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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: Thinking About Diversification Date: 2/19/2006 4:01 PM
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Jack writes: “It is irresponsible of us to advise anyone to consider themselves diversified with two bonds of equal maturity. This doesn't mean they made a poor saving or investing choice but it isn't diversified. They are fully exposed to how the market treats that one maturity.”

Jack,

It is also irresponsible to advise anyone owning those two bonds that they are NOT diversified unless you are both able and willing to lay out a comprehensive theory of diversification, which you have not done, nor has anyone on this board done so. Therefore, anyone who comments on the holdings of that (presumably hypothetical) bond holder is speaking from ignorance, which is not unusual when it comes to talking about money and investing. To paraphrase a cynical comment: “Those who can, invest; those who can't, post.”

In his book, VALUE INVESTING: A BALANCED APPROACH, Marty Whitman claimed that it was meaningless, within the context of value investing, to talk about risk. He explicitly stated:

“There is no general risk. There is [only] market risk, investment risk, securities fraud risk, excessive promoters' compensation risk, and so on.” (p. 22)

I would argue that the same point could be made about diversification. There is no “general diversification” that can be obtained in fixed-income investing through the deployment of a pre-determined, one-size-fits-all amount of capital to buy a certain number of bonds.
Instead, there are only specific types of diversification strategies can might prove effective in mitigating specific types of risks.

Thus, I would repeat the claim I made in an earlier post that buying a single Treasury bond created a diversified portfolio. The words that I assumed were understood in the context of that particular discussion were these: “default risk”.

Buying a thousand Treasury bonds (of whatever maturities) does no more to protect against default risk than does buying a single bond. But choosing the issuer can be a sufficient strategy for protecting against default risk, and it is the only strategy for protecting against default risk that is available to those with insufficient capital to pursue alternative strategies. Therefore, a person with limited capital can own their own bonds and be diversified. They do not need the $50,000 that is so self-interested pimped by the financial industry. In buying that one Treasury bond, the investor might not have protected himself against a gazillion imaginable risks, but he has protected himself against default risk, which the financial industry regards as the 800-pound gorilla that cannot be avoided unless a would-be investor has $50,000 to deploy in bonds.

I challenge you to attend the workshops that are pitched at beginning fixed-income investors and keep track of the types of risks that are talked about. Default risk is likely to be the only risk that is talked about, and the argument always goes like this: Bonds are very complicated instruments. You do not have the expertise necessary to keep yourself out of trouble. However, we do. You do not have the capital necessary to keep yourself out of trouble. However, we do. Therefore, we will do you the great favor of managing your money for you at the low cost of our industry-competitive fees.”

Jack, I'm not picking on you specifically. But what I find infuriating is the persistent attempt to scare people away from owning their own bonds and the shabby arguments offered to justify bond funds as the solely appropriate vehicle for those with limited capital. For every investing/trading risk that can be identified, there are many defensive strategies can be devised and deployed. The investing task simply becomes a matter of identifying risks that are important to the investor and then guarding against those risks in cost-effective, time-effective, and skill-effective ways. This means that, often enough, some investments/trades have to be backed away from. They are too big to do, too risky to do, or simply not worth the effort. But it also means that a lot of things that are conventionally regarded as “too risky” can be done quite safely. In fact, finding such inefficiencies can create an effective “edge”. Thus, maturity risk might not be an important risk to an investor. In such as case, two bonds might be an adequately diversified portfolio, all other things being equal, which, of course, they never are. But it's for the individual himself to identify the risks that have to be protected against, not external observers with other agendas.

That's what a beginning fixed-income investor needs to be told and what she or he needs to realize, that a whole lot more of the investing world really is available to them that the entrenched interests want investors to realize. So genuinely, self-directed investing is the very last thing the middlemen want to encourage, because they would be out of a job. My claim is that whatever the so-called “experts” can do, an individual can likely also do if they really, really want to do it and they are willing to learn how to do it responsibly. This mean, of course, that they had better develop for themselves a theory of risk management instead of depending on the generally irrelevant advice of others and the vacuous warnings of “not being diversified”.

If a person knows that they know what the term “diversified” means operationally within the context of their own investing, then they are the only proper judge of their portfolio and its risks and the only proper judge of whether the risks that can be mitigated through diversification (which is not all risks) have, in fact, been mitigated. All else is the chatterings of the ignorant or the envious.

Charlie
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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15457 of 35400
Subject: Re: Thinking About Diversification Date: 2/19/2006 6:25 PM
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Jack writes: “It is irresponsible of us to advise anyone to consider themselves diversified with two bonds of equal maturity. This doesn't mean they made a poor saving or investing choice but it isn't diversified. They are fully exposed to how the market treats that one maturity.”
____________________*,*__________________

Today, the prize goes to Jack. Now I know this is only my prize and worthless on the eBay market, but,

While Charlie made valid points and brings in some good arguement material, Jack seems to be speaking of interest rate risk. Charlie then counters with a diseration on default risk. NOT THE SAME THING!

So this is apples to oranges!

To me interest rate risk and time diversity are also seperate, but this is not a common view as one easily ties time to interest rate, but remember a change in near term interest rates does not equate to the same change in long interest rates. So lets look at interest rate diversity.

If you have one, two, a thousand bonds with the same maturity then you are exposed to interest rate risk in an undiversified portfolio. Now, the fact that you have some coupon payments will give a little help as the cash flow over the entire bonds is not effected the same. But the maturity date - when the principal is returned is still subject to a nasty blow. And all the risk is tied to one interest rate.

In the recent interest rate climbing environment we have perfect examples of this. Lets say you owned 10 bonds with a 2-3 year maturity. Over the last year, you have witnessed a loss of principal. This is because the short, close, near end of the interest rate curve has gone up, a lot.

But if you had bonds with various maturities 2, 5, 10, 30 (25) then you have noticed a loss on the short end but on the long end the rate have not gone up, in fact the has been a little down movement. So, the value of some long bonds have gone up. That is diversity.

Now, in recent times this has been helpful, it other times it is not so helpful. The long end is very tempremental and can crush even a strong trader. The interest rate is not as volatile, but the end multiplier on value is.

So, two bonds with the same maturity does not really diversify interest rate risk. How many would depend on your feeling about the interest rate curve. This may be an interesting mathematical exercise I may tackle if some time is available. I guess you would want to see what maturities would reduce volatility to a minimum and then call a 90% reduction - diversified???

So, I guess I am irresponsible, because I have not laid out a plan for divesification, Sorry Charlie, this ain't starkist! But - one, two or a thousand bonds with the same maturity is not diversified for interest rate risk. And if they are all from the same issuer, then not for default risk either.

"It is irresponsible of us to advise anyone to consider themselves diversified with two bonds of equal maturity"

If anyone thought that my example of one bond meant that one bond diversified all risk, interest rate/liquidity/re-investment or charlies default, then that was my bad. Each of these require attention and some adjustments, but one thing that is common - the more maturities the better for each of topics.

DrTarr



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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15458 of 35400
Subject: Re: Thinking About Diversification Date: 2/19/2006 10:39 PM
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Charlie,

I certainly don't feel picked on so don't sweat that.

What is irritating is and out of my/our control are the assumptions of the reader/poster at the other end of the cyber world. There are some things that we can do to minimize that confusion and some things that we cannot.

If people want to pin on me the label of the 50k supporter then refuting it more then twice is a waste of my time.

I strongly disagree that we both(who ever both is) need to lay out a complete theory of diversification. As you know one size doesn't fit all. What is conducive to growth is to continue the banter about possibilities. Sometimes we get to the annoying point of hair-splitting definitions, the type that make you yawn to read.

I'll go back to a point I made about duration; diversification is a tool. Unlike simple metrics, which anyone can yahoo or a few take on the trouble of calculating for themselves, it is a powerful tool that if you aren't attentive and careful it will use you rather than you using it.

If forced I illustrate my hierarchy this way:
Goals
Strategy(ies)
Tactics

Diversification is, for me, a tactic. It is a means to implement my strategies, which are a means to reach my goals. This means that my diversification needs are shaped by my goals and strategies. I don't manage risk entirely via diversification. This keeps diversificaion, for my purposes, as one tool among others to manage varying types of risk.

This may or may not be true for other posters on this board. This also shapes how I respond. I stand by what I posted before; I do not believe that a portfolio of one or two bonds is diversified. This does not make that choice wrong or right. For me it doesn't pass the common sense defintion of "what is diversified". If I had 30 green M&Ms I wouldn't not say that I had a diversity of M&Ms. If I had one M&M of any color I wouldn't state that I had a diversity of M&Ms.

What I try to recognize is that for some diversification is either a meta-tactic or it lies within thier strategies. This is their major tool, strategy, for managing all of the risks they face within the fixed income markets. If this is so then they need to find a langauge and a way of identifying the risk(s) of greatest concern to them and diversifying them to a tolerable level.

If some hypothetical investor is looking to buy one 1k bond to balance their 5k in stocks and they buy one 3 year treasury to garner the "risk free" aspect while nearing similar duration as a full spectrum of treasuries I can't answer the question "Am I propery diversified?" nor can I answer the question "Did I make a good decision?". I'm happy to chat within them about their decision in hopes that they find for themselves the answer.

I do firmly believe that playing with definitions is unwise when we are speaking to multiple tiers of investor understanding. It may work on a personal level but in a public forum we need to stick to common understandings and work from there. It simply is not fair to ask someone who is just getting comfortable with price/yeild movements, treasury direct and the online bond shopping to play fast and loose with definitions they thought they already understood. This makes them feel like they know even less, that the mountain is too tall and that maybe bond funds are best.

For me, this moves the one bond, 2 bonds, 50 bonds, into the realm of tactics. Its answering the question; how do I deploy this cash within this market that best benefits me? Diversification, risk management, time to use, cash flow needs, time available, etc are all legitimate issues to question and to manage. What tools best address these issues? What tactics do I employ? Will one 3yr treasury cut it, is that best I can do under current conditions? What tactics or set of tactics best implements my strategies?

'nuff for now

jack

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15459 of 35400
Subject: Re: Thinking About Diversification Date: 2/19/2006 10:45 PM
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Jack seems to be speaking of interest rate risk

And reinvestment risk. It may be picking at nits but I see this a different then interest rate risk or at least subset of the issue. One the problems we run into is all the coupons would arrive at the same time and the principal will mature at the same time. If our intent is to remain as fully invested as possible then we are restricted by these due dates as to what we can do with the money.

jack

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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15460 of 35400
Subject: Re: Thinking About Diversification Date: 2/20/2006 12:50 AM
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Jack,

Not picking at nits at all. Even in my last post I referred to interest-rate/liquidity/re-investment/default all as seperate risks. And noted that one common contribution of holding various maturities is "diveristy" for most of these (and the only one it really doesn't help guard against - default - was used to argue against your point) In fact, if you had said interest rate risk was the same as re-investment risk, I would have tried to split that hair - they're not.

DrTarr

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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15473 of 35400
Subject: Re: Thinking About Diversification Date: 2/20/2006 3:49 PM
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Jack,

Thanks for your, as ever, thoughtful reply and your pointing out, graciously, something I was overlooking, i.e., the need to advance stepwise toward understandings for the benefit of newcomers to the conversation.)

Yours is a centrist approach, which has proven its usefulness. Mine is to consider the peripheries on the assumption that a theory has to handle all cases, so I might as well deal with the most extreme ones first. Hence, my trying to defend something like a one-bond portfolio forces me to deal with problems that are going to be common across a portfolio of any size and allows me to avoid dealing with problems that are size-dependent. So, it's a modeling technique; it's an investigative tactic.

But I would argue that the approach has real-world pay-offs. A beginning bond investors likely have a limited amount of capital and knowledge and the very first thing they will nearly universally hear is that they don't have enough capital or experience to do their own bond investing. So my approach is to de-emphasize the need for capital and to de-emphasize the utility of getting investing knowledge from others. The majority of offered advice and knowledge (including everything I say) is worthless, for several reasons.

(1) All most no financial advisor, newsletter writer, market commentator, etc. is making a living from their investing efforts. They are generating their income from the wages, fees, etc. they are extracting from sales of their products or services. The sooner a beginning investor learns that he is really on his own, the sooner the real learning can begin.

(1) No one can trade another man's game. Every investing approach, ultimately, is unique in its goals, strategies, and tactics for the reason that each human being is unique. Solipsism is the fundamental characteristic of investing/trading. So, once again, the sooner a beginning investor learns that he is really on his own, the sooner the real learning can begin.

(1) Therefore, every single definition has to be questioned and rewritten in terms of the investor's own experiences. Every exiting tool has to be tested before use. Every formula and calculation has to be verified.

That more responsibility than most people want to accept. That's more work than most people want to do. And I don't blame them one bit. Just getting through a normal workweek is job enough without taken on the task of also becoming a self-directed investor. But the costs of not doing one's own thinking can be horrendous, as people found out after March 2000, and as people are likely to re-discover going forward. So, it becomes a Catch-22 situation. OTOH, they are asked to believe that they don't have enough capital and knowledge to begin the learning process. OTOH, they really don't have enough knowledge to know that they really do have enough knowledge to begin the learning process.

Therefore, I prefer to tell them this:

Yes, you do have to keep yourself out of trouble, because if you get yourself thrown out of the game, you won't be able to learn the game. But the game you are going to have the best chance of winning is the game you create for yourself. Therefore, you want to be the one who's writing the rules. Therefore, you had better learn how to build games and how to test rules, and one of the key problems you're going to be dealing with is Diverisfication. You need to understand what you mean by the term, operationally, within the context of your own investing activities. No one else's ideas matter. It's your money and portfolio, not theirs.

Charlie


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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15478 of 35400
Subject: Re: Thinking About Diversification Date: 2/20/2006 9:00 PM
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DrTarr,

(1) Nothing I post has any more enduring importance than oar-prints made on the surface of a lake as the fisherman rows himself home in the evening.

(2) Whitman's assertion that risk(s) is/are specific, not general, can be adopted/adapted to fixed-income investing as each person sees fit.

(3) That for each risk a multiplicity of defensive strategies can be devised is also a notion that be accepted or rejected according to needs/abilities of each person.

(4) There are risks for which diversification, however defined, offers no protection.

(5) Conventional notions of diversification, built as they are upon classical statistics, are financial foolishness (due to “fat tails”).

(6) Position sizing would likely prove a more readily determinable, more easily implemented, and far more effective risk-management tool than “diversification” in the lives of most investors, fixed-income or otherwise.

(7) The tools of duration and convexity are noise, not information, for me due to how my bond portfolio is constructed and managed.

(8) I chose to exclude television from my life years ago, but I still love that Starkist commercial.

Charlie


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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15499 of 35400
Subject: Re: Thinking About Diversification Date: 2/21/2006 10:42 PM
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I too know that a week from know, my ripples will be glass.

(5) Conventional notions of diversification, built as they are upon classical statistics, are financial foolishness (due to “fat tails”).

For equities - Not to mention leptokurtic and skewed!!


(7) The tools of duration and convexity are noise, not information, for me due to how my bond portfolio is constructed and managed.

For most - "investors," these have no place, as - if held to maturity, the return is what it is and par is what you see. For me more often than on the links.

DrTarr






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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15501 of 35400
Subject: Re: Thinking About Diversification Date: 2/22/2006 9:46 AM
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For most - "investors," these have no place, as - if held to maturity, the return is what it is and par is what you see.

If by "investors" you mean "people who have decided to buy-and-hold, no matter how overvalued the market gets in the interim, because it will be fairly valued at the end."

In my case, I would consider selling a bond early if its price was out of line on the high end and if I had somewhere better to put the money.

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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15508 of 35400
Subject: Re: Thinking About Diversification Date: 2/22/2006 9:41 PM
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For most - "investors," these have no place, as - if held to maturity, the return is what it is and par is what you see.

If by "investors" you mean "people who have decided to buy-and-hold, no matter how overvalued the market gets in the interim, because it will be fairly valued at the end."

In my case, I would consider selling a bond early if its price was out of line on the high end and if I had somewhere better to put the money.


jrr7,

What is theoretically desirable and what is actually possible are often two very different things when it comes to bonds.

If you meant "a bond", as in one bond, not 5-10 bonds with the same CUSIP, then your chances of capturing that premium to par are slim to none due to how bonds are traded. On enough occasions I've attempted to offer out my bonds, and the broker would shop them around (as they are required to do), but no one would bid on them. And these were bonds for which there was an active enough market and I was willing to sell them at market. But my lot of 5 (or whatever) drew no interest.

Just last week I tried to sell 10 of an issue in which I have a fat profit from where I bought them, but the sell order was rejected for being under a 25-bond minimum for that particular issue.

It is very easy to sell almost any stock, in almost any quantity, and get a fair price. That is not the case with bonds. So a bond holder often ends up having to hold to maturity.

Treasuries are an exception. They really are liquid, and I've had no trouble trading small quantities to capture premuims. However, commish and spreads seriously cut into profits.

Charlie




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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15513 of 35400
Subject: Re: Thinking About Diversification Date: 2/23/2006 10:33 AM
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jrr7,

In my case, I would consider selling a bond early if its price was out of line on the high end and if I had somewhere better to put the money.

This is a good method if you understand the value of your holdings. You need to undestand this in a dual value sense; the value you apply to your holdings and the value the market places on your holdings. When they diverge their is opportunity for someone to make an outsized profit.

This takes an understanding of the market your holdings are traded in. For those that have no desire to become a sophisticated, high end, high speed, low drag investor it isn't too difficult to understand the basics of the debt market. Someone used the grocery shopping analogy which works nicely here. If beef goes on sale we eat beef. But one needs to know the typicaly price of beef to make it work. Charts and trends identified on them or simple market watching, week to week, is adequate to this task.

jack

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