Recommended Book and Ratings on Performance

Comment on “Investor’s Best of the Web 2021,” by AAII Staff, in the November 2021 AAII Journal:

Thank you for this very important and insightful update. I’m sorry there can’t be a ninth category: Current Recommended Books. I would include “What’s Wrong With Economics?” by Robert Skidelsky, one of the greatest living economists.

Also, since performance information can be very helpful, I believe that is a missing category. Independently audited advisory service information is available through Hulbert Ratings: http://hulbertratings.com/since-inception.
—Michael D. from California

Calculating Buffett’s Owner Earnings

Comment on “Warren Buffett and the Evolution of Value Investing,” an interview with Robert Hagstrom, in the November 2021 AAII Journal:

Another valuation method is to calculate residual earnings, the difference between net income and a charge for the cost of equity. Or you can calculate residual income.

If you reformulate the financial statements by separating operating assets and operating liabilities, and by separating financial assets and liabilities on the balance sheet, you will get net operating assets and net financial assets (debt). This allows you to value the company without regard to how it is financed and facilitate comparisons. You will value the business operations to get the enterprise value and then factor in financial assets and liabilities to get the equity value.

By calculating net operating income after tax (NOPAT) on the income statement, you can then subtract a charge for the cost of capital to arrive at residual income. This is analogous to free cash flow for valuation purposes.

The higher the return on capital, the less cash needed to reinvest to finance growth. That leaves cash available as free cash flow for dividends, buybacks and debt reduction. In theory, that is cash that can be withdrawn from the company without impairing its ability to continue its operations. Warren Buffett calls this “owner earnings,” and this is of ultimate importance to an investor.
—David P. from Alabama

Portfolio Correlation

Comments on “Good Portfolio Teammates Boost Returns and Reduce Downside,” by Craig L. Israelsen, Ph.D., in the October 2021 AAII Journal:

Craig Israelsen’s articles are always great. They are typically the first ones I read. (Well, after Charles’ Editor’s Note.) But I was perplexed by how the correlations were determined. The article just says that “Monica modeled the two funds as a 50/50 portfolio (with annual rebalancing).” How? Where do you find the return data? What frequency of returns and reinvestment? What were the methods and assumptions in addition to portfolio balancing?
—Thomas K. from Washington

Craig Israelsen responds:
Thomas, all the calculations were done in Excel using Morningstar data (annual returns) from 2011–2020. Total returns were used, which implies reinvestment of dividends and capital gains. Each portfolio (50/50 mix of Vanguard Balanced Index and the “companion” fund) was rebalanced at the end of each year. To calculate the correlation between two funds, you can use the Correl function in Excel. I hope that helps.

Diversification for Individual Investors

Comments on “Meaningful Diversification Can Lead to Higher Returns,” an interview with Chris Pedersen, in the October 2021 AAII Journal:

Allocations and withdrawal rates are something that one needs to be flexible with. While there is a consensus that trying to time the market is a loser’s game, one can still adjust allocations periodically to respond to future threats. Too much in bonds now does not seem prudent to me.

And considering you may live in retirement for 30+ years, a healthy exposure to equities is needed. I’ve been using a bucket approach: Periodically take profits from assets that have grown and put them in the safe bucket, draw from the safe bucket.
—Victor S. from North Carolina

The article does not reflect true diversification on the asset class level. Diversifying monies within an asset class has value if the asset class is appreciating in price. One good example is bonds or debt asset class. We have negative interest rates with the expectation given the debt levels that interest rates will increase so bond prices will decrease over time.

In the past, brokers would argue that owning foreign stocks and bonds should insulate the investor. But all equity markets are tied together, so in a global economic downturn all stocks will decrease during the period.

In my view there are six asset classes: cash, equity, debt, foreign exchange instruments (including cryptocurrency), real estate and future market or commodities. I believe investors need to diversify among these six to obtain the risk mitigation benefits of diversification.
—Ronaldo J. from Illinois