By: Frank Armstrong, CFP, AIF
Would you like to exert more control over your investment results, explore strategies with the highest probability of achieving your goals, lower your costs, lower your risk, and increase your rates of return? Modern financial research has been focusing on these goals for about 40 years. It’s been time well spent. What researchers have uncovered about how markets really work can help you and your family to invest more profitably.
Investing for Keeps will examine practical applications you can implement now. One of the most useful concepts, asset class investing, is a radical departure from traditional investment techniques. While institutions have embraced this concept, few individuals manage their investments this way. For those of us brought up in the traditional school, asset class investing takes a little getting used to. Individual investors can easily implement this approach, however, and the rewards are well worth the effort. The payoff is a much higher probability that our investment plans will succeed.
Asset class investing grew out of academic research by Gary P. Brinson, L. Randolph Hood, and Gilbert Beebower. Their pioneering study, Determinants of Portfolio Performance (published in the Financial Analysts Journal July-August 1986), demonstrated that the single largest driving force behind investment results was the policy decision allocating between stocks, bonds and cash. They found that if they knew the percentage allocated to each class, they could account for the vast majority, 94%, of the variations in returns between large domestic pension plans. More recent studies have concluded that when the size and style characteristics of the portfolio are factored in, you can account for over 98% of the plan results!
The factors that most investors had assumed contributed the most to investment returns, individual stock selection and market timing, contributed less than 6% to the result. Worse yet for active managers, on average the contribution was negative.
Hiring active managers to either pick individual securities or make market timing calls turned out to be a total waste of time and money. The area with the biggest impact on investment returns was the selection of asset classes and the relative weight given to each. This consideration swamped all the others.
If traditional methods of investment management (individual issue selection and market timing) were of such marginal or even negative value, it was time to rethink the investment problem from the ground up.
Meanwhile, other academics building on Modern Portfolio Theory and the Capital Asset Pricing Model concluded that the most efficient portfolio one could construct would hold equal weights of all the world’s investable assets. In other words, diversify widely to obtain the best possible return for each unit of risk you are willing to put up with.
These twin insights triggered a race to develop new investable asset classes for investors.
Just what is an asset class? An asset class is any defined portions of the world’s capital markets that share similar characteristics.
Anybody can define an asset class. There is nothing mysterious about the process. But some asset classes will turn out to be more useful than others When I was a kid, I believed that marbles and baseball cards were an important asset class. It wasn’t until much later that I discovered that my preferred asset classes didn’t get much respect on Wall Street.
So, we might say that domestic large company stocks, foreign small company stocks, and emerging market debt are separate asset classes. Or we might want to narrow our definition to domestic large company growth stocks, foreign small company value stocks, and Brady Bonds.
Once we have defined our asset class, we must find an index to track the performance of our assets. There are already thousands of indexes out there already that are used by investors to track portions of the world’s capital markets. Not all of them are very useful to us. Very few of them have their own index funds.
Because capital markets work rather nicely to reward investors for the risks that they choose to bear, each asset class will have a fairly predictable long-term rate of return. That return can be obtained by investors in the asset class without any skill, and without relying on either a forecast or prediction. So, you don’t have to have magic powers of market timing, or an extraordinary ability to select individual stocks. The rate of return is there for the taking. You just have to be there. Now there is a revolutionary and genuinely useful idea!
Of course, each asset class will carry risk. But, by properly combining the asset classes together to form portfolios, we can reduce this risk to its lowest practical level. This is the role of asset allocation and Modern Portfolio Theory.
In the real world, few investors buy all available asset classes. They pick and choose. Some asset classes are better than others. So, enlightened investors will be constantly on the lookout for new asset classes to help spread the risk or increase rates of return. What makes a great asset class? I get warm and fuzzy feelings for a new asset class when it has both desirable risk and reward characteristics, and a low correlation to other asset classes I already hold in my portfolio.
Of course, an asset class investor will insist on selecting investments with the lowest possible tracking error to each of our desired asset classes. Because they can be designed to replicate almost any asset class of traded securities, mutual funds (especially no-load index funds) can be ideal building blocks for asset class investing. Properly employed, mutual funds level the playing field for the retail investor. Using an appropriate combination you can build a portfolio as effective and sophisticated as the largest institutions.
OK. So much for theory. Beginning next column we’ll consider a real world illustration to see how you, an enlightened mutual fund asset class investor, can utilize new financial theory to dramatically improve your long term investment results.