The optimal investment is a globally diversified, tax-managed, and small and value tilted, mix of
index funds (risk exposure) matched to your unique risk capacity, referred to as CEO Investing: Capacity-Exposure
Optimization.
Index
funds (either mutual or exchange traded) are funds with clearly defined sets of rules
of ownership, that are adhered to regardless of
market conditions. There are about 1,000 index funds available to investors. We like many of them, but our current favorite are the index funds or passively managed funds are from Dimensional
Fund Advisors (DFA).
IFA offers 100 iPortfolios, which are individualized and indexed. The iPortfolios are allocated among three broad asset
classes: fixed income (bonds); U.S. stocks; and foreign stocks (see a sample of 20 iPortfolios in Figure 3 below). The
stocks are further divided by size and value (book-to-market ratio).
For an explanation as to why asset allocation explains 100% of your long term expected risk and return, please read this article: Investment
Policy Explains All.
If you are having trouble understanding this article, please call IFA,
888-643-3133.
According to the Financial
Economists Roundtable, index portfolios are the best
estimates of the principal risk factors that are likely to influence
fund risks and returns in the future.
Matching People with Portfolios
Once the above article is understood, the only decision
left is where should an investor be on the risk capacity versus risk exposure
line. This is very important because returns are optimized when investors
are on the line. Risk capacity can be estimated using the Risk
Capacity Survey and risk exposure correlates to the 100 iPortfolios (investment
policies or asset allocations of indexes), 20 of which are shown in Figure 3 below.
Where
are you and your investments on the graph in Figure 2. If you do not
know, your investments are equivalent to an uninformed guess or speculation.
In Figure 2, iPortfolios with the lowest expected risk and return
have higher allocations toward fixed income with a moderate investment
in stocks. Conversely, iPortfolios with the highest expected risk and
return have less fixed income and more stocks and are tilted toward
small companies and value companies in the U.S., International and Emerging
Market.
Figure
1
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Figure
2
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Figure 3b - Standard Error
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The
Risk Return Table below includes standard deviations
for twenty iPortfolios. Standard
deviation expresses the spread of individual observations around
the mean or average. A standard deviation is the square root of
the variance. Variance is the measure of the spread of variability
of quantitative measurements.
In other words, the standard deviation is a statistic measurement
that tells you how tightly the various annual returns are clustered
around the average. When the annual returns
are pretty tightly bunched together the standard deviation is small and the bell-shaped curve is
narrow. When the annual returns
are spread apart and the bell curve is relatively flat, it tells
you that you have a relatively large standard deviation.
The combination
of the average and the standard deviation characterize various bell
curve shapes and those shapes represent the risk and return of the
iPortfolio. Figure A shows you graphically what a standard deviation
represents.
One standard deviation away from the average in either direction
on the horizontal axis (the green area on the graph) accounts
for somewhere around 68 percent of the annual returns in the time
period. Two standard deviations away from the mean (the green
and blue areas) account for roughly 95 percent of the annual returns.
And three standard deviations (the green, blue and red areas)
account for about 99 percent of the annual returns.
The standard error of the mean (see Figure 3b)
indicates the degree of uncertainty in calculating an estimate from
a sample, like a series of returns data. A standard
error can be calculated from the standard deviation by dividing
the standard deviation by a square root of the sample size. So with only 3 years of returns data
on the S&P 500, the error in the average return is 2.6 times
larger than having 20 years of data. |
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