The Feynman Study: Part 1

This first Part of the Study identifies the 10 Asset Groups and 18 individual EFTs that comprise the Feynman Portfolio and looks at the general market behavior, as defined by the Vanguard Total Stock Market Fund (VTSMX), over the 6 year period from 06/29/2007 to 06/30/2013.  The VTSMX will be used as the reference, or benchmark, for comparison of portfolio performance through each future phase of the Study. Ideally we would like to use a more balanced benchmark like Lowell’s customized ITA Index, but unfortunately no such standard index exists, so we will use the VTSMX.

Over the 6-year period of the Study, the value of the VTSMX increased by 10.81% or at a modest Compound Annual Growth Rate (CAGR) of 1.73%. This barely absorbs the impact of inflation. During this period the US equity markets absorbed a maximum drawdown of 56.53% (based on VTSMX) over an 18-month period before taking almost 4 years to rebound to its starting value. Remember that a 50% portfolio drawdown requires a 100% “bounce” to recover to initial portfolio values.  Volatility over the period also fluctuates significantly.

Future Parts of this Study will examine how the Feynman portfolio might have performed during this period of major market moves. Each part of the Study will focus on one aspect of portfolio construction or Risk Management and reference the performance of the portfolio to the performance of the VTSMX.

Although regular readers of this Blog will be familiar with Lowell’s use of the Hoadley Portfolio Analyzer to generate Efficient Frontier profiles, Part 1 of the Study also introduces the reader to other sections of the analyzer that Lowell does not usually show. More details will be provided in future parts of the Study and it is hoped that this will give the reader a better understanding of this analytical tool and how it is used.

Before closing this Post I would be remiss not to mention some of the benefits and pitfalls of back-testing. Back-testing inherently assumes that the analysis of past performance can help us improve future performance – this is an arguable point – especially if past history does not reflect likely future behavior. In this Study we have chosen a period of market activity with little change in total market value from the beginning of the Study to the end. Thus the Study period is not dominated by either a predominantly bull or bear market. In the interim, the market sees both major and minor moves both to the downside and to the upside. It is difficult to visualize a scenario with much more diversification, so, from this perspective it would seem fair. However, there are numerous routes the market could take to get from beginning to end with the same level of fluctuation or volatility. The use of Monte Carlo analysis is useful to examine these differences and the QPP software used by Lowell to analyze some of his portfolios is one way to examine the impact of these fluctuations. Although I have significant experience in using Monte Carlo techniques, I will not be including this type of analysis in the Study. Lowell may choose to run the Feynman Portfolio through QPP to provide additional insights.

Perhaps the biggest pitfall in back-testing is the temptation to look at the data with hindsight and develop a “system” that demonstrates good performance – this is often referred to as curve-fitting or over-optimization. Unfortunately the “system” invariably performs poorly in forward looking tests.

In this Study I go out of my way to avoid any tendency to curve-fit or over-optimize by using logical rules that can be reasonably applied under all market conditions.

Unfortunately, there is no Crystal Ball or Holy Grail and historical data is all we have to work with. I firmly believe that any price chart merely reflects investor’s collective reaction to news and to their general feelings of optimism or pessimism in the markets/economy – sometimes these reactions run contrary to what we might expect (e.g. price drops following good earnings report) but, over time the reactions are repeated. For those readers that may be familiar with Chaos Theory – there is Order in Chaos.

Please download the Word file at this link found on my PogoPlug site to view Feynman Portfolio Study – Part 1 and be sure to provide feedback as to how these documents might be improved or for clarifications if I have not explained things clearly.  If you have problems downloading the Word document, let it be known immediately.

Part 2 will examine the benefits and limitations of diversification using a “Passive” Feynman Portfolio.  Stay tuned.

Part 2 and Part 3 of this study are now available here at ITA Wealth Management.