4A portfolio should address all three of these areas.
But there are a lot of challenges facing investors, when you design a plan,including stock market volatility5
Wall Street and the financial media are another challenge.They can sometimes turn investing into entertainment6
That is why it is so important to focus on what really matters—your financialand life goals
A good plan should be designed around an investor’s financial AND lifegoals—and as this chart shows, these goals can cover a wide variety of areas.8
Once you understand what is important to you as an investor, then you canstart to build an appropriate portfolio with your financial advisor.
Like the story of the three little pigs—you don’t want a straw portfolio built withwhatever investments are “Hot” right now in the financial media.10
Nor do you want a “wood” portfolio which is just a collection of investmentswhich may not work well together and don’t necessarily reflect your uniquegoals and needs.11
Portfolios should be built with investments that provide proper diversification,work well together and reflect the right balance or risk and potential reward foreach investor’s chosen level of risk and time horizon.12
And we believe that science and academic research are critical to building aprudent portfolio. Great thinkers and economists such as Adam Smith,Frederich Hayek, Paul Samuelson, Merton Miller, Bill Sharpe, DanielKahneman and of course Harry Markowitz have provided us with powerfulinsights into how portfolios should be constructed.13
When it comes to portfolio construction, we believe investors have three keydecisions they need to make. Read slide.14
From the smartphone in your pocket to the department store where you buyyour clothes, many companies that are a big part of our lives are publiccompanies that are listed for trading on a major stock exchange. Not all ofthem are big with well-known brand names and not all will be successful long-term.However, one of the best opportunities to grow your money over the long-termcan come from making an investment in capitalism and the stock market.This chart is a good illustration of the long-term growth of US businesses overthe past eighty years.15
To be an effective “shock absorber,” the portfolio should contain:• Bonds with shorter maturities that have lower correlations historically tostocks. This means the bond typically has a 3 to 5 year “lifespan” and does notgo up and down in value at the same time or to the same extent as stocks.Generally, longer maturity bonds entail more risk• Higher-quality bonds that can help dampen portfolio volatility and lower therisk of a default.The chart illustrates the risk and reward to portfolios from fixed incomeholdings. Of note is the lower volatility of short-term bonds that you can seerepresented by the standard deviation number (how much the portfolio goesup or down in a year). Note also that investors are typically not properlycompensated for the additional risk of longer-term bonds.16
Now that you understand about not putting all of your eggs in one basket, byinvesting in both stocks and short-term bonds it just makes sense to applydiversification to the global markets. Today, more than 56% of the total marketcapitalization is outside of the US markets!17
This slide depicts the world not according to land mass, but by the size of eachcountry’s stock market relative to the world’s total market .Population, gross domestic product, exports, and other economic measuresmay influence where people invest. But the map offers a different way to viewthe universe of equity investment opportunities. If markets are efficient, globalcapital will migrate to destinations that offer the most attractive risk-adjustedexpected returns. Therefore, the relative size and growth of markets may helpin assessing the political, economic, and financial forces at work in countries.The slide brings into sharp relief the investible opportunity of each countryrelative to the world. It avoids distortions that may be created or implied byattention to economic or fundamental statistics, such as population,consumption, trade balances, or GDP.By focusing on an investment metric rather than on economic reports, thechart further reinforces the need for a disciplined, strategic approach to globalasset allocation. Of course, the investment world is in motion, and theseproportions will change over time as capital flows to markets that offer themost attractive returns.18
While the US outperformed almost all other countries in 2012, the long termpicture still points to a need for international diversification, with the US comingin 39th out of 45 countries in terms of 10-year stock market returns.19
This is why we build asset class portfolios that typically contain over 9,000companies in 45 countries, representing 36 currencies.While we love the great U.S companies, the science suggests that investing inthousands of stocks globally rather than a few can help mitigate the overall riskof the portfolio and may increase your return.The reason is simple: if you own a lot of companies around the world you willeliminate the “company specific risk” that comes when your portfolio isexposed to a reversal that may affect one company or one sector or even onecountry.Capitalism and creation of wealth is a worldwide phenomena and the countrieswith the highest — and lowest returns — change year by year.International stocks can be riskier than U.S. stocks and are subject to a varietyof additional risks, including currency and political risks. That is why investorsmust carefully decide how they will allocate the equity portion of their portfoliobetween U.S. and international stocks.20
21When you consider all you want to achieve in life — today, tomorrow and formany years to come — how hard does your money have to work to help youget there?We intuitively understand that when a risk is unrewarded, it is rarely worthtaking, just as we know that we are seldom compensated for taking nochances at all. “Nothing ventured, nothing gained” as the old saying goes.Investing involves risks regardless of what you invest in.In 1992, academic research by Professors Ken French and Eugene Fama Sr.,identifying two equity risk factors — small companies and value companies —that investors should expect to be compensated for. As an investor, you needto decide how much of these risks you are willing to take. As the chart shows,the greater the risk exposure, the greater the expected long-term return
The size and BtM – or value -- effects appear in both US and internationalmarkets—strong evidence that the risk factors are systematic across theglobe.This chart demonstrates the higher expected returns offered by small capstocks and value (high-BtM) stocks in the US, non-US developed, andemerging markets. Note that the international and emerging markets data isfor a shorter time frame.Small cap stocks are considered riskier than large cap stocks, and valuestocks (as defined by a higher book-to-market ratio) are deemed riskier thangrowth stocks. We believe these higher returns reflect compensation forbearing higher risk.22
This is some of the key academic research we draw upon to help us buildportfolios23
This is some of the key academic research we draw upon to help us buildportfolios24
This is some of the key academic research we draw upon to help us buildportfolios25
This is some of the key academic research we draw upon to help us buildportfolios26
To be a successful investor you need discipline and structure — and ongoingeducation — to manage THROUGH markets rather than TO markets.You don’t want to “guess” when it comes to investing to meet your life goals.And don’t let emotions derail your best laid plans
Rebalancing is an important step that many people neglect when they try tomanage their own investments. Without rebalancing, portfolios can drift as themarkets change. This drifts can add extra risk to your plan that you neverintended or expected.28
As you can see from this chart, the annually rebalanced portfolio washistorically less volatile over the last twenty years. It may not have soared asmuch during bull markets, but it didn’t decline as much during bear markets.And overall, it offered slightly better performance with less risk than the driftingportfolio.29
30Investing can be an emotional roller coaster. In this age of the “24-hour newscycle” it is easy to forget the role that maintaining our investment portfolios canplay in achieving our long-term goals.As the illustration shows, at the moment of greatest potential risk, many wantto invest even more money. And at the moment of greatest potentialopportunity, many are tempted to sell. It can be difficult to stay focused on thelong-term when the short-term consumes our thoughts and emotions.
31Just to show you how investors can sabotage their returns when they don’ttake a long-term perspective, consider this chart which shows that over thelast twenty years, the average investor did substantially worse than majorindices.Why the big difference? Some investors might think they know when to buyand sell. But this means they have to be right twice: picking the right time tobuy and the right time to sell. That is a pretty tall order!Other investors might give in to panic or even greed and make hasty,emotional decisions.Whatever the reason, the results as a whole are shocking. The average equityinvestor in the study above underperformed the S&P 500 by almost 4% eachand every year. A gap that large can have a real impact over time on aninvestor’s long-term goals – even quality of life.
Your future is too important to play games with and take unnecessary chances. Wedon’t believe you should gamble by trying to time markets or pick winning managers.32
Beating the S&P 500 isn’t easy. Of the 862 U.S. Equity Funds from 1998 –2007, only 420, or less than half managed to beat the S&P 500. So you mightthink, just invest in one of those winning managers, and you’ll do fine.33
But 5 years on, in 2012, 248 funds (almost 30%) have closed their doors,merging or going out of business.34
And—five years later--of the original 420 funds that outperformed, 70% failedto sustain their performance or closed their doors.And a few of the underperformers even managed to beat the S&P 500. Butthere is no predictable pattern to any of this performance up or down. Nothingthat we believe offers a sound guide to which manager to invest with for thefuture.35