Archive for September 2008
President Bush: “This sucker is going down!”
Today the Dow dropped 777 or 6.98%, making it the largest one-day point drop in history.
The ten largest one-day point drops in history of the Dow (before this one) are recorded in the table below, with subsequent one year returns calculated.
| rank | date | close | drop | % drop | 1 yr later | 1 yr return |
| 1 | 9/17/2001 | 8920.7 | -684.81 | -7.13% | 8380.18 | -6.06% |
| 2 | 4/14/2000 | 10305.77 | -617.78 | -5.66% | 10126.94 | -1.74% |
| 3 | 10/27/1997 | 7161.15 | -554.26 | -7.18% | 8432.21 | 17.75% |
| 4 | 8/31/1998 | 7539.07 | -512.61 | -6.37% | 10914.13 | 44.77% |
| 5 | 10/19/1987 | 1738.74 | -508 | -22.6% | 2137.27 | 22.92% |
| 6 | 9/15/2008 | 10917.51 | -504.48 | -4.42% | TBD | TBD |
| 7 | 9/17/2008 | 10609.66 | -449.36 | -4.06% | TBD | TBD |
| 8 | 3/12/2001 | 10208.25 | -436.37 | -4.10% | 10632.35 | 4.15% |
| 9 | 2/27/2007 | 12216.24 | -416.02 | -3.29% | 12684.92 | 3.84% |
| 10 | 7/19/2002 | 8019.26 | -390.23 | -4.64% | 9188.15 | 14.58% |
Data source: Yahoo Finance
History seems to suggest guarded optimism but I will let you decide if history is any guide for the situation today. We don’t know what the future will bring, but if we have a globablly diversified all-weather portfolio, we will be fine.
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All-weather portfolio: how Harvard and Yale Endowments invest for bad times
Posted on: September 21, 2008
This post was written at the depth of the financial crisis. If you stuck to the Swensen Model through out the crisis, you would be ahead now. See our model portfolio.
– Michael Zhuang
Wall Street Journal headline: “Harvard Endowment Returned 8.6%”
In light of the events of the last few weeks when financial companies collapsed in rapid succession, an all-weather portfolio is what all of us need. Yale and Harvard University endowments have portfolios that do well in both good and bad times. You’d expect these smart people to know what they are doing. They do!
In any one fiscal year (ending in June) since 2000, The Yale Endowment has never had a loss. Don’t you wish you had a portfolio that could do so well? Sadly, your record is likely to be worse than that of S&P 500. Harvard’s endowment portfolio had only two years with small losses. The worst was in 2001. That was when it suffered a loss of 2.7%. Here are the details:
Table 1: Comparison of returns for Yale, Harvard, and the S&P 500
| Year | Economic Cycle | Yale | Harvard | S&P 500 |
| 2000 | Tech bubble | 41% | 32% | 7% |
| 2001 | Tech bubble bust | 9.2% | -2.7% | -14.83% |
| 2002 | Tech bubble bust | 0.7% | -0.5% | -17.99% |
| 2003 | 8.8% | 12.5% | 0.25% | |
| 2004 | 19.4% | 21.1% | 19.11% | |
| 2005 | RE bubble | 22.3% | 19.2% | 6.32% |
| 2006 | RE bubble | 22.9% | 16.7% | 8.63% |
| 2007 | RE bubble bust | 28% | 23% | 21% |
| 2008 | RE bubble bust | 4% | 8.6% | -14.8% |
| Average Return | 17.8% | 14.4% | 1.6% | |
| Volatility | 12.4% | 11.3% | 14.6% | |
How did Yale and Harvard achieve such return stability through two major cycles of boom and bust?
The answer lies in their unconventional asset allocation. The typical US investor allocates 60% to domestic equity, primarily in large-cap growth stocks, and 40% to fixed income assets. In contrast, the endowments allocate to six non-cash asset classes that have low correlation with each other. In particular, domestic equity and fixed income make up only a small percentage of the overall portfolio: see Table 2 below. This broad diversification across weakly correlated asset classes is the primary reason why the endowment portfolios did well in both boom and bust times. (I will discuss secondary reasons in the future.)
Table 2: Asset allocations of Yale and Harvard endowments
| Asset Classes | Domestic Equity | Absolute Return | Foreign Equity | Private Equity | Real Assets | Fixed Income | Cash |
| Yale | 11% | 23.3% | 14.1% | 18.7% | 27.1% | 4% | 1.9% |
| Harvard | 12% | 18% | 22.% | 11% | 26% | 16% | -5% |
Both endowments allocate over 25% to real assets, such as real estate and basic materials. This allocation seeks to protect against the double threat of a weak dollar and inflation.
Chart: Evolution of Yale Endowment asset allocation
As the chart above shows, Yale Endowment significantly increased its exposure to real assets in the last three years. Average investors like you and me would be well-served to heed the unspoken message of these intelligently-managed endowments. And now for your take-home lesson:
1. Broadly diversify
2. Hedge against inflation and the weak dollar.
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Life insurance and annuity
Insurance companies who issue life insurance and annuity contracts are regulated by state insurance commissioners. The holders of life insurance and annuity contracts are protected by the state insurance guarantee fund up to some limits. While laws governing maximum limits and types of policies covered vary from state to state, most states set basic limits of:
- $300,000 in life insurance death benefits
- $100,000 in cash surrender or withdrawal value for life insurance
- $100,000 in withdrawal and cash values for annuities
- $100,000 in health insurance policy benefits
The National Organization of Life and Health Insurance Associations has more information.
Bank accounts
Bank accounts are insured by the Federal Deposit Insurance Corporation on a per depositor per type of account basis. Four types of accounts are eligible for FDIC insurance, the maximum dollar limit for each type being:
- Single ownership accounts – $100,000 per depositor. This is sum of all checking accounts, savings accounts, CDs, etc., owned by the depositor.
- Joint ownership accounts – $100,000 per depositor. Same as above.
- Certain retirement accounts – $250,000 per depositor. This is sum of all eligible retirement accounts, such as IRA and self-directed Keogh plans.
- Testamentary (revocable trust) account – $100,000 per beneficiary named for each account, with the amount held in the account being paid out to the beneficiary upon the depositor’s death, usually to one of the depositor’s children.
This site has a detailed explanation.
Brokerage accounts
In the event of brokerage failure, securities investors are protected by the Securities Investor Protection Corporation (SIPC) up to $500,000 per account type, of which $100,000 can be cash. SIPC insurance does not insure investors against the loss of value of securities in the account. SIPC just had a press release about the safety of brokerage accounts.
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“Ignorance is bliss” – American proverb
In 2002, Daniel Kahneman, an Israeli-American, won the Nobel Prize in Economics for his ground-breaking work in behavioral finance. During last prolonged bear market, the Israeli Pension Authority came to him with an all too common problem. Pensioners kept changing their investment allocations according to prevailing market conditions. These frequent changes not only were unhelpful for the long term, but also added costs to pension management. Kahneman gave them one simple solution: send the pensioners statements quarterly instead of monthly.
How can it help to know less about your investment performance?
I studied all seven bear markets since 1970 and calculated their peak-to-trough drawdowns (a reduction in account equity) from the perspective of four different types of investors:
- A: Investors who check their accounts intra-daily
- B: Investors who check their accounts monthly
- C: Investors who check their accounts quarterly
- D: Investors who check their accounts annually
Here are the results:
| S&P 500 | Peak to trough drawdown | ||||||
| Peak date | Peak | Trough date | Trough | A | B | C | D |
| 3/24/2000 | 1552.87 | 10/9/2002 | 768.63 | -51% | -46% | -46% | -40% |
| 7/17/1998 | 1190.58 | 10/8/1998 | 923.32 | -22% | -10% | -10% | 0% |
| 7/16/1990 | 369.78 | 10/17/1990 | 294.54 | -20% | -15% | -15% | -7% |
| 8/25/1987 | 337.89 | 12/4/1987 | 221.24 | -35% | -30% | -23% | 0% |
| 11/28/1980 | 141.96 | 8/12/1982 | 102.2 | -28% | -24% | -19% | -10% |
| 9/21/1976 | 108.72 | 3/6/1978 | 86.45 | -20% | -17% | -15% | -12% |
| 1/5/1973 | 121.74 | 10/3/1974 | 60.96 | -50% | -46% | -46% | -42% |
Two observations emerge from this study:
- Regardless of the cyclic nature of bull and bear markets, the S&P 500 index keeps marching upward. (You don’t want to stop that march!)
- The more frequently you check your accounts, the more painfully you feel (and probably will react to) a bear market.
Take the bear market in 1987 for example; the intra-day peak-to-trough drawdown was 35%. For type C investors who checked their accounts quarterly, the drawdown was only 23%. Type D investors who checked their accounts annually would not feel the pain at all since the bear market began and ended within the year. Who would be more likely to stay the course? Go figure!
The author is president of MZ Capital, a RIA serving DC/MD/VA. Get his monthly newsletter in your mailbox or get to the directory of his past articles.
The Investment Scientist 