated that active management and deviation from indexing, passive management involves risk. Additionally, the belief of investors that "portfolio biases create potential for significant value added . . . value strategies dominate growth strategies . . . that small-capitalization stock provide superior stock picking opportunities" (p. 136). Regarding active management, Swensen differentiates explicit and implicit leverage. Explicit leverage occurs when investors borrow funds to finance investment purchases. Implicit leverage happens when holding positions that embody greater risk than contemplated by the asset class within which they are categorized, such as derivatives.
Within the category of traditional asset classes, Swensen mentioned domestic equities, or stocks, U.S. Treasury bonds, foreign equities, and emerging markets. Swensen described the nature of these instruments, the hedge they act against inflation and deflation, the reasons they add diversity to the portfolio, the alignment of the interests of their managers and that of investors, and the interplay between the American and foreign markets and currency fluctuations. Previous discussion has detailed how domestic equities and U.S. Treasuries operate according to factors. Regarding foreign equities, Swensen concluded that historical data "supports the assumption of approximate equivalence between expected returns for domestic and international equities" (p. 170). However, he observed that "sensible investors invest in foreign equity markets through thick and thin" (p. 174). The political and economic stability and regulatory immaturity of emerging economies cause a high degree of risk for investors of these securities. Analysis has shown that many suffer periods of either "nationalization or war" (p. 175). "Of the thirty-six markets that operated in 1900, fully fifteen remained classified as emerging markets more than 100 years later" (p. 175). Although Swensen saw a correlation between inflation on domestic equities and emerging markets, he observed, "basic commodities play an important role in a number of emerging markets economies. To the extent that the U.S. suffers commodity-price induced inflationary pressures, investments in emerging markets stocks may provide partial protection against the inflation" (p. 177).
In his chapter on the investment process, Swensen argued that two principles should govern an organization that manages endowments: "developing an organization with the capability of selecting high quality active managers, and (b) deploying a strategy with an emphasis on bare bones passive vehicles" (p. 297). Some asset classes do not allow for passive investment success, according to the author: "absolute return*, real assets, and private equity" (p. 299).
Annual performance reviews
When making decisions, place allocations targets at the center on the discussion, targets that undergoes a review once a year. Other strategic reviews include the portfolio evaluation. This review details the "character and performance of the overall endowment and individual asset classes in depth, placing results in the context of conditions and identifying factors that influence significant investment opportunities" (p. 317).
"Portfolio review memoranda describe individual asset classes in depth, placing results in the context of market conditions and identifying factors that influence significant investment opportunities. The positioning of an asset class relative to its benchmark with respect to fundamental characteristics--such as size, sector, and style--highlights significant portfolio bets that are evaluated retrospectively and prospectively. Active management efforts receive grades in the form of detailed report cards for each manager. The individual manager assessments include not only performance data, but information on reporting, transparency, fee structure, and co-investment. Analysis of strengths and weaknesses of portfolio strategies leads to an outline for future projects to improve portfolio management. In essence, the portfolio evaluation meeting provides a backward-looking assessment and a forward-looking strategic plan" (p. 317).
"The remaining two quarterly meetings generally have a topical focus, frequently involving in-depth analysis of a specific asset class. Meetings centered on individual asset classes drill deep to provide a granular view, allowing committee staff to evaluate thoroughly every aspect of asset class management. Decision-making assessments consider the impact of bets regarding size, sector, and style . . . Asset class reviews provide a chance for external investment manages to engage investment committee and staff in discussion of significant market issues" (pp. 317-318).
Performance Assessment
Consistent with active portfolio management, the book stressed three themes. The first addressed "taking action within the context of an analytically rigorous framework, implemented with discipline and undergirded with thorough analysis of specific opportunities" (p. 4). The second theme, agency issues, confronted the personal, internal, and external forces which inhibit portfolio managers from adhering to their fiduciary responsibilities--from fee chasing to purchasing assets of companies that compromise investor interests. The last theme, active management challenges focused on the two variables of active management, market timing and security selecting, to realize rewarding pricing for assets.
In explaining the investment goals of Yale University, Swensen articulated the need for sustainability. He quoted Tobin, "the trustees of an endowed institution are the guardians of the future against the claims of the present" (p. 25). To achieve this goal, Swensen defined his investment philosophy, "by choosing to place asset allocation at the center of the investment process, investors ground the decision-making framework on the stable foundation of long-term policy actions . . . expressing an equity bias and maintaining appropriate diversification provide the foundation for building strong investment portfolios" (p. 52).
Swensen also specified Yale endowment’s spending philosophy. Sustainability requirements result from the balance of preserving the endowment and funding operations. Specifically, “Yale’s policy relates current year spending both to the previous level of spending from endowment and to the previous endowment market value. Under Yale’s rule spending for a given year equals 80 percent of spending in the previous year plus 20 percent of the long-term spending rate applied to the endowment’s market level at the previous fiscal year end” (p. 29). The older the endowment value the smaller the weight given to that value, ensuring less volatility and allowing greater risk. “Target spending rates sit at the center of fiscal discipline”, stated Swensen (p. 37).
Portfolio managers classify asset classes in a variety of ways. Swensen designated the groups noting the "broad sweeping differences in fundamental character" Debt versus equity, domestic versus foreign, inflation sensitive versus deflation sensitive, private versus public, liquid versus illiquid" (p. 101). Furthermore, Swensen described the type of economic environment in which each of the classes performed best.
"Under normal circumstances, bond returns exhibit high positive correlation to stock returns When interest rates fall, bond prices rise as a result of the inverse relationship between prices and yields. When interest rates decline, stock prices tend to rise as investors subject future earnings streams to lower discount rates. Strong positive correlations between stocks and bonds in normal environments produce little diversifying power. In the case of unanticipated inflation, bonds suffer. Inflationary price increases erode purchasing power of fixed nominal bond payments, causing investors to push bond prices down. While inflation may have negative short-term consequences for stocks, in the long run stocks react positively to inflation. With unexpected inflation, the long-term correlation between stocks and bonds prove to be low, providing substantial diversification to the portfolio. In a deflationary environment stocks perform poorly as economic woes cause earnings to suffer. In contrast, bonds generate handsome returns since fixed payments appear increasingly attractive as rice levels decline. During periods of deflation, low or negative correlations between stocks and bonds provides strong diversification" (p. 117-118).
In the context of the economic factors that influence asset allocation, the investor must decide on a portfolio. Yale identified the following two goals: "preservation of purchasing power and provision of substantial, sustainable support for operations" (p. 122). Given these goals, Yale defined its "'spending trauma' as a 10 percent reduction in real endowment distributions over five years" (p. 122). The responsibility rested on the portfolio manager "in selecting the portfolio best suited to satisfy, to the extent possible, both goals" (p. 123).
Having established portfolio management philosophies, goals, objectives, and investment and spending targets, the Yale team undergoes iterative portfolio simulations to verify performance. "Returns for each asset class, based on assumed returns, risks, and correlations and drawn from the specified distributions, determine portfolio returns for the initial period. The spending rule dictates the amount withdrawn from endowment, leaving the residual to be invested in the second period. After rebalancing the portfolio to long-term policy weights, repeating the return level for the subsequent year. The process continues, creating a time series of spending and endowment values" (p. 123). The team had multiple criteria for judging portfolio performance: failure to meet the team's goals and failure to realize both goals in equal weights. The exercises of simulations "encourage investors to create well-diversified portfolios" (p. 127), containing larger domestic equity classes, smaller reliance on bonds, and the inclusion of "private assets, including venture capital, leveraged buyouts, real estate, timber, and oil and gas" (p. 127). This exhibits a strategy geared to higher returns with less risk than the less-diversified endowments, the 'free lunch'.
In his chapter on portfolio management, Swensen emphasized, that the "fundamental objective of portfolio management is faithful implementation of long-term asset allocation targets" (p. 130). He continued, "If investors allow actual portfolio holdings to differ materially from asset class targets, the resulting portfolio fails to reflect the risk and return preferences determined by the asset allocation process" (p. 130).
After establishing asset allocation targets, Swensen contends that “risk control requires regular rebalancing to policy targets” (p. 132). A contrarian mindset lies at the heart of a rebalancing philosophy. Rebalancing requires discipline. An investor’s frequency of rebalancing ranges from daily, monthly, quarterly, or annually. “Since rebalancing requires sale of assets experiencing relative price strength and purchase of assets experiencing relative price weakness, the immediacy of continuous rebalancing causes managers to sell what others are buying and buy what others are selling, thereby providing liquidity to the market . . . To the extent that markets exhibit excess volatility, continuous rebalancing generates excess returns” (p. 134-135).
On consequences of active management, Swensen reiterated that active management and deviation from indexing, passive management involves risk. Additionally, the belief of investors that "portfolio biases create potential for significant value added . . . value strategies dominate growth strategies . . . that small-capitalization stock provide superior stock picking opportunities" (p. 136). Regarding active management, Swensen differentiates explicit and implicit leverage. Explicit leverage occurs when investors borrow funds to finance investment purchases. Implicit leverage happens when holding positions that embody greater risk than contemplated by the asset class within which they are categorized, such as derivatives.
Within the category of traditional asset classes, Swensen mentioned domestic equities, or stocks, U.S. Treasury bonds, foreign equities, and emerging markets. Swensen described the nature of these instruments, the hedge they act against inflation and deflation, the reasons they add diversity to the portfolio, the alignment of the interests of their managers and that of investors, and the interplay between the American and foreign markets and currency fluctuations. Previous discussion has detailed how domestic equities and U.S. Treasuries operate according to factors. Regarding foreign equities, Swensen concluded that historical data "supports the assumption of approximate equivalence between expected returns for domestic and international equities" (p. 170). However, he observed that "sensible investors invest in foreign equity markets through thick and thin" (p. 174). The political and economic stability and regulatory immaturity of emerging economies cause a high degree of risk for investors of these securities. Analysis has shown that many suffer periods of either "nationalization or war" (p. 175). "Of the thirty-six markets that operated in 1900, fully fifteen remained classified as emerging markets more than 100 years later" (p. 175). Although Swensen saw a correlation between inflation on domestic equities and emerging markets, he observed, "basic commodities play an important role in a number of emerging markets economies. To the extent that the U.S. suffers commodity-price induced inflationary pressures, investments in emerging markets stocks may provide partial protection against the inflation" (p. 177).
In his chapter on the investment process, Swensen argued that two principles should govern an organization that manages endowments: "developing an organization with the capability of selecting high quality active managers, and (b) deploying a strategy with an emphasis on bare bones passive vehicles" (p. 297). Some asset classes do not allow for passive investment success, according to the author: "absolute return*, real assets, and private equity" (p. 299).
Annual performance reviews
When making decisions, place allocations targets at the center on the discussion, targets that undergoes a review once a year. Other strategic reviews include the portfolio evaluation. This review details the "character and performance of the overall endowment and individual asset classes in depth, placing results in the context of conditions and identifying factors that influence significant investment opportunities" (p. 317).
"Portfolio review memoranda describe individual asset classes in depth, placing results in the context of market conditions and identifying factors that influence significant investment opportunities. The positioning of an asset class relative to its benchmark with respect to fundamental characteristics--such as size, sector, and style--highlights significant portfolio bets that are evaluated retrospectively and prospectively. Active management efforts receive grades in the form of detailed report cards for each manager. The individual manager assessments include not only performance data, but information on reporting, transparency, fee structure, and co-investment. Analysis of strengths and weaknesses of portfolio strategies leads to an outline for future projects to improve portfolio management. In essence, the portfolio evaluation meeting provides a backward-looking assessment and a forward-looking strategic plan" (p. 317).
"The remaining two quarterly meetings generally have a topical focus, frequently involving in-depth analysis of a specific asset class. Meetings centered on individual asset classes drill deep to provide a granular view, allowing committee staff to evaluate thoroughly every aspect of asset class management. Decision-making assessments consider the impact of bets regarding size, sector, and style . . . Asset class reviews provide a chance for external investment manages to engage investment committee and staff in discussion of significant market issues" (pp. 317-318).
Performance Assessment
Swensen listed both qualitative and quantitative factors in evaluating a portfolio. qualitative factors encompass "the quality and commitment of a firm's principals and maintenance of an appropriate organizational structure, regular face-to-face meetings between fund managers and external advisors constitute the most important tool for performance evaluation" (p. 326).
"Portfolio return data provide essential hard input into the performance assessment process. By comparing manager returns to passive market benchmarks and active manager benchmarks, investors measure the successes and failures of an investment program" (p. 326).
"If the sense of partnership diminishes because of changes in people, philosophy, or structure, then tough-minded fiduciaries move on" (p. 327).
* Absolute return investing consists of inefficiency-exploiting marketable securities positions that exhibit little or no correlation to traditional stock and bond investments . . . Merger arbitrage represents a typical event-driven absolute return strategy, with results related to the manager's ability to predict the probability that a deal will close, the likely timing and the expected consideration for the transaction" (p. 183).
Swensen, D. F. (2009). Pioneering portfolio management: An unconventional approach to institutional investment. New York: Free Press.Thursday, February 19, 2009
Swensen: Unconventional Success: A fundamental approach to personal investment
David F. Swensen, the Chief Investment Officer at Yale University, wrote books as instructions for the average investor. Swensen's investment strategy rests on Tobin's construct for understanding stock prices. Tobin's "q" a "means of understanding stock prices . . . compares the replacement cost of corporate assets to the market value of those assets. In equilibrium, Tobin argued, the ratio of replacement cost to market value, which he named "q", should equal one" (pp. 40-41).
Swensen's book, Unconventional success: A fundamental approach to personal investment, described three activities of portfolio management, asset allocation, market timing, and security selection. Asset allocation, Swensen defined as "the long-term decision regarding the proportion of assets that an investor chooses to place in particular investments" (p.11). Investors divide investments into six classes, such as domestic and foreign equities, emerging market securities, inflation-indexed bonds, conventional bonds, and real estate. Investors compare the returns from these classes against benchmarks to determine results.
Market timing, Swensen explained, "represents a purposeful attempt to generate short-term superior returns based on insights regarding relative asset class valuations" (p. 12). Security selection "refers to the method of construction of the individual asset classes, beginning with the choice of a passive or active management" (p. 12). Passive management mirrors results of indices, such as the S&P 500, Russell 3000, and others. Active management "involves making bets against the market with the investor attempting to overweight attractively priced stocks and underweight expensively priced stocks" (p. 12). Research, Swensen attested, attributed to asset allocation 90 percent of the variability of returns. The other two investment tools have a 10 percent impact.
Within the context of asset allocation, three principles shape a well-structured portfolio, "equity bias . . . substantial diversification . . . tax considerations" (p. 17). Equity bias acknowledges that equities outperform other asset classes. Research of Ibbotson and Siegel support this proposition. Substantial diversification assumes a sufficient number of investments to distribute risk. Swensen perceived that current market risk "required a portfolio of fifty securities" (p.22).
Swensen advocated the following breakdown of asset classes in a typical portfolio:
Domestic equities 30%
Foreign developed equities 15%
Emerging markets 5%
Real Estate 20%
US Treasury Bonds 15%
US TIPS 15%
Deviations to this portfolio would result from investment time horizons, the level of commitment to an equity orientation, and personal circumstances.
To minimize risk, Swensen pointed to US Treasury bonds and US Treasury Inflation Protected Securities (TIPS). However, investors should understand of the relationship between these government instruments and inflation. Similarly, when rebalancing a portfolio, investors should consider the tax ramifications of their actions.
Although Swensen castigated mutual funds generally, as "performance deficit" (p. 208), he mentioned some mutual fund managers that exhibited traits that promoted the investors interests: owning a significant stake in their fund, have a passion for superior returns, engaging in relentlessly research in the companies they follow, shunning a herd mentality about the market, and demonstrating the courage of their convictions. Under the headings of "Principal orientation . . . clear strategy . . . long-term focus . . . portfolio concentration . . . stable client base . . . fair fee arrangements . . . substantial co-investment . . . limits on assets under management . . . shareholder communication" (pp. 303-310), Swensen explored traits on good mutual fund managers. For the active investor, Swensen examined exchange traded funds (ETFs) as an investment option. An costly vehicle for small investors who trade in small increments, they offer investors who make larger trades a more cost effective choice than mutual funds. Swensen cautioned investors to watch the fees. Unfortunately, some ETF managers have mimicked the mutual fund market.
Swensen, D. F. (2005). Unconventional success: A fundamental approach to personal investment. New York: Free Press.
Swensen's book, Unconventional success: A fundamental approach to personal investment, described three activities of portfolio management, asset allocation, market timing, and security selection. Asset allocation, Swensen defined as "the long-term decision regarding the proportion of assets that an investor chooses to place in particular investments" (p.11). Investors divide investments into six classes, such as domestic and foreign equities, emerging market securities, inflation-indexed bonds, conventional bonds, and real estate. Investors compare the returns from these classes against benchmarks to determine results.
Market timing, Swensen explained, "represents a purposeful attempt to generate short-term superior returns based on insights regarding relative asset class valuations" (p. 12). Security selection "refers to the method of construction of the individual asset classes, beginning with the choice of a passive or active management" (p. 12). Passive management mirrors results of indices, such as the S&P 500, Russell 3000, and others. Active management "involves making bets against the market with the investor attempting to overweight attractively priced stocks and underweight expensively priced stocks" (p. 12). Research, Swensen attested, attributed to asset allocation 90 percent of the variability of returns. The other two investment tools have a 10 percent impact.
Within the context of asset allocation, three principles shape a well-structured portfolio, "equity bias . . . substantial diversification . . . tax considerations" (p. 17). Equity bias acknowledges that equities outperform other asset classes. Research of Ibbotson and Siegel support this proposition. Substantial diversification assumes a sufficient number of investments to distribute risk. Swensen perceived that current market risk "required a portfolio of fifty securities" (p.22).
Swensen advocated the following breakdown of asset classes in a typical portfolio:
Domestic equities 30%
Foreign developed equities 15%
Emerging markets 5%
Real Estate 20%
US Treasury Bonds 15%
US TIPS 15%
Deviations to this portfolio would result from investment time horizons, the level of commitment to an equity orientation, and personal circumstances.
To minimize risk, Swensen pointed to US Treasury bonds and US Treasury Inflation Protected Securities (TIPS). However, investors should understand of the relationship between these government instruments and inflation. Similarly, when rebalancing a portfolio, investors should consider the tax ramifications of their actions.
Although Swensen castigated mutual funds generally, as "performance deficit" (p. 208), he mentioned some mutual fund managers that exhibited traits that promoted the investors interests: owning a significant stake in their fund, have a passion for superior returns, engaging in relentlessly research in the companies they follow, shunning a herd mentality about the market, and demonstrating the courage of their convictions. Under the headings of "Principal orientation . . . clear strategy . . . long-term focus . . . portfolio concentration . . . stable client base . . . fair fee arrangements . . . substantial co-investment . . . limits on assets under management . . . shareholder communication" (pp. 303-310), Swensen explored traits on good mutual fund managers. For the active investor, Swensen examined exchange traded funds (ETFs) as an investment option. An costly vehicle for small investors who trade in small increments, they offer investors who make larger trades a more cost effective choice than mutual funds. Swensen cautioned investors to watch the fees. Unfortunately, some ETF managers have mimicked the mutual fund market.
Swensen, D. F. (2005). Unconventional success: A fundamental approach to personal investment. New York: Free Press.
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