Mark Hebner / Mary Brunson

IFA's Quote of the Week - 8 (Harry S. Truman)

 

"The only thing new in this world is the history you don't know."

 

- Harry S. Truman, 33rd President of the United States

 

 

The decision of how and where to invest your money is the key to long–term wealth accumulation. Only a good understanding of the long-term historical risk and return of various indexes will enable you to know how to allocate indexes in accordance you’re your risk capacity.

The importance of asset allocation cannot be overstated. A 1986 academic study conducted by Gary Brinson, among others, contends that more than 90% of a portfolio’s variability depends on the asset allocation, leaving less than 10% of a portfolio’s variability of returns to the fund manager.

So, the key to prudent investing involves first identifying the indexes that are available for investment. From there, you should extract from that universe the combination of indexes that provide the highest rate of return for the level of risk that matches your risk capacity.

This process of asset allocation is much easier when you understand that a big difference exists between track records of actively managed mutual funds and the historical returns of passively managed indexes.

The most obvious distinction is the difference in time periods, or to borrow a statistical term, the sample size. Statisticians will quickly remind you that the smaller the sample size, the more error there is in the information obtained from the sample.

Statisticians tell us that we need at least 20 years of historical risk and return data to determine luck over skill when it comes to fund manager performance. This quickly narrows the vast universe of fund manager data to the about 1,000 passively managed asset class indexes, eliminating active managers who do not have such a long-term track record.

Examining the historical risk and return data of indexes is a completely different exercise than examining the track records of specific active mutual funds. In sharp contrast to the unclear investment methods of active fund managers, indexes deploy a clear and consistent strategy, and they hold fast to that strategy over time.

The best index fund managers have identified the risk factors that generate higher stock market returns. They structure the rules of construction of those indexes for maximum exposure to those specific factors. This is the simple process of taking advantage of the fundamental relationship between risk and return.

Specifically, the groundbreaking discoveries achieved by Nobel-prize winning economists are the springboard for risk-appropriate asset class investing. A prudent asset allocation strategy  is the best way for you to implement the important risk diversification methodologies set forth by Markowitz, Sharpe and Miller — the fathers of Modern Portfolio Theory. Building on their important Nobel prize-winning research, Eugene Fama and Kenneth French, two renowned economists determined that more than 90% of stock market returns come from exposure to three specific risk factors: market, size and value.

The chart below illustrates the historical impact of size and value investing across global asset classes. This is the type of historical information that enables you to select a prudent asset allocation. In the chart, you see 80 years of history for U.S. Large and Small Capitalization Stocks, 25 years of history for Non-U.S. Developed Markets and 18 years for Emerging Markets. Across each asset class represented here, you see that small and value carry increased risk and return characteristics for each time period shown. Fama and French’s discovery of the significant increase in risk and return for small and value enables you to isolate those specific risk factors in specific indexes to achieve higher expected returns that are commensurate with your risk capacity.