take-aways
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Stock is to be held for the long term.
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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 losses at times, no matter how skilled
- They don’t appreciate the risks with stocks. And after they have suffered the inevitable loss, they sell.
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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 Multiple changes refer 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 changes are the speculative return (impossible to estimate).
- Benjamin Graham – “In the short run, a stock market is a voting machine (speculative return), but in the long run, it is a weighing machine (fundamental return).
- Return = Dividend Yield + Dividend Growth Rate + Multiple Change
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Those who are ignorant of investment history are bound to repeat its mistakes
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In general, Bond durations of 6 months to 5 years are ideal for the risk dilution portion of the portfolio.
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Something everyone knows isn’t worth knowing
- Identify the era’s conventional wisdom and then ignore it
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Next year’s efficient frontier portfolio (high return at low risk or decent returns with no risk) will be nowhere near last year’s.
- No one consistently times the market
- Some managers spend lots of money researching macroeconomic, political, and market analysis to determine 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
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Effective portfolio diversification can increase return while reducing risks. Achieving this benefit requires rebalancing the portfolio to its target or “policy” AA. This isn’t easy to do and almost always involves moving against the market sentiment
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Long-term success in individual security selection and market timing is difficult to impossible
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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
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Sticking to your target AA through thick and thin is much more important than picking the right AA
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An optimizer will heavily favour those assets with high historical or assumed returns. This is a problem because asset returns tend 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 historical returns is a one-way ticket to the poor house
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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
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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
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It is impossible to forecast future optional portfolios by any technique
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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
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Charles Ellis (an avid tennis player) first saw the data demonstrating a lack of money management skills. And He thought I had seen this before in tennis matches.
- Most amateur tennis matches winning or losing was less a matter of skill and more of a matter of playing conservatively and avoiding mistakes
- This applies to investors who buy and hold a diversified stock portfolio and usually come out on top (Indexing).
- Success in 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 buy and hold the entire market or to index
- This reduces all the expenses associated with active management
- Success in tennis and investing is less a matter of winning and more a matter of avoiding losing.
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Dunn’s Law – When an asset class does relatively well, an index fund in that class does even better
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The only money made from newsletters is from the subscriptions, not from taking the advice
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Money managers do not exhibit consistent stock-picking skill
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Nobody can time the market
- Because of the above 2 points, it is futile to select money managers based on 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
- If Nobel winners have tried and failed (Long-Term Capital Management), what chance do I have? And during a bear market, stocks usually decline much faster than they advance during a bull market. But you don’t want to get out of the market then because you will miss the rally.
- Because of the above 2 points, it is futile to select money managers based on past performance
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Long-term returns are usually higher when valuations are cheap and lower when they are expensive
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Paul Miller did the first study on cheap stocks called the Dow P/E strategy. He examined buying the ten lowest P/E stocks in the Dow from 1936-1964 and discovered that the lowest P/E stocks (those everyone hates) outperformed the market, and the highest P/E stocks (those everyone loves) greatly underperformed
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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
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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.
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The best explanation for value stocks can be found in Robert Haugen’s The New Finance: The Case Against Efficient Markets. In 1993 the highest 20% P/E stocks (Growth) had an average P/E of 42. The earnings yield was 2.36% or 1/42. The lowest 20% P/E stocks (Value) had a P/E of 12. The 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, you received $8.38 in earnings for every $100 invested. That means growth stocks’ earnings have to grow 3x larger than value stocks to break even. The growth stocks did have higher earnings than value, but not enough to catch up.
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The behavioural (people don’t like buying bad companies) and increased risk (companies are not in great financial shape) explain value companies’ higher returns than growth.
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Value companies tend to do better than growth during bear markets
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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 have a higher DR
- DR can also be thought of as the expected return on 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
- The DR is determined by the cost of money (Risk-Free Rate) plus the risk to the lender
- The reduction is called the Discount Rate (DR)
- 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.
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Dynamic asset allocation is 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
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When stocks get more expensive, their future returns are likely to be lower; 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 is thus cheaper.
- When you 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 or political conditions or analyst recommendations. That is a poor idea
- In the authors’ opinion, overbalancing is likely to increase returns 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.
- When you rebalance your portfolio to maintain your target AA, you purchase more of an asset that has declined in price and is thus cheaper.
- 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.
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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 modern society, specifically in investing.
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Vanguard and DFA are great choices for funds. The shareholders own Vanguard.
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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 immediately. 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.
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Value Averaging (VA) – Is another technique for investing in the market (read the book for more information on how to do it)
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Become familiar with the long-term history of the behaviour of different classes of stocks and bonds
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Portfolios behave differently than their constituent parts
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A safe portfolio does not necessarily exclude very risky assets. Even the investor who seeks the safest possible portfolio will own some risky assets
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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
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Focus on the behaviour of your whole portfolio, not its parts. Some will be doing very well or very badly at times
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The markets are smarter than you are
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Do not run with the crowd
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Keep an eye on market valuations
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Changes in your policy AA should be made only in response to valuations changes and in a direction opposite the market
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Good companies are usually bad stocks; bad companies are usually good stocks
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Favor a “value” approach to investing
asset allocation
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When to change your asset allocation
- 3 Reasons to change your AA
- Financial goal is well within reach
- You realize you will not need all your money during your lifetime
- Your risk tolerance isn’t what you thought it was
- Any AA changes should require deep thinking and even-handed judgement. Don’t make changes during times of duress
- 3 Reasons to change your AA
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Allocate our investments across multiple asset classes to reduce overall portfolio risk
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Invest broadly within each class to eliminate the risk of owning any single security
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Keep your costs down, including taxes
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Rebalance periodically
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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
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The more complex your AA, the more tracking error you will get vs the index (Like the S+P 500). Do you have to ask yourself how much that will 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
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Your precise AA will depend on three factors
- Tolerance to tracking error
- Number of assets you wish to own
- Tolerance for risk
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Dividing your portfolio between assets with uncorrelated results increases returns while decreasing risks. A 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.
- Mixing assets with uncorrelated returns reduces risk. You can find these.
- Two assets with positive returns should not have persistent, highly negative correlations.
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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
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Sticking by your AA policy through thick and thin I much more important than picking a “best” AA
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A good idea is to decide on a static percentage of stocks, bonds, and alternative investments that fit your needs and then maintain that allocation for a long, long, long time. Then rebalance as needed.
protect your wealth
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As a nation, we are not saving enough in retirement accounts to make up for diminishing Social Security benefits and other traditional sources of income
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10% savings of pre-tax income is a good target for most people
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We also have a fondness for seeing patterns where they don’t exist. Stocks that have done well in the past are expected to continue to do well, and stocks that have done poorly are expected to continue to do poorly
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Avoid following the herd and investing in the hottest sectors or stocks.
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Don’t chase popular investment styles. Stick with your plan and give it time to work out
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It is impossible to predict which type of fund will outperform any given year. Therefore, the best strategy is to hold a diversified portfolio that contains all types and stick with it
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The more a mutual fund charges in fees, the lower the expected return
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Take caution when you get financial advice. Most of it is just salesmanship
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Schools have spent lots of money and hours trying to figure out which actively managed mutual fund managers will likely outperform in the future. They discovered two facts
- Funds with low fees tend to outperform the market
- It is unreliable to assume that managers who have beaten the market in the past will continue to do so over the long term
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On any given year, many actively managed funds will beat the index fund. But in the long run, the index fund will be at the top
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Reduce your estimated Social Security check at retirement by 60-70% and an increase of 5-7 years for retirement
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Treat Social Security and defined pension plans as a separate account and don’t use them in your equity/bond calculations
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In the short term, it is nearly impossible to predict the movement of the stock market. But over the long term, the performance of the stock market is predictable because it follows the growth of the U.S. economy
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Earnings Growth (Corporate Earnings or GDP) +Dividend (Yield)+Speculation (P/E ratio) = market return
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In the short run, speculation creates volatility in stock prices, but economic growth is the real driver of returns in the long term. You can’t guess what P/E ratio the market will assign in the future, so don’t try
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It is impossible to forecast the movement of the inflation rate, but you can limit risk by purchasing short-term bonds. They don’t have the volatility of long-term bonds. You do get extra yield from long-term bonds, but it does not justify the added interest rate risk
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Make sure your investments have a low correlation with each other, or you don’t get the benefits of diversification
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Use a long-term strategic asset allocation or “buy and hold.” No predictions are needed.
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A successful lifelong investment experience hinges on three critical steps
- Development of a prudent financial plan
- The full implementation of that plan
- The discipline to maintain that plan in good AND bad times
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6-12-month Emergency Fund recommended
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Investing in the next hot item is very difficult to do
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Picking a manager who can pick the next hot item is equally difficult to do
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Do not select mutual funds on past performance. Past performance is not an indication of future results
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T-Bills are “risk-free” but can still lose money due to taxes and inflation. If their - purchasing power doesn’t keep up
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High volatility means erratic returns. Low volatility means more consistent returns
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You cannot eliminate all risk from a portfolio, but you can reduce it
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You will lose money during some times. Don’t try to market time your way out of it. You can’t
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Do NOT abandon your plan because you lose money. In the last 50 years, the market is up 4 years for every one down
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Owning several asset classes is better than owning a few
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Choose asset classes that have positive real returns and lower correlation
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You can select a good asset allocation but not a perfect one. Don’t overanalyze
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It is impossible to know which asset classes will perform well at any given time. Therefore, it is important to retain ALL asset classes in your portfolio at all times and to rebalance these annually.
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Foreign stocks are great for US investors
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They do not always move in correlation with the US market
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They trade in foreign currency, which is another diversifier
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There is no known way to design a portfolio that is fully hedged against downturns while fully participating in the upswings
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Look for mutual funds that have low expense ratios and no redemption fees
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Prefer index mutual funds and ETFs
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Stay away from high-cost illiquid investments unless you know what you are doing
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You have to stay invested during all market conditions to benefit from the gains
Examples of various AA based on complexity
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Level 1 AA
- Large Cap US
- Large Cap Foreign Stocks
- Short Term US Bonds
- Level 1B
- Small Cap US
- Level 1B
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Level 2 AA
- Large Cap US
- Foreign Large Cap
- Small Cap US
- Small Cap Foreign
- Emerging Market
- REITs
- Short Term US Bonds
- Level 2B
- Precious metal equity
- International Bonds
- Level 2B
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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
- Level 3B
- Everything in level 2 but tilt toward value stocks
Risk, reward and correlation
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In the long run of investing, you are compensated for taking risks
- Conversely, if you seek safety, your returns will be low
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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
- There are no risk-free investments
- Practitioners view risk as investment volatility
- Individuals view risk as losing money
- Investments with less risk of income disruptions have lower expected returns
- Portfolio risk cannot be eliminated, but it can be controlled with an asset allocation strategy
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Do not expect high returns without high risk. Do not expect safety without correspondingly low returns
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The longer a risky asset is held, the less chance of a poor result
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One sign of a dangerously overbought market is a generalized underappreciation of the risks
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Nonsystematic Risk – Risk that disappears with diversification
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Systematic Risk – Risk that cannot be diversified away
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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 two uncorrelated assets, and it is practically impossible to find 3
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Correlation coefficient ranges from -1 to +1
- Uncorrelated is 0
- the inverse is -1
- Perfect is +1
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Correlation is measured on a -1 to +1 scale
- +0.3 or greater is positive
- -0.3 or less is negative
- -0.3 to 0.3 is noncorrelated
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If two investments move in the same direction simultaneously, they have a positive correlation. If they move in opposite directions, they have a negative correlation.
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You want investments that have a lower correlation to each other
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Don’t purchase new investments that have a high positive correlation with investments you already have
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Negative correlation is theoretically ideal when selecting investments, but this doesn’t occur in the real world. Typically, the best asset pairs you will find are noncorrelated
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Correlations are dynamic, not static. And you can’t guess when/how they will change. For example – The S+P 500 and Intermediate-term treasury bonds have been between +0.49 to -0.42 correlated in the last 20 years (1990-2009). The average was 0, so they are noncorrelated
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Correlation is not the only reason to invest. The security must also have a positive expected rate of return. It is impossible to find two negatively correlated asset classes that both earn a positive rate of return. Noncorrelated is your best bet
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During extreme volatility, when you want low correlation among asset classes, positive correlation increases drastically across all classes. Especially during bear markets or disasters
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For a given degree of risk, there is a portfolio that will deliver the most return. But this can only be known in retrospect
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The perfect portfolio can only be known in retrospect. So, don’t overanalyze
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But in real life, risks, returns, and correlations of various assets fluctuate considerably over time
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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 a large number of investors who wind up with average returns (if they are lucky)
- For all practical purposes, there is no such thing as stock picking skill
rebalancing
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Rebalancing is the most difficult because it forces you to sell what is going up and buy what went down
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Try to rebalance through changes in what you buy, try not to rebalance by selling assets
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Rebalancing increases long-term portfolio performance
- It instills the investor with the discipline to buy low and sell high
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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
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Rebalancing is based on a theory called regression to the mean. That is, there is a natural tendency in the marketplace for all broad asset classes to return close to their history risk profiles.
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When you rebalance, you sell some of the winners to buy some of the losers. It may feel counterintuitive at first, but it follows the logic of buying low and selling high
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Calendar-based rebalancing is a good idea. Pick a date and rebalance it, then. You are more likely not to procrastinate
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Rebalancing only works if the investments in the portfolio don’t act the same way. You want assets that don’t correlate with each other
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Rebalancing in your tax-advantaged accounts every year or two should be ok
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Try not to rebalance your taxable accounts or do it as little as possible. Try to rebalance through buying because rebalancing triggers taxable events
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Rebalance your portfolio at least 1 per year
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Do not rebalance too frequently. Let momentum work for you.
- This means rebalancing at most once per year
Investment Pyramid – 5 levels
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Base 1 – Cash accounts for living expenses
- Checking
- Savings
- Money Market
- Emergency Fund
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2 - Discretionary long-term liquid investments
- Mutual Funds
- ETF
- Bonds
- CD’s
- Annuities
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3 – Discretionary long term illiquid assets
- Personal Home
- Properties
- Business
- Collectibles
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4 – Nondiscretionary assets
- Social Security
- Pension
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Top 5 – Discretionary Speculative
- Commodities
- Individual Stocks
Equities
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An investment in a total US stock market fund is a solid foundation for a US stock market allocation. Total Index is heavily weighted toward large-cap stocks
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Take your age x 1.5 for your % AA to a TDF. Example. 40 x 1.5 = 60% allocation to TDF
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Midcap indexes are highly correlated with total stock market indexes and are, therefore, a poor diversifier. You don’t need them
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25% max dedicated toward factor tilts
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If you want to tilt, be patient and stick to your guns. Don’t chase returns. Once you decide to tilt, you need to stick with that strategy and not bailout of it
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The enemy of a good asset allocation is the quest for a perfect one. Fight the urge to be perfect
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Study in 1992 By Fama and French – Performance of a broadly diversified US stock portfolio relied on three primary risks axis to determine its return. 95% accuracy as to what the portfolio would return
- A market risk or Beta – all portfolios move up or down to the total stock market
- Percent of small cap in the portfolio by weight – small stocks have higher returns and do not always correlate with the total stock market
- Percent of value orientation – value stocks have a higher return than growth and do not correlate with growth stocks
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Small-cap value index has outperformed growth with less standard deviation from 1979-2009
- Having a 50/50 value/growth index during this time added no return and increased standard deviation
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Small-cap stocks have higher expected returns but also higher standard deviation than large-cap
- This occurs in foreign markets too
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Small Cap value, along with the total stock market, is a good choice in your portfolio
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4 Layers of Mutual Fund Costs
- Expense Ratio
- Commissions
- Bid-Ask Spreads
- Market-Impact Costs
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ETFs
- Advantages – Can be traded throughout the day, does not generate capital gains taxes
- Disadvantages – Incur commissions and spreads
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Stocks outperform 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)
International
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International equity provides currency diversification
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Global equity invests in both US and internationally. Not usually a good idea unless you have a very small amount of money and want diversification from 1 fund
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Good idea to have both US AND International equities in your portfolio at all times. You don’t know which one will win. The US won from 1970-2001 then the International has won since
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Canada’s economy is weighted heavily toward finance, energy and basic materials. Canada has lots of natural resources and investing in them acts as a hedge against commodity prices
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A permanent allocation to emerging market stocks is recommended. Emerging markets are very volatile. Recently Emerging markets have increased their correlation to US markets but this may or may not continue
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Generally, the allocation to international stocks is about 30% of the equity portion of your portfolio
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Independent studies prove the size and value premium (F+F study above) works in international stocks as it does with the US. This means an international small cap is a good idea too
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Foreign stocks are subject to currency, political, trading, custody and regulatory risk. You must understand these risks. But they do provide diversification to a portfolio
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Foreign stocks belong in everyone’s portfolio. The primary benefit is to reduce standard deviation or risks
Fixed Income
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A diversified fixed-income portfolio enhances return
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Low-cost bond mutual funds are an ideal way to invest
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Tax considerations may be an important element in fixed income when investing in a taxable account
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Bond Structure
- Short – 3 years or less
- Intermediate – 4 to 9 years
- Long – 10+ years
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Longer term bonds have higher interest rate risk. Longer maturity = higher rates. Opposite true
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Lower quality bonds have higher credit risk. Lower credit rating = higher rates. Opposite true
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High-yield bonds have not only credit risks but the real danger that the issuers will default
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Municipal bonds are a good choice for people in higher tax brackets in taxable accounts
REIT
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Real estate is a separate asset class from stocks and bonds
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REIT are a convenient way to invest in real estate
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REITs have low correlation with stocks and bonds
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Nearly all commercial lease contracts have a built-in inflation hedge. Therefore, REITs are a good inflation hedge
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REITs are the simplest way to participate in the real estate market. They are also liquid
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Index Equity REITs and ETFs are a good choice
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REITs are divided into 3 categories
- Equity – Real estate properties. Most pure holding
- Mortgage REITs – do not own property, they finance property. Bond investment
- Hybrid – Hold both
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10% allocation to REIT is enough
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Do not include home equity in your asset allocation models
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Equity REITs are portfolios of apartments, hotels, malls, industrial buildings, and other rental property
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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
Behavioral
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Realistic expectations are important to investment planning
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Market volatility is more predictable than the market return
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Investments with expected positive investment return and higher volatility have a higher expected return
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All investments have risk. Even T-Bills which is inflation risk. There is no risk-free investment
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No more than 12 funds because it gets too complex with higher fees and diminishing returns
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Do not change your percentage of equity/bond based on what you think the market will do. Once you select a ratio, stick with it.
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Most people can’t stomach a 100% equity portfolio
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A well-developed plan works only when the investor sticks to the plan through good and bad times
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A sensible investment plan never fails an investor. The investor fails the plan
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People tend to be more optimistic about stocks after the market goes up and less after it goes down
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Investors give too much weight to recent information
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People tend to buy investments that have had a recent run-up in performance
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Investors label investments good or bad depending on the price relative to where they bought it
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People are reluctant to admit errors
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Overconfident investors generally believe they have more knowledge and information than they do. Therefore, they tend to trade too much and underperform
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Males tend to be overconfident
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Females tend to do better at sticking to a long-term plan and usually perform better
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Do not change your investment strategy during a bear market
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If you can rebalance without hesitation, even during bad markets, your risk tolerance is good
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Investors tend to suffer from overconfidence
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Many portfolio failures occur when investors take on too much risk
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Recency bias – the 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, the 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 peril
- If you do diversify abroad, only do where you can drink the water
- In 2000, when the book was published, the US was doing better than foreign stocks. What were the experts saying at that time?
- Beware of recency, and do not be overly impressed with the asset class returns over less than 2-3 decades.
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If you are unhappy with the degree of risk in the portfolio, you have two ways to reduce it
- Employ less risky individual assets (Not a good idea) – like adding a large cap for small-cap stocks, domestic for foreign stocks, and utility for industrial stocks. It changes the dynamics of the portfolio
- Stick with your basic asset allocation and replace some of your 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-averse strategy will almost always involve at least a small amount of exposure to very risky individual assets
- 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
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The average investor suffers from overconfidence and thinks they can beat the market, but this is a mathematical impossibility.
- The average investor must obtain the market return minus expenses.
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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 who buy equities as they rise and sell as they fall.
- 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 advantageous to be a concave trader and vice versa.
Where to put your money
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Tax Deferred
- Corporate bonds
- CD
- High turnover mutual funds
- REITs
- Commodities Funds
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Taxable
- Low turnover equity funds
- ETFs
- Municipal bonds
Quotes
“10% savings of pre-tax income is a good target for most people”
References
- https://www.reddit.com/r/Bogleheads/comments/obcxqu/richard_ferri_all_about_asset_allocation_and/
- https://www.reddit.com/r/Bogleheads/comments/scdblp/the_intelligent_asset_allocator_by_william/
- https://www.spillsspot.com/finance-blog/2018/01/17/7-key-takeaways-intelligent-asset-allocator/
- Global Asset Allocation