Author Topic: Statistics, personal experience, and risk management  (Read 4444 times)

scottish

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Statistics, personal experience, and risk management
« on: April 15, 2015, 03:36:47 PM »
Derived from Retired to Win's dividend stock thread...


Retired to win and Dodge were discussing dividends versus the indexes over here: http://forum.mrmoneymustache.com/investor-alley/anyone-else-only-buying-dividend-stocks/150/.   I think that the two sides of the discussion are really statistics (Dodge and Scandium) versus experience (Retire to Win).    I think both sides are a little misleading.   

No individual investor is a statistic.   If your purchases turn out to be timed poorly (just by luck, not suggesting market timing here), your performance will be much worse than if your purchases are timed well (also by luck).    Similarly, there are no guarantees that one person's experience will be repeatable.  If you've got an investment approach that you can stick with that does some kind of dollar cost averaging you're doing better than most people.

Does anyone practice risk management?    You know, bonds are great if the stock market is a bear for 5 years?   You can live off the bonds instead of selling your capital at a discount?  Dividends are a half-decent hedge against inflation that erodes the values of bonds.   But you can lose out on a lot of small cap gains if you have only large cap companies and the economy is firing on all cylinders.   How about managing your tax situation by minimizing your realized income?

One of the great things about the S&P500 or the total stock index is that it covers both large cap companies that pay dividends and smaller growth companies.    You get so much mileage out of one simple investment, it's no wonder MMM likes it.

But what about the risk that the US economy just sucks for 5 or 10 years?   Maybe you get in a war in the Balkans, spend another umpty trillion dollars on it and are crippled by debt.  Stock prices are down, companies default on bonds, inflation is up.   Another example is China, which is going to be the largest economy in the world before long.  I don't think the wealth transfer from the US to China is going to stop anytime soon.   What if it gets worse?  What if Xiao-mi clobbers apple and Baidu clobbers Google?  I hear so much about the US index market, but very little about international diversification.

Up here in Canada with our resource intense economy, I pay more attention to international diversification every year.

Does anyone have a good risk management strategy they'd like to share?

waltworks

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Re: Statistics, personal experience, and risk management
« Reply #1 on: April 15, 2015, 04:48:03 PM »
The S&P 500 is considered close-enough to internationally diversified by many folks just because a lot of the companies in it are huge international conglomerates that happen to be based in the US. So there's a ton of international exposure (for better or worse) built in.

-W

scottish

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Re: Statistics, personal experience, and risk management
« Reply #2 on: April 15, 2015, 05:55:32 PM »
Here's some data about Procter and Gamble and GE sales by region:

General electric 2013 annual report

GEOGRAPHIC REVENUES
(In billions)                2013     2012       2011
U.S.                         $ 68.6   $ 70.5    $ 69.9
Europe                        25.3      26.7       28.2
Pacific Basin                25.5      24.4       23.2
Americas                     13.1      13.2       13.2
Middle East and Africa 13.5      11.9       12.0
Total                        $ 146.0 $ 146.7 $ 146.5

Procter and Gamble 2014 annual report
Sales by region
North America  39%
Europe             28%
Asia                 16%
Latin America   10%
IMEA               7%

Their sales do look pretty international.

forummm

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Re: Statistics, personal experience, and risk management
« Reply #3 on: April 15, 2015, 06:08:12 PM »
For your equities, why not put about half in VTSAX and about half in VTIAX? Then it doesn't matter. That's about what the global market cap is like. The expense ratios are really close to each other. Sure Coke, Apple, etc sell products all over the world. Sure Toyota, Nestle, and Novartis do too. There's a lot of diversification there, and some overlap. But you'll own everything. If the US has a Japan situation, you'll be diversified. Same with Germany, or whatever other country.

Financial.Velociraptor

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Re: Statistics, personal experience, and risk management
« Reply #4 on: April 15, 2015, 07:07:26 PM »
I have an "income centric" portfolio consisting of a mix of high yield-low growth stocks, low yield-high growth, and written puts, and/or covered calls.  Basically everything except my insurance company holdings is intended to produce income for immediate use in FIRE.  Surplus income earnings over lifestyle burn rate are deployed into a mix of buy/hold insurance companies with strong underwriting history and income producing securities.

I have since late 2014 also started mixing in municipal bonds.  NIO and NEA both pay about 6% tax exempt (NIO has a tiny portion subject to AMT), which is a pretty good equivalent yield in the 25% TB.  Volatility is very low on these holdings and they meet the income test while being tax efficient.  I'm having a "long think" about whether to revise my personal AA policy to accumulate more munis at the expense of insurance companies.

scottish

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Re: Statistics, personal experience, and risk management
« Reply #5 on: April 15, 2015, 07:37:21 PM »
VTIAX looks good to me.  I believe I'd have to use the ETF version (VXUS) since I'm Canadian.

raptor, are you are selling options?   what are you hedging with these?    And then when you say insurance companies, are you buying common shares, preferred shares, or something else?

Unfortunately for me, municipal bonds aren't tax exempt in Canada.   (As far as I know this is a US thing.)

Dodge

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Re: Statistics, personal experience, and risk management
« Reply #6 on: April 15, 2015, 08:20:24 PM »
The best risk management available, in terms of risk/return, is bonds.  I keep 20% of my portfolio in bonds.  Although the stock market often commands more media attention, the bond market is actually much bigger and is vital to the ongoing operation of the public and private sector:



Don't fall into the trap of convincing yourself to hold less international stocks, because VTSAX companies also sell products internationally.  Those same international stocks also sell products to the US, but does anyone ever make the argument that you aren't truly exposed to the US if you don't own international?  These are all just rationalizations for a home-bias, to keep all your money in the US.

The dozen large companies in NY state are closely linked to both the international economy, and the US economy.  Why shouldn't I just buy them? GE often follows movements in the S&P 500, why not just own one stock?

If Samsung beats Apple in the multi-billion smartphone business, how much will it help me that Apple also sells phones in South Korea?  Why would I want to own Chevy and Ford and skip Honda and Toyota, or BMW and Mercedes, if you could own them all at low cost?

Consider that in international markets you will find...

  • 7 of the 10 largest automobile companies
  • 7 of the 10 largest diversified telecommunications companies
  • 8 of the 10 largest metals and mining companies
  • 6 of the 10 largest electronic equipment and instruments companies
  • 5 of the 10 largest household durables companies

It's nonsense to say that a companies participation in a market, is an excuse to not own all stocks in that market.  I tried to find some correlation between companies with a strong foreign presence, and the performance of the international/domestic market, but was unconvinced.  Looking at Fidelity's Export and Multinational Fund - FEXPX, which invests "primarily in securities of U.S. companies that are expected to benefit from exporting or selling their goods or services outside of the United States."



Let's look at the first three phases:

1.  International greatly underperformed the US, so we would expect the export fund to be pulled down, yet it outgrows domestic.

2.  International drop just about matches the US drop (might have dropped a bit further), yet the export fund is almost flat, not pulled downward.

3.  International greatly outperforms the US, but the export fund is in-line with the US.

In short, you shouldn't make investment decisions, based on expectations like "US company share price with a strong foreign presence will be pulled by economic performance in those countries in the long run." unless you have data showing this effect (if it exists) is strong enough to make an impact on your portfolio.  Do you have this data?

Indexing makes sense globally as much as it makes sense domestically.  Here's an example of what can go wrong during retirement, when you're 80/20 US stocks/US bonds, vs 40/40/20 US Stocks/International Stocks/US Bonds (global market cap portfolio):



In this catastrophe scenario, the USA only portfolio would have dropped to 0, while the 3 fund portfolio would have grown to $920,365 an overall gain of over 30%.  Also, the obligatory 25 year Japan chart:



TL;DR - The best way to manage your risk is by starting with a cap-weighted world stock portfolio, and adding bonds.

Financial.Velociraptor

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Re: Statistics, personal experience, and risk management
« Reply #7 on: April 15, 2015, 08:31:03 PM »
VTIAX looks good to me.  I believe I'd have to use the ETF version (VXUS) since I'm Canadian.

raptor, are you are selling options?   what are you hedging with these?    And then when you say insurance companies, are you buying common shares, preferred shares, or something else?

Unfortunately for me, municipal bonds aren't tax exempt in Canada.   (As far as I know this is a US thing.)

Yes, I *sell* the options.  I collect income up front that is mine to keep, win/lose/draw.  I prefer to write puts on big slow moving blue chips.  That way, if I get assigned, I'm usually only a few percent in the hole and can either take my medicine if there is reason to believe there will be a continued slide, or use various options strategies to claw my way back out.  For insurance companies, it is mostly the common shares (although I've bought preferred before.)  An insurance company with a long history of profitable underwriting is basically investing free money (float) and can outperform the general market even if their float is just in top rated bonds.  It's like a form of leverage with a negative interest rate.

Too bad you can't get a free tax ride on muni bonds.  They are super safe (at least in US) with very low historical default rates (and when Orange County went bankrupt, they ultimately paid back all their bonds anyway; they needed to be able to borrow again the future...) 

Love your James Doohan.  The only red shirt that couldn't be killed.

scottish

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Re: Statistics, personal experience, and risk management
« Reply #8 on: April 16, 2015, 05:30:39 PM »
Dodge, I'm Canadian, so I have a significant amount of CAD investments both in bonds and in stocks.    With the recent decline in the CAD, I'm really glad I had about 30% in US and international investments.   This is a classic example of a risk I could have done a better job of avoiding.  My Canadian holdings haven't gone down in value measured in CAD, but their total purchasing power is down substantially.   This is very much a side effect of recency bias.  The portfolio did ok through 2008 and then grew steadily in 2014 so I seem to have ignored most of my asset allocation rules for the last 5 years.   VTIAX looks like an excellent investment vehicle to use to correct the allocations.

I'm going to have to reread Bernstein's book every 2 years to make sure this doesn't happen again.

Anyone investing in Hong Kong and Asia specifically?   iShares has index funds in these regions.  I've focused on them because of the ongoing economic growth in that part of the world, although i'm a little worried about the impact of corruption or government action.

Raptor, tracking options is too much work for me.   It's an interesting way to get an income stream though.   I considered using them as Taleb suggested in his Anti-fragile book, but after scraping data from Yahoo for about 6 months, I thought the time premiums seemed too big to make it work well.   Unless you see something that's just out of whack and are willing to take a big risk on it.

My avatar - yeah I'm an engineer with a Scottish heritage who loves Star Trek.   It seemed natural.   And Montgomery Scott grows a mustache as he gets older.  :-)

Financial.Velociraptor

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Re: Statistics, personal experience, and risk management
« Reply #9 on: April 16, 2015, 05:37:12 PM »
Scottishstash,

My time doesn't go into researching options.  It goes into researching the underlying companies, which I'd be doing anyway.  So for example, if I think IBM is currently attractive, I look up the premium on a  near the money put.  I can often get 20% annualized, even on big slow moving blue caps I wanted to own anyway.  For really fat premiums, I'll buy a half allocation and write a strangle to play both ends against the middle.  The additional time for the options part of the strategy is negligible.

scottish

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Re: Statistics, personal experience, and risk management
« Reply #10 on: April 16, 2015, 07:41:29 PM »
is it correct that you're making money by assuming the risk on the option?

For example, you could sell a put call on IBM on July 17th at $165 for about $7.25.  If the option is never exercised, you've made $7.25.  If IBM's trading at $170 on July 17th and the option is exercised then you've made $2.25.

Have I got it?   (IBM may not be the best example right now, it's moving around a lot.)

(Edit:  I think I had it backwards.  A put is an option to sell, so if you sell a put option and it's exercised, it means you - as the seller of the option - have to buy the shares from the exerciser.  )
« Last Edit: April 16, 2015, 07:59:23 PM by scottishstash »