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Now
that you understand risk capacity, the next step is to match the results
of the risk capacity survey with a specific risk exposure. By doing this,
investors position themselves to achieve personalized optimal returns.
Not all investors have the capacity to expose their investments to high
levels of risk; therefore, a continuum of risk exposures is needed to
meet the unique risk capacities of each investor. This concept extends
to larger institutional investments, such as fire and police pension plans,
church funds, college endowments, and any other funds governed by committees.
Numerous studies including
those by Gary Brinson, Ron Surz, and Roger Ibbotson have determined there
is essentially only one decision that investors need to make: Which mix
of indexes is best for them.
There are 20 premixed portfolios of indexes presented in this step. These
portfolios have a specific percentage allocation of asset classes that
match the 20 specific Risk Capacities. Figure 11-1 shows the asset class
allocations of the 20 IFA Index Portfolios, labeled 5 through 100 in five-point
increments. Each one is coupled with a specific risk capacity. Investors
can be matched to one of these based on the results of Step 10’s
Risk Capacity Survey.
Once investors determine
their best mix, they or their investment advisor can determine which available
index funds will best represent the chosen mix of indexes.
Figure 11-1
 |
The
mix of indexes in your portfolio, or your asset allocation, accounts
for a little more than 100% of your total return
on average. The "little more than" refers to the negative
returns of active management. Active returns are near zero, but
negative on average. (see
article)* This
is also referred to as your Investment Policy. As Charles Ellis
points out in his 1985 classic, Investment Policy, it
is the most important choice an investor can make. In this
Step, we will review various mixtures of risk exposures and
show the long- term historical returns of those portfolios. Now
that you have established a Risk Capacity™, you need to evaluate
risk before actually taking it. This will complete the matching
of Risk Capacity™ (people)
and
risk exposure (portfolios).
Numerous
studies, including one by the worldwide accounting firm
PriceWaterhouseCoopers , conclude that index funds will best
achieve an investor's goals, making them a perfect way to implement
your Risk Exposure. This concept is even incorporated into legal
guidelines, under the Prudent Investor Rule.
 Prudent
Investor Rule
In 1992 The American Law Institute published Restatement of
the Law, Trust, Prudent Investor Rule. This is meant as a guideline
for the prudent management of trust assets.
In 1995, the National Conference of Commissioners on the Uniform State
Laws adopted the Uniform
Prudent Investor Act as a guideline for states to create their
individual laws. It
has been made into law in many states. In California it became law
in 1996 under the title of the Uniform Prudent Investor Act.
(Also see here.) This
rule points out the value of Modern Portfolio Theory. It essentially
tells trustees that index funds are the prudent way to invest
trust assets. The rule acts as a legal road map for estate planning
attorneys, trustees of all types of trusts, and investment advisors.
The Reporter's Notes to the Prudent Investor Rule point out
the problems with active management.
"Economic evidence shows that from a typical investment perspective,
the major capital markets of this country are highly efficient,
in the sense that available information is rapidly digested and reflected
in the market prices of securities. As a result, fiduciaries and other
investors are confronted with potent evidence that the application
of expertise, investigation, and diligence in efforts to 'beat the
market' in these publicly traded securities ordinarily promises little
or no payoff, or even a negative payoff after taking account
of research and transaction costs. Empirical research supporting the
theory of efficient markets reveals that in such markets skilled
professionals have rarely been able to identify under-priced
securities (that is, to out guess the market with respect to
future return) with any regularity. In fact, evidence shows that there
is little correlation between fund managers' earlier successes
and their ability to produce above-market returns in subsequent periods."
Principles
of Prudence
-
Sound
diversification is fundamental to risk management and is therefore
ordinarily required of trustees.
-
Risk
and return are so directly related that trustees have a duty
to analyze and make conscious decisions concerning the levels
of risk appropriate to the purposes, distribution requirements,
and other circumstances of the trusts they administer.
-
Trustees
have a duty to avoid fees, transaction costs and other expenses
that are not justified by the needs and realistic objectives
of the trust's investment program.
-
The
fiduciary duty of impartiality requires a balancing of the elements
of return between production of current income and the protection
of purchasing power.
-
Trustees
may have a duty and the authority to delegate as prudent investors
would.
|
 |
"
Investment planning is about structuring exposure to risk factors.
" |
 |
Eugene
Fama, Jr., The Error Term, Dec, 2001 |
|
 |
"
Investment Policy [asset allocation] is the foundation upon
which portfolios should be constructed and managed. " |
|
Charles
D. Ellis, author of Investment Policy, 1985 |
|
 |
"
'Tis the part of a wise man to keep himself today for tomorrow,
and not venture all his eggs in one basket. " |
|
Miguel
de Cervantes (1547-1616), Author of Don Quixote
|
|
 |
"
Risk is good. Not properly managing your risk is a dangerous
leap " |
|
Evel
Knievel, Motorcyclist |
|
 |
"
History shows that in the long run a thoughtfully designed,
diversified strategy of "passive" funds typically beats all
but a few active managers. It's not easy to structure and maintain
such a strategy. It requires some initial research and discipline
to stay the course. But it’s much easier than predicting which
active managers will randomly beat this approach. " |
|
Eugene
Fama, DFA |
|
 |
"
We can extrapolate from the study that for the long-term individual
investor who maintains a consistent asset allocation and leans
toward index funds, asset allocation determines about 100% of
performance. " |
|
Roger
Ibbotson, Ibbotson Associates, The True Impact of Asset
Allocation on Returns |
|
 |
"
The essence of effective portfolio construction is the use of
a large number of poorly correlated assets " |
|
William
Bernstein, The Intelligent Asset Allocator |
|
 |
"
There is safety in numbers. " |
|
Euripides;
Lady Luck by Warren Weaver, The Theory of Probability |
|
 |
"
The $4.8 billion Orange County Employees' Retirement System,
Santa Ana, Calif., more than doubled its total indexed assets
to $1.2 billion during the 12 months ended Sept. 30, 2001 from
$593 million the year before. We think that (indexed) exposure
was a reasonable portfolio for the return characteristics and
compared favorably with active (management). " |
|
Farouki
Majeed, chief investment officer, ASSETS UP 30%: Where the
action is: Funds embrace enhanced indexing, by Fred Williams,
www.pionline.com, Jan, 2002 |
|
|
"
On average, 90 percent of the variability of returns and 100
percent of the absolute level of return is explained by asset
allocation. " |
|
Roger
G. Ibbotson and Paul D. Kaplan, "Does Asset Allocation
Policy Explain 40%, 90% or 100% of Performance?," December,
1998, revised April 1999 |
|
|
"
Ninety-seven percent of performance variation is due to asset
class structure -- Study by of 31 institutional pension funds
during a range of six- to 12-year periods. " |
|
Eugene
F. Fama Jr., Dimensional Fund Advisors' Conference, University
of Chicago Graduate School of Business, 1997 |
|
|
"
Don't invest all your money in just one or two stocks. That's
the danger. I know a man who put all his money in just two stocks
--a paper towel company and a revolving door company. He was
wiped out before he could turn around. " |
|
Dave
Astor, 2001 |
|
|
"
Approximately 94 percent of variability of a fund's investment
return is due to asset allocation -- Study of 91 large pension
funds over a 10-year period. " |
|
Gary
P. Brinson, L. Randolph Hood and Gilbert L. Beebower, Determinants
of Portfolio Performance," Financial Analysts Journal,
July-August 1986, Follow-up study, "Revisiting Determinants
of Portfolio Performance: An Update," 1990 Working Paper,
1986, 1990
|
|
 |
"
It is a truth very certain that when it is not in our power
to determine what is true we ought to follow what is most probable.
" |
|
Rene
Descartes, Discourse on Method, Lady Luck, the theory of probability
by Warren Weaver |
|
 *According
to Ibbotson Associates
|
