Asset Allocation, Risk Tolerance and Shortfall Risk

Asset allocation is the biggest driver of portfolio performance, particularly over the long-term. Moreover, it also is reflective of an investor's risk tolerance. The recent financial crisis has negatively impacted investment psychology, particularly among younger investors. As a result, the so-called "Generation-Y" has over half of their assets held in cash -- a "non-earning" asset. While this is safe, there is a risk of loss in value, as cash does not even hold up with inflation. In the long-term, such an allocation means a lower retirement balance--i.e., shortfall risk. Thus, these investors have essentially traded one type of risk for another. See article here, Investment News.

Volatility and Derivatives

There are six primary inputs used to determine the price of a stock option: underlying stock price, exercise price, time to expiration, volatility of the underlying stock's price, market interest rate, and dividend yield on the underlying stock. Each has a particular relation to option value. For example, as stock price increases, the value of a call would increase, while the value of a put would decrease. For volatility, an increase in volatility has a positive impact on the value of both puts and calls, since payoffs are asymmetric. That is, no matter how low the stock's price goes, all an investor can lose is the premium. Last year market volatility was low. This led to a good year for equities, but the derivative market lagged as a result of the lower volatility. See article here, The Trade News.

Rising Interest Rates

Interest rates have remained at historically low levels since 2008; however, with the recovering economy and the prospect of the Fed reducing its intervention, it is likely that interest rates will rise. Such a move will reduce bond prices, particularly longer-term bonds, so what asset classes should investors consider? A recent Wall Street Journal article suggests that certain equity sectors (e.g., energy, financials, and consumer discretionary) tend to perform well (at least relatively) in such environments. See article here.

The Wolf of Wall Street

With the recently released movie (The Wolf of Wall Street), the fraudulent activities of the IPO underwriting firm Stratton Oakmont have come back into public view. For a detailed review of how the fraud took place, see here (Wall Street Journal).

Floating Rate Notes

As interest rates rise, bond prices fall. Given historically low interest rates, many investors are concerned about bond prices, particularly since the loose monetary policy being implemented by the Fed may trigger inflation and therefore higher future interest rates. To hedge away this interest rate risk, some investors have used inflation protected securities. The Treasury, however, just launched another alternative -- floating rate notes. The interest paid on these notes rise as market rates rise, thereby also protecting the bond's price. See article here, WSJ.

Timing Matters -- Dollar Weighted Returns.

While a mutual fund manager may make good decisions that result in a positive return, if investors time cash flows incorrectly, they will end up with lower (even negative) returns. This illustrates the difference between time weighted and dollar weighted returns. Unfortunately, the average investor succumbs to human nature, buying high and selling low, instead of the opposite. See a good summary article here, WSJ.

Covered Calls

A Covered Call is created by purchasing stock and simultaneously writing a call on that stock. The position limits upside, as the stock will be called away if the price rises above the exercise price. But, the premium from selling the call provides extra income, which is the primary reason for executing such a strategy. See the article here, WSJ.