Zaks Investment Advisory Service

Model Portfolios on ZaksInvest.com Web Site – Part II

Last time, we described two model portfolios, presented on the Portfolios page of our site, www.zaksinvest.com. One of them, which we called Moderately Aggressive, had at the end of May produced an annual return rate of 19 percent over a three-year period. Since then, a mini-correction hit the market, and between Tuesday and Friday, the market fell by three percent. So if you look at the chart now, the current results will be slightly lower. Nevertheless, comparisons between portfolios should be made over the same timeframe, so we will examine their returns through the end of May. The second portfolio, which we called Basic, earned an annual return rate of about 15 percent over the same period (i.e. three years). We mentioned that the first portfolio was more risky than the second, and indeed, the standard deviations of return of the Moderately Aggressive portfolio were higher than those of the Basic. In our last program, we also said that risk alone was not enough to guarantee portfolio performance – that the portfolio must also be effective.

We will return to this problem in a minute, but first let us take a look at the third line from the top. It is dark blue and called Market (BL, Baseline S&P 500 Portfolio). The Market portfolio was built realistically, on the basis of index funds that imitate the S&P 500 index. We specifically built this portfolio based on the funds and not the index itself. This resolved two problems. First of all, the index reflects the price of the constituent stocks, but not of the dividends. But the fund, made up of real stocks, pays dividends corresponding to the average for stocks in the index. Dividends on S&P 500 stocks pay about 1.5 percent. In other words, an index that does not take dividends into account loses about 1.5 percent of its return compared to the actual fund. Second, all real asset portfolios have expenses. We included these, too, by using real funds. You may read the specifics about how we did this in the detailed explanation. Why are we comparing the returns of our model portfolios to the S&P 500? Out of tradition: most firms that analyze mutual fund performance and returns compare them to the S&P 500. We decided to do the same. Through the end of May, the Baseline fund earned an average three-year annualized return rate of 13 percent. As I said in our last program, compared to average statistical results, this is quite a high rate of return. In other words, on average, during the last three years the market behaved very well. However, both of our model portfolios, the Moderately Aggressive and the Basic, achieved better results: the Moderately Aggressive by an average of six percent a year, and the Basic – two percent a year. These are terrific results.

Our Moderately Aggressive portfolio had a slightly higher standard deviation of return than the Market portfolio, i.e. it was slightly riskier (hence its name). But as I mentioned in our previous program, the very fact that a certain portfolio carries more risk in no way guarantees that it will outperform the market. As you understand, one can build a risky portfolio with high standard deviations whose returns still lag the market average. The fact that our Moderately Aggressive portfolio provided such good returns (and a 19-percent annual average is an extremely good result) means that it was constructed efficiently. A portfolio’s efficiency is determined by what additional returns it brings with higher risk. A portfolio’s return is compared to the performance of an instrument that has no risk at all. We know that Treasury bills are such instruments. The rationale behind this comparison is as follows: if one portfolio provides one additional percentage point of return for every unit of risk, and another returns two percent, than the second portfolio is better – it is more efficient than the first. This measure of efficiency is called the Sharpe Ratio, in honor of the famous economist and Nobel Prize laureate William Sharpe. The higher the Sharpe Ratio, the more efficient the portfolio. In a table below the chart, we display the Sharpe Ratios of our model portfolios. The Sharpe Ratio of the Moderately Aggressive portfolio is higher than the Sharpe Ratio of the Market one, which means that it is highly effective.

We called the third model portfolio Moderately Conservative; its returns are represented on the chart by a light-blue line. This portfolio really is the least risky of all. One may confirm this by looking at its standard deviation in the table below the chart. Interestingly, this portfolio’s return was still fairly high: about 11 percent a year, averaged over three years. Thus our Moderately Conservative portfolio retuned about two percent less than the Market one, while its risk – expressed by the standard deviation – was smaller by a factor of nearly 1.5.

Whom is our Moderately Conservative portfolio suited to? An investor who on the one hand would like to invest money in the market, but on the other would not want to risk too much. (Investors who do not wish to risk at all should not, of course, be investing in stocks and bonds, and instead should be buying CDs, Treasury bills, and similar instruments – something called “money market instruments.”) Whom else would such a portfolio fit? For example, a person who would like to invest for a fairly short period of time (we still, of course, are talking about years rather than months).

We discussed three model portfolios and compared them to a Market one. And what was the return of your investments over the past three years? If you know, you may compare it to our model portfolios. If you do not, contact us and we can calculate the return of your investment portfolio. This was Sergey Zaks. Thank you for your attention and until next time.