A Perfect Marriage
A Perfect Marriage Ă˘â‚¬â€ś Classic Portfolio Theory and ETFs
I want to get back to basics and talk about fundamental finance theory that we seem to forget at times and that is classic asset allocation. I teach finance and I talk about the benefits of the asset allocation theory time after time, I tell my students that this is where the money is. I practice what I preach Ă˘â‚¬â€ś I am a portfolio manager at my firm and I make money for my clients, time after time, based on solid finance foundations.
Before I start I would like to thank the folks at TheStreet.com who provided me this opportunity to talk about what I love doing, what I am passionate about Ă˘â‚¬â€ś making money in steady, stable way with ideas grounded in modern finance. My background is a former physicist at Harvard after which I turned to management consulting and then money management at GE Capital, before I founded my own investment management firm.
I will be with you here every week to share my thoughts about making money, based on what I know, based on what I teach and most importantly, based on what I actually do. I will provide my take on some topics that you have heard about already from others, but with my own practical and personal interpretation and other topics that are new to you, but I hope that it will always be something interesting, something that will make you think and something you might even implement in your portfolio.
So now letĂ˘â‚¬â„˘s get back to the topic at hand Ă˘â‚¬â€ś classic asset allocation. If you are here on this website and if you reading this column, you are like me, not a high frequency trader, nor you are a day trader. You and I probably have a lot in common Ă˘â‚¬â€ś we take time, sometime a lot of time analyzing the market, reading Wall Street Journal, maybe BarronĂ˘â‚¬â„˘s, reading financial news on the Internet and even watching CNBC at times, although it is way too fast for us to make any practical decisions. We donĂ˘â‚¬â„˘t trade a lot, but when we do, we have a conviction and we have a good story why.
I am a big fan of modern finance and hence classic allocation theory. So let me tell you how I rephrase asset allocation Ă˘â‚¬â€ś Ă˘â‚¬Ĺ“stock picking does not workĂ˘â‚¬Âť. Whether you are chasing a hot stock or whether you are spending hours and hours analyzing individual company 10Qs and 10Ks, you are taking too much risk. Not that there are no talented stock pickers, there absolutely are, but you cannot give them your money and they will not take your money because the few of them are in high demand, but more importantly Ă˘â‚¬â€ś you can pick some winners some of the time, but you cannot pick many winners most of the time. Unless you are a hedge fund with a large variety of financial instruments to invest in, unprecedented access to information and great financial engineering skills, as a typical retail investor you can only put money in equity mutual funds, which over a long term cannot beat their respective benchmarks.
The truth of the matter is that if you are making money on individual stocks you are basically taking on more risk than necessary and too often Ă˘â‚¬â€ś it always comes down to risk vs. reward. According to the classic paper by Brinson, Hood and Beebower (if you really want to read it is on my website), the bulk of the returns in any stock does not come from picking the stock itself, but comes from the sector that the stock is in. I jokingly say that it is better Ă˘â‚¬Ĺ“to be in the right general area at approximately the right timeĂ˘â‚¬Âť rather than Ă˘â‚¬Ĺ“being exactly at the right time at exactly the right placeĂ˘â‚¬Âť Ă˘â‚¬â€ś chances of being consistently in the latter category are very slim.
As I explained it to some of my non financially oriented friends, think of it as if you are looking to have a good dinner, most likely you have to know a good restaurant and most likely you will not be disappointed if you go there, this would be opposite of going to a specific place, on a specific date, with a specific chef. If you get all right you will have a stupendous meal, but if you miss one of some necessary required factors, you are out of luck. Yes, you will get a superb meal once in a while, but you will often miss a good meal on a regular basis.
So why do ETFs matter so much in this context, well because if you think what I say is reasonable enough, it is very straight forward, very cheap and simple to execute the required asset allocation through well know ETFs.
As the most, most basic asset allocation breakdown, that we are all familiar with, you would split your assets into 60% equities, 30% bonds and 10% cash. The first question would be which stock do I buy, which bonds do I buy and say that these are wrong questions. I recommend the entire portfolio to be implemented through ETFs. So in this very simple, but well regarded portfolio allocation you would buy a large cap ETF (SPY), a broad-based indexed bond ETF (AGG) and keep the rest in cash or money market fund. Now letĂ˘â‚¬â„˘s take it to the next level. LetĂ˘â‚¬â„˘s break down our equity position into large cap equities and small cap equities. In this caseĂ‚Â you would invest half of your equity allocation or 30% of your asset allocation with SPY and the other 30% into a small cap ETF such as DCC. This is just a tip of the iceberg. As the next level of deeper asset allocation split I would suggest putting on a position, maybe 10%, in international markets equity ETF (SCHF) from the total equity allocation, you can also put some of the fixed income (bond) allocation, maybe 5%, into an Emerging Markets fixed income ETF (PCY). And so on and so forth.
Doing this in any variation will give you a good portfolio, will provide steady long term market outperformance and will let you sleep at night.
Position disclaimer: no positions in mentioned ETFs.