Nobel laureate Milton Friedman is generally credited with stating, “There’s no such thing as a free lunch.” Actually, if you know what you are doing, you can get a free lunch in investing. Unfortunately, most investors get stuck with very expensive meals.
Diversification is a free lunch
Diversification is a free lunch. It basically refers to the concept of not putting all your eggs in the same basket.
There are major benefits of holding a diversified portfolio. Obtaining these benefits costs you nothing. Author and blogger Mike Piper recently explained the benefits of diversification. He correctly explained the likely returns from a basket of only five stocks are extremely unpredictable. That’s because of what is known as “idiosyncratic risk,” meaning risks unique to a particular stock.
Lots can go wrong when you hold just a few stocks. Common examples include embezzlement, natural disasters and expropriation.
You can mitigate idiosyncratic risk through diversification. In addition, you gain a level of predictability regarding returns. As Piper notes, your returns are unlikely to be either spectacularly high or spectacularly low, which is a prudent way to structure a long-term portfolio.
The cost of putting together a diversified portfolio is low and getting lower. Fidelity and Vanguard are currently engaged in a price war. Fees on low-cost index funds and exchange-traded funds (ETFs) have never been lower. The average net expense ratio of Fidelity’s index funds is now only 0.102 percent. Fees on its ETFs are even lower. They are now 0.084 percent, which are currently the lowest in the market.
It has never been easier to own a globally diversified portfolio of low-cost index funds or ETFs in an allocation suitable for you. This is a free lunch. You owe it to yourself and your loved ones to take advantage of it.
A laddered bond portfolio can be a free lunch
Most investors would be better served by owning bonds in a low-cost, high-quality, short- or intermediate-term bond index fund. However, for investors with $1 million or more to invest in bonds, a properly structured laddered bond portfolio can be a free lunch.
My colleague, Larry Swedroe, set forth the requirements for putting together a laddered bond portfolio in this blog. He noted that it’s possible to assemble a bond portfolio with higher-quality bonds (and therefore less risk) than comparable bond funds, at a lower cost. It is also possible to purchase FDIC-insured CDs (which mutual funds cannot purchase) with higher yields than comparable Treasury bonds but no greater risk (since both are backed by the full faith and credit of the U.S. government).
Investors who don’t have large bond portfolios can take advantage of this disparity by buying these CDs instead of Treasuries. Obtaining higher yields with no greater risk is the essence of a free lunch.
Sticking to your investment plan is a free lunch
The precipitous drop in the markets, followed by a rapid recovery, after the Brexit vote was announced illustrates why so many investors don’t take advantage of another free lunch.
When there is a crisis in the market, the financial media often turns to “experts” to explain to the rest of us “what is going on.” Their opinions often vary widely, contributing to investor anxiety.
One economist declared that Brexit would have no lasting impact on the market. Historian Antony Beevor disagreed, noting ominously that “the danger is that Britain suddenly pulling out of the European Union at such a moment of crisis … could pull the whole thing down.”
Investors who panicked suffered meaningful losses when the market recovered.
Investors who have an investment plan in place pay little attention to market gyrations. They understand stocks go through negative periods. Their asset allocation permits them to weather the storm. They stay focused on their long-term goals. They understand that market prices are set by millions of traders viewing publicly available information every minute of every day. The possibility of any “expert” uncovering something missed by the collective wisdom of these traders is highly unlikely.
The ultimate free lunch is ignoring much of the financial media and staying focused and disciplined. It costs you nothing. The benefits in higher expected returns are significant.
This commentary originally appeared July 12 on HuffingtonPost.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
Two of the most powerful explanatory factors in finance are value and momentum. Research on both has been published for more than 20 years. However, it was not until recently that the two have been studied in combination and across markets.
The study “Value and Momentum Everywhere” by Clifford Asness, Tobias Moskowitz and Lasse Pedersen, which appeared in the June 2013 issue of The Journal of Finance, examined the value and momentum factors across eight markets and asset classes (individual stocks in the United States, the U.K., continental Europe and Japan, as well as country equity index futures, government bonds, currencies and commodity futures). Following is a summary of their findings:
There are significant return premiums to value and momentum in every asset class. The value premium was persistent in every stock market, with the strongest performance in Japan. The momentum premium was also positive in every market, especially in Europe, although statistically insignificant in Japan.
Value strategies are positively correlated with other value strategies across otherwise-unrelated markets. Momentum strategies are positively correlated with other momentum strategies globally. This persistence assuages data-mining concerns.
Value and momentum are negatively correlated with each other within and across asset classes. The negative correlation between value and momentum within each asset class is consistent and averages -0.49. For stocks alone, the correlation averaged -0.60. Value and momentum’s negative correlation and high positive expected returns implies that a simple combination of the two is much closer to the efficient frontier than either strategy alone. Combining value and momentum strategies results in improved Sharpe ratios.
There’s significant evidence that liquidity risk is negatively related to value and positively related to momentum globally across asset classes. The implication in this case is that part of the negative correlation between value and momentum is driven by opposite-signed exposure to liquidity risk. However, liquidity risk can only explain a small fraction of the value and momentum return premiums and co-movement.
The authors offered this explanation for why momentum loads positively on liquidity risk and value loads negatively: “A simple and natural story might be that momentum represents the most popular trades, as investors chase returns and flock to the assets whose prices appreciated most recently. Value, on the other hand, represents a contrarian view. When a liquidity shock occurs, investors engaged in liquidating sell-offs (due to cash needs and risk management) will put more price pressure on the most popular and crowded trades, such as high momentum securities, as everyone runs for the exit at the same time, while the less crowded contrarian/value trades will be less affected.”
More Evidence
We now have a second paper examining the two factors together. Victor Haghani and Richard Dewey, authors of “A Case Study for Using Value and Momentum at the Asset Class Level,” which appears in the Spring 2016 issue of The Journal of Portfolio Management, also found that combining the value and momentum factors can offer both higher expected returns and lower risk than when they are used independently.
The authors explain that the benefit comes primarily from value and momentum’s tendency to operate over different time horizons. They write: “The negative correlation arises from value investing’s reliance on reversion to fair value (i.e., negative autocorrelation), while momentum investing is predicated on divergence from the mean (i.e., positive autocorrelation). Often, momentum acts as a check on value, discouraging an investor from buying before a bottom or selling before a peak.”
Their study covered the period 1975 through 2013, and included data from the following 12 asset classes: U.S. equities, U.K. equities, Europe ex-U.K. equities, Japan equities, Pacific ex-Japan equities, Canada equities, emerging market equities, U.S. REITs, commodities (as represented by the GCSI), U.S. nominal Treasurys, U.S. investment-grade credit and 90-day Treasury bills. Importantly, all the preceding asset classes are liquid and can be accessed with low-cost vehicles. Unlike much research, the authors built long-only a portfolio, which forced them to choose “fair value” centering points for their valuation signal.
They note: “Intuitively, these centering points should be thought of as asset valuations that provide fair compensation for bearing the risk associated with a specific asset class.” At the end of each month, Haghani and Dewey derive valuation signals for each asset class. If the signal was above (below) that centering point, signaling undervaluation (overvaluation), they increased (decreased) the allocation relative to its baseline weight in the subsequent month, and vice versa.
The authors explained: “There is no consensus in the literature or by practitioners on the ideal metric or level for measuring valuation in each asset class. In deriving our centering points, we attempted to balance common sense practitioner metrics with the findings in the asset-pricing literature. In an effort to reduce bias, we tried to select these centering points ex-ante and did not change or optimize them at any point in the research.”
Different Portfolio Construction Approaches
Haghani and Dewey constructed four portfolios at the end of each month: baseline (no adjustment), value, momentum and value plus momentum. Rather than give equal weight to each asset class, they followed approximately a 65%/35% (equities/bonds) portfolio construction method. They also constructed a portfolio that gave equal weight to each asset class: 20% equities, 20% real estate, 20% commodities, 20% bonds and 20% T-bills.
The following represents a basic summary of their construction methodology. For their baseline portfolio, they rebalanced at the end of each month. For valuation measures, they scaled exposure by the asset’s valuation, giving higher weight to the cheaper assets. And they increased an asset’s weight by half if the momentum signal was positive, and decreased the weight by half if it was negative (then repeated the process monthly).
Following is a summary of the authors’ findings:
Valuation-based scaling of asset allocations produces a return that exceeds a static-weight portfolio by 0.86% per annum.
Momentum-based scaling of asset allocations produces a return that exceeds a static-weight portfolio by 1.55% per annum, almost twice as large as the benefit from scaling value.
The combination of these two portfolio adjustments produces a return that exceeds the static-weight portfolio by 2.66% per annum.
The dynamically scaled portfolios also produce higher Sharpe ratios and reduce risk as measured by maximum drawdowns.
There was no asset class for which value and momentum scaling together diminished returns.
The outperformance was particularly high in bear markets, at 6.51% per annum.
Correlations between value and momentum were negative in every case, with the exception of Japanese equities, demonstrating that value and momentum are complementary in portfolios.
Additional Observations
Haghani and Dewey observed that their portfolios didn’t employ leverage (explicitly or implicitly through the use of futures or derivatives); didn’t take short positions; and didn’t allow for the significant concentration of risk in a small subset of the asset classes. This makes their results very relevant for the practitioner, who often faces similar restrictions.
They also noted that when they extended their study back to 1926, using a more limited set of assets, the results were consistent. And finally, while their study ignored transaction costs, turnover was not high enough to significantly impact the results, especially since, as mentioned above, all the investments they examined can be made in low-cost, highly liquid vehicles.
The annual turnover for the baseline portfolio was roughly 15%, arising from the monthly rebalancing back to fixed weights. Turnover for the baseline-plus-value portfolio was roughly 70%, and turnover for the baseline-plus-value-plus-momentum portfolio was just more than 100% per annum.
Haghani and Dewey concluded: “Using simple measures of valuation and momentum to dynamically adjust asset allocation has historically produced superior investment returns compared to a more static investment strategy…. We find that a strategy employing value and momentum together provides higher quality returns than using either value or momentum alone. This can be attributed to negative correlation and the general complementary nature of value and momentum.”
Increasingly, we see mutual funds, such as those from AQR and Bridgeway, combining the two factors in one fund strategy. (Full disclosure: My firm, Buckingham, recommends AQR and Bridgeway funds in constructing client portfolios.)
This commentary originally appeared July 18 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
Do you have a generally positive or negative impression of the word “retirement”?
I ask because it dovetails nicely with a series of questions (inspired by Rick Kahler) that I use to begin most speaking engagements. These questions are designed to incite self-awareness, offering us clues about how our life experiences have shaped the (often unarticulated but powerful) beliefs that unavoidably influence the decisions we make with and for money.
Regardless of an audience’s homogeneity, their responses are consistently inconsistent. I have, however, seen some generational persistency on the topic of retirement. For example, on average, baby boomers have a generally positive view of retirement—no doubt shaped in part by the incessant financial services commercials that promise a utopian post-career existence with beaches, sailboats, golf and an unlimited supply of vintage Pinot Noir.
On the other hand, the finance and accounting students that I had the privilege of teaching at Towson University—almost all members of the Millennial generation—had a generally negative view of the notion of retirement. This is for two prominent reasons:
A. They pictured hot, humid, early buffet dinners in rural Florida.
B. They don’t think that the American dream of retirement is available to them.
Interestingly, according to a new study from AARP’s Life Reimagined focusing on full-time workers 35 and older, this generational pessimism is now creeping up the age ladder to Generation X and baby boomers as well. AARP reports that “while 87% of those surveyed who are working full time say they want to retire someday with nearly 70% of those hoping to retire by 65, just over half don’t expect to retire by 65 or at any age.”
Sheesh. Can I get a ho-hum?
It deserves mentioning that the working set 35 and older does appear to accurately assess their retirement readiness. Corroborating common perception with reality, the National Retirement Risk Index (NRRI) estimates that “52% of households are ‘at risk’ of not having enough to maintain their living standards in retirement.”
Old news, right? But what interests me a great deal more is the following finding in the AARP’s survey: “Although this group acknowledges that they will be working longer, fewer than one in five people across the Gen Xer and Boomer demographics say the thing that motivates them to get up in the morning is going to a job that fulfills them.”
So, more than 80% of the workforce over the age of 34 doesn’t like their work? No wonder they’re so stricken by this distressing conundrum: They desperately want to retire but can’t stand the only vehicle likely to help them reach their destination.
We must acknowledge that our views of retirement and work are inextricably intertwined.
It’s a vicious circle: If you don’t like your work, you’re likely to overvalue retirement. But if you undervalue you’re work, it’s logical to assume your performance will be less than optimal and, therefore, that your wages—your retirement savings engine—will be suppressed.
But there’s a virtuous circle to counter: If you love your work, it’s likely that you undervalue retirement. But ironically, because you love your work, it’s logical to assume your lifetime performance is improved and your lifetime earnings (and savings potential) are increased, better preparing you for retirement.
Yeah, but it’s unrealistic to think that everyone can have their dream job! This is absolutely true, but that doesn’t mean we can’t purposefully and intentionally move toward it, shifting in the direction of a more virtuous cycle.
Or, in the words of career guru Jon Acuff, “Please don’t tell me you’re too busy to look for a new job and then show me your perfectly detailed fantasy football team.… Please don’t tell me you’re too busy to update your resume and then update your social media accounts incessantly.”
And most fascinatingly, the AARP study seems to help point us in the direction of a more fulfilling career: “If money was not a factor, most would volunteer or donate to a cause and travel the world.… The most popular types of ideal jobs for those who would switch are doing something that helps or teaches others and doing something creative or artistic.”
You probably don’t have the same talents that will likely launch 12-year-old Grace VanderWaal into a lifetime of fulfilling work (I still can’t watch this without choking up). But I’d be willing to bet that you could do something to move one step, small or large, in the direction of more fulfilling work, which will likely help you make and save more money over your lifetime while reducing any desperation you might feel about the need to retire.
To help you make the most of this article, please consider these two questions:
1. Is yours a vicious or virtuous work/retirement circle?
2. What is the next action you’ll take to move in the right direction?
This commentary originally appeared July 23 on Forbes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE