DIY Investing Resource #3: The Intelligent Asset Allocator
We have previously featured JLCollin’s “Stock Series” and John Bogle’s “Little Book of Common Sense Investing” to introduce the concepts of low-cost, passive index investing. Our third resource to help DIY investors get started is William Bernstein’s The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk.
Bernstein is a neurosurgeon, author of 7 published books and several e-books and founder of the money management firm Efficient Frontier Advisors (I just threw that all in there for any of you who think that you don’t have the time to learn to manage your own money) . “The Intelligent Asset Allocator” now builds on these concepts, explaining why you should consider adding small amounts of complexity to hold a more broadly diversified investment portfolio. I will warn you that this book is a bit less accessible and requires some effort and concentration to comprehend compared to the first two resources. I found that effort to be fully worth it for the timeless lessons shared in the book. I am going to focus this review on a few of those key concepts that made it a valuable read.
Modern Portfolio Theory
The overall point of this book is to explain the concepts behind modern portfolio theory, enabling DIY investors to build a diversified portfolio. The key to this theory is spreading your money across multiple uncorrelated asset classes. In Bernstein’s words, “Diversified portfolios behave very differently than the individual assets in them, in much the same way that cake tastes different from shortening, flour and sugar.” A few key points from the book:
- The goal is to not have the optimal asset allocation, which is impossible to know in advance. The purpose of holding a diversified portfolio is to be able to expect to do well in a variety of different circumstances.
- Much more important than worrying about optimum allocation is choosing an allocation that one is comfortable with, understands and gives a good chance of success and then sticking with it. It is also important to rebalance regularly, once every 1-2 years, to stay at your target allocation.
- Bernstein clearly shows that diversification is not a panacea eliminating risk. In the worst of bear markets, the correlation of most assets is much higher than in good times. This means in Bernstein’s words that “diversification fails us when we need it most.”
- Data shows that adding a more risky asset class in small amounts can actually lower volatility of a portfolio while increasing returns. Likewise adding a less volatile asset class with lower expected returns in small amounts can considerably decrease volatility of a portfolio with minimal loss of return.
- You must own international stocks to have enough different asset classes with adequate risk/reward ratios and low correlation.
- The most benefit of diversification is gained through holding a few different asset classes. As you add more asset classes you start to get diminishing returns for the effort. The book does a great job of giving sample portfolios for both the investing junkie who can tolerate great complexity and the “simpleton” who wants little more complexity than that offered by traditional indexing and can be widely diversified with as few as four funds.
Historical Perspective of Investing
We started investing shortly after starting our careers around 2001. We have experienced two of the biggest crashes in US market history (albeit with very little and then only a moderate amount of skin in the game) and one of the biggest and longest running bull markets. Throughout this, we have stayed our course and so we felt we were comfortable with the cyclical nature of the market. However, we had little understanding of the longer term history of peaks, crashes and the amounts of time it can take to recover in the US economy. We had no idea that there were full decades in history where the US market underperformed international markets and even bonds. This book does a great job of giving long historical perspective to investing to allow you to make fully educated decisions on your asset allocation.
Reading this book, which some may consider dated, over a decade after its original publication made it more interesting in my eyes. It allowed us to see how the lessons in it continue to be true today and how accurately Bernstein was able to predict the lower returns that materialized in the decade after it was written. It was also interesting that he suggested to invest in “low cost” index funds which he described as bond funds with expenses <.5%, stock funds with expenses <.7% and international funds with expenses <1%. Our current all in expenses are about .21% and after we sell off the last of our managed funds we should be at about .1%. This shows the power of educated consumers who through Vanguard and the competition it places on the market have made it possible to virtually eliminate investment expenses, which was not possible just 10-15 years ago.
The Risk Reward Relationship of Investing
Bernstein points out that there is an inherent risk/reward relationship in investing. Investors should be rewarded for taking on more risk. Historically this is for the most part true. On a continuum, the least to most risky (volatile) assets are cash, bonds, large stocks and small stocks. Long-term returns are the exact opposite. The best performers are small stocks, then large, then bonds and then cash.
However, this risk/reward relationship is not always present. Asset classes such as precious metals and long-term bonds historically have excessive risk for the return they are expected to provide. There are also occasions where an entire market is so overvalued that it can not be seen as a good investment. Currently, we feel this relationship is particularly out of proportion with bonds which have a pathetically low yield if you hold them due to historically low interest rates. At the same time, they hold a horrible risk/reward profile if you are required to sell them as their value will drop when rates begin to rise.
The Valuation of Investments
Bernstein points out that you would not walk into a grocery store and buy tomatoes without knowing if they were $1/pound or $10/pound. However, that is exactly how most people buy their investments and project their returns. In chapter 7, Bernstein outlines several simple ways to evaluate market valuations including Price/Earnings (P/E) ratios, Price/Book (P/B) ratios and dividend yield to determine whether investments are over or undervalued. Bernstein makes a compelling case to weight your portfolio towards value oriented funds, especially for small cap stocks. He also discusses how to value bonds.
He recommends that you not alter your asset allocation as most people do based on fear and greed based on public sentiment, political conditions, etc. However, he hints that there are times when it may be wise to alter your allocation to buy more “tomatoes” when they are especially cheap and sell some more when they are getting too expensive. He also explains how current valuations enable you to predict with more accuracy what expected returns will be in the future than simply using past average returns. While this book does not provide enough information to make me feel that I am an expert on investment valuation, it has opened my eyes to an important area for future study. It also has given us some confidence to make more accurate projections of our future investment returns that will shape our retirement strategies, allowing us to decrease longevity risk associated with an early retirement.
This review is just the tip of the iceberg as far as the timeless investing knowledge contained in this book. For those who agree with the concepts of traditional index investing in the US market and are open to put in just a bit more effort and bear just the slightest increase in costs, I would highly recommend The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk.