As Warren Buffett's quote above refers to, risk is not knowing or understanding what you are doing.
To help combat this "risk," I’ve put together a list of some important measures to consider when evaluating your investment portfolio.
These metrics can be used to measure individual stocks, ETFs, and mutual funds.
Underlying Holdings: Probably the single most important information to know. This is the driver of how your portfolio (or the fund) has performed in the past and how it will perform in the future. Know what you own and why.
Geographic Exposure: Measures where in the world are the funds’ largest holdings located geographically. Where are these companies based? Are they located in U.S., European, or in Asia? Why is this important? Different countries have different accounting standards, regulatory requirements, and governmental intervention.
Weighted Average PE Ratio: Measures what the weighed average price/earnings ratio is of the funds’ underlying holdings. The higher the number, the more investors are paying for every dollar of earnings. All else being equal, lower is better.
Valuation Percentage: The valuation percentage shows how far above or below its current price the stocks or funds historical valuation is. This factors a long-term average of the Price to Sales Ratio and Price to Earnings Ratio and mathematically determines whether the current price is high or low relative to those historic valuation multiples. A negative value indicates the current price is above the historical valuation while a positive value indicates it is currently trading at a discount to the historical valuation. This is NOT a measurement of how the stock's price relates to its "intrinsic value” but is instead a measurement of how the market is valuing the stock or fund relative to how it was valued historically.
Return on Equity (ROE): Measures the rate of return on the money invested by stock owners. ROE shows how well a company uses investment funds to generate income and growth. Return on equity is useful for comparing companies within a sector and industry. It’s also useful at the fund and portfolio level. Return on Equity = Net Income / Average Common Shareholder's Equity. All else being equal, higher is better.
Dividend Yield (and Current Yield): The sum of all dividends paid (and interest paid), divided by current share price; a higher dividend yield (and current yield) indicates a larger payout.
Dividend Payout Ratio: The percentage of company net income paid as dividends to shareholders. Typically, investors who want income from their investments favor a higher dividend payout ratio.
Dividend Growth: Period over period growth of dividends paid, usually expressed as trailing 12-month (TTM) growth. Growth in dividends can be a sign of strong financial health.
Dividend Consistency: The track record of paying dividends to shareholders at a regular interval, usually quarterly, over a given lookback period; a company cutting or canceling a dividend payment is a negative event.
Total Returns: Unlike price return, total return includes dividends and interest in addition to price appreciation; a higher total return is better. It’s important to look over various time periods and under various market conditions (Bull markets, Bear markets, and sideways markets). As I’m sure you’ve heard before, “past returns are no guarantee of future returns.”
Sharpe Ratio: The Sharpe Ratio measures the risk-adjusted return of a security. This is a useful metric for analyzing the return you are receiving on a security in comparison to the amount of volatility expected. Sharpe Ratio is measured as annualized return on Lookback Period - Risk-Free Rate) / Historical Annualized Standard Deviation of Monthly Price Returns.
Benchmark: For a security, a fund, or a portfolio, a benchmark is used to track against. Generally, the benchmark is an index or weighted return stream of multiple indices that help give an idea of what your investment should strive to match or beat. Measuring against the proper benchmark is critical to properly understanding performance and risk. Benchmarks are also used to calculate risk metrics like Alpha, Sharpe Ratio, and Beta for securities and portfolios.
Upside/Downside Capture Ratio: The upside/downside capture ratio measures the ratio of the upside and downside of an investment vs a benchmark. This ratio explains how an investment typically performs in relation to their benchmark index. An upside/downside ratio of 100 means that the investment typically performs the same as the benchmark, regardless of if it is rising or falling. If the benchmark increases by 10%, the investment increases by 10%. If the benchmark decreases by 5%, the investment decreases by 5%. Sometimes, an investment may rise 15% when their benchmark rises by 10% but falls 12% when the market falls 10%. In this case, we calculate the upside/downside capture ratio by dividing the investment's upside return and dividing by the downside return: (.15/.10)/(.12/.10) = 1.25. Multiplying this by 100 gives us an upside/downside capture ratio of 125 for this investment. All else being equal, higher is better.
Expense Ratio: The percentage of fund assets that shareholders pay as management fees and operating expenses. A lower expense ratio means less fees. All else being equal, lower is better.
Market Cap Allocation: The percentage of fund assets invested in large-cap, mid-cap, and small-cap stocks.
Understanding what you own and why is critically important. What I argue is even more important is understanding that having 100% accuracy to what the future holds is impossible, so taking measured risks is really what investors are doing when they invest.
As Napoleon said, "Nothing is more difficult, and therefore more precious, than to be able to decide."
-Paul R. Rossi, CFA
What is Portfolio Rebalancing?
Portfolio rebalancing is the systematic process of periodically realigning an investment portfolio’s actual allocations with the allocation percentages that were originally planned. This is accomplished by reducing positions that have become an outsized percentage of the portfolio (due to relative outperformance) or increasing positions that make up a lesser-than ideal percentage of total holdings (due to relative underperformance).
Why is this done? Typically, it’s done to ensure the portfolio matches an investors risk tolerance, time horizon, and goals.
Some things to consider when rebalancing:
The two most commonly used rebalancing policies are based on:
So which strategy is best for managing risk and maximizing performance?
A research platform I use within my own financial planning business has recently done a deep dive into this particularly important question that I thought was interesting.
The research was conducted using 6 different rebalancing strategies, each beginning with a broad based 60% equity (stock) and 40% fixed income (bond) portfolio.
Each of the 6 portfolio rebalancing strategies was studied over a 25 year period, the analysis looked at performance and volatility.
This 25 year period includes four bull markets and three bear markets. The findings show the pros and cons of different rebalancing policies and may inform your own best practices for portfolio management.
Some of the questions that were answered are:
On a cumulative basis, rebalancing strategies that rely on the triggering of drift thresholds outperform those with rebalancing strategies based on calendar frequencies. And while portfolios that never rebalance do perform relatively well over time, such a strategy can miss out on secular growth if only a small percentage is allocated to asset classes that eventually become market leaders, even if only temporarily. While more frequent rebalancing keeps actual portfolio allocations more in line with target allocations, the risk-management benefits diminish when a portfolio is rebalanced too frequently.
The optimal rebalancing strategy for managing risk, maximizing performance, and minimizing costs will change over time, based in part on market conditions. However, more important than any of these factors is your comfort level with the chosen rebalancing strategy and your comprehensive financial plan.
As is often said, "peace of mind can be priceless."
-Paul R. Rossi, CFA
Probably and Potentially Quite a Bit - read on
Below are some questions that you should review as Biden's proposed tax plan might have dramatic implications for you and your family.
Do you make pre-tax contributions to traditional retirement accounts (e.g., a 401(k) or IRA)?
Do you hold appreciated assets with a low cost basis (excluding pre-tax assets such as IRAs, most annuities, and other items of income in respect of a decedent)?
Do you earn wages in excess of $400,000?
Does your household income exceed $400,000?
Does your household income exceed $1,000,000?
Does the value of your estate exceed $3.5 million (or $7 million, if you are married)?
Are you a small business owner?
Are you an informal caregiver for an individual in need of long-term care services?
Do you have significant corporate ownership interests?
As always, it's important to talk with a tax professional to ensure you are making the best decision for your own particular situation.
-Paul R. Rossi, CFA
Several determinants play a critical role in why some individuals become value-oriented investors and others become growth-oriented investors.
With so much research being done on various aspects of investing, surprisingly little effort has been made to explain the factors that influence individual investors’ decision making. The authors (Nerik Cronq, Stephan Siegel, and Frank Yushow) whose published work was in the 'Journal of Financial Economics' shows that an investor’s investment style (i.e., value versus growth) can be derived from two sources: a genetic or biological predisposition and environmental factors. The authors reference several previous studies and provide their own analysis to contribute a new perspective about why investors gravitate toward value or growth investments.
Differences in individual investor behavior stem from:
Several factors explain an individual investor’s investment preference for either value- or growth-oriented portfolios. The authors estimate that genetic differences account for approximately 26% of the orientation when measured by Price/Earnings ratio and 27% when measured by Morningstar’s Value-Growth Score. This result is consistent with the findings of previous researchers, who have shown that approximately 30% of the cross-sectional variation in financial risk preferences is explained by genetic predispositions. In addition to biological considerations, the analysis demonstrates that particular individual life experiences have a large impact on investment styles.
Significant macroeconomic events (think of Global Financial Crisis, Dotcom Bubble, etc.) that investors experience can also have long-term and persistent effects on that individual’s behavior much later in life.
Conversely and consistent with previous studies, the research find that investors with:
This research contributes to and supports the growing body of evidence regarding behavioral finance, which demonstrates that life experiences, behavioral biases, and genetics have a dramatic impact on investors’ behavior.
This research, coupled with the growing body of literature on cognitive biases can be extremely helpful for individual investors to help understand their tendencies and why they may lean toward various investment strategies or products. By digging a bit deeper and learning more about ourselves, we can make better informed decisions.
-Paul R. Rossi, CFA
Paul R. Rossi, CFA