Advanced Portfolio Management Strategies for the Affluent Stuart Chaussée ADVANCED PORTFOLIO MANAGEMENT All rights reserved. No part of this publication may be reproduced, stored in a special system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without prior permission. The publication contains the opinions of its author and is designed to provide useful advice in regard to the subject matter covered. However, this publication is offered with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, investment, tax, estate planning or other professional service. If legal, investment or other advice is required the services of a competent professional should be sought. The author and publisher specifically disclaim any responsibility for liability, loss or risk, personal or otherwise, that is incurred as a consequence, directly or indirectly, of the use and application of any of the contents of this book. Notwithstanding anything to the contrary set forth herein, Palisade Press (or the author) its officers and employees, affiliates, successors and assigns shall not, directly or indirectly be liable, in any way, to the reader or any other person for any reliance upon the information contained herein, or inaccuracies or errors in or omissions from the book, including but not limited to financial or investment data. Printed in the United States of America, 2002. Stuart Chaussée, Palisade Press, Inc. All rights reserved. ISBN: 1-893958-72-8 ADVANCED PORTFOLIO MANAGEMENT For Linda, R. Allison, Daisy and Henry In loving memory of William B. Slottman Professor of History University of California at Berkeley ADVANCEDADVANCED PORTFOLIO PORTFOLIO MANAGEMENT MANAGEMENT ADVANCEDADVANCED PORTFOLIO PORTFOLIO MANAGEMENT MANAGEMENT Table Table of of Contents Contents TableTableIntroductionIntroduction of of Contents Contents 1010 IntroductionIntroduction 1010 1.1. Dete Dete rmining rmining your your proper proper allocation allocation - - notnot for for beginners beginners only only 1212 1.1. DeteDeterminingrmining your your proper proper allocation allocation - - 2.2. 3 3Keys Keys to to investment investment success success 2121 notnot for for beginners beginners only only 1212 3.3. EquityEquity investment investment management management - -your your choices choices 3030 2.2. 3 3Keys Keys to to investment investment success success 2121 4.4. ExchangeExchange-traded-traded funds funds - -ideal ideal vehicles vehicles for for structured structured 3.3. EquityEquity investment investment management management - -your your choices choices 3030 indexingindexing 4545 4.4. ExchangeExchange-traded-traded funds funds - -ideal ideal vehicles vehicles for for structured structured 5.5. MeasuringMeasuring risk risk 6868 indexingindexing 4545 6.6. MeasuringMeasuring risk risk and and return return 8282 5.5. MeasuringMeasuring risk risk 6868 7.7. StockStock valuations valuations and and correlations correlations 8686 6.6. MeasuringMeasuring risk risk and and return return 8282 8.8. LargeLarge-cap-cap structured structured indexing indexing 9999 7.7. StockStock valuations valuations and and correlations correlations 8686 9.9. BuildingBuilding your your large large-cap-cap sector sector portfolio portfolio 126126 8.8. LargeLarge-cap-cap structured structured indexing indexing 9999 10.10. MidMid-cap-cap structured structured indexing indexing 133133 9.9. BuildingBuilding your your large large-cap-cap sector sector portfolio portfolio 126126 11.11. SmallSmall-cap-cap structured structured indexing indexing 140140 10.10. MidMid-cap-cap structured structured indexing indexing 133133 12.12. SampleSample equity equity portfolios portfolios 152152 11.11. SmallSmall-cap-cap structured structured indexing indexing 140140 13.13. Bonds,Bonds, unfortunately unfortunately you've you've got got to to own own some some 163163 12.12. SampleSample equity equity portfolios portfolios 152152 14.14. BondBond laddering laddering - -my my preferred preferred approach approach to to 13.13. Bonds,Bonds, unfortunately unfortunately you've you've got got to to own own some some 163163 owningowning bonds bonds 174174 14.14. BondBond laddering laddering - -my my preferred preferred approach approach to to 15.15. PortfolioPortfolio rebalancing rebalancing to to control control risk risk 181181 owningowning bonds bonds 174174 16.16. TaxTax planning planning 15.15. PortfolioPortfolio rebalancing rebalancing to to control control risk risk 181181 17.17. PortfolioPortfolio withdrawals withdrawals - -probabilities probabilities and and survivability survivability 212212 16.16. TaxTax planning planning 18.18. CreatingCreating your your income income stream stream in in retirement retirement 223223 17.17. PortfolioPortfolio withdrawals withdrawals - -probabilities probabilities and and survivability survivability 212212 19.19. DoesDoes buying buying and and holding holding make make sense sense for for you? you? 233233 18.18. CreatingCreating your your income income stream stream in in retirement retirement 223223 20.20. ApplicationApplication of of the the Fed Fed Mo Modeldel - -a agood good alternative alternative to to 19.19. DoesDoes buying buying and and holding holding make make sense sense for for you? you? 233233 a abuy buy-and-and-hold-hold strategy strategy 239239 20.20. ApplicationApplication of of the the Fed Fed Mo Modeldel - -a agood good alternative alternative to to 21.21. Stock Stock indexes indexes 254254 a abuy buy-and-and-hold-hold strategy strategy 239239 22.22. Value Value vs. vs. growth growth - -the the ongoing ongoing debate debate 266266 21.21. Stock Stock indexes indexes 254254 23.23. Sector Sector investing investing - -passive passive vs. vs. active active 274274 22.22. Value Value vs. vs. growth growth - -the the ongoing ongoing debate debate 266266 24.24. Creating Creating your your own own price price-weighted-weighted sector sector indexes indexes 280280 23.23. Sector Sector investing investing - -passive passive vs. vs. active active 274274 25.25. Betting Betting on on tech tech stocks stocks - -not not a agood good idea idea 288288 24.24. Creating Creating your your own own price price-weighted-weighted sector sector indexes indexes 280280 25.25. Betting Betting on on tech tech stocks stocks - -not not a agood good idea idea 288288 ADVANCED PORTFOLIO MANAGEMENT ADVANCED PORTFOLIO MANAGEMENT 26. Turbocharging your portfolio 294 26.27. UsingTurbocharging correlation your coefficients portfolio to diversify an 294 27. Usingexisting correlation portfolio coefficients to diversify an 299 28. Theexisting low -portfoliobasis stock dilemma 299304 28.29. Optimizers,The low-basis can stock they dilemmahelp you build the "optimal" 304 29. Optimizers,portfolio? can they help you build the "optimal" 309 30. Theportfolio? case against investing in foreign stocks, and 309 30. Theone reasoncase against you may investing want to in foreign stocks, and 315 31. Annuityone reason blues you may want to 315322 31.32. RealAnnuity estate blues investment trusts 326322 32. EpilogueReal estate investment trusts 332326 AppendixEpilogue 335332 AppendixGlossary 335397 BiblioGlossarygraphy and recommended reading 414397 FavoriteBibliography Web andsites recommended reading 417414 FavoriteAcknowledgments Web sites 417418 AboutAcknowledgments the Author 418419 About the Author 419 INTRODUCTION Introduction We learn geology the morning after the earthquake. —RALPH WALDO EMERSON, writer IT’S BEEN ABOUT TWO YEARS since the Nasdaq crashed from its highest reading of 5,048 on March 10, 2000. The ensuing collapse, one of the worst in history for a major stock market index, brought the Nasdaq down 72%. It hit a low on September 21, 2001. During the same period, the broad stock market, as measured by the S&P 500, was off approximately 37% peak-to- valley. The meltdown during the last couple of years has reminded professional and private investors of the importance of diversification and risk control in a portfolio. When stocks were recently punishing investors, Barclays Global Investors, the largest institutional asset manager in the world, along with several other financial institutions, rolled out in excess of 90 new exchange-traded funds (ETFs). These offerings have changed the way indexers invest forever. The new ETFs, which track indexes that cover various sectors of the market, and both style- (value and growth stocks) and size- (small-, mid-, and large-cap stocks) specific asset classes, arrived at an opportune time. Investors have taken advantage of these investments, which allow participants to control risk and diversification beyond what is available from traditional index funds. ETF assets now account for over $80 billion. In short, with over a hundred ETFs available to investors, covering every asset class imaginable (real estate and foreign markets included), this is indeed the new age of indexing. — 10 — INTRODUCTION This book is much more than an updated version of my first book entitled Portfolio Management for the Affluent: Guide to a tax-efficient, low-cost, growth-oriented portfolio (Palisade Business Press, 2000). I have attempted to show investors (professional and individual) how to take advantage of the new ETF offerings to improve on traditional index-based portfolio management. My preferred approach to equity investing is called structured, index-based portfolio management. Structured indexing involves a more detailed, hands-on approach to indexing than traditional