Intelligent investing strives to maximize the probability of return for an acceptable level of risk. Today, this concept is identified as Modern Portfolio Theory (MPT). MPT is the bedrock to our approach when investing our client’s assets. This theory explains that capital markets work efficiently and provide a positive investment return to investors.
Consequently, a portfolio should be designed to hold a range of asset classes that represent the market rather than an isolated number of stocks and bonds. Asset classes are different categories, or strata, of the investable market. All investments in an asset class have a similar risk and return profile.
Portfolio construction is the process of grouping these asset classes into an investment portfolio in a particular manner such that volatility is reduced while returns are not, or at least not reduced commensurately.
So the first question for investors is not which individual stocks, bonds, or mutual funds to purchase, but which asset classes should be held in the portfolio and how their investment dollars should be allocated across those asset classes. Once that question is answered, specific securities can be purchased to occupy each asset class.
Our Three Principles
Principal 1: Increase allocation to value and small cap companies.
When selecting asset classes, we begin with a portfolio that represents the market as a whole. This portfolio will hold most types of assets classes, such as large cap, small cap, growth companies, value companies, domestic companies, international companies, real estate, commodities, and emerging markets, to name a few. However, academic research has shown that two types of classes offer investors a greater return over time:
a. Value Companies: Companies with a high book-to-market ratio. The book-to-market ratio is the net asset value on a company’s balance sheet divided by the market share of the company stock:
Book-to-Market Ratio = Net Book Value (Actual Accounting Value)
Market Value (Shares Outstanding x Share Price)
Companies with a ratio greater than one are potentially undervalued, whereas companies with a ratio less than one are potentially overvalued. Research has shown that over time value companies (those with a high book-to-market ratio) will provide a higher return than growth companies (those with a low book-to-market ratio). Consequently, we weight our client’s portfolios with a higher allocation to value companies.
b. Small Companies: Companies with market capitalization of less than one billion dollars. Market capitalization is equal to the number of shares outstanding multiplied by the share price. Most small cap companies are not known to the general public. Research has shown that over time, small companies will provide a higher return than large companies. Consequently, we weight our client’s portfolios with a higher allocation to small companies.
Principal 2: Investor behavior determines the majority of returns over time
Modern Portfolio Theory assumes investors will always act rationally to maximize the probability of returns. However, the study of behavior in financial decision-making has shown that investors more often than not act emotionally rather than rationally. Specifically, investors make irrational decisions due to the following biases:
a. Anchoring Bias: Investors peg, or anchor, their expectations of the future to some reference point from the past even though that reference point may not have relevance today. For example, investors commonly want to wait to sell a depressed stock until it reaches a prior 52-week high. The problem is, it may never reach it, or at least not for a long time.
b. Confirmation Bias: Investors have preconceived opinions and want to look for reasons to support those opinions rather than healthy questioning. For example, an investor is enamored with Google stock because they love Google and think it’s going to own the world someday. The investor looks only for reasons to confirm this thinking, regardless of what is actually happening to Google.
c. Hindsight Bias: Investors believe that some past event and its timing were predictable, whereas in reality it was completely unpredictable. For example, in hindsight we feel we should have foreseen the collapse of the real estate bubble. The truth is that although some of us felt it was inflated, no one knew how over inflated it was or when it would burst.
d. Herd Behavior Bias: Investors tend to mimic the actions of the majority, such as the investment frenzy in the dot coms in the late 90s.
e. Overconfidence Bias: Investors tend to overestimate their ability to choose stocks and time the market, leading them to trade more, incur greater expenses, and receive a lower return. Investors have a selective memory and tend to forget their mistakes (and they certainly don’t disclose those mistakes to their friends).
Principal 3: Investors should spend more time on what they control
Our investment philosophy encourages us to focus less on what we don’t control, like the market trends, and focus more on what we can control, risk management, tax planning, and investment expenses.