 |
|
||||||||||
|
Modern Portfolio Theory for Dummies
When you combine different assets in a portfolio, you get the average returns from the different assets, but your risks (the variability of these returns) tend to cancel each other out, since one asset is likely to be up when another is down. Implications for Investors:
We use Monte Carlo simulations to develop well-tempered portfolios that can weather a variety of investment climates. Unless you practice extreme diversification, you are taking too much risk for the returns you are getting. Pseudo-diversification Imagine that you are fortunate enough to own a core Dimensional Fund portfolio like Dimensional Global Equity (DGEIX). At last count, this fund owned 13,194 stocks from domestic, foreign developed and emerging markets. Yet from our point of view, it is significantly underdiversified. How can this be? It is underdiversified because domestic, foreign and emerging market stocks are all highly correlated with each other. The intercorrelations all hover in the 0.80 range. Just because a portfolio has a bunch of pleasantly different-sounding names for its investments does not mean that it is diversified. Diversification is not a function of language -- it is a function of the actual behavior of the components of your portfolio You can always diversify a global equity portfolio by loading it up with bonds, but these also neutralize your performance. A better option is to raise the level of diversification to where you take maximum advantage of Modern Portfolio Theory. This means including carefully selected real estate investment trusts, commodities, utilities, regional banks, health care, consumer staple, and individual country stocks. Unless these are represented in your portfolio at beyond a market-weighted level, you are not getting the optimal return for the amount of risk you are taking. Even if you hold a DFA portfolio elsewhere, why not let Conservative Wealth Management LLC design a diversifying portfolio around it so that you can take full advantage of the portfolio diversification effects? Diversification is the only free lunch in financial economics -- it's a shame that so many smart investors settle for less than a full meal. Tactical Asset Allocation In addion to practicing extreme diversification, at Conservative Wealth Management LLC, our target core asset allocation is not static. We overweight asset classes that are undervalued relative both to their long-term fundamentals as well as to each other, while underweighting those that look pricier. Tactical asset allocation is Market Timing in practice....
|
|||||||||||
 |