Kindle Notes & Highlights
Investors have demonstrated the unfortunate tendency to sell well after market declines have already occurred and to buy well after rallies have long begun. The result is they dramatically underperform the very mutual funds in which they invest. That is why it is so important to understand that investing is always about uncertainty and about never choosing an allocation exceeding your risk tolerance.
Investing is not an exact science. It is foolish to pretend we know in advance exact levels for returns, correlations, and standard deviations.
There is an old and wise saying that those who fail to plan, plan to fail. Yet, many investors begin their investment journey without a plan, an investment policy statement (IPS) laying out the plan’s objectives and the road map to achieving them. The IPS includes a formal asset allocation identifying both the target allocation for each asset class in the portfolio and the rebalancing targets in the form of minimum and maximum tolerance ranges. A written IPS serves as a guidepost and helps provide the discipline needed to adhere to a strategy over time.
Plan B should list the actions to be taken if financial assets drop below a predetermined level. Those actions might include remaining in or returning to the workforce, reducing current spending, reducing the financial goal, or selling a home and/or moving to a location with a lower cost of living.
Taking a broader view, asset allocation can be defined as the process of investing assets in a manner reflecting one’s unique ability, willingness, and need to take risk.
An investor’s ability to take risk is determined by four factors: (1) investment horizon, (2) stability of earned income, (3) need for liquidity, and (4) options that can be exercised should there be a need for “Plan B.”
The willingness to take risk is determined by the “stomach acid” test. Ask yourself this question: Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough?
The need to take risk is determined by the rate of return required to achieve the investor’s financial objectives. The greater the rate of return needed to achieve one’s financial objective, the more equity (and/or small and value) risk one needs to take.
Therefore, in considering the financial objective, carefully consider what economists call the marginal utility of wealth: how much any potential incremental wealth is worth relative to the risk that must be accepted in order to achieve a greater expected return.
“The inconvenience of going from rich to poor is greater than most people can tolerate. Staying rich requires an entirely different approach from getting rich. It might be said that one gets rich by working hard and taking big risks, and that one stays rich by limiting risk and not spending too much.”1
Prudent investors do not take more risk than they have the ability, willingness, or need to take. Think about it this way: If you’ve already won the game, why still play?
In general, we recommend choosing the lowest equity allocation derived from the three tests and then altering your goals.
Instead, it is the degree of exposure to three risk factors that explains the majority of returns.
The first risk factor is the portfolio’s exposure to the overall stock market.
The second risk factor is the size of a company as determined by market capitalization.
The third risk factor considers “value.” High book-to-market (BtM) value stocks are intuitively riskier than low BtM growth stocks.
The equity to fixed-income allocation, small-cap stock to large-cap stock allocation, and value stock to growth stock allocation decisions are the all-important determinants of the risk and return of a portfolio.
Sectors do not have truly unique systematic risk and return characteristics.
Investing in international stocks, while delivering expected returns similar to domestic stocks, provides the benefit of diversifying the economic and political risks of domestic investing.
the gains from international diversification come from the relatively low correlation among international securities.
The logic of diversifying economic and political risks is why investors should consider allocating at least 30 percent and as much as 50 percent of their equity holdings to international equities.
Tracking error is defined as underperformance versus a benchmark.
Unless investors can tolerate negative tracking error and rebalance when appropriate, an international allocation will not be of much value.
The riskiness of emerging markets should not preclude investors from allocating some portion of their portfolio to them. Modern portfolio theory (MPT) tells us that sometimes we can add risky assets and actually reduce the risk of the overall portfolio. The reason is the diversification benefit.
Historical evidence shows that emerging market equities have high returns with high volatility. They also have low correlations to both domestic and international equities.
Therefore, value stocks should provide a risk premium in the same way that equities should provide a risk premium over the return of safer fixed-income investments.
Value stocks are not riskier than growth stocks. They believe investors systematically overprice growth stocks and underprice value stocks.
Investors who are exposed to value risk factors in ways other than investments should use this strategy.
REITs reduce the overall risk of the portfolio by adding an asset class that responds to events differently from other asset classes: Its correlation to other asset classes is low
Owning a home provides exposure to just the residential component of the larger asset class of real estate.
Second, a home is undiversified geographically.
Third, home prices may be more related to an exposure to an industry than to rea...
This highlight has been truncated due to consecutive passage length restrictions.
While clearly an asset with value that should appear on the balance sheet and be considered a possible source to fund future cash-flow needs (through a reverse mortgage or sale), it should be excluded from consideration when thinking about asset allocation.
Negatively correlated assets act like portfolio insurance. Including them reduces potential dispersion of returns, reducing the opportunity for greater than expected portfolio returns while lowering the risk of less than expected ones.
The main roles of fixed-income assets in a portfolio are reducing portfolio risk to the level appropriate for the investor’s unique circumstances and providing a reliable source of cash flow.
Short-term bonds have the benefit of less volatility and lower correlation to equities.
The appropriate maturity varies depending on the equity allocation.
At equity allocations below 80 percent, five-year Treasuries produced the most efficient portfolios, though long-term bonds produced the portfolios with the highest returns. At high equity allocations (80 percent or higher), the portfolio with long-term Treasuries produced the highest return and highest Sharpe ratio.
The volatility of equities is the dominant factor in the portfolio’s volatility. At high fixed-income allocations the reverse is true:
