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Frank answers . . . [archives]
Volume XXXVII: Frank Armstrong, author of Investment Strategies For The 21st Century, answers questions from members of the MFI community. To submit a question to Frank, please write to us.
Questions and Responses
Is Europe or the US the "safest" market?
Q: Currently I've got about 66% of my portfolio in Scudder Greater Europe Mutual Fund. The rest is a mix of S+P 500 index mutual fund and bonds (about 50/50). With the recession in Japan and turmoil in Asia, where is the safest place for most of my savings?
I see Europe as the greatest potential for growth as opposed to Wall Street over the next few years, but is Europe more vulnerable to problems in Asia than the US? Should I move money into more US bonds or US mutuals?
A: Nobody knows the answer to your question. Of course there will be lots of opinions, all equally valid, or flaky. While it's fun to speculate about which market might do the best, it's not good investment policy. There is no evidence that anyone can successfully predict world market behavior over short periods. Your observations and questions are being considered by hundreds of millions of investors all over the world right now. Many of them have access to very sophisticated information. All of them are trying to outguess all of the others. The chances that any one of us will be "right" are essentially random.
Unless you have a much better crystal ball than I do, the lowest risk, most sensible policy is to buy a globally diversified portfolio rather that trying to time or predict markets.
What's the best four-year fund for my borrowed investment money?
Q: I would like to know what mutual fund will give me biggest return in 4 years. I'm using money from a loan I'm getting.
A: It's a very bad idea to borrow money for investment. Your transaction is the same as a 100% margin account. You have no equity in the deal. Even a very small downward movement in your investment account will put you in the red for the amount of the decrease and the interest on the loan. In other words, you stand a fair chance of getting totally wiped out. For that reason, current US regs only allow a 50% margin. It's still high risk, but chances of running the account to zero are reduced considerably.
As for which fund might do the best over the next four years, your guess is as good as any. There are a number of high risk, high return markets. I certainly wouldn't want to speculate which one of them might do the best in a short time period. It would be plain nuts to borrow money for that speculation.
If anyone could really predict future returns of asset classes, why would they diversify?
from Craig
Q: The majority of responsible writers try to convince investors that the markets are reasonably efficient and very unpredictable. There follows good advice about diversification, minimizing costs, index funds, and asset allocation. But ultimately the asset allocation advice comes up with optimized mixes based on expected future asset class returns, standard deviations and co-variances....
If anyone was really good at predicting future returns of asset classes why would they diversify? And if they're not good at predicting future returns (or sd's or covar's) how do they know the portfolio will be efficient, i.e. "garbage in...."?
Finally, a number of advisors are giving clients the option of specifying a percentage chance of not making their target return, i.e., only a 10% chance of missing the target return versus a 50% chance.(see financialengines.com) Given the built-in inaccuracy of optimization based on expected returns, etc., do you think this adds anything to the process?
A: If I was good at predicting future returns of asset classes, I wouldn't think of diversifying. I would just pick the next hot sector and enjoy the ride. It grieves me to report that I have no such ability. Even worse, I don't know anybody else that can do it either. What a drag! So, we are stuck with diversification and asset allocation as a rational means of reducing risk and obtaining reasonable rates of return.
However, all is not lost. There is a great deal of information about how various segments of markets have performed over the long term. Real rates of return (inflation adjusted), risks, and correlation between markets are remarkably stable over the long haul. This allows us to build sensible investment models as an aid to our investment strategies. These models are not reality, but are useful in estimating predicted rates of return, and assigning probabilities to a range of possible outcomes.
By extension, we can design portfolios with a minimum return expectation (with a given confidence level). For instance we can be 95% certain that a given portfolio will not return less than 5%. We can never be entirely certain, and by designing the portfolio to meet minimum return levels we limit the upside. This still can be an attractive solution for many investors that have loss constraints such as defined benefit pension plans or life insurance companies.
I'll be the first to admit that decision making in an atmosphere of uncertainty is difficult. These statistical tools are the best that we have now, and are constantly getting better. Investment risk can never be eliminated, but it can be managed more intelligently than previously possible.
- Copyright (c) 1998 Frank Armstrong.
Frank Armstrong is author of Investment Strategies for the 21st Century, published here, and president of Managed Account Services, Inc., a fee-only advisor specializing in global asset allocation strategies utilizing no-load mutual funds. Frank is a Certified Financial Planner (CFP) with 24 years' experience helping investors build wealth. The firm, an SEC Registered Investment Advisor currently manages in excess of $60 million for over 140 clients worldwide. Visit Frank's Managed Account Services, Inc. or call 1-800-508-8500 for more information about the Alternative to Business as Usual on Wall Street.
- Copyright © 1998, Frank Armstrong.
- Frank Armstrong is author of Investment Strategies for the 21st Century, published here, and president of Managed Account Services, Inc., a fee-only advisor specializing in global asset allocation strategies utilizing no-load mutual funds. Frank is a Certified Financial Planner (CFP) with 24 years' experience helping investors build wealth. The firm, an SEC Registered Investment Advisor currently manages in excess of $60 million for over 140 clients worldwide. Visit Frank's Managed Account Services, Inc. for more information about the Alternative to Business as Usual on Wall Street or call 1-800-508-8500.
Disclaimer
Investing in equities involves a serious principal risk, and no assurance can be given that the techniques described here will be successful. Returns vary and you may have a gain or loss when you sell your shares. Past performance is no guarantee of future results. Index returns shown are historical and include the change in share price, reinvestment of dividends, and capital gains. Indexes are unmanaged and do not reflect the impact of transaction costs. Transaction costs would have reduced the total returns.
International investments, especially those in emerging markets, entail greater risks (as well as greater potential rewards) than U.S. investing. These risks include political and economic uncertainties of foreign countries, as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less-established markets and economies.
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