Portfolio Navigation Update

We experienced the first air pocket on Friday, March 6th when the market closed off 278 points (1.54%).  The PRI account closed off .71%.  On March 10th the Dow was off 332 points or -1.85% while the PRI portfolio was off -.54%.   I knew we were in the clouds and I could not see where we were going but I did not know we would hit an air pocket.   However, as I explained in the previous posting, that is why I chose the alternative route of 6%.

The 7.09% cash position shown below in a clip from the Schwab account is the equivalent of saying; keep your seat belt fastened.  I am providing this update to help you understand the concept of portfolio navigation.  A recent article in the San Francisco Chronicle criticized Schwab for holding 6% in cash in their most aggressive ROBO portfolio and 30% in the most conservative.   The notion that cash is a cop out and not a useful tactical tool, is part of the old buy and hold mindset that worked so well back in the 50’s, when the NYSE and NASDAQ accounted for all of the daily trades.  They now account for less than 50%.  That is why I am testing this portfolio navigation strategy.  The good ‘ol days are gone and the strategies that worked well then are ill suited for today’s algorithm driven trading.  I believe portfolio navigation could prove superior to a Robot.  On March 29th I will tell you the asset allocation strategy this navigator started with on February 1st.

First air pocket 2-9-15

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Navigation Index 1st Month Report

On February 2nd 2015 I launched this index with funds in the PRI account at Charles Schwab and notified three trusted leaders in the industry of the following: I will test the efficacy of this index with my own money and post the results on my blog. I am purposefully starting at a very high level in the market to provide a public record of this research project. The Sortino-Index has five colored triangles that either point up, down or sideways.

The SNI Color Code

Initial Sortino-Index code was: BLUE (take profits and decrease equity exposure).

The Process:
Portfolio Navigation begins by plotting a course to a financial destination based on an original discount rate (ODR) that discounts the future payout to the present value of the assets. In this case I chose an ODR of 8%, which seems to be a popular choice for most DB plans and was often used in my past research.
Next I will consider the weather conditions on this flight path. The near term forecast looks bad (see previous postings on this blog for market outlook). The world is in a mess, congress and the president are at each other’s throats, and yet, the stock market is at an all time high. We may well be heading into a financial storm front. This is similar to the problem discussed in the current issue of Pensions and Investments magazine (Feb 23rd), “Corporations weigh derisking vs. re-risking.” Graph 1 below presents the Portfolio Navigation solution to this issue. As navigator, I will investigate an alternate heading of 6% that might provide a reasonable chance of getting back on the 8% ODR course in a year or so.

Graph 1

ODR Graph 1B

The blue curves in Graph 2 below represent the distribution of returns for the totally passive PRI portfolio on the Charles Schwab platform that replicates the Sortino-Index. The black probability curves represent a combination of active and passive managers which, by my calculations, are superior to the totally passive distributions for both the ODR and AH cases. However, I do not want to confuse the active vs passive debate with the efficacy of portfolio navigation. Therefore, this research project will focus only on the passive portfolio. The Alternate Heading 6% distribution shown in graph 2 not only has a mean ( i.e. expected return) of 8.7%, it has the potential to earn 3% more than the AH of 6% (i.e., the upside potential is 3% + 6% = 9%).

Graph 2

First month SNI Graph 2

Comparing this with the 8% ODR graph (not shown) indicates I am not being compensated for taking additional risk. Therefore, I chose to make the initial investment in accordance with the 6% AH. The performance results for the first month are shown below in Graph 3 and indicate we are above the 8% ODR course at this time with 50% less equity exposure than the 60/40 mix shown in the color code index at the top of this posting. It is important to note that the PRI optimizer does not just minimize the risk of falling below 6%, as derisking would. It maximizes the potential to exceed 6% relative to the risk of falling below 6%.

Graph 3

First month SNI Graph 3

I believe performance should be measured relative to where you are on the path toward your goal, not relative to the S&P index or any other index. The goal is a specified payout. The investment objective is what you have to achieve in term of a risk-return trade off in order to accomplish your goal. Ergo, the investment objective for PRI is to maximize the potential to exceed 8% relative to the risk of falling below 8%. Graph 4 is an illustration of how performance should be presented. The star would represent the PRI portfolio’s current location. As Dr. Merton said in his HBR article (see previous Crisis posting), you need to know how you are progressing toward the pay out. If you are on or above the line, that’s good. You are fully funded.

Graph 4

1st mo-Performance-graph 4

Blog-Sortino Navigation Index-1st monthly performance report

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New Index

The SNI Color Code
I am pleased to inform you of a new research project I intend to pursue. I want to explore the possibility of developing a new index to help investors gain some insight into when it might be advisable to increase or decrease equity exposure in their portfolio. I believe the old buy &hold strategy of the 20th century are passé and that the concepts of Portfolio Navigation and PMPT might provide a better way of dealing with the increased volatility of the 21st century.
To that end, I have decided to use the funds in my PRI account at Charles Schwab to develop the “Sortino Navigation Index (SNI).”

The SNI is similar to the airport security warning system in that there are five colors to signal different perceived degrees of risk. The Black and Blue triangles point down. The black will signal 90% in fixed income. The Blue will signal somewhere between 39% and 89% in fixed income; the exact percentage will not be announced for 30 days after executed. The Green triangle faces right and will signal 60% in equities and 40% in fixed income. The Orange and Red triangles point upward. The Orange will signal between 61% and 89% in equities; the exact percentage will not be announced for 30 days after executed.
This is a research project, but unlike most research projects that only publish results if they are good, this will be conducted in real time for all to see and judge. The purpose is to see if the concepts of Post Modern Portfolio Theory and Portfolio Navigation that I developed can be employed to achieve the goal for an investor whose investment objective is to maximize the potential to exceed 8% relative to the risk of falling below 8%. If there is evidence to support this idea, I would hope the SNI might prove useful to investors.

• This is a very different strategy than that offered at Sortino Investment Advisors LLC (SIA). It will not move investors between five different portfolios as their DTR changes. Furthermore, the SNI, and therefore the PRI portfolio, will be very much different from any portfolio constructed at SIA.
• Also, no active managers will be used in this research project, although the SIA optimizer has provided evidence that active managers can add value. This will focus attention on the efficacy of portfolio navigation instead of the active versus passive debate.

The monthly account report from Charles Schwab will be used to document the original portfolio composition on 2/2/2015 but will not be disclosed for 90 days. The color chosen for the initial portfolio will be announced on March 29th (my birthday).

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Perception is?

“Perception is reality” is often presented as a truism that explains why the stock market behaves in a way experts perceive as irrational.  A number of experts, including myself, remarked about over exuberance in the late 90’s during the run up of internet stocks and the flipping of real estate for a quick profit.  In 2009, the perception was that the world was entering the worst depression since 1929.  In both instances, the perception was right… until reality slapped speculators in the face.

The perception now is that we are in a bull market and the U.S. economy is booming.  As the graph below shows, only two of the nine iShares ETFs that account for over 5000 companies earned a higher return than the S&P 500 year to date.

Surz 12-19-14

Ron Surz, who invented these 9 indexes, said: 8 out of 9 of his “Surz Style Pure” indexes underperformed. The point is: none of the foreign indexes are at their all time high and the vast majority of U.S. equity indexes are not at their all time high. As for the economy, every economy in the world is sagging except ours and ours is probably not as rosy as leading indicators would have us believe. The world X U.S. is down about 7% YTD.

What about the petro panic?

Is this a game changer that will launch a new bull market because it is equivalent to a $100 billion tax break to the U.S.? Maybe. But Jason Sweig in his “Intelligent Investor” column in the WSJ had this to say: “Start by recognizing that the recent drop was too short and shallow to turn stocks into a bargain. At the market’s peak on Dec. 5, U.S. stocks were valued at 27.4 times their long-term, inflation-adjusted earnings, according to data from Robert Shiller , the Yale University finance professor and Nobel laureate in economics. At the bottom of the petro panic, this past Tuesday, that figure was 26 times earnings. By Friday morning, stocks were back at 27.3 times long-term earnings.”

As I told my wife a few years ago when we were on safari: Just because you got away with it doesn’t mean you didn’t take any risk!






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Wall of Worry or Pile of Sand?

One story to explain today’s stock market is, the final stage of a bull market climbs a wall of worry.  However, one version of chaos theory is, the stock market behaves like a sand pile built by dropping grains of sand to form a cone.  At some point the last grain of sand causes the pile to collapse.  The wall climbers are saying, “leverage up on whatever’s moving.”  The sand box people say, “the market structure is unstable; get out before it collapses.”  Which one is right?  That is the wrong question.

If your goal is to make as much money as you can, subject only to how much risk you can tolerate, you may be waiting to make a killing in the Alibaba IPO.  That is not an investment strategy.  That is speculating.  However, If you are investing for retirement, remember, you don’t have to pay taxes on the profits you take.  Think of this as a battle for investment success.  The dollars you have invested are like your troops.  If you always have all your troops fully committed to a frontal attack you most likely will eventually get wiped out.  Keep some of those troops in reserve to protect your flanks.

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On The Coming Crisis

                                    Dr. Frank Sortino and Dr. Hal Forsey

In the July-August issue of Harvard Business Review, Dr. Robert Merton says; The seeds of an investment crisis have been sown. The only way to avoid a catastrophe is for plan participants, professionals, and regulators to shift the mind-set and metrics from asset value to income. Merton goes on to say, “Investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular income.” We highly recommend you read this article. While we do not agree with his solution, We do believe he makes many cogent observations. What we would like to focus on now is the implication for performance measurement.

Whose performance are you measuring? For too long the performance of money managers has been presented as synonymous with the participant’s performance toward their goal.   Participants are deluged with returns on each manager for the last 3 months, 1 year, 3 years, 5 years…but always with the warning that past returns may not predict future returns.   How about seldom ever predict future returns? Then, to fill up a few more pages of the performance report, each manager is measured against the returns on a benchmark, like the S&P 500 or 50 other irrelevant indexes.  What do any of these returns over some arbitrary time period have to do with showing the participant where they are relative to their goal?  NOTHING!

Forget the moments: Recalling the first moment (the mean), or second moment (the standard deviation) from historic returns to capture a past experience or tell you anything meaningful about future experiences is like  trying to remember the experience of seeing the Grand Canyon for the first time by recalling only the date and time of day you saw it.  Conjuring up an image is what the mind does.  Better yet, take a picture that will capture what you saw and what to expect the next time you go there.

Here is the big picture taken with our special 21st century camera.  Think of it as a financial X-ray camera. Do you have a clue as to what Graphic 1 is portraying?  In addition to the graphic being too small it is not intuitively obvious (Click on the picture).

 Graphic 1


Merton rightly says: to my mind it’s a real stretch to ask people to acquire sufficient financial expertise to manage all the investment steps needed to get to their pension goals. That’s a challenge even for professionals. You’d no more require employees to make those kinds of decisions than an automaker would dump a pile of car parts and a technical manual in the buyer’s driveway with a note that says, “Here’s what you need to put the car together.”

Well, we are not talking to a car buyer.  We are talking to people who have the fiduciary responsibility for seeing to it that the 401(k) buyer is getting her money’s worth.  For that reason, YOU, the fiduciary, need to learn more about how to help your client, your employee, your participant…your beneficiary.  You don’t need to learn how to read X-rays in order to benefit from them, but you do need to know they exist and that you can go to a doctor with the training to read them.

So, let’s get started: the blue image shows the entire range of possible returns for the passive indexes that exactly fill up all those asset allocation boxes at the top of graph 1.  The black image shows what happens when you add those few active managers, out of thousands of possible managers, who could actually add value.  The arrow points to the upside potential ratio that shows the optimal portfolio with active managers has 30% more upside potential than downside risk, where risk is that you will not have enough money at retirement to achieve the payout that Merton says is the true goal.  The totally passive portfolio has 10% more downside risk than upside potential.  There can be no justification for choosing the totally passive portfolio.  PRI has provided empirical evidence[1] that the statistics provided in Graph 1 are better predictors of future performance than the mean and standard deviation of returns (historical, current, or projected).  So, what information should the plan sponsor pass on to their employees?

Relevance:   Merton has this to say on that subject: “The only feedback she needs from her plan provider is her probability of achieving her income goals. She should not receive quarterly updates about the returns on her investment (historical, current, or projected) or about the current allocation of her assets. These are important factors in achieving success, but they are not meaningful input for the choices about income that the customer has to make.” So, we say, the plan sponsor should not require the participant to make those choices, but instead, use the managed account QDIA option to provide the plan participant the following information:

Graph 2


The MapVest® report shown above says, in the top left hand corner, “Currently, you are on track to replace 70% of your pre-retirement salary from your retirement account.” There is more, but suffice it to say, what Merton calls for, we can deliver.

Where we differ:

While there is much that we agree with in Dr. Merton’s important article in Harvard Business Review, there are these important differences:

  • Merton’s solutions ignore the return each investor needs to earn on their investment over time to achieve that desired payout at retirement. Instead Merton posits a “safe, risk-free asset,” which, if you had enough money, and it existed, would be an inflation-protected annuity. We do not believe such a thing can be created through a liability-driven investment strategy called “immunization.” I did my doctoral dissertation on immunization strategies. In our opinion, the costs associated with trying to create Merton’s Category 1 or 2 inflation protected income vehicles are not worth the hidden risks.
  • We do not see 401(k) plans as a liability management problem, as Merton claims. We see 401(k) plans as an asset-liability management problem. As we have pointed out for many years, the link between assets and liabilities is the return that discounts all those future payouts after retirement to the present value of the current assets and future contributions. This Desired Target Return® is directly related to what the participant is trying to achieve whereas the mean and standard deviation of historic returns are not, and interest rate risk is not. Therefore, the DTR® is the single most important calculation one can make with respect to any investment whose goal is some future payout.

Conclusion:  If participants are ever to achieve the goal of replacing a percentage of their salary at retirement we are going to have to drastically change the way we measure their performance toward their goal.  It is up to the plan sponsor to demand a solution for participants designed around the Desired Target Return that leads to each participant’s payout goal.  We end with a thank you to Dr. Merton for his important insights and a major point of agreement:

Merton: Clearly, the risk and return variables that now drive investment decisions are not being measured in units that correspond to savers’ retirement goals and their likelihood of meeting them. Thus, it cannot be said that savers’ funds are being well managed.”


[1]  Bernardo Kuan’s study, page 30, the Sortino Framework for Constructing Portfolios, El Sevier, Amazon.com






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The 401(k) Conundrum

Here is the problem: each participant wants to invest part of their salary each month in order to replace a sufficient amount of their salary at retirement.  To help them achieve this, the plan sponsor provides a number of investment vehicles, like mutual funds and/or ETFs for each investor to select from.

Unfortunately, the participant does not know which investment vehicle is best for them because the participant does not know how much money would be sufficient at retirement to achieve the payout.  Kathleen Pender at the San Francisco Chronicle says some pundits  claim participants will need 8 times their final salary while others claim the figure is more like 12 times.  The reason it is a conundrum is because all the solutions being proposed are developed by marketing people with simple solutions to complex problems that usually begin with, “all you have to do is…”

Kathleen Pender then correctly points out, “The real answer, of course, depends on your individual circumstances, including your income, age at retirement, life expectancy, expected return”…WHAT!

I was in full agreement until this point.

The expected rate of return is   the   wrong focal point.   The correct return to focus on is the return one NEEDS to earn on current assets and future contribution in order to achieve the actuarially determined payout.

The expected return is commonly calculated as an average return achieved on some market index over time.  The NEEDED return is the return that discounts the future payout to the present value of the assets (current assets + contributions).  We call this the Desired Target Return or DTR.  It is this DTR that separates the risk of failing to achieve the estimated payout from the potential to exceed that payout.  Returns below the DTR cause failure to achieve the payout.  Returns above the DTR are the reward for taking on the true risk…that you will not have enough money to retire.  The average return is not directly related to the payout, the DTR is.

But who knows how to estimate that DTR and use it to guide participants toward their needed payout even when market corrections occur?

C’est moi!



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