Simple Pound

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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