Build Your Own Investment Portfolio, Part 6

Teresa, March 19, 2008 @ 11:30AM ET | Link | RSS | Read via Email | Start a Discussion  

In Part 5, we reviewed the two major roadblocks to achieving one’s goals. In this article, we will analyze a typical article that investors have come to accept as gospel.

The critic — no doubt with good intentions designed to set me straight — submitted two articles:

  1. An Easier Path to Real Returns
  2. The Benefits of Low Correlation

After reading them, may I suggest:

1. Avoid The Rear View Mirror

The problem with both articles is that they emphasize inflation protection. As recently as 2003, the investment world was focused on deflation.

Commodities were not in vogue until the last year or two. For example, Calpers — the largest pension fund in the United States — is position to diversify into anything it chooses, yet it did not announce an increase in allocation to this alternative asset class until February 28, 2008. And even then, the allocation is to be 0.5 to 3 percent.

Using the rear view mirror to perform select asset classes always leaves the investor one step behind. An equal weighting scheme increased allocation to commodities even further to 14.28%.

Investors must construct all-weather investment portfolios impervious to fads and fashion.

2. Avoid Hypothetical Situations

All is (sort of) well until we reached page four. We find that the article feaures a hypothetical seven asset class portfolio from Fantasy Island.

feature2_0711_02.jpgThe time frame covered in this study was the 37-year period from 1970-2006. Assets included in this analysis were large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities (see Figure 2). The 37-year historical performance of large-cap U.S. equities is represented by the S&P 500 Index, while the performance of small-cap U.S. equities is captured by using the Ibbotson Small Companies Index from 1970-1978 and the Russell 2000 Index from 1979-2006. The performance of non-U.S. equities was represented by the Morgan Stanley Capital International EAFE Index (Europe, Australasia, Far East) Index. U.S. intermediate-term bonds were represented by the Ibbotson Intermediate Term Bond Index from 1970-1976 and the Lehman Brothers Intermediate Term Bond Index from 1977-2006.

The historical performance of cash is represented by 3-month Treasury Bills. The performance of real estate was measured by using the annual returns of the NAREIT Index (annual returns for 1970 and 1971 were estimated as the NAREIT Index [National Association of Real Estate Investment Trusts] did not provide annual returns until 1972). Finally, the historical performance of commodities was measured by the Goldman Sachs Commodities Index (GSCI). As of February 6, 2007, the GSCI is now known as the S&P GSCI Commodity Index.

While I appreciate going back to 1970 for historical data, the fact is that a typical investor could not have implemented even a single leg of this portfolio until the 1990s when the S&P SPDR was launched.

3. Maintain low transaction costs

The difference between four symbols found in our core portfolio and seven in their hypothetical portfolio is not trivial. It nearly doubles transaction costs unless the investor has access to a flat-fee account.

4. Acknowledge the Benefits of Homeownership

Most people in position to invest already own a house, affording them a long-term hedge against inflation in the cost of living. Sure, gas and food goes up over time, but history since 1970 tells us that the price of accommodation generally exceed that of gas and food. Allocating additional funds in the portfolio to real estate and/or overweighting commodities may not be appropriate for homeowners.

5. Rebalance More Often

It goes without saying that rebalancing should be done as frequently as possible to take advantage of price movements. Allowing excessive drift away from policy targets exposes the portfolio to increased risk.

6. Avoid Equal Weight Allocation

Correlation can and does change over time, sometimes dramatically. Just ask any hedge fund manager. Allocating an equal percentage to each asset class does not maximize the risk/return of a portfolio and exposes it to correlation change.

The article quotes Harry Markowitz, but does not employ his crown jewel, the mean-variance “efficient” frontier — for which he won the 1990 Nobel Prize in Economics — to allocate the assets.

Establishing policy asset allocation targets requires a combination of quantitative and qualitative inputs. Financial markets invite quantification. Return, risk, and correlation lend themselves to numerical measurement. Statistical methods allow analysis of possible portfolio combinations through a number of frameworks, including the capital asset pricing model (CAPM), arbitrage pricing theory (APT), and modern portfolio theory (MPT). Quantitative analysis provides essential underpinnings to the portfolio structuring process, forcing investors to take a disciplined approach to portfolio construction. Systematic specification of inputs for an asset allocation model clarifies the central issues in portfolio management. — David Swensen, Pioneering Portfolio Management

Assets can be allocated according to a number of frameworks, and that will be the subject of our next article.

CLICK HERE to read Part 7.

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