Unconventional Success

Text in black are quotes; text in green are my notes. I sometimes write in Spanish.

• A nontraditional approach leads to greater likelihood of investment success. #

• By abandoning an unconventional strategy in the face of poor performance and implementing a conventional alternative after a run of strong investment results, investors sell low and buy high. #

• Unconventional Success concludes that the mutual-fund industry fails America’s individual investors. #

• Capital markets provide three tools for investors to employ in generating investment returns: asset allocation, market timing, and security selection. #

• Establishing a coherent investment program begins with understanding the relative importance of asset allocation, market timing, and security selection. #

• Asset allocation refers to the long-term decision regarding the proportion of assets that an investor chooses to place in particular classes of investments. #

• Market timing refers to deviations from the long-term asset-allocation targets. Active market timing represents a purposeful attempt to generate short-term, superior returns based on insights regarding relative asset class valuations. #

• Passive market timing consists of inadvertent deviations from long-term targets caused by the action of market forces on the values of a portfolio’s various asset classes. #

• Security selection refers to the method of construction of portfolios for each of the individual asset classes, beginning with the choice of passive or active management. #

• Asset-allocation decisions play a central role in determining investor results. A number of well-regarded studies of institutional portfolios conclude that approximately 90 percent of the variability of returns stems from asset allocation, leaving approximately 10 percent of the variability to be determined by security selection and market timing. #

• Three basic investment principles inform asset-allocation decisions in well-constructed portfolios. First, long-term investors build portfolios with a pronounced equity bias. Second, careful investors fashion portfolios with substantial diversification. Third, sensible investors create portfolios with concern for tax considerations. #

• Finance theory and common sense support three long-term asset-allocation principles—the importance of equity ownership, the efficacy of portfolio diversification, and the significance of tax sensitivity. #

• Equity ownership beats holding bonds or cash, hands down. #

• Generations of economics students who learned that “there ain’t no such thing as a free lunch” may be surprised to discover that Nobel laureate Harry Markowitz called diversification one of the economic world’s rare “free lunches.” #

• The act of diversification provides a free lunch of enhanced returns and reduced risk, increasing the likelihood that an investor will stay the course in difficult market environments. #

• Since few investors engage in systematic rebalancing activity, most portfolios wax and wane with the markets, subjecting the portfolio to a strange form of market timing. #

• Strong evidence exists that markets exhibit mean-reverting behavior, a tendency for good performance to follow bad and bad performance to follow good. #

• Only by regularly rebalancing portfolios to long-term targets do investors realize the results that correspond to the policy asset-allocation decision. #

• The provision in the tax code that causes taxes to be due only upon realization of gains allows investors to delay payment of taxes far into the future. Deferral of capital gains taxes creates enormous economic value to investors. #

• Individuals making investment decisions must consider not only the structure of future tax regimes, but the character of their individual circumstances. #

• Keeping current on the general nature and specific character of available opportunities pays significant dividends in the form of enhanced after-tax returns. Rational market participants take maximum advantage of tax-advantaged investing. #

• Investors generally fail to follow the most basic investment precepts. Instead of concentrating on the central issue of creating sensible long-term asset-allocation targets, investors too frequently focus on the unproductive diversions of security selection and market timing. #

• Instead of constructing equity-oriented, well diversified, tax-sensitive portfolios, investors too frequently choose to mimic the conventional, poorly structured consensus. Disappointing results represent the nearly inevitable consequence of ignoring fundamental investment principles. #

• Real conviction proves necessary to stick with an out-of-favor strategy in the face of apparently poor results and obvious public skepticism. #

• Investors ultimately reap rewards only if they maintain positions in the face of market woes. #

• Over reasonably long periods of time, stocks trump bonds and stocks trump cash, hands down. #

• Taxes matter. Since payments to the tax man represent a direct diminution of investor assets, careful investors structure portfolios to avoid or defer as much tax as possible. #

• Six asset classes provide exposure to well-defined investment attributes. Investors expect equity-like returns from domestic equities, foreign developed market equities, and emerging market equities. Conventional domestic fixed-income and inflation-indexed securities provide diversification, albeit at the cost of expected returns that fall below those anticipated from equity investments. Exposure to real estate contributes diversification to the portfolio with lower opportunity costs than fixed-income investments. #

• In the portfolio construction process, diversification requires that individual asset-class allocations rise to a level sufficient to have an impact on the portfolio, with each asset-class accounting for at least 5 to 10 percent of assets. Diversification further requires that no individual asset class dominate the portfolio, with each asset class amounting to no more than 25 to 30 percent of assets. #

• Core asset classes share a number of critical characteristics. First, core asset classes contribute basic, valuable, differentiable characteristics to an investment portfolio. Second, core holdings rely fundamentally on market-generated returns, not on active management of portfolios. Third, core asset classes derive from broad, deep, investable markets. #

• Satisfying investment objectives proves too important to rely on serendipity or the supposed expertise of market players. Core asset classes, therefore, depend fundamentally on market-driven returns. #

• Core asset classes encompass stocks, bonds, and real estate. Asset classes that investors employ to drive portfolio returns include domestic equities, foreign developed market equities, and emerging market equities. Asset classes that investors use to create diversification include U.S. Treasury bonds, which promise protection from financial catastrophe, and U.S. Treasury Inflation-Protected Securities, which provide ironclad assurance against inflation-induced asset erosion. Finally, asset-class exposure to equity real estate produces a hybrid of equity-like and bond-like attributes, generating inflation protection at a lower opportunity cost than other alternatives. #

• Investment in domestic equities represents ownership of a piece of corporate America. Holdings of U.S. stocks constitute the core of most institutional and individual portfolios, #

• Jeremy Siegel’s two hundred years of data show U.S. stocks earning 8.3 percent per annum, while Roger Ibbotson’s seventy-eight years of data show stocks earning 10.4 percent per annum. No other asset class possesses such an impressive record of long-term performance. #

• The long-term historical success of equity-dominated portfolios matches the expectations formed from fundamental financial principles. #

• Stocks generally provide protection against unexpected increases in inflation, although the protection proves notoriously unreliable in the short run. #

• stocks trade in broad, deep, liquid markets, affording investors access to an impressive range of opportunities. #

• Arnott points out that the overwhelming importance of dividends to historical returns “is wildly at odds with conventional wisdom, which suggests that…stocks provide growth first and income second.” #

• Arnott uses his historical observations to draw some inferences for the future. He concludes, with dividend yields below 2.0 percent (in April 2003), that unless real growth in dividends accelerates or equity market valuations rise, investors face a future far different and far less remunerative than the past. Noting that real dividends showed no growth from 1965 to 2002, Arnott holds out little hope of dividend increases driving future equity returns. #

• in Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market, James Glassman and Kevin Hassett conclude that equities exhibit no more risk than bonds.5 The authors ignore the intrinsic differences between stocks and bonds that clearly point to greater risk in stocks. The authors fail to consider experiences outside of the United States where equity markets have on occasion disappeared, leading to questions about the inevitability of superior results from long-term equity investment. Perhaps most important, the authors overestimate the number of investors that operate with twenty- or thirty-year time horizons and underestimate the number of investors that fail to stay the course when equity markets falter. #

• Perhaps most important, the authors overestimate the number of investors that operate with twenty- or thirty-year time horizons and underestimate the number of investors that fail to stay the course when equity markets falter. #

• Former General Electric chief executive Jack Welch brought shame on himself and his company with a retirement package filled with personal perquisites. Beginning with lifetime use of a $15 million apartment bought by General Electric, the list includes access to the company’s Boeing 737 jets, corporate helicopters, and a car and driver for him and his wife. #

• U.S. domestic equities represent the asset of choice for many long-term investors. #

• Yet investors must guard against relying on equities to exhibit their general characteristics in any specific time frame or allowing equities to account for too large a portion of the target portfolio. #

• The best protection for investors against the shortcomings of equity investments lies in owning an all-inclusive, market-like portfolio of equity securities in the context of a well-diversified collection of asset classes. #

• Of all risky investments, investors expect the lowest returns from U.S. Treasury bonds, due to the high degree of security intrinsic in obligations of the U.S. government. #

• Unless investors match holding period with maturity, price and rate changes may cause portfolio values to diverge from expected levels. #

• The protection to portfolio values provided by government bonds comes at a high price. Expected returns for fixed-income instruments fall short of expected returns for equity-oriented investments. #

• The purity of noncallable, long-term, default-free Treasury bonds provides the most powerful diversification to investor portfolios. #

• For holders of traditional Treasury debt securities, changes in inflation rates influence after-inflation returns in unpredictable ways, leading to potential variation between anticipated and actual outcomes. #

• When inflationary expectations fail to match actual experience, bonds tend to behave differently from other financial assets. #

• U.S. Treasury bonds provide a unique form of portfolio diversification, serving as a hedge against financial accidents and unanticipated deflation. #

• Since the fixed coupon rate on TIPS applies to the inflation-adjusted principal of the bonds, both interest and principal payments reflect changes in inflation rates. #

• Unanticipated inflation harms regular bonds by reducing the purchasing power of the fixed stream of payments. In contrast, unanticipated inflation flows through in the form of higher returns to holders of TIPS as payments adjust for increases in the price level. Unexpected deflation helps regular bonds by increasing the purchasing power of the fixed stream of payments. In contrast, unexpected deflation reduces the stream of periodic interest payments to holders of TIPS, even though deflation fails to reduce the final principal payment. #

• Sensible investors pursue diversification as a policy to reduce risk, not as a tactic to chase performance. #

• Unless foreign currency positions constitute more than roughly one-quarter of portfolio assets, currency exposure serves to reduce overall portfolio risk. Beyond a quarter of portfolio assets, the currency exposure constitutes a source of unwanted risk. #

• Sensible investors invest in foreign equity markets through thick and thin, regardless of recent past performance. #

• Market observers frequently confuse strong economic growth with strong equity market prospects. #

• Investors in emerging markets equities require substantial expected returns to compensate for the high level of fundamental investment risk. #

• Real estate returns and risks fall between those of bonds and equities. #

• The distinction between public and private positions in real estate lies in form, not substance. Both public and private holdings of real estate assets expose investors to the benefits and perils of property positions. #

• A REIT, unlike a typical corporate entity, pays no income taxes as long as the REIT distributes at least 90 percent of its taxable income and generates at least 75 percent of that income from rents, mortgages, and sales of property. #

• Like all of Vanguard’s index products, the Vanguard REIT Index Fund provides high-quality, low-cost exposure to its target market. #

• In terms of risk and return, real estate falls between higher-risk equity and lower-risk debt. #

• Time horizon constitutes one of the most influential variables in structuring investment portfolios. #

• The necessity that each asset class matter indicates a minimum of a 5 or 10 percent allocation. The requirement that no asset class matter too much dictates a maximum of a 25 or 30 percent allocation. #

• Personal preferences, circumstances, and abilities affect portfolio construction in a profound manner. #

• Investors who desire more certain protection from inflation increase the U.S. Treasury TIPS allocation. Investors who require greater protection against financial crises expand U.S. Treasury bond exposure. Investors who lack confidence in emerging markets avoid emerging markets investments. #

• Lack of conviction and absence of comfort cause investors to buy high and sell low, damaging portfolio returns. #

• Home mortgages and personal loans comprise the largest components of most individual financial liabilities. #

• Adjustment of portfolio allocations for personal preferences leads to greater likelihood of maintaining asset-class exposures through thick and thin. #

• Time horizon influences particularly the asset-allocation decision. #

• Asset allocation depends on the time of forecasted use for the invested funds. #

• By aggregating various needs and desires, a full picture of the investor’s time horizon emerges. #

• as the investor’s investment horizon contracts, the investor moves assets from high-risk to low-risk positions. Ultimately, when one or two years remain before expenditure of the funds, the portfolio consists entirely of low-risk positions. The nature of the risky portfolio need not change, only the proportion committed to risky assets. #

• Effective investors combine science and art in constructing investment portfolios likely to satisfy long-term aspirations. #

• Non-core asset classes fail to meet at least one of the three criteria that define core asset classes: contribution of a basic, valuable, differentiable characteristic to a portfolio; fundamental reliance on markets, not on active management, to generate returns; and representation in a broad, deep investable market. #

• Sensible investors avoid non-core asset classes. #

• Regardless of the cause, if history provides a guide to the future, bond investors can expect more bad news than good on credit conditions. #

• The best outcome for holding bonds to maturity consists of receiving regular payments of interest and return of principal. The worst outcome represents default without recovery. #

• Sensible investors avoid corporate debt, because credit risk and callability undermine the ability of fixed-income holdings to provide portfolio protection in times of financial or economic disruption. #

• Buying yesterday’s winners and selling yesterday’s losers inevitably hurts tomorrow’s performance. #

• Apparently, the power of Morningstar’s rating system stems from the investing public’s search for any source of guidance in making investment decisions. #

• The firm originally defined risk as “underperformance relative to a…90-day Treasury bill.” According to Morningstar, “if a fund’s return exceeded this benchmark each month, the fund was deemed riskless.” #

• Under normal market conditions, systematic rebalancers trim winners and bolster losers, moves that go against the conventional grain. #

• In spite of the importance of rebalancing in maintaining appropriate asset-allocation targets, few investors pursue the practice systematically. #

• Contrarian investment behavior requires shunning the loved and embracing the unloved. Most people do the opposite. #

• Rebalancing represents supremely rational behavior. Maintaining portfolio targets in the face of market moves dictates sale of strong relative performers and purchase of poor relative performers. #

• Stated differently, disciplined rebalancers sell what’s hot and buy what’s not. #

  • Rebalancear tu portafolio no es más que vender lo que está de moda, y comprar lo que no.
  • Casi nadie lo hace porque se dejan llevar por las emociones, ¿por qué vender cuando está yendo tan bien? Sienten la adrenalina y esperan seguir viendo esas subidas.

• In other words, nearly seven of ten investors made minimal, if any, changes to their new money allocations over the decade. #

• In other words, nearly nine of ten investors made minimal, if any, changes to their existing portfolio holdings. #

• In contrast to the wide valuation swings experienced by the unrebalanced portfolio, the rebalanced portfolio produced a much steadier pattern of results. #

• Just as in Aesop’s fables, the rebalancing tortoise beat the undisciplined hare. #

• Generating profit while controlling risk represents an unbeatable combination. #

• Rebalancing to long-term policy targets plays a central role in the portfolio management process. #

• Individual investors possess neither the time nor the resources to succeed in active management of marketable securities portfolios. #

• In aggregate, a total of 2.35 percent of assets disappeared from the median active investor’s account, representing a high price to pay to play a zero-sum game. #

• Self-reliance in the form of pure-execution brokerage avoids the brokers’ noise and saves money, producing a win-win for the investor. #

• The details beneath the aggregate figures suggest that sensible investors pay close attention to individual ETF expense ratios. #

• The ETF market makes no sense for investors who deal with modest pools of capital or who make small incremental trades. #

• Vanguard and TIAA-CREF both operate on a not-for-profit basis, allowing the companies to make individual investor interests paramount in the funds management process. #