Below I have listed the 2008 returns for the iShares corresponding with various asset classes. These are not total returns. They do not include dividends and/or interest. First, I have organized the data by asset class and later a sort of all returns from best to worst.

Although commodities were strong performers until the middle of 2008, they ended the year as one of the worst performers. In fact GSG declined 63% from its July peak to the 2008 close.

In the pursuit of balanced and diverse portfolios, it looks like treasuries are an obvious sell at the beginning of 2009. From a mechanical rebalancing stance, it is likely that they have become materially overweight. From a subjective stance, with 10 year treasuries yielding 2.24%, 5 years at 1.55%, 13 weeks at 1.15%, how much lower can yields go? Correspondingly, how much higher will treasury prices go?

The proceeds from treasuries, strictly, should be destined for domestic and foreign equity. Real estate, after two consecutive years of poor performance, calls out for increased investment. However, from a tactical or subjective vantage point, it appears commercial real estate is about to experience a terrible period fundamentally.

Investors that are strictly disciplined about rebalancing will sell treasuries and invest the proceeds in equity, real estate, and commodities. They will also be buying high-yield bonds if their portfolio includes that asset class. For those that are primarily strategic and disciplined but make rare tactical sales when allocations deviate dramatically from target allocations, they might sell treasuries and keep the proceeds in cash until the fundamentals of the other asset classes appear to stabilize or until their formal rebalance date. The purely tactical investor should simply note the degree of the 2008 declines in consideration of valuation and fundamentals to form weighting decisions for 2009.

In a recent discussion on the current fear and anxiety plaguing the financial markets, Lawrence Raifman, behavioral finance observer at Johns Hopkins University, considered the investor’s tendency to irrationally over-react in volatile times.  Raifman takes a look at the current market situation through the behavioral lens of investing, pointing to the common failure for investors “to adjust their appetites for risk until it is too late, getting swept up in flight to safety, either by abruptly selling their stock or failing to buy.”

The behavior Raifman is describing is not exactly a new concept.  There’s a long documented history over the past century of changing market conditions that illustrate a similar pattern.  A strong market will breed excessive risk taking in a portfolio like a mass crowd gathering around a hot Vegas craps table. The inevitable market correction that follows always results in the same investor response: massive risk reduction and a moratorium on buying new stocks until the market conditions appear to become more stabilized.

When asked for reasoning about the long history of over-reactions, Raifman describes a tendency for people to “rely upon simple rules of thumb known as heuristics when making decisions.”  Heuristics are the mental shortcuts we take to save time and effort in decision making.  They might prove to be economical in time management, but they are often illogical, full of bias, and lack rational analyses for reaching an optimal decision.  There’s a vast range of heuristic examples in investor behavior but a few common ones are provided below:

Availability Bias- describes a tendency for only the most vivid or recent information to be available in our memory when making a decision and does not include a complete set of data.

Loss Aversion- a propensity for people to view gains and losses differently.  The result is the negative effect of losses having a much greater impact on the investor than the positive effect of gains.

Status Quo Bias- a cognitive bias for preferring things to stay relatively the same and be averse to drastic changes in market performance (either good or bad).

Anchoring- basing decisions on an irrelevant stock price. The result is that a particular stock price becomes “locked in” mentally and serves as the basis for all future decisions to buy and sell.

Self Serving Bias - Occurs when people are less likely to claim responsibility for successes than failures and in turn will seek out external causes for their poor performance.

Gambler’s Fallacy- When an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.

Avoiding heuristics is no small feat for the investor and their presence in our investment decision making is certainly an ongoing battle.  That said, a good place to begin in combating the heuristic mindset is with a firm understanding of your risk tolerance.  As we move towards outlining a proper framework for defining one’s risk tolerance we’ll continue to bring these heuristics (and others unnamed) into the picture and discuss ways to evade slipping into their common pattern.

Clay Shirky, author, professor and media & technology enthusiast, recently posted a graphic on Boingboing visualizing where 2008 YTD S&P returns fall in historical context.  His conclusion: the distribution of S&P returns is “a rough bell curve, with 45 of those 185 years [between 1825 to 2008] falling in the +0-10% column.  There are only 5 years each in the 40-50% and 50-60% return columns, and through 2007, there were only one year each in the -31-40% and -41-50% columns.”

One can see from the graphic that 2008 (unless it recovers some of its losses in the last few weeks) will be a 3 standard deviation move from expected, qualifying it as a fat tailed event.

Given the magnitude of the move we’ve seen this year, if history provides any indication, it might not be prudent to take your money out of the market just yet.  In the 8 years that the market loss more than 30%, 6 out of 8 times (or 75%), the market was positive the following year, with gains of 30% or more occurring 2/3 of the time.  There was just one year (1930) that experienced two consecutive down years.

Note: we did a similar analysis of historical daily returns for MSFT, illustrating how close its probability distribution comes to normal.

In addition to the plethora of negative market news, economic statistics, and revised outlooks for 2009, there has been a lot of discussion on the high levels of volatility in the market since the credit crises went into overdrive this past September. I know most people are aware it’s volatile, but a little context might help us understand by just how much. Taking a quick look at VIX shows a pretty graphic image.

The CBOE Volatility Index (VIX) is based on ‘implied volatility’ of the underlying market and is calculated by using prices at which options are trading. Corresponding directly to a percentage of volatility, the higher the index number, the more volatile the market is expected to be for the coming 30 days. When the VIX is at 30, that tells us the S&P 500 might move as much as 2.5% (30% divided by 12 months) up or down over the next 30 days.

Historically (since 1990), the VIX has an average around 19 (think up or down around 1.6% for the coming month). Since October 1, the VIX has averaged 67 (think up or down around a whopping 5.6% for the month) and has even closed above 80 on two separate occasions (October 27th and November 20th). At a rate nearly 3.5x its historical average, that’s high volatility in the purest sense of the term (see chart below for VIX Year to Date). This is a clear indicator to us that the market is rampant with fear, full of uncertainty, and the risk associated with making investing decisions in the short term is extremely high.

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Back in grad school, I took an Investments class with professor Sanjay Unni, a director at LECG (and whom is now an informal advisor to the company).  I remember in his very first class, he put up a couple slides that really helped visualize the insight we can gain from a stock’s historical daily stock returns.  Some of the content in his slides is reproduced below.

One of the biggest challenges we face as investors is that the future returns of most assets are unpredictable or random.  Take a look, for example, at MSFT’s daily historical returns over an 8 year period between 2000 and 2008.

Although seemingly random, the returns on MSFT (as with all stocks) are governed by certain patterns of probability, which are described by their probability distributions.

The probability distribution of a stock’s return can tell us:

• the range within which the stock’s return can fall.
• the probability of each possible return within this range.

Click the image below to see the complete transformation.

According to the Wall St. Journal, the Harvard Endowment gained an impressive 7-9% in fiscal 2008, beating out all endowments and foundations in a difficult down market.  This is no small feat considering the S&P 500 lost more than 10% over the same period.

Much of Harvard’s performance can be attributed to the fund’s big bet on commodities at the beginning of the year (17% of the portfolio), which outperformed all other sectors and asset classes. As the table below indicates, over the past years, Harvard Management Co. (HMC) has moved away from US stocks and bonds and toward alternatives investments including commodities, hedge funds and private equity investments.

Source: Harvard Management Co. (click to enlarge)

What can individual investors learn from Harvard?

While it doesn’t hurt to have a $35 billion portfolio behind you to gain access to all of the top hedge fund and private equity managers, selecting the right managers (or stocks) is only one piece of the puzzle.  In fact, Harvard attributes much of its past and current success to having a disciplined investment process to implement the right asset allocation:

Each year, HMC’s Board of Directors and management team determine an appropriate “neutral” allocation of Harvard’s capital across various markets given the University’s desired return target and risk tolerance (it reviews the risk/return prospects for individual asset classes and their likely correlations)… Once the neutral allocation guidelines are determined, HMC’s management is charged with the selection of appropriate implementation vehicles.  Both internal and external vehicles are used to optimally deploy capital across all asset classes.  This active use of specific investment strategies is aimed at delivering value over and above what can be realized by investing in a passive portfolio…HMC’s risk mitigating measures include the use of risk limits as they pertain to investment strategies, single names, and managers; assessment of correlations across investment strategies, managers and asset classes…”

Similarly, individual investors could benefit from having a more structured approach to asset allocation and portfolio management.  This includes evaluating expected returns, volatilities, and correlations among all of the asset classes available to them.  Asset classes can range from different sectors/industries (e.g., energy, technology, retail, etc), to more traditional categorizations such as stocks, bonds, and real estate.

Harvard’s performance results indicate that active investing can pay off.  Take a look at Harvard’s asset class performance against its benchmarks over the past 10 years, and you’ll see that HMC has managed to consistently outperform all of its benchmarks.

Source: Harvard Management Co. (click to enlarge)

How to construct a Harvard Portfolio

Given the expanding universe of publicly-traded securities that track industry sectors, geographies, and indices, average individual investors could have replicated the Harvard Endowment portfolio using a combination of stocks, index funds, and ETF’s for the respective asset classes.

Determining how much to allocate to each sector would require making estimates about return, volatility, and correlation among asset classes and plugging these numbers into an optimizer.  Granted, Harvard may be better than most in choosing the right inputs that go into their models, but they also have the guts to overweight certain areas where they have strong conviction.  For an institutional investor of that size ($35 billion), that is impressive.

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“People in crowds behave just like sheep…by blindly following one or two people who seem to know where they are going.”

- Telegraph.co.uk/

Sheep don’t always make good investments.

Many average investors think they can beat the pros. While it’s true technology and the Internet have helped level the information and resource edge professional investors used to have over others, average investors still have a ways to go to catch up – especially in their approach and the way they think about investing. Having evaluated hundreds of professional money managers, I’ve noticed some subtle but important differences that separate the pros from everyone else. Here’s what we can learn from them.

1) Adopt a portfolio approach

One of the common mistakes average investors make is to place too much emphasis on individual stock selection (i.e., picking which stock) and not enough on portfolio management (e.g., understanding how that stock interacts with other positions in their portfolio). Unless you have better information than the rest of us and/or have the ability to consistently identify mispriced stocks, you’re better off behaving more like a portfolio manager than an investment analyst. That means identifying and selecting stocks or sectors you believe will have high expected returns and low correlation with the other stocks in your portfolio.

2) Appreciate the role of uncertainty

Many average investors tend to be overconfident or under the illusion they have more control over the outcomes of events than they really do, when in reality, there’s an element of chance that plays a huge role in investing. Overconfident investors can learn from professional poker players by adopting a probabilistic frame of mind when investing. The savviest investors, much like the best poker players, know not only know when to bet big and when to get out, but also accept that despite making the right play, sometimes the cards don’t get always play out in their favor. Once in a while, you are going to get that bad beat on the river. The important thing, however, is to keep your head in the game and stick to your strategy – unless, of course, there’s something wrong with it. The trick is being able to tell the difference between a flawed game plan and just bad luck.

3) Always watch your downside

Given the large role that uncertainty plays, investors should spend more time focusing on risk control. In Jack Schwager’s book, “Market Wizards”, Steve Cohen, manager of SAC Capital said “containing your losses is 90% of the battle”. While Cohen is generally regarded as a short term trader, the same philosophy can be applied to long-term investors as well. Investors should constantly verify that the reasons for their investing in a stock are still very much in tact. If not, it’s time to get out. Many of the successful fund managers I have met employ a rigorous set of risk controls that includes cutting or reducing their losses after certain losses have been breached. For example, a 10% loss in a position may trigger a flag, at which point the position is reevaluated. Cutting your losses early is an important way to avoid large potential losses down the road.

4) Play to your edge

People are wired differently. Some people have a better feel for market timing, are able to identify when positions are over and under bought, and operate coolly under pressure. Others are better at identifying long term secular trends, where market timing plays less of a factor. Investors need to be aware of their strengths and weaknesses and play to their edge. A prime example of an investor who trades his edge is an energy and commodity hedge fund manager I once met. This guy was a quirky (but brilliant investor) who spent a lot of his time analyzing oil and gas production reports and building forecast demand models, and even scheduled vacations to Mexico and Saudi Arabia so that could visit oil and gas fields. The amount of detail he went into was even beyond than that of the average fund manager. But it was easy for him to dig into that level of detail because that was how he was wired. That’s what made him one of the best in his business. In contrast, I once met with a commodity hedge fund that had a large-scale presence throughout dozens of countries around the world. Through their network of local on-the-ground professionals, they had built an information edge that was difficult to replicate and took advantage of it. Understand your edge and play to it.

5) Recognize patterns and cycles

As the saying goes, the more things change, the more they stay the same. In our financial system, it seems the same story seems to play out over and over again despite claims that “this time will be different”. Hyman Minsky (1919-1996) proposed a theory for why business cycles and market crashes occur. While the financial instruments have changed (e.g., Junk bonds in the 80’s, Internet stocks in the late 90’s, and more recently, subprime MBS/CDO’s, our capacity to abuse them hasn’t. Savvy investors often recognize the earliest signs of such cyclical patterns and position themselves to profit from the opportunities created by them. For example, in 2002, professional investors that recognized they had just passed the inflection point of a cyclical credit downturn were able to pick up low-risk distressed assets at bargain prices and subsequently were able to earn significant profits as the market recovered. Those same distressed investors have been waiting for years like an opportunity like our current credit environment to materialize.

6) Don’t be afraid to go against the consensus

It’s no surprise the largest investment gains usually come when you bet against a prevailing trend and happen to be right. Eddie Lampert started buying up K-Mart debt while it was in Chapter 11 and even doubled down as creditors fled. His bet earned him a $1 billion payday in 2004, making him the first hedge fund manager to earn a billion in a single year. John Paulson was shorting subprime-backed securities years before the crash, earning him close to $4 billion last year. George Soros, who has a history of making contrarian bets, began picking up silver back in 1994 and began shorting the dollar in early 2000 when it was still rather strong. As you’re probably aware, those bets paid off enormously. The best investors tend to be innovators, not followers. Superior performance requires not only picking the right stock or trend but also having the balls to bet big.

7) Try to avoid fads

The savviest investors tend to be cynical people. After all, they’ve learned to be skeptical and to find reasons why an investment won’t work. They question assumptions and constantly search for instances where the consensus is wrong. Savvy investors also avoid “fad stocks” – the type of stocks the masses generally gravitate to because they have a good story behind it. When I first started out at a hedge fund, my boss raised an eyebrow when I recommended Taser (TASR) as a buy. In so many words, he told me that owning TASR is playing Russian roulette – you never know when it’ll blow up in your face. Growth companies like TASR or CROX that make for salient stories and are in the public limelight, are much more difficult to value and hence, more prone to unreasonably lofty valuations because of increased investor interest. These valuations can also plummet without warning on an unfavorable rumor, news, or even whim. If you decide to invest in fad stocks you need to be willing to accept the risk that you might to be the last one holding the bag. Many savvy investors aren’t in the business of playing Russian roulette and generally avoid these types of investments.