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This is the third part of my book review for Richard Ferri’s “All About Asset Allocation”. If you haven’t read the previous parts, I strongly suggest you do here.

Chapter 4 - Multi-Asset-Class Investing

The key idea to take away from this chapter is that adding multiple asset classes pushes the portfolio risk and return toward the Northwest Quadrant. This means that you’ll get higher returns at a constant, or even reduced, risk level. Obviously you should strive for the best asset allocation possible, but the idea of the perfect portfolio is just an utopia. Ferri repeatedly reminds you not to forget that.

Ferri provides a short list of points to bear in mind when building a portfolio:

• The future risk, returns, and asset-class correlations cannot be known with any degree of certainty.
• A portfolio with more asset classes is better than a portfolio with fewer asset classes.
• The best portfolio you can design is one that fits your needs.

Especially the last point is of importance for the whole concept of asset allocation, because you will only keep re-balancing and stick to the originally designed allocation if you’re completely comfortable with your selections.

And just when you thought you’ve heard enough warnings and points to bear in mind when designing your portfolio, he leaves you with another list of just as important facts to take away before you are allowed to learn more about the individual assets available and the design process that comes with them.

This time, Ferri sums up important points about the correlation between asset classes:

• It is very rare to find low-cost investable asset classes that are negatively correlated or even noncorrelated with each other.
• The correlation between asset classes can change.
• During a time of extreme volatility, positive correlation can increase dramatically.

The author illustrates the last point by mentioning that after 9/11 all stock markets around the world fell by more than 5% and that no diversification could have found a way around this.

An extensive example portfolio is given in this chapter as well, but it only illustrates the key points mentioned above so I won’t go into any more detail on it here. After all, you might still decide to read the book after reading my reviews, so you should be getting some extra information for your money…

Chapter 4 is the last chapter in part 1 of the book, so the next review will dive into part 2 which covers the most important and most widely available asset classes that you might want to add into your portfolio.

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This is the second part of my book review for Richard Ferri’s “All About Asset Allocation”. If you haven’t read the first part, I strongly suggest you do here.

Chapter 3 - Asset Allocation Explained

Ferri gives the most concise definition of the term that I have come across so far when he says: “Asset allocation is a mathematical approach to diversification. It involves estimating the expected risk and return on various investments, observing how those investments interrelate to one another under different market conditions, and then methodically constructing a portfolio that has a high probability of achieving your goals with the lowest level of expected portfolio risk.”

The main points made in this chapter involve the importance of rebalancing and the theory behind correlation and how it affects a portfolio’s return. I shall try to capture Ferri’s main ideas.

Your asset allocation strategy will be based on long-term expected returns and the associated risks of different asset classes. Regardless of how well these values model the long-term performance of your portfolio, it is bound to behave differently in the short run. In order to bring it back on target a portfolio thus needs to be rebalanced by selling the positions that performed well and now dominate the allocation and buying more of the positions that underperformed. While at first it seems counterintuitive to do this, it ties in with a strategy of buying low and selling high.

There are two main strategies for rebalancing: by percentage or by time. If you have a portfolio that is, for example, evenly divided between stocks and bonds (i.e. 50% stocks, 50% bonds) and you decide to re-balance as soon as any of the positions stand at 10% more (or less) than their target (e.g. stocks have performed well and now constitute 60% of the portfolio’s assets), you are rebalancing by percentage. While this yields slightly higher returns and lower risks than just rebalancing once a year (i.e. by time), it also involves more monitoring and higher trading costs which could potentially erode the additional return. In general, the author holds the opinion that rebalancing annually is sufficient for any individual investor.

The author then introduces the concept of correlation and how it affects asset allocation and portfolio returns. In short, to maximise stability and guarantee steady returns, investors should be looking to include asset classes that are in negative correlation with each other. Negative correlation describes a concept where the returns of two (or more) asset classes will always move in the exact opposite direction. For example, assuming asset class A is negatively correlated with asset class B, then B will go down in value whenever A increases and vice versa. In reality, it is very hard to find assets that are negatively correlated with each other, and investors can be lucky to include categories that either have no correlation with each other or which are only slightly positively correlated.

A further difficulty arises from the unsteadiness of the correlation factor which tends to fluctuate over time. This is illustrated by a chart showing the rolling 36-month correlation between intermediate-term treasury notes (a bond) and the S&P 500 (a major US equities index). Between 1952 and 2004 the correlation factor between these two asset classes has experienced highs of +0.67 (where +1 represents perfect positive correlation) and lows of -0.62 (where -1 represents perfect negative correlation). Despite these two extremes, however, the average correlation for the given period was +0.12, which suggests that bonds and equities are not correlated (it is commonly assumed that where a correlation factor lies between -0.30 and +0.30 no definite correlation can be proven).

To conclude this chapter, Ferri introduces the classic risk-and-return frontier. Starting off with two asset classes, this frontier depicts the annualised return and standard deviation which can be achieved by combining the two asset classes in a portfolio.

(Apologies for the bad image quality, but Excel wasn’t very co-operative this morning so I decided to scan the illustration from the book.)

The graph shows that a portfolio would have an expected return of ~6% (with a standard deviation of ~5.8) if it was fully dedicated to Investment #1 while at the same time a 12% return could be achieved by only buying into Investment #2. The problem with the latter is the high standard deviation of ~17.5 since we learned in Chapter 2 that (in the long run) a consistent return is preferable to a volatile return in terms of overall portfolio gains.

The dots on the graph represent a varying mixture of the two asset classes, where each “dot” represents a 10% change. Therefore it becomes clear that by buying 20% of Investment #2 and 80% of Investment #1 we achieve a higher overall return while maintaining a relatively low-risk portfolio. By introducing more asset classes, we aim to move as high up into the left corner as possible (also called “Northwest Quadrant“), which represents an allocation of high returns and low risk (i.e. low volatility).

More about multi-asset class allocation in Chapter 4.

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I finished this book within 2 or 3 days and figured I might as well share not only my opinion on it but also its key points as a neat summary for me (and others) to look up.

In general I think this book is immensely helpful, well written, thoroughly explained while still engaging and I definitely recommend it to anyone who wants to organise his / her own portfolio.

The book is divided into three parts: “Asset Allocation Basics”, “Asset-Class Selection” and “Managing Your Portfolio”. I will look at these in turn, but spread the review across several posts to give you some time to digest what you’re reading.

Since I am planning to write more of these reviews (especially about books that are there to teach you something and thus contain some actual advise), I have added a new heading to the menu so that you can access all reviews from a convenient and central place. I’ve just ordered “A Random Walk Down Wall Street” and still have Jack Slater’s “Zulu Principle” sitting on my shelf, so there are definitely more reviews ahead!

Asset Allocation Basics

Chapter 1 – Planning for Investment Success

This chapter mainly focuses on the basics underlying investment success: the development of a prudent investment plan, the implementation of that plan, and a commitment to follow the plan in good times and bad. He explains that there are no shortcuts to stable financial well-being (“It takes only one bad investment decision to wipe out years of prudent saving and investing”) and that people who learn to manage their money early, will end up being better off – both financially and emotionally.

Ferri explains how difficult it is to beat the market and how few investors actually manage to do so – be they individuals or fund managers. He uses various examples to illustrate his point, the technology stocks boom in 2000 being one of the most obvious choices. While trying to beat the market might certainly be a very exciting job to do, it is also a highly risky one and thus not suitable for most (individual) investors. Instead, asset allocation provides a fairly reliable (but unfortunately boring) alternative that will – if done properly – secure you a decent return with limited risks.

A paper by Roger Ibbotson (University of Yale) supports Ferri’s view in that it concludes that “more than 90 percent of a portfolio’s long-term variation in return was explained by its asset allocation” and that “only a small portion of the variation in return was explained by the individual stock or bond selections”.

The remaining part of the first chapter advocates mutual funds as the optimal way of building a portfolio across the different asset classes. This guarantees a diversification within the asset class on top of the diversification benefits gained from asset allocation itself and therefore reduces risk while increasing long-run returns.

Chapter 2 – Understanding Investment Risk

The second chapter is dedicated to the analysis of risk and the risk-return relationship. Ferri explains that one can only expect higher returns from an investment if simultaneously accepting greater uncertainty and hence risk. Most people who have thought about investing will be aware of this relationship. But what I learned is this: “A properly designed portfolio is expected to have a higher risk-adjusted return than each of the individual investments that make up the portfolio”. Therefore, by adhering to a proper asset allocation strategy, you will increase your long-run returns while reducing your overall risk. While you’ll never be able to compete with the highest-return portfolios in a bull-market (i.e. a market that shows increasing stock prices and great investor confidence), you’ll certainly outperform your friends in a bear market if you stick to your original asset allocation.

Ferri further explains the different perceptions of risk: while risk translates into portfolio volatility for investment managers/practitioners, individual investors tend to see risk as losing money. The volatility of a portfolio can be observed by monitoring the up-and-down movement in the value of an investment, either on a daily basis or by comparing weeks, months or years. A bond with regular interest payments, for instance, will have a lower volatility than a small-cap stock that might gain 30% in value today only to lose 20% tomorrow.

Practitioners measure volatility in units of standard deviation, which measures the movement around the mean of a data sample. This measurement, however, is by no means static (even though the range tends to be fairly consistent) and changes along with the general market, economy and investor’s confidence. One important thing to note is that greater variation in returns reduces long-term compounded returns. To illustrate this point, the author gives the following table of example portfolios:

As you can see, despite the fact that all portfolios share a simple average of 5% return per year, the actual compounded return (that represents the steady increase in portfolio value divided by number of years) gets lower the higher the variance of the returns per calendar year. Therefore, by reducing the volatility of your portfolio, you’ll increase the overall return in the long run (as demonstrated in portfolio A).

There are two further chapters in the first part, which go into a bit more depth about the asset allocation procedure, but I want to have a think about the important points mentioned so far and decide for yourself whether or not you can live with an investment plan that is – as Ferri puts it – rather boring.

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