The American special
2022.01.25 10:07 Sirsean120 The American special
2022.01.25 10:07 captmorgan50 The Intelligent Asset Allocator by William Bernstein Book Summary
The Intelligent Asset Allocator by William Bernstein
- In the long run of investing, you are compensated for taking risks
- Conversely, if you seek safety, your returns will be low
- Experienced investors understand risk and reward are intertwined
- One of the easiest ways to spot investment fraud is the promise of excessive returns with low risk
- One sign of a dangerously overbought market is a generalized underappreciation of the risks
- Nonsystematic Risk – Risk that disappears with diversification
- Systematic Risk – Risk that cannot be diversified away
- Stock are to be held for the long term.
- Individual investors are drawn into stocks during powerful bull markets
- They don't appreciate the risks with stocks. And after they have suffered the inevitable loss, they sell.
- No investor ever avoids loses at times, no matter how skilled
- REIT's and Precious Metals stocks can have a place in a portfolio even if they have lower expected returns
- They are inflation hedges and likely to do well in an inflationary environment in which other stocks and bonds would be adversely affected
- The best way to estimate future stock returns is the DDM (Dividend Discount Method)
- Return = Dividend Yield + Dividend Growth Rate + Multiple Change
- Dividend yield is the yield on the investment (Example – 2020 S+P 500 yield is 1.5%). The Dividend growth rate is historically 5%. And the Multiple change refers to the increase or decrease in the overall P/E ratio.
- The Dividend yield and dividend growth rate is the fundamental return (easy to estimate). The Multiple change is the speculative return (impossible to estimate).
- Benjamin Graham – "In the short run the stock market is a voting machine (speculative return), but in the long run, it is a weighing machine (fundamental return).
- Do not expect high returns without high risk. Do not expect safety without correspondingly low returns
- The longer a risky asset is held, the less chance of a poor result
- Those who are ignorant of investment history are bound to repeat its mistakes
- Dividing your portfolio between assets with uncorrelated results increases returns while decreasing risks. Most important concept in portfolio theory
- Two assets with positive returns should not have persistent highly negative correlations.
- Mixing assets with uncorrelated returns reduces risk. You can find these.
- In the long run though, meaningful negative (inverse) correlations are never seen. That would be too good to be true if they did.
- The optimal Asset Allocation of the last 20 years is unlikely to look anything like the one for the next 20 years.
- The optimal AA can only be known in retrospect
- Rebalancing increases long term portfolio performance
- It instills the investor with the discipline to buy low and sell high
- If two assets have similar long term returns and risks are not perfectly correlated, then investing in a fixed rebalanced mix of the two not only reduces risks, but also actually increases return
- The excess return though is not obtained without rebalancing. It forces you to buy low and sell high to rebalance your asset allocation
- Sticking by your AA policy through thick and thin I much more important than picking a "best" AA
- But in real life risks, returns, and correlations of various assets fluctuate considerably over time
- Real assets are almost always imperfectly correlated (Mostly positive) in real life (An above average return in one is somewhat more likely to be associated with an above-average return in the other)
- It is difficult to find 2 assets that are uncorrelated and it is practically impossible to find 3
- Correlation coefficient ranges from -1 to +1
- Uncorrelated is 0
- Inverse is -1
- Perfect is +1
- In general, Bond durations of 6 months to 5 years are ideal for the risk dilution portion of the portfolio.
- If you are unhappy with the degree of risk in the portfolio, you have 2 ways to reduce it
- Employ less risky individual assets (Not a good idea) – like adding large cap for small cap stocks, domestic for foreign stocks, utility for industrial stocks. It changes the dynamics of the portfolio
- Stick with your basic asset allocation and replace some of your entire stock AA with short term bonds. (Good idea)
- Risk Dilution – if you believe that you have arrived at an effective stock allocation, it is generally a better idea to employ risk dilution as this leaves the stock AA undisturbed
- A conservative risk adverse strategy will almost always involve at least a small amount of exposure to very risky individual assets
- Recency bias – biggest mistake most experienced investors make
- We tend to extrapolate recent trends indefinitely into the future
- Try as hard as you can to identify the current financial wisdom so that you can ignore it
- In 2000, when the book was published, US was doing better than foreign stocks. What were the experts saying at that time?
- Stay at home for higher returns
- Buy only companies you know
- Diversify abroad at your own peril
- If you do diversify abroad, only do where you can drink the water
- Beware of recency and do not be overly impressed with the asset class returns over periods of less than 2-3 decades.
- Foreign stocks belong in everyone portfolio. The primary benefit is to reduce standard deviation or risks
- Something everyone knows isn't worth knowing
- Identify the era's conventional wisdom and then ignore it
- Next year's efficient frontier portfolio (high return at low risk or decent returns with no risk) will be nowhere near last years.
- No one consistently times the market
- Some managers spend lots of money researching macroeconomic, political, and market analysis to try to guess which assets will perform best in the future. And this is a fool's errand.
- Why? The market has already priced this information into the current price
- Periodically rebalance your portfolio back to your policy allocation. This will increase your long-term return and enhance investment discipline
- Effective portfolio diversification can increase return while reducing risks. Achieving this benefit requires rebalancing the portfolio back to its target or "policy" AA. This is difficult to do and almost always involves moving against the market sentiment
- Long term success in individual security selection and market timing is difficult to impossible
- The future cannot be predicted, so therefore it is nearly impossible to specify in advance what the best asset allocation will be. Our job is to find an AA that will do reasonably well under a wide range of circumstances
- Sticking to your target AA through thick and thin is much more important than picking the right AA
- An optimizer will heavily favor those assets with high historical or assumed returns. This is a problem because asset returns have a tendency to "mean revert".
- If you can predict the inputs to the optimizer well enough, then you didn't need an optimizer to begin with.
- Don't use an optimizer to try to develop an asset allocation. We can't predict returns, standard deviations, or correlations accurately enough. And if we could, we wouldn't need one anyway.
- And optimizing historic returns is a one-way ticket to the poor house
- A well-diversified portfolio is not a free lunch. It does not come anywhere near eliminating risk. You will still suffer loss from time to time
- Diversification not only reduces risks, but also gives a "rebalancing bonus" or extra return from rigorous rebalancing.
- The benefit is also psychological because you are getting into the habit of buying low and selling high. Thus, profiting by moving in the opposite direction of the market
- A distrust of "expert opinion" is one of the investors most useful tools
- It also limits your exposure to only one market segment
- AA The Three-Step Approach
- How many different asset classes do I want to own?
- How "conventional" of a portfolio do I want?
- How much risk can I and do I want to take?
- How much complexity can you tolerate and tracking error?
- The law of diminishing returns applies to asset classes. You get a diversification boost from the first several, after that, you are just amusing yourself
- Examples of various AA based on complexity
- Level 1 AA
- Large Cap US
- Large Cap Foreign Stocks
- Short Term US Bonds
- Level 1B
- Level 2 AA
- Large Cap US
- Foreign Large Cap
- Small Cap US
- Small Cap Foreign
- Emerging Market
- Short Term US Bonds
- Level 2B
- Precious metal equity
- International Bonds
- Level 3 AA
- Everything in level 2 but tilt toward value stocks
- Level 3B
- Precious Metals Stocks, Natural Resources, Utilities
- Specific nations equity or bonds
- The more complex your AA, the more tracking error you will get vs the index (Like the S+P 500). You have to ask yourself how much will that bother you?
- Tracking error means that your portfolio will behave very differently than everyone else's
- If that bothers you, then you need a simpler portfolio. If it doesn't, then you can be more complex.
- Increasing the number of asset classes will improve diversification but will also increase your work and tracking error
- It is impossible to forecast future optional portfolios by any technique
- Your precise AA will depend on three factors
- Tolerance to tracking error
- Number of assets you wish to own
- Tolerance for risk
- Two types of investors, those who don't know where the market is headed, and those who don't know that they don't know
- For all practical purposes there is no such thing as stock picking skill
- Those early high returns attract large number of investors who wind up with average returns (if they are lucky)
- Mutual fund manager performance does not persist and the return on stock picking is zero
- These managers ARE the market, so there is no way they can ALL perform above the mean
- 4 Layers of Mutual Fund Costs
- Expense Ratio
- Bid-Ask Spreads
- Market-Impact Costs
- Charles Ellis (an avid tennis player) first saw the data demonstrating a lack of money manger skill. And He thought, I have seen this before in tennis matches.
- Most amateur tennis matches winning or losing was less a matter of skill and more of matter of playing conservatively and avoiding mistakes
- This applies to investors, those who simply buy and hold a diversified stock portfolio usually come out on top (Indexing).
- Success in both tennis and investing is less a matter of winning and more a matter of avoiding losing.
- The easiest way to lose is to trade excessively.
- The ultimate loss avoidance strategy is to simply buy and hold the entire market or to index
- This reduces all the expenses associated with active management
- Dunn's Law – When an asset class does relatively well, an index fund in that class does even better
- The only money made from newsletters is from the subscriptions, not from taking the advice
- Do not rebalance too frequently. Let momentum work for you.
- This means to rebalance at most once per year
- Money mangers do not exhibit consistent stock picking skill
- Nobody can time the market
- Because of the above 2 points, it is futile to select money mangers on the basis of past performance
- Because of the above 3 points, the most rational way to invest in stocks is to use low cost passively managed index funds
- Stocks perform almost all other assets in the long run because you are buying a piece of our almost constantly growing economy
- But then investors make the mistake of thinking the most profitable stocks to own must be those of the most rapidly growing companies (Growth Stocks)
- Long term returns are usually higher when valuations are cheap and lower when they are expensive
- Paul Miller did the first study on cheap stocks called the Dow P/E strategy. He examined buying the 10 lowest P/E stocks in the Dow from 1936-1964 and discovered that the lowest P/E stocks (those everyone hates) actually outperformed the market and the highest P/E stocks (those everyone loves) greatly underperformed
- Dreman has observed that "value" stocks tend to fall less in price than "growth" stocks when earnings disappoint. Conversely, "value" stocks tend to rise more in price than "growth" stocks when earnings exceed expectations.
- To put it another way, good companies are generally bad stocks, and bad companies are generally good stocks
- It has puzzled academics EMH theorists why these value type strategies have worked so well for so long even after they were discovered. (The market should have arbitrated this away long ago). The reason the strategies still work is that cheap companies are dogs, and most people cannot bring themselves to buy them. This concept is very difficult for investors and money managers alike.
- The best explanation for value stocks can be found in Robert Haugen The New Finance: The Case Against Efficient Markets. In 1993 the highest 20% P/E stocks (Growth) had an average P/E of 42. Earnings yield was 2.36% or 1/42. The lowest 20% P/E stocks (Value) had a P/E of 12. Earnings yield was 8.38% or 1/12. So, if you bought growth stocks in 1993, you received $2.36 for every $100 invested. If you bought value stocks then, you received $8.38 in earnings for every $100 invested. That means growth stocks earnings have to grow 3x larger than value stocks just to break even. The growth stocks did have higher earnings than value, but not enough to catch up.
- Both the behavioral (people don't like buying bad companies) and increased risk (companies are not in great financial shape) explain value companies higher returns than growth.
- Value companies tend to do better than growth during bear markets
- Dividend Discount Method (DDM) formulated by John Burr Williams in 1938 was formulated by a simple idea. Since all companies eventually go bankrupt, the value of a stock, bond or the entire market is simply the value of all its future dividends discounted to the present.
- And since a dollar in the future is worth less than a dollar today, its value must be reduced or discounted to reflect the fact you won't receive it today.
- The reduction is called the Discount Rate (DR)
- The DR is determined by the cost of money (Risk Free Rate) plus the risk to the lender
- Safer investments have a lower DR and risker investments a higher DR
- DR can also be thought of as the expected return of the asset
- Lower risks = lower DR = Lower expected return/Higher Present Value
- Higher risks = higher DR = Higher expected return/Lower Present Value
- Formula – Reasonable Price = (Annual Dividend Amount)/(DR – Dividend Growth Rate)
- But you can make this formula say anything you want depending on your inputs. So be careful with this formula
- Dynamic asset allocation refers to the possibility of varying your policy allocation because of changing market conditions.
- Only people who have mastered fixed asset allocation and the required rebalancing should consider dynamic asset allocation.
- He used to recommend changing your equity/bond AA based on conditions but that doesn't work anymore. Now he only recommends changing equity allocations
- When stocks get more expensive, their future returns are likely to be lower and when stocks are very cheap, future returns are likely to be higher.
- Based on this, it is not a terrible idea to change your AA slightly in the opposite direction based on valuations, but not by much.
- When you rebalance your portfolio to maintain your target AA, you purchase more of an asset that has declined in price, and thus cheaper.
- When you actually increase the target portfolio weighting of an asset when its price declines and gets cheaper, you are simply rebalancing in a more vigorous form – you are "overbalancing"
- Do not change your AA based on changes in economic, political conditions or analyst recommendations, that is a poor idea
- In the authors opinion, overbalancing is likely to increase return if done correctly. But few investors have the nerve and discipline to rebalance and "overbalancing" requires even more of that nerve and discipline so few should try it.
- The average investor suffers from overconfidence and thinks that they can beat the market, but this is a mathematical impossibility.
- The average investor must by definition obtain the market return minus expenses.
- Investors suffer from recency bias.
- When prices fall, investors estimate of future returns goes lower too. This is irrational.
- Investors tend to overweight more recent data and underweight older data
- Most investors are "convex" traders in which they buy equities as they are rising and sell as they are falling.
- The opposite is a "concave" investor who buys as prices fall and sells as they rise
- In a world dominated by convex traders, it is an advantage to be a concave trader, and vice versa.
- Human beings experience risk in the short term. This is because in nature, our ancestors had to focus on short term risks to survive.
- Unfortunately, this is of less value in a modern society, specifically in the world of investing.
- Vanguard and DFA are great choices for funds. Vanguard is owned by the shareholders.
- Advantages – Can be traded throughout the day, do not generate capital gains taxes
- Disadvantages – Incur commissions and spreads
- Dollar Cost Averaging (DCA) vs Lump Sum investing – from a purely financial point of view, it is usually better to put your money to work right away. However, if you are not used to owning risk assets, then it might be best to go slow and DCA your way into the market
- DCA – Involves investing the same amount regularly in a given fund
- Do not underestimate the discipline that is sometimes necessary to carry out a successful DCA program.
- Value Averaging (VA) – Is another technique for investing in the market (read the book for more information on how to do it)
- Rebalancing in your tax advantaged accounts every year or two should be ok
- Try not to rebalance in your taxable accounts or do it as little as possible. Try to rebalance though buying because rebalancing triggers taxable events
- Risk and reward and inextricably entwined
- Do not expect high returns from safe assets
- Those who do not learn from history and condemned to repeat it
- Become familiar with the long-term history of the behavior of different classes of stocks and bonds
- Portfolios behave differently than their constituent parts
- A safe portfolio does not necessarily exclude very risky assets. Even the investor who seeks the safest possible portfolio will own some risky assets
- For a given degree of risk, there is a portfolio that will deliver the most return
- But this can only be known in retrospect
- The investor's objective then is not to find the efficient frontier, rather the goal is to find a portfolio mix that will come reasonably close to the mark under a broad range of circumstances
- Focus on the behavior of your whole portfolio, not its parts. Some will be doing very well or very bad at times
- Recognize the benefits of rebalancing
- The markets are smarter than you are
- Very few money mangers beat the market over the long term
- Do not run with the crowd
- Keep an eye on market valuations
- Changes in your policy AA should be made only in response to valuations changes, and in a direction opposite the market
- Good companies are usually bad stocks; bad companies are usually good stocks
- Favor a "value" approach to investing
- In the long run, it is very hard to beat a low-cost index fund
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