As you add more strategies, investment styles, asset classes, or differing methods for selecting securities, their impact on the portfolio declines. You, in effect, diversify away the potential risk associated with each. The portfolio becomes more like an index fund and the return should mirror the market return. Such mirroring of the market is what the efficient market hypothesis suggests will happen as you construct a well-diversified portfolio. Your return primarily depends on the portfolio’s asset allocation and not on your methods for selecting individual assets.
As is discussed in several places in this text, some individuals believe that financial markets are not efficient. For example, it has been suggested that the recent occur- rence of “bubbles” is proof that the markets are not efficient. The dot-com craze of the 2000s and its subsequent collapse and the large increase in housing values during the mid 2000s followed by declining home values, mortgage defaults, and foreclosures are often given as illustrations of bubbles. Some analysts suggest that the existence of these bubbles and the large swings in securities prices are indication that financial markets are not efficient.
The essence of the argument that bubbles invalidate the efficient market hypoth- esis rests on the following points: The efficient market hypothesis is built on the con- cepts that investors are rational and that prices are the result of investors correctly processing current information and discounting future cash flows. The assertion that
the existence of price bubbles proves markets are inefficient is based on the premise that participants are acting irrationally and prices could not be the result of dis- counting cash flows.
There is no denying that there have been periods of extreme changes in secu- rity prices. Individuals can act irrationally. A “herd” instinct certainly influences individuals who fear they will be left behind and appear to act irrationally. In some cases they bid up prices. (See, for instance, the extreme run up in the prices of Bos- ton Chicken, Ariba, and Ask Jeeves in the section on IPOs in Chapter 2.) Prices have also dramatically fallen. For example, the Dow Jones Industrial Average declined from 14,280 in 2007 to 6,440 in March 2009, a decline in excess of 50 percent.
That suggests the typical stock portfolio lost about half its value. While proponents of inefficiency offer these periods as evidence of market inefficiency, supporters of efficiency reply that such volatility is what would occur in an efficient market when there is much uncertainty.
Even if financial markets are not always efficient, an important implication of the efficient market hypothesis remains. Investors cannot expect to outperform the market on a risk-adjusted basis consistently. Here is a fundamental question: Who is respon- sible for verifying the assertion that financial markets are not efficient? Do you think that proponents of efficiency need to prove that it exists or do you think that the pro- ponents of inefficiency should verify that financial markets are not efficient and that it is possible to outperform the market on a consistent basis?
Even believers in inefficient markets admit that it is difficult to beat the market.
For instance, Robert A. Haugen emphatically believes that a value strategy produces superior results but admits that “it’s hard to beat the market because there is a gale of unpredictable price-driven volatility . . .” (See Robert A. Haugen, The Inefficient Stock Market, 2nd ed., Upper Saddle River, NJ: Prentice Hall, 2002, p. 134.) Andrew W.
Lo and Jasmina Hasanhodzic interviewed several successful investors who use techni- cal analysis in The Heretics of Finance (New York: Bloomberg Press, 2009). Most of the individuals “agreed their practice of technical analysis is based on intuition 10 to 50 percent of the time” (p. xix) and “The most successful . . . are those, who through experience, have gained perceptive insight into how the economy and the markets func- tion” (p. xx). Based on these quotes, you might ask yourself: Do I have that “intuition,”
“experience,” or “perceptive insight”? Do I have the time, motivation, and perseverance to develop them?
If the answer is no, then perhaps you should consider learning more about yourself and steps you may take to increase the probability of making fewer investment errors.
Two possible places to start are John Nofsinger’s The Psychology of Investing, 4th ed.
(Upper Saddle River, NJ: Prentice Hall, 2011) or Richard Lehman’s Far From Random (New York: Bloomberg Press, 2009). It is naive to believe that your investment decisions will be independent of your personal biases and tendencies. Understanding yourself may help you avoid mistakes and make better investment decisions in either an efficient or inefficient financial market.
The question of market efficiency will in all likelihood not be answered, but your belief in the degree of market efficiency affects your approach to investing. The stron- ger the belief in inefficiency, the stronger is the argument for active portfolio man- agement. The existence of anomalies offers hope; the ego of some investors and the
excitement associated with investing suggest that some individuals will follow an active trading strategy.
For other investors, however, exceptions to market efficiency may be a diversion.
If anomalies are of little use, a passive strategy built around well-diversified mutual funds or exchange-traded funds may be more appropriate. Minimal turnover reduces commission costs, and the fewer realized gains reduce the investor’s capital gains tax obligations. For the investor who is convinced that financial markets are sufficiently efficient, such a strategy may be the best means to achieve his or her financial goals.
Why, then, is there so much emphasis on those investors who do appear to beat the market? Part of the answer rests with the distribution of returns. Figure 20.1 illustrates portfolio returns for a time horizon, such as a year. The mean (15 percent) represents the return on the market. Individual returns are both above and below the market.
The figure indicates that some investors and portfolio managers did beat the market.
There were, of course, some investors and portfolio managers who underperformed the market.
The positive tail clearly suggests that some investors must outperform the market during a specified time period. If a portfolio manager does outperform the market, that information is disseminated. Money flows into funds that do well, and a portfolio manager’s compensation is often tied both to performance and to the amount of assets under management. Obviously, it is beneficial for portfolio managers and money man- agement firms to capitalize on their success.
figure 20.1
Frequency of Occurrence of Portfolio Returns Over One Year
5 10 15 20 25 %
Frequency of Occurrence of Portfolio Returns
One-Year Period
Source: © Cengage Learning
The answer is also related to the financial press. Portfolio managers who do excep- tionally well often receive publicity and are touted in the popular press. Articles appear in Money or Forbes. The fund managers may be interviewed on talk shows, and the funds they manage receive “five stars.” In a few cases, the portfolio managers develop superstar status. Underperforming portfolio managers, of course, do not receive this kind of publicity.
Although Figure 20.1 presents a distribution for one period, Figure 20.2 adds a distribution for a longer time horizon. During a short period, several investors and portfolio managers do exceptionally well as is illustrated by the flatter distribution, but over longer periods of time, their numbers diminish. The distribution becomes nar- rower and taller and indicates that more investors earn returns that mirror the markets in which they invested and fewer earn exceptional returns. The positive tail, however, remains. A few, exceptional investors earn higher returns. Perhaps their existence gives false hope to the vast investing public, but these investors and portfolio managers may have exceptional skills that are not transferable to the ordinary investor.
The typical investor, however, should take the concept of efficient financial markets seriously. Instead of trying to emulate the few who have done exceptionally well, most individuals should devote time to developing their financial objectives and construct- ing well-diversified portfolios that meet those objectives. Correspondingly, they should spend less time trying to beat the financial markets and not follow the day’s investment fad or hot mutual fund.
figure 20.2
Frequency of Occurrence of Portfolio Returns Over Five Years
5 10 15 20 25 %
Frequency of Occurrence of Portfolio Returns
One-Year Period Five-Year Period
Source: © Cengage Learning
A large proportion of the material covered in this text can aid in this process of financial planning and investment management even if the information cannot pro- duce superior investment results. This text has described the features of alternative investments, explained factors that affect securities prices, and illustrated many of the analytical tools portfolio managers use to select securities. The text has also argued for the construction of diversified portfolios to reduce the unsystematic risk associated with a specific asset. It is through this construction of well-diversified portfolios and patiently waiting for compounding to work its magic that individuals achieve their financial goals.
Vanessa Avoletta is a very successful self-employed freelance writer of romantic novels. She has a repu- tation for writing rapidly and is able to complete at least four books a year, which net after expenses
$25,000 to $50,000 per book per year. With this much income, Avoletta is concerned with both shel- tering income from taxes and planning for retire- ment. Currently she is 40 years old, is divorced, and has a child who is entering high school. Avoletta anticipates sending the child to a quality college to pursue a degree in computer sciences.
While Avoletta is intelligent and well in- formed, she knows very little about finance and investments other than general background mate- rial she has used in her novels. Since she does not plan to write prolifically into the indefinite future, she has decided to obtain your help in financial planning.
At your first meeting, you suggested that Avo- letta establish a tax-sheltered retirement plan and consider making a gift to her child, perhaps in the form of future royalties from a book in prog- ress. Both of these ideas intrigued Avoletta, who thought that funds were saved, invested to accu- mulate over time, and then transferred to heirs after death. While Avoletta wanted to pursue both ideas, she thought approaching one at a time made more sense and decided to work on the retirement plan first. She asked you for several alternative courses of action, and you offered the following possibilities.
1. An IRA with a bank with the funds deposited in a variable-rate account.
2. A self-directed Keogh account with a major brokerage firm.
3. A Keogh account with a major mutual fund.
4. An account with a brokerage firm to accumu- late common stocks with substantial growth potential but little current income.
Avoletta could not immediately grasp the im- plications of these alternatives and asked you to clarify several points:
1. What assets would be owned under each alternative?
2. What are the current and future tax obliga- tions associated with each choice?
3. What amount of control would she have over the assets in the accounts?
4. How much personal supervision would be required?
How would you reply to each question? Which course(s) of action would you suggest that she pursue?
Finally, how would each of the following alter your advice?
1. Avoletta has a record of poor health.
2. Avoletta would like to write less and perhaps teach creative writing at a local college.
3. Avoletta has expensive tastes and finds saving to be difficult.
Goals and Portfolio Selection
The Financial Advisor’s Investment Case
The Financial Advisor’s Investment Case
Goals and Asset Allocation
You have new clients, Erik and Senta Bruckner. They are in their mid-30s and have two children, Stella and Chloe, ages 6 and 8. The Bruckners’ primary financial objective is to provide for their children’s college education. Their secondary objective is to plan for retirement. They own a home with a mort- gage and have total family income of $100,000.
Senta’s employer provides medical insurance and life insurance. She participates in her employer’s 401(k) retirement plan and currently has $40,000 in the plan. The funds are invested in her company’s stock.
Erik is self-employed and works from their home.
He has not established a retirement plan. After deducting the amount of the mortgage, the family has total assets of $200,000 available for investing in addition to the $40,000 in the retirement account.
The Bruckners want sufficient liquid assets to cover six months’ income as a precaution (0.5 3
$100,000 5 $50,000). At least 20 percent of the
$50,000 should be in exceedingly liquid assets, but the remaining 80 percent may be invested elsewhere provided that the assets meet the objective to pro- vide sufficient liquidity.
The remaining assets ($150,000) are available for other investments. These funds could be allo- cated in numerous ways. Since the couple is gener- ating income, you expect the Bruckners to conclude that income-producing bonds are not a necessary component of their portfolio. That conclusion, however, is not necessarily correct. Bonds do offer potential diversification and may be included as part of any tax-deferred retirement account. The interest income will not be taxed until the proceeds are removed from the retirement account and the flow of interest income will compound over time. If Senta’s employer offers a bond fund as part of the retirement plan, selecting the bond fund instead of the company’s stock makes sense from an overall asset allocation perspective.
You decide to develop a sample asset allocation illustration. Once the Bruckners have grasped the concept, you can further subdivide the allocation.
The starting amount is $240,000: the $40,000 in the retirement account, the $50,000 needed for liq- uid assets, and the $150,000 balance. You decide that the retirement account should be invested in bonds and the liquid assets should be in a money market mutual fund that stresses federal govern- ment Treasury bills. The balance should be divided equally between large cap and smaller cap stocks.
To illustrate the allocation and its possible re- sults over time, prepare answers to the following questions.
1. How much is allocated to each class of assts?
2. The expected returns for each asset class are as follows:
Large company stocks 10%
Small company stocks 12%
Corporate bonds 6%
Treasury bills 3%
How much will be in each account when the girls approach college age ten years from now?
3. Given the terminal values in the previous ques- tion, what is the portfolio’s asset allocation?
What steps should be taken?
4. The expected returns in Question 2 are based on historical returns, but the period 2008–
2009 has proven that returns can be much lower than those in Question 2. Suppose the returns on large cap and small cap stocks were only 1.4 and 3.2 percent, respectively. How much would be in the account after ten years?
(Assume the yields on corporate bonds and Treasury bills remain 6 percent and 3 percent, respectively.)
5. If the Bruckners do not need the funds to finance their daughters’ college educations, how much will be in each account when they approach re- tirement in their mid-60s under the original allo- cation? (Use the expected returns in Question 2.) 6. If the rate of inflation is 3 percent, goods and
services cost that $100 will cost how much at their retirement? How much annual income is necessary to maintain the purchasing power of their $100,000 current income?
7. If their combined life expectancy is 15 years at their retirement, can the Bruckners maintain their standard of living if they have the amount determined above and their funds earn 7 percent after they retire? What is the future rate of infla- tion assumed in your answer? Is that assumption reasonable?
8. Based on the above answers, what are some sug- gested courses of action the Bruckners should consider taking?