One day in the early 1950s, a Ph.D. candidate in economics sat in the library at the University of Chicago. The young man, Harry Markowitz, was studying leading investment guides used by professional money managers. The guides seemed to recommend that an investor should invest in stocks with the highest expected return and ignore all the rest. After awhile, it suddenly occurred to Markowitz that investors should consider risk as well as return.
It was a simple conclusion; however, it spawned one of the most important investment ideas of the 20th Century, and has generated a whole body of scholarly work known as "Modern Portfolio Theory." Thirty-eight years later it earned Markowitz a Nobel Prize in Economics. The fact that trillions of dollars around the globe are now invested and managed according to the principle
by Markowitz is
testament to its central importance in the investment process. This revolutionary
insight has not only transformed the investment world of corporate and government
pension plans, insurance companies, banks and other large institutional
investors, it has also changed the way individual investors invest.
Markowitz knew that no one had really tried to systematically understand the importance of risk in the investment process. Up to that time, investors had focused on an investment's return, but if they believed it contained some arbitrary, undefined notion of risk, then the investment wasn't included in the portfolio. Markowitz understood quite clearly that risk and return are related. After all, investors like return and want to increase it, and they dislike risk and want to reduce it. On that day in the library, Markowitz set out to show investors how they could improve their investment performance by optimizing trade-offs between risk and return.
Because it seems so obvious, it's hard to appreciate how truly profound Markowitz's idea was. Of course both risk and return should be considered. In spite of the evident nature of this idea, the investment media continues to spread the "good news" of returns, while downplaying the "bad news" of risk.
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.
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 prudent, a portfolio should include 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 8/31/2013, the United States alone made up 50% of the total global market capitalization or $19 Trillion of the $38 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 67% US. However, we estimate that about 20% of sales from the US companies come from international markets, which would bring the allocation closer to 47% 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 55% or more. While higher than the CAPM suggested percentage of 50%, 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.11.2.4
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.
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.
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.
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.
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."
1. Sound diversification
is fundamental to risk management and is therefore ordinarily required
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.
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.
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.
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.
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
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