Martin Luther King Jr. had a dream and so does Professor Robert Shiller. Civil rights trump financial freedom, of course, in the grand scheme of priorities and so I don’t presume to equate one with the other. That said, it’s a lot tougher to maintain civil rights in the long run without some progress in building and maintaining financial freedom and so on some level we all have a vested interest in advancing both.
Certainly we can all agree that prudent, sound advice on matters financial helps everyone as well as the economy generally. Assisting the masses in the cause of building, growing and preserving wealth won’t solve all the world’s problems, but it helps. With that in mind, Shiller’s piece in the Times yesterday raises the idea that promoting financial literacy is productive as public policy. It’s also timely, given the huge losses suffered recently by so many investors, large and small. “Many errors in personal finance can be prevented,” he writes. “But first, people need to understand what they ought to do.”
Alas, financial literacy seems to be the exception rather than the rule in the world of dispensing investment advice. We can debate how to go about changing that, but there’s no doubt that clear thinking on managing money is in short supply. Given the current economic and financial climate, a solution is needed post haste. Letting the masses fumble what is increasingly a central decision for securing their retirement security is the equivalent of fiddling while Rome burns.

The basic solution is recognizing the world as it exists. Finance doesn’t have hard-and-fast rules like physics, but there are some essential truths. Indeed, the challenge of investing begins by forging a bit of order out of the chaos of markets and developing a strategic framework for making investment decisions. That comes from taking advantage of what we’ve learned over the decades about how to manage money wisely.
That’s not easy for the uninitiated, in part because practical investment strategies don’t come naturally to homo economicus. Money does strange things to the brain, as Jason Zweig explains so convincingly.
As such, progress here takes a fair amount of study and a willingness to stay focused on monitoring the markets and keeping up to date on financial research and the lessons learned in the money management business. No mean feat, and so it’s no wonder that hiring an advisor is often the best solution for those who have neither the time or inclination to immerse themselves in the finer points of portfolio management.
Even so, everyone needs a basic financial education. After all, it’s your money. The idea that you can turn over your retirement portfolio to a financial advisor and remain completely uninformed about what constitutes sound money management is an accident waiting to happen. Just ask the many investors who were burned by one Bernie Madoff.
All sound investing begins by reviewing the choices in the broadest terms. As I explain in the inaugural issue of The Beta Investment Report, the 1,000-mile journey of investing begins with asset allocation. The default choice on that all-important strategic front is the market portfolio, defined as the world’s capital and commodity markets, each weighted initially by their respective market values. In effect, this portfolio represents Mr. Market’s asset allocation.
This is the ideal benchmark because it owns everything, or at least everything that’s reasonably accessible for the average investor in terms of liquid, organized markets and available via index mutual funds and ETFs. The returns associated with this definition of the market portfolio are available to everyone, and it requires no skill or trading to tap into what has proven to be a reasonable return over the long haul. That’s one reason why I monitor and analyze this benchmark, among other things, on a regular basis in my newsletter.
Finance theory teaches that the market portfolio is the ideal investment for the average investor with an infinite time horizon. Obviously, that describes no one. The challenge, then, is deciding how to adjust the market portfolio to suit your particular investment needs. The key factors for making this decision include your time horizon, investment objectives, tolerance for “risk” and other variables. Once you’re clear on those items, you can begin to figure out how to change the market portfolio to satisfy your financial goals.
Here’s where it gets tricky. Indeed, the choices are virtually infinite. That means that the hazards of doing too much usually outweigh doing too little. Indeed, a few examples of the options include: Changing the asset allocation relative to the market’s mix; dropping one or more asset classes entirely; leveraging one or more pieces of the portfolio; introducing so-called alternative betas/strategies into the mix; managing the asset allocation tactically vs. using a milder approach by way of a modest rebalancing strategy that reacts to market trends rather than trying to anticipate them.
Putting these and other choices into some historical context with the present, while surveying the current investment landscape with an eye on finding where opportunity and risk lie, is the focus of The Beta Investment Report. Why? It’s a fundamental focus that’s directly related to bottom-line investment results.
Every investment strategy, at its core, reflects an asset allocation decision. The investor may not be thinking in those terms, but that’s the paradigm just the same. Let’s say you’ve assembled a small-cap U.S. equity portfolio, carefully selecting each stock with a rigorous methodology. You’re convinced that this portfolio is all you need for the long haul. What’s asset allocation got to do with that? Everything. In essence, you’re making an extreme asset allocation bet in your portfolio by excluding everything save small-cap stocks. What’s more, you’re consciously trying to do the heavy lifting with alpha rather than beta, even though the former is likely to end up being a sizable driver of returns and risk.
All investment portfolios draw from the same capital and commodity sources. Whether you’re running a global macro hedge fund or a plain vanilla large-cap long-only domestic stock portfolio, the basic financial DNA arises from a common gene pool. There are countless ways to reassemble and reengineer the genes. Regardless of the final outcome, the process begins by understanding the basic rules, surveying the fundamental choices and intelligently exploiting the opportunities (and staying mindful of the risks) as they ebb and flow.
There are other ways to manage money, of course, but it’s debatable if they’ll be as successful, if at all, in the long run. Fifty years of finance theory and a much longer legacy of real-world money management history teach us no less. Understanding why that’s so is the first step in developing a successful investment strategy.