Our strategic approach to portfolio management is one based on the premise that choosing stocks or funds that will outperform the market averages is, at best, difficult. Academic studies stretching back to 1900 have consistently demonstrated that passive investment management strategies produce superior results for most investors. An active strategy, whether based on security selection or market timing, may be successful for months or even years but over a lifetime, most investors are better served by a strategic or passive approach.
Asset allocation is the simple act of designing an investment portfolio with different asset classes based on an investor’s financial goals and risk tolerances. It is the most important investment decision any investor makes because it is the composition of the portfolio that will ultimately determine the risk and future return of your portfolio.
Many academic studies have shown this to be true. Studies by Gary Brinson, L. Randolph Hood and Gilbert Beebower in 1986 and 1991 analyzed the returns of 91 large pension funds. They concluded that asset allocation explained more than 90% of the variance of returns. Another study conducted by Roger Ibbotson and Paul Kaplan, published in 2001, confirmed the earlier results. These studies show that it is not the selection of individual stocks or bonds but rather the asset allocation of the portfolio that drives investment performance. The percentage of your assets devoted to stocks (or any other asset class) is vastly more important than the specific stocks you choose.
Modern Portfolio Theory
Modern Portfolio Theory, pioneered by Harry Markowitz and refined by many other academic studies, suggests that a broadly diversified portfolio that includes dissimilar asset classes can potentially increase returns while reducing risk. Eugene Fama and Kenneth French of the University of Chicago and Dartmouth respectively, demonstrated in their three factor model that adding small cap and value stocks to a portfolio of large cap growth stocks enhances the return of the portfolio over a long holding period. This addition of assets with low or negative correlation is the key to producing superior investment results. When large cap growth stocks are zigging, small cap value stocks may be zagging. This effectively reduces the volatility of the portfolio as a whole and can also produce higher returns over time.
Buy, Hold and Rebalance
The strategic or passive approach is not a one decision, buy, hold and forget portfolio. Rebalancing the portfolio to maintain the intended mix of assets that reflects your goals and risk tolerance is very important and should be done periodically. How often a portfolio is rebalanced can be influenced by market factors, tax considerations and cash flow needs.
- Increase the long term return of a portfolio.
- Maintain the desired risk profile of the portfolio.
- Impose discipline on investors. Rebalancing forces an investor to buy assets that have gone down in value and sell assets that have gained. In other words, rebalancing forces an investor to buy low and sell high.
Our strategic portfolios consist of index funds and/or exchange traded funds. History has shown that passively managed investment vehicles that track market averages outperform the majority of actively managed funds. In addition, index funds generally have lower costs. Management fees are significantly less than actively managed funds. Turnover is also generally lower resulting in reduced trading costs and greater tax efficiency.
State pension funds and other institutional investors widely use index funds for the majority of their equity portfolios. Examples include: The states of California, New York, Connecticut and Washington.
Warren Buffet of Berkshire Hathaway is a legendary portfolio manager with a long track record of success that has made him one of the richest men in the world. About investing, he has said: “Most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals.” This from one of the greatest stock pickers of all time.
So turn off the noise of CNBC’s talking heads and Wall Street’s army of commission driven sales forces and let Alhambra Investment Partners construct for you a globally diversified portfolio of low cost index funds across a variety of asset classes (stocks, bonds, real estate and commodities) that matches your risk tolerance and financial goals.
We have five strategic portfolios. Both portfolios are global in nature. We feel it is important to obtain sufficient international diversification as the US represents only slightly more than 40% of the world economy.