Building a successful investment plan for the twenty-first century may require a fundamental change in the way we think about investing. For instance, while taking less risk, a portfolio comprised of only 60 percent equities that outperforms the S&P 500 by a wide margin should certainly be considered a superior portfolio. Furthermore, new advances in investment and finance offer us solutions both simpler and more elegant (and very, very different) than what we grew up with.

Old School Investing

We have been conditioned to think of market timing, stock selection, and manager performance as the keys to success. Because these beliefs are deeply ingrained, even superior investment strategies like Strategic Global Asset Allocation take a little getting used to.

What I’m advocating is so different from public expectations that sometimes people look at me as if I’m not quite right or a few bricks short of a full load. For instance:


  • As an investment advisor, I’m expected to have an opinion on where the market is going. Well, I have an opinion, but it’s no more likely to come true than yours or your dog’s. People are offended and disappointed when I tell them that.
  • Thanks to the media, we are exposed daily to countless “experts” who are worried about the market. Their indicators and forecasts point to a possible “correction.” They are prepared to retreat to the “safety” of cash. This allows them to look responsible, conservative, and caring. By pandering to the public’s fear, they hope thousands of anguished investors will decide to trust them with their money. On the other hand, advisors who insist on remaining fully invested at all times appear wild and crazy.
  • Advisors are supposed to beat somebody or something. Often the first question people will ask is: “What kind of numbers have you achieved this year?” Those numbers become the chief yardstick to determine if the advisor is good or bad.
  • I’m still waiting for the first investor to ask: “What’s the best long-term allocation?” Or, “How much risk do I need to take to meet my goals?”

Without tools to evaluate risk or choose between alternative strategies, investors are left with just one number to compare performance. By default, year-to-date or last year’s performance figures are the only criteria for measurement. If those figures alone determined a successful investment plan, we could all buy one copy of Money Magazine each year, pick the single, top-performing mutual fund, and go sailing. Unfortunately, the Money Magazine approach is often the worst way to form a strategy.

Turning Your Goals into a Strategy

Every strategy has certain performance implications. The word strategy implies a conscious effort to achieve stated goals. As we saw in Chapter 12, the Joneses’ goal is not to beat the S&P 500, or any other index or person. They are not interested in maximum performance. Their concern is to at least meet their minimum acceptable return levels without taking excessive risk. They want a comfortable and stress-free retirement.

The asset-allocation design will determine results in both short- and long-term periods. What’s more, both risk and returns will be driven far more by asset allocation than stock selection or market timing.

We could have looked at the 20-year, asset-class returns and seen that foreign, small-company stocks produced the highest return. But putting all the Joneses’ money in foreign, small-company stocks will not produce a comfortable and stress-free retirement. Any asset class can and will have extended periods of serious under-performance from its long-term trend. And foreign, small-company stocks can and do have wild swings in short-term performance.


Let’s Get Risky

So why put any of that risky stuff in the Joneses’ plan? Why not just buy them a few utility stocks and forget it? The reason is this: When we measure risk at the portfolio level, we can see that the best way to construct a conservative portfolio is not to have all “safe” assets, but to have a conservative mix of attractive assets. A risky asset with a low correlation to other assets in the portfolio can actually reduce risk in the portfolio. It’s a question of trying to get as much bang (return) for the buck (risk) as possible. A diversified portfolio offers much higher returns per unit of risk than does a utility or “blue chip” portfolio.

If we individually examine each asset class, we will see that some have considerable risk. I have used the traditional definition of the risk-reward line as falling along the points between the “risk free” Treasury Bill rate, and the S&P 500. Any point falling above or to the left of the line is “good” while below or to the right of the line is not. Investment managers all strive to have their performance fall somewhere in the northwest quadrant.

Index Performance

Over the long term, investment markets and portions of markets generally sort themselves out just about as they are here. In the short run, we might expect just about anything. It’s not terribly unusual to see a negative-sloping, risk-reward line for short time periods. That just means the market went down, and that stocks performed worse than T-Bills. In the business, we tend not to put many of those charts on the wall, but you should know that they exist. You must think of these temporary reverses as just another non-event on the way to meeting your goals.


Balancing Risk with Return

While you are looking at the chart, you might notice that the statistics generally confirm that small stocks have a higher return and risk than large ones – and that “value” has a higher return without any more risk than “growth.” During this particular time period, value stocks had higher risk than the S&P 500, but turned in higher returns. Foreign stocks, adjusted for currency back to U.S. dollars, have had higher returns and risk than domestic stocks.

EAFE had somewhat lower returns than we might have expected, but higher ones than our own domestic stocks. Because it is primarily a large growth portfolio, it falls considerably below the large foreign-value stocks. Foreign small-company and value stocks are particularly attractive in terms of return — generating much higher rewards than EAFE. Fortunately, they also have low correlation to our domestic stock markets. Notice how far below the line the long-term bond portfolio falls. Long-term bonds show much higher risk for no more reward than a short-term portfolio. How do they find people to buy that stuff anyway?

What is important is how much risk the portfolio has, and that it is reasonably conservative. From another perspective, few portfolios with this level of risk will offer better total return. While the “efficient frontier” is a constantly changing target, we must conclude that our superior portfolio is reasonably “efficient.” Here’s another view of our efforts to improve the starting portfolio:

Improving A Portfolio

How did each of our “improved” portfolios perform over the 20-year period? Check out the year-by-year performance of each of the portfolios along with the inflation, T-Bill, and S&P 500 returns.

The word strategy also implies a long-term approach. Even the “best” long-term strategy will not be the best each year — or even each five years. And since we are dealing with equities, and equities have risk, it’s important to understand that even the “best” strategy isn’t a guarantee against occasional bad (negative) periods. Remember, risk happens!

Expect Periodic Declines

One measure of risk that investors use is chance of loss. Let’s face it, none of us like even temporary declines. In a 20-year period, our portfolio had only one loss. Both the S&P 500 and Portfolio One had three losses. But that doesn’t mean that worse performance wasn’t possible.

For instance, had the data been available to build our model, we would have seen larger losses in the dismal 1973-74 period. The possibility for larger losses is incorporated in the model. We have enough data points during the last 20 years to build a reliable model and have faith in our Standard Deviation measurement. Just keep in mind that performance can and will exceed one standard deviation about three years in 10. Of course, few complain if the performance exceeds a standard deviation on the upside!

Investors also seem to have any number of mental yardsticks that they employ relentlessly either against themselves or their financial advisors during periods of under-performance. Investors want to do better than CD rates — and they want to do that every day! Of course, even a superior portfolio will not outperform CD rates every day or every year. In fact, this portfolio fell short of that yardstick a total of five times during the 20 years.

No More Second-Guessing

Investors often have one more mental yardstick for comparison. The temptation to second-guess yourself or your strategy is enormous. Investors are, after all, quite human, and they believe, quite reasonably, that they should have it all. For instance, often they want to “beat the S&P 500.” We have gone to a great deal of trouble to build a portfolio which doesn’t look anything like the S&P 500. The S&P 500 is made up of large domestic-growth stocks. These tend to have a relatively low return per unit of risk that they endure.

Our strategy has been to seek out asset classes that have a higher rate of return and very low correlation with domestic large-company growth stocks. It stands to reason that our portfolio will not track with the S&P 500. This means that sometimes the S&P 500 will outperform our superior portfolio. When foreign, small-company, or value stocks are having bad years, it is not likely that we will outperform an exclusively domestic, large-company, growth portfolio. In fact, the S&P 500 outperformed our portfolio 10 out of 20 years! So, in summary, our superior portfolio had one loss, failed to beat CDs five times, and failed to beat the S&P 500 10 times!

Investors often tend to narrowly focus on any yardstick which is exceeding their portfolio performance for the moment. This practice can lead to some interesting conversations between investors and their advisors. Unless investors can focus on their own goals, risk tolerance, and strategy, performance becomes an impossible moving target. Investors must understand that a superior portfolio will underperform from time to time, no matter what mental yardstick they are using. If they are prepared for this disconcerting reality, they are less likely to find themselves abandoning their superior portfolio in favor of Wall Street’s deal of the day.

Adjusting the Portfolio

As good as this portfolio is, it won’t be right for every investor. Some will want more return, some will want less risk. But it’s pretty easy to modify the portfolio to meet most objectives. For investors seeking lower risk, we can just shift the proportion of assets from equities (stock) to short-term bonds. We started with a 60/40 mix of stocks to bonds. More conservative investors might opt for a 40/60 or even 20/80 mix. However, they ought to hold each of the asset classes, even the riskiest in their portfolios – they will just hold a smaller percentage of each.

Investors wanting higher risk and reward can just reduce the proportion of bonds. Once they get to zero bonds they have two potential courses to follow if they still want higher returns. First, they could shift the asset allocation to more value and small-company stocks. While this example didn’t include emerging markets, we can assume that they might opt for a healthy portion of them in their portfolio as well. As an alternative, they might consider purchasing the portfolio on margin.

As a practical matter, most investors would not be comfortable with these higher levels of risk – very few of my clients have complained that we aren’t taking enough risk. My view is that, properly practiced, investing should be reasonably boring. Perhaps there are some intrepid souls out there craving excitement, but they don’t find their way to my door in large numbers. So, while I have a number of investors fully invested in equities, I have exactly zero investors on margin.

Proof Is in the Performance

Here is how the portfolios would have performed. Each portfolio containing equities is comfortably above the old risk-reward line. You should also notice that the most conservative, balanced portfolio with 20 percent equities has both lower risk and higher performance than a pure short-term bond portfolio.

Each of our adjusted portfolios is a very good strategy at a particular level of risk.

Adjusting the Risk

You can also check out the year-by-year results of each of the several portfolios.

Happiness through Asset Allocation

Back to the Joneses. How would the portfolio have performed for them? Would it have met their need for income, an inflation hedge, and an increase in real value? And how should they turn this portfolio into an income-generating machine?

If the Joneses had looked at their total capital each December 31 and withdrawn six percent for the following year’s income needs, the income stream would have been very favorable.

Growth above the six percent income withdrawal is reinvested to provide an inflation hedge and long-term growth of capital. The healthy level of short-term bonds keeps us from having to consume stocks during market declines. The process of reallocation each year back to the original proportions will result in selling bonds following bad years, and stock following good years. Reallocation actually contributes to total return, while holding the risk level constant.

Income under the Joneses’ plan began at $79,674 and grew to $410,450 last year. Income from CDs started at $66,300 and trended up until 1981 when it reached $172,700, then tapered off to $26,600 in 1993 and “recovered” to $36,900 last year. Total income under the plan of $4,884,848 compares favorably to income of $1,633,200 with the CDs.

CD Income v. Portfolio 5

The Joneses had a clear choice, and they could have gone the safe route. Of course, the CDs are still only worth $1 million and the example portfolio has grown to $6,430,380 by the end of 1994. Rather than nibbling caviar and toasting champagne, the Joneses would be out cashing in McDonald’s discount coupons. While they are there, they can check out employment opportunities behind the counter. Not all those smiling older faces are there just because they’re bored with retirement. That million dollars didn’t go as far as you might have thought if you simply put it in the bank 20 years ago.

Reality Rears Its Nasty Head

Please don’t read too much into this model. The time period we were forced to use was considerably better than normal. (Data is not available in all the markets we wanted to demonstrate for longer than 20 years.) The 20-year period was characterized by falling interest rates, falling inflation, and superior stock markets. Both nominal and real rates of return were significantly higher than long-term trends. For instance, if we had included the dismal 1973-74 years, our rates of return would be lower.

No one should base their planning on attaining anything like the rates of return here. As a rule of thumb, don’t expect long-term results higher than eight percent above the inflation rate. If you do get better, celebrate. Just don’t base your whole strategy on attaining returns which are so much higher than normal.

A Strategy for Everyone

We have demonstrated a superior investment strategy. Looking forward, our strategy should yield superior results while limiting risk for long-term investors in almost any economic environment short of unlimited nuclear war or total global economic collapse.

Whether you are playing tennis, flying fighters, or practicing medicine, you should be constantly looking for the highest probability shot. The combination of Strategic Global Asset Allocation and Modern Portfolio Theory (with an appreciation of the cross section of expected returns in various parts of the world’s markets) offers investors the highest probability shot of making their objectives a reality.

Coming Up

Designing a strategy is one thing. Implementation is another. In the next chapter, we will begin to implement our strategy. We will start by examining the profound changes in the financial services industry over the last generation. These changes allow knowledgeable investors to execute sophisticated strategies in a very economical manner. You don’t have to be a multibillionaire, but you do have to know what is available. Wall Street isn’t going out of its way to show you how to economize. “Business as usual” is just too profitable – for them! Until you demand better, Wall Street is only too happy to sell you the same old stuff.