The More You Know – Investing

I have been reading up on investing recently and there are some key notes I want to jot down so I can recall them when necessary.

The first four are based on the Four Pillars of Investing:

• Asset Class Selection & Weight is the single most important driver of portfolio returns and risk. Various studies have shown that for portfolios the drivers are: 91.5% asset allocation, 4.6% individual investment selection, 1.8% market timing, and 2.1% other. Crazy right? When a portfolio contains more than 1 asset class (eg. Equities and Bonds), the performance of the Asset Classes determines the majority of the return of the portfolio.
• Based on Modern Portfolio Theory, if you have multi-asset investing that combines investments with less than perfect corrleation (<1) then it produces portfolios with higher risk adjusted returns. The key factor is to have different investments that can be uncorrelated to each other over various periods of time. The lower the correlation, the greater the benefits derived – there are no consistent winners or losers. (eg. A balanced portfolio of 25% in each asset category of large cap, small cap, international, and short-term bonds) This is true diversification, asset classes with low correlation to one another. It has been said that “Diversification is the only free lunch in the investment world.” Have things that zig when others zag.
• Index investing minimizes hidden costs. Active management costs are significantly higher than index investing costs. Some costs are visible “Above Water” (higher management fees – 1% versus 0.2%) and others are hidden “Below Water” (trading commissions – churning, bid/ask spread, market impact costs – large buy/sell orders affect price). In addition, there is no consistency for any mutual fund. Star mutual fund managers generally do not continue to outperform, historical performance is no guide to the future.
• Alternative Investments can add significant value when combined with traditional portfolios by reducing risk. Such would be hedge funds, commodities, and managed futures. But generally those are not available to the individual investor.

Asset Allocation Clock:

• Economic Recovery & Low/Moderate Inflation – Domestic Equities, Nondomestic Equities, High Yield Bonds, Emerging Market Debt, Private Equity & Venture Captial
• High Inflation – Real Assets, Real Estate, Inflation-Protected Securities, Art, Antiques, and Collectibles
• Disinflation & Deflation – Cash Instruments, High-Quality Domestic Bonds, and High-Quality Nondomestic Bonds.

Other Insights:

• Efficient Frontier – The goal is to achieve a portfolio of assets that generate the highest level of return for a given level of risk. These points of high return, low risk lie on the efficient frontier and is attained through reasonable asset allocations that are truly diversified.
• Portfolio Rebalancing – Establish targeted percentages of your total portfolio that are to be placed in stocks, bonds, cash, real estate, and other investments based on your goals. Along the way, the prices and return of each investment in the portfolio will fluctuate in varying degrees. Then to get back to the originally targeted mix of equities and bonds, you reallocate and rebalance the portfolio. Hence, asset allocation has us selling those assets that rise & swell to too large a percentage of the portfiol and redeploying the money into more out-of-favor sectors and asset classes. This results in Buying Low and Selling High.
• Mean Reversion – What goes up must come down. Through time, things go back to average. In investing this says that over a period of several investment cycles, most assets’ returns will tend to generate their long-term average returns. Almost everytime an asset class goes too far in one direction, it eventually swings the other way – the only questions are how far and for how long. But keep in mind that when the reversing move does occur, prices will often push far past their long-term average in the opposite direction. Note however, a given asset class is probably a better investment after everyone has sold. Buying low, selling high.

Remember:

• The popular concept of every Bull Market is that the public has bought into the value of long-term investing and will never sell their stocks simply because of market fluctuations. And time after time, the investing public loses heart after the inevitable punishing declines that stock markets periodically dish out, and the cycle beings anew.
• Understand that market cycles will occur from time to time and don’t freak out.
• Properly managed and implemented, investing has all the excitement of watching grass grow and paint dry.
• Long term data provides a necessary “reality check.” This combats the virulent behavior of “overemphasis on recent history.”
• Instead of joining the herd mentality, get out when “everybody” knows that something is a good thing. It only means that everyone who wanted to buy already has; there are no buyers left. Prices can only fall.
• To avoid market timing, staggered contribution (dollar-cost averaging) lowers the risk.

Related posts:

• Personal Investment Style
• The Permanent Portfolio
• A Picture’s Worth
• Review: The Little Book of Main Street Money
• Tax Efficiency