Post on 22-Dec-2015
transcript
Review
• Asset allocation is the single biggest determinate of portfolio results
• Major asset classes– Stocks– Bonds,– Cash
• How you allocate your investments depends upon the returns you need and risk you can take
• Rule-of-thumb: %stock = 100 - age
Where We Stand
• You have determined your:1. Investment objective 2. Risk tolerance3. Asset allocation
• Now - what investments do you buy in each asset class?
Modern Portfolio Theory
• Asset class investments tend to move together – correlation– For example, in a recession
• But investments do not always move together– For example, high oil prices are good for oil
companies but bad for airlines– Bad quality may affect only one company
• Diversifying your investments, can increase your average return and lower your risk!
Not All Risk is the Same
Firm Risk = Systemic risk + Idiosyncratic Risk
BusinessCycles
FinancialMarkets
GlobalConditions
Risk Unique to theFirm
Source of Correlation
Idiosyncratic risk can be diversified away!
Diversification – Simple Example
IBM and AT&T
When IBM went down, AT&T went up.When AT&T went down, IBM went up.Not always. Maybe we should add moreor different stocks.
With large portfolio, 30 – 200 stocks, idiosyncratic moves cancel out!
Risk and Diversification
Note: adding some stock to a 100% Treasury portfolio increases the return and decreases the risk!
Modern Portfolio Theory
• Optimal portfolios are a combination of the risk free asset and a market portfolio.
• Implications– Buy a money market fund (~risk free)– Buy an index fund (the market)– Asset allocation is determined by your risk
tolerance
• Big Question – what is the market?
Efficient Markets Hypothesis
• Markets prices reflect all known information• You can not beat the market consistently without luck
– Advisors may be correct, just not consistently– Advisors love to talk about winners but not losers– Survivorship bias
• What to do?– Go with the market– Invest in broad market index funds– Less than 3% of actively managed funds beat index funds over
last 20 years*
* “Index Funds Win Again,” NY Times, Feb. 22, 2009.
Index Funds
• A fund is a pool of securities that allow investors to buy a share of many securities
• Many index funds available for stocks and bonds
Vanguard Index 500Total Stock Market
Index Total Int’l Stock IndexTotal World Stock
IndexLong Term Bond
Index
Fidelity500 IndexTotal Market IndexInternational IndexU.S. Bond Index
SchwabS&P 500 IndexTotal Stock Market
Index International Index
Target Date Funds
• “Index” Funds whose asset allocation becomes more conservative over time
• Percent of stocks goes down, bonds go up• Issue
– What happens after target date?– You still have many years to go– Retirees face inflation risk, do not want to be too
conservative– What does fund do after target date?
Building Your Market Portfolio
Scott Burns' Lazy Portfolios
Coach Potato Portfolio:- 50% in Vanguard Total Stock Market Index Fund (VTSMX)- 50% in Vanguard Inflation Protected Securities Fund (VIPSX)
Margarita Portfolio:- 33.3% in Vanguard Total Stock Market Index Fund (VTSMX)- 33.3% in Vanguard Inflation Protected Securities Fund (VIPSX)- 33.3% in Vanguard Total International Stock Index Fund (VGTSX)
Four Square Portfolio:- 25% in Vanguard Total Stock Market Index Fund (VTSMX)- 25% in Vanguard Inflation Protected Securities Fund (VIPSX)- 25% in Vanguard Total International Stock Index Fund (VGTSX)- 25% in Vanguard REIT Index (VGSIX)
Building Your Market Portfolio
Five Fold Portfolio:- 20% in Vanguard Total Stock Market Index Fund (VTSMX)- 20% in Vanguard Inflation Protected Securities Fund (VIPSX)- 20% in Vanguard Total International Stock Index Fund (VGTSX)- 20% in Vanguard REIT Index (VGSIX)- 20% in American Century International Bond Fund (BEGBX)
Six Ways From Sunday Portfolio:- 16.65% in Vanguard Total Stock Market Index Fund (VTSMX)- 16.65% in Vanguard Inflation Protected Securities Fund (VIPSX)- 16.65% in Vanguard Total International Stock Index Fund (VGTSX)- 16.65% in Vanguard REIT Index (VGSIX)- 16.65% in American Century International Bond Fund (BEGBX)- 16.65% in Vanguard Energy (VGENX)
But You Want More
• Not happy with getting what everyone else gets?• More potential return means more real risk• NOT ALL RISK IS REWARDED
– Think you can beat the pros?– Some will win, others will lose– Beware greed (remember Madoff?)
• Take risk knowingly, intelligently
Post Modern Portfolio Theory
• Any investment other than the market is a bet• Bets are zero-sum propositions• Can you beat the pros?
Post-Modern Portfolio Theory
• Divide your portfolio into two parts• Alpha
– Percentage of your portfolio that you are willing to “bet”
– Can be individual stocks or bonds, or funds• Beta
– Percentage of your portfolio to invest in the market
– Invest according to your asset allocation– Use index funds for asset classes
Example
• Your investment objective– You want to save for retirement
• Your risk tolerance– You can take some risk but want to be able to
sleep at night
• Your alpha– You believe Asian stocks will beat the market– Willing to bet 10% of your money
Example – Your Investments
• Alpha– Buy Asian index fund with 10% of your money
• Beta– Asset allocation with moderate risk– 60% stocks
• Purchase a total stock market index fund– 35% bonds
• Purchase total bond market index fund– 5% cash
• Purchase a money market fund
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Twelve Financial TruthsJonathon Clements, WSJ 6/18/06
1. It’s hard to cut back2. You will never be satisfied3. Borrowings have to be repaid4. Fancy cars and expensive clothes are not a
sign of wealth5. Your family could prove to be your
greatest liability6. Investors face three enemies
1. Inflation2. Taxes3. Investment costs
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Twelve Financial TruthsJonathon Clements, WSJ 6/18/06
7. Adding investments can lower risk8. Diversification is a mixed bag9. Not all risk is rewarded10.Most investors fail to beat the market11.Change is costly12.Your best investment strategy is saving
Summary
1. Determine your investment objective2. Know your risk tolerance3. Identify your alpha and beta
• Alpha – percent you are willing to bet• Beta – percent invested in the market
4. Place your bets with your Alpha5. Invest Beta according to asset allocation
• Use index funds to match the market