Have you shifted into a Permanent Portfolio yet?

Here are the returns of the individual components of the lazy portfolios:

*Note that these results use Yahoo! Finance adjusted historical returns with the exception of IFA portfolios results from IFA.com that include IFA’s fee.

Permanent Portfolio performance during the very volatile month of May

This May was the worst May since 1940.  The Dow and VTI (total stock market) both had losses of -7.9%.  Volatility has returned to the market!  When the market is volatile, the wisdom of investing in the Permanent Portfolio becomes apparent.  The Harry Browne Permanent Portfolio always has the same four assets: total stock market (VTI), gold (GLD), long term Treasury bonds (TLT) and short term Treasury bonds (SHY).  These assets are rebalanced each year.

Let’s see how the Permanent Portfolios performed on a weekly basis for the very volatile month of May.

Date                Stocks            Gold           Long Bonds     Short Bonds      PermPort
—               VTI               GLD                 TLT                  SHY

May   3 –   7          -7.0%               2.5%              4.1%                  0.3%                     0.0%
May 10 – 14           3.0%               1.8%             -0.7%                  0.1%                     1.0%
May 17 – 21          -4.5%              -4.3%              3.7%                 0.1%                    -1.2%
May 24 – 28           0.7%               3.2%             -2.0%                  0.0%                     0.5%

Total for May       -7.9%               3.1%              5.1%                  0.5%                     0.2%

2010 to May          -0.1%             10.8%              8.9%                  1.4%                     5.5%

The week-by-week returns show that the Permanent Portfolio is much less volatile than the VTI.  The volatility is amazingly low because the VTI and TLT (and GLD) move in opposite directions — they are negatively correlated.  The first week of May provides a good example of the negative correlation of the assets:  the VTI was down -7.0% while GLD was up 2.5%, TLT was up 4.1% and SHY was up 0.3%.  This resulted in a 0.0% change for the Permanent Portfolio.  The returns for each of the other three weeks further demonstrate the negative correlations of the assets.

The final returns for the month of May show that if you had been invested in the Permanent Portfolio you would have been ahead by 0.2% instead of being behind by -7.9% for a VTI investment.  A Permanent Portfolio investor would not think that this May was the worst May since 1940.

The last line in the table shows the year-to-date returns for each of the assets.  The advantage of the Permanent Portfolios over the VTI (total stock market) is obvious.

The main problem with the Permanent Portfolio is that it is just too boring for most investors!

Below is a Return vs. Risk Chart for these portfolios from 1985 through 2009 (Note: this chart does not include returns through the end of May 2010). The ideal portfolio would be high return at low risk and thus appear at the top left of the chart. [Chart data is computed using Simba's spreadsheet from the Bogleheads.org forum with the exception of IFA portfolios from ifa.com.]

See how there is almost an invisible boundary line from lower left to upper right? That is the “Efficient Frontier” and shows that returns are correlated with risk over the long term. It is nearly impossible to construct a portfolio that will be above that efficient frontier. So the only question you need to answer is, how much risk are you willing to accept. That is, can you tolerate the downturns in the market in the short term?

Looking at a shorter term, here is a chart showing just the previous ten years from 2000 through 2009.

I like the boost to returns the Paul Boyer Permanent Portfolio got during prosperity and it didn’t hurt too much during recession either.

And to see if you can indeed stomach a bad short term, here is a chart with just the previous three years:

How about a chart of just the recent heyday of stocks from 2003 thru 2006:

Looking at past charts is fun, but should not be the only data you use to make investment decisions. I like the Permanent Portfolio concept because it is so simple, has low fees, and covers the four economic cycles of prosperity, inflation, deflation, and recession. It has been shown to be the lowest in risk among the lazy portfolios while not sacrificing returns. They are the only portfolios to include gold.

Here are the components of each of the portfolios*:

*Note that these results use Yahoo! Finance adjusted historical returns with the exception of IFA portfolios results from IFA.com that include IFA’s fee.

Would you be interested in an all-weather portfolio that, despite hardly ever changing its composition, performs creditably in almost all market environments?

Hulbert characterizes the Permanent Portfolio this way:

Browne’s idea was to invest in a basket of asset classes, each one of which has a low correlation with the others. As a result, when any one of the asset classes is performing poorly, there is a good chance that the others will at least be holding their own — if not actually appreciating in value.

He describes Harry Browne’s Permanent Portfolio as an antidote to volatility. He then gives some past performance of the PRPFX fund which somewhat implements Harry Browne’s concept:

This fund over the last 15 years (through Apr. 30) has produced an 8.2% annualized return, which is remarkable given that stocks, gold and bonds did not, individually, do as well: The Wilshire 5000 index gained 7.9% over the same period, the Shearson Lehman Treasury Index produced a 6.3% annualized return, and gold bullion rose at a 7.7% annualized pace.

I might suggest that while the result of the four asset classes is low correlation, that is not the way Harry Browne explained the reasoning. Instead, the portfolio is designed to have one component that does well in each of four different economic circumstances: prosperity (stocks), inflation (gold), deflation (LT Bonds), and recession (cash). Harry said that while you can expect one of the assets to go down, the one that goes up more than makes up for the loser. For example, while one asset may go down 30% or 40%, the winning asset can go up 200% or 300%, more than making up for the loss.

I think the best thing about the portfolio is this: No one can predict the future so we might as well invest in all possibilities.

Thru yesterday’s market turmoil, the components have done the following:

VTI +2.8% (Stocks)

TLT +9.2% (Bonds)

SHY +1.3% (Cash)

GLD +10.4% (Gold)

And the total portfolio, assuming 25% in each at the start of 2010 is…

+5.9%

How’s that compare with YOUR portfolio?

And here’s the book you need to read:

First, the original portfolio:

Stocks: VTSMX (Total US Stock Market)
Bonds: VUSTX (Long-term Bond)
Cash: VMPXX (Money Market)
Gold (Kitco 1972-2004, GLD 2004-2009)

yielded the following return vs. risk:

P1 (HBPP):

Compound Annual Growth Rate (CAGR): 9.1%
Standard Deviation (Risk): 8.02%
Sharpe Ratio: 0.46

Next, substitute 2-Year Short Term Treasuries (VFISX) instead of Money Market:

P2 (P1 with 2-yr T-Bills):

CAGR: 9.5%
Standard Deviation (Risk): 8.17%
Sharpe Ratio: 0.50

Alternatively, how about for the “Prosperity” component, i.e., Stocks, we substitute  half US Small-Cap Value and half Emerging Markets for the US Total Stock Market:

P3 (P1 with 12.5% VISVX and 12.5% VEIEX):

CAGR: 10.8%
Standard Deviation (Risk): 8.57%
Sharpe Ratio: 0.64

And finally, combine P2 and P3 to have 2-yr T-Bills, US Small Cap Value, and Emerging Market:

P4 (P2 with 12.5% VISVX and 12.5% VEIEX):

CAGR: 11.3%
Standard Deviation (Risk): 8.65%
Sharpe Ratio: 0.68

And just for comparison I ran “Solver” on Simba’s spreadsheet to find the least risky portfolio that yielded 11.3% of that time span. It came up with the following mix:

VISVX (US Small Cap Value): 13.43%
VEIEX (Emerging Market): 14.30%
PCRIX (Commodities): 5.19%
VFITX (5-Yr T-Bills): 49.31%
VFISX (2-Yr T-Bills): 7.88%
Gold: 9.88%

Which resulted in:

P5 (Solver optimized portfolio):

CAGR: 11.3%
Standard Deviation (Risk): 7.25%
Sharpe Ratio: 0.80

And here is a chart with them all plotted, CAGR vs. Standard Deviaion (Risk):

I’ve played with lots of combinations of back-tested portfolios through many different time periods and one thing is common: substituting VISVX and VEIEX for VTSMX resulted in higher returns and a higher Sharpe Ratio. And short term T-Bills for cash also added nicely.

Note that I only show the Solver optimized portfolio (P5) for reference. I believe it strays too far from the Permanent Portfolio strategy to be safe going forward.

I talked about P4 on MMM-175: The Perfect Portfolio. While I am not yet invested in it, it is the one I am targeting. I do not expect a CAGR of 11.3% for the next 37 years, but if I can get 6% I will be very happy.

Oh, and don’t miss THE END-ing!

• Name: iPad (Ding!)
• Size: 9.7″ (Ding! I said 10″)
• Form Factor: Basically a large iPod Touch (Ding!)
• Home Button? (Ding!)
• Aluminum back? (Ding!)
• Buttons and holes: headphone (Ding), microphone (Ding), volume (Ding), mute (Ding), sleep (Ding)
• USB port? (Bzzzt!) Only has Apple dock. But that serves to connect to your computer. And it does have adapters for cameras.
• Orientation: (Ding! Both portrait and landscape)
• WiFi (Ding)
• Internet connectivity: (Ding? 3G is optional. Nice surprise that it is easy to get 250MB/mo for $14.95)
• Won’t have a phone (Ding!)
• Software: (“It will be like an iPhone with some iWork apps available for download” DING! DING!) It actually runs iPhone apps like I expected.
• Books: (“They will probably start selling books through iTunes.” DING! DING!)
• GPS and big maps (DING!)
• Cameras: (BZZZZZT!) Not three, not two, not even one camera. Maybe version 2?
• Cost? I said $899 dropping to $699. I assumed it would have a 3G card installed. Their price for 3G? $629 to $829. Plus you want to buy the keyboard, case, and adapters. So I give myself a DING! for the price as well.

So I think I got most everything right. Big misses on cameras and USB port. Bottom line is that the iPad is pretty much exactly what I pictured it to be in my mind. I will own one (or more).

I have a small window of time before the official announcement is made before which I can make my own predictions, wish lists, and observations about the new miracle device. Apple is expected to announce it on January 27th at a media event. I guess there is not enough time for them to get all my wish list items incorporated into the thing, but at least they will have my wish list for their 2nd generation of it by 2011.

First, my preferred name for the thing is the Apple iPad. I like the way it rhymes with iPod and it is alliterative with iPhone as well. iSlate is my 2nd choice just because it sounds cool. iBook would be my 3rd choice as it would fit into the MacBook line nicely, but iBook places too much emphasis on this thing being just an eReader and not enough on the other things I want it to do. Read on. iTablet? Sounds like something Dell would call it.

Form factor. The iPad will have the 10” screen everyone is expecting and will basically be a “Honey I Blew Up the iPhone” looking thing. A home button at the bottom and that’s all you see physically. Aluminum back, buttons and holes along the edges. Nice places to put your fingers as you hold it in portrait or landscape orientation.

Buttons and holes will include those found on the iPhone: Headphone/microphone jack, volume buttons, mute switch, sleep button. But it will also include USB. The BIG question is will it include a power hole or a iPod dock hole? You see, it makes a difference in deciding if the iPad will SYNC with a computer or will BE a computer. Will your iTunes library still be on your MacBook and you have to sync it with the iPad, or will the iPad have enough storage to hold all your music by itself? My guess: it will BE a computer and can run iTunes on its own. It could still share music with your MacBook with that family sharing  route and it could share photos and files and so forth. So my money is on it having a nice magnetic power adapter with all kinds of neat accessories we can buy like a car charger and external battery. PLEASE let me use the same magnetic adapter as my MacBook. My guess: they won’t! (They make TONS of money on those things!) And make some kind of adapter that lets me plug it into all my various iPod connectors in the car and external speakers.

The USB adapter will allow commonly needed connections like cameras, flips, and, wait for it… iPhones! And yes, i want to be able to charge my iPhone from the battery of my iPad. You won’t need USB for the external keyboard and mouse because those will connect via BlueTooth. And while you are typing and mousing on your iPad, you will need it to somehow stand up, won’t you? So I’m wondering if this thing will have some sort of picture-frame-like stand on its back that lets you sit it on a desk or table either in portrait or landscape orientation.

I keep harping on orientation. For me this is key to the iPad: being able to read books and long pdfs on it in portrait mode. Already it is more useful than a MacBook for that reason alone. I find reading books in landscape to be too small a window into the text. I don’t know how many others are like me, but the first thing I do on a new computer is move all of those dock or taskbar things from the bottom of the screen over to the left side. That gives me a little more reading room on my MacBook. And I try to trim menu bars and status bars away as well. With the iPad in portrait mode I will be in reading heaven even on a smaller 10” screen.

How will this thing get on the Internet is a key question. Of course it will have Wi-Fi. But will it be on the 3G and EDGE networks as well? Will I have to buy more service from ATT Wireless? Will it tether through my iPhone? Will the iPad BE a phone? My hopes are that it will BE a phone that uses the same phone number as my iPhone, that I can talk on either one, that I can switch between one and the other during a call, that I can surf the net on the iPad while talking on the iPhone, that it can let me make and receive calls with my BlueTooth headset, and that it can act perfectly well as a desktop speakerphone. Not too much to ask, right? If iPhone was the “Jesus Phone” then what would this iPad be, the “GOD” phone?

But my guess of what will actually happen is more limited. I think for this first release it will have Wi-Fi and 3G and EDGE DATA networking only. You will have to add some sort of appendage to your ATT Wireless iPhone plan to get remote internet on the thing. No calls, talking is for iPhones and that is the way we say it will be, says Apple. Maybe in a later release they can figure out if it makes sense to add a phone or not. Perhaps too many people will end up using the data plan to make Skype calls and they will come around.

What about software? Is the iPad a small MacBook or a big iPhone? Wow, this is a tougher one to call. I can make a good case for both. You want to be able to run iWork on the thing, right? But yet Apple wants you to buy 10 billion apps for the thing too. So like a flash it hits me: it runs MacOS but with an iPhone mode so you can do BOTH. But the iPhone OS is all about limiting what you can do. Will Apple want to limit what you can do in the iPad? If so, it will be more like an iPhone with some iWork apps available for download. Actually in that case they will probably throw in some iWork apps for free but you gotta buy all the other cool stuff.

How will you use this thing if you already have a MacBook and an iPhone like I do? You will have your iPhone in your pocket, your MacBook on your desk, and your iPad in your hands. On the couch, in a seat, or in bed. This is the “media comes to me” device. Read a book? Sure, the iPhone already has the Kindle app from Amazon so you can buy thousands of books for $9.99 and start reading. Knowing Apple, they will probably start selling books through the iTunes store. Don’t wanna miss a market, right? But I better be able to get pdfs onto this thing easily and freely or it goes in the trash.

You will also of course watch movies, listen to music, surf the net, and make blog postings. Standard fare. It is the book reading thing that makes the iPad so special. And of course it will be the first successful touch screen computer from Apple. The iPhone set the stage, but now we will have pinch and zoom super-sized. We’ll be using our arms more to see those details from the satellite view. Ah yes, GPS. Big maps finally. Would this thing be appropriate on the dashboard? Not unless it has a camera that can show what is in FRONT of the car! And speaking of cameras, it needs at least two: One on back like normal on the iPhone for taking vids of others and one on front for taking vid of you. Maybe one on the side just to be sly. And I’d really love it if the one on the front is actually UNDER the center of the screen, invisible to us but fully able to see us nonetheless. That way on video calls people will be looking AT YOU instead of somewhere off into space.

Finally, the dreaded question: How much will they want for this thing? Remember when the Jesus Phone first came out how much they charged? Same deal here, waayy more than what we want to pay. They will really put it to those early-adopter guys, hahaha! I expect that early price to be $899. Gasp! With netbooks retailing for $399! Yep, but it will drop after a few months to $699 and everybody will be like, “Whew, now I can afford one at last.”

So prepare for the iPad invasion. Prepare for the weeping, shaking bodies to behold not the iTablet being brought down from the mountain but the iPad being unveiled on Steve’s stage. I can’t wait.

To start, I selected a widely-followed portfolio of stocks and bonds. The Fund Advice Vanguard Moderate portfolio has the following composition:

(Fund Advice recently split their recommended 12% of VDMIX into 6% VDMIX and 6% VFSVX, the All-World ex-US Small Cap index.)

The Fund Advice portfolio placed 32% in fixed-income and 68% in equities. For the period 1972 through 2009, the portfolio achieved a compound annual growth rate (CAGR) of 10.95% with a standard deviation (risk) of 11.6%. This works out to a Sharpe ratio of 0.51.

Let’s now see what would have happened if instead of 100%, we placed 75% of our investment in the Fund Advice portfolio and the remaining 25% in gold. We would have achieved a CAGR of 11.09%, a risk of 10.08%, and a Sharpe ratio of 0.58. So gold did add to the returns for the period while reducing the risk. How could that be since gold itself was very risky over the period? Gold by itself returned only 8.62% while being a whopping 26.88% risky.

How about instead of investing the 25% in risky gold, we had placed the 25% in safe but similarly rewarding Treasury Money Market fund? The Vanguard VMPXX by itself for 1972 through 2009 had a CAGR of 5.66% with a risk of only 3.03%. The resulting combination with the Fund Advice portfolio shows a CAGR of 9.75%, a risk of 8.77%, and a Sharpe ratio of 0.5.

The return vs. risk of the three portfolio mixes and the individual components gold and money market (MM) are shown in the following graph.

So against our intuition, investing in risky gold actually reduced risk in the overall portfolio while adding to the returns. It even beat a comparable portfolio that invested in money markets. This is the power of Modern Portfolio Theory in action showing that while some assets zig, others zag to combine in wonderful ways.

Sources: Vanguard.com, Simba’s spreadsheet (with 2009 data added), Bogelheads.org, FundAdvice.com.

Here is the model portfolio composition which is based on the IFA Index Portfolio 25 (source). We will call this the Vanguard 25 portfolio:

I am going to use the time period from 1999 through 2009 for the analysis. Crunching the numbers in Simba’s spreadsheet (Revised with 2009 data added. More info about the spreadsheet at the Bogleheads forum.) I come up with a compound annual growth rate (CAGR) of 5.6% with a average annualized standard deviation (risk) of 7.1%. This works out to a Sharpe ratio of 0.41 for the time span.

So, what if instead of having 100% of our total investment in the Vanguard 25 portfolio we placed just 75% of our investment in it and placed the remaining 25% in gold? Running the numbers in Simba’s spreadsheet (Simba uses this source for gold’s annual return.)  I come up with a CAGR of 7.5% with a risk of 6.9% resulting in a Sharpe ratio of 0.70. Call this one Vanguard 25 w/ Gold. The following chart plots these two results. As a reference I also show on the following charts the Harry Browne Permanent Portfolio which is comprised of 25% each of Total Stock Market (VTSMX), Long Term Gov’t Bond (VUSTX), Money Market (VMPXX), and Gold.

Also shown in the chart is the same exercise but instead of placing 25% in gold we substitute a Treasury bill money market fund (VMPXX) for the 25%. The portfolio with money market fund added resulted in a CAGR of 5.0%, risk of 5.3%, and a Sharpe ratio of 0.41. Call it the Vanguard 25 w/ T-Bills. Note that the Sharpe ratio is the same as the original portfolio because in a Sharpe ratio calculation we subtract out the risk-free rate of return of money markets. So adding money markets to a portfolio does not change the ratio of return vs. risk.

The next chart adds the individual return vs. risk of gold and money market for the same time period showing the higher risk with accompanying higher return of gold for the period.

This next chart adds the individual return vs. risk of all of the other components of the Vanguard 25 portfolio for the same time period.

And for the fun of it, I computed the optimal portfolio for the time span based upon the highest Sharpe ratio and as computed by Excel Solver. This tool allows you to specify an attribute you wish to maximize while varying the percentage amounts of the various funds. In this case, we chose to maximize the Sharpe ratio and allow Excel Solver to pick which combination of which funds achieved it. The following table shows the result.

The OPTIMAL portfolio resulted in a CAGR of 5.8%, a risk of 2.6%, and the resulting Sharpe ratio of 1.12. Its addition to the first chart is shown below.

How about continuing to optimize with a high Sharpe ratio yet obtaining greater return? To do that I subtracted some short-term bonds and added some gold leaving the other two components the same. That is, gold at 35% and bonds at 57%. This resulted in a CAGR of 7.6%, risk of 7.7% and Sharpe ratio of 0.99 and can be seen in the following chart.

Therefore, to answer the original question, “Should a portfolio own gold?” it appears that for the period 1999 through 2009 the answer would have been a resounding “yes.” We find that adding gold to the portfolio resulted in higher returns with less risk.

I caution that this process is called data mining and should only serve as input into future portfolio analysis and not serve as the only decision regarding future investments. In subsequent analysis I will not limit the possibilities to just the Vanguard 25 fund set but will open it up to Vanguard funds available since 1972 and/or 1985.

Sources: Vanguard.com, Bogleheads.org, IFA.com, and http://www.finfacts.ie/Private/curency/goldmarketprice.htm

As you can see, the Harry Browne Permanent Portfolio still has the best “top-leftedness” of these select Lazy Portfolios. It had an annualized return of 8% with an annualized standard deviation of 8.8%. That results in a nicely high Sharpe ratio of 0.75, assuming a risk-free rate of return of 1.37% for all 5 years (not likely).

The HBPP’s out-performance is due to the stellar performance of gold through all of these years. I am still not convinced this is the one for all seasons. So I will be performing some analysis of this portfolio for the years that were most favorable to equities and not gold and see how the HBPP would have held up.

Remember that you’d want your portfolio to be at the top left of the chart because their you get the higher return with the lower risk.

So for the three year period from 2007 through 2009 the Harry Browne Permanent Portfolio showed the best return and the least risk of any of the featured lazy portfolios. More analysis to come…

Here are some takeaways from the table:

1. These portfolios have different objectives, different asset class mixtures, and different risk profiles. Simply comparing them on historic returns is not a way to pick one for an investment.
2. Therefore, a better way to view these would be to look at them on a return vs. risk graph where risk is defined as the standard deviation of the portfolio. Then we could see at a glance which portfolio has the more desired “top-leftedness” (meaning it had higher return for its level of risk).
3. Only two of the portfolios invested in gold, the two top performers. Future results may vary.
4. I believe most funds have no load.
5. I changed the Harry Browne Permanent Portfolio cash holding from VFISX to SHY which results in a slightly lower return (about 1% less). I would prefer to hold it in a money market fund, but Yahoo! Finance does not give me historical returns for them.
6. Remember, this table probably has errors!

Have a look at this table:

On day 1, XLF rose 10% so FAS rose 30%. Great, you’re in the money.

But on day 2, XLF dropped back down to its starting price of $10.00, a decline of 9.09%. The bad news is that FAS declined 3X this amount or -27.27%. This takes its share price down to $9.45 instead of the $10 that you might expect.

So whereas XLF is unchanged after 2 days, FAS is down 5.45% after those same two days.

Why? The power of daily compounding instead of cumulative compounding. The leveraged ETFs are structured in a way that they compound on daily percent changes, not cumulative price changes. The day 2 decline of FAS should only be 23.08% to take it back to its original $10.00 per share price. But because it is 3X of XLF’s daily change, instead it declines 27.27%.

Said another way, the leveraged ETFs operate on the daily percent change not on the price of the underlying index.

Definitely not a buy and hold type of ETF! Not even for one day. Traders: set tight stops!

I’ll discuss on show 150.

"…they don’t even perform as expected. The index the SKF tracks is down 14% over the past three months, so you’d figure an ETF that double or triple shorts that index would offer great returns, right? Wrong. The SKF is down 28% over the same time period.

I took a quick calculation of XLF vs SKF to see if he is right. I brought weekly historical quotes from Yahoo finance into a spreadsheet, inverted the SKF’s weekly returns and divided by two and charted it. Here’s the chart, you decide if he’s right.

Fed Chairman Ben Bernanke said the same thing on February 18th:

Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation. The Fed’s lending activities have indeed resulted in a large increase in the reserves held by banks and thus in the narrowest definition of the money supply, the monetary base. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time.

He acknowledged that they are inflating. But he threw a red herring into the mix by talking about weak economic activity and low commodity prices (Heh, except gold, right Ben?) trying to infer that they are somehow the cause of inflation. No, they are the result of inflation. Next, he went into how they will correct their inflation:

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply and begin to raise the federal funds rate. To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink. … However, the principal factor determining the timing and pace of that process will be the Federal Reserve’s assessment of the condition of credit markets and the prospects for the economy.

Bernanke recognized that the plane is in a nosedive and at the last minute he plans to push on the stick and go airborne again. I hope it is not a cloudy day when he has to judge how far the plane is from the ground. He wrapped up his thoughts on inflation and how to avoid it:

As we consider new programs or the expansion of old ones, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster maximum employment and price stability.

What do *you* think the chances are that the Fed will get all of the necessary actions right? Have they gotten the necessary actions right up to this point? Let us examine a scenario where they are not able to get it right and we do indeed experience undesirable inflation, which I will define to be anything above 5% annually.

How might the various asset classes be affected in times of inflation? To answer this question, I utilized Simba ’s spreadsheet for back-testing portfolios (which I imported into Google Spreadsheets) to do a correlation between CPI (Consumer Price Index, the government’s official inflation number) and various stock fund, bond fund, and gold returns. The data in the spreadsheet uses annual returns of Vanguard index funds along with the yearly closing price of gold from the years 1971 – 2008.  The spreadsheet already calculated the cross-correlation between each of the mutual funds and it lists the annual CPI index. So it was very easy to drop the CPI into one of the mutual fund slots and instantly see the correlation between every asset class and inflation. Here are the results, sorted by correlation:

The table shows those asset classes that were most closely correlated with the CPI at the top. Note in the third column that a value of 1 would mean the asset is perfectly correlated, -1 would mean perfectly correlated inversely (it went down exactly as CPI went up), and 0 means there was no correlation: it was random.

So we see that those assets that were most highly correlated with CPI were T-bills, gold, long-term government bonds (inversely), short-term Treasuries, and commodities.  Everything else was below 0.25 correlation. Interestingly, micro cap stocks were totally uncorrelated with inflation.

So how did a portfolio of those assets perform during the years 1973-1981 in which CPI was 8.7, 12.3, 6.9, 4.9, 6.7, 9, 13.3, 12.5, and 8.9%?

I constructed a portfolio along the lines of the Harry Browne Permanent Portfolio (HBPP invests 25% each into total US stock market, long-term bonds, money market, and gold) but I added some small cap value, micro cap, and eliminated the long-term bond fund. I then back-tested that portfolio during those inflation years. Here is the portfolio what I came up with:

The Inflation Portfolio:

VISVX (Small Cap Value) 15%
BRSIX (Micro Cap) 15%
PCRIX (Commodities) 10%
VMPXX (Money Market) 45%
Gold 15%

The "Inflation Portfolio" had a CAGR (Compound Annual Growth Rate) of 15.5% and a risk (as measured by standard deviation) of 10.5%. Plotting that on a chart, here’s what it looks like compared with some other portfolios and the assets themselves:

The chart shows plots for various portfolios during those inflation years. The plot point directly above HBPP simply substituted BRSIX for VTSMX in the HBPP. The major components of the Inflation Portfolio are also plotted separately showing how volatile gold and BRSIX were themselves. When tempered together with VMPXX, the risk came down considerably while retaining significant returns. You can see all of the rest of the details in the Google spreadsheet that I created for this scenario and you can test out other hypotheses yourself.

The Inflation Portfolio worked from 1973 through 1981. If we see inflation return, would it work again? Some folks are discussing these findings at the Bogleheads forum if you want to chime in.

Please note this is not a recommendation to invest your net worth in the Inflation Portfolio!

That posting is in error (that I do not believe was my fault). I have corrected it. It turns out that Feb 1, 2008 thru Jan 31, 2009 was not the worst 12-month rolling period, but it did come close.

I’ll be watching to see what happens at the end of this month.

Here is the corrected chart.

I have copied Simba’s Backtest Portfolio spreadsheet from the Bogleheads forum into a Google Spreadsheet that you can use to back test a portfolio of Vanguard mutual funds and compare their performance from 1972 – 2008 to the IFA Index Portfolios. Combine the funds any way you like and compare them against IFA’s twenty portfolios. I included the "returns" for gold there for your convenience.

This graph from that spreadsheet shows the plots of a few others including the Coffeehouse portfolio, Harry Browne’s Permanent Portfolio, Scott Burns’ Four Square portfolio, and a couple of others along with IFA’s portfolios (they follow a nice line). Unfortunately, Google spreadsheets doesn’t do labeling very well on the data points. I would have liked each point to be colored and have a legend identifying those colors. Anyway, remember you want to be at a point at the top left on this graph. The line that is formed is called "The Efficient Frontier" beyond which it is difficult if not impossible to achieve. The strong correlation between returns and risk is evident.  However, it is easy to be bottom right!

If you want to play with the spreadsheet yourself, feel free to bring it up. You’ll need a Google account. Leave the years to be 1972 – 2008 in order for the comparisons to be valid. Here’s the link:

https://spreadsheets.google.com/ccc?key=pOjc3ot10vgs0eml-DJZKcw&newcopy

But wait, there’s more!

IFA is now allowing you to submit your past financial statements to them so that they can compare you’re portfolio’s performance against their index portfolios. Go their web site at ifa.com to learn more. Here are some comparisons they have already performed.

I owned the Kindle 1 for about a year. I purchased a total of 3 books for it. Yet I had about 100 books on the gadget. How? I used software called mobipocket to convert pdf files to the format the Kindle likes. Many sites on the internet allow you to download free public-domain books. I also didn’t purchase many books because many times the books I wanted to read were not available at Amazon for the Kindle. And if I could get the book from the library, I actually think I prefer the hardback version to the electronic version, possibly because I get immediate feedback of where I am in the book just by feeling it.

I do like the idea that I can carry a stack of thousands of books around on one device. I like that my home is not as cluttered with books. But I’m thinking that if I can find a great pdf reader for the iphone, I’ll just use that instead.

The web site is http://www.icarra.com

Get over there and create an account and try it out. They have really made some nice improvements since I last used it.

FOR BEST RESULTS, AFTER YOU CLICK PLAY, CLICK THE ARROW BUTTON IN THE BOTTOM RIGHT THEN SELECT "HQ" TO GET EVERY OUNCE OF INDEXING JOY FROM THESE VIDEOS!!!

Steps 1-3

Steps 4-6

Steps 7-9

Steps 10-12

This was a lot of fun to put together. I used Keynote and then exported the show to iMovie to render the video. Images and diagrams are from ifa.com. For backtested performance information go to ifabt.com.

At the end of October 2008 we experienced the worst 12-month rolling period for stocks in 50 years. Then at the end of November we outdid that.  Now at the end of January 2009 we have a new low for a 12-month rolling period in many indexes and portfolios. We came close to the worst rolling 12 months again, but did not pass it.

The following table is taken from ifa.com, combining the returns for 11 months from 1 Feb 08 through 31 Dec 08 and the 1 month return for Jan 09.

Here is the corrected table.

Previous table, wrong:

Source: http://www.ifa.com/portfolios/PortReturnCalc/index.aspx and http://www.ifa.com/portfolios/

We have probably seen it 20 times. Every viewing is “spoiled.” So who cares if the plot is spoiled? Nevertheless, if you have not seen Groundhog Day and do not want to be spoiled, please stop reading now. This post includes SPOILERS.

A quick plot review: Phil Connors, played brilliantly by Bill Murray, is a bitter and sarcastic weatherman sent to cover the Groundhog Day festivities at Gobbler’s Knob near Pittsburgh. He gets stuck in time and wakes up on the same day over and over. Phil is the only one who realizes it. He can learn new things but everyone else is unaware. They are living the day for the first time every time.

At first Phil is bewildered. The next few loops of days later he gets angry. Several loops later he gets depressed. Then he repeats loops in which he tries to take advantage of his unique situation. He is learning while others stay frozen in their knowledge. This becomes boring to him eventually. He becomes depressed and resigns his fate. He comes to marvel at how his producer Rita (Andie MacDowell) is genuinely kind to everyone she meets and he comes to realize that he too can be kind. He sets out in the final loops of days to be kind in each and every situation in which he places himself. He learns to play the piano, to speak French, and to ice sculpt. He knows everyone in town and much about them. He truly changes his character. The last loop ends after Phil completes his transformation from bitterness to kindness. He, like the groundhog Phil, sees his shadow. His winter ends.

Groundhog Day works on many levels. It is funny, tender, philosophical, sad, clever, and though-provoking. I imagine this must have been a joy for writers Harold Ramis (of Ghostbusters) and Danny Rubin because of its roller-coaster cleverness. And it must have been fun to shoot because many of the sets were used in a variety of multiple takes to demonstrate the various stages of Phil’s time loops.

But the main reason the film appeals to me so much is because the movie unwittingly portrays the life of a computer programmer, like me. We are a unique breed of people; we who interact constantly with others, in our case computers, that are stuck in time. We are always trying things, failing, and ultimately succeeding. We code up something that never works the first time. We start over, make a change, and try again. We get angry, sad, frustrated, resigned, and ultimately overjoyed at our software loops. The computer doesn’t know what we’ve been through. We are the ones learning while the computer simply responds to our interaction. We come to realize that we must be kind to our computer, we must be careful what input we provide to it. It only knows us by our inputs.

After 10,000 hours at the keyboard, we master our environment. We learn the new languages. We sculpt out of the hardness that which time melts away. We use our skill for genuine good, not expecting reward. We’ve been through the cold and the gray but tomorrow does come and it is a better day.

From BLUE YORK by John thomas Oaks and Grand Central
Music and Lyrics by John thomas Oaks
Featuring Tim Caudill — Bass, Gary "Biscuit" Davis — Banjo, Kevin Moore — Fiddle, Jeff Zona — Acoustic Guitar, Lakieta Bagwell and Jimmy Bryant — BGVs

Then look at this…

Returns in the stock market are randomly distributed over time.

First, can you imagine the immediate shock the the economy? Could anyone really process all of these changes at once, including all of the second-order effects and how they would impact your particular situation? Shocking if done instantaneously. Even shocking if done over the span of one year. But big deal. Get over it. We can be shocked and still survive, right?

Yeah, if the USA were a closed system I think we would be just fine. We would trade our gold for the farmer’s corn. Farmers would trade gold for tractors. Tractor builders would trade gold for houses. On and on. We would employ all the former government workers as road builders. New banks would arise in cities eager to lend us some gold for capital projects. We would do just fine here in the USA.

It is the fact that the USA is not a closed system that complicates the issue. See, in this process we trade dollars for gold. Each dollar is worth 1/900 oz of gold (let’s say). Bring in your pieces of paper, your Federal Reserve Notes, to the bank and they will give you gold coins or a receipt for 100%-reserve gold coin storage.

So now we all have gold in our pockets. And we want to buy a giant LCD TV. With what exactly and from where? Dollars? Ha, they’re gone now. A TV made in the USA? Yeah, right. You gotta give up some gold to some other country. So we load up our Wal-Marts, our Dollar Trees, and our shopping malls with stuff that we trade away our gold for. That represents an outflow of gold from USA. To keep the system in balance, don’t we need a corresponding inflow of gold? Otherwise someday we completely run out of gold, right? Can’t just print more gold can we?

It is the same scenario with any government that is left over. How are they going to pay out Social Security in gold? How are they going to send thousands of troops overseas and build billion-dollar airplanes and pay people to read newspapers in fancy offices? Since they don’t have a gold mine to readily tap into, they either have to take away your gold, or have to borrow gold from China, or they have to stop spending gold. The first option quickly reaches either a point of diminishing returns or reaches a point of torches and pitchforks. The third option is their option of last resort. Which leaves us with the USA borrowing gold from China. Which is kind of making my head spin trying to think of how we are going to come up with the gold to not only pay that back but also to pay the interest.

But maybe that is the point. We would have to figure out some way of getting gold from other countries. We would have to actually make or do things that they want. For example, we could trade our tractors and our corn for their gold. We could build houses for them. We could even help build their roads. Either that or we build our own LCD TVs and stock our Wal-Marts and Dollar Trees ourselves. Shocking isn’t it? Economics does work.

As I ponder this scenario, I realize just how fortunate and prosperous we in the USA have been these past few decades. Being able to "manufacture gold out of thin air," that is, print dollars to trade to foreigners. We are so lucky that they want our fiat dollars. Because that guy reading the newspaper really isn’t a very good road builder.

He goes on to say that buy and hold is not the right approach. And I think the reason might have to do with the notion of "Austrian Investing," though he does not use those words.  Here is what he does say about buy and hold:

The problem with that approach was and is government. Government alters currency values, and this alters the value of different kinds of investments. Government creates booms and busts, and that alters investment values. The presence of government forces us to speculate.

Then he goes on to talk about how we need to find value and buy it, be it stocks, real estate, or even timber.

I am on the hunt for more information about Austrian Investing. They’ve been right about the economy, maybe they would be right about investing too.

Oh, and BTW: Mish does a pretty good destruction of Peter Schiff’s approach to Austrian Investing. Good read.

]]> http://MadMoneyMachine.com/2009/01/26/austrian-investing-continued/feed/ 0 http://MadMoneyMachine.com/2009/01/26/grinch-movie-remake-again/ http://MadMoneyMachine.com/2009/01/26/grinch-movie-remake-again/#comments Mon, 26 Jan 2009 16:36:19 +0000 Paul Douglas Boyer http://MadMoneyMachine.com/?p=1363 Check out IFA Quote of the Week Issue #44 where they speculate that Hollywood may remake How the Grinch Stole Christmas with Bernie Madoff in the lead role: (Click bottom right corner to watch in HD)

Where did the money go?

The USA Today ran a story that read, "$2 trillion wiped out of retirement funds " so far in 2008. Really? Two trillion dollars is wiped out? Lost? This is a fascinating notion. You wake up one day and wealth is suddenly gone. Vanished. Like some ice cube that has melted on a hot street. Here one moment and gone the next. As we shall see, the ice cube metaphor may be even better than it first appears. Stocks have melted.

The NPR Planet Money podcast a few weeks ago sought to answer the question "What is money?" and recently asked "Where did the money go?" To help us visualize the "loss" of money, they acted out a little skit with three market participants. At the start of the skit it was noted that among them the sum total of money was $400. Russ had $200, Alex had $200, and Lois had a house. (It was a little green Monopoly game piece house.) Russ Roberts (of EconTalk fame) decided he wanted a house. So he offered Lois $200 for hers and she accepted. Russ has the house, Lois has $200. Some time passed and then Russ wanted to sell his house. Alex was the only one who made an offer and it was for $100. Russ took the offer but was obviously unhappy about "losing" $100. At the end of the skit, Alex owned the house and $100, Lois had $200, and Russ had $100. The sum total of money was $400. Therefore, the net amount of money remained unchanged although some of the market participants had varying emotions about their transactions.

Lois was happy to receive the $200 for her house because she said she had originally purchased the house for $100. But she said that she still had to live somewhere and would now have to go and buy another house. Russ was obviously unhappy because he has $100 less than when he started. And still no house. Alex was probably the happiest because he has a nice house and still has $100 of his original $200 remaining. But with the net amount of money remaining the same, they didn’t really ask the question, "Why did the house only get an offer of $100?"  Why not a $300 offer? Don’t house prices continuously rise and never fall?  It was a fun exercise to walk through, but it still left me unsatisfied. What’s behind the rise and fall of prices? Let’s try to figure that out. But instead of houses, let’s switch over and talk about gold for a moment.

Gold and the Market

Gold is different than houses. We can’t live in gold. Instead, gold is money. Ancient money. Gold would still be money today if the governments would stop prohibiting it from being money. Consider these characteristics of money: money must be marketable, easily transportable, relatively scarce, relatively imperishable, easy to store, easily divisible, and uniform in quality. Gold meets all of these characteristics and has been used as money by default through the ages. Ironically the dollar, the world’s reserve currency, doesn’t meet all of these characteristics. It misses the scarcity test.

So let’s trade two things: dollars and gold. It used to be that a dollar represented a fixed amount of gold, but today we can trade one for the other at different amounts. If you have dollars and I have a one ounce gold coin, you can make me an offer to trade some of your dollars for my coin. I can accept or refuse. If you offer me $200, I will refuse. If you offer me $2000 I will accept. Somewhere in between these two ranges we may reach an agreement (or we may not). The more people there are around to offer bids and ask for bids, the greater the chance that someone can reach an agreement on a fair trade. As an example, say your bid for my gold coin is $600 but Troy bids $800. You may consider increasing your bid to $850 in light of his bid. But before you do, Bill next to me accepts Troy’s $800 bid for his coin. You witness that and decide to limit your bid to me to $800 also. Why pay more, right? Or if you are really trying to game me, you may hold your bid at $600 thinking that no one else is around now that will bid something higher.

This is the workings of the market. Bidding and asking is how we reach agreed-upon prices. This is why stock prices are what they are: dynamic. It is a continuous mixture of people wanting to sell at the highest asking price and people wanting to buy at the lowest bid price. But they know they are competing with other sellers and buyers for those same shares.

Motivated Sellers

Competition is the heart of the market. It is the heart of the gold market and the heart of the real estate market and the heart of the stock market and even the heart of the currency market.

In the NPR skit, Alex was able to buy the house from Russ for only $100 because there were no other offers higher and Russ really wanted to sell. A motivated seller they say. Perhaps he needed to move because of a job relocation. There are motivated sellers in all markets just as there are motivated buyers. Are there more motivated sellers than motivated buyers? Prices will fall as bids dry up. Prices will fall as the number of offers rise and the amount asked for sinks. Are there more motivated buyers? Prices will rise as bidders compete. Prices will rise as owners hold tight.

Presently in our global stock markets our global real estate markets and our global commodity markets we have not just a boatload of motivated sellers but a whole fleet of cruise ships full of motivated sellers. We have banks, brokers, hedge funds rushing for the exits at the same time, needing to sell just to get the dollars to pay off debts and client redemptions. We even have investors motivated to sell simply because they see so many other motivated sellers selling.

As naturally happens when motivated sellers outnumber motivated buyers, prices drop. We might call this an asking war , the opposite of a bidding war. Sellers lowering their asking prices in the face of other low asking prices. Asking prices for stocks go lower. Asking prices for houses go lower. Asking prices for copper goes lower. But motivation in a particular market is only part of the story. We need to also consider motivation across markets. I may want to sell my house not because of physical reasons but because of economic reasons. Perhaps I want to trade house wealth for stock wealth. I may prefer at present to rent and hold 10,000 shares of an index fund rather than owning a house. I probably will not find the exact trade I’m looking for; that is, someone to offer to trade me their 10,000 shares for my house. Instead, I’ll have to trade through money. I sell the house for dollars and then sell the dollars for the index funds.

But the net amount of money in the system doesn’t change as a result of motivations. The buyer gets to keep the net amount that the seller loses out on. Alex has the $100 instead of Russ. When prices kept going up, did anyone ask, "Where did that money come from?" Not likely. We don’t care how we got it. Yet we darn sure want to know how we lost it. But both answers are the same. The net amount of money remains constant among the total pool of buyers and sellers.

[Note that I am for purposes of this discussion ignoring the effect of fractional reserve banking and the creation of money when lent and the destruction of money when a loan is paid back. This effect is indeed serious and makes an enormous impact to the economy as a whole.]

Lost Wealth?

Now we know where the money went. It is still there. Not a satisfying answer to owners of stock mutual funds in their 401K plans who say, "Oh great, more motivated sellers means any bids I seek for my shares will be lower if I were to try to sell today." Penny’s 401K plan may have a cost basis of $100,000. And last year when she checked the bids on her portfolio it may have fetched nearly $300,000. But based upon recent offers, it may only receive bids for $150,000. That seems like lost wealth to Penny. Is it?

It depends. It might not be lost wealth to Penny. We need to look at what Penny would have wished to trade her shares of stock for? A house? If so, Penny is in luck because houses she liked that used to fetch $300,000 bids are now asking only $150,000. So Penny’s 401K plan would buy the same amount of house even though its dollar value has fallen in half. Similarly, Penny may have wished to use her 401K to travel or to eat or to pay her gas bill. Dollar values for each of these things may have fallen, but their values may have stayed relatively close to the value of her stocks over that time.

We are living in a world where bids for practically every asset are lower in comparison to bids for dollars. Many motivated sellers of stuff, many motivated buyers of dollars.

So the problem is the thing we are using as money, which itself is becoming more "valuable." The banks, brokerages, and hedge funds that need to get dollars are not just motivated sellers of stocks and commodities, but they are also motivated buyers of dollars. There are lots of motivated dollar buyers. Prices of dollars rise. Everything else seems more expensive compared to dollars as a result.

But we the investing public with 401K plans are typically not motivated buyers of dollars. We are more typically motivated buyers of the things that dollars buy. Food, travel, cars, shelter, heat, etc. When we trade one of these for the other, we might expect roughly the same item-for-item transaction this year as we did last year. The thing in the middle is what has changed: the money. The demand for the dollar by banks, brokers, and hedge funds has skewed the monetary valuations of both the things that we need to sell and the things that we want to buy. But in the end, it might possibly be that our wealth remains somewhat unchanged just like the amount of money remains unchanged among buyers and sellers.

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I think we need to take the discussion to the next step and talk about open source Government. One of the keys of open source software is the idea of “forking” the code. If someone wants to go a different way, they can make a copy and do their own thing with it. I suppose the idea of “state’s rights” is like forking the code on a governmental level. 

One thing they talked about regarding open source development is that it works best (especially graphical user interface development) when there is a “dictator” who approves the changes. We’ve come to think of dictators in government as being a bad thing. Maybe it is a matter of scale. If the dictator role is moved down the the smallest level of government, maybe the the analogy could work. But certainly not at a national leve.

But the thing that I got caught up in was the emotion, the joy, people were experiencing at the change of our Chief. They really believe things are going to be different and are going to be better. So far, I have to say they are right. The inauguration itself was indeed a spectacle. Good thing inaugurations aren’t held in June or there would have probably been ten million people trying to get down there. I don’t think I’ve ever seen so many JumboTrons. The media is just fawing over him. He is the rock star’s rock star. He is the Tiger Woods of presidents. BHO is the new JFK.

I believe that joy can be contagious. Like yawning. Like laughter. And with better than one half of our country experiencing sheer joy, maybe the other half can set aside their bitterness, sourness, or skepticism or whatever for a while and give this new executive branch a chance. Let’s see if Obama and his team push the pendulum toward liberty or toward tyranny. Let’s see if it is going to be  Austrianism or Keynesianism that gets the upper hand. Let’s see if government does indeed get better.

That’s one of the things I remember from his address. Don’t focus on whether government gets bigger or smaller. Focus on whether it gets better. He will evaluate the effectiveness of each org, and the ones that don’t cut the mustard get dropped. (That could turn out to be a whole lot of orgs!)

So my question is this: After the white tablecloths get balled up and sent to the laundry tonight, will there still be joy tomorrow? Will John Stewart get nasty every night toward this Chief? Or will there be some spirit of civility?  Will BHO really bring out the best of the politicians so that they work for us and not themselves? Or is this all just some audacity of hope?

Probably won’t play it on the show, but it is worth watching to see the lyrics.

These days though we are hearing the word "trillion" a lot more. Million. Billion. Trillion. They all basically sound the same. Like dime, nickel, quarter. Are they really that much different? It is amazing that they are indeed very much different. In fact, in order to get a billion of something you have to have a thousand million of them. Then to get a trillion of them you need a thousand billion.

More remarkable is how many millions of something you need to get a trillion of them. Let’s supposed that in addition to paper money in denominations of ones, tens, twentys, and one hundreds that the FED just happened to print up for convenience a one million dollar bill. It would have printed on each corner, "1,000,000" and below would be "ONE MILLION DOLLARS." (Oh hey, I just realized, there is no "$" symbol on US money. Hmmmmm.)

If you could get a legitimate one, would you like to have a ONE MILLION DOLLAR bill? I suspect you would. It would pay for a lot of things. In fact, for most people it would completely pay off all their loans and would also carry them through tough times in case they had to leave their job. A million dollars is a lot of money to a person. Yes, a ONE MILLION DOLLAR bill is a lot of money.

So with these one million dollar bills, how many of them would you need to have $1 Trillion? It is astonishing to realize that you would need ONE MILLION ONE MILLION DOLLAR bills to reach $1 Trillion. A million times a million. To write all that out is $1,000,000,000,000. I learned today that Zimbabwe is now printing a one trillion dollar bill (correction: a $100 trillion! ). It is worth something like $30 or $300 US dolllars because of their currency’s hyperinflation.

But I keep hearing how the TARP, the government stimulus, the unfunded liabilities, and all that stuff are putting the US somewhere between $1,200,000,000,000 and $65,000,000,000,000 in debt. Literally mind-numbing numbers for most people. So let’s average the two and round it to 30 trillion. With 6 billion people on the planet, that works out to be $30,000,000,000,000 divided by 6,000,000,000. To simplify by getting rid of excess zeros say $30,0000/6 which is equal to $5,000 of debt for every man, woman, and baby on the planet.

I’m hoping that this is the peak. I’m hoping that we will not have to start using the word quadrillion. But what can I do about it?

I noticed one feature that GrandCentral has that Skype does not: the ability to DOWNLOAD the audio file! No longer do I have to go through hoops rigging up some audio hijack software to play and record the Skype message. Nice. I also like the fact that I get emailed immediately upon receiving a voicemail. I don’t have to have an application running on my computer to get the voice message too.

Maybe someday I will merge all my numbers to this one number, once I really get my contacts put in there correctly. It supposedly allows you to allow calls through from people you know while routing others to voicemail.

So let me outline a few points that need to be understood in order to discuss this rationally.

The Lazy Portfolio Smackdown was set up to compare the return vs. risk characteristics within index investing. We did not compare index investing vs. other strategies. However, in 2006 we did run a comparison against a stock-picking strategy. We compared Jim Cramer’s buy buy buy stocks against two lazy portfolios, one with ETFs and one called the IFA Index Portfolio 100 . The lazy portfolios gained over 20% that year and the stock-picking portfolio was -0.2%. But that’s just me, not a scientific study. Let’s move on.

He asks, "what is the point of standard deviation in this table?" Yes, it is shown over one year here. The context is that we are comparing the volatility of an investment vs. the return it generates. After all, risk is the source of returns. Why use standard deviation? It helps us compares apples to apples. It is a good way to compare the performance of a 100% equity allocation against a 60/40 equity/bond allocation, for example. The 100% equity is expected to have a higher risk than the 60/40 split. But what if both portfolios had the same return? Obviously the 60/40 would have been a better choice. Said another way, there must be something wrong with the composition of the all equity portfolio.

But I do caution that looking at portfolios over just a one year period is not sufficient. We really need to look at much longer time frames to statistically capture the correlation of return to risk. But this is also the escape hatch of active managers. If they are lucky one year, they tout their "out performance" as proof they know something. Why do we never hear from the "under-performers?" Very few of active managers have long term records of performance. And of those that do, fewer still have outperformed the market. In fact, I don’t know of any who have. Remember Bill Miller of the Legg Mason Value Trust fund (LMVTX) who was the only manager to outperform the S&P 500 for 15 consecutive years? Have a look at a chart of LMVTX for 2008. His long-term returns are completely wiped out.

Let me answer another way. The standard deviation is used to calculate the Sharpe Ratio of the portfolio. The simplest definition of this ratio is that it measures "top-leftedness" of a portfolio when plotted on a chart of return vs. risk. As return goes higher on the y axis and risk gets larger going right on the x axis we want our portfolio to be top left as far as possible. High returns at low risk is the ideal.

Here is a return vs. risk chart of some of the Lazy portfolios in 2008:

Source: Foliodex.com (when it works) You can see a pretty tight correlation between risk and return.

Remember that risk also measures the potential losses in a portfolio as well as the potential gains. The higher the risk, the higher the potential magnitude of both losses and gains. Sure the Lazy Portfolios had large losses in 2008. But compared to what? Freddie Mac? GE? AIG? GOOG? Or how about these gems from one of Andrew’s posts at the beginning of 2008. He says, "It is a good time to look for deep value…" while cautioning not to chase yield.

I skipped some of the banks in his "screen" just to save time. What would these stock picks look like plotted on the chart above? Pretty much bottom right. Some would be completely off the chart both bottom and right.

But let’s say you were an absolute genius and picked the five best of these and invested your portfolio there. With 20% in each of LEG, PFE, EQR, PGN, WIN I calculate a 2008 return of -14.9% with a risk of 23%. Looking that up on the chart, it would indeed have been better than most. So, what are the chances you would have been a genius and picked the absolute five best? And when should you sell? You have to be right twice, remember? What if, instead, you picked a couple of the worst stocks?

I mentioned that risk is the source of returns above. But keep in mind that there are various types of risk: unsystematic and systematic are two. Systematic risk refers to the risks of the entire market as opposed to the unsystematic risks specific to one stock. Unsystematic risk is not rewarded. Investing in the stock of a single company adds only risk but not return. Better to invest in a market portfolio which minimizes the unsystematic risk of any one particular company. Take a look at this reward vs. risk chart over a period of 20 years. It compares a market-based approach vs. picking individual stocks. Remember that you want to be top-left. Sure, MSFT had higher returns, but would you have been able to put your entire net worth in that one stock and ride its volatility? Even the entire Dow Jones underperformed portfolios 50 thru 100.

What portfolio of stocks can you pick that go further top left than in that chart? And at what effort? If being lazy yields such great reward vs. risk characteristics, why waste time, energy, bid/ask spreads, commissions, tax consequences, and other expenses doing anything else?

Why would someone be so antagonistic towards lazy portfolios when it can be shown they have the best return to risk ratio over the long term? Let’s look at the economic incentives of holding different positions on investing. If someone wants to make money in the investing business, would they try to come up with a unique angle and give their clients the impression they know something that everyone else does not? Or would they follow a scientific approach that most everyone else already knows? Most try the former, thinking it appeals to clients who are seeking answers.

If one were to make commissions from trading stocks, would that person advocate trading or not trading? If one were to make a fee from assets under management, would that person ask you to invest with them or would they say you can do it yourself? Sure, some people don’t want to do it themselves. In that case they need an advisor that can assess their risk capacity and place their investments in a portfolio of index funds.

If one were to write a book on investing, would they try to come up with unique strategies to outperform the market or would they simply tell people to invest in the market? You know there have been studies of active managers showing that the odds of them beating the market over the long term are about 1 in 38, the same odds of picking one number on a roulette wheel? But of course your manager is the one that beats the market, right? Hey, maybe he actually did beat the market last year. Everyone floods into his fund or firm. Like Bill Miller’s or Bernie Madoff’s. It is what happens next that sickens.

When one takes a rational look at Lazy Portfolios, one can hardly call them "idiotic." Unless of course one is in the business of making money trading stocks on behalf of others.

Now guess what? The sound is gone. No audio. Mute. I have tried everything that is reasonable including replacing the sound card from my old XPS onto this one, downloading new audio card driver software, and switching things around. No joy. It just ain’t fun watching YouTube videos with no sound.

But the biggest problem is that I can no longer use Adobe Audition on the PC to record and edit my shows. Sure, I’ve recorded and edited shows on the MacBook in GarageBand. But Audition is the super-ultra-supremo-king of audio editing. I’ve got all the keyboard shortcuts down and can whiz through a show faster than real time now. Not so in GarageBand.

And from what I’m reading on the net, nothing on a Mac is as good as Audition. Some say that Soundtrack Pro from the Final Cut Studio 2 is pretty good, but guess how much that want for that sucker? $400? Nope. $800? Nope. Try north of $1500! Yikes. Can I get a TARP for that?

So I hang my head and commit to GarageBand. Hey, I even tried running Audition under Windows 7 under VMWare Fusion on the MacBook. Hardee har har har on that one. Sounds like this, “a. et. ip. o. ot.” Seems to get about every 1/2 second of sound out.

So Mac here we come full force. I have a countdown list of PC-only applications that I’m trying to figure out how to migrate from. Luckily, none of them require sound. So I can still run them for a while until I figure it out. They are: Fidelity Active Trader Pro (don’t chastise ME!), Microsoft Expression Web, Microsoft Excel, Natara Bonsai outliner, and of course my iTunes library. I’ll let you know how it goes.

http://www.nytimes.com/interactive/2009/01/06/business/20090106-comeback-graphic.html

What’s neat is that if you put in a negative inflation rate, say -3%, you can get your money back in a few years even at 0% Annual return!