Improving Portfolio Returns - Steps 3 & 4

On May 25^th, 2010 Dr. Paul Woolley of the London School of Economics laid out ten policies that he claims could increase annual returns (after inflation) by 25% and long term returns by at least 50%.  As promised we are taking a few weeks to cover these points in more details.  Dr. Woolley was addressing his steps to large institutional investors but we feel as if they are just as well suited for individuals. 

Step 3 – Understand that all tools now used to manage risk and return are based on the discredited theory of efficient markets.

In one sentence Dr. Woolley is telling you to throw out all the academic theory on investment management that has been taught to and is believed by the majority of finance professionals over the past four decades.  His only reason, which I find pretty appropriate, is that it doesn’t work. 

Modern Portfolio Theory (MPT), and its offshoot the Efficient Markets Hypothesis (EMH), may not ring a bell with you.  So let’s just take two items that you, your advisor or consultant has to believe in, in order to place the “science” of portfolio management over your own common sense.  MPT does not look at risk as a loss.  Instead, it is only concerned with how much your portfolio’s market value changes over time. Whether this is a portfolio that appreciates or declines are unimportant.  This measurement uses math to calculate and define risk as standard deviation or variance.   EMH wants you to believe that the current market price reflects all that is known about the future.  EMH also requires one additional belief; the past market returns, standard deviations and variance of the asset class returns relative to each other are the appropriate method used to measure future returns. 

If you believe that risk is a permanent loss of your investment dollars; if you believe that you cannot tell the future; And if you believe that sometimes your fellow investors react to their fear by selling cheaply or sometimes paying ridiculous prices for an investment then you know that using MPT and EMH to build your portfolio is not for you.

Step 4 – Adopt a stable benchmark such as growth of GDP plus a risk premium.

Why would you want to increase your bond holdings when they only pay 2%, and sell your bonds when they pay 10%?  Why would you sell your stocks when the companies are earning 10% on your investment, and buy stocks when they are earning less than 4% on your investment?  There is only a couple of reasons you would find yourself doing this.  Either you are letting your emotions make your decisions or you have decided that a fixed asset allocation based on something other than value is the correct way to manage your portfolio. 

A benchmark used by the majority of institutional investors is simply a targeted return that has its base in the relative performance of asset classes.  For you, mutual fund companies and in many cases your advisor has incorporated this benchmark approach.  A target date fund with a fixed percentage of your portfolio in stocks, bonds and cash based on your age is one example.  Your advisor may incorporate this by creating an “investment policy statement” allocating your portfolio over various asset classes with predetermined rebalancing dates.  For most of us, a benchmark to a set asset allocation is unimportant.  What is more likely is that our benchmark is liability driven.  These liability driven benchmarks are stated as goals, such as having enough money available to pay for a wedding or a college education.  For others it is an unknown quantity so an arbitrary benchmark is set, usually stated as a rate of return earned over a long period of time.  Most of us are pretty good at setting our benchmarks.  What we are not good at is keeping those benchmarks on the top of our minds when we make changes in our investment accounts. 

Next week:  Fees, Transparency and Hot Investments – Steps 5, 6 and 7.