How to construct a portfolio using simplified modern portfolio theory

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Title: How to construct a portfolio using simplified modern portfolio theory


1
How to construct a portfolio using simplified
modern portfolio theory
Travis Morien Compass Financial Planners Pty
Ltd travis_at_travismorien.com http//www.travismorie
n.com
2
Before viewing this presentation
  • The presentation you are about to view on
    building portfolios is the sequel to a
    slideshow on selecting managed funds. Some
    concepts are carried forward from that
    presentation and are assumed knowledge.
  • If you havent already done so, download the
    original presentation from http//www.travismorien
    .com/investment.ppt

3
Part One
  • The asset classes

4
Basic principles
  • There are many asset classes out there and many
    of them are useful to investors.
  • Some asset classes are noted for their long term
    stability (low risk), others for their high
    returns.
  • Generally speaking, the higher the reward you are
    after, the more risk youll need to take.
  • Portfolios can be constructed out of multiple
    asset classes that exhibit superior risk and
    return relationships to any single asset, because
    diversification can significantly reduce risk.

5
Why risk and return are linked..
Investment A is the obvious choice
but add risk, is the choice still obvious?
B would die out through lack of takers!
When two investments appear to offer identical
risk, investors will prefer to buy the higher
returning one. If the market is peopled by
reasonably well informed investors, there simply
wont be any high returning low risk investments
left and nobody will buy high risk assets with a
low expected return.
6
Risk and return continued
  • In a portfolio construction context risk is
    usually measured with some sort of measure of
    price volatility.
  • There are other risks of course that need to be
    taken into account.
  • Inflation risk is a major problem with the more
    conservative asset classes such as fixed
    interest and cash. Many pensioners find to their
    horror that they can no longer live off their
    savings, despite the conservatism of their
    strategy, simply because their returns werent
    high enough to maintain the portfolios real
    value after inflation, costs and withdrawals.
  • It is necessary for all but the most short term
    oriented investors to consider at least some
    exposure to growth assets like shares and
    property, just to fight inflation.

7
Major asset classes shares
  • Shares are part interests in businesses. How
    good a return you get on your share depends to a
    large extent on the fundamental business
    developments of the company itself and on the
    price you paid for the share.
  • Averaged out over many companies, shares as an
    asset class tend to respond to interest rates and
    the economy.
  • Although in the last few years many markets have
    fallen substantially, shares are still the
    highest performing asset class over the long term
    and by far the most tax efficient.
  • Shares generally go up in price over the long
    term because businesses dont pay out 100 of
    their profits as dividends, they keep some to
    grow the value of the business itself.
  • Over the long term, shares have beaten inflation
    by about 6pa.

8
Major asset classes property
  • There are many types of property to invest in,
    each are different.
  • The highest income yield comes generally from
    commercial and industrial property, which often
    pay the owner as much as 10pa in rent alone.
  • Residential property is an asset class that has
    really been booming over the last few years, but
    rental yields are now alarmingly bad by
    historical standards meaning that investors are
    highly reliant on capital growth.
  • Over the longer term you can expect property to
    grow in capital value at about the same rate as
    inflation (because the salaries with which we
    have to pay the mortgages only grow with
    inflation there eventually comes a limit when
    growth above inflation just cant be sustained),
    though local supply and demand issues mean actual
    returns could be higher or lower over a
    particular period of time.

9
Major asset classes fixed interest
  • A fixed interest investment is a debt that can
    be bought and sold.
  • The borrowers are usually governments and
    companies. A typical fixed interest investment
    pays a regular coupon (interest payment) and
    will repay the principle on maturity.
  • Some fixed interest securities have a maturity of
    several decades, others are shorter term.
  • The actual price of a fixed interest investment
    will fluctuate in response to many things, most
    particularly interest rates. If general interest
    rates fall, the price of a long term fixed
    interest security will usually rise such that the
    yield to maturity is similar to those of other
    investments with a similar risk. On the other
    hand, if interest rates rise, fixed interest
    investments fall.
  • A typical fixed interest portfolio is yielding
    less than 5 right now, though falling interest
    rates over the last decade have helped bonds to
    deliver very strong performance which included a
    growth component.

10
Major asset classes cash
  • Cash may mean currency, but in an investment
    context cash is just a really short term highly
    liquid fixed interest investment.
  • Longer term fixed interest investments are
    usually called bonds, shorter term fixed
    interest investments may be called notes and
    really short term ones are often called bills.
  • Cash management trusts usually invest in a
    portfolio of high quality short term fixed
    interest investments. Because of the short
    maturity, these fixed interest investments arent
    as sensitive to interest rate changes and thus
    dont have a great deal of capital volatility.
  • Many cash investments are returning about 4 at
    the moment.

11
Other asset classes
  • Shares, property, bonds and cash are the major
    asset classes, but there are many others to
    choose from.
  • Hedge funds are sometimes called a distinct asset
    class as they pursue unconventional strategies
    that give them performance very different to the
    asset classes that they invest in.
  • Private equity is basically a shares
    investment, but in companies not listed on a
    stock exchange.
  • Agribusinesses are agricultural investments in
    things like tree farms and vineyards.
  • Some people also consider commodities like gold
    to be an asset class of its own, and many people
    consider collectibles, race horses and fine wines
    to be useful alternative investment asset classes.

12
The point of portfolio construction
  • A portfolio is often more than the sum of its
    parts. Because not all asset classes perform the
    same way over the short term, a portfolio of many
    asset classes usually offers a superior overall
    relationship between risk and return to any
    single asset.
  • A portfolio consisting only of shares would have
    done badly in the last few years since the US
    market crashed, but property and bonds have
    performed very well. This is quite typical, more
    defensive asset classes often do well when
    equities are falling.
  • A diversified portfolio has a reasonable long
    term growth rate because over time all asset
    classes offer a positive return, but being
    invested across different asset classes smooths
    out returns and offers a more predictable growth
    rate.

13
The last twenty years have seen very good returns
for all major asset classes, well in excess of
inflation, but the risk and return are highly
variable.
14
Part Two
  • Creating diversified portfolios

15
How diversification reduces risk
  • There are two mechanisms by which
    diversification reduces risk dilution and
    interference.
  • Dilution is easy enough to understand, if you
    swap half your shares for cash then you lose half
    your equity exposure and therefore half your
    equity risk. If the market crashed tomorrow
    youd only lose half as much.
  • Interference (a term I pinched from physics
    where it is used to describe the way waves
    interact), is where negative movements in some
    assets are partly cancelled by positive ones in
    other assets. A good example is with property
    vs. shares, in the recent bear market in shares
    property did very well while shares tanked, the
    opposite may be true in the next few years.

16
Interference and correlation
Correlation is the word given to the extent to
which assets move together, this is measured with
statistical formulae. Correlations can range
from -1 (perfectly negatively correlated) through
to 1 (perfectly positively correlated). If asset
B tends to move in the opposite direction to
asset A then these two assets are said to have
negative correlation, and they can be highly
effective at cancelling out each others
volatility. If the assets both trend upwards
over the longer term a combination of them will
have a return equal to the average of the two
assets returns but with substantially reduced
volatility.
Negatively correlated assets cancel the greatest
amount of each others volatility.
17
Negative correlation isnt essential
  • Assets dont need to be negatively correlated to
    have some volatility smoothing.
  • As long as the correlation is less than 1 the
    assets will be at least a little bit different
    and at least some volatility will be cancelled.
  • Most real world assets are positively correlated
    because most prices are related somehow to
    important macro factors like global economic
    growth, interest rates, oil prices etc.
  • Even if negative correlations are rare,
    substantial volatility reduction is possible by
    using assets with a low positive correlation.
  • For example, the annual correlation of Australian
    listed property with Australian shares from 1982
    to 2003 has been about 0.68, but the correlation
    of property with international shares was about
    0.30, the correlation of Australian shares with
    international shares was about 0.64, so a mixed
    portfolio would be quite effectively diversified.

18
The efficient frontier is the name given to the
line that joins all portfolios that have achieved
a maximum return for a given level of risk
(portfolios that are efficient). If you
programmed a computer to chart every possible
portfolio that could be constructed out of a
group of assets and plotted a point on a risk vs.
return chart, the resulting plot usually looks
much like the chart below. The top of the curve
is the efficient frontier, anything below that
curve is an inefficient portfolio, anything
actually on the curve, or close to it, is an
efficient portfolio.
19
Efficient vs. inefficient portfolios
  • It is impossible to predict in advance which
    portfolios will be the most efficient as this
    would require knowing in advance asset class
    performance and correlations.
  • A portfolio that has been diversified into a
    variety of asset classes should be close to
    efficient over the longer term, provided it is
    rebalanced regularly.

20
Rebalancing
  • Rebalancing a portfolio is the process of
    adjusting a portfolio to bring it back to its
    original asset allocation.
  • Since assets perform differently at different
    times, the portfolio is likely to drift from your
    desired asset allocation.
  • Failure to rebalance means that a portfolio can
    change risk profile over time and may no longer
    be appropriate.

21
A simple rule of portfolio construction
  • If you have two assets with roughly equal
    expected returns, putting 50 into each is a way
    to hedge ones bets (and spread the risk) without
    compromising expected return. The lower the
    correlation of those assets, the more the risk
    will be reduced while not reducing expected
    returns at all.
  • Actually, this holds true with a greater number
    of investments as well. For example, if you have
    five equally attractive assets you could invest
    one fifth in each.

22
Since 1982 Australian shares (ASX500 index),
international shares (MSCI world index) and
property securities (ASX300 listed property
index) have had roughly the same return
23
So using our simple rule of thumb that if the
three assets have similar returns well use a
third in each, we get the following portfolio
which has outperformed all three with much less
volatility! (Rebalanced monthly)
24
Diversifiable vs. undiversifiable risk
  • There is such a thing as diversifiable risk, as
    you add extra assets to the portfolio the
    volatility tends to decrease but only up to a
    point. When a portfolio reaches a certain level
    of diversification the only way to reduce risk is
    to add lower risk assets which will reduce
    volatility by dilution, this usually reduces the
    return.
  • Risk which cannot be diversified away is
    undiversifiable or systemic risk. Holding
    every stock in the market (i.e. with an index
    fund) smooths out the maximum amount of
    diversifiable risk for shares, but you are still
    left with the risk of the market itself, that
    risk cannot be reduced unless you spread your
    portfolio across more asset classes.
  • According to financial theory, investors only get
    rewarded for taking on systemic risk. Having an
    under-diversified portfolio results in greater
    risk but no extra expected return. This is one
    definition of speculation. (There are others.)

25
Diversification can also increase returns
  • A higher return may often be obtained from
    rebalancing the portfolio as a result of
    reversion to the mean.
  • If you believe that at some point in the future
    two assets will give the same cumulative return
    then it would make sense to invest in the asset
    class with the worst recent performance and sell
    the one with the best performance!
  • Rebalancing does precisely this, although it is
    normally seen only as a risk management
    technique.
  • This is why the diversified portfolio did a
    little better than all three component asset
    classes. A small rebalancing premium is quite
    common because last years worst performing asset
    class often outperforms last years best
    performing asset class this year.

26
Improving the efficient frontier
  • Investors desire higher returns with lower risk.
    There is however a limit to what can be achieved
    with a particular set of assets, that limit is
    drawn on charts as the efficient frontier.
  • By adding more assets we can change the shape of
    the efficient frontier. Assets carry two items
    of interest to us, their returns and their
    correlation with the rest of the portfolio.

27
Refining our asset allocation
  • There is wide acceptance that so-called value
    stocks outperform growth stocks, and small
    companies tend to outperform large companies,
    at least over the longer term.
  • Their higher long term performance is very
    interesting, but so too is the fact that they
    often have a low correlation to large growth
    companies, the dominant stocks in the market.
  • They provide what asset allocation buffs call an
    independent source of risk and return. This
    may enable us to improve the efficient frontier.

28
Fama and Frenchs Three factor model
  • Your returns mostly come down to asset
    allocation
  • The mix of stocks vs. bonds
  • The average company size
  • The value characteristics of the stocks - how
    cheap stocks are compared to book value.

Picture credit Dimensional Fund Advisors
29
Over the long term value stocks and small
companies have outperformed large companies.
These are the returns of global value, large
company and small company indexes calculated by
Dimensional Fund Advisors from January 1975
December 2003
Global value 19.70pa
Global small caps 20.29pa
Global large companies 14.98pa
30
Adding value and small caps to a large cap growth
equity portfolio gives a better return than a
large cap only portfolio, but the volatility is
actually lower, not higher. A mixed portfolio is
more efficient.
Large cap Large value small
Annualised Return pa 14.00 16.33
Total Cumulative Return 2433 4072
Monthly Standard Deviation 4.19 3.93
Monthly Average Return 1.19 1.35
Annualised Standard Deviation 14.53 13.62
20 Australian large 20 Australian value 10
Australian small 20 global large 20 global
value 10 global small
Data from Dimensional Fund Advisors DFA Returnw
program, gross return of indexes tracked by DFA
equity trusts. See http//www.dimensional.com.au
Annualised standard deviation is presented as an
approximation by multiplying the monthly or
quarterly standard deviation by the square root
of the number of periods in a year. Please note
that the standard deviation computed from annual
data may differ materially from this estimate.
50 Australian large 50 global large
31
Total stock market vs. slice and dice
  • The stock market is dominated by what would be
    classified as large growth companies, also
    known as blue chips. As a portion of market
    capitalisation, the very largest companies
    dominate the market and so an exposure in market
    weightings tends to have a very small amount of
    small company and value exposure.
  • Many asset allocators believe a portfolio should
    have more small company and value exposure than
    the market gives. Although small companies might
    only make up 5 of the market by capitalisation,
    they make up the vast majority of listed
    companies by number. Despite the tiny market
    weighting, asset allocators often allocate a
    larger amount of 10 to 20 to small caps and
    similarly overweight value companies.

32
Computer backtest optimisation
  • A common tool used is called a mean-variance
    optimiser or MVO, a computer program that
    backtests portfolios to find the ones that lie on
    the efficient frontier. It looks at historical
    correlations, mean returns and volatility.
  • The idea isnt as good in practice as it sounds
    in theory because past performance is no
    guarantee of future results. The program usually
    only does what inept investors have always done
    chase past performance, wags have dubbed MVOs
    error maximisers.
  • A non-technical approach goes back to the basics
    try to build your portfolio from many
    independent sources of risk and return. This
    simply means you should diversify into many
    different asset classes.

33
So how do you go about constructing a portfolio?
  • The usefulness of historical correlations and
    returns is usually overstated, but can form a
    crude guide as long as we dont take them too
    seriously.
  • Dont get too hung up on quantitative data, but
    try to find assets that are very different (e.g.
    property vs. shares.)
  • Our first example of a diversified portfolio had
    a one third allocation to Australian shares, one
    third to international shares and one third to
    property. Since over the longer term these asset
    classes deliver approximately the same returns
    but operate on somewhat different cycles, that
    isnt a bad allocation to start with for a high
    growth portfolio.

34
Decisions, decisions
  • Active funds or passive/index funds?
  • How much to growth assets, how much to income
    assets?
  • Balance of value stocks to growth stocks?
  • How much large cap shares, how much small caps?
  • How much money to put in developed markets vs.
    emerging markets?
  • Currency hedged or unhedged international shares?
  • Listed or unlisted property?
  • Short or long maturity fixed interest?

35
  • Within the one third allocated to Australian
    shares in our simple starting portfolio, we can
    allocate money between large cap growth, small
    cap growth, large cap value and small cap value.
    We can also allocate along the lines of
    industrials vs. resource stocks.
  • Within the one third allocated to international
    shares we have the same asset classes above, but
    we can also allocate to developed markets or
    emerging markets.
  • One might even consider allocating some of the
    shares investments to private equity (unlisted
    shares), which may often provide a very high
    return yet at substantial risk. A small
    allocation to a risky asset with low correlation
    to other asset classes can actually reduce the
    volatility of the overall portfolio.
  • Long/short managed funds can also be useful as
    they usually have a very low correlation with the
    indexes.

36
Risky assets vs. risky portfolios.
  • It is important to think about risk in a
    portfolio context, not an asset context.
    Portfolio building should be seen more like
    cooking we are more concerned with the final
    product than the taste of each ingredient.
    Pepper tastes great on a steak, but makes a lousy
    meal by itself.
  • Small percentage allocations to riskier assets
    like emerging markets, private equity,
    commodities, hedge funds and agribusiness can
    actually reduce the risk of the overall portfolio
    because they dont operate on the same cycles as
    major asset classes. Small allocations to such
    assets can have a great impact on the efficient
    frontier.

37
Are risky assets like emerging markets too risky
for conservative portfolios?
  • Emerging markets are by themselves a very risky
    asset class, their monthly volatility is about
    50 higher than global large companies (DFA
    indexes). On the other hand, their correlation
    with the global large caps indexes is quite low.
  • Despite the high volatility of emerging markets,
    their low correlation with global large cap
    equities means a small percentage allocation of
    emerging markets to a global portfolio can
    actually reduce the volatility of a portfolio
    while potentially increasing returns.

January 1988 to January 2004, DFA Emerging
Markets index plus Global Large Company index.
38
A little volatility can go a long way
  • In a sense, the high volatility of the riskier
    asset classes is one of their most valuable
    attributes for a portfolio.
  • The high volatility of asset classes like
    emerging markets and commodities means they punch
    well above their weight in contributing risk and
    return to the portfolio.
  • A 5 allocation to a risky asset class with low
    correlation to mainstream asset classes might
    contribute as much diversification as a 20
    allocation to a less volatile asset class, so
    only a small amount needs to be invested to
    improve portfolio diversification.

39
Review of the return vs. volatility of major
asset classes from January 1988 to January 2004.
40
  • Obviously some asset classes have been more
    efficient than others over this time frame, but
    which asset classes will be best over the next 10
    years is another matter entirely.
  • Australian value stocks for example continued to
    provide strong gains over the last few years as
    the rest of the stock market, especially
    international stocks, did poorly. In 2003,
    Australian small caps rose 40 (nearly twice what
    large companies returned) despite underperforming
    over the previous decade.
  • There really is no way to forecast which assets
    are going to outperform, although that doesnt
    stop people from trying!

41
Adding conservative assets
  • So far weve only shown what happens when growth
    assets of the various flavours of shares and
    property are added together.
  • Although we can substantially improve on large
    cap growth share portfolios in terms of risk and
    return there are limits to how conservative a
    portfolio of growth assets can be, to push the
    efficient frontier more toward lower risks the
    income asset classes (bonds, cash, mortgages)
    will need to be added.
  • We have to accept that over the longer term this
    will probably cost the investor money due to a
    lower expected return, but the risk reduction
    potential is tremendous and this may be more
    suitable for conservative investors.

42
Half the risk doesnt mean half the return!
  • Risk to reward ratios get more favourable for
    conservative portfolios.
  • Putting half a share portfolio into cash will
    basically halve the risk, but since cash doesnt
    return 0 you wont halve the return.
  • If you gear a portfolio though you do double your
    risk (if you use 50 leverage), but because you
    have to pay interest on the loan you wont double
    your return.
  • Conservative portfolios therefore can greatly
    reduce risk without necessarily having the same
    amount of reduction in the return. This can be
    seen on the efficient frontier, which is usually
    curved instead of straight.

43
A property of efficient frontiers is that the
left side of the chart is usually a lot steeper
than the right side. Addition of even a small
amount of cash to a share portfolio (here we have
used the ASX500 All Ordinaries share index from
January 1980 to January 2004) can significantly
reduce volatility with very little impact on
returns and the addition of a small amount of
shares to a cash portfolio can significantly
increase returns without increasing volatility
much.
All cash
All shares
44
Part Three
  • Risk profiling and portfolio design

45
So why not always use a medium risk portfolio?
  • If diversification makes it relatively easy to
    substantially reduce risk for only a small cost
    in return, why not do it all the time?
  • The answer lies in compounding interest. Over a
    long period a small increase in returns makes a
    big difference to the final portfolio value.
  • The difference between a portfolio that returns
    8 over 20 years and a portfolio that returns 10
    over 20 years is very substantial. Ten thousand
    dollars invested at 8 for 20 years will grow to
    46,610, one thousand invested at 10 for 20
    years will grow to 67,275 - a very significant
    difference! If you are young then your time
    frame on retirement assets is likely to be 30
    years or more.
  • Growth assets are also generally more tax
    efficient and therefore the gap between
    aggressive and conservative portfolios widens
    after tax.

46
Over a short period of time there is very little
difference so it may not be worth taking a risk,
but if you do have a long term horizon then
serious thought should be put into ways to get an
extra percentage point or two out of the
portfolio. An extra point of risk is often hard
to notice without a computer, but an extra point
of return makes a very big difference in the long
term! Risk is important but being overly
conservative can be a costly mistake over the
long term.
47
Choosing a level of risk vs. return
  • Risk profiling is a tricky business that
    depends on the time horizon, risk tolerance and
    return requirements of an investor.
  • As a financial planner I spend a lot of time
    working on this with clients, but it is a complex
    area and it is outside the scope of this
    presentation.
  • Some model portfolios with different levels of
    risk and their risk/return profiles are shown on
    the next few slides.

48
Three dimensional approach to risk profiling
  • Most advisors discuss risk tolerance in terms of
    potential volatility only, often using short
    multi-choice questionnaires. In my opinion, this
    is inadequate and doesnt really address the
    clients needs. I think there are actually three
    dimensions to risk profiling
  • Time frame when is the money required?
  • Volatility tolerance how much volatility?
  • Conventionality given the different cycles of
    value and small cap shares and that they may
    underperform large growth companies for extended
    periods of time, how much of a value and small
    cap tilt is acceptable?

49
 Example model portfolios High growth Growth Balanced Low growth Conservative
Growth assets 100.00 85.00 70.00 55.00 30.00
Income assets 0.00 15.00 30.00 45.00 70.00
           
Australian Value Equities 15.00 13.00 10.00 8.00 4.50
Australian Large Equities 15.00 13.00 10.00 11.00 6.00
Australian Small Equities 5.00 4.00 3.00 0.00 0.00
Global Value Equities 15.00 13.00 10.00 8.00 4.50
Global Large Equities 15.00 13.00 10.00 11.00 6.00
Global Small Equities 5.00 4.00 3.00 0.00 0.00
Listed Property 30.00 25.00 24.00 17.00 9.00
Australian Bonds 0.00 5.00 10.00 15.00 20.00
International Bonds 0.00 5.00 10.00 15.00 20.00
Bank Bills (cash) 0.00 5.00 10.00 15.00 30.00
           
Annualised Return 14.12 13.76 13.25 12.84 11.86
Monthly Standard Deviation 3.39 2.93 2.41 2.01 1.25
50
(No Transcript)
51
February 1985 to December 2003, monthly
distribution of returnsNote the higher peak and
narrow spread of the conservative portfolio
compared to the higher risk portfolios, but note
also that the riskier portfolios peak further to
the right showing that on average they have had
better returns.
52
Maximum drawdown is another way to look at risk
which is more meaningful to most people.
Drawdown is calculated as the loss from the
highest previous high. The losses each portfolio
experienced in past bear markets can be clearly
seen and compared.
53
Compared to the individual asset classes, the
historical drawdown of the diversified High
Growth portfolio was much less. Individual
growth assets have tended to have up to twice the
downside risk.
54
Typical downside risk as measured by maximum
drawdown
  • A High Growth model portfolio would have lost
    about 25 in the crash of October 1987 and by the
    bottom of the next largest three subsequent bear
    markets (September 90, January 95, February 03),
    losses were about 12.
  • Every 15 of allocation to income assets reduced
    the average magnitude of the drawdown at the
    bottom of each significant bear market by an
    average of about 15 (not surprisingly!) at a
    cost of about 0.5pa in annualised returns.
  • It is also worth noting that the drawdown periods
    tended to last slightly longer in the aggressive
    portfolios as it took more time to make up the
    greater losses.
  • Bear in mind the inferior tax efficiency of the
    conservative portfolios, so for taxable investors
    the gap between each portfolio would be slightly
    greater.

55
Designing a portfolio risk tolerance
  • First, determine the time frame of the
    investment.
  • Examining data from model portfolios and adding
    on a margin of safety, decide how much downside
    risk over that time frame that you can accept.
  • Remember, the consequence of risk is more
    important than the probability of risk. Risk
    should be assessed in terms of how much damage it
    would do to your ability to pay for something you
    need at some time in the future. Dont get too
    obsessed about daily, weekly, monthly or even
    annual volatility if your investment horizon is
    20 or 30 years!
  • Of course if your investment horizon is quite
    short term, you probably should be obsessed about
    short term volatility!

56
Designing a portfolio value vs. growth
  • Value stocks and small companies tend to
    outperform large cap growth companies over the
    longer term but they do have risks of their own.
  • Value stocks outperformed by a huge margin during
    the bear market of the last few years, in fact
    Australian value stocks even outperformed
    property trusts during a time which is generally
    remembered as a property boom.
  • The trouble though is that during the tech boom
    of the late 1990s, value stocks lagged by a large
    margin. We know with hindsight this was a
    bubble, and most of those gains were lost, but
    this wasnt that easy to spot at the time. The
    newspapers were all touting the new economy,
    and value investors seemed like they were
    obsolete. As a dimension to risk profiling, this
    one is about how willing you are to ignore
    underperformance and the prognostications of
    pundits.

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Designing a portfolio value vs. growth
  • Personally I am happy to have a very strong tilt
    toward value stocks, but not everyone feels that
    way.
  • The numbers for value vs. growth strongly favour
    value for more than half a century in the US and
    many foreign markets where data is available, the
    track record of value is impressive.
  • But how many years will you persist with value
    investing if it underperforms the general market?
    One year? Five years? Ten years? How do you
    know there isnt really a new paradigm and
    markets havent really changed?
  • Most people prefer to hedge their bets,
    allocating some but not all of their portfolio to
    value stocks, buying growth stocks and having a
    balanced exposure. This may not be the highest
    returning strategy for the very long term, but it
    seems more conservative for most people.

58
Is value more risky than growth?
  • Many academics argue that the outperformance of
    value stocks vs. growth stocks is a risk
    premium, i.e. that investors are merely being
    rewarded for taking on more risk.
  • Others who dont believe in the efficient market
    hypothesis think that the outperformance of
    value is caused be systematic errors made by
    analysts who overestimate the future profits of
    growth stocks and underestimate the future
    profits of value stocks, this would be an
    inefficiency, an opportunity to earn a higher
    return without higher risk.
  • Various people have put forward various theories
    about the extra risk of value, but one of the
    most obvious troubles with the value risky
    theory is that value based portfolios tend to be
    less volatile, not more, in fact growth
    portfolios, which have lower returns, can be much
    more volatile.
  • This debate has gone on for years and will
    continue to go on for years more, to some people
    the idea of a free lunch in value stocks is
    theoretically impossible, so they hypothesise new
    forms of risk.

59
Citigroup BMI value and growth indexes, July 1989
to Jan 2004 (Australian shares)Although the
value index in this example outperformed the
growth index by more than 3pa, if there is much
extra risk in value stocks then it doesnt show
in the volatility or drawdown figures.
60
Longer term in the US Fama and French large
value vs. large growth indexes January 1926 to
December 2003. Again, if there is extra risk it
isnt obvious in the drawdown figures. Value
outperformed growth by more than 2pa over the
entire period but this didnt translate into
meaningfully greater downside risk. Value was
marginally more volatile though, 7.45 per month
vs. 5.48.
61
Risk of value stocks
  • The main reason why many academics say value
    stocks are more risky is because in theory they
    would have to be more risky for the efficient
    markets hypothesis to remain valid. Many
    explanations are given, but some tend to be
    almost metaphysical, claiming that the risk cant
    be measured but is there somehow and somewhere.
  • Interestingly, prior to academics discovering the
    value premium, nobody claimed value stocks were
    more risky, this claim was made by efficient
    market supporters only after the higher returns
    were proven.
  • It is an interesting issue, but from a personal
    investors point of view it is a question of
    whether the value premium is likely to persist
    for ever and whether they are willing to tolerate
    periods of underperformance where growth does
    better than value.

62
Value vs. growth
  • In the late 1990s, growth stocks outperformed
    value stocks. If you had switched out of value
    and into growth following that period of
    outperformance you would have been hurt badly by
    the bear market that followed, where value stocks
    outperformed growth by a big margin.
  • Growth stocks often outperform in rising markets,
    especially in the latest stages of bull markets
    when most people invest the most money.
    Typically, value stocks offer more consistent
    performance.
  • If you cant tolerate underperforming the market
    or dont want to bet on a value premium
    continuing, stick with normal large cap blue
    chip shares. Strongly tilted value and small
    cap portfolios arent suitable for everyone.

63
Conclusions
  • Asset allocation is an overlooked and underrated
    field of investment, but studies show it is more
    influential on the behaviour of a portfolio than
    stock selection or market timing, more
    importantly you can exercise more control over
    asset allocation whereas the others are often a
    matter of luck.
  • Used properly, asset allocation is the major risk
    management tool in an investors arsenal, but it
    can also be a source of higher returns.
  • Asset allocation can be a complex area with many
    fine points that are often overlooked and is
    particularly important for pension portfolios.

64
  • Recommended reading
  • Common Sense on Mutual Funds by John Bogle
  • The Intelligent Asset Allocator by William
    Bernstein
  • The Four Pillars of Investing by William
    Bernstein
  • A Random Walk Down Wall Street by Burton G.
    Malkiel
  • The Intelligent Investor by Benjamin Graham
  • Contrarian Investment Strategies The Next
    Generation by David Dreman
  • Against the Gods The Remarkable Story of Risk by
    Peter Bernstein
  • John Neff on Investing by John Neff

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Web sites of interest http//www.stanford.edu/wfs
harpe/art/active/active.htm http//www.stanford.ed
u/wfsharpe/art/talks/indexed_investing.htm http/
/marriottschool.byu.edu/emp/srt/passive.html http
//www.diehards.org/ http//www.investorsolutions.c
om/ArticleShow.cfm?Linkart_It_Dont_Get_Much_Worse
_Than_This.cfm http//www.investorhome.com/cherry
.htm http//library.dfaus.com/faqs/ http//library
.dfaus.com/articles/dimensions_stock_returns_2002/
http//www.indexfunds.com/ http//faculty.haas.b
erkeley.edu/odean/ http//www.efficientfrontier.co
m/ http//www.tweedy.com/library_docs/papers.html
http//www.travismorien.com
66
Disclaimer Information contained herein has been
obtained from sources believed to be reliable,
but is not guaranteed. This article is
distributed for educational purposes and should
not be considered investment advice or an offer
of any security for sale. Investors should seek
the advice of their own qualified advisor before
investing in any securities. Please note that
returns quoted in this article are based on
historical performance of indexes, not actual
products. Real world products (index funds) are
available to track the majority of indexes quoted
in this presentation, but returns will be
affected by fees and taxes. Past returns are not
a reliable indicator of future returns.
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