Philosophy
Submitted by Liberty Valley on Sun, 2006-12-24 20:45.
Balanced asset allocation
By selecting among equities, bonds, real-estate, precious metals, and cash, our portfolio can be diversified and positioned for maximum protection of capital. Different asset classes have different total return concepts, which are usually a combination of growth and income. Some of the growth results from monetary inflation*. The income has to be viewed in relation to the purchase price of the asset. Relative income is small for a high purchase price, resulting in more dependence on growth.
Determination of value
After estimating income and real growth for each asset class (and the general inflation growth), the results are compared with their historical averages. Higher than historical relative income and higher expected growth result in a discount to fair value. Higher inflation outlook adds to the discount for stocks, real estate, and precious metals, but reduces the discount for bonds. The value approach comes into play by overweighing the sector with the largest discount and underweighing the sector with the largest premium.
Contrarian approach
Since future trends are unknown and present trends can be misleading, a contrarian approach is another factor for adjusting our strategy. A contrarian bias prevents us from falsely extrapolating a present growth into the future, if the growth is caused by overly optimistic investors. If, for example, real estate gets widely recognized as a great investment, more and more people will invest in real estate. As more investors enter that market, it is virtually guaranteed that growth in price follows. Price increases lead to further confirmation that real estate is a great investment, drawing more and more people into the investment pool. It is this "increase" in participation that leads to an "increase" in the present growth rate. Such an increase should not be counted if more than an average number of participants are placing bids in that market. On the contrary, once a historically high percentage of people participate, it is more likely that participation can reverse. To properly account for this possibility, we will remove the "excess" growth and additionally apply it as a possible negative-growth component for our best estimate of a future trend.
Our investment philosophy is based on three fundamental concepts: 1. Balanced asset allocation, 2. Determination of value, and 3. Contrarian approach.
By selecting among equities, bonds, real-estate, precious metals, and cash, our portfolio can be diversified and positioned for maximum protection of capital. Different asset classes have different total return concepts, which are usually a combination of growth and income. Some of the growth results from monetary inflation*. The income has to be viewed in relation to the purchase price of the asset. Relative income is small for a high purchase price, resulting in more dependence on growth.
If the relative income is the same, there is in principle no asset class that is as favorable as common equities, e.g. shares in producing enterprises. As an investor, one is entitled to an income (the part of the earnings that is not reinvested), a real growth (rising productivity or expansion of the business), and an inflationary growth (prices rise universally). Other assets, like real estate, do not have the real growth component (unless certain localities become more desirable). Regular bonds or cash do not have either growth component and are left with a "fixed" income. And precious metals, on a very long-term perspective, do not have any income or real growth, but do rise with inflation.
Some allocation among these sectors is obtained by being naturally diversified to spread the risk, but more important is the determination of value.
After estimating income and real growth for each asset class (and the general inflation growth), the results are compared with their historical averages. Higher than historical relative income and higher expected growth result in a discount to fair value. Higher inflation outlook adds to the discount for stocks, real estate, and precious metals, but reduces the discount for bonds. The value approach comes into play by overweighing the sector with the largest discount and underweighing the sector with the largest premium.
For example, if stocks have less relative income than in the past, one might try to move some capital into real estate. If real estate also provides less relative income than historically, one might move more into bonds. If bonds also provide low yields, and inflation growth is taking a respectable size, then the function of precious metals comes into play.
Some of the variables are unknown as they refer not only to the present but also to the future. For growing earnings, we avoid predicting the future by emphasizing a "bird in the hand" approach (Graham), and putting higher weight in current earnings, yield, and inflation numbers.
Since future trends are unknown and present trends can be misleading, a contrarian approach is another factor for adjusting our strategy. A contrarian bias prevents us from falsely extrapolating a present growth into the future, if the growth is caused by overly optimistic investors. If, for example, real estate gets widely recognized as a great investment, more and more people will invest in real estate. As more investors enter that market, it is virtually guaranteed that growth in price follows. Price increases lead to further confirmation that real estate is a great investment, drawing more and more people into the investment pool. It is this "increase" in participation that leads to an "increase" in the present growth rate. Such an increase should not be counted if more than an average number of participants are placing bids in that market. On the contrary, once a historically high percentage of people participate, it is more likely that participation can reverse. To properly account for this possibility, we will remove the "excess" growth and additionally apply it as a possible negative-growth component for our best estimate of a future trend.
*We define monetary inflation as the growth in the supply of money and credit. (See the Austrian economics definition of inflation.) Issuance of new dollars into circulation lowers the value of any existing dollars proportionately.