Excerpts from The Intelligent Asset Allocator - Part I

Here are some excerpts from The Intelligent Asset Allocator by William Bernstein, a very practical hands-on guide on how to derive a feasible asset allocation plan suitable for yourself. The first part (Chapter 1 to Chapter 6) is to convey the concept of asset allocation and portfolio theory, the rationale behind it, and how does it manifest in the real market. It also tries to convince readers that index approach is better than active managed funds.

Preface

  • The serviceable portfolio: the “simpleton’s portfolio” consisting of index funds—one quarter each of:
    • U.S. large stocks
    • U.S. small stocks
    • foreign stocks, and a
    • short-term U.S. bond fund.

At the end of each year, rebalance your accounts so that each of the four parts are again of equal size. (Page ix)

Introduction

  • The essence of portfolio theory: diversified portfolios behave very differently than the individual assets in them, in much the same way that a cake tastes different from shortening, flour, butter, and sugar. (Page xiv)

Chapter 1 - General Considerations

  • The simplest measure and still practical measure of risk: standard deviation. (Page 7)
  • Check whether the fund salespeople or brokers know about SD and convey such information. (Page 8)
  • One sign of a dangerously overbought market is a generalized underappreciation of the risks inherent in it. (Page 8)

Chapter 2 - Risk and Return

  • Stocks are to be held for the long term. Don’t worry too much about the short-term volatility of the markets; in the long run, stocks will almost always have higher returns than bonds. The longer one’s time horizon, the less likely the risk of loss. (Page 15)
  • Caution: when you measure risk as the standard deviation of end wealth, stocks actually become riskier with time. For example, the difference between the highest and lowest 30-year return is almost 5%. Compounding a 5% return difference over 30 years produces an almost fourfold difference in end wealth. (Page 15)
  • The simplified stock returns, according to discounted dividend method, is $$ \text{Return} = \text{dividend yield} + \text{dividend growth rate} + \text{multiple change} $$ (Page 23)

Chapter 2 Summary

  1. Risk and reward are inextricably intertwined. Do not expect high returns without high risk. Do not expect safety without correspondingly low returns.
  2. The longer a risky asset is held, the less the chance of a poor result.
  3. The risk of an asset or a portfolio can be measured. The easiest way to do this is by calculating the standard deviation of returns for many time periods.
  4. Those who are ignorant of investment history are bound to repeat its mistakes. Historical investment returns and risks of various asset classes should be studied. Investment results for an asset over a long enough period (greater than 20 years) are a good guide to the future returns and risks of that asset. Further, it should be possible to approximate the future long-term return and risk of a portfolio consisting of such assets.

Chapter 3 - The Behaviour of Multiple-Asset Portfolios

  • The most important concept in portfolio theory: Dividing your portfolio between assets with uncorrelated results increases return while decreasing risk. (Page 30)

Simple Portfolios: Two Assets

  1. If two assets have similar long-term returns and risks and are not perfectly correlated, then investing in a fixed, rebalanced mix of the two not only reduces risk but also actually increases return.
  2. If two poorly correlated assets have similar returns and risks, then the optimal mix of the two will be close to 50/50.
  3. There is plenty of margin for error available in asset allocation policy. If you are off 10% or 20% from what in retrospect turned out to be the best allocation, you have not lost that much. (Page 35)

Dealing with More Than Two Imperfectly Correlated Assets

  • Real assets are almost always imperfectly correlated. The correlation of two assets can be expressed by a correlation coefficient. The correlation of two assets can also be understood by plotting the returns against each other. (Page 37)

Chapter 3 Summary

  1. The concept of correlation of assets is central to portfolio theory — the lower the correlation, the better.
  2. Diversifying your portfolio among uncorrelated assets reduces risk and increases return. It is necessary to rebalance your portfolio periodically to capture this increased return.

Chapter 4 - The Behaviour of Real-World Portfolios

  • In general, however, you will not go far wrong by sticking to bond maturities of six months to five years for the risk-diluting portion of your portfolio. (Page 45)

Risk Dilution

  • Risk dilution: refers to this process of traveling from right to left on a return-versus risk curve. (Page 45)
  • The stock composition of a high-risk portfolio usually does not differ much from that of a low-risk portfolio. The main difference is in the broad allocation between stocks and bonds. (Page 45)

Foreign Assets

  • Again, the essence of effective portfolio construction is the use of a large number of poorly correlated assets. (Page 46)
  • The main advantage of international diversification was not increased return but decreased risk. (Page 50)
  • Bernard Baruch’s famous dictum: Something that everyone knows isn’t worth knowing. I.e. Identify the era’s conventional wisdom and then ignore it. (Page 52)
  • The real purpose of portfolio backtesting, mean-variance analysis, or any other kind of portfolio analysis is not to find the “best” asset mix. Rather, it is to find a portfolio mix that will not be too far off the mark under a wide variety of circumstances. (Page 53)

Efficient Frontier

  • The key point about the efficient frontier is this: it’s a chimera, the image of your Aunt Tillie in a cloud scudding overhead a few minutes ago. (Page 59)

Chapter 4 Summary

  1. The addition of a small amount of stock to a bond portfolio increases return while actually reducing risk slightly; even the most risk-averse investor should own some stocks.
  2. The addition of a small amount of bonds to a stock portfolio significantly reduces risk while reducing return only slightly.
  3. Favor short-term bonds (of six months to five years) as your “risk diluting” asset, rather than long-term bonds.
  4. Small stocks have to be diluted with more bonds than large stocks in order to obtain the same degree of risk (i.e., a 50/50 small-stock62 The Intelligent Asset Allocator and bond mix will have about the same degree of risk as a 75/25 large-stock and bond mix).
  5. Beware of recency, and do not be overly impressed with asset- class returns over periods of less than two or three decades. In spite of their recent poor showing, foreign stocks and small stocks have a place in your portfolio.
  6. Periodically rebalance your portfolio back to your policy allocation. This will increase your long-term return and enhance investment discipline.

Chapter 5 - Optimal Asset Allocations

The Calculation of Optimal Allocations

  • Optimal allocation can be about: future, hypothetical, historical. (Page 64)
    • Future: Get a competent pilot for your Gulfstream V now.
    • Hypothetical: the process of postulating a set of returns, SDs, and correlations and then calculating the optimal allocations for these inputs.
    • Historical: what was optimal in the past, can be calculated. It is a very poor way to determine future allocations.
  • Forget about getting the answer from a magic black box. We’ll have to look elsewhere for a coherent allocation strategy. (Page 71)

More Bad News

  • In practical terms it is nearly impossible to find three mutually uncorrelated assets. Consequently, we cannot hope for a risk reduction of more than about one-quarter to one-third from diversification. (Page 72)
  • This is why simple portfolio backtesting is a valuable supplement to MVO (mean-variance optimizer); one can actually see how well a proposed portfolio responded in an actual bear market. (Page 72)
  • Probably of greater importance than the risk reduction derived from diversification is the “rebalancing bonus,” the extra return produced by rigorous rebalancing. (Page 73)

International Diversification with Small Stocks

  • Further diversification benefit can be obtained through the use of international small stocks. (Page 74)

Allocating Assets: The Three-Step Approach

Ask three questions in sequence for asset allocation:

  1. How many different asset classes do I want to own? (Page 76)
    • Level 1: you can get most of the diversification of far more complex portfolios from this short list.
      • U.S. large stocks (S&P 500)
      • U.S. small stocks (CRSP 9-10, Russell 2000, or Barra 600)
      • Foreign stocks (EAFE)
      • U.S. short-term bonds
    • Level 2: for the individual who is serious about diversification and wants its full benefit.
      • U.S. large stocks (S&P 500)
      • U.S. small stocks (CRSP 9-10, Russell 2000, or Barra 600)
      • Foreign large stocks
      • Emerging markets stocks
      • Foreign small stocks
      • REITs
      • U.S. short-term bonds
  2. How “conventional” a portfolio do I want? (The proportion) (Page 78)
    • While it may be true that the long-term returns of a highly diversified portfolio are the same as a more conventional portfolio, from time to time it will seriously underperform it.
    • The more exotic asset classes you add to your mix, the higher your tracking error will be. Remember, that tracking error does not mean lower returns, it just means that your portfolio will behave very differently from everyone else’s, and that it will often temporarily underperform everybody else’s.
  3. How much risk do I want to take? (Page 79) Risk is controlled by the overall mix of stocks and bonds.
  • The aggressiveness of your portfolio is reflected in your overall stock and bond mix, not in the kinds of equity you hold, which should be similar at all levels of risk. (Page 80)

How the asset allocation process work: (Page 82)

  1. Decide how many different stock and bond asset classes you are willing to own. Increasing the number of asset classes you employ will improve diversification but will also increase your work load and tracking error. Try to get around this problem with a heavy weighting of large and domestic stocks in its equity portion.
  2. Decide just how much tracking error you can tolerate. If you are unable to tolerate much tracking error, keep your proportion of foreign and small-cap stocks low.
  3. Adjust your stock-versus-bond mix according to how much risk you can tolerate, ranging from a maximum of 75% stock for the most aggressive investors down to 25% for the least aggressive.

Chapter 5 Summary

  1. It is impossible to forecast future optimal portfolios by any technique.
  2. Over the long term, a widely diversified global portfolio of small- and large-company stocks should have favorable return-versus-risk-characteristics.
  3. Your precise asset allocation will depend on three factors: your tolerance to S&P 500 tracking error, the number of assets you wish to own, and your tolerance to risk.

Chapter 6 Market Efficiency

“How to statistically test for skill”, an intuitive and useful explanation on skill evaluation. (Page 87)

From Alpha Man to Apeman

  • The Four Layers of Mutual Fund Costs (Page 90-91)
    • Expense ratio: the fund’s advisory fees (what the managers get paid) and administrative expenses.
    • Commissions: paid on transactions.
    • Bid-ask spread: of stocks bought and sold, and may be as large as 10% for the smallest stocks.
    • Market-impact costs: the magnitude of impact costs depends on the size of the fund, the size of the company, and the total amount transacted. As a first approximation, assume that it is equal to the spread.

Investment Newsletters

  • The corollary of the efficient market hypothesis is that you are better off buying and holding a random selection, or as we have shown above, an index of stocks rather than attempting to analyze the market. (Page 105)
  • In the end, it is easy to understand why the aggregate efforts of all of the nation’s professional money managers fail to best the market: They are the market. (Page 105)

Chapter 6 Summary

  1. Money managers do not exhibit consistent stock-picking skill.
  2. Nobody can time the market.
  3. Because of 1 and 2, it is futile to select money managers on the basis of past performance.
  4. Because of 1, 2, and 3, the most rational way to invest in stocks is to use low-cost passively managed vehicles, i.e., index funds.
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Leo Mak
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