Tuesday, February 27, 2007

Thoughts on porfolio construction & All About Asset Allocation

I've been reading Richard Ferri's All About Asset Allocation. Interesting read. About 1/3 of the way through. I'll summarize some key points:

Ferri discusses the benefits of portfolio diversification
Examines rebalancing
Explains Risk and Volatility
Asset Correlation (lower is better)
Key elements of a diversified portfolio
Exploration of different asset classes for consideration / inclusion into a portfolio

I've written about the importance of bonds to diversify one's portfolio, he has a very good discussion of it. One of the interesting model portfolio's in the recent Lazy Man's portfolio articles had 40% bonds, yet had one of the best track records of the lot. Quit interesting!

The sweet spot in the US markets seems to be small cap value. It represents only 3% of market capitalization and has varyling levels of correlation (as do all asset classes). One chart illustrates a 70% total market portfolio and a 30% small cap value portfolio (over a 30 year period) -- the small cap value assets add a 2.7% increase in return with no increase in portfolio volatility. Very impressive point.

Another interesting discussion is the long term edge that Value stocks (large cap) have over growth. 60% total market and 40% value (composed of 85% large cap value and 15% small cap value) had a 1.2% increase in return without additional portfolio volatility.

Of course you could add more value or more small cap value if you don't mind adding volatility. Unfortunately, my current investments do not include much small cap, small cap value or large cap value - primarily due to the tendency for life cycle target retirement funds to prefer market or growth asset classes - which seems ridiculous - as if the portfolio managers tippy toed into the pool of diversification because it was well defined in the popular press, but never read the rest of the research which indicated that stock selection was a very small component of return (but can be a high expense - look at those high ERs).

Regards, makingourway


Jim said...

Small cap value stocks are the way to go. If you have a long investing horizon, small cap value beats all other investment styles as

makingourway said...

You're exactly right. But small cap value can't be the only portion of your portfolio, or you wouldn't be able to diversify out the volatility through rebalancing. If you overconcentrate in one asset without rebalancing the volatility will destroy your cumulative annual returns.
Try small cap value with some short term bonds, some international (maybe value) and some large cap value, plus some REIT thrown in as well.
Regards, makingourway