H OW TO C HOOSE & E VALUATE Y OUR F INANCIAL A DVISOR & P ORTFOLIO Ed Butowsky Chapwood Investments, LLC 15455 North Dallas Parkway, Suite 1200 | Addison, Texas 75001 | (972) 865-2223
T HE C ONVENTIONAL W AYS TO C HOOSE AN A DVISOR • Firm name • Referrals from friends/colleagues • Company sponsored event/Guest speaker • Personal Accountant (CPA) • Lawyer
C URRENT S TATE OF THE I NDUSTRY The world of personal investing is flooded with a bewildering mix of half truths and conflicts • of interest. Even worse, the vast majority of people are ill equipped to navigate through the muddy waters of investing, so they turn to investment professionals seeking professional assistance. However, vast majority of these investment professionals have little to no training on • structuring portfolios, and therefore lacks the knowledge to minimize risk while maximizing returns in the portfolios they manage. After growing up at a major brokerage firm and working with investors for over 25 plus years • it became clear to us that the whole investment management industry as a whole was broken in its current state.
C URRENT S TATE OF THE I NDUSTRY The field is overwhelmed with salesmanship, product sales, PR and marketing and is • managed for the betterment of the underlying investment firm versus the well being of its’ client, the investor. The goal of this presentation is to educate you so you are able to objectively and • dispassionately analyze portfolios for their strengths and weaknesses, to truly understand the fees they are being charged and most importantly provide investors full transparency into their investments/portfolios. The lack of transparency and information in the investment/portfolio management • marketplace has allowed all companies, big and small, to take advantage of investors. This represents “The Lack of Information Dividend” (LOID), the amount of money lost due to lack of information. We want to empower investors with knowledge because, ignorance is not bliss, it’s simply investment suicide.
G LASS -S TEAGALL A CT • Enacted in 1933 by Senator Carter Glass and Congressman Henry Steagall, created silos with in the investment/financial industry. • The Act prohibited commercial banks from collaborating with full-service brokerage firms or participating in investment banking activities. • After 66 years, in 1999 the Gramm-Leach-Bliley Act dismantled the Glass Steagall Act, which resulted in mass confusion in the industry. • The distinction between commercial banks and brokerage firms has blurred; many banks own brokerage firms and provide investment services. • Investors were lost on where to go and how to judge.
M ODERN P ORTFOLIO T HEORY “The Rule Book” • In 1990, Harry Markowitz, Merton Miller and William Sharpe were awarded a Nobel Prize in Economics. • MPT focuses on investment analysis, portfolio design, and performance evaluation. It confirmed that it is not enough to look simply at risk and return. • MPT statistics provides us the guidelines, “The Rule Book”, to quantitatively measure risk and analyze the efficiency of portfolios. • MPT focuses attention on the overall composition of the portfolio rather than analyzing and evaluating its individual components. • MPT statistics quantifies risk and its relationship to return and how the return was achieved as well as the relationships between the assets in the portfolio and how they relate to one another.
O BJECTIVELY E VALUATING Y OUR P ORTFOLIO 1 Rate of Return (ROR) 2 Standard Deviation (STD) 3 Variance Drag Phantom Tax (VDPT) 4 Sharpe Ratio 5 Probability of Any Loss in the Next 12 Months 6 Amount of Money at Risk in the Next 12 Months Upper and Lower Return 7 8 Correlation to S&P 500
R ATE OF R ETURN 1 This is the rate you need to make on your portfolio in order to not lose purchasing power after subtracting your expenses, taxes, and cost of living increase. • Shown as a percentage change from the original investment • 93.6% of a portfolio’s return is derived from the overall architecture of the portfolio; the investment policy
S TANDARD D EVIATION 2 This is a statistic that measures how much risk you are taking, versus your return. Your standard deviation should be 70-80% of your historical rate of return. • The lower the ratio, the better and more consistent the performance. • It is a measure of the distribution of average historical annual returns of • your portfolio. • The more spread apart the returns, the higher the deviation/risk • 98% of a portfolio’s standard deviation is derived from its • architecture •
W HICH P ORTFOLIO W OULD 2 Y OU C HOOSE ?
2 ROR: 10% P ORTFOLIO I STD: 15% 2 O UT OF 3 Y EARS 19 O UT OF 20 Y EARS 10 10 25 -5 40 -20 -10 10 30 -30 -10 10 30 50 -30 -10 10 30 50
2 ROR: 10% P ORTFOLIO II STD: 6% 2 O UT OF 3 Y EARS 19 O UT OF 20 Y EARS 10 10 4 -2 16 22 0 5 10 15 20 -5 5 15 25 -5 5 15 25
2 ROR: 10% P ORTFOLIO III STD: 2% 19 O UT OF 20 Y EARS 2 O UT OF 3 Y EARS 10 10 8 12 6 14 0 5 10 15 20 0 5 10 15 20
W HICH P ORTFOLIO W OULD Y OU C HOOSE ? 2 Portfolio III Portfolio I Portfolio II ROR 10% ROR 10% ROR 10% STD 2% STD 6% STD 15% 10 10 10 2 out of 4 16 25 -5 3 years 12 8 -30 -10 10 30 50 -5 5 15 25 0 5 10 15 20 -10 10 20 30 0 5 10 15 20 10 10 19 out of 10 20 years -2 40 22 -20 14 6 -30 -20 -10 0 10 20 30 40 50 -5 5 15 25 0 5 10 15 20
V ARIANCE D RAG P HANTOM T AX 3 Variance Drag Phantom TAX (VDPT) is a ratio that calculates the degree of your standard deviation in proportion to your rate of return. Ideally, your VDPT will be a 0.8 or lower. Anything over 1.5 is not acceptable.
S HARPE R ATIO 4 • The Sharpe Ratio is a measure of the risk-adjusted return. It was derived by Professor William Sharpe, now at Stanford University, one of three economists who received the Nobel Prize in Economics in 1990 for their contributions to the "Modern Portfolio Theory". • The Sharpe Ratio is a direct measure of risk vs. reward. The greater a portfolio's Sharpe, the better its risk-adjusted performance. The Sharpe Ratio shows the investor whether the returns of a portfolio are due to smart investment decisions or a result of excess risk. • The Sharpe Ratio can be very useful in comparing portfolios to determine the amount of risk taken verses the rate of return achieved. For example, one portfolio may have higher returns than its peers, however, it is only a better portfolio if it did not take additional risks to achieve these higher returns.
= ROR - MM S HARPE R ATIO 4 STD ROR :Rate of Return MM : Money Market Rate (Risk Free Rate averaged over the observed time period) STD : Standard Deviation Portfolio III Portfolio II Portfolio I ROR 10% ROR 10% ROR 10% STD 2% STD 6% STD 15% SHARPE 2.50 SHARPE .83 SHARPE .33 10 10 19 out of 10 20 years -2 40 22 -20 14 6 -30 -20 -10 0 10 20 30 40 50 -5 5 15 25 0 5 10 15 20
P ROBABILITY OF A NY L OSS IN THE 5 N EXT 12 M ONTHS Based on historical data, this measures the probability of your portfolio losing any value during the next 12 months. The goal is to have that probability at zero, but realistically, you want it to be 15% or less.
M AXIMUM A MOUNT A T R ISK IN 6 THE N EXT 12 M ONTHS This measures the amount of money at risk with a 95% degree of confidence. This is based on historical 12-month rolling periods. Your goal is zero but realistically it should be as low as possible.
U PPER & L OWER R ETURN 7 This identifies, based on historical data, the range of returns that you should expect over the next 12 months.
C ORRELATION TO THE S&P 500 8 This is the performance of your portfolio relative to that of the S&P 500 Index. It accounts for the extent to which these two investments’ returns move together. • This metric addresses the use of diversification to reduce risk, which places major emphasis on finding investments that are distinctly different from one another. Correlation coefficient is a measurement to determine this difference between investments. • This metric is important because, in a diversified portfolio, each metric’s unique pattern of returns partially offsets the others’. This has the effect of smoothing the portfolio’s overall volatility. • The correlation coefficient is between +1.0 and -1.0.
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