In Part 1 of this article, I listed finance pioneers Andrew Lo (MIT) and Stephen Foerster (University of Western Ontario) interviewed for their book, In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the way we invest. These pioneers of finance observed and described the market to academics, financial advisors and the public far better than anyone before them. Their work helps investors and their advisors understand the implications of their actions on their portfolios.
Today’s article summarizes the pioneering ideas of the perfect wallet as Lo and Foerster captured them.
What is the perfect wallet?
I was very struck by how few attributes the pioneers collectively identified to help investors identify their perfect portfolio – I only found 11. That’s a small number of action guides compared to the avalanche of ideas available every day in the financial press.
I suspect many of these investment attributes will be familiar to you. It’s impressive in itself. This suggests that these ideas have found a home in popular culture, beyond Wall Street and the Ivory Tower.
Most of the attributes are simple and easy to understand, which is the main source of their power. While today’s large investment firms employ economists, mathematicians, physicists and statisticians in hopes of finding an investment edge, these fundamental portfolio attributes are available to all. . Individual investors can succeed without resorting to extensive research or analytical gymnastics – the attributes below tell us how.
I interpreted the text freely. I looked for an agreement and disagree (finding none of these). I’ve listed the attributes in descending order of popularity (defined as the number of pioneers who cited them in the book).
- Diversification – It is the “free lunch” par excellence of the economy. Harry Markowitz was the first to rigorously demonstrate the benefits of “not putting all your eggs in one basket”. To be efficient (offer the best return for a given level of risk, or the least risk for a given expected return), a portfolio must be diversified.
- Stock and bond market index – William Sharpe demonstrated that the market index was the most effective diversified portfolio attribute (under certain assumptions).
- Incorporate personal circumstances – The human capital (earning capacity) and the financial plan of the investor will influence his “perfect portfolio”. An investor whose career generates income uncorrelated with stock market performance (a teacher or a doctor) can afford more risk than an investor with similar assets who works on Wall Street. Likewise, an investor living well within their means can afford more risk than a living paycheck to paycheck.
- International Equities – Investing outside your home country, even if its market is very large, offers additional diversification benefits. These benefits go beyond simple correlation. In the event of a disaster in the home country, having assets abroad could provide at least some protection.
- Focus on goals – As the work of Robert Merton suggests, the best portfolio design begins with an understanding of the investor’s goals. Designing the perfect portfolio requires knowing the investor’s target retirement date and desired spending level, for example.
- TIPS for risk-free assets – TIPS (Treasury Inflation Protected Securities) are treasury bills whose face value adjusts to match US inflation as measured by the consumer price index (CPI). They are an excellent hedge against unexpected inflation. Owners can rely on the full faith and credit of the US government for payment of interest and principal. TIPS have a unique combination of very low credit risk and very low inflation risk. Zvi Bodie, an economist who does not appear in the book, is probably TIPS’ main advocate.
- Save – No portfolio design can compensate for a lack of savings.
- Financial Advisor – A financial advisor can provide objective advice. A financial advisor should also be more knowledgeable about financial products and markets than the average individual. People should be able to make better financial decisions with the support of an advisor.
- Keep capital expenditure low – The evidence strongly supports the idea that net returns are higher on average for mutual funds with lower expenses. John Bogle is perhaps the most vocal pioneer on this topic, and certainly the one most directly responsible for reducing mutual fund expenses for investors.
- Manage risk – Tools that allow investors to adjust the profile of returns they get are beginning to appear. Myron Scholes is the main advocate of this idea among the pioneers. Specifically, combinations of derivatives (like put and call options) offer the opportunity to reduce downside risk at the expense of upside potential. Structured ETFs and ETNs now offer this capability to consumers. The use of products of this type can allow investors to reduce the variance of the annual return.
- Slope factor – Certain attributes of companies and stocks are correlated with higher investment returns, as demonstrated by the work of Eugene Fama. Attributes showing evidence of outperformance include value (stocks with low ratios of market to “book” or book value), company size (smaller companies), momentum (companies with rising stock markets) and profitability (companies regularly making a profit).
The authors did not ask the pioneers if they agreed with each of the attributes I identified. Instead, they asked open-ended questions and noted what the pioneers came up with.
4 fundamental investment principles
When I started this article, I thought I would find some attributes more important than others based on a vote among the pioneers. The structure of the book does not allow this, however – the authors did not provide ballots for the pioneers, and we cannot guess how the pioneers would have voted.
After a careful reading of the book, I gathered the attributes into coherent groups, suggesting 4 fundamental principles:
- buy the market – To diversify. Stock and bond index. Incorporate international stocks (if you feel comfortable doing so). [Not one pioneer advocated market timing.]
- Personalize your portfolio – Consider your personal circumstances, and especially the nature of your human capital – earning power. Focus on achieving your personal goals. You may want to work with a Financial Advisor, who knows you and gives you personalized advice you trust.
- Spend carefully and wisely – Save more. Don’t rely on extraordinary investment returns to replace savings. Keep capital expenditures low.
- Stay close to the market index portfolio – Very few deviations from the market index portfolio receive pioneering support. Keep TIPS as the best risk-free asset. Tilt factor if you are hoping for extra return and are willing to accept the extra risk. Manage risk by changing the pattern of gains over time and market cycles (products for individual investors are just starting to appear).
That’s all? Almost 70 years of hard work by many serious people on how to invest, how to select the best investments, and we get 4 fundamentals?
I say that’s a lot! This is wonderful news! You can be sure to have an (almost) perfect portfolio by following 4 simple guidelines.
Follow the 4 fundamental principles to avoid rash decisions
The principles can save you a lot of time and emotional energy. When family, friends or colleagues (or the financial press!) share their financial ideas, you can filter them using these principles. Investing in ideas that conflict with these principles will require a huge amount of evidence before you pay attention.
Even though there are only 4 fundamentals, finding the best wallet for you is not easy. Knowing your goals and situation and applying that knowledge to your investments takes work. You will need to do an analysis to determine how much to save. You will also need to follow. You may find an advisor helpful in assessing your investment situation and goals and deciding how much to save.
Nevertheless, finding your best wallet is totally doable, if you focus on these fundamentals and save. And while you don’t always need in-depth product knowledge or investment information, you may need the help or advice of a financial advisor. Adhering to the basics will help you design your own perfect portfolio!
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