Build Your Own Investment Portfolio, Part 2

Teresa, March 4, 2008 @ 4:45PM ET | Link | RSS | Read via Email | Start a Discussion  

In Part I, we discussed the reason why trading does not replace long-term investing. In this installment, we will review the cornerstones upon which an investment portfolio is built.

These cornerstones may be unfamiliar to most traders, but as John Maynard Keynes wrote, “The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future,” while directional trading is relatively a straight-forward beauty contest.

Cornerstone: Total Return

Traditional asset classes earn dividends and interest payments that compound over time to produce total returns. This fact is rarely mentioned in “avoid bear market” sales literature designed to promote trading as a “risk management” tool.

04-djitr.gif

This chart shows the power of total return. The Dow Jones Industrial Average closed the first week of October 1987 at 2,640.99. The total return index (pink line) shows the true return for the buy-and-hold investor while the blue line is the index quoted in the newspapers. So the next time someone tells you that “the Dow has gone nowhere since 2000″, just smile and walk away.

Cornerstone: Asset Allocation Policy

As the old saying goes, do not put all eggs in one basket. We would go further to check that none of those eggs are rotten to begin with, and not always keep them in baskets. Some eggs should be stored in the fridge, while the golden ones should be locked in a vault.

How your assets are allocated will influence the returns on your investments a great deal:

Defining and selecting asset classes constitute initial steps in producing a portfolio. Many investors simply allocate among the asset classes popular at the time in proportions similar to those of other investors, creating uncontroversial portfolios that may or may not address institutional needs. By relying on the decisions of others to drive portfolio choices, investors fail to consider the function of particular asset classes in a portfolio designed to meet specific goals. — David Swensen, Pioneering Portfolio Management

Be on the lookout for managers that “tactically” shift their asset allocation to hot or “alternative” asset classes (that generally do not pay dividends or interest) to boost return. It’s market-timing in disguise. Investors must not chase performance, use hindsight and follow fads and fashion.

Cornstone: Vanguard’s Nine Commandments

Please keep in mind that Vanguard is not referring to buying-and-holding QCOM, TASR, CROX, AAPL, GOOG or any individual stock du jour as a long-term investment strategy like many retail investors do. They are referring to quality asset classes:

Successful investing is difficult. Some of history’s most successful investors, such as my friend Warren Buffett, were early to understand the now well-documented anomaly that the rate of return on stocks, even adjusted for risk, exceeds that on less-risky bonds and other debt instruments, provided one is willing to buy and hold equities for the very long run. “My favorite holding period is forever,” said Buffett in an interview. The market pays a premium to those willing to endure the angst of watching their net worth fluctuate beyond what Wall Streeters call the “sleeping point.” — Alan Greenspan, The Age of Turbulence

Cornerstone: Engineered Portfolios

After establishing asset allocation policies, risk control requires regular rebalancing to policy targets. Movements in prices of financial assets inevitably cause asset class allocations to deviate from target levels. For instance, a decline in U.S. stock prices and an increase in bond prices leads stocks to be underweight and bonds to be overweight relative to target, causing the portfolio to have lower than desired expected risk and return characteristics. To restore the portfolio to target allocations, rebalancing investors purchase stocks and sell bonds.

Investors debate the frequency with which porfolios should be rebalanced. Some follow the calendar, transacting monthly, quarterly, or annually. Others attempt to control transaction costs, setting broad limits and trading only when allocations exceed specific ranges. Pursuit of continous rebalancing provides greater risk control with potentially lower costs than either the calendar or trading range approaches. — David Swensen, Pioneering Portfolio Management

After the appropriate asset classes have been chosen, the proportion assigned to each must be determined. The portfolio must also be rebalanced on a regular basis but things are never that simple. Do we allocate the assets based on discretion? Equal weight? Or something else? Do we rebalance daily, weekly or monthly?

Further reading:

In our next article, I will show readers how to craft a core investment portfolio without non-traditional (real estate securities, commodity-linked securities, and TIPS) or alternative asset classes, and how the asset are allocated so that the rebalancing mechanism uses, rather than fights, the forces of capital markets to achieve investment success.

CLICK HERE to read Part 3.

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