How do you define the perfect portfolio?

It’s probably not the most optimal allocation based on historical market data. The perfect portfolio up to the 1970s, was less perfect in the 1980s. The same can be said for the ’80s in relation to the ’90s, the ’90s relative to the 2000s, and so on to today. The market changes and is too unpredictable for that type of consistency. The data only tells us what happened not what will happen in markets.

It’s probably not whatever offers the highest returns either. That requires foresight, which we all lack. Too much dumb luck and risk involved to be worth considering. You’re far more likely to end up broke instead of rich.

It’s also not some cookie cutter portfolio you copied online. Not the worst choice but it’s missing an important consideration.

So, what is it then? One might argue that the perfect portfolio “is the one you can stick to.” Except that catchy phrase is incomplete.

A new book by my friend Peter Lazaroff, titled The Perfect Portfolio, breaks it down for you.

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Quote for the Week

Risk and time are opposite sides of the same coin.

This conclusion suggests that duration — the concept of risk that the fixed-income people use — has relevance for all kinds of risks, not just for bonds and mortgages. Duration is a weighted average of cash flows over the life of an investment, with the present values of those cash flows as the weights. Duration does not always fit the bill precisely, because it does not reflect the uncertainty of those cash flows, but it does capture the sense of what we are after.

Indeed, in a fundamental sense, duration conveys more information about riskiness than volatility can convey. As fixed-income investors learned long ago, duration explains volatility — long-term bonds are more volatile than Treasury bills, and stocks are more volatile than long-term bonds. Thus, as I argued at the outset, volatility is a useful concept but an incomplete one. We are closer to the essence of risk when we look at it through the prism of duration. — Peter Bernstein (source)

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What do fortunetellers, psychics, and stock market forecasters have in common? They all claim to know what happens next…for a price.

But how good are they? Horrible! Yet some investors pay for it anyways. It’s a lesson investors can learn from history.

Alfred Cowles was one of the first to put market forecasters to the test almost a century ago. He conducted two studies, the first in 1932 and again in 1944.

The first study was based on the period from 1928 to 1932. Cowles first looked at how successful 20 insurance companies and 16 financial services firms were at picking stocks that would outperform the market. He next looked at the accuracy of 25 financial publications in predicting the movements of the markets. He also included the 26-year record of the editor of the Wall Street Journal, Peter William Hamilton.

The results were not surprising.

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Quote for the Week

One of the pieces of advice that I’ve had in my books, going back ten years now, is that investors in bonds should invest only in “full faith and credit” securities. Bonds that have call options or bonds that have credit risks or bonds that are highly structured, like the asset-backed securities and CDOs, just don’t belong in the portfolios of sensible investors.

There’s just systematic mis-pricing of credit and options and complexity. Now it’s obvious when I say that. It wasn’t so obvious when I wrote it ten years ago, and then again in Unconventional Success, and now again in the new version of Pioneering Portfolio Management.

People on Wall Street who are structuring these securities are more sophisticated than the people to whom they are selling them. With that kind of dynamic, when really smart, highly compensated, very clever people are on one side of the trade, and less highly compensated, less clever people are on the other side, you know who’s going to end up in the soup. — David Swensen (source)

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Quote for the Week

It’s important to recognize what I call the twin impostors. They are short-term gain or outperformance, and short-term underperformance. Both are impostors, because neither one says anything about real investment skill. Investing performance is what happens when events collide with an existing portfolio. Maybe a portfolio has been assembled very wisely, very prudently, and with a lot of analytical talent, and the events that occur just were unforeseeable. That doesn’t mean the performance that results tells you anything about the wisdom of the portfolio or the ability of the investor.

I refer a lot to The Black Swan, which is an excellent book by Nassim Nicholas Taleb. Here are a couple of points, or my characterization of points that he makes. Investors are right and wrong all the time for the wrong reasons. We all know people who got famous in our business for being right once in row. The correctness of a decision cannot be judged merely from the outcome. Good decisions fail all the time. Bad decisions work all the time. Randomness alone can produce just about any outcome in the short run. It is for reasons like these that we must be leery about attaching great importance to short-term performance. — Howard Marks (source)

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