2019-08-20

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.




























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