Mastery or Ignorance Part III

This post was also featured at Fortune Financial Advisors

Written by Lawrence Hamtil and Daniel Sotiroff with help from Alpha Architect’s Jack Vogel and Severian Asset’s Sam Lee

In the first installment in this series, we discussed how, contrary to conventional wisdom, the most profitable industries historically have tended to be not the companies most closely associated with technological innovation, but rather those that are least subject to disruption. In other words, industries such as tobacco and beer have tended have higher risk-adjusted returns than more glamorous industries such as software and financials.

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The Sharpe Ratio As An Efficiency Metric

Ratios and normalized metrics are used regularly in the hard sciences, particularly when it comes to comparing scenarios and outcomes. The efficiency of a vehicle, for instance, is typically measured in miles per gallon, or the distance traveled per unit of energy. A Toyota Prius at about 50 MPG is without a doubt substantially more efficient compared to say a top fuel dragster.

The financial world has its equivalent of miles per gallon: the Sharpe Ratio, which combines both return and volatility into a single metric

Sharpe Ratio Equation

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Confessions Of An Asset Allocator

Several years ago when I made my first real attempts at managing my own assets the idea of a fixed asset allocation strategy made a lot of sense. Diversify by allocating broadly to a wide range of foreign and domestic securities using fixed income to control volatility. Rebalance regularly, limit transactions as much as possible, and always mind fees. When you run strategies such as these through a back-test the results come out to be fairly decent over many different time periods and market cycles. There is nothing wrong with these strategies, and the vast majority of individual retail investors out there are most likely well served through such investment policies. The difficulty is often finding a strategy that aligns with one’s personal preferences and tolerance for volatility.

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The Five Laws of Gold

The Richest Man In Babylon was originally a collection of parables penned by George Clason in 1926 that focused on the judicious handling of money. Ninety years later these stories are still very applicable to our modern financial lives, with many of the lessons having been repeated numerous times in various forums. For all the time spent analyzing portfolio strategies and understanding asset class behavior there are some foundational concepts that must be in place to ensure personal financial success. Sound advice seldom, if ever, changes.

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Quantitative Value

The idea of buying stocks that are cheap and holding on as they appreciate in value over time is well aligned with the simple heuristic “buy low and sell high.” This central concept has created, for myself, a natural and intuitive pull towards value investing. The problem is that not all “cheap” stocks eventually go on to appreciate in value. Some are cheap for a reason–they have poor prospects and will likely end up in Wall Street’s corporate boneyard.

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Getting Real With Inflation

Inflation is one of the oldest and most well known adversaries faced by investors. Simply put it measures the change in price of goods and services that we purchase or consume including food, fuel, utilities, housing, clothing, entertainment, etc. That being said, investors must achieve a rate of return in excess of the rate of inflation in order to improve their purchasing power.

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Cost of Capital

Good businesses, by definition, earn more than they spend. Those that can’t or don’t simply cease to exist. A quick glance at any corporate balance sheet reveals a wide ranging list of liabilities including: wages and salaries, accounts payable, employee benefits, etc. But there is an additional liability not disclosed on GAAP compliant balance sheets: the cost of capital.

Cost of capital is essentially what a company must pay it’s investors for financing its business activities. It is roughly equivalent to the return an investor should expect to receive for investing in a company.

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