In this recent piece I discussed some of the shortfalls with relying on a mean-variance-optimization (MVO) technique to build an investment portfolio. In short, MVO relies on too many user-provided inputs to arrive at an accurate “efficient” portfolio for the future. So if MVO is flawed, is there a better way? I think there is at least a simpler, more honest way.
1) Decide how much equity exposure vs. bond exposure you want to have in your portfolio. Historically, more stocks means higher returns but more volatile returns. More conservative investments (cash and bonds) reduces this expected volatility but also reduces expected returns. No free lunch, sorry. (Yes, by doing this you are admitting that you will deviate from the global financial asset portfolio, which is fine. There’s no reason that you should believe that your risk tolerance is the same as the average of every investor in the world.)
This is about where the “science” ends and more subjective decisions begin. Every decision that follows, each step you move away from the global asset portfolio, is based upon your understanding, research, risk tolerance and opportunity costs. These are your decisions, and you will need to defend them.
2) On the bond side: decide if you will deviate from the broad global bond market portfolio. Will you only own domestic bonds, or will you own a local-currency hedged version of the global bond market? Why or why not? Will you take more or less duration (interest rate) risk than the market average? Why? Will you take more credit risk than the global market by buying fewer government bonds and more corporate bonds? Why?
3) On the stock side: start with the market-cap-weighted global stock market, which assumes that (risk-adjusted) the collective opinions of all global investors are reflected in today’s stock prices. Will you deviate from this? (This, by the way, is where “three-fund-portfolio” advocates will stop, which is just fine. Buy a domestic bond index and the global stock market via a US total stock market fund and an international total stock market fund and call it a day.) If you are going to deviate from the global market cap weighted index, how and why?
3a) Are you going to take a home bias by overweighting stocks domiciled in your own country? Why? (You’d better have a good reason on this one).
3b) Will you tilt your portfolio to small caps and value stocks based on generally accepted research of additional risk premiums to be garnered? If so, are you prepared to tolerate the additional expected volatility? Are you prepared to wait out extended periods wherein this tilt may very well deliver lower returns than the cap-weighted index? How much will you “tilt?” 2x the market weight of small caps? 4x? 5x? How “deep” of a value tilt will you take? Will you only own “value” stocks or will you blend with a total market position? Again: Why?
3c) Will you overweight other sectors or asset classes relative to the global market? Decisions here likely include the treatment of emerging vs. developed markets and including or overweighting REITs, commodities, natural resources and other “alternatives.” If so, why? Remember that your justification should be for long term reasons and not because “that’s where the action is.”
Go ahead and take a look at your portfolio’s allocation. For every position, every deviation from the global stock market, ask yourself why. Why do I have this position? What purpose does it serve? Is it based on sound long-term evidence or my own “hunch” about what is coming next? Did I have a good reason for buying it? Is it true diversification or diversification in name only? This is the equivalent of your high school trigonometry teacher telling you to show your work. Come on, show your work. Have a sound reason for each position in your portfolio and how it contributes to the overall structure of your investments.
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