Financial Hazards, Market Obstacles, Inefficient Strategies, Market Timing, Technical Analysis

There has always been and will always be many investors, and financial service professionals, who try to make money by timing the market or picking just the right stock or mutual funds. But for nearly half a century, studies have shown that asset allocation policy, rather than individual security selection or market timing, is by far the most important determinant of total performance.

Market timers have to be "right" an extremely high proportion of the time in order for their strategies to work over the long run. Furthermore, with transaction costs, taxation, incorrect timing, and incorrect market calls, it becomes almost counterproductive. Listed at the bottom are some quotes from a few notable authorities in the financial arena.

Basic Principles of Modern Portfolio Theory (MPT)

Harry M. Markowitz developed the basic underpinnings of asset allocation theories that are commonly accepted today. In the 1950s he demonstrated that it was possible to construct a portfolio of risky individual stocks that was less risky than any of the individual stocks comprising it. In addition to that he showed that by utilizing the advantage of covariance one could build a portfolio of securities that would provide maximum return for any given level of risk. For his contribution is the area, he shared a Nobel Prize in 1990 with William F. Sharpe & Merton H. Miller.

Since he first illustrated his basic theories, his asset allocation and diversification principles have been the subject of much research, commentary and fine tuning. The principles continued to be used by many financial professionals and investors over time. Over time it has been shown that his theories apply equally if not better, to diversification among whole classes of assets.

Asset Allocation

The term means to diversify investment dollars among various asset classes in such a way as to minimize overall risk and enhance return. The general short list of asset classes would be comprised as follows: Equity assets (international and corporate), Natural Resources, Real Estate, Emerging Markets, Domestic fixed income assets (government and corporate), International fixed income assets (government and corporate), and Tangibles.

Diversification

As a commonly used term today, means purchasing a number of investments within a single asset class to minimize risks and enhance overall return. Not only would you invest in the equities of a single issuer, but of several. In addition, you would diversify among many different sub-categories of equities, such as small cap, large cap, etc. With regard to debt securities, the same concept would be taken into consideration with regard to different sub-categories, domestic/international, corporate/government, qualities, and types of debt issuers.

The Efficient Frontier

The primary goal of correct asset allocation and diversification is to arrive at a portfolio that is efficient. An efficient portfolio is defined as one that provides the maximum amount of expected return for any given amount of perceived risk. Or it provides the minimum amount of risk (standard deviation) for a given rate of return.

The efficient frontier is demonstrated by graph, on which the vertical axis shows increasing returns, and horizontal axis shows increasing risk. By plotting points expressing the risk/return ratios of various theoretical portfolios, and joining those points with a line, one can demonstrate the efficient frontier. Theoretically, an investor's overall portfolio should be on the efficient frontier, to have the best possible return with the least possible risk. If the portfolio falls below the efficient frontier the portfolio is receiving too little return for the inherit risk. By adjusting the portfolio asset mix an investor can achieve maximum return for the amount of risk accepted.

Covariance (Correlation)

The phenomenon of the "efficient portfolio" is possible by the fact that different asset classes respond differently to the same stimuli. For example, when one type of asset class increases in value, another type may decline in value. By figuring out how the different classes respond in relation to one another, and weighting the asset class accordingly, one can reduce the overall risk of the portfolio and potential enhance its return.

Covariance, or correlation, is a measurement of the degree that two asset classes move in relations to one another. Correlation is measured on a scale of -1 to 1, with a 1 meaning the two asset classes are perfectly and positively covariable. A -1 means they respond in opposite ways to the same stimulus, and a 0 means there is no predictability to the given stimulus.

Asset Allocation

Strategic Asset Allocation consists of constructing a portfolio of assets, based upon the assessment of the covariance between the assets, predicted long term returns, and the individual investor's parameters including, risk tolerance, time frame, target returns, and goals. A passive strategy is implemented where the basket of investments are held riding out the market gyrations. There is no market timing or re-allocation among the asset classes. If a particular asset class has moved outside of an acceptable percentage then the entire portfolio can be re-balanced to achieve the initial target weighting for each class. A modification of the original allocation will be conducted only if the investor's goals or objectives have changed.

Notable Quotes

1. It must be apparent to intelligent investors that if anyone possessed the ability to do so (forecast the immediate trend of stock prices) consistently and accurately he would become a billionaire so quickly he would not find it necessary to sell his stock market guesses to the general public. - Weekly Staff Letter, August 27, 1951, David Babson and Company, quoted in Charles Ellis, The Investor's Anthology.

2. (Investors) think of the so-called professionals as having all the advantages. That is total crap. They'd be better off in an index fund. - Peter Lynch, Barron's, April 2, 1990

3. The best way to own common stocks is through index funds. - Warren Buffett, Berkshire Hathaway, Inc. 1996 Shareholder Letter --- Additionally, those index funds that are very low-cost (such as Vanguard's) are investor-friendly by definition and are the bet selection for most of those who wish to own equities. - Berkshire Hathaway Inc. 2003 Annual Report

4. Severe underperformance of active equity managers has raised the whole issue of performance for all asset managers, including bond managers. - PIMCO managing director Brent Harris, Institutional Investor, May 1998

5. By periodically investing in an index fund. the know-nothing investor can actually outperform most investment professionals. - Warren Buffet

6. Buy an index fund or stay out of the market. Period. - UCLA professor Schlomo Benartzi, Investment News,December 14, 1998

7. I do not believe that they (investment advisors) can identify, in advance, the top-performing managers - no one can? - and I'd avoid those who claim they can do so. - John Bogle (of the Vanguard group of Funds) , Common Sense on Mutual Funds

8. Most of my investments are in equity index funds. - William F. Sharpe, Nobel Laureate in Economics, 1990, Business Week & The Parable of Money Managers.