Your best investment is a global tax-managed mix of
index funds (risk exposure) matched to your unique risk capacity.
We call this CEO Investing: Capacity-Exposure
Optimization.
Index
funds are funds (mutual or exchange traded) with clearly defined sets of rules
of ownership, that are adhered to regardless of
market conditions. There are about 1,000 index funds. We like many of them, but our current favorite is the index funds from Dimensional
Fund Advisors (DFA).
The index portfolios that are the best long-term target
asset allocations for investing are divided among three broad asset
classes: fixed income (bonds); U.S. stocks; and foreign stocks. The
stocks are further divided by size and value (book-to-market ratio).
For an explanation as to why Investment
Policy Explains All, please read this article.
This article essentially confirms that your asset allocation of a portfolio
of index funds explains 100% of your long term expected risk and return.
If you are having trouble understanding this article, please call IFA,
888-643-3133.
To confirm the consensus of opinion of Financial Economists
for the use of risk-scaled index portfolios as simulated historical benchmarks,
please refer to the Financial Economists Roundtable: Statement
on Risk Disclosure by Mutual Funds, September 18, 1996.
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 20 investment
policies (asset allocations of indexes) shown in Figure 2 below. Where
are you and your investments on the graph in Figure 1 If you do not know,
your investments are equivalent to an uninformed guess or speculation.
In Figure 1, investment policies with the lowest expected risk and return
are tilted toward fixed income with a moderate investment in stocks.
Conversely, index portfolios 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, as
seen Figure 2 below.
Figure
1
 |
Figure
2
 |
Modern Portfolio Theory
considers 3 parameters when constructing a portfolio on the efficient
frontier; risk, return and the correlation of the different assets to
each other. Rollover of Figure 1 illustrates risk versus reward for the
twenty different index portfolios. Harry Markowitz received a Nobel prize
for coming up with the idea illustrated in Figure 2, also see Step
2: Nobel Laureates; 1952 Harry Markowitz. The resulting portfolios
are referred to as efficient portfolios, which are portfolios that provide
the greatest expected return for a given level of risk, or equivalently,
the lowest risk for a given expected return. These portfolios are said
to exist on the efficient
frontier.
|
Figure 3b - Standard Error
|
| |
|
The
Risk Return Table below includes standard deviations
for twenty portfolios of indexes. The standard deviation is a statistic
that tells you how tightly all the various annual returns are clustered
around the average of the total period. When the annual returns
are pretty tightly bunched together and the bell-shaped curve is
steep, the standard deviation is small. 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
portfolio.Computing the value of a standard deviation is a little
complicated. 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.
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. The standard error of the mean
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 n (with n representing
the number of years measured). 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. |
|
