Principles that can point you to profits
If there’s one thing investors wish for, it’s a perfect portfolio that can withstand the downturns and grows faster than the market during upturns. In a new book, In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest, finance professors Andrew Lo at MIT Sloan School of Management and Stephen Foerster at Ivey Business School trace the past 70 years of investment research and share insights into what constitutes the “perfect” portfolio through interviews with 10 key luminaries in the investing field, including diversification expert Harry Markowitz, Vanguard Group Inc. founder John Bogle, and Robert Shiller, one of six winners of the Nobel laureate in economics who are featured.
In Pursuit of the Perfect Portfolio is for both seasoned experts and new pandemic investors. Here, we excerpt some lessons that Lo and Foerster gained from their research. The perfect portfolio is ultimately a moving target based on individual age and stage in life, but market conditions and short- and long-term goals, the fundamental principles for success, remain constant.
Our endgame revolves around a fitting alliteration as the culmination to the Pursuit of the Perfect Portfolio: the Three P’s of Investments. These three investment P’s are principles, process, and path. We’ll describe seven investment principles that apply universally and offer an important checklist for you to use before you invest. Our process involves a simple self-assessment of key characteristics that best describe who you are — related to investing, saving, and spending — and what kind of investment environment in which you find yourself. As Charley Ellis put it, “It is about you, your values, your history, your financial situation.”
Your answers to these simple questions help place you in one of sixteen categories or archetypes. These archetypes provide you with a quick assessment of your financial situation, which in turn points you to our final P, the path to the Perfect Portfolio, including what action you might need to take today.
Let’s begin with the principles of how you construct your Perfect Portfolio, which is the same starting point for everyone:
❚ P1. Determine how much expertise you have in financial planning and how much time and energy you’re willing to devote to managing your Perfect Portfolio. This will determine whether you can embark on your investment pursuit alone or whether and when you should seek professional help. Back to our health analogy, in the same way that you may need to see an obstetrician, surgeon, or allergy specialist, you may also need to seek the assistance of financial specialists with expertise in mortgages, taxes, or estate planning.
❚ P2. Determine what your current and future financial needs are. This isn’t easy and requires deep personal reflection and a significant time commitment as well as regular reviews and some financial expertise, so you may also need the help of a professional here. Some obvious starting points are identifying your current income, both professionally and through any current investments. Next, identify your current expenses. The harder part is identifying future income and expenses. Don’t forget about Social Security and the important decision of when to take it. There may be some tough decisions involving family planning, saving for education, and retirement planning. The key is to start with overall life goals, then translate them into financial goals.
❚ P3. Find your comfort zone regarding financial gains and losses. How much can you lose in your savings or retirement account before you begin to freak out and start moving your assets into safer investments? How much will you allow your portfolio to grow before you decide that you want to lock in your gains? Think about the riskiness of your job or your business and what illiquid assets you might hold. Even if you can’t hedge against some risks, you don’t need to double down. For example, you may not want to invest in your own company (if it’s a publicly traded one), or even in companies in your industry. If recessions lead to big problems in your business, then a portfolio that might crash in recessions or becomes illiquid along with your job isn’t such a good idea.
❚ P4. Think about your investment philosophy and what you believe about markets. We hope that the journey with our investment pioneers has inspired you to reflect and develop your own philosophy. For example, are you in Fama’s camp, and are you convinced that, by and large, markets are efficient (particularly the U.S. stock market)? If so, then index funds are the place to start. That’s what the average investor would probably do. Do something else only if
you think you’re different from the average. But also recognize, as Shiller and other behaviouralists point out, that almost everyone thinks they’re smarter than average. Be prepared to update your investment philosophy based on new and convincing evidence.
❚ P5. List all the assets that you have and the assets you’re willing to hold, such as mutual funds, ETFS, stocks, bonds, real estate, and so on. Keep in mind that mutual funds and ETFS come in many different shapes and sizes. As Bogle pointed out, the traditional index funds (TIFS) that are broad-market, low-cost, no-load index funds are designed to be bought and then held for the long term. What about derivatives — are you comfortable with them, as Scholes and Merton are? You may not even be aware that many investment products are actually derivatives in disguise. Your list will be the menu of assets from which the Perfect Portfolio will be built. Also, think about assets you aren’t willing to hold. Think about Leibowitz’s dragon risks. Keep in mind, you should never make an investment based on what you think will happen if you don’t know what might happen — a lesson many learned the hard way during the financial crisis of 2007–2009.
❚ P6. Develop a sense of the current investment environment and how stable that environment appears to be relative to historical norms. In a stable environment, stable investment rules such as 60-per-cent stocks and 40-per-cent bonds might be sufficient, but in a rapidly changing economy, investment rules may have to be equally dynamic. The key here is to manage the risk of your Perfect Portfolio so you are (a) exposed to only those risks that you’re comfortable bearing (based on principles P2 and P3 above), (b) maximally diversified across investments that carry the highest possible premium relative to their risk, and (c) comfortable monitoring your investments on a regular basis, especially as market conditions and your own personal circumstances change over time.
❚ P7. Avoid obvious investing mistakes. Bogle and Ellis remind us that these mistakes may include paying higher fees than needed, experiencing high (and potentially costly) turnover in your portfolio, needlessly incurring taxes, and investing with active managers based solely on trust and friendly connections. That guy, Bernie, may be charming on the golf course, but be careful giving him your money. If you decide to take on a lot of additional risk by borrowing to invest, make sure you’ve got the cash reserves for margin calls. Shiller reminds us that we don’t always act rationally. We may think of ourselves as Star Trek’s Mr. Spock, but often act more like Homer Simpson.
If this checklist of principles seems complex, well, it is. And this is why our ten experts ended up with ten different Perfect Portfolios.
None will be exactly right all the time for all investors, but they’re all based on the seven principles we just described, and in the context of the AMH, they all make sense because they represent distinct adaptations to different environments and investor types.
Excerpted with permission from the publisher, Princeton University Press, from In Pursuit of the Perfect Portfolio by Andrew Lo and Stephen Foerster. Copyright© 2021 by Andrew Lo and Stephen Foerster. All rights reserved. This book is available wherever books and e-books are sold.