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Chapter 12: Building Your Portfolio

By: Investor Solutions

Let’s see how what financial economists have learned over the last 20 years can help us build a portfolio. After all, we haven’t come all this way together just to go back to doing things the way our grandparents did.

In the Real World

While we are building an investment strategy, we must acknowledge that we operate in an uncertain world — few of the variables are under our control. Because we are dealing with future events we cannot see, we know in advance that any strategy we are able to devise is unlikely to turn out to be the “best” strategy in retrospect.

However, with what we do know, we can build a very good strategy. Rather than trying to beat some yardstick, or every other investor around, a superior strategy has the highest possible probability of meeting our long-term goals, and will subject us to the least risk along the way. It will attempt to maximize our returns for the risks we are willing to take, and systematically whittle down the risks and costs of being wrong.

In the short term, every portfolio will be “wrong” a great deal of the time. At the end of each period, with the benefit of hindsight, we will wish that we had been more or less committed to each asset class. For instance, we might have wished for more stocks in a year when the markets did well, and more cash in a year when they did poorly. We will just have to accept this in order to be “right” for the long term.

A Quick Review

Let’s take a minute to review some key points found in earlier chapters:

 

  • Capitalism is the greatest wealth-creating mechanism ever devised. As each of us goes about serving our own interests, the value of the world’s economy increases. The markets, which are an integral part of capitalism, rise to reflect the increase in the world’s economy. We expect this trend to continue. Markets offer each of us the surest opportunity to participate in the growth of the global economy.
  • Risk should not be avoided, because it offers an investor the opportunity for higher returns. In particular, equities offer investors the highest real returns over time. Most investors cannot expect to meet their reasonable goals without accepting some level of market risk.
  • Asset allocation decisions explain the vast majority of investor returns, and offer investors the biggest chance to control their investment results. The impact of market timing and individual security selection pale by comparison to asset allocation. It follows that the greatest share of the investment process and attention should be devoted to the asset allocation decision.
  • Risk can be actively managed. Diversification is the primary investor protection. Asset allocation between stocks, bonds, and cash allow investors to tailor portfolios to meet their risk tolerance. Modern Portfolio Theory offers investors the chance to obtain efficient portfolios that maximize their returns for each level of risk they might be able to bear. New research by financial economists (Fama-French) examines the expected cross section of returns, which gives us an opportunity to predict expected returns by categorizing stocks by their size and Book-to-Market Ratio. The practical implication of the Fama-French research encourages investors to construct portfolios with higher expected returns than the market as a whole by increasing their holdings in smaller companies and value stocks.
  • To paraphrase the popular license plate: “Risk Happens!” Investors must accept and expect reasonably regular market declines. These events should be viewed as perfectly natural. At worst they are a non-event to long-term investors; at best they may represent buying opportunities. It is vital that investors maintain a long-term perspective and exercise discipline if they are to avoid the dreaded “buy high, sell low” behavior.
  • Markets are efficient, and attempts to either time the market or select individual securities have not been effective or reliable methods of enhancing returns or reducing risk. Active management cannot demonstrate sufficient value added to offset their increased costs. Deviations from benchmark portfolios can explain the variability of mutual fund and institutional performance.
  • Market and economic forecasts are notoriously unreliable. Accordingly, strategies based on forecasting have not been successful when compared to a long-term, buy-and-hold strategy. The only forecast we make is that the world is not likely to end, that the world economy is going to continue to expand, and that the world’s stock markets will continue to be an efficient mechanism to capture this growth in value.
  • Past performance of investment managers is not a reliable indicator of expected future performance. Neither this season’s big winner nor it’s big loser is any more likely to repeat than pure random chance might predict.
  • Cost is a major controllable variable in investment management. Low cost is strongly correlated to higher investment returns. Management fees, transaction costs, and taxes all serve to reduce investor return. Cost must be rigidly controlled.

Plan of Attack

Our discipline to attack the investment problem is called “Strategic Global Asset Allocation,” a long-term strategy in which we will divide the investor’s available wealth among the world’s desirable asset classes. Naturally enough, our first task is to decide which assets to include and which to exclude.

We will confine ourselves to liquid, marketable securities. This policy represents a major constraint, but not a particularly burdensome one. It allows us to price each asset in our portfolio on a daily basis. Should we wish to liquidate any or all of the portfolio, we can cash out for full value within one week. Right off the bat, we have excluded many asset classes, some of which might be frivolous, some desirable. Baseball trading cards, diamonds, postage stamps, rare coins, antique automobiles, and commemorative plates are all out.

Other asset classes are excluded for different reasons. Most individuals will not be comfortable with options, commodities, futures, and the more exotic derivatives. Far fewer “professionals” understand the complicated trading strategies than claim to, as can be attested to by the occasional multi-billion dollar losses suffered by major institutions. If Barings Bank can’t monitor its trading strategy, how can you and I hope to?

Managed commodity pools are sometimes touted as prudent diversifiers for balanced portfolios, but results have been distinctly under-whelming. As a general rule, all investors, no matter how sophisticated they judge themselves, should restrain the occasional urge to invest in things they don’t fully understand. Looking back over my own career, the more I have adhered to this general guideline, the better job I have done.

To me, gold is just another commodity, an asset with a limited expected rate of return and a very high risk level. Many managers include gold as an asset class in their portfolios. They are attracted by its very low correlation to other asset classes. While I understand this point of view, I won’t tie up any percentage of my clients’ wealth in an asset with such a dismal return history. Lots of gold bugs are still holding on to “treasure” purchased at prices of almost $800 an ounce 20 years ago.

By now, you are probably beginning to suspect that asset class selection may be rather arbitrary. If so, go to the head of the class. Mine is a very “stick-to-basics” approach, and subject to my own value judgments. In addition, as a manager of other people’s money, I must respect their constraints. For instance, some clients may dictate that their portfolios contain no emerging markets.

A Shining Example

Mr. and Mrs. Jones are 60 and 55 years old, respectively. Mr. Jones is about to retire with a fixed pension of $50,000 a year from a major corporation. Recently, Mr. Jones received a substantial inheritance. The Joneses’ total accumulated liquid assets are one million dollars. The Joneses lead an active lifestyle and will need an income from their liquid assets of approximately $60,000 fully adjusted for inflation. The Joneses expect that inflation will run at least 3.5 percent on average over the rest of their lives. They are very reluctant to consider invading principal to fund their income needs, and feel an obligation to pass on their wealth to their children, if possible. Above all they do not wish to outlive their income, and would like to remain financially independent. The Joneses describe themselves as conservative investors, and describe their goal as inflation-adjusted income and conservation of wealth. They are sophisticated enough to realize that they cannot accomplish their objectives using guaranteed investments, but do not wish to assume excessive risk.

My first observation is that the Joneses have a very long time horizon. As we have observed, the average life expectancy for a survivor of this couple (from a government table used widely for tax calculations) exceeds 34 years. Because this is an average life expectancy, about half of such couples will have a survivor longer than this. In addition, the Joneses do not want to invade principal, so amortizing the funds over their projected lives is not an option.

In addition, the Joneses will need a fair withdrawal (starting at 6 percent of initial capital) each year in order to sustain their projected lifestyle. Because they expect inflation to run an average of 3.5 percent, their minimum acceptable return must be at least 9.5 percent.

A quick look at the long-term data on bond and CD returns confirms that the Joneses are not going to be able to come close to meeting their objectives without accepting some equity risk. On the other hand, their known withdrawals for the next several years are high, so they cannot accept the risk of a 100 percent equity portfolio. In a bad market, they might run the risk of depleting their capital to finance withdrawals.

For Starters

As a first cut, we could examine a traditional institutional asset mix of 60 percent equities and 40 percent bonds. A very naive and simple strategy would be to buy the S&P 500 index for 60 percent and the Lehman Brothers Corp/Government Index for 40 percent. Once a year we could rebalance the funds to account for withdrawals and the natural market value fluctuations.

This strategy is certainly simple enough to execute. It doesn’t require expensive consultants or a giant staff. It has low cost, meets our minimum required rate of return, sets aside enough in bonds to meet our known income requirements for almost seven years, and has a tolerable risk level.

But wait a second, this is for the dumb guys, right? Certainly large institutions must do better! How could we brag at cocktail parties? Everyone would think we were just big rubes. We want a sophisticated, power strategy with lots of consultants to impress our friends and get those big returns we always read about in Money Magazine. Where is the pizzazz? Where is the beef?

As it turns out, this would be a very good strategy indeed. During the five-year period ending December 1993 (the last full period of reliable data I presently have available on the largest pension plan results), this dumb little strategy would have outperformed 29 of the largest 30 pensions in the United States! While the media is full of stories touting enormous returns and legendary managers, perhaps only 1-2 percent of individual American investors actually obtained investment results this good.

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If the Joneses adopt this simple, naive, dumb little strategy, they will meet their objectives, outperform most large institutions, and be way ahead of their fellow investors.

Improving the Portfolio

Using this pretty good little portfolio as a benchmark, let’s see if we can use what we have learned to form an even better portfolio. We will hold the original asset allocation of 60/40 stocks to bonds constant, but expand our asset class choices to see if we can lower risk or improve return.

First, we will look at the bonds. The primary reason to hold bonds in a portfolio is to reduce equity risk. As you will recall, long-term bonds have a reasonably high risk and offer a very limited return. Bond-holders generally demand increased interest rates for longer maturities to compensate them for the increased risk. But an in-depth examination of bond returns would indicate that there is very little extra return associated with increasing maturities. What would happen if we dumped the Lehman bond portfolio and substituted two portfolios with a much shorter maturity? Let’s substitute a high-quality bond portfolio with a maximum average maturity of two years.

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The new portfolio exhibits a very satisfactory decrease in risk without suffering any decrease in expected return.

The Foreign Connection

Next, let’s look at equities. It has long been established that international diversification will increase returns and decrease risk in a domestic-only portfolio. So, we test the effect of splitting half the equity portfolio into the EAFE (Europe, Australia, and Far East) index and S&P 500. True to our expectations, we note a gratifying increase in rate of return and a decrease in risk. This apparent magic can be explained by the low correlation that EAFE has with our domestic stocks.

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Think Small

EAFE and the S&P 500 are composed of large companies in developed countries. Small companies offer much higher returns than large companies, so let’s divide both our domestic and foreign portfolios to capture some of this extra return. Not bad. Small company stocks not only have a higher return than large ones, but they also have a reasonably low correlation with them.

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Think Value

Most of the index comprises growth stocks (stocks with low book-to-market ratios). The Fama-French research, which subsequent studies have confirmed, points out that value stocks (stocks with high book-to-market ratios) have a much higher rate of return without additional risk. So, let’s split the equities again to add a strong value tilt.

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Moving On

The process could continue, testing the effects of including such asset classes as emerging markets or real estate (in the form of equity REITS). However, this example does not include them because we don’t yet have reliable 20-year data. As new asset classes are defined, their usefulness will be determined by whether they increase return or reduce risk at the portfolio level. If so, they add a valuable diversification effect. Given an appropriate data series, a little trial-and-error and a little judgment will identify which asset classes add enough value to justify inclusion.

The Rewards of Success

While our initial 60/40 mix of S&P 500 and Lehman long bond index was a pretty good portfolio, we have been able to substantially improve it. We have met the clients’ minimum required rate of return, stayed well within their risk tolerance, and improved both risk and return over the initial portfolio.

Our “improved” balanced account has greatly out-performed the S&P 500 while taking less risk. We accomplished this by making no forecasts, selecting no individual stocks, and not attempting to time the markets. We didn’t try to pick the “best” asset class, and we didn’t trade frantically. We just put a number of attractive asset classes together in a way that made sense. You don’t need to watch the market 24 hours a day, and you don’t need to be wired to your PDA while you play golf.

Portfolio Returns and Standard Deviations

 

A Minor Adjustment?

The last 20 years have been good to equities. But our time period included a few anxious moments. We witnessed the final fall of Saigon, three minor police actions (Panama, Haiti, and Grenada), and one all out war with Desert Storm. We had nuclear confrontation and the fall of the Berlin Wall. We had low inflation, high inflation, booms, and recessions. We had high interest rates and low interest rates. We had a strong dollar, and we had a weak dollar. We had Democrats and Republicans in both the Congress and White House. We had good markets and a couple of spectacular crashes.

In short, it was a little better than average for investors, but they still had plenty to worry about if they were so inclined. Depending on your particular personality, it took either courage, faith, or a very laid-back attitude to stay fully invested every day. Whatever it took, remaining fully invested in a diversified portfolio was a key element in success.

Because we had better-than-average returns for the last 20 years, it would not be appropriate to forecast those rates of return forever. A prudent person might knock off 3-5 percent for planning purposes. If we get more, we can all celebrate. If not, we haven’t built a plan destined to fail due to pie-in-the-sky estimates of future returns. Even with a liberal discount from the expected rate of return, we are still well within the minimum required rate of return for the Joneses.

The Leading Edge

The portfolio we designed is on the leading edge of financial research. But research continues, so the story is far from over. Each year we get better and better tools. Today’s leading edge research becomes state of the art tomorrow and, ultimately, becomes generally accepted practice. As the new tools are developed, they will first be available to large institutions and investment advisors. The speed at which they filter down to the retail level is purely a function of demand. Until enough of you demand it, only professionals will have the best tools. For instance, when consumer demand develops for a no-load, international small-cap value fund, one or more of the retail fund families will make it available.

Demand, in turn, is a function of education. In general terms, Wall Street has little interest in educating investors to prefer low-cost, low-profit-margin investment strategies. The old ways are so much more profitable — for it. Because Wall Street has enormous advertising and public relations budgets, it shapes the debate and discussion in the popular media. Independent investment advisors advocating low cost, low-profit-margin investment strategies tend to have rather smaller budgets for advertising and PR.

For instance, it’s rare to see an intelligent discussion of value vs. growth investment style, or anyone advocating index fund investing either on TV or in what passes as the sophisticated financial press. But it’s not unusual at all to see yesterday’s hero sharing tidbits, gossip, and speculation. This type of activity may have great entertainment and amusement value, but is of little help in assisting investors to formulate their plans. Some of the more popular Wall Street TV programs have little trouble giving a half dozen conflicting strategies in a single 30-minute program.

So, investors will have to get used to the idea that they must educate themselves and go beyond the traditional Wall Street sources of investment advice if they want to utilize the most effective investment strategies. Many of you will decide to work with a professional. But you still must know enough to choose between the con artists and the true pros. The Net can help. In particular look for academic research from the economics and finance departments of the major universities that now maintain sites on the Web.

As you educate yourself, demand better strategies, lower costs, and better research. Don’t settle for what Wall Street wants you to know. Don’t settle for what Wall Street wants you to have. That’s the financial equivalent of letting the foxes guard the hen house. Perhaps the thing that Wall Street understands best is a loss of market share. Demand better. The best way for you to send that message is to vote with your feet. Refuse to put up with high costs, conflicts of interest, poor strategy, and amateur advisors.

Coming up

This portfolio won’t meet the needs of every investor, however it can easily be tailored for many other investor needs. In the next chapter, we will illustrate how to adjust the relative proportion of bonds in the portfolio to increase rate of return or decrease risk. We will also take an in-depth look at how our portfolio performed, and the implications of the strategy we designed.