AI & Asset Allocation, Part 3

Third part of an opinion in three parts

Part 1  |  Part 2  |  Part 3  |  Appendix 1  |  Appendix 2  >

image: Fischchen, Breeding Ostrich (May 2007, shared per license)
In Part 1, we considered and opined about:
1. The strenuous life of the beach investor.
2. Artificial intelligence (AI).
3. The appearance of low risk with investments in cash and bonds.

In Part 2, we considered and opined about:
1. Using some of your investment portfolio for investing in cash and bonds.
2. Getting higher rewards by taking risks with investment in stocks.
3. Managing increased risks through diversified stock investments.
4. Managing increased risks through broadly diversified stock index ETFs.
5. Getting higher rewards with broadly diversified growth stock index ETFs.
6. Offsetting personal medical expenses with health-and-pharma sector funds.
7. Metrics for choosing among broad stock index funds.

In this article, Part 3, we will take a close look at making small bets in individual stocks and sector ETFs. Appendix 1 considers another view, investing in actively managed funds. Appendix 2 discusses definitions and formulas for some terms and calculations.

On Placing Small Bets

There are no sure things in sector funds and individual stocks. You MUST be ready to accept some significant (perhaps total) permanent losses on some or many of your choices when you invest in sector funds or individual stocks, for the sake of making extraordinary profits on a few. If you can't do that, then go back to the paragraph on “Sensibility and Prudence”  in Part 2, and choose the 100% solution. By investing in broadly diversified stock index ETFs, you use diversification of holdings to reduce the risk you bear. You avoiding putting all your eggs in one basket. When you buy a S&P500 index ETF, you put your eggs in 500 baskets.

The investor in sector funds and individual stocks makes many small investments so that lightning has many chances to strike somewhere in the portfolio of holdings, and there ignite the next Microsoft or Google or Netflix or Facebook. But most of these hoped-for bolts of lightning never strike, so you want keep your losses small by keeping the initial investment small.

Be skeptical. Don’t rely on “sure things”. Jettison your vanity, and think small. Invest on the order of $1000, $2000, $5000, $10000, definitely no more than 1% of your portfolio in any one stock or sector ETF, and 1% seems too much to me. Smaller is better.

If you rely on your intuition, or reading about hot stocks in the news, or unverified information you heard from a friend, then you won’t find a better motto than “Smaller is Better”, and you should keep your maximum cash investment in any individual stock or sector ETF to $1,000. If you intend to make larger investments in individual stocks or sector ETFs, then to outperform the index ETFs, you MUST read a lot of detail, have some understanding of basic financial statements and their line items, do some calculations, and have the ability and willingness to seek and find information you don’t already have. If you can’t or won’t do these, then save your money, go back to Part 2, forget about individual stocks and sector ETFs, put your money in broad stock index funds and go back to the beach (see Part 1).

You might wonder “How small is too small?” Two disincentives push against smaller holdings. First, the broker’s commission should be small enough to ignore. In days of yore, we would allow 2.5% for the commission. In our modern enlightened era, you can easily find reliable brokers that charge less than $5 per trade. If you pay much more than $5, then change brokers. If your trades are $1000 or more in size, then the commission will be less than 0.5%. You can generally ignore that level of commission, because the price of almost any stock can unsurprisingly vary more than 0.5% in one trading day, making the commission a relatively insigniicant cost for the long term investor on the beach. So keep your buy orders to $1000 or more.

A platoon of assistants
(The Denmark Staff, 1914, Wikimedia, shared per license)
Second, small sizes of investments can, with time, produce a portfolio holding many different stocks. If you have a platoon of assistants, you can instruct them to attend to portfolio operations. But if you manage your portfolio between dips in the sea (see Part 1), then personnel management may crowd your schedule uncomfortably. Then, someday, while doing an end-of-quarter review, you find a stock or fund in your portfolio that you didn’t know you had. This implies either that some other person trades in your account, or more likely that you forgot about it and your chosen investment size is too small. If you are trading $1000, then switch to perhaps $5000 or $10,000. If you are trading $10,000, switch to $50,000 or $100,000, but always an amount well less than 1% of your portfolio.

Sector funds

Sector funds specialize in particular industries. Look for index funds intended to track the performance of all, or of the largest, companies in the industry. Beware of arcanely contrived indexes, synthetic strategies, and leveraged indexes unless you lust for risk injected directly into your central nervous system. Play it safe. Look for long-established indexes managed by long-established firms, including but not limited to MSCI, S&P Dow-Jones and FTSE Russell.

Telecom, Petroleum, Robotics, Biotech and other fairly indexed sector funds can grow less quickly in value than individual stocks, but since the many individual stocks held in these funds will offset the ups and downs of each other, the fund will fluctuate more moderately. While an individual stock can lose nearly all its value in a few months, the fund will probably take decades to decay to oblivion, if it comes to that.

For choosing sector index funds, I have found these metrics relevant:

1. 10-yr price growth (ignore younger funds, prefer more rapid growth, positively correlated),
2. Rate of dividends per share (negatively correlated, a low number is better, as in golf),
3. Beta  (negatively correlated, a low number is better, as in golf),
4. Book value divided by price (negatively correlated, a low number is better, as in golf).

Individual stocks

If investing in stocks bores you, or if you seek certainty, or if you fear losing money more than you look forward to gain, or if you perceive mere randomness governing choices in the madhouse which is the stock exchange, or if it takes more time than you want to spend on it, or if you expect that what you might choose likely won’t beat the S&P500, then stay away from investing in individual stocks.

There are good people who will treat you well, and they are honest, phronetic, well-intentioned, knowledgeable and fair-dealing traders in the market for individual stocks. And you will also find troublesome people, charlatans, hucksters, rogues, chislers, persons with conflicts of interest, ignorant persons, incompetents and the well-intentioned misguided. Think, judge and choose. Seek and work with the good people and abandon the others.

The stock market is where, if you put all your money in one investment, then you can lose all your money. This is the school of hard knocks for people who have more money than they want to spend for the next few years. This is the land of opportunity that can produce millionaires from people who make serendipitous choices. This is the arena in which you see all kinds of ugly and beautiful, wild and crazy, useless and fabulously enriching stuff. This is the midway where you can invest in stodgy insurance companies, or skyrocketing disruptive high tech, or old reliable industrial giants, or lithium mines in Chile, or a breakthrough in next-generation atomic fusion electricity, or small companies currently managed by the third generation of the family that produce profit year after year, or brilliant business models that will turn profitable any day now, or companies that never earned a profit or sold one unit of product, or the next Microsoft.

You won’t be able to choose with certainty, so cast your net widely, and keep your losses small. See "On Placing Small Bets", above.

For choosing individual stocks, I have found these metrics and practices relevant:

1. Ignore any company that reported a loss (negative net income available to common stock including extraordinary items) in any of the last five fiscal years reported in their latest annual report, a publicly available document. (If your broker doesn’t offer this information on their website, then get another broker, seriously.) If you are eager to invest in companies that have lost money in recent years, then expect that you will lose on most of these bets, and keep the amount of your investment utterly minimal.
2. Price change between Oct 9, 2007 and Mar 9, 2009 (ignoring stocks too young to measure, prefer higher growth and less decline, positively correlated).
3. 10-yr growth of price, credibility weighted, giving more credibility to all-stocks average versus specific stock observation for stocks younger than 10 years (prefer higher rates of growth, positively correlated). If you don’t know how to do the credibility calculation, then use the 10-year growth of price, ignoring stocks younger than 10 years.
4. 10-yr growth of price, ignoring stocks younger than 10 years (prefer higher rates of growth, positively correlated).
5. Number of years during the last 5 that the annually reported revenue has increased from the prior year, using the 5 most recently reported years, and ignoring stocks for which you can't find reliable numbers for all 5 years. You will find, at most, 4 increases (a perfect score) in 5 years. (positively correlated).

On Selling

Trim your holdings once every year or two so that no one stock or sector fund is more than 25% of all the individual stocks and sector funds you own. When any one stock or sector fund is more than 25% in value of your stocks-and-sector portfolio (the stocks-and-sector portfolio is all the individual stocks and sector funds you own) then it is too much. Sell it (trade it for cash) down to 10% of all your stocks-and-sector portfolio, and trade the cash for something else.

Otherwise, sell the stocks and sector funds that have lost the most value, but only when metering out steady income in your old age, when paying unusually large medical bills, or when buying a house to live in.

If there is a stock market crash, don't sell. The broadly diversified portfolio, historically, usually recovered fully within two years, rarely more. People who tried to sell to avoid further loss were usually too late or too early. Those who tried to buy just before the upturn were usually too early or too late. Those who tried to time their trades for just the right moments seldom became richer for the experience than those who just held on.

Before investing in individual stocks, re-read the "Sensibility and Prudence" paragraph in Part 2.

Concluding remarks

Almost all investments in our modern era involve the use of computers. Some of the calculations and algorithms might be called AI. Whether it’s AI or not, it helps to have some idea of what services it provides you, and you should definitely seek some understanding of pertinent risks and rewards before investing your money in any bonds or stocks. We think of cash as an investment of low risk, because the price never changes. A dollar is worth one dollar.  A euro is worth one euro. However, cash has no promise of big earnings or investment returns. We think of bonds backed by governments or large, well-managed companies as having little risk, especially when we buy many different bonds aggregated in broadly diversified index ETFs or funds. Generally the bond funds have better return than cash, but bonds fall in value when interest rates rise. We expect that broadly diversified stock index funds will have much larger returns than bond funds in the long (5+ years) run. We also expect the risk of wider fluctuations in price with stocks and stock funds. Sector funds invest in stocks of particular industries. They fluctuate more widely than the broadly-diversified index funds, so we call them riskier, and they can provide bigger returns in the long run. Individual stocks can produce thunderously wonderful returns in the long run, but at risk of partial or total loss. With individual stocks, seek to keep your losses small by never putting more than 1%, at most, of your portfolio (all the stocks, bonds, ETFs, mutual funds, and cash you own) into any one stock. With individual stocks, you give good fortune a chance to visit your portfolio and greatly increase your wealth. If your investments are so risky that you can’t sleep at night, then sell off enough of your riskier holdings so that you can sleep easily. 

Full Disclosure

I own shares of Alphabet (Google, GOOGL), Netflix (NFLX), and Facebook (FB).

Part 1  |  Part 2  |  Part 3  |  Appendix 1  |  Appendix 2  >

Images and Sources

See Part 1.

Michigan, USA, Aug 2019
Image: Daniel Brockman, Public Domain.

AI & Asset Allocation, Appendix 1

History is opaque. You see what comes out, not the script that produces events.
-- Nassim Taleb, "The Black Swan" 2008

Part 1  |  Part 2  |  Part 3  |  Appendix 1  |  Appendix 2  >

A Selection of Actively Managed Funds

Image: Belfius, Scales
(2012, shared per license)
Mr. Rock Brockman, ChFC, CLU, principal of WHB Financial Advisors of Rockville, Maryland, on reading Parts 1 and 2, wrote to me identifying seven mutual funds, with their performance measures, that outperformed the S&P500 over the last 40 years. These are “actively managed” funds, in which the manager chooses investments according to some method that depends on her own principles of good investments. They aren't “passively managed” funds based on an index the manager seeks to match. (Those funds we have discussed in Parts 1, 2 and 3 of this article are “passively managed” funds, for which the method can be duplicated.)

This table shows seven funds that have, from 1976 to 2019, increased in value more than the S&P500. The table shows the cumulative growth of a $10,000 investment, assuming reinvestment of dividends. Mr. Rock Brockman provided these figures from sources he believes to be accurate. (VFINX, a S&P500 index fund, is shown for comparison).

Fidelity Magellan
American Funds Growth Fund
T. Rowe Price New Horizons
Fidelity Contrafund
American Funds
Dodge & Cox Stock
Davis NY Venture
Vanguard 500 Index Investor

No one can assure that these funds will perform similarly in the future.

Part 1  |  Part 2  |  Part 3  |  Appendix 1  |  Appendix 2  >


See Part 1.

Image: Daniel Brockman, Public Domain

AI & Asset Allocation, Appendix 2

"... when you can measure what you are speaking about, and express it in numbers, you know something about it;" 
-- Lord Kelvin, 1883

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Guide to Terms and Calculations

Lord Kelvin 1824-1907
Image: Messrs. Dickinson
London, New Bond Street
Here we have an extremely brief look at some arcane but useful terms and simplified useful techniques, and a little guidance toward more information for readers interested in further investigation. Generally, the research pages of your broker’s website are the easiest place to find this information (except what you must calculate yourself). You can readily find most or all of these terms and calculations using your favorite search engine or reading about them in Wikipedia.org.

Find explanations of some additional terms in Part 2.
For additional readings, see the sources list in Part 1.

Assets: All the company’s money, amounts loaned to or invested in others, property, supplies and materials on hand, funds set aside to pay future employee benefits, tax refunds expected but not yet received, and amounts billed to customers but not yet paid.

Bond: A debt owed by a company or government and divided into many uniform shares called “bonds”, having a maturity value (a.k.a. face value) to be paid at a future “maturity” date. Most bonds pay interest, a stated percent of maturity value, though some pay no interest. Some bonds are traded on securities exchanges.

Book value (a.k.a. Equity or Stockholder’s Equity): Assets minus liabilities. For a stock, see the company’s balance sheet, published annually. For stock ETFs for the long term beach investor (see Part 1), book value is the sum of the book values of the stocks held in the ETF, and the ETF has no significant liabilities (ETFs that have significant liabilities are called “leveraged” ETFs, and if you are wary of risk, then know that leveraged funds are playing with fire.).

Book Value Divided by Price: Your broker’s website will probably show the price per share divided by book value per share, or maybe they will show a blank or “N/A”. If the broker shows you price divided by book value, then calculate book value (b) divided by price (p) as

b/p = 1 / (price divided by book value).

If the broker shows you a blank or “n/a” or the like, then they feel challenged by b less than or equal to zero, in which case you should calculate book value manually from the most recently reported quarterly balance sheet (provided by the broker). Then, using market capitalization for the entire company, calculate

b/p = book value divided by market cap

If your broker reports multiple versions of book value, I recommend using "tangible book value (MRQ)", or something like that. "Tangible" means goodwill and intangible assets are excluded, two features of financial accounting that one may easily confuse with hot air. "MRQ" means "Most Recent Quarter" reported by the company.

Positively Correlated.
Image: Wikimedia, "Ordinary Least Squares", Public Domain
Correlated: If the price change usually goes up when the metric goes up, then we say the price change and the metric are “positively correlated”. If the price change goes down when the metric goes up, then we say they are “negatively correlated”. Correlation doesn’t tell us whether one causes the other, or how certain we are, or how intense is the effect. Correlation is a number between -1 and 1. Nearly all spreadsheet apps include the correl() function which calculates correlation, or the equivalent pearson() function. Example: For sector ETFs, we say beta (the metric) and the price change are negatively correlated, the correlation is a negative number, meaning that as beta decreases, we expect the future price change will increase, and as beta increases, the future price change declines.

Credibility: A weighted average of a useful, though not fully believable, measurement and a standard value, though general and non-specific and less relevant, such as the average for all stocks. The credibility calculation allows us to compare a stock like TWTR, which began trading about 5 years ago, with a stock like MA which has been around for decades. If you think an 5-yr price growth metric (g) is a more believable predictor than a 2-yr price growth, but you would need a 10-yr growth of price metric to believe it “completely” and compare it with other stocks, then we can base the weighting on the number of years available (y), divided by 10. Then we calculate the credibility (c) as 

c = square root of the number of years available divided by 10
c = sqrt( y / 10 )
("sqrt()" is the spreadsheet software function for square root) 
Example: TWTR has price history since 2014, so y=5, and then c=0.707.

What we take as the standard (s) could be the average for all stocks for which we have 10 years of information, or the median, or the S&P500, or whatever we are prepared to believe if we don’t know the 10-yr metric for the specific stock, knowing we aren’t exactly right, but knowing the standard is a better estimate than “n/a”. Then we weight the partial growth information (g) we do have by the credibility (c), and for the information we don’t have, we use the standard (s) weighted by (1 - c).

Credibility weighted 10-yr price growth = c * g + ( 1 - c ) * s
Example: if TWTR, y=5, g=1.1, s=3.1, then c=0.707 
credibility-weighted 10-yr growth = 1.7.

Liabilities: Money owed to others, salaries and benefits owed to employees, advance payments from customers, amounts billed to those few customers that probably won’t pay (doubtful accounts), bills for purchases not yet paid, taxes not yet paid, and payments promised to lenders, stockholders and investors.

Market Capitalization (a.k.a. Market Cap or Capitalization): Generally, price multiplied by the number of shares outstanding. If a company has more than one kind of stock, then the market cap of the company (your probable topic of interest) is the sum of the market caps of the various kinds kind of stock.

Price: Unless otherwise indicated, these articles refer to the price of the last trade when the exchange closes for the day, the “closing price” or “last price” on a given day.

Rate of dividend increase (or decline) per share: I take the most recent five years of dividends reported by the company, summarize them by 12-month periods, and apply exponential least squares regression to get the average annual rate of increase. NO, you don’t need to do that. All you need is some way to come up with an unambiguous, repeatable, generally applicable estimate of what rate of increase to expect in the future, so that you can compare one stock with another. If you don’t know exponential least squares regression, and you don’t feel like reading how to do it on Wikipedia https://en.wikipedia.org/wiki/Ordinary_least_squares, or asking a friend, there are satisfactory alternatives.

Here is one. Use the slope() function included with nearly all spreadsheet software. A stock with larger (steeper) slope number has dividends increasing faster.

  s = slope of least squares line
= slope(y1:y5,x1:x5) 

For more information, type “slope function” into your favorite search engine.

Here is a second. Divide the year 5 (most recent) dividend (d5) by the year 1 (earliest) dividend (d1), take the square root of that, then take the square root of that. That is, you can get an estimate of the future rate by either of the following two equivalent calculations.

Estimated rate = sqrt( sqrt( d5 / d1 ) ) = ( d5 / d1 ) ^ ( 1/4 )

Reinvestment of dividends: Using dividends you receive to buy additional shares of the investment that produced them. Many or most brokers will automatically reinvest dividends for you, at no charge, on your request.

Return: The amounts of money you get from an investment, usually compared with what you pay to get it in the first place. That is, how much money do you have when you get out of this investment, compared with how much you put into this investment in the beginning.  Includes the dividends you receive while you hold it, and the price you get when you sell it, less the costs of holding and keeping and selling it, including taxes and broker’s fees and your time. For many purposes, the price you sell for, compared with the price you buy for, gives you a good approximation of the return.

sqrt(), square root. The square root of x is sqrt(x). Nearly every spreadsheet app provides sqrt(), and you probably have a square root function on the calculator app on your phone, and you can type “square root of 0.93” into your favorite search engine to get the calculation, and you can calculate it by hand (ask your favorite search engine).

Ticker (a.k.a. Ticker Symbol): A standardized few letters or numbers representing a stock or bond or ETF or mutual fund or something else traded on an exchange. Examples: AMZN is the ticker for Amazon.com, IYR is the iShares U.S. Real Estate ETF, LUV is Southwest Airlines, VOO is the Vanguard S&P500 ETF, STZ/B is the Constellation Brands Inc. class B shares.

10-yr growth of price: the most recent price divided by the price on this date ten years ago.

Part 1  |  Part 2  |  Part 3  |  Appendix 1  |  Appendix 2  >

Images and Sources

See Part 1.

Alma, Michigan, USA.
Image: Daniel Brockman, Aug 2019, Public Domain