Portfolio Management 101

Investment Commentary June 2000
Copyright © 2000 Meyer Capital Management, Inc. All Rights Reserved.

An Evening with Pachelbel
Recently, while waiting for my son John’s middle school strings concert to begin, a neighbor settled into the seat beside me. By way of background, this friend regularly lets me know that he is a do-it-yourself investor because, in his words, "there is no magic to picking stocks." Curiously, this doesn’t prevent him from routinely seeking my investment advice, for free of course.

This particular evening he lamented about how he purchased Procter & Gamble stock only a few months earlier at close to its 52-week high of $118.50/share because it looked like the stock price was breaking out to the upside. He then watched in horror as the price of his newly acquired shares fell dramatically to $55.00/share in only a few weeks. I asked if he was a momentum investor since he based his original purchase decision on a short-term movement in the stock price. "No," he said, "I just figured the price would continue to go up and the stock would split two-for-one." If only the world were so simple.

He went on to tell me how, after P&G’s initial free-fall, he swallowed hard and bought more P&G shares near their recent lows only to have the company announce that earnings would fall short of Wall Street’s expectations again and that it’s President and CEO was stepping down. I asked if he was a technician since technical analysts base their investment decisions on movements in stock prices relative to historical price patterns. "No," he said, "I just figured that the price was so low compared to where it had been just a few days earlier that it had to be a bargain." The expression on his face made it clear that these events had taken an emotional toll on him.

His voice took on a hint of hopefulness as he asked me at what price I thought P&G would end the year 2000. I told him, truthfully, that I had no idea whatsoever. I went on to explain that at MCM we are fundamental investors. That means we base our investment decisions and advice on fundamental variables like sales, earnings growth, profit margins, competitiveness, economics, valuation, etc., not on past or present stock prices. This research provides us with a clear basis for making buy/sell decisions.

My friend looked at me, somewhat incredulously, as if I couldn’t possibly know anything about investing if I wouldn’t make a price prediction on a stock six months into the future. With renewed conviction, he said that he thought P&G’s share price would end the year around $85.00/share, up from its current $55.00/share. I asked him what he based this prediction on. He responded with, "I don’t know, I just think it will."

At last, I understood. He is not a momentum investor or a technician or a fundamentalist. He is a speculator and, as Webster’s Ninth New Collegiate Dictionary indicates, speculators base their investment decision on insufficient evidence and unadulterated hope. The fact that my friend construes this to be investing is, I fear, an all too common mistake among professionals and non-professionals alike.

Portfolio Management 101
I share this story with you because it illustrates the naiveté with which people can approach the capital markets and the very real and painful experiences that often result. Even for those who employ investment professionals to manage their assets, it is necessary to understand something of the "what" and "why" underlying the investment activities undertaken on your behalf, lest you become frustrated and dissatisfied.

Risk Aversion
Investment risk is the probability of losing one’s money. Portfolio management, at least as we practice it at MCM, assumes that our clients are more or less risk averse. This means that given the choice between two investments with equal rates-of-return, you will chose the investment with the lower level of risk. Choosing the other only guarantees a higher probability of losing your money. Evidence that most people are risk averse lies in our purchase of various types of insurance, including life, auto, health, etc. Buying insurance implies that we are willing to pay the current known cost of the insurance premiums to avoid the uncertainty of a potentially large future cost related to a car accident or major illness.

This does not mean that everyone is equally risk averse or that investors are completely risk averse. For example, not everybody buys insurance for everything, either by choice or because they cannot afford it. In addition, some of us buy insurance related to some risks such as auto accidents and illness, but also buy lottery tickets or gamble in Las Vegas where it is known that the expected rates-of-return are negative. The latter point means that we are willing to pay for the excitement of the risk involved and that earning a positive rate-of-return is of secondary concern.

This combination of risk preference and risk aversion can be explained by an attitude toward risk that is not completely risk averse or risk preferring, but is a combination of the two that depends on the amount of money involved. Taking on more risk doesn’t guarantee a higher rate-of-return. It can just be a way to go broke faster. My neighbor was attracted to P&G by what he thought would be an attractive rate-of-return, but since he did not act in a risk averse fashion, he failed to earn a positive return at all. While we recognize these various attitudes, our basic assumption is that MCM clients committing large sums of money to developing investment portfolios are risk averse and expect positive rates-of-return.

Expected Rate of Return
I am often asked, "What can I reasonably expect to make annually on my investment portfolio?" It is a fair question. The short answer for an all-stock portfolio is about 10% annually, which is the historical average rate of return for the entire stock market since its inception decades ago. For example, you could lose 10% one year and make 20% the next. The results are different for balanced and/or fixed income accounts.

The real answer is a little more involved. It begins with the idea of a risk-free rate-of-return. This is nothing more than the pure time value of money (i.e., having $1.00 today is worth more than receiving $1.00 sometime in the future because money has the ability to earn interest). The interest rate paid on short-term US Government Treasury Bills is widely accepted as a proxy for the risk free rate. Since an investor buying treasury securities doesn’t incur any risk, he/she should expect to earn a relatively low rate-of-return. We can see that this is the case today with short-term treasuries paying about 6% interest.

We know, however, that inflation exists in the world and acts to erode the purchasing power of our cash and any investments that pay a fixed rate of interest, like treasury bills. Therefore, many investors require that an inflation premium be added to the risk free rate before we will agree to invest. In doing so, we are compensated for any expected rise in inflation. Failing to do so is irrational.

Some investors will still not be satisfied earning the risk-free rate plus the inflation premium. In order to have a chance to earn even greater investment returns, we are forced to overcome our basic tendency toward risk aversion and expose our hard-earned money to risk of loss. In exchange for taking on this increased risk, we have a right to expect potentially higher returns. This added return potential is called the risk premium. The level of risk involved in each and every investment opportunity we consider determines the amount or size of the risk premium. The risk premium has two main parts:

1. Systematic Risk -- Also called market risk, this is the portion of an individual asset’s price variability attributable to the variability in the total market. In other words, this is simply the risk of being in the market and there is nothing any individual investor or professional investment manager can do to minimize or avoid it. Significantly, this explains why an individual security tends to move up and down with the market regardless of what security it is (i.e., its not a matter of holding the right ones). Market forces impact all securities that, combined, make up the market.
   
2. Non-Systematic Risk -- Also called fundamental risk, this is the portion of an individual asset’s price variability attributable to it’s own unique features, unrelated to total market variability. Non-systematic risk is comprised of the following components:
   
   Business risk – the unpredictability of income due to the nature of the business.
   Financial risk – the uncertainty coming from how the firm finances itself. The more debt the firm takes on, the higher the financial risk.
   Liquidity risk – how easy (or hard) it is for the investor to convert his/her investment to cash, should they so desire.
   Exchange rate risk – factors in the uncertainty relating to currency changes.
   Country risk – political and economic uncertainty within a country.

Therefore,

Total Risk = Systematic Risk + Non-Systematic Risk

and

Expected Rate of Return = Risk-Free Rate + Inflation Premium + Risk Premium

By carefully combining individual securities with different risk/return characteristics into a single portfolio, non-systematic risk can be completely diversified away! That sounds almost too good to be true, doesn’t it? Wow! This is why crafting well-diversified portfolios is the main focus of our daily research and the primary basis for our trading activity. Moreover, it becomes easy to see how a well-diversified portfolio is far more than just a collection of hot stocks whose all-important inter-relationships may not even be known, let alone understood.

The Efficient Portfolio
In the 1950’s and early 1960’s, a man named Harry Markowitz published what has since become the definitive model for optimizing the relationship between investment risk and return. A portfolio that does so is said to be efficient in that no other portfolio of assets offers higher expected return for the same (or lower) risk, or lower risk for the same (or higher) expected return. An efficient portfolio is, by definition, well diversified. Adequate diversification can be achieved with as few as ten to twenty individual stock holdings. Less than that leaves one exposed to nasty surprises like the one suffered by my neighbor. As too many stocks are added to a portfolio, the additional diversification benefit becomes immaterial. The investor would do better to simply buy more shares of his/her existing holdings.

The name of the game then for investors serious about making money is to invest at the point where we can get the most return for a given level of risk or, conversely, the least risk for a given level of return. Where might that point be? It is unique to each individual investor depending on his/her investment objectives and risk tolerance. Hence, the criticality of understanding these aspects of one’s own or client’s psychological makeup.

Know What to Look For In a Money Manager
We are proud of the diligence, rigor, and expertise we bring to client portfolios. Anyone can buy & sell a stock; that does not make them an investor. It’s likely they are only speculating. It concerns us that many falling into this category are professionals within our own industry. Over the past year, thanks largely to your referrals, we have had the opportunity to establish new working relationships with a variety of institutions, families and individuals. Frequently, we begin by correcting damages incurred previously. Unfortunately, important monies have usually been lost by then and people find themselves trapped in undesirable securities by penalties, fees and/or taxes.

At MCM, all clients can talk directly with the individual making the investment decisions for their account. We encourage questions and are happy to explain our thinking and processes. We operate under a full disclosure policy at all times. Nothing is hidden. There are no soft-dollar arrangements, no sales charges and no product commissions of any kind. As a result, we are free of the conflicts of interest that often accompany these practices.

Timothy R. Meyer
President