4 Core Principles For Your Perfect Portfolio (Part 2)

In part 1 of this article, I listed the financial 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 financial trailblazers observed and described the market to academics, financial advisors, and the public far better than anyone had before them. Their work helps investors and their advisors understand the implications of their actions on their portfolios.

Today’s article summarizes the pioneers’ ideas about the perfect portfolio as Lo and Foerster captured them.

What is the perfect portfolio?

I was most struck by just how few attributes the pioneers collectively identified to help investors identify their perfect portfolio – I found only 11. That is a small number of guides to action compared to the avalanche of ideas available every day from the financial press.

I suspect that you will find many of these investing attributes familiar. That is impressive by itself. It suggests 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 a primary source of their power. While today’s major investment firms employ economists, mathematicians, physicists, and statisticians in the hope of finding an investment edge, these foundational portfolio attributes are available to us all. Individual investors can find success without resorting to extensive research or analytical gymnastics – the attributes below tell us how.

I interpreted the text liberally. I have looked for agreement and disagreement (finding none of the latter). I ranked the attributes in descending order of popularity (defined as the number of pioneers who cited them in the book).

• Diversification – This is the quintessential “free lunch” of economics. Harry Markowitz was the first to rigorously demonstrate the benefits of “not putting all your eggs in one basket.” To be efficient (offer the greatest return for a given amount of risk, or the least risk for a given expected return), a portfolio must be diversified.
• Market index for stocks and bonds – William Sharpe demonstrated that the market index was the most efficient diversified portfolio attribute (under certain assumptions).
• Incorporate personal circumstances – The investor’s human capital (earning power) and financial plan will influence their “perfect portfolio.” An investor with a career producing earnings uncorrelated with the performance of the stock market (a teacher or a physician) can afford more risk than an investor with similar assets who works on Wall Street. Similarly, an investor living well within their means can afford more risk than one living paycheck to paycheck.
• International stocks – Investing outside of your home country, even if its market is very broad, affords additional diversification benefits. These benefits go beyond simple correlation. In the event of a home country catastrophe, having foreign assets could provide at least some protection.
• Focus on goals – As Robert Merton’s work suggests, the best portfolio design begins with an understanding of the investor’s objectives. 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 bonds 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’ leading advocate.
• Save – No portfolio design can make up for a lack of saving.
• 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 an advisor’s support.
• Keep investment expenses 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 of the pioneers on this subject, and certainly the one most directly responsible for bringing lower mutual fund expenses to investors.
• Manage risk – Tools that allow investors to adjust the pattern of returns they experience are beginning to emerge. Myron Scholes is the primary advocate of this idea among the pioneers. Specifically, combinations of derivatives (such as put and call options) offer the opportunity to reduce downside risk at the cost of reducing upside potential. Structured ETFs and ETNs now offer this capability to consumers. Using products of this sort may allow investors to reduce annual return variance.
• Factor tilt – Certain attributes of companies and stocks are correlated with higher investment returns, as Eugene Fama’s work demonstrates. Attributes with evidence of outperformance include value (stocks with low ratios of market value to “book” or accounting value), company size (smaller companies), momentum (companies with rising stock prices), and profitability (companies steadily earning profits).

The authors didn’t ask the pioneers whether they agreed with each of the attributes I have identified. Rather, they asked open-ended questions, and recorded what the pioneers volunteered.

4 core investing principles

When I started this article, I thought I would find that some attributes were more important than others based on a vote among the pioneers. The structure of the book doesn’t allow that, however – the authors didn’t provide the pioneers with a ballot, and we can’t guess how the pioneers would have voted.

After a close reading of the book, I gathered the attributes into coherent groups, suggesting 4 core principles:

• Buy the market – Diversify. Index for stocks and bonds. Incorporate international stocks (if you are comfortable doing so). [Not one pioneer advocated market timing.]
• Make your portfolio your own – Incorporate your personal circumstances, most importantly, the nature of your human capital – earning power. Focus on accomplishing 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 substitute for thrift. Keep investment expenses low.
• Stay close to the market index portfolio – Very few deviations from the market index portfolio receive pioneer support. Hold TIPS as the best risk-free asset. Factor tilt if you hope for extra return and are willing to accept the extra risk. Manage risk by shifting the pattern of payoffs over time and market cycles (products for individual investors are just beginning to emerge).

That’s all? Nearly 70 years of hard work by many serious people on how to invest, how to select the best investments, and we get 4 core principles?

I say that’s a lot! It’s wonderful news! You can be confident that you have a (nearly) perfect portfolio by following 4 simple guidelines.

Follow the 4 core 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 ideas that conflict with these principles will need a huge amount of evidence before you pay attention to them.

Even though there are only 4 core principles, finding the best portfolio for you isn’t easy. Knowing your goals and your circumstances and applying that knowledge to your investments takes work. You’ll need to do some analysis to determine how much to save. You’ll also need to follow through. You may find an advisor helpful in assessing your circumstances and goals from an investment perspective and deciding how much to save.

Nevertheless, finding your best portfolio is eminently doable, if you focus on these core principles 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 core principles will help you design your own perfect portfolio!

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