Sunday, April 6, 2008

Retirement Planning and Risky Portfolios

They must be pretty smart down in Corpus Christi. I’ve never been there. Judging by the personal finance column that appears in the Caller-Times, H. Swint Friday a professor of finance at Texas A&M University-Corpus Christi with a doctorate in finance and a master's in economics and is a certified financial planner thinks they are. From what I gather, the folks who live there, even the beginners down in Texas take risks.

Corpus Christi Harbor

Mr. Friday, whose column titled Personal Finance 101 suggests some restructuring for your portfolio based on research offered by Harry Markowitz, a mathematical economist. Professor Markowitz, also no slouch in the credit department is also mentioned as the founder of the Modern Portfolio Theory and was involved in optimal portfolio performance research.

We all know what optimal portfolio performance is. Right? No? Without a lot of the mathematical twists and turns, it is the perfect balance of risk. Providing of course you know what kind of risk tolerance you have, which many of us don’t, you can create what Mr. Friday and Markowitz call an M portfolio.

This, at least according to Mr. Friday, is beginner’s stuff. All you have to do is understand that “Higher standard deviation portfolios are more volatile” which I'm sure all of you know.

In all fairness, before he dangles the hope of the perfect portfolio in front of those readers, he does offer some disclaimers. You should be well aware of composition, a nice word that offers up a blend of not only tolerance and wealth but also the intent. The desire for returns, as Mr. Friday writes is not even on the list when investors in Corpus Christi consider building this type of investment.

You would hope that your financial adviser has the sense to pick up on all of these nuances, subtract liabilities and then, calculate what you are worth as an earner. The higher the net pay, the greater the score your financial adviser might give you for your ability to live up to your potential human capital.

“Human capital” is what pensions are all about. Companies were able to exploit your human capital when you were younger and as you aged, offered payment for years of loyalty with a pension for your after-work years. In retirement planning outside of a pension, this carries extra importance. It is why it so critical to get going as early as possible in your working career on building a retirement account to allow compounding to do most of the heavy lifting.

When Mr. Friday discusses human capital, he is looking at the potential for losing everything against the how long your income recovery time is.

Mr. Markowitz’s portfolio research suggests that his M portfolio, after buying risk free T-bills as a hedge against the risk, what the investor should “own to some degree is a mix of all the assets in the world at their respective values in the world portfolio of assets. That is, each asset including oil, timber, gold, silver, beef, art, real estate and so on is included in this portfolio and they are included at their current representative value in the world portfolio. So, for example, if the total value of the world's portfolio is $100 and the total value of the world's oil is $1 then oil would have a 1 percent representation in the M portfolio.”

All you beginners out there get that? Did it offer any of you experts out there something that you might find plausible?

Mr. Friday’s lesson in how to build a portfolio has merit but not for anyone who considers themselves at more than the halfway point of their working career. Such a portfolio would probably do spectacularly considering the rising prices of commodities of late. With demand looking to increase for the world’s limited supply of what looks like a long list of raw materials, even a few that might qualify as hedges against inflation, the average investor would be better off avoiding such risk the way the M portfolio outlines.

But if it seemed like something you just have to try, consider doing it as part of a mutual fund/ETF. One, operated by the noteworthy Jim Rogers comes to mind. According to RCG Alternative Investments site, “The Rogers International Commodity Index (RICI) represents the value of a compendium (or "basket") of commodities employed in the global economy, ranging from agricultural products (such as wheat, corn and cotton) and energy products (including crude oil, gasoline and natural gas) to metals and minerals (including gold, silver, aluminum and lead). As of July 31, 1998, there were thirty-five different contracts represented in the Index.”

This would mean your portfolio, if constructed as suggested, would be based on only two investments: The commodity index (The RICI TRAKRS Index is a total return index designed by Merrill Lynch, Pierce, Fenner & Smith Incorporated and is traded as a Dow Jones Index) and T-bills. I would be wary of that kind of limited diversification no matter how much you made, how risky you felt, or what you estimated your human capital to be worth.

Adding some additional investments and bringing each of those investments down from 50% each to only 10% would give you just enough risk for any portfolio. Both investments are hedges against inflation and although that might seem like a logical place to put your money today, allocating too much of it in both would not give you the long-range options that a balanced risk portfolio would.

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