The Basics of Investing and Portfolio Theory

Efficient Frontier is aimed at investors who are familiar with the basics of finance and portofolio theory. For those who are not, and wish to pursue this area further, the following suggestions are offered:

Investing competence does not come without some sweat. Expect to put at least as much time, effort and intellectual energy into this task as you would for a difficult college course. Four basic areas must be mastered, in the following order:

A. You must acquire a working knowledge of the nature, returns, and risk of various asset classes.

B. You must then acquire an appreciation of how various assets behave in diversified portfolios. This is called portfolio theory. The central concept of portfolio theory is that of the "efficient frontier." This involves identifying the portfolio composition(s) that provide one with the maximum return for a given degree of risk (or alternatively, the least amount of risk for a given return).

C. You must then develop a coherent and well-defined personal strategy for the allocation of your assets among broad asset classes (i.e., foreign and domestic stocks and bonds, small versus large, growth versus value stocks, cash, real estate, precious metals, etc.).

D. Finally, you must implement this strategy through the proper choice of investment vehicles (individual stocks and bonds, mutual funds). Here are some simple portfolio illustrations. They are not intended as recommendations:

1. Stone simple: 50% S&P 500 (Vanguard index trust 500) and 50% bonds (Vanguard Bond Index Fund.)

2. Slightly more complex and diversified: 25% each S&P 500, bonds, small stocks (Vanguard small stock index), and foreign stocks (one third each Vanguard European, Pacific, and Emerging Markets Index funds).

3. Highly complex and diversified: A fixed mix of U.S. stocks, bonds, and foreign stocks from #2 above, plus foreign bonds, foreign small stocks, US small value stocks, REITs, precious metals, natural resources, utilities, junk bonds, etc.

The following bibliography provides a start towards accomplishing the above goals. These four books should be read in order:

1. A Random Walk Down Wall Street, Burton Malkiel, Norton Publ. (about $15 in paperback).

2. Asset Allocation, Roger Gibson, Business One Irwin (about $35).

3. Global Investing, Roger Ibbotson and Gary Brinson, McGraw Hill (about $40, also available through Ibbotson Associates).

4. Value Averaging, Michael Edleson, IPC ($22.95).

If your time and resources are limited, you can "get by" with the Gibson book alone. Unfortunately, this is also the driest and least well written of the four. The other three books are actually quite pleasant and interesting reads. There is alot of math in all four, which can be discouraging. Simply ignore what you do not understand. The remainder will reward you. An appreciation of the dangers of growth stocks is essential. A good start can be had from a pamphlet from the Tweedy Browne mutual fund group, What Has Worked in Investing. Those whose appetites have been whetted can proceed to The Intelligent Investor (Harper and Row) by Benjamin Graham. If you wish a lucid explanation of the mathematics of mean variance optimization, try Harrry Markowitz' Portfolio Selection.

Investment competence is a lifelong learning process. It helps to subscribe to some periodicals. I highly recommend The Wall Street Journal. This is a lot of reading, so pick and choose only what interests you. The first section is an excellent national newspaper, and the Your Money Matters weekly feature in the last section provides an excellent review of investment technique. Also, join the American Association of Individual Investors and get a free subscription to the AAII Journal, which is another valuable source of general investment info.

A few words are necessary concerning Lou Rukeyser's Wall Street Week, the most widely followed piece of financial media. To quote Bernard Baruch, "something that everyone knows isn't worth knowing." Studies show that your long term investment returns will be almost entirely dependent on your allocation of assets among broad asset categories. Mr. Rukeyser instead concentrates almost exclusively on stock picking and market timing. To the unsophisticated investor this may seem useful. In fact, however, long term success in the former is rare, in the latter nonexistent. It is mathematically impossible for the thirty million viewers of this show to beat the market, since they are the market. The same applies to Barrons, Forbes, Money, Kiplinger's, and all newsletters. It goes double for Dan Dorfman. (As an example, Forbes has a highly respected mutual fund ranking system. Unfortunately, academic analysis has shown that the future performance of its best rated "honor roll" funds is slightly less than average. To cite another remarkable example, a recent National Bureau of Economic Research working paper analyzed the performance of over 200 newsletters, and found that none reliably beat the market on a risk adjusted basis, although many underperformed it with astonishing regularity, including one which lost money at a 5% compounded rate for over 20 years. This is a remarkable accomplishment for the 1974-94 period.)

There is a wealth of inexpensive and powerful investment software available. For $99 per year Morningstar will provide you with quarterly updates of a program which will allow you to screen, sort, compare, rank, and display mutual funds using dozens of criteria. This program also provides a quick and easy way to follow the valuations of many foreign and domestic sectors, i.e, to determine what's cheap and what's overpriced. (This is accomplished by looking at the price/book and price/earnings ratios of the Vanguard Index, Dreyfus Wilshire Target, and DFA foreign and domestic small cap index funds.) For a few dollars more they will also sell you a program to do the same with individual stocks. Last, and most certainly least, is the web. It is difficult to comprehend how so much garbage has found its way into such a small corner of cyberspace. Do not waste your time. To be sure, there is a great wealth of data out there, but this is not of much use to the novice investor. One of the founding fathers of modern portfolio theory, William Sharpe, has both a fascinating homepage and a nearly impenetrable textbook in progress on the web. The only worthwhile educational piece I've found is Frank Armstrong's Investing for the 21st Century. This is a well written, highly entertaining, but somewhat superficial tour of basic finance, portfolio theory, and in particular the pitfalls of modern investing. It will reinforce what you get from the above sources.

Copyright © 1996, William J. Bernstein. All rights reserved.

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