Moshe Milevsky, a professor at York University, recommends thinking strategically about your “personal beta” for managing risk. That begins by evaluating your human capital, he advises in today’s Wall Street Journal. “It’s a measure of your future earnings, a product of what you’ve invested in yourself.” Good advice. In fact, evaluating your career risk is job one when considering how to modify the broad market portfolio. But even before you do that, you need a good definition of the market, and the usual suspects just won’t do.
I spend a lot of time studying an expansive definition of the passively allocated market portfolio. It’s hardly a silver bullet, but it’s a critical part of developing an investment strategy and surveying market opportunity and risk. Surprisingly, it’s routinely ignored by most investors. Maybe that’s because it’s hard to find good measures of the market portfolio, which is why I decided a while back to calculate it myself. In each monthly issue of The Beta Investment Report I review the broad market’s performance, asset mix, risk allocation, etc. Why? Because over the long haul, a robust definition of all the major asset classes, weighted by their passive market cap weights, is the optimal investment portfolio for the average investor. Many investors will outperform this benchmark, but many will trail it. And if you factor in taxes and trading costs, perhaps the majority of investors will fall short of the broad market portfolio benchmark over time.
Decades of financial economics predict no less, as outlined in my book Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor. Theory, of course, doesn’t pay the bills. Is there any reason to think that academic deciphering of asset pricing has any relevance in the real world? Yes, based on my analysis on the proprietary index published in The Beta Investment Report.
For instance, over the past decade, the Global Market Index (a passively weighted measured of all the major asset classes) posted a roughly 3.4% annualized total return. (For a list of the underlying indices used in the calculations, see the benchmarks noted here.)
That’s more or less middling, if not disappointing. But in other periods, the market portfolio has done better. Returns can and do fluctuate. As for the past 10 years, times were tough on two of the index’s biggest components: equities in the U.S. and foreign developed nations–both trailed the market portfolio. On the other hand, the last 10 years also delivered stellar returns in REITs and emerging market stocks and bonds.
The point is that a mindless indexing strategy of owning everything in its market-weighted proportions delivered a modest return over the past decade. Could you have done better? Sure, but you could have also done worse, perhaps a lot worse. In fact, many investors suffered for taking radical asset allocation bets, believing that a given manager could easily beat the market, etc.
The central challenge for strategic-minded investing is deciding how to modify the market portfolio. The possibilities are, of course, endless. We could, for instance, alter Mr. Market’s asset allocation, or manage it dynamically, or use actively managed funds as replacements for the various index components, and so on. In fact, there’s a case for some prudent modifications, if only because individual investors are something other than average and the market’s aren’t always and forever a pure random walk.
But we should proceed cautiously in changing the market’s allocation. In other words, we need to pick our poisons carefully. History suggests that the path of least resistance does otherwise. A fair amount of the modification’s to the passive asset allocation ends up delivering self-inflicted wounds. Owning U.S. equities in isolation over the past 10 years, for instance, hasn’t worked out that well. Of course, if we go back a decade to the year 2000, expectations were sky high in thinking that stocks would bring big, easy gains.
The debate about what to do, and when to do it, is a career unto itself when it comes to considering the possibilities for modifying the market portfolio. All the more so if we factor in the confusing messages that bubble forth from Wall Street. To be blunt, much of what passes for productive advice is misguided, misleading or just plain dangerous.
Fortunately, there’s a great place to start, as Milevsky’s article suggests. In effect, he tells us to “think smarter about risk.” That’s also the advice embedded in decades of financial econoimcs research, i.e., successful investing is primarily a task of managing risk as opposed to chasing return.
As one example, imagine that you work for an oil company. Your career is tied up with the fortunes of energy. In effect, you’re personal beta is long energy, perhaps in a big way. If the energy business does well, you’ll do well, and vice versa. That suggests lightening up on the allocation to energy stocks in your investment portfolio, if not avoiding energy companies altogether. In fact, you might even consider shorting energy firms.
Thanks to ETFs and index mutual funds, customizing Mr. Market’s portfolio is easy, efficient and inexpensive. Some of the customization is a no-brainer. But some of it’s speculative, and other decisions are downright foolish. Knowing how to spot the difference is the first step in boosting the odds that you’ll end up with something more than Mr. Market’s returns over the next 10 years.