“The Intelligent Portfolio” by Christopher L. Jones

This book offers easy to understand investment advice, explains what’s important and what is not, and how/why things work the way they do based on modern portfolio theory. Well worth your reading time. While the book does a great job on the retirement asset accumulation part of one’s lifecycle unfortunately, it dismisses quite lightly the decumulation phase critical for those approaching or already in retirement. (Jones is CEO of Financial Engines, “a leading provider of personalized investment advisory and management services in workplace retirement plans”. FE was founded by William Sharpe and now provides advisory services to 6.8 million employees at 109 Fortune 500 companies according to the book’s jacket.)

Some of the insights from the book:

-10 basic concepts to make good investment decisions: risk and reward are connected, history will deceive, use wisdom of the “market”, select risk level, don’t bother with stock picking, limit investment fees, intelligent diversification, forward looking fund selection, realistic funding of financial goals, and tax-efficient investing.

– regular rebalancing to a fixed asset allocation is a market timing strategy, specifically a contrarian vs. a momentum strategy. “If equities were to increase as a proportion of the market portfolio, then all other things being equal, the average investor would desire to hold a bit more equity, negating the need for rebalancing to the previous allocation.

-market timing assumes that most other investors are stupid; do you want to make that assumption?

-risk levels are calculated relative to market portfolio which is set at 1.0; the market portfolio “consists of an aggregation of all the assets in the world, weighted in proportion to their total market values.” (p.80 gives Financial Engine’s January 2007 view of the market portfolio broken down into 15 asset classes: cash 2.6%, US bonds (intermediate/long government, corporate, mortgage-backed) 16.0%, foreign bonds 18%, US (growth/value) equities large-cap 26.2%, US mid-cap 7.4%, US small-cap 3.6%, foreign equities- Europe 15.8%, Pacific 8.1%, emerging 2.4%.)

-the use of optimization to estimate the implied future returns of each asset class based on market portfolio allocation, assumed future volatilities and correlations

-the individually selected risk level (relative to market) is potentially the dominant decision

-explanation of the range of potential future outcomes in terms of downside (5-percentile) median (50-percentile) and upside (95-percentile) outcomes. He notes that the value of median is lower than the value average outcomes; the size of the median outcome decreases as a proportion of the average outcome with increasing volatility. He also explains that while the value of the median portfolio increases with risk, but so does the downside i.e. the 5-percentile is lower).

-more risk is only beneficial with (very) long horizon

-considerations in selecting risk level: the degree to which the timing of when the money is needed is changeable, the impact of failing to (fully) achieve goal (how about by a small amount), level of comfort with market fluctuations, how exposed are investor’s other assets or sources of income to poor market performance

-individual stocks picking not a good strategy as individual stocks are 3-5 times more risky than the market portfolio (because risk= (market + industry + company) risk

-the biggest retirement investing error is overconcentration in employer’s stock (because success of the stock is correlated with job)

-with volatility, the cumulative “growth rate” will always be lower than the average return for a multi-period horizon”, it will be approximately the same as the median portfolio outcome (see Table 6.6 on p.138)

-fees/expenses can take a significant share of returns and there is a strong correlation between higher fees and lower returns. After costs, a dollar invested in active funds will underperform that invested in passive funds, by definition

-types of costs: expense ratios, 12b-1, loads, redemption, transaction, investment advisory, brokerage commission, bid-ask spread, turnover cost (avoid high turnover funds)

-‘smart diversification’: “only taking risk for which likely to be rewarded”, objective of diversification is “to take minimum risk to get desired expected return”; do not let risk/asset allocation decisions drive you into expensive funds for implementation (i.e. explains cost-driven asset allocation decision, an important topic for people in 401(k)s with a limited available menu of funds)

-value of ‘alternative assets’ is questioned: real estate (illiquid, most people already have enough), REITs (high dividend/tax, volatile), commodities and precious metals (not clear of long-term expected return positive), hedge funds (not an asset class, expensive), TIPS (maybe useful- explicit inflation protection). Author recommends keeping ‘alternatives’ to a small allocation.

-‘good funds’ are not defined by superior historical performance, but how they’ll perform in the future. Criteria for fund selection are cost/expenses, investment style, your risk tolerance, trading costs, manager performance, fund risk, length of track record. Failure to account for fund expenses is indefensible

-the future? Investment returns, inflation and longevity are all unpredictable. Flexibility is the key: horizon, size ($), type of goal requires one to fund one-time or recurring expenses

-how much do you need? Use put and takes relative to current expenses to determine future needs, assume income increases 1.5%/yr after inflation; one typically need 60-80% of pre-retirement income, but it is really a function of the planned puts and takes on the pre-retirement expenses

-estimated wealth required to achieve some income stream can be based on assets required to purchase an inflation indexed annuity of same value as the expenses (this assumes no estate). The pricing of annuities implies you need less the later you retire.

-to increase confidence in achieving financial goal you must save more and have a more conservative investment strategy. Higher risk can lead to higher returns, but it also comes with a larger range of outcomes (including downside)

-“tax-efficient investing” goal is not to minimize taxes, but to maximize after-tax returns; considerations include: tax rate for short vs. long term cap gains(US), no cap gains tax in some states(US), interest income taxed higher than capital gains or qualified dividends. Paying tax later is better and lower rate is also better. Equities/dividends more tax efficient than interest income. More tax-efficient investments better in taxable accounts, while less tax-efficient investments better in tax-sheltered accounts. Municipal bonds may be advantageous to high income investors. Lower turnover rates are more tax-efficient, as are passively managed index funds. Experts can add value in taxes!

-personal tax-rate: difference between marginal vs. ‘effective’ tax rate

And finally, the book comes with a coupon for one year subscription of Financial Engines’ “Personal Online Advisor” which gives investors the “ability to realistically simulate investments, receive personalized investment advice on any number of retirement and taxable investment accounts in a household portfolio”. This alone is worth many time the cost of the book. (This service is used by millions of investors whose employers have made it available through a bulk arrangement with FE; the service is also available at some fundcos like Vanguard as a complimentary service to investors above some threshold level of invested assets. The service is also available to be purchased on an individual basis.)


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