After reading Wayne Thorp’s article on Rule #1, I am confused [“The Rule #1 Approach to Finding Wonderful Companies,” October 2007 AAII Journal]. There seems to be a disconnect between the conservative don’t-lose-money philosophy espoused by Mr. Town and the fantastic returns he claims to have achieved ($1,000 to $1 million in five years). He tripled or quadrupled his money annually. In finance, reward is generally tied to risk. His results indicate a high-risk, high-reward philosophy—not one that seeks to prevent losses. Perhaps he addresses this discrepancy in his book. But for readers who haven’t read the book, it would have been enlightening to address that issue. Even your own backtesting doesn’t produce those kind of results.
The Rule #1 philosophy is sound—really just generally a rehash of Warren Buffett and Ben Graham. It’s just a question of whether Town achieved his returns with it and whether he’s truly in their class. I would have rather had that question answered first before launching into a screen of the Rule #1 philosophy.
John Markese wrote a very important article about benchmarking portfolios in the November 2007 issue of the AAII Journal [“A Performance Tape Measure: How to Benchmark Your Portfolio”]. He wrote that “…we have to measure: how well our funds have done individually, and how well our fund portfolio has performed as a whole.”
Performance has to be measured on two variables: return and risk. The article did an admirable job of demonstrating how to benchmark return and risk of individual funds, but there was little, if any, attention paid to the return and risk of the portfolio as a whole.
The most difficult question is how to evaluate the risk of the benchmark portfolio and the actual portfolio. It is not as simple as combining the standard deviations of individual holdings, because the correlation of individual holdings can make this number larger, if undiversified, or smaller, if diversified. Both portfolios can be evaluated for free at www.riskgrades.com. Note that these RiskGrades change with time, and an average RiskGrade for the past year should probably be used.
Renwick E. Curry, Ph.D.
I wholeheartedly agree with Mr. Curry about the evaluation of risk being as equally important as return for a portfolio. Evaluating the risk of an individual mutual fund as well as return compared to the risk and return of an appropriate benchmark is critical in making an investment decision, as the article demonstrated. From the information provided in the annual “Individual Investor’s Guide to the Top Mutual Funds,” this can be accomplished as described in the article. To do this for an entire portfolio of funds and a benchmark portfolio is quite statistically complicated, and it is difficult for individual investors to obtain the necessary information, and that is the reason the article does not delve into portfolio risk.
RiskGrades is a convenient source to determine portfolio risk, but as a note, RiskGrades weights their portfolio risk measures—giving greater weight to most recent portfolio behavior, for even one-year risk measures.
AAII’s December 2007 Tax Planning Guide was great, as it has been for a number of years. It is an extraordinarily useful document.
I had one clarification regarding health savings account HSA contribution amounts, starting in 2007, as a result of legislation signed into law on December 20, 2006. Prior to 2007, the HSA contribution was limited to the deductible amount of the associated policy. As pointed out in the HSA section of the Treasury site you reference (www.treas.gov), this changed to a maximum of $2,850 (for an individual policy) or $5,650 (for a family policy), regardless of the deductible amount. These amounts are indexed for inflation.
Philip C. Levinton