The Diversification Debate

In addition to the question of how many stocks they should own, another similar question many investors ask is how many funds or asset classes they should own. In a recent Financial Times column, David Stevenson offers some interesting data on the topic, as well as some comments from top strategists.

The “proper answer” to those questions, Stevenson says, is to follow the modern portfolio theory developed by Harry Markowitz, which “suggests that you look at risks and returns, alongside volatility, and then compute something called ‘an efficient frontier’ of different assets, allocated sensibly, in an optimised fashion.” But, he adds, many of the top financial minds in the world — including Markowitz himself — don’t do that. Markowitz actually once said that he regretfully split his portfolio 50/50 between bonds and equities.

“He’s not alone,” Stevenson continues

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Paulson on Financial Buying Binge

After profiting hugely from shorting financial stocks last year as the sector tanked, hedge fund guru John Paulson has been buying up beaten-down financials this summer.

Paulson has bought a stake of about 2% in Citigroup, the New York Post reports, citing sources. “One source said that Paulson sees Citi’s shares trading closer to its book value of $5 to $7 a share, and that he has been scooping up shares in the bank over the past several weeks,” the Post stated, adding that a Paulson spokesperson declined to comment.

Earlier this month, The Wall Street Journal reported that Paulson bought 168 million shares of Bank of America in the second quarter, as well as 14.9 million shares of Capital One Financial Corp., 35 million shares of Regions Financial Corp., and smaller stakes in Fifth Third Bancorp and Goldman Sachs Group. He also made large investments in mining companies that deal with gold and in gold exchange-traded funds, the Journal reported, noting that Paulson had previously said he was bullish on gold.

Beating the Timing Temptation

As Liz Ann Sonders notes in the posting below, a lot of investors are now wondering whether it’s too late to jump into the market, or, for those who have been in the market during the rally, whether it’s time to cash out. As Sonders says, such all or nothing decisions are very dangerous — and The Stingy Investor’s Norm Rothery has laid out some excellent reasons why.

In an article titled “Tempting Temptation” (originally published earlier this summer in Canadian MoneySaver but still quite relevant now), Rothery touches on a number of studies and data sets on market timing — all of which show that trying to jump in and out of the market often leads to major underperformance.

“Even normally level-headed index investors suffer from poor timing,” Rothery writes. “Morningstar.com reports that the Vanguard Total Stock Market Index fund lost 1.59% annually during the 10 years ending April 30, 2009 but index fund investors suffered a 4.04% annual decline. In this case, poor timing reduced returns by 2.45 percentage points annually.”

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Sonders Says We’re in “Coiled Spring” Recovery, Warns Against All or Nothing Bets

Charles Schwab Chief Investment Strategist Liz Ann Sonders tells Fox Business Network that she thinks we’re in the early stages of a “coiled spring” recovery, and says that too many investors are trying to make all-or-nothing calls as they ponder whether to get back into the market right now.

Sonders, who correctly called the start of the recession, says there’s a risk that what we’re seeing now is a “sugar high”. But, she adds, “I think that the better case right now is that there’s going to be a little more sustainability thanks to corporate profitability than a lot of people think. And I think we could see a longer lasting pop here than certainly the pessimists believe.”

Guru Strategy Rating Changes: Dish Network, Under Armour Rising

Each week, I take a look at which stocks my Validea.com Guru Strategy computer models have newfound interest in, and which they have soured on. Here’s a look at some of the stocks that my strategies have upgraded or downgraded today. Among the bigger names on the move: athletic apparel maker Under Armour and gaming company Electronic Arts.

Guru Strategy Rating Changes -- Aug. 26, 2009

They Got It Right in March; What Do They Say Now?

A few weeks ago, we highlighted how Jeremy Grantham — who quite presciently had advised investors to “reinvest when terrified” back in March — is now sounding much more cautious. And, according to The Wall Street Journal, Grantham isn’t the only strategist who correctly called the market’s upturn but is now feeling less optimistic.

“In March, analysts who picked the bottom were a lonely lot,” writes the Journal’s Mark Gongloff. Now, he says, several of those who did get it right “say they aren’t roaring bulls about the long-term outlook, although their views for the next 12 months are split.”

Among them is Grantham’s colleague at GMO, Ben Inker. “The past 12 years have seen two bubbles that were really good for corporate profits,” says Inker, GMO’s director of asset allocation. “Now things are unlikely to be anywhere near as good as people have gotten used to, because we’re not going to have a bubble to help us.”

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Berkowitz: “Great Environment” for Stock-Pickers

Top fund manager Bruce Berkowitz, whose Fairholme Fund has earned about 12% per annum over its 10-year history while the S&P 500 has lost about 3% annualized, says that this is a “great environment for an investor, for a value-based stock picker, security picker”, and that he’s continuing to see a number of bargains in the market even after its recent rise.

Berkowitz, who is something of a contrarian, tells Steve Forbes that his fund remains high on healthcare stocks, despite — or perhaps because of — all the talk of sweeping healthcare reform. “They’re in the high to mid-single digit [price/earnings ratios] with rock solid balance sheets and you really can’t ask for much more,” he says of Fairholme’s healthcare holdings, which include Pfizer, Forest Drugs, Forest Labs, Humana, and WellPoint. “And my question is: Well, if these companies aren’t going to do it … in healthcare, who is going to do it for us?” Berkowitz says it’s a similar story with some defense stocks.

Berkowitz also delves in to the ins and outs of his portfolio management style. One of his key tenets: Keep a focused portfolio. “Once you get much more than 25 securities, you’re going be lucky to, you know, you’ll be approaching the averages,” he said.

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M.I.T. Hedge Fund Guru Shares His Secrets

In an interview with WealthTrack’s Consuelo Mack, hedge fund manager, author, and M.I.T. professor Andrew Lo says that the financial crisis has shown that a new type of diversification is needed, that buy-and-hold investing is an incomplete approach, and that using a long-only approach puts individual investors at a significant disadvantage.

Lo, who also heads M.I.T.’s laboratory for financial engineering, says buy-and-hold investing is “not necessarily wrong, but it’s incomplete.” Back in 1970s and 80s and 90s, the market had its ups and downs, but overall there was a level amount of risk and a reasonable risk premium, so returns were good. “In order for us to get that kind of return going forward, the long run may now actually be 50, 60, 70 years, not 10 or 20,” he says. “And so, the fact that financial markets have experienced such a significant dislocation really requires us to rethink that paradigm, and think, again, more broadly of not just stocks for the long run but perhaps a combination of other asset classes for the long run.”

Lo

Among those other asset classes, he says, are commodities, currencies, Treasury Inflation-Protected Securities, and real estate.

Lo, a major student of investor psychology, also notes that while the recent crisis was severe, the underlying drivers were the same. Human psychology and free enterprise naturally combine to produce financial crises, he says, and as we understand more about that phenomenon, we can better detect warning signs and plan for the crises.

Lo also discusses why he thinks skittish investors need to get back in the saddle; why he thinks another bubble is bound to form; and why he thinks funds like his new fund, which aims to track the performance of a hedge fund in terms of diversification and long/short approach, could become the new market indexes.

Stiglitz: Asian Recovery Is “Remarkable”

Two-time Nobel Prize-winning economist Joseph Stiglitz, who recently said he sees a period of “malaise” coming for the U.S. economy, is much more upbeat on Asia’s economies.

“Asia’s recovery has been remarkable,” Stiglitz said at a conference in Bangkok, Voice of America reports. “People are talking about a ‘V’ shaped recovery. The big issue that it raises is can Asia decouple from the West — the U.S. and Europe? You have a robust large economy here in Asia and so you have the basis of developing a regional economy.”

“Stiglitz says Asia’s economies are in a good position to reduce their dependence on exporting goods to the United States and Europe,” VOA reports, adding that he was “upbeat over the economic outlook for the region.”

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Ritholtz Cautious, But Says “Traders’ Rally” Still Has Room to Run

Barry Ritholtz — who presciently started turning bullish back in March — says much of the market’s oversold status has been worked off, but thinks the market could continue to head upward into the fall.

Ritholtz, of FusionIQ and The Big Picture blog, tells Yahoo! TechTicker that mutual fund managers have gone from a very low average exposure to equities during the financial crisis back to the more invested levels at which they were back in October of 2007. “We’ve worked off lots of that oversold position,” he says, “[But] it’s not a sign the rally is over. It’s a sign that one source of fuel is starting to run low.”

Ritholtz says this is a traders’ rally — not a multi-year rally, but he “wouldn’t be surprised to see 60, 70, 80 percent” gains before the market’s rise ends. He thinks we could see the S&P 500 hit 1,050 to 1,080, and, potentially, as high as 1,200. But he advises investors to be cautious, and use stop-loss positions to avoid losses if things head south.

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