SpreZZaturian
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Före detta hedgefondförvaltare, partner och VD på Futuris som utsågs till Årtiondets hedgefond i Europa för perioden 2000-2009
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How to build a professional investment portfolio

In this article you will get a beginner’s guide to building your own investment portfolio (4 different methods, including the Quattro Stagioni). But first this:

 

Burying the grand piano

Pianos were all the rage in the early 1900’s. The iconic Steinway & Sons thrived together with hundreds of other piano companies.

You would almost be forgiven for investing your pension in Steinway as part of your BAH, Trend, Quattro or BLSH portfolio strategy (more about these four classes of investment methods last in this article).

Then, quite suddenly actually, recorded music stole their march, and the dying piano company had to use its aging wood inventory for building coffins (!) for war casualties.

Peak piano was reached quickly and early.

Since then the recorded music industry of course has expanded rapidly, and employs many more than ever worked in piano related jobs*. It’s only fitting that the futurologist Ray Kurzweil was responsible for the final nail in the coffin by inventing the piano synthesizer.

(*it’s not every day I use the word “piano related jobs” in a sentence, but when I do it’s glorious)

Peak everything

Malthusians have throughout history predicted peak food, peak wood, peak oil, peak energy, peak jobs and other catastrophic developments associated with the growing global infestation called humanity.

Right now, it’s automation that piques the doomsayers’ interest.

Is it different this time? It might be. Will unemployment rise uncontrollably, or will the advent of increasingly competent machines (as always before) just result in relieving humans of boring, heavy and dangerous work, rather than create an irreversible increase in unemployment?

Could the accelerating speed with which new inventions are made make a difference vs. history? Companies like Amazon and Google, e.g., have replaced labor intensive industries with machines and machine intelligence. Where are those laid off supposed to go? Unless they acquire new sets of skills, probably straight into long term unemployment. It really could be different this time with technology causing massive unemployment (not necessarily a negative development though).

A recent Freakonomics podcast episode elaborated on the death of the middleclass, where clerical and blue collar employees in repetitive jobs risk being replaced by robots and AIs. Only work requiring a responsive and adaptive human touch, both in the low end (massage therapists, dog walkers) and high end (business managers, creative artists, psychologists, physicians, marketing) are safe (for now). The process of automation is speeding up and machines are increasingly crowding out humans from the middle and out.

Note: whatever career path you choose, make sure it’s creative and change resistant, preferably something where you utilize the rapidly evolving technological tools to ride upon into the future, rather than being replaced by them.

How is it different this time?

This article is neither about the death of jobs, nor about the future of technology. It’s not even about the new version (with a disturbing duplopicture of me) of my book The Retarded Hedge Fund Manager (free for newsletter subscribers).

It’s not about asking if various aspects of today are different from similar historic episodes. It’s about asking in which way it is different this time. Not least regarding the economy, money, wealth and in particular the financial markets.

The stock market is different this time

Okay, read-bait, I admit. But still, the market is different, everything is different. The question is only how. More about that later (my next article which I will publish shortly). Here is what is not different: investing.

The principles of investing remain the same as always, i.e. postpone consumption for productive endeavors, as opposed to gambling and speculation (buying things at any price, hoping for luck or a bigger fool). Investment is about value, true intrinsic value that is likely to be realized and compensate for the risk involved. You should approach investments in the stock market and investments in your own business in the same manner.

Four classes of investment methods

These are four of the most common investment methods:

  • Buy And Hold
    • Main local index
    • Global
    • Selective
  • Trend Following
    • Long only
    • Long and Short
  • Quattro Stagioni (recommended)
    • Static
    • Adaptive
  • Buy Low Sell High
    • Long only
    • Long and Short

 Let’s go through the models in more detail below.

Buy And Hold

It couldn’t be more easy: Buy stocks any time and every time. Hold on to the stocks forever. Live off of the dividends and reinvest what you don’t need right now.

Over time (100 years, and most 25 year intervals) BAH has produced real returns of around 6 per cent per year. But remember that even the fantastic cycles of 1994-2003 and 1995-2015 only returned 7% per year (including dividends and adjusted for inflation)

The best things with BAH are:

  • It’s super easy, no maintenance at all
  • The returns are decent, as long as you don’t start investing too late in life and happen to get in near a peak
  • You’ll ride every bubble all the way to the peak, periodically making you feel like a genius

The main drawbacks are:

  • Sometimes the return is negative over 10-20 years
  • You have to stay calm when your portfolio halves in value every now and then, since you’ll ride every crash all the way to the bottom, making you feel exactly like the schmuck you probably are :)
    • (e.g., 2001-2002 and 2007-2009. In addition, before that, a BAH investor had to live through the downturn of 1998, the 1987 overnight crash, not to mention the crashes of the 1970s, which was an era eerily reminiscent of the current period since the year 2000)
  • The last 20 years leading up to your death can be hard to manage – the method has no guidance as to how or when to sell

If you want to try to improve on the model, you could be selective in which stocks to buy and hold, e.g.:

  • You could choose last year’s worst performing stocks and hope they rebound. This is most famously known as Dogs of the Dow, but it can really be the “dogs” of anything.
  • You could choose high growth stocks, e.g. stocks with the highest historical or projected growth rates or measured any other way you like.
  • You could choose particular industries, such as high tech only, media only or pharmaceuticals only or any combination that suits your preferences
  • You could choose your main national index – or some other country, or diversify globally.
  • You could churn your portfolio annually and replace your most expensive stocks with the cheapest stocks, or cheapest markets based on any valuation method or methods you fancy: P/S, EV/EBIT, market cap/GDP, various forms of P/E

In short, with BAH you’ll get low single digit returns over time (typically 2-6% real return per year depending on when you buy and how long you stay invested), while experiencing dizzying doublings, triplings as well as gut wrenching halvings. If you are lucky enough to buy near a trough and eventually sell at a peak, your average returns will of course be much higher.

The coming years any BAH investor should expect the S&P 500 index to dip below the peak level of year 2000, thus producing negative returns over 16-18 years, depending on when the downturn and subsequent recovery occur.

S&P 500 index 1994-2015

Green line: 600 day moving average

Trend Following

Device a trend identifying model (e.g., based on a moving average), calibrate and back test. Consider fees, trading too often on false signals and missing turning points by a mile. Then set your alarms and start trading.

Trend Following takes more work than BAH, at least initially, and it can be stressful when the model doesn’t deliver. In return, a well calibrated model can deliver (much) better than BAH. The hedge fund Lynx within the Brummer group (the same group as my fund Futuris), e.g., has delivered spectacularly well with its trend following models in all conceivable asset classes (stocks, bonds, currencies etc) over the last 15 years.

Look at the chart above and imagine you base your trend discovery and trading on the 600 day moving average for the S&P 500 index. Let’s say you decide to buy when the index breaks through the moving average from below and not just sell but go short when it breaks through from above. After one signal you have to wait one year (1 yr filter to avoid false signals) before trading again and then you buy or sell (or stay put) depending on which side of the MAV the index is by then.

With that extremely simple and non-optimized model you would achieve the same return over 1995-2015 as a buy and hold strategy. However, you would only experience one episode of -32% return, instead of two -50% crashes. With my settings above you unfortunately wouldn’t have caught the current rally until 1400-1450 and if a downturn starts soon you wouldn’t sell higher than around 1750, thus only bagging some 20%-points of the recent 200% rally. On the other hand, if the rally continues you would stay invested.

The best with Trend Following models is that they can produce higher returns with less downside risk than a BAH strategy.

The worst is that it can be difficult to trust one’s models fully. Back testing is not the same as future testing.

Quattro Stagioni

The four seasons model of portfolio building is a simple diversification model. Invest one quarter of your assets in, e.g., respectively stocks, treasuries, corporate bonds and gold. The asset classes can be complemented with real estate, soft commodities or longer shorter maturities for government bonds. Other adaptions include the same as for BAH (local, global, selective industries, laggards [aka dogs], cheap, growth etc.)

Reset the asset weights to 25% once a year or semi annually on fixed dates. Usually 2-3 of the asset classes will perform decently every year and make up for the one(s) lagging.

A more adaptive model, that I strongly advocate, increases the stock weights by 15%-points for every consecutive negative year on the stock market: 25%, 40%, 55% etc all the way up to 100% after five consecutive negative years (at which point you would have zero weight for the other three asset classes). Halve the stock weight after the first up-year but with a floor at 25%.

Another (daring) amendment could be reducing the stock weight by 6% points for every consecutive up-year that returns above 25%. After five such years you would be 5% net short in stocks. Or, set a floor at 0%, prohibiting yourself from going short.

The Quattro model takes a fair bit of work, in particular if you want to control the type of stocks and corp bonds in the portfolio rather than just pick the main index constituents. Perhaps you should avoid too much detailed work that eats into your quality time and might produce negative returns unless you know exactly what you’re doing.

The diversification reduces volatility. Adaptive weights both improves performance and reduces volatility. The Quattro model thus is better than both the BAH and Trend models, in particular on a risk adjusted basis (which also means you could try leveraging up, i.e. using borrowed money to invest more than your actual net worth).

In summary, the Quattro takes some work (as much as you like really), but it’s still simple enough for most. The draw downs are small (no crashes), the stress much less than for trend followers that doubt their own models, and the average return is at least as good as for BAH. This is the model most amateurs should adhere to.

Buy Low Sell High, a.k.a. the bullshit (BLSH) model

It really should be called Buy Cheaply and Sell Expensively, but old habits die hard.

Sounds good? Too good? Anybody calling “bullshit” on buying low and selling high? How do you do it?

Choose an objective valuation parameter (or combine several) for the stock exchange. Consider e.g. Price/Sales, CAPE (cyclically adjusted Price/Earnings ratio) and Market cap/GDP.

Over a century of market data, BLSH has performed consistently and remarkably well, for investments with a full business cycle’s (7-10 years) investment horizon. The returns have been at least as good as for the other three strategies and with much lower volatility and draw downs, thus opening up for using leverage (borrowing to increase the return).

Just make sure you do some serious back testing to identify appropriate trading levels. Decide whether to allow for going net short or not. Set alarms and start trading. 

You probably should combine the pure fundamental valuation signals with trend measures (e.g., uniformity among industries) and other technicals (such as junk bond yields) that could help signal peaks and troughs when valuation already is extreme. Just look at John Hussman’s trouble in the current cycle, where ridiculously high valuations have gone stratospheric, leaving him stranded with a fully hedged portfolio (and me fully short!).

BLSH takes a great deal of work. It’s difficult to set fixed levels for trading signals. It’s difficult to once and for all pin down what is expensive and what is cheap. In addition, extreme valuations can be sustained for years depending on the level of investors’ risk tolerance/aversion. The model performs nominally in line with the other models, but (potentially much) better on a risk adjusted-basis.

The best thing with the model is that it intuitively feels right, and like trueinvesting, to buy things that are priced below their intrinsic value and that thus can be bought and hold indefinitely for a good return. And then sell (even go short) at levels where investor euphoria has driven prices above any reasonable measure of true value.

The next best thing is that the returns will be less volatile than BAH and thus allow for leverage (or simply sleeping tight)

The worst thing is that it requires real work (as all real investing does). Buying low and selling high can be made just as complicated as you like.

In addition you will miss riding bubbles to their peaks, thus making you look stupid in the final years of every mania.

The last 20 years of bubble blowing, and in particular the last 6 years, have given the BLSH a bad rep, whereas BAH has gotten the upper hand. Since I think both models will continue to hold up over time, it’s time for the tables to turn now, and let BLSH catch up to BAH the coming decade or so.

I personally prefer to use the BLSH model as a guidance for entire stock markets (right now it’s screaming SELL for the S&P 500) and short or stay neutral the market in the down phase.

Once markets are reasonably valued or getting cheap, I’ll start accumulating individual stocks, that I like and know particularly well, and stick to them until my market model signals SELL again (mainly based on big picture variables such as market wide P/S, complemented with risk aversion signals in the bond market and narrowing advance/decline ratios in the stock market).

In addition, I complement my stock portfolio in a Quattro Stagion-like fashion with gold and commodities, fixed income (lending to individuals and companies, buying convertibles etc.) as well as counting my living quarters as a real estate investment.

When to choose which model

  • If you are lazy but calm and composed, go for Buy and Hold.
  • If you are a little more easily stressed, and willing to do a minimum of work, go for the Quattro Stagioni.
  • If you are somewhat more industrious, first check if the market is extremely expensive. Wait if that’s the case. Once it’s less extreme, start buying and holding. If you’re a Quattro guy, just adjust the stock weight appropriately – perhaps to 13-19% currently instead of 25%.
  • The next level, no matter if you started out with BAH or Quattro, is to keep a lookout for when the market is becoming extremely highly valued (like now). Then sell your holdings and wait for more reasonable times. That, however, takes constant surveillance – at least annual check points.
  • If you like to gamble and think you might be able to improve on billions of dollars’ worth of trend research, try your own trend following models. It’ll probably work like a charm for a while. And then you’ll go broke. Good luck.
  • If you’re really into investing and not easily stressed go for BLSH; stocks only.

I‘m somewhere between the Quattro and the BLSH type of investor.

A note on switching models:

If you have two models, like BAH (Buy and Hold) and BLSH that have both performed more or less equally well over a hundred years of investing, then you should switch from the one that has outperformed in the most recent 5-10 year period to the one that has underperformed. Well, unless you think the table really has turned and that it is fully different this time and going forward.

The last 2-3 years, BLSH has performed poorly, while BAH has been a spectacular success. Some might get an urge to switch from the lagging BLSH to the better performing BAH. That would, however, probably end in tears, as the BLSH is bound to catch up with BAH over the coming years, unless a hundred years of investing information suddenly has become worthless.

State of play – summary

I would advice against trying trend following. You’re up against mighty opponents and it has nothing to do with actual investing. It’s pure speculation.

Do go for buy and hold, but be prepared for 10 years of no or negative returns first (with a couple of halvings in between), before you start getting any rewards for your risk.

The market is currently more expensive than it has ever been (on some important measures for the median stock – more about that in my next article). That is not a good time to start investing in stocks.

I would thus recommend building a Quattro Stagioni inspired portfolio of gold and safe corporate bonds and keep money in the bank, money market or short term treasuries. Given 6-7 years of consecutive bull years, I would keep the stock component to a minimum (rather than the standard 25% weight) until we see a significant correction (at least -25% from the peak). Personally I’m short the stock market now, but that’s not for everyone.

When the stock market is more reasonably valued on a P/S or market cap/GDP basis, and some market technicals turn more positive (dispersion, advance/decline, junk bonds), I would increase the stock weight to 25% (normal Quattro).

Since I am a stock guy at heart, if stocks fall deeply for 2-3 years, similarly to the troughs of 2003 and 2009, I’ll go 100% long in stocks only, going full retard BLSH until markets look expensive again, where I’ll switch to a Quattro strategy.

What do you do now?

There it is, four (three) time tested investment models, but really all boiling down to the Quattro Stagioni  – perhaps complemented with the Rothschild advice of buying (more) when there’s blood in the streets. See any revolutions on the horizon?

And right now? Buy gold, keep cash, perhaps try buying some oil (I don’t have any right now, March 15, 2015), but stay away from U.S. stocks in general (unless you have some special, unloved, single stocks the market has forgotten about).

Wait. Study. Pounce (next year perhaps – stay tuned by subscribing to my newsletter if you want to make sure to get a note when I start buying stocks again).

Disclaimer: Nothing above constitutes any kind of recommendation to buy or sell financial instruments or engage in any kind of investing behavior

P.S. This article was originally written and published March 14, 2015, which makes certain date-related comments nonsensical.

Taggar (blogg): 
Bluewater's picture
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Bluewater

Fantastikt intressant och lärorikt inlägg! För mig ser det ut som den aktiva varianten av Quattro Stagione framöver är rätt strategi. Aktiedelen är nu mycket liten och jag söker som många trygg avkastning. Någon tanke hur tänka här?

SpreZZaturian's picture
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SpreZZaturian

Aktiv quattro låter bra. Den trygga minimala aktiedelen bör bestå av någonting som 1) gör vinst 2) har kassaflöde 3) inte baseras på hype & hope 4) inte har en uppblåst värdering. Vilka dessa aktier är undrar jag också i dagsläget... Det finns i vilket fall inte särskilt många av dem.

Bluewater's picture
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Bluewater

Tack för svar!

Du har rätt att det inte är lätt att hitta till nuvarande värderingar. Har idag lite långsiktiga värdebolag som i och för sig var dyra.Gällande framtiden på Aktiedelen tänkte jag ev. fylla på med en del billiga indexfonder och investmentbolag när priset på aktier faller, allt för att göra det lite enkelt för mig, om jag tvekar på min egen analysförmåga ;-)

Den fundering jag hade var med vad jag skulle kunna fylla på med när det gäller bonds? Ligger så tungt i kassa just nu.

Ser du kanske att Hedgefonder kan spela en övergångsroll i väntan på sättning i aktievärderingarna, och vad kan då vara ett lämpligt val? har idag en del Brummer Multi Strategy med belåning.

Ta en fin helg!

 

SpreZZaturian's picture
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SpreZZaturian

Jag tycker BMS 2xL är en bra defaultstrategi om man inte har bättre idéer och inte vill lägga någon tid på efterforskningar för tillfället. Den är förstås inte bombsäker, men konstruktionen är bra.

Bluewater's picture
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Bluewater

Tack för att du tar dig tid att svara och coachande råd. Läste i eftermiddags din bok. Något för fler att läsa! Ja, nu vet jag mer om resan med er Hedgefond och att den var en del av Brummer. Ser fram mot dina vidare blogginlägg och nyhetsbrev!

guld och gröna skogar's picture
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guld och gröna ...

Tack SpreZZaturian för att du delar med dig av din kunskap och din filosofi! Du gör verkligen mig en stor tjänst.

Själv är jag 80% likvid och 20% kort OMXS via Nordeas produkt "Blanka OMXS N"

Hard Made Easy  - true story!

SpreZZaturian's picture
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SpreZZaturian

Kul att höra. Jag tror att du kommer få så grymt mycket bättre ingångsvärden på börsen om 1-2 år, så jag tror att du gör helt rätt.

 

Sen ska man inte glömma att det kan finnas stora pengar att göra på att våga specka på studsarna på vägen ner. De kommer bli många och ofta över 15% på indexnivå.

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