The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk

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Contents

Preface to the Paperback Edition

Preface to the Hardcover Edition

Introduction

1. General Considerations

2. Risk and Return

3. The Behavior of Multiple-Asset Portfolios

4. The Behavior of Real-World Portfolios

5. Optimal Asset Allocations

6. Market Efficiency

7. Odds and Ends

8. Implementing Your Asset Allocation Strategy

9. Investment Resources

Appendix A: Becoming Your Own Portfolio Analyst

Appendix B: Correlation Coefficients Among Asset Classes

Glossary

Bibliography

Index

Preface to the Paperback Edition

Twenty-five years ago, when I first became seriously interested in finance, I never dreamed it would take over such a large chunk of my life. As a neurologist, all I wanted to do was figure out the basics of asset allocation: collect returns series on different stock and bond asset classes, then mix them together in the most efficient way possible. This, though, was just a means to an end: to acquire enough assets with as little risk as possible so that I might some day retire.

Finance turned out to be a deep and labyrinthine rabbit hole, and once I fell down it, there was no climbing back out. The book you hold in your hand, which was first published in 2000, represents the first third or so of that free fall.

As with most enterprises, I encountered both success and failure. On the success side, the book sold well enough to please me and my publisher. On the failure side, I missed my target audience by a wide margin; I thought I was writing the book for regular folks with regular jobs trying to accomplish the same thing as me.

Instead, I had written a book for math geeks: engineers, physicists, mathematicians, and, worst of all, the very finance professionals I had trashed in multiple chapters.

So what good is a book written for a limited audience that’s more than a decade and a half old?

First and foremost, it provides a reasonably rigorous introduction to the basics of finance, not just its quantitative facets, but also the historical, psychological, and institutional aspects as well—a springboard, if you will, for those wishing to dive deeply into the subject. Second, the book was published in September 2000, which means that, because of the length of the production process, I had completed its final written form earlier that year—precisely at the peak of the greatest market bubble in U.S. history. About a decade before, I had read Charles Mackay’s Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, which described the Dutch Tulipmania of the 1630s and the twin Mississippi Company and South Sea Bubbles of 1720, and wondered what it must have been like to live through such an episode.

A decade later, the parallels between what I saw all around me and what I read in Mackay’s book struck me, and on the whole, I am fairly proud of the suspicions I voiced in the book you are now reading, that ranged from a comparison of the New Eras of the 1920s and 1990s, through a detailed deconstruction of the hyper-bullish Dow 36,000 concept, to an emphasis on asset classes that largely escaped the mania and subsequent crash (small/value stocks, REITs, precious metals equity, and TIPS).

Still, while it’s easy to identify bubbles in retrospect, it’s much harder in real time, and I did have doubts about crying bubble! in a crowded NASDAQ. This is a long way of saying that a firm grasp of market history is essential to success in finance, and this book provides a portrait of what a genuine market mania looks and feels like in real time, when the final outcome is anything but certain.

Third, the book’s portfolio recommendations have stood the test of time—that is, they’ll serve just as well today as they did back then. While I did recommend a few actively managed foreign small-mid cap funds, this was only because passively managed ones were not available to the broad investing public. Now they are.

After nearly two decades, the book’s basic messages remain the same:

Stocks are riskier than bonds, and so they must offer a high probability, but not the certainty, of higher returns to attract buyers.

The future returns of stocks will likely be smaller than in the past.

Invest passively wherever you can; today, with the explosion in ETFs, this is far easier than it was in 2000.

The key to long-term success lies in a coherent strategy for allocation among broad categories of assets, principally foreign and domestic stocks and bonds.

Understand that market timing and stock or mutual fund picking are nearly impossible long term; they are at best a distraction. Put another way, it is far more important to come up with a prudent mix of low cost mutual funds that index foreign stocks, U.S. stocks, and bonds than it is to pick the best stocks or mutual funds or to call the tops or bottoms of the markets. Nobody consistently calls the market, and almost nobody picks stocks or actively managed mutual funds with any persistent skill.

Some things, though, have changed. Not only was the book published at the height of a massive market bubble, and not only did that bubble subsequently collapse, but six years after that it was followed by another far more serious financial crisis that shook investors’ faith in the entire system. Those episodes, as well as my further explorations of the finance rabbit hole, have taught me several things that, had I written the book today, I would have included.

The book directs investors to think of all of their investing accounts as a single portfolio with an overall asset allocation. This is still a useful concept, but in reality, I now realize that each of us owns two portfolios: one that we own, which we will consume in retirement (unless we get carried out of the work place feet first); and, God willing, a second portfolio that we will leave to our heirs, charities, and, if we’re patriotic enough, to the government. It naturally follows that the first portfolio should be matched to one’s real living expenses—call this a liability matching portfolio (LMP). Two different asset classes accomplish that well: an inflation-adjusted annuity and a TIPS ladder whose maturities match one’s living expenses.

Neither approach to the LMP is perfect; commercially available fixed immediate annuities have low yields and carry some credit risk—i.e., the possibility that the insurance company will go belly up; and a TIPS ladder, even one with a 30-year rung, can be outlived. Further, assuming either you or your spouse have a normal life expectancy, before considering either of these options, you should spend down your assets in order to delay Social Security until age 70, which is the best inflation-adjusted fixed annuity money can buy.

How big should your LMP be? Approximately 25 years of residual living expenses (RLE). For instance, if your living expenses, including taxes on both income and retirement fund required distributions equate to $70,000, and you will be getting $30,000 in pensions and Social Security, your RLE is $40,000, so therefore your LMP should be $1 million.

Any assets above that in reality don’t belong to you, but to your heirs, charities, and Uncle Sam. This is your risk portfolio (RP). If your RP does well, you can pilfer it to splash out on first class travel and the BMW you’ve always wanted, but if it doesn’t, at least you won’t be pushing a shopping cart under a bridge in the rain, which can happen if you invest your LMP too aggressively.

That’s not to say that a young person should invest only in safe assets—more on that in a bit—but once you’ve achieved your LMP, you should start de-risking your portfolio. Once you’ve won the game, you stop playing it with your LMP.

As an aside, some may consider such a strategy suboptimal. I don’t happen to think so, but this raises an important point, which is that at its base, investing is a psychological game. A suboptimal strategy you can live with and execute is better than an optimal one you can’t. The best tonic for staying the course is a big, fat LMP when the excrement hits the ventilating system, which will inevitably happen during your retirement.

This gets us to another point not discussed in detail—the riskiness of stocks. Finance academicians make a parlor game of asking if equities get more or less risky over time. The correct answer is, of course they do: while annualized returns converge with longer time periods, total returns diverge. Further, stock and index put premiums rise, not fall, over time.

The above logic pertains only to buy-and-hold investors. As pointed out in the book, young savers should get down on their knees and pray for a long, brutal bear market that accumulates shares at low prices, while the opposite is true for recent retirees. Said yet another way, a low-returns-first/high-returns-last sequence savages retirees and benefits young investors, and vice versa.

So how risky are stocks? Not so much for young savers and Three Mile Island toxic for older ones; hence the need for an LMP.

Let’s consider risk. What exactly is it? In the book, I lean heavily on standard deviation (SD). Pedants will point out that stock returns are not normally distributed; as Eugene Fama has said, life has a fat tail. This, however, misses a much more important point. SD, as commonly used, measures only short-term risk, and as such is a poor descriptor of the real risk that investors face, which is that of poor long-term inflation-adjusted returns. Further, there are specific types of historical events that produce this, and the worst and most likely risk is inflation, which over time and around the world is nearly endemic.

What protects against inflation risk? On the LMP side, TIPS, of course, inflation-adjusted annuities; and, on the RP side, stocks, which although they don’t do well with unanticipated inflation in the short term, in the long term represent claims on real assets. Commodities producers, for obvious reasons, do particularly well, and so do value stocks that carry more nominal debt than growth stocks, and whose real debt burden gets melted away with inflation.

What about one of the hottest asset classes over the past decade, commodities futures funds (CFFs)? Avoid fads, particularly those pushed by the old-line wirehouses. No need to name names, we all know who they are, the point being that, starting around 2000, these institutions all began recommending CFFs and so drove up futures prices to the point that they exceeded the realized spot prices, a situation known as contango. This is not a dance they do in Buenos Aires, but rather a serious drag on commodities futures strategies that savage their investors. This sequence points out two lessons: first, it reinforces the point that in the long run, the shares of commodities producing firms protect against inflation; and second, that if all the wirehouses recommend something, you should stay as far away from it as possible. As put by John Kenneth Galbraith, Wall Street keeps reinventing the wheel, and in new and slightly more unstable form.

It’s only a slight simplification to say that we own stocks to hedge long-term risk and bonds to hedge short-term risk. The major lesson taught by the global financial crisis of 2008-2009 is to rigidly segregate them in your portfolio: in order to meet your living expenses and to scoop up stocks at the fire sale, stocks can be as risky as you like, but your fixed income assets should mainly consist of government-guaranteed securities—Treasuries and CDs—that won’t take a haircut during a severe crisis. Corporate bonds do have higher returns than government bonds, but this is only because they embed a bit of stock risk; if you want to go for that extra return, you’re better off owning a smidge more stocks than losing sleep because your riskless short-term, high-quality corporate bonds turned out to be not so riskless after all. The corporate bonds haircut is mainly due to their low liquidity, which municipal bonds suffer from as well. Municipal bonds can be advantageous in taxable accounts, just don’t bet your entire fixed-income farm on them.

This book also spent some time talking about the psychology of investing. In the intervening years, neuroeconomics—the study of how brain function influences financial choices—has become a hot topic. Its value to investors has been grossly oversold; if you don’t realize that investors tend to be overconfident and routinely make poor timing decisions, then you haven’t been paying attention.

Far more relevant to investors is the empirical research on forecasting accuracy pioneered by psychologist Philip Tetlock, who discovered several things that investors should take to heart. First, humans are lousy forecasters, which reinforces the point about the futility of market timing and stock selection. Next, some forecasters are worse than others, particularly those he terms hedgehogs, which is another word for ideologues. The lesson here is to be especially suspicious of those who mix their politics with their investing strategy.

The media and financial punditocracy interact in a most toxic manner. If someone asks about future market direction, there is only one correct answer: How should I know? This response disqualifies one from appearing on CNBC or being quoted in USA Today. What those folks are looking for is attention-grabbing extreme predictions, either on the upside or on the downside. Which gets us to the last of Tetlock’s lessons: extreme forecasters (doomsters and boomsters) tend to be the poorest. Worst of all, frequent media invitations make pundits overconfident, and corrode their accuracy even more, which puts in motion a downward spiral of extreme forecasts, frequent media appearances, and worsening accuracy. Bottom line: if you must watch CNBC, do so with the sound off.

Finally, a truly depressing dynamic is taking hold in an ever richer world. Without getting too deeply into the macroeconomic weeds, as societies become wealthier, the amount of available investment capital grows faster than the amount of investing opportunities, and so the expected rate of return falls. In the beginning of human finance, ancient societies existed on the edge of subsistence, and so had little capital to spare. This drove interest rates as high as 30 percent.

Over the millennia, as societies have grown wealthier, the return on capital has fallen. For the past two decades, stock valuations have remained at near historical highs, with only brief forays into normally valued territory, and bond yields remain at historically low levels. If stocks are priced to produce a real expected return of 3.5 percent (a 2 percent dividend plus 1.5 percent of real dividend growth) and short-term bonds, a zero real return, this suggests that we can expect the long-term real return of a traditional balanced stock/bond portfolio to be quite low, in the range of 2 percent.

In addition, life expectancies are increasing; the typical retired couple has a pretty good chance of one spouse surviving into his or her mid-nineties. Hence, a big squeeze between low returns and a longer retirement to fund. There’s not much you can do about it besides living not just within your means, but well below your means, and abiding by the tenets of this book: keep costs down, keep an eye on the investment policy ball, and stay the course, come hell or high water.

Particular thanks go to Jonathan Clements, Robert Barker, Frank Armstrong, John Rekenthaler, David Wilkinson, Steve Dunn, Scott Burns, and the many others who have provided me with advice and countenance over the past few years. I’m deeply grateful to Susan Sharin, whose unique combination of money-management skills and financial knowledge proved invaluable. Finally, the greatest thanks go to my wife, Jane, without whose encouragement and editing support this book would not have been possible.

William J. Bernstein

Portland, OR            

August 2017             

Preface to the Hardcover Edition

On July 31, 1993, I came across an article in The Wall Street Journal (Your Money Matters series) which examined the performance of various asset allocations for the period 1973–92. The article was based on research done at the T. Rowe Price mutual fund group. The technique used was quite simple: imaginary portfolios were constructed from various combinations of