Asset Allocation Concepts for Investment Management.

1) Market Timing: Whenever one makes an investment decision based on a forecast of a market, asset class, or security going up or down, market timing is being utilized.

2) Security Selection: This is deciding which investment to buy or sell compared to others of the same type. For example, deciding whether to buy a bond or a growth stock would be an asset allocation or market timing decision. Deciding whether to buy AMD or Intel would be a security selection decision. This is because both stocks are in the same asset class. Stock picking is the most common form of security selection.

3) Asset Allocation: The art and science of how money gets divided up between different asset classes to lower risk and increase returns. This is also known as optimizing an investment portfolio, making it more efficient.

Asset classes are how different types of investments are categorized to distinguish them from one another. For example, CDs, bonds, stocks, gold, and real estate are different in terms of risk, reward, taxation, and income.

All three methods can be used simultaneously in making one investment decision.

The focus of this page is only on asset allocation. We hire mutual fund managers to time markets and select securities (and think financial planners and individual investors should too).

Asset Allocation Helps and Saves You in many Ways

· You don't always realize more return by assuming more risk in the Real World. Most of the time, when you assume more risk, you just lose more money. Asset allocation allows more control over how much return you'll probably get in exchange for assuming more risk.

· Asset allocation is the only non-derivative technique you can use to reduce risk (lower overall portfolio volatility), increase income, and get better returns, all at the same time. It's the only one of the three ways of managing money that reduces risk. The other two methods greatly increase risk.

For example, if the S&P 500 goes down 20%, you'll probably be down less than 17%. This is because you'd have less exposure to stocks when you hold other asset classes. If you're a stock picker or a market timer, chances are you'll be down over 25%.

· Even though using asset allocation eliminates the need for you to time markets and pick securities, it still has to be done by someone. That's the mutual fund manager's job. They have the armies of analysts and millions invested in computers, people, and systems needed to perform these mostly futile tasks. You don't, and that's the point. If you want to compete with them, then you'll lose most of the time. Winning means realizing low risk and great returns, while not having to waste time and money trying to manage money.

· Asset allocation saves you a lot of time. Other than updating mutual funds and quarterly rebalancing, you don't have to pay much attention to investment portfolios. If you really want to minimize time, you can use index funds or index ETFs, which rarely need to be monitored or updated (but still need to be rebalanced).

· Asset allocation saves you grief, worry, anxiety, stress, from losing sleep, and having to be glued to the TV or computer to keep track of the markets and your holdings. There's no need to baby-sit a security, and have access to a phone or the internet, to be ready to trade at all times to avoid losses. Asset allocation allows you to sleep and take real vacations.

· Asset allocation saves you money because you don't have to pay top-dollar for all of the trading costs associated with high-turnover market timing and/or stock picking strategies. It's the mutual fund managers' job to do all of the trading. You have to pay these mutual fund management fees, but they're much less than you'd pay on your own. They're able to keep their expenses down because of competition and economies of scale.

· You can still brag at parties that you were smart enough to buy something before it took off. When you hold a diverse portfolio of mutual funds comprised of many asset classes, you're bound to be holding securities of the current fad. Whatever the current hot thing is you'll most always be able to say, "I bought that before it went through the roof!"

· Asset allocation strategies are also great for diversifying and enhancing portfolio income, which is critical during retirement. Maximizing income reduces the need to dip into principal (sell shares). Investment portfolios will last much longer if you can get the spendable income needed to pay living expenses mostly by their normal income distributions (interest, dividends, and realized capital gains).

· If you're an investment professional, asset allocation saves you from having to pass FINRA Series 7 licensing exam. Our asset allocator systems use mutual funds, so only a Series 6 is required.

· Asset allocation saves advisors from having to deal with client phone calls when the markets go down. They'll just look up their account values online, see that less than half of their holdings went down, about a quarter went up, and not bother you. They also won't complain that you lost them a ton of money in bad markets, because this would be minimized. Clients tend to call advisors when their portfolio lost more than the markets - which is usually what happens when it's managed using market timing or stock picking. You'll almost always lose less than the markets with a well-allocated portfolio.

· Asset allocation also saves advisors from getting into trading trouble. First, there are no B or C share classes in our mutual fund recommendations, so those red flags will never be raised.

There are also many times fewer trades when you buy and hold mutual funds compared to trading stocks or timing markets. So compliance won't annoy you about excess trading nor churning to drum up commissions. Fewer trades result in lower trading costs, less administrative work, and fewer mistakes that need to be fixed.

Next, you can use our mutual fund picks to justify trading to FINRA or BD compliance. It has the reasons for the switches, so if anyone questions your trades you can say, "I'm using this investment management program, and I was just following their recommendations." Once they see what you're doing, they'll leave you alone because compliance loves this type of investment management program.

Once they see that you're fact finding correctly to determine investment risk tolerance (and maybe even using an IPS), they'll not only leave you alone, but may even use you as an example to show others how things should be done. This will put you on their good side, even if you've been on their watch list in the past.

So not only will asset allocation save you time, worry, money, and work; once you start getting better returns with lower risk for your clients, you'll be on everyone's good side. This will help let compliance cut you slack if you ever end up under their microscope. All of this will help keep your U5 clean, which is very important.

The Disadvantages of Asset Allocation

You're going to pay a little more in taxes with asset allocation, because you're going to be making more income and profits. You'll also be realizing less tax-deductible losses.

You won't be the life of the party when the topic is stock trading or market timing. Why? For the same reason the media only focuses on market timers and stock pickers. Because asset allocation is boring! There's literally nothing to talk about other than which asset class is currently up or down. This is shown on the table of mutual fund and index returns.

You're also guaranteed not to strike it rich if a bet pays off. If something doubles overnight, only that portion of the portfolio that was invested in that asset class will be affected. This is usually less than 15% with asset allocation.

Gambling with a large portion of money (using stocks, margin, derivatives, etc.), and lucking out, is the only way to get rich quick in financial markets. Very few people can do this in efficient markets these days. You've been at it for years, and haven't struck it rich yet. It just gets harder, so why keep trying?

The Four Methods of Performing Asset Allocation
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Links to our Three Asset Allocation Programs

Method #1: The most common method of performing asset allocation is by using pre-determined (canned) asset allocation models.

If a set mix of asset classes in a portfolio exists before an investor's risk tolerance is determined, then that allocation mix is called a model portfolio. The only life factor that determines which portfolio model to use is risk tolerance category. This is determined by filling out and scoring an investment fact finder.

Most financial advisors make investing models based on what their firm specializes in. Then they just put everyone's money with the same risk tolerance into the same portfolio model. This makes everything much easier to manage.

Investor models are the best way to get the concept of how an advisor wants to invest money across to investors. All it takes is explaining a table and a pie chart and telling what historical performance has been.

The problem is that stated performance is usually just the history of the current recommended investments, meaning they don't account for past trades/recommendations. This is misleading, because returns are less when past recommendations are accounted for. But because models are the most logical way for advisors to invest money for clients, FINRA and BD compliance will let advisors use them with hypothetical returns, as long as it's done properly. Both our model's hypothetical returns and their actual returns (accounting for past trades) are shown on the first two rows on the table below so you can see these differences.

Method #2: Use comprehensive asset allocation software that accounts for all of the important life factors needed to match an investment portfolio to someone's life.

Unlike allocation models, which exist before someone is around to invest in them, the investor inputs various life factors needed to calculate a custom allocation mix that reflects their life situation. So it's not just using one of a few generic pre-existing model allocations.

Model portfolios only take one life factor into account - investment risk tolerance category. Comprehensive allocation calculators also takes investing risk tolerance into account as the most important factor in determining the mix. But it also uses several more life factors. The result are portfolios that match up with lives as well as possible.

It then displays current and proposed portfolio snapshots, and future projections of both current and proposed portfolios. This allows complete control over every aspect of the asset allocation process. Model portfolios only show current investment recommendations (the proposed snapshot).

Differences between asset allocation models and comprehensive asset allocation calculator are listed on the product description pages (click a link above to go there). The best list of differences are at the bottom of the comprehensive asset allocation software page (right above the disclaimer which is right above the pricing table).

Method #3: Use asset distribution tools that don't calculate, nor recommend, a mix of asset classes. In other words, you're just winging it. Most canned investment software uses this technique.

It doesn't calculate the recommended mix of asset classes, so using an investment fact finder to determine risk tolerance is not needed. The user is just guessing about both risk tolerance and the allocation mix that matches it.

It's not that common, but it's easy and efficient for financial advisors working with small clients. It's the quickest way to show investors where they are and where the advisor wants to take them, in terms of asset classes and investment vehicles used to fund them.

As long as you're adding viable asset classes, then it's better than doing nothing (and better than trying to pick stocks or time markets).

No rebalancing is needed because there is no recommended asset class mix to reference to.

Method #4: Refine any of the above method's results using portfolio optimization. This is sometimes erroneously referred to as Monte Carlo.

Doing this "correctly" substantially squeezes out risk (as measured by standard deviation), while not compromising returns very much. The more risk is squeezed out, the more efficient the portfolio is said to be per unit of return.

We've been using optimizers since they could run on 386 PCs in the late 80's. They were instrumental in developing both our model portfolios and comprehensive asset allocation software. But we don't use them anymore because it's not needed once you see the same outcomes thousands of times over different market environments, a couple decades, using Real World client money. Read about portfolio optimizers and why portfolio optimization is usually more trouble than it's worth.

This may help understand: The comprehensive asset allocation software was developed from working with asset-level portfolio optimizers all day for years. Too much work was being done for too little money like this, so the model portfolios were created using an average of thousands of outcomes to have something static to use for smaller clients.

How Asset Allocation Works

Different correlation coefficients between investments are why asset allocation works much better for individual investors than anything else humanity has invented.

When investments move up and down perfectly in sync with each other over a certain time frame, its correlation coefficient is 1. When investments move in the opposite direction with each other, its correlation coefficient is -1. Both of these scenarios never happen. The average is around 0.7. All it takes is for a new investment not to be over 0.9 to add diversification value to a portfolio. This is the core of MPT (Modern Portfolio Theory), which started in the 1950s.

This 21st century's investment environment is a good example. Until Q4 2006, if you were stock picking or market timing in the US equity markets, you were getting poorer in flat-to-down equity markets. If you invested in asset classes that move in semi-opposite directions to the US equity markets (e.g., real estate, gold, or oil), then you were getting richer.

The point is to hold a balanced mix of asset classes that have both good returns on their own, and go up and down at different times relative to the other investments in the portfolio. Determining which asset classes to hold is an art, a science, and depends on the circumstances and goals of the investor.

The different asset classes can be looked at as ingredients that go into making a pie. Each one individually tastes pretty bad. But when they’re all put together in the right combinations, the result is a yummy pie.

Holding an investment portfolio comprised of asset classes with healthy correlations to each other is just about the only way to reduce risk while still getting the returns that will end up beating the markets.

This is because whenever you check the portfolio's value, there's usually always something that's doing so well, that it keeps the portfolio as a whole from having negative returns, even when the US stock markets are down.

Here's a Word document with screen prints showing how all of the 21 asset classes we use performed during the worst month for the S&P 500 since 1999 (when all of the indices were there, and the world wasn't ending, making EVERYTHING go down at once, which happened in Feb '08 and Oct' 08). In Sept '02, the S&P 500 lost 10.87%. The only asset classes that lost more were:

MSCI EAFE (Int'l All-cap): -11.04%
Russell 1000 Value Index: -10.49%
NASDAQ 100 Trust (Technology index): -11.65%
Morningstar Information Superhighway Index (Internet Index): -14.27%

The following asset classes made money that month:

Goldman Sachs Commodity Index (Tangibles): +4.57%
BarCap Municipal Bond: +2.19%
BarCap Aggregate Bond: +1.62%
BarCap 1 -3 Year Bond: +0.81%
BarCap 3 Year Municipal Bond: +0.79%
Citicorp Non-$ World Bond (Int'l Bonds): +0.61%

Asset Allocation Facilitates the Ability to Provide Consistent Positive Alpha

Alpha is the risk-adjusted measure of excess return. It quantifies an active investment manager's performance, compared to passive management. The calculations display a number that represents how much the active manager's returns exceed a passive benchmark, adjusted for risk.

In our investing models, alpha is the value of selecting open-ended mutual funds over using benchmark indices to fund the asset classes. Both active and passive models are included in our Model Portfolios. Our Moderate Model's alpha is calculated using the same model funded with appropriate benchmark indices, and is calculated and displayed monthly on the third sheet to the right of the asset allocation calculator demo (this sheet is also pasted into the Word doc in the Model Allocation demo). As you can see, it's always a huge positive number because this investment strategy usually always beats everything we compare to. We don't think you'll find a higher alpha in time frames over five years from anyone else ever.

The ability to consistently provide positive alpha for investors is the goal of both investment managers and their clients (although most are unaware of its existence - they just want to do better than the markets). Portfolio managers that can provide positive alpha consistently are earning the money investors pay them. Without it, investors are paying and seeing no benefit. This is because they could have just bought no-load index funds or index ETFs and realized more profit, fewer losses, without having to pay anyone.

If an investor is realizing investment returns less than the markets, then the portfolio manager is probably providing negative alpha. In this case, the investor is paying the advisor to lose money by utilizing inefficient investment management strategies. Unfortunately, most investment managers do not provide consistent positive alpha. This is usually not recognized because few know how to correctly compare investment performance (this is also a service you can hire us for, so if you want to see the actual reality of how your money manager is doing, all you need to do is feed us some money and tell us what you're holding - we don't even need to know the dollar amounts - just X% and X% that. Be prepared to be unhappy, because we haven't seen a strategy yet that beats the markets for more than a few months out of the year, other than our own of course).

Asset allocation provides the framework for beating the markets on two fronts. First, the different correlation coefficients between the asset classes, and then funding the asset classes with indices, lowers risk without sacrificing returns. This is usually enough to beat the S&P 500. Comparing the the third and fourths rows from the bottom on the table below shows this.

Next, this is given the necessary added boost when open-ended mutual funds (not ETFs) are used that outperform their benchmark indices. When this makes more money than the same investment strategy using indices, it provides positive alpha. This is shown in the fourth row of the table below.

Many investment strategies beat the markets here and there in the short run. What's extremely difficult to do is outperform the markets and provide positive alpha, most all of the time, and more than two years in a row. Asset allocation using mutual funds is the only investment strategy that has the capability of doing this.

Using the Table of Historical Investment Returns Below

As you can see on the table below, active management in the environment of pure asset allocation usually outperforms passive management (when one can do even a mediocre job of picking mutual funds). This is contrary to what you've been brainwashed to believe, and is shown in the fifth row. That's all that's needed for investment portfolios to outperform the US-based equity market indices, like the S&P 500. This is shown in the third row from the bottom.

The longer the time frame, the more meaningful the comparisons are. The one-month figures (and YTD somewhat) are very volatile, and jump around from one extreme to the other. The five-year and since inception columns are the most important time frames to compare.

The bottom line for this past month is if you'd invested $10,000 in the S&P 500 since inception of 1/1/99; you'd have around $10,996. If you'd invested $10,000 in our Fee-Based Moderate Portfolio Model (and followed the directions), you'd have around $24,639. This 124% difference translates into having almost three times the income to spend during retirement.

For investors managing their own money, the 1.1% annual investment advisor fee would not have been deducted from the Moderate Model Portfolio's performance (a non-realistic assumption made just to show the difference because investor's usually can't avoid paying the load on load funds, but some can, or they can get advisors to manage their money without annual fees). The difference would have then been $27,994 vs. $10,996 resulting in having around 155% more money (which would have resulted in having around three times the retirement paycheck). We didn't use the No-load Models here because they only go back to '03.

For those the like to compare things properly, if you'd invested $10,000 in the same Moderate Model Allocation funded with benchmark indices since inception of 1/1/99, you'd have around $14,264 vs. $24,639 in our Moderate Fee-Based Model after fees; which is a 73% difference. This shows the Real World results of long-term positive alpha, which is due to the value of our monthly-updated mutual fund recommendations. This also proves, contrary to what you've been brainwashed to believe - that it's possible for an actively managed investment strategy to consistently beat the markets (even after all fees)

The best fitting moderate investment model comprised of only American Funds would have returned around $15,394 since 1/1/99. This 60% difference compared to our Fee-Based Moderate Model shows how American Funds has consistently underperformed. This translates into having a little less than twice the income to spend during retirement.

If you would have given "The World's Greatest Investor" (Warren Buffet) $10,000 to manage on 1/1/99, you'd have around $16,709, which is around 68% less money than our Fee-Based Moderate Model without fees.

On the mutual fund picks page, you can see how our 21 mutual fund recommendations (and 21 ETF selections) have performed compared to their proper benchmark indices. All 21 asset classes that we screen mutual funds and ETFs for are listed and updated monthly. The asset class name is given, and then below it is the name of its proper benchmark index. The rows below each asset class/index are the current returns for our open-ended mutual fund picks and current ETF picks. As you can see, our mutual fund screening process is usually able to select mutual funds that consistently outperform their benchmark indices (and ETFs and index funds) over most time horizons. This is where our consistently large positive alpha comes from.

A detailed explanation of how returns are calculated is in the model directions.

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Asset Allocation for 401(k) / 403(b) and Similar Retirement Plans

Investment Vehicle used (below)	Month of July '10	YTD (31 Dec '09 to 31 July '10)	Last 12 Months	Last 3 Years Annualized Average	Last 5 Years Annualized Average	Last 10 Years Annualized Average	Annualized Average Since Inception of 12/31/98 (using monthly compounding)
Hypo Fee-Based Moderate Asset Allocation Model Hypothetical performance, as shown in the demo (which has returns and yields for all 56 models). Investment returns are not linked to account for past mutual fund switches, nor quarterly rebalancings. Returns shown are after 1.1% annual management fees that an advisor would charge clients	4.77%	4.73%	19.29%	0.88%	Not Available - Some current recommended mutual funds don't have a five-year track record and past trades are not accounted for in the hypothetical model	N/A - Some current mutual fund picks don't have a ten-year track record and past trades are not accounted for in the hypothetical model	N/A - Some current mutual fund picks don't have even a ten-year track record and past trades are not accounted for in the hypothetical model
Fee-Based Moderate Model Asset Allocation without Fees Deducted This is the same actual model as the row below, but it does not have the 1.1% advisor fees deducted from them. These are the returns individual investors would use because they'd be doing it themselves, so they wouldn't be paying an advisor 1.1% This is similar to the Moderate All No-Load Mutual Fund Model). This isn't Real World because few investors can buy the loaded mutual funds without paying the load	5.10%	1.85%	14.53%	1.95%	7.50%	6.32%	8.92%
Fee-Based Moderate Model Asset Allocation with Fees Deducted Actual performance, with investment returns linked to account for past mutual fund changes, rebalancings, and 1.1% annual management fees that an advisor would charge their clients (and everything else FINRA needed to pass compliance)	4.83%	1.02%	13.31%	0.83%	6.40%	5.22%	7.81%
Moderate Benchmark Index Asset Allocator Model Same portfolio model as above, but funded with Indices. The difference is the value of active management - or mutual fund picking. No past Index Fund switches to account for (so there's no need to distinguish between hypo and actual). After the same 1.1% annual management fee that an advisor would charge clients	4.18%	-0.04%	10.76%	-3.29%	1.63%	1.63%	3.07%
Difference between the Actual Fee-Based Moderate Model (with 1.1% fees) and the same Portfolio Model Funded with Benchmark Indices This is the correct apples-to-apples method of comparing portfolios, and shows the value of active vs. passive investment management from the mutual fund selections This is alpha when it's working correctly This is also an example of what our portfolio benchmarking service is all about- comparing investment strategies properly	+0.65% (or 16% better)	+1.06% (or 2,650% better)	+2.55% (or 24% better)	+4.12% (or 125% better)	+4.77% (or 293% better)	+3.59% (or 220% better)	+4.74% (or 154% better)
DFA Global 60/40 I Portfolio This is their best-fitting Moderate portfolio after 1.1% annual management fees that an advisor would charge clients (but not after all of the other fees and expenses DFA charges advisors, which are passed on to clients, so the returns clients would see would be even less than what's shown here	5.40%	1.96%	11.22%	-2.47%	2.26%	N/A	N/A
SEI GoalLink Moderate Strategy Fund A After 1.1% annual management fees that an advisor would charge clients	2.19%	3.84%	18.02%	-5.16%	0.3%	N/A	N/A
SEI GoalLink Tax-managed Moderate Strategy After 1.1% annual management fees that an advisor would charge clients	3.45%	2.65%	10.67%	-0.59%	1.90%	N/A	N/A
SEI Moderate Strategy Allocation Fund A After 1.1% annual management fees that an advisor would charge clients	5.75%	2.95%	18.02%	-5.16%	0.34%	N/A	N/A
SEI Private Client Moderate Strategy After 1.1% annual management fees that an advisor would charge clients	2.10%	3.29%	12.56%	-3.85%	0.02%	N/A	N/A
All American Funds Moderate Model Actual, because no funds changed since inception. NO 1.1% annual management fees that an advisor would charge their clients were deducted. But front-end loads paid are estimated and deducted like this: For time frames less than one years, 3% initial sales load was deducted. For time frames 3 & 5 years 2% was deducted, and over that, 1.1% was deducted. (So for 10 years and over, the same amounts were deducted in fees as in our Fee-Based Models)	2.32%	-1.01%	8.88%	-3.90%	1.10%	3.20%	3.73%
Difference between our Actual Fee-Based Moderate Model (with fees) and the American Funds Moderate Model	+2.51% or 108% better	+2.03% or 201% better	+4.43% or 50% better	+4.73% or 121% better	+5.30% or 482% better	+2.02% or 63% better	+4.08% or 109% better
Market Indices	Month of July '10	YTD (31 Dec '09 to 31 July '10)	Last 12 Months	Last 3 Years Annualized Average	Last 5 Years Annualized Average	Last 10 Years Annualized Average	Annualized Average Since Inception of 12/31/98
DJIA	7.23%	1.87%	17.28%	-4.78%	2.34%	2.31%	3.41%
S&P 500	7.01%	-0.11%	13.84%	-6.78%	-0.17%	-0.76%	0.82%
NASDAQ	6.90%	-0.64%	13.96%	-3.97%	0.63%	-5.00%	0.24%
Russell 2000	6.87%	4.79%	18.43%	-4.32%	0.47%	4.03%	5.18%
MSCI EAFE NR USD	9.41%	-6.70%	3.47%	-12.84%	-0.58%	-0.85%	0.42%
BarCap Aggregate Bond Index	1.07%	6.46%	8.91%	7.63%	5.96%	6.48%	5.94%
For Investment Advisors: Difference Between the Actual Fee-Based Moderate Model and the S&P 500 NO 1.1% ANNUAL FEES are subtracted from the S&P500 here, like they are in the actual and hypo Moderate Models. This is not a proper comparison, like what's shown above with the Index Model, but it's popular	-2.18%	+1.13% (or 1,028% better)	-0.53%	+7.61% (or 112% better)	+6.57% (or 3,865% better)	+5.98% (or 787% better)	+8.63% (or 852% better)
For Individual Investors: Difference Between the Actual No-Load Moderate Model and the S&P 500 Caution! Up until now the comparisons were with the Fee-Based Moderate Model. This changed here to the No-Load Moderate Model - which is for individual investors. No annual 1.1% advisory fees were deducted from the No-Load Moderate Model's returns because individual investors would not pay them. The returns shown here are very similar to the Fee-Based Moderate Model without fees	-1.67%	+2.77% (or 2,519% better)	+1.55% (or 11% better)	+8.64% (or 127% better)	+2.02% (or 1,188% better)	+8.39% (or 1,104% better) Note that this row and column intersection is as of 1/1/03, and not Last 10 Years. The S&P500 did 5.07% since 1/1/03	N/A
Warren Buffets BRK-A (no fees deducted)	-2.50%	14.50%	27.34%	2.08%	6.98%	7.82%	4.44%
Fee-Based Moderate Model Asset Allocation without Fees Deducted This is the same actual model as the row below, but it does not have the 1.1% advisor fees deducted from them. These are the returns individual investors would use because they'd be doing it themselves, so they wouldn't be paying an advisor 1.1% This is similar to the Moderate All No-Load Mutual Fund Model). This isn't Real World because few investors can buy the loaded mutual funds without paying the load	5.10%	1.85%	14.53%	1.95%	7.50%	6.32%	8.92%
Difference between our Actual Fee-Based Moderate Model (without fees) and Warren Buffet's BRK-A (no fees deducted	+7.60% (or 304% better)	-12.65%	-12.81%	-0.13%	+0.52% (or 8% better)	-1.50%	+4.48% (or 101% better)

More on Why Asset Allocation using Mutual Funds Works Better than Market Timing and/or Stock Picking

If you like adrenaline pumping all the time over investments, and realizing returns that are less than the S&P 500, then market timing and stock picking is for you.

The biggest reason people do this is because it's fun to play on Wall Street. Some advisors just need their jobs to be exciting more than they need to make a stable income and realize good returns for their clients. It's an exhilarating ego-boost to make a lot of money being correct on a stock bet. You feel like you've just won a sophisticated high-tech battle in an intellectual war with people that thought they were smarter and better than you. To these warriors, using mutual funds is not only too boring; it's just resigning to join the herds of plodding commoners. It's also fun to gamble in Vegas, and you know how that usually ends up.

The tortoise and hare analogy fits well here - where the tortoise (asset allocation) is slow and boring, but eventually wins over the exciting fits and starts of the hare (market timing or stock picking).

Why can't making low-risk money be fun and exciting? In order to make exciting money using market timing or stock picking techniques, you need to show a net profit on four decisions: You need to sell something (#1 - what to sell out of investments currently held) at the right time (#2), to drum up money to make new purchases, (#3 - what to buy) at the right time (#4).

Usually a "mistake" is made on one of the four decisions, and those losses negate gains on the correct decision(s). On top of that, one needs to make a major market timing call weekly to keep up with events. Then on top of that, you have to subtract all of the trading costs, administrative costs, and taxes. If all of that weren't true, then someone would have figured out how to make market timing or stock picking work by now, and they have their own crazed TV show.

Markets are the sum of millions of people reacting to random daily news by trading securities. Because nobody can predict the news, and nobody can predict the future no matter what techniques, strategies, or computer models they use. That's why you'll never see the same investment guru on TV for more than a few years. It's usually the one that got lucky recently. When their luck runs out, they're replaced.

Even gurus like Jim Cramer that have their own TV show are just guessing. On the first week of March 2008, he said to not sell Bear Stearns, after reading a concerned viewer's letter which read, "Should I be concerned about Bear Stearn's in terms of liquidity problem, and get my money out of there?" Cramer replied in his usual tirade, "No no no! Bear Stearns is fine.... Don't move your money from Bear, that's just silly...." The stock went from $80 to $2 overnight one week later (and was $171 a year before). Five days before this rant, "Bear Stearns is not in trouble! The Bear franchise, you know what, for $69 I'm not going to give up the thing. And I just think that this one has a very big upside and a very limited downside here." And seven weeks before it went belly-up, "I'm asking people watching this video to buy Bear Stearns. Now Bear Stearns acts much better than it should... now that's just intuition. And I don't want to put much faith into intuition, but I have had good intuition over 29 years of investing."

Then in 2008, the legendary Warren Buffet, the "Greatest investor ever," lost around 44% of his Berkshire Hathaway's money in less than a year (and has never recovered fully to reclaim past glory).

These are the "best" stock pickers ever, so think how well your local Joe Blow stock picker is going to do with your money! No matter what their "stories" are, the results are all always exactly what you'd expect - terrible and way worse than the markets.

This is also why media gurus are usually mutual fund managers (and are CFA Charterholders). Only large institutions like these have the resources needed to have any chance at profiting on all four trades simultaneously, and have the economies of scale to keep expenses down (then they don't have to care about capital gains taxes).

Everyone else is just misleading by hype, and is making you lose money. This is because these gurus are selling after making their public recommendations (the "greater fool theory"). They're basically telling you when to buy, but not when to sell. First the guru buys a ton of stock to make it go up a lot. Then to get on TV, they make something up about how its fundamentals or charts (technical analysis) indicate it's going to go up much more. Then they convince fools to buy it on TV. Then it will go up when these fools buy it, allowing the guru to sell it all at much higher prices. This drives the price lower. All of the fools that bought it from the guru are then left "holding the bag," while the guru locked in large profits. This makes the guru's performance look spectacular, which gets them invited back to the show.

So if you're prone to taking a market guru's advice because you agree with what they're saying, and it's working great at the moment, just wait. Most of the time, it will be around a year before their luck runs out, they've lost a lot of money, and have disappeared from the media. The point is you don't know when their lucky streak will expire. In reality, you have no clue about what's really going on with TV gurus (and you don't want to buy our models because you don't know what's going - even after every detail is explained here?). Why is that? Do you think the overpaid talking heads on TV are more reliable than the internet? Why is that?

Try to remember who the big TV financial gurus were a few years ago. How long has it been since they've been on TV? How many were either booted out of the business or went to jail for insider trading or similar infractions? How did their stock tips pan out a year after they recommended them? How is their long-term track record? They don't even have one you can look at (because it's so bad it would be embarrassing). Did you do any due diligence on any of them before following their recommendations and trading their stock picks? No. You'll follow them blindly over the cliff because they're on TV, but don't trust anything on the web. Why is that?

Conclusions and Additional Information

Real World results reflect the most infamous asset allocation study.* It concludes that 91.5% of returns come from the asset allocation decision and not the security selection nor market timing decisions. In English - The behavior of asset classes, and their interaction with each other, are way more important than choosing the best-performing securities to represent them, or when to trade them.

In other words, it doesn't matter too much that we consistently pick mutual funds that outperform their proper benchmark indices. What matters most is utilizing optimized and efficient asset allocation strategies, and then consistently picking mutual funds that are a close proxy to their asset classes (or just using index funds).

* Gary Brinson, Brian Singer, & Gilbert Beebower "Determinants of Portfolio Performance: An Update," Financial Analysts Journal, July ‘91

Below are a few sites that have detailed empirical research on asset allocation and tables of historical asset class correlation coefficients. Most of the numbers they discuss are generated by portfolio optimization software (AKA efficient frontier software).

http://www.stanford.edu/~wfsharpe/art/stars/stars2.htm

http://www.efficientfrontier.com/ef/996/rebal.htm

http://gummy-stuff.org/correlation.htm

http://www.efmoody.com/investments/correlation.html

The bottom line is that asset allocation works much better for individual investors than anything else ever created. Even if you just fund the asset classes with index funds, you'll most always beat the large market indices. You'll probably also beat whatever the vast majority of rich and famous investment managers are doing with their unlimited budgets and armies of CFA Charterholders picking stocks and timing markets. The more you try to prove otherwise, the more you'll realize this is all true and like it or not, this is just the way it is.

More on market timing and security selection.

Other Investment Services

Read about our mutual fund recommendation, screening, and analysis service where you can get professional, unbiased, opinions on just about any open-end mutual fund, with no conflicts of interest.

We have an investment portfolio benchmarking service, where we can help you compare as assess investment performance properly. This is the only way to see how an investment strategy is really working.

You can also hire us to build custom or model investment portfolios. We can even make them from the limited investment choices of just one mutual fund family, or those investors are "stuck with" in 401(k) plans, variable annuities, life insurance policies, etc.

We keep getting the same questions/comments about our unusual performance, so here's an e-mail paste that will help:

Yes on one hand, the investment performance is remarkable. On the other hand it shouldn't be, because it's exactly what the CFA program teaches. It just so happens that I'm apparently the only CFA Charterholder that practices exactly what's taught. Everyone else went off to get rich being a hedge fund manager or creating derivatives like CDSs that started the current crisis.

What the CFA program teaches in a very small nutshell is this: Individual investors should not be market timing at all, period. Nobody can predict the future, so this is worse than futile. Individual investors should also not be trying to pick stocks (bonds or anything else), unless they have quasi-insider information, like they work there, used to work there, or know someone working there that's not technically an insider that's feeding them accurate and timely info. The only "people" that have enough information, resources, and data to profit by picking stocks (and/or time markets) are large institutions like mutual funds.

So once that huge battle is understood and won, and since there are only three ways to make investment decisions, and the most popular two are taught to be no-no's by the CFA program, there is only one methodology left - asset allocation. So I took that to mean that this is what I should become an expert on, because my biz is managing money for investors in a RIA and financial planning setting (my job as an employee at the time).

What you're supposed to do is determine a mix of viable asset classes that fits an individual investor's life, and then either fund it with something very diversified like mutual funds, ETFs, or index funds (the CFA program likes index funds the best, as most people can't even pick open-ended mutual funds well enough to beat an index fund).

So the questions then become, how do you determine what asset classes to use and how much? Well, I did it in both the Comprehensive Asset Allocation software and the Model Portfolios using the best asset-level portfolio optimizer, educated guesses, and way too much trial and error. After doing it a million times, I found what works and am sticking with it. I've looked at every else's harebrained investment strategies since the mid-'80s, and found none to be better. I admit I've stolen many ideas from many people (mostly from the hundreds of job interviews I went on), and so I've tinkered with just about everything everyone else has come up with since 1986. The ideas that work, I keep, and the ones that don't, I poke fun at on the site.

Once that war is over, the battle is reduced to what to use to fund the asset classes with? To make a very long story short: Stocks - no, no diversification compared to a mutual fund that may own 100 stocks. Closed-end funds, no - there's no way to screen them to get any predictive value whatsoever because of the large and random premiums and discounts. ETFs, no they are mostly just lame index funds... with fees (and then on top of that, commissions to pay when you buy and sell them). Index funds, maybe, but the way I pick open-ended mutual funds creams index funds by way too large of a margin about 90% of the time. So all of these questions are now answered - the way I screen and pick mutual funds adds by far the best value to the investment process than anything else I've ever seen, so I'm sticking it with it to the bitter end.

The magic isn't all in the infrastructure (the software), it has a lot to do with finding predictive value in the mutual fund picks (I look at many things, like historical performance, and try to predict that it will keep up long enough to be useful). After millions of trials and errors, I found a way to pick mutual funds that have a one- to two-year predictive value (all mutual funds crap out eventually and have to be replaced, which is why it's critical to keep the subscription going and rebalance. When I say crapped out, I don' t mean it in a smelly sense, but the casino gambling way). It doesn't always work, but the winning picks beat the duds enough to add more long-term value than any other investing strategy I've ever seen. Plus every month I learn something new, so the screening process is continually refined and saved, so it gets better all the time.

I used to sell these little Morningstar screening filter mcr files that can be used by others in their offline version of Morningstar, but a big NY firm tried to copy my screening process in '03, so I don't sell them anymore. So if the information about how I pick mutual funds is not on the mutual fund recommendations page already, then it's a trade secret now. There's no secrets about the software nor models. Just the opposite, every tiny little detail is explained ad nauseum somewhere on the site. And when you buy the allocation software or model portfolios, not much is protected, so you can see exactly what's going on. Plus you'll get the same spreadsheet I use to calculate model returns to account for mutual fund switches, fees, rebalancings, and all that since 1/1/99. So you can audit the returns and figure everything out.

Disclaimer: This financial plan software is designed to allow financial planners, investment managers, other financial services professionals, and investors, to demonstrate and evaluate various financial strategies in order to help achieve their clients', or their own financial goals. There are no guarantees that any of the software will perform this function. The investment choices and services on this site are provided as general information only, and are not intended to provide investment, tax, legal, financial planning, or other advice. This site is for information purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any security, which may be referred herein. Mutual fund recommendations made are suggestions only, and customers should evaluate the suitability of each fund for their own holdings on their own or seek professional advice. Consult with your financial, legal, or tax advisor with regard to your individual situation. Toolsformoney.com is not engaged in rendering legal, accounting, tax, or other professional advice. In no event shall Toolsformoney.com be liable to customers for any damages whatsoever, including lost profits or savings, missed gains, or other incidental or consequential damages arising out of the use, or inability to use, any of the software or information obtained from this website. Financial estimates are generated by using many assumptions made by the program, clients, and the user. No person or software program can predict the future with any degree of certainty. No warranty as to correctness is given and no liability is accepted for any error, or omission, or any loss which may arise from relying upon data generated from reports produced by this program. In no event shall Toolsformoney.com be liable to you or any other party, for any special, consequential or incidental damages suffered by you or such other party as a result of any problems that may arise because of the installation or improper use of this software or presentation of reports produced by this software. All reports generated by this financial software are only rough estimates of many possible future scenarios.