Step 11: Risk Exposure

Diversification

Diversification in investing refers to the process of spreading out risk. Let's look at a single stock in an index versus the entire index as seen in Figure 11-3. Because of the random nature of risk, no one knows what is going to happen in the short term to a subset of stocks in the index.

Members of the Dimensional Fund Advisors team explain the benefits of diversification.

A subset of the index would actually be another index altogether with different risk and return characteristics. At an extreme, one stand alone stock represents its own index, but it has a very high risk and offers no additional expected return over the asset class to which it belongs.

Look at one small value stock in Figure 11-3. It has a risk of about 75% and an expected return that's the same as the small value index. However, the index only has a risk of 30%. So, why buy just one stock? Or better yet, why buy any stocks with an expected risk higher than the index? There is no logical answer, other than to speculate on the random outcomes of a higher risk investment. What is the expected return of speculation? Answer: Zero minus your costs.

When investors concentrate their investments, they are increasing their risk with no added benefit of higher expected return. In other words, investors are not rewarded for taking the higher risk of concentrating their investments such as selecting just a handful of stocks for their portfolio. The result is that over a period of 20 years or so the risk or volatility of an individual stock is about 2.5 times that of a market index with no expected extra payoff.

The most prudent approach to minimize risk and maximize the probability of achieving a market rate of return is to hold the entire index. The optimal approach is to find an index with desirable risk and return characteristics and then adhere to the index rules of ownership, which is the job of the index mutual fund manager. This way the specific risk of each stock in the index is diversified down to near zero. This leaves investors with the systematic risk of the market the index is designed to track. Anything less than this optimal approach will cause the portfolio's risk to exceed the risk of the index as a whole.

When Harry Markowitz wrote his Nobel Prize-winning paper in 1952 titled "Portfolio Selection," he laid out the mathematics of diversification and the foundation of the design of risk exposure. He set out to apply his engineering background to investing, so, his thesis could be referred to as "portfolio engineering." In his paper he indicated that it's best to engineer a portfolio to include stocks that do not act like each other or move together.

For example, stock A and stock B move in opposite directions. When stock A goes up, stock B goes down and vice versa. This is called a low correlation of the two investments. If each stock yields returns with the exact same average, investors actually earn a diversification benefit of lower volatility and higher returns if they hold these stocks in the same portfolio. This is a good thing! As Markowitz stated in 1952, investors should consider expected returns desirable and variance of returns undesirable.

Unfortunately, many investors still do not get this important point. One diversification detractor is the book, The Battle for Investment Survival, written by Gerald Loeb in 1935. Loeb expressed a conventional investing idea that became popular in the 1950s. He claimed that an investor who diversifies is basically admitting a lack of knowledge and trying only to strike an average. Loeb recommended that one, two or at most three or four securities should be bought. He said that competent investors will never be satisfied beating the averages by a few small percentage points. Broad diversification was considered undesirable, and he suggested that investors analyze securities one by one, focus on picking winners, and concentrate holdings to maximize returns.

Fortunately, there is now ample evidence to counter and debunk Loeb's theories. This 12-Step Program was created to educate those investors who still insist on practicing futile investment strategies, such as non-diversification of portfolios.

Global Diversification and Regional Bias

Global diversification is a good idea because the international market is increasingly important in the world economy. The United States used to be a much larger percentage of the world market. It declined from 68% of the global equity value to 46% in 2004, as seen in Figure 11-4.

As of 2009, the US and Canada has declined to about 46% of the world total market value. There are additional risk factors in international markets that can both smooth out your volatility and increase your expected returns. To be effective, a portfolio cannot afford to exclude international investments.

Regional bias, also known as home bias, is the tendency for investors to hold a higher percentage of their portfolio in their home country than would be suggested by the weighting of their country relative to the rest of the world.

For example, as of 4/30/2010, the United States alone made up 43% of the total global market capitalization or $12.6 Trillion of the $29.3 Trillion global market. An American investor who has a higher percentage than this in U.S. equities is exhibiting regional bias. Even when it comes to international investing, regional bias is also present, as shown in "Home Bias in Foreign Investment Decisions" (Ke, Ng, and Wang, 2006). Specifically, American investors are more likely to overweigh foreign companies that have a strong American presence (e.g., Sony, Toyota, BP).

The extent of regional bias around the world is pervasive and surprisingly high, as illustrated by data from a 1997 IMF survey of cross-border equity holdings.

Although in theory it would be the most efficient approach in accordance with the Capital Asset Pricing Model, it is not IFA's recommendation that investors hold the global market percentage of their home countries, as this would be simply unrealistic. Most investors follow their home markets much more closely than they do foreign markets. In the U.S., for example, we are constantly bombarded by news and commentary from outlets such as CNBC.

During time periods when the U.S. market outperforms the foreign markets (as in the late 1990's) the pain of not having all of our investments in U.S. stocks is felt acutely. In other words, we have a tendency to assign a mental tracking error to our portfolio with respect to the U.S. market.

One objective to portfolio design is to minimize the urge to trade. Having a large percentage of our portfolio in U.S. equities mitigates that urge to trade and trades placed under duress are often deleterious to investor wealth.

The true US equity portion of IFA's standard portfolios is hard to determine, but the allocations indicate that it would be 65% US. However, we estimate that about 20% of sales from the US companies come from international markets, which would bring the allocation closer to 45% US. On the other hand, several international companies have a portion of their sales in the US, which may move the US allocation back to 50% or more. While higher than the CAPM suggested percentage of 43%, IFA considers this to be a reasonable allocation that aligns with IFA's goal of matching investors with portfolios that they will be more likely to hold when they are out of sync with US market returns.

The IFA Index Portfolios also address the issue of investors being overly attracted to foreign companies with a strong American presence. These companies tend to be categorized as large growth, and IFA's tilt towards small and value companies will result in de-emphasizing these companies.

Portfolio Rebalancing

One idea built into the long-term buy and hold strategy of risk exposure is the concept of maintaining consistent exposure to risk as the individual indexes that comprise a portfolio change along the way. For example, an original mix may include 10% of a U.S. small value index. If that grows to 15% of the overall mix, the portfolio now has a different overall risk exposure. In this case, it would be important to trim the 15% back down to 10% by investing the proceeds in other indexes that have gone down or not grown as much. Then, the original mix is restored to its proper allocation.

Whole Portfolios and Tax Hybrid Portfolio Design

Most investors end up with at least three accounts. They have a 401(k) or 403(b) at work, an IRA or Roth IRA, and a regular taxable investment account. The risk capacity analysis applies to an investor's total investable assets, so the resultant risk exposure represents all accounts as if they were one whole portfolio.

This is where the tax hybrid portfolio design process gets a little tricky. A tax hybrid strategy must be applied to optimize the tax deferred and taxable nature of different types of accounts. For example, fixed income and REIT index funds should be placed in tax-deferred accounts (like IRAs) and equity or stock index funds should be placed in the taxable accounts.

Tax hybrid design is necessary because fixed income and REIT index funds generate high-tax-rate non-qualified dividend income and tax-managed equity index funds have very little, if any, high-tax-rate non-qualified dividend income. Therefore, fixed income and REITS derive more benefits from tax-sheltering. If they were held in a taxable account, their non-qualified dividends would be taxed at ordinary income rates up to 35% for Federal taxes and whatever state taxes may apply.

In addition, when these investments are distributed during retirement, the full amount of each distribution is taxed at your ordinary income tax rate. Therefore, the lower expected return asset classes, like fixed income, are better off residing in tax deferred accounts. This way you will have less overall gain and therefore less high-tax-rate ordinary income taxes upon distribution, even at the lower tax rates of retirement income levels.

Tax-managed equity index funds, on the other hand, achieve most of their life time returns in the form of unrealized capital gains (no tax incurred until sold) and to a far lesser extent, realized long term capital gains from rebalancing and long term capital gains and qualified dividends from fund distributions. Tax-management virtually eliminates short term capital gains. These long term capital gains in equity funds are typically a lower percentage of the fund value than the non-qualified dividends are of fixed income and REIT fund values. The long term capital gains and qualified dividends of tax-managed equity funds are also taxed by Uncle Sam at a more favorable long term capital gains rate of 15%, plus applicable state tax, as of 2008. If this is still confusing to you, please consult your investment advisor and/or tax advisor. Also, see this article by Jason Zweig. A related subject has to do with the questionable protection of your IRA assets from lawsuits, see here.

A spreadsheet that combines the assets of each account and verifies overall risk exposure is a required tool for determining the dollar amount to be invested in each mutual fund and to optimize future cash outflows, inflows, rebalancing, and tax loss harvesting. This is where an index funds advisor adds substantial value to an investor's portfolio. Since risk is the source of returns, and too little or too much risk is undesirable, the maintenance of proper risk exposure and the optimization of a tax-hybrid strategy is a highly rewarded effort that leads to optimal returns unique to each investor.

The Prudent Investor Act

Index funds are an ideal way to implement risk exposure making them the best way to achieve an investor's goals. This concept is even incorporated into legal guidelines under the American Law Institute's so-called "Restatement of the Law, Trust, Prudent Investor Rule."

The rule, published in 1992, was written as a guideline for the prudent management of trust assets and many states passed it into law. In California it passed into law in 1996 under the title "The Uniform Prudent Investor Act." This rule points out the value of Modern Portfolio Theory. It essentially tells trustees that index funds are the prudent way to invest trust assets. The rule acts as a legal road map for estate planning attorneys, trustees of all types of trusts, and investment advisors.

The following reporter's notes on the Prudent Investor Rule points out the problems with active management. "Economic evidence shows that from a typical investment perspective, the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in the market prices of securities. As a result, fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to ‘beat the market' in these publicly traded securities ordinarily promises little or no payoff or even a negative payoff after taking research and transaction costs into account. Empirical research supporting the theory of efficient markets reveals that in such markets skilled professionals have rarely been able to identify under priced securities, (that is, to outguess the market with respect to future return) with any regularity. In fact, evidence shows that there is little correlation between fund managers' earlier successes and their ability to produce above-market returns in subsequent periods."

Five Principles of Prudence

1. Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.

2. Risk and return are so directly related that trustees have a duty to analyze and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts they administer.

3. Trustees have a duty to avoid fees, transaction costs and other expenses that are not justified by the needs and realistic objectives of the trust's investment program.

4. The fiduciary duty of impartiality requires a balancing of the elements of return between production of current income and the protection of purchasing power.

5. Trustees may have a duty as well as the authority to delegate as prudent investors would.

Problems

How Much Risk is There?

It is extremely rare for any stockbroker, investment advisor or mutual fund manager to quote the risk level of a client's whole portfolio or any part of it. This is one of the many reasons investors do so poorly. So where do investors obtain this rare and important data? The most convenient and accessible measurement is the standard deviation, and the data becomes more reliable the longer the time frame is considered.

The standard deviation quantifies the variation of the returns around the average return. A larger variation or standard deviation often goes hand in hand with a higher risk that an investor may sell the investment out of fear or panic when it goes down. This obviously is an undesirable outcome. Ideally, a high risk exposure is accompanied by a high expected return. That is not always the case. Clearly there are high risks with low expected returns such as small growth and large growth indexes.

Statisticians require a minimum of 20 years of data to reduce the error and increase the confidence to an acceptable level of the reported risk and return characteristics of any investment. This dramatically reduces the investments options to index mutual funds and ETFs, since the indexes they track provide more than 20 years of data. There are currently only 86 active managers in the Morningstar database with 20 years or more tenure.

As with anything, the best strategies are useless without quality input — "garbage in." A minimum of 20 years of data is necessary to generate quality output. So how much risk is in a fund or portfolio? A globally diversified portfolio of indexes with a 50-year history holds a risk with a standard deviation of approximately 14.1%. Coincidentally, the simulated return is also 13.4%. However, in order to handle this level of risk exposure, an investor must score 90% on The Risk Capacity Survey.

Where is the Data?

Virtually all reliable data about the stock market originates from the University of Chicago's Center for Research of Security Prices (CRSP). CRSP is a descendant of the Cowles Commission, which was created out of the deep pain caused by the 1929 stock market crash.

Today, many firms and research organizations obtain new data from CRSP and crunch numbers. Among them are Dimensional Fund Advisors (DFA), Ibbotson and Associates, and Standard and Poor's Micropal. Other data sources include Morningstar and Lipper.

Of all the mutual fund companies, DFA stands alone in providing its pool of unique financial advisors with a complete data set on numerous indexes, going back to 1927. This allows index funds advisors to perform analysis that is normally only available to academic researchers. DFA is the only company that provides several seminars per year, offering the best and brightest of academia to lecture and interact with practicing professional advisors. The term "professional" here is important. Genuine professional advisors use index funds to construct portfolios.

So, where is the data? DFA houses the best source of meaningful long-term data, including the unique indexes or rules of ownership established by Eugene Fama, Kenneth French, Merton Miller, Myron Scholes, David Booth (CEO), and Rex Sinquefield. On a Web site that offers peer-reviewed academic research in the social sciences, (www.ssrn.com), Fama is the number one downloaded author from more than 50,000 authors. Out of 8.8 million downloads, Fama has 3 of the top 10 downloaded articles. Besides his Ph.D., Fama has received honorary degrees and numerous awards.

Investors Want to Avoid Risk

Another problem related to risk exposure is that most investors do not like risk, but they do want returns. Unfortunately, it just does not work that way. To avoid risk is to avoid returns. If an investor is feeling uncomfortable taking a risk, not much return can be expected.

The desire to avoid risk is at the very core of the poor performance many investors experience. Investors like to invest after the market has already gone up. They like to invest in companies that are best described as glamour stocks, otherwise known as large growth stocks. They like to turn their hard earned money over to the fund manager with favorable three to five years of market beating returns — the manager that appears on the cover of Money Magazine. All these tendencies feel good, safe, and less risky. The fact is: these featured funds are all relatively expensive due to their popularity. These funds provide their sellers a low cost of acquiring an investor's capital. Here's the big lesson: an investor's expected return is the same as the seller's cost of capital. A low cost of capital exists in all high priced investments; therefore, investors end up with a low return, hence the adages, "No risk, no return. Nothing ventured, nothing gained. Buy low and risky, sell high and safe." Simply put, risk is good. Embrace it.

Risk is Good in Proper Doses

Investors must learn to relish risk and to realize it is the source of their returns, not their nemesis. It's all a matter of matching people with portfolios or risk capacity with risk exposure. This process results in the arrival of a risk exposure that each investor can hang onto through thick and thin, sickness and health, bull or bear markets, for richer or poorer or until there is a need to withdraw the money.

In proper doses, risk is a beautiful thing. This concept is brought to investors by the brilliant minds of academics and Nobel laureates.

Portfolios get out of Balance

Another concern for investors is the maintenance of risk exposure or portfolio rebalancing. As discussed in the definition of rebalancing, this procedure is far more complex than it appears, especially when it is conducted across several investment accounts with different tax considerations. There is also a balance between the transaction costs and capital gains generated by rebalancing. A trade-off between risk exposure maintenance and transaction costs must be carefully weighed and include the changes in risk capacity since the previous measurement.