(B) Most investors buy high and sell low when they should do the reverse. To be able to buy low and sell high, investors need to maintain contrarian positions during both difficult times and exuberant times. For Mr. Swensen, the famous Chief Investment Officer of Yale’s endowment fund, there are three sources of returns: asset allocation, market timing, and security selection. Active portfolio managers attempt to time the market and successfully choose which stocks to buy or sell. Over time, very few managers (if any) succeed consistently in both of those attempts.
Market timing proposes to overweight or underweight a certain asset class in the short-term. This demands to forecast the direction of the market which requires assessing the impacts of future worldwide economic, social and political events into the stock market. Most economists fail even to forecast the timing of a recession. And, the relationship between the ”causes” and the “effects” of stock price variations can only somewhat and sometimes be understood after the facts.
Security selection is a zero-sum game since for every investor who is rightly buying a security there is another investor who is wrongly selling the same security (and vice versa). Over time, most funds that are buying and selling securities are underperforming the market indexes.
Having said that, “an inverse relationship exists between efficiency in asset pricing and appropriate degree of active management. Passive management strategies suit highly efficient markets, such as U.S. Treasury bonds where market returns drive results and active management adds little or nothing. Active management strategies fit inefficient markets, such as venture capital, where market returns contribute very little to ultimate results and investment selection provides the fundamental source of returns.”
Mr. Swensen outlines that most of the return of a portfolio results from asset allocation. The best asset allocation favors equity, embraces many types of assets, and carefully considers the implications of taxes. As stated by Nobel price Harry Markowitz, diversification is a “free lunch” which provides higher returns for a given level of risk or lower risk for a given level of returns. Ideally, each asset class should be at least between 5 and 10% of the total portfolio, and no asset class shall be amounting to more than 25 to 30%.
Correlation between asset classes
While equity is the best asset to protect against inflation, bonds are the best asset to protect against deflation. Over the long-term, equity wins over bonds but bonds lower the risk of a given portfolio. According to Professor Siegel’s Stock for the Long Run, one dollar invested in stocks in 1802 would have grown to $8.8 M (all gains and dividends reinvested) in 2001, while it would have been only $14,000 for one dollar invested over the same period in long-term government bonds.
Wealth multiples for US asset classes and inflation between 1925-2005
For retail investors (you and me), Mr. Swensen advises investing in six types of assets: domestic equity, foreign developed equity, emerging market equity, Treasury bonds, Treasury inflation-indexed securities (TIPS), and real estate.
Mr. Swensen recommends investing only into two types of bonds: Treasury bonds and TIPS. Treasury bonds serve as a hedge when markets turn insane, and against unanticipated deflation. TIPS serves as a hedge against inflation.
Mr. Swensen does not recommend to invest in other types of fixed income instruments. Following is why (and this is technical so skip it if needed): “fixed income markets fall short of the diversifying power inherent in default-free, full-faith-and-credit obligations of the US government. Factors including credit risk, call options, illiquidity, and foreign exchange exposure limit the attractiveness of investment-grade corporate bonds, high-yield bonds, foreign bonds, and asset-backed securities.”
Among real assets, Mr. Swensen likes real estate which falls between equity and debt. Real estate combines attributes of both equity and bonds; lower returns than equity but higher risks than bonds.
Mr. Swensen does not recommend individual investors to purchase commodity futures since future contracts only offer exposure to inflation, and as a consequence provide low expected returns than other types of assets (and, TIPS provides already exposure to inflation in the portfolio).
So here how to invest as Mr. Swensen:
• Domestic equity: 30%
• Foreign developed equity: 15%
• Emerging market equity: 5%
• Real estate: 20%
• US Treasury Bonds: 15%
• US TIPS: 15%
Other asset classes not available for individual investors include hedge funds, leveraged-buyout partnerships, and venture capital participation.
But those proved to be successful investments only “when managed by extraordinarily talented (or unusually lucky) individuals.” And, “because of the enormous difficulty in identifying and engaging superior active managers”, those assets should only be pursued by professional investors.
But for professional investors, Mr. Swensen recommends investing in commodity assets since over the long term they show inverse correlation to equity. But to gain commodity exposure without betting exclusively on prices, Mr. Swensen recommends to chose active managers who invest in value-added purchases of well-defined natural resources.
So here how to invest as Mr. Swensen if you are a professional investor:
• Domestic equity: 12%
• Foreign developed equity: 10%
•Emerging market equity: 5%
•Hedge funds: 25%
•Private equity: 17%
•Real estate: 13.5%
“Unconventional Success: A Fundamental Approach to Personal Investment”, David Swensen, Free Press
“Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment”, David Swensen, Free Press
Video: This video is part of a class of Yale’s famous finance Professor Robert Shiller. The Q&A with the students is quite interesting.
Note: The picture above is from Nice in France.
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