2018

January 19, 2019
Once again, the SmallTrades Portfolio failed to outperform 
the Standards & Poor 500 TR Index ('benchmark'). In 2019, I
will replace five exchange-traded funds (ETFs) with a single ETF.

The SmallTrades Portfolio is actively managed within a tax-protected Roth IRA.  No cash has been added or removed from the account since the time of inception in 2007.  Figure 1 describes the portfolio and its investment strategy:

portfolio 2018 v3

Fig. 1. The holdings as of 12/31/2018.

The following strategies are used to earn capital gains:

  • The passive strategy is to collect dividends and capital gains from exchange-traded index funds (ETFs).  Each ETF is ‘passively’ managed to match the performance of a market index rather than ‘actively’ managed to outperform or underperform a market index.
  • The swing strategy is to buy the stock at a low price (‘bargain’) and sell it at a high price, however long the price-swing happens to occur.
  • The growth strategy is to purchase a reasonably priced stock and hold it until the company stops growing over several-to-many years.  The stock price should increase with the company’s profit.
  • The drip strategy is to buy a reasonably priced stock to collect dividends and reinvest them in additional shares of stock.  The beneficial effect of ‘drip’ increases as the stock survives several market cycles.

2018 Performance

Figure 2 shows the changes in value for every $1 invested in the Portfolio (solid blue line) and Benchmark (dashed blue line) after 12/31/2007.  The market value of the benchmark was consistently higher than that of the portfolio.

invested $ portfolio

Fig. 2.

 

In 2013, I replaced the Portfolio‘s mutual funds with ETFs that match the performance of 4 market sectors based on a model portfolio of global stocks, U.S. real estate investment trusts (REITs), U.S. bonds, and gold bullion.  I rebalanced the ETFs as needed and continued to actively manage a group of stocks.  Figure 3 shows annual fluctuations of the stock values (solid red line) and ETF values (dashed red line) as if $1 were invested in each group on 12/31/2013.

invested $ stocks

Fig. 3.

The benchmark (solid blue line) underperformed the stocks and outperformed the ETFs until 2018, when the benchmark surpassed both groups of investments (Fig. 3).

Why?

Several events in 2018 worked against the portfolio.

  • The U.S. stock market lost its collective annual earnings in the last quarter of 2018.  Most stocks declined in value.
  • Stop-loss trading orders triggered steep losses from 5 stocks in the portfolio.  Four were high-risk investments in small companies that failed to generate returns.  One investment was a large company with steadily declining earnings.
  • The 4-sector model portfolio predicted that the portfolio’s ETFs would collectively grow by nearly 9% every year, but instead they grew at half that rate, 4.4% annually.  The databases for the model portfolio were outdated (limited to the time period of 1997-2011) and have not been updated.

Plan

The new SmallTrades Portfolio will hold one index fund, the Schwab U.S. Large-Cap ETF (i.e., SCHX), and a group of stocks.  The SCHX is designed and tested to match the performance of the benchmark (more information in Model Portfolios, updated). The stocks will initially comprise 20% of the portfolio’s market value and they will be actively managed to outperform the SCHX.  Consequently, the portfolio’s growth should outperform the benchmark’s growth.

Copyright © 2019 Douglas R. Knight


2017

January 1, 2018

My SmallTrades Portfolio holds stocks and broad-market index ETFs (chart 1).

chart 1. SmallTrades Portfolio in 2017.

Chart 2 shows the diversification of ETFs as measured by percentages of year-end market values among ETF classes.

chart 2. Diversification of ETFs in 2017.

Chart 3 shows the diversification of stocks among 8 market sectors as measured by percentages of year-end market value for each stock sector and the ETFs.

Chart 3. Distribution of stocks and ETFs by market sectors.

Chart 4 shows the distribution of stocks according to market capitalization.

Chart 4. Combined market capitalizations.

Performance

My investment goal is to outperform the “Benchmark” Standard & Poors 500 Total Return Index, yet my portfolio has never outperformed the Benchmark (chart 5).

Chart 5. Portfolio performance.

Chart 5 shows growth trends for the benchmark (blue dashed line) and portfolio (solid blue line) since 2007 [the benchmark represents a passively managed, buy-and-hold investment; my portfolio is an actively managed investment].  On the Y axis, a unit value of $1.00 was assigned to both the total market value of the Portfolio and the Benchmark on December 31, 2007. Ratios of subsequent market- and benchmark values to the 2007 baseline are displayed line plots on the chart.

In 2014, my investment policy was modified to buy stocks of good companies and hold them for the long term. Chart 6 shows the result of my stock investments (red line) compared to the Benchmark Index (blue line) and ETF investments (red dashed line). The unit value of $1.00 was calculated on December 31, 2013. Since then, the stock group clearly outperformed the Benchmark and ETFs.

Chart 6. Stock and ETF performances.

Risk Management of ETFs

Broad-market index ETFs are primarily protected against stock losses by the passive management of investment portfolios which mimic the composition and performace of reputable market indices.

ETFs are secondarily protected by rebalancing significant allocation errors as described in the SmallTrades Portfolio’s strategies for risk management. In theory, a significant drift of asset classes occurs when one asset class surpasses a 24-28% allocation error. My preferred allocation of ETF market values is 30% stocks, 30% REITs, 20% bonds, and 20% gold bullion.

A perfect allocation of ETFs would result in 0% allocation error.  Furthermore, allocation errors would reflect disproportional gains or losses of market value.  Chart 7 shows the year-end allocation errors (blue bars) and error limits (red dashed lines) of my ETFs. There was growth of the Global Stocks ETF and decline of the remaining ETFs. Any allocation error that exceeds an error limit (red dashed line) should trigger trades that rebalance the ETFs to the preferred allocation.  My ETFs were not rebalanced in 2017.

Chart 7. ETF allocation errors in 2017.

Risk management of Stocks

My stocks are primarily protected against risks of steep loss by diversification of the market sectors, as illustrated in the preceding chart 3. The second line of defense is stop-loss orders.  In keeping with the investment goal of holding good stocks for the long run, I set ‘stops’ at a wide margin to prevent recent market fluctuations from triggering an unwanted sale.

Plan

The SmallTades Portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. In 2017, I failed to sell large cap stocks in order to buy good small cap and mid cap stocks. Consequently, 60% of the total market capitalization of my stock portfolio was in the Large Cap category.  In 2018, I would like to reduce the Large Cap category to 40% total market capitalization and boost the market capitalization of small- and mid cap stocks issued by good companies with potential growth of earnings.

Portfolio history

  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in a Roth account.
  2. During 2007-2010 the actively managed mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’.  Four mistakes led to a big loss:
  3. mistake #1: after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of the company’s large debt and lost $45,000 during Lehman’s decline to bankruptcy.
  4. mistake #2: substantial long term profits from good companies were lost by selling holdings for short term profits. My strategy was to earn a quick 30% in the first year and re-invest in the next winners. It was too difficult to identify the next winners.
  5. mistake #3: day-trading was a game of chance that I played and managed to break even; meanwhile, good stocks grew in value.
  6. mistake #4: a trial of investing in leveraged ETFs resulted in losses due to negative compounding.
  7. I abandoned the goal of a 30% annual return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad-market index ETFs and 20% stocks for the long term. ‘Good’ companies attract and retain investors for many years. I will search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, partiicipating in an investment club, using stock screeners, and attending investor conferences. Then I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  8. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since my retirement income didn’t depend on making withdrawals from the SmallTrades Portfolio, I increased my ETF exposures to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

2014

February 4, 2015

The SmallTrades Portfolio holds investments in five financial markets.  Tax expenses are reduced by trading the Portfolio’s underlying holdings in a tax protected brokerage account.  For tax reasons, any stock or exchange-traded index fund (ETF) issued by a partnership is excluded from investment.

The Portfolio has two subgroups:

  1. Established ETFs that are traded infrequently in the markets for global stocks, global gold, U.S. real estate, and U.S. bonds.
  2. Common stocks that are traded frequently in the U.S. market.

Both subgroups contain high risk investments which are expected to outperform a benchmark index called the Standard and Poors 500 Total Return Index.

The investment performances of the Portfolio and its benchmark index are measured graphically by plotting changes in the market value of an invested dollar (chart).

performance2014

For every dollar invested on the inception date of 12/31/2007, the market values of the Portfolio and benchmark index dropped by nearly half during the Recession year of 2008.  Recovery from the Recession left the performance of the Portfolio lagging behind the benchmark due to the underperformance of a large subgroup of stocks.  Starting in 2013, the Portfolio’s investment capital was gradually shifted from stocks to ETFs and the result was a gradual rise in market value.   Starting in 2014, the ETF for emerging-market stocks (VWO) was replaced by one for global stocks (VT).  At the end of 2014, the market values of the holdings were distributed into a 79.4% portion from ETFs and 19.7% portion from stocks (table).

 portfolio2014

The Portfolio’s performance is measured statistically by its compound annual growth rate (“CAGR”) of market value since inception.  The performance improved during 2014 (CAGR -3.3%) compared to 2013 (CAGR -5%), but still lagged the benchmark index (CAGR 7.3%) and U.S. inflation of prices (CAGR 1.8%) by considerable margins.

Calendar year 2014 was the inaugural year for graphing the performance of the ETFs and Stock subgroups.  The following chart shows that stocks outperformed ETFs during the first year of assessing subgroups.

subgroups2014

ETFs subgroup

The ETFs subgroup is designed to match the performance of financial market indices for global stocks, U.S. investment-grade bonds, U.S. real estate, and global gold bullion when equal amounts of cash are invested in each market.  The market indices for global stocks and U.S. real estate are expected to outperform the U.S. bond index.  The gold index is expected to fluctuate according to changes in investor sentiment for stocks, bonds, currencies, and commodities.  The gold index typically moves moves up when investors seek the gold market and down when investors seek other markets.

The main risk of losing money from established ETFs is derived from a large decline in market prices.   Consequently, the risk management strategy is to rebalance every asset class to 25% of total market value when any asset class drifts below 18% or above 32% of the total market value.  Drifts did not trigger a rebalance of asset classes during 2014 (chart).

ETFassets2014

Stocks subgroup

The investment strategy is to buy stocks at a discount price and sell them at a premium price.  Discount prices are selected from undervalued companies in several ways:

  • Use of a stock screen
  • IPO’s of potentially successful companies after the first day of public trading
  • Media disclosure of good companies
  • Previously owned stocks

Premium prices are discovered by setting alerts for rising prices and placing conditional sell orders in the broker’s trading platform.

The typical holding is selected by a stock screen, held less than one year, and sold with a conditional sell order.  Small-cap stocks characteristically offer better growth potential and higher returns – but at a higher risk – compared to large-cap stocks.  Consistent with the Portfolio’s high-risk investment goal, the total market value of the Stocks subgroup is divided into portions of 22% for large-cap stocks and 88% for lower capitalizations (chart).

MktCaps2014

Conclusions

The SmallTrades Portfolio is an unleveraged, diversified collection of high-risk securities that are traded in the U.S. stock market.  The Portfolio continues its gradual improvement in performance following the 2008 Recession, but its performance still lags that of the benchmark index.  Acceleration of the Portfolio’s performance will depend on the future resurgence of stocks in the emerging markets coupled with high performance of the U.S. real estate market.  Rebalancing the Portfolio’s holdings is expected to partially offset the potential loss from a future declining market.

Copyright © 2015 Douglas R. Knight


My portfolio on 12/31/2012

January 30, 2013

Summary

I use the investment strategies of “speculation”  (timing the market to earn quick profits) and “indexing” (holding index funds for a long time) to earn profits from the stock market.  Unfortunately, my portfolio underperforms the U.S. stock market and needs revision.  An analysis of annual returns indicates that I could improve portfolio performance by doing more indexing and less speculation.

History

Before 12/31/2007, I made annual contributions to a tax-deferred brokerage account that was created and managed by a financial advisor.  After retirement in 2007 I stopped adding cash to the account and began making the investment decisions.

Performance

The performance of my portfolio is shown in the following chart:

portfolio performance

At the baseline date of 12/31/2007, my portfolio’s market value was $1 for every 95 cents of cost basis.   The time course of the year-end market value (blue dots) is plotted as a series of ratios to the baseline market value. Also, the year-end cost basis (brown dots) is plotted as a sequence of ratios to the baseline cost basis.  The market value and cost basis plunged downward during the 2008 Recession and never fully recovered.  By comparison, the black-dotted line represents a hypothetical $1 investment in the benchmark portfolio named the S&P 500 Total Return Index.  The benchmark also crashed during the 2008 Recession and then recovered with steady growth.  The portfolio’s market value has a 5-year CAGR of -5.32% and the benchmark’s 5-year CAGR is 1.38%.  By these measures, my portfolio underperformed its benchmark by a staggering 6.7% difference in CAGRs.  An analysis of the annual returns showed that speculative trading of stocks explains the underperformance.

Planned corrections

My portfolio held the following securities at the end of 2012: holdings2012

The red colored securities were bought on speculation and the green colored securities are index funds.  I plan to modify the portfolio by selling the red colored holdings and using the proceeds to increase the cost basis of the green colored ETFs.


My portfolio on 12/31/2011

January 14, 2013

Portfolio performance as of December 31, 2011.  Chart (below) displays the compound annual growth rate (CAGR) of my portfolio since December 31, 2006.  The S&P 500 TR is an index for the total return of the largest 500 U.S. stocks as determined by rankings according to market capitalization.  My portfolio is underperforming the Investment goal and the S&P 500 TR.

Perspective.  According to recent data, many hedge funds underperformed the S&P 500 during this time period.

Portfolio holdings.  Table data (below) show the year-end assets held in my portfolio.  Ticker is the stock exchange trading symbol.  % of Total Market Value is calculated by the formula “100 (year-end asset value/year-end portfolio value)”.


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