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What Makes a 'Perfect Portfolio'? Thoughts From Bogle, Markowitz, Siegel, Others

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Taking a deep dive to examine the philosophies of 10 prominent investing pioneers, professors Andrew W. Lo, of MIT, and Stephen R. Foerster, of Western University, have created a new book, “In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest” (Princeton University Press, Aug. 17, 2021).

In an interview with ThinkAdvisor, Foerster, a chartered financial analyst, explores what five of the experts say go into making the perfect portfolio.

But he stresses: “We want to encourage our readers to develop an investment philosophy and to have a conviction and a reason for that particular philosophy that should guide their actions.”

As for what constitutes the perfect portfolio, the co-authors argue: “Our perfect portfolio today is really just a snapshot of what’s best for you at the moment and in the current environment.”

Lo is a professor at the MIT Sloan School of Management, director of the MIT Laboratory for Financial Engineering and a principal investigator at the MIT Computer Science and Artificial Intelligence Laboratory.

Foerster is a finance professor at Ivey Business School at Western University in London, Ontario. He writes regularly for The Perfect Portfolio Investing Blog.

In the interview, Foerster discusses the philosophies of investing superstars John Bogle, Charley Ellis, Harry Markowitz, Robert Shiller and Jeremy Siegel, shedding light on both their investing similarities and differences. 

At least one says stocks and bonds alone form the perfect portfolio; others take a more broad-based approach.

Active or passive investing? Foerster talks about how the pioneers strongly disagree on this, along with varying opinions concerning portfolio rebalancing.

But here’s a theme consistent among all the pioneers, six of whom were Nobel Laureates: Pursuit of the perfect portfolio requires an astute financial advisor referred by a reliable source. 

This is “to save us from ourselves in terms of the biases we have,” as Foerster puts it.

ThinkAdvisor recently had a phone interview with Foerster, who was speaking from London, Ontario.

In conducting the extensive research for the book, he got a real surprise: One of the experts uncharacteristically bought gold for a particular investment.

Read on to find out who.

THINKADVISOR: How diverse are the investing philosophies of the experts you’ve profiled?

STEPHEN FOERSTER: Not even these 10 luminaries agree on one philosophy.

As one of them, Martin Leibowitz [who co-wrote “Inside the Yield Book: The Classic that Created the Science of Bond Analysis”], said, at certain periods, being passive might work a lot of the time — but it might not necessarily work all the time.

Let’s look at the “perfect portfolio” as described by five of the experts you’ve written about. 

First: Harry Markowitz. He conceived Modern Portfolio Theory and won a 1990 Nobel Prize for developing it. What does he think goes into creating the “perfect portfolio”?

Markowitz’s big breakthrough was showing mathematically why diversification matters. It’s all about correlations — how stocks move relative to one another, which is really important.

So by having a diversified portfolio of risky assets, we can get the proverbial free lunch, where we can either reduce the amount of risk for a given level of expected return or have a higher expected return for a given level of risk through diversification. 

Markowitz’s perfect portfolio would be to invest in low-cost ETFs and a number of individual bonds. He said that the perfect portfolio is about “rational decision-making for financial planning.”

In contrast to Markowitz, Robert Shiller, a Nobel Prize-winning economist and author of the bestselling “Irrational Exuberance,” is a proponent of active investing. Please discuss.

Shiller’s point is that we should always be looking for new innovations that can help us optimize the portfolio in terms of risk and return. 

Aspects of his “trill” idea [a new security he proposed called trillionth] —  buying shares in a country’s GDP — have been adopted by some countries. But I think it has a long way to go to get traction.

The idea is that if the government creates a product that would be related to the performance of the overall economy, it’s almost like you’re sharing in the equity of the country and its overall productivity. 

It’s sort of a win-win because it would have inflation protection and be built on growth opportunities — and the governments wouldn’t be as leveraged. 

His point is that we should be open from a public policy perspective and that governments should look into these types of ideas.

Behaviorist Shiller argues that individuals should “get a good financial advisor — one that good people recommend” since do-it-yourself investing isn’t the best approach for many. Did others in your book advocate that too?

It was a consistent theme among many of our luminaries. 

Shiller is best known for uncovering irrational behaviors that many investors have. So left to our own devices, we might trade excessively and end up underperforming. 

Having a financial advisor should give us a good reality check to keep our emotions in [control] and try to save us from ourselves in terms of the biases we have.

John Bogle famously created the first stock index mutual fund and founded The Vanguard Group. Your book quotes him as saying, “Stop trying to find the needle; invest in the haystack.” Please explain.

The haystacks would be all the equities that might be available in the U.S. market, and the needle would be the ones that seem to consistently outperform.

His notion is that since you could potentially end up underperforming, you’re better off buying the haystack — all the securities that are available in that market. Thus, his notion of index funds.

No other asset classes, such as real estate or other alternatives, are required in the portfolio, Bogle argued.

This is a point where our luminaries have some differences of opinion. Others would take a more broad-based approach and certainly have real estate as part of the overall portfolio

But Bogle said that stocks and bonds will get you very far without having to worry about other asset classes.

From a risk-and-return perspective, his philosophy was that by limiting yourself to stocks and bonds, you’ll go a long way in terms of getting those benefits from the diversification that Markowitz talked about.

Bogle also contended that “investors make a big mistake by thinking too much of the value of the account and not enough about the monthly income [including Social Security] they want to get.” What’s your take on that?

Some investors are overly focused on the price they’re paying but lose sight of why they’re investing. If investing for retirement, what you really care about is the income that’s going to be derived. 

Bogle said also that in retirement, there isn’t a real need to rebalance major asset allocation classes. “Regular rebalancing isn’t terrible but not necessary” was his way of thinking. Comment?

Again, there are conflicting perspectives on the whole notion of rebalancing, and I think the verdict is out on that. 

If there’s more of a momentum trend in a long bull run in equities, say, then by not rebalancing, you’d be better off. 

Bogle’s [general] perspective was: Let it ride and perhaps not be as regimented about rebalancing according to a [specified time frame]. 

Jeremy Siegel, the Wharton finance professor who wrote “Stocks for the Long Run,” recommends that at least one-third of an equity portfolio should be invested in international stocks. What’s his rationale?

Research shows that [regardless of] the proportion of equities the country you live in might represent relative to the world portfolio, people tend to be overinvested in domestic equities — that’s known as home-country bias — regardless of where they live.

I think the U.S. might now be roughly in the 50% range in terms of the market cap of U.S. stocks as a proportion of world stocks.

Siegel is trying to nudge people away from this home-country bias to include at least a third of international equities.

He argued to “tilt the portfolio toward value stocks that have low P/E ratios or higher dividend yields.” What’s the advantage?

That goes back to the work of [University of Chicago professors] Eugene Fama and Kenneth French about price vs. value. [Fama won a Nobel Prize in economic sciences in 2013.] 

Fama and French found that value stocks tended — over the long run, decades — to outperform growth stocks. And small-cap stocks tended to outperform large-cap stocks.

So Siegel says don’t just chase growth stocks that have prices that have been going up quickly. They might not be paying out dividends. In the long run, you may be better off with a stock at a relatively lower price that has better prospects for dividend payments and therefore return.

In your book, Siegel says the ideal portfolio should have an equity holding of 50% in world index funds — 30% U.S.-based, 20% non-U.S.-based — and to allocate the remaining 50% to strategies that will enhance the return. Please elaborate on the latter. 

For example, be aware of emerging industries that may have enhanced growth opportunities at a particular point in time, like real estate investment trusts [REITs] or certain sectors, perhaps [pharma or consumer staples, for example].

Siegel is firm about avoiding “hot stocks” and IPOs. Why steer clear of IPOs?

The literature shows that the typical pattern is a bump in the IPO’s stock price on the first day — even to the tune of 10% to 15%.

However, after that one-day bump, over the next three to five years, IPOs typically tend to underperform the market, though, clearly, some stocks run counter to that, like Google.

Charley Ellis, the renowned investment strategy consultant, is author of the classic “Winning the Loser’s Game.” What does he say about constructing the perfect portfolio? 

In the 1970s, he saw that individual investors often tried to outperform but ended up shooting themselves in the foot. He was the first person well known inside the industry to advocate for passive investing even before the index fund was available as a retail product.

In aspiring for the perfect portfolio, he says, “Don’t invest in commodities, as prices can fluctuate wildly; and if you’re a long-term investor, don’t own domestic bonds in a low-interest-rate environment.”

So, his thinking is more along the lines of Bogle in terms of the narrower approach with asset classes and domestic bonds.

Ellis also emphasizes paying attention to taxes. He says: “Index funds typically turn over at 5% a year, and a well-managed index fund will match gains and losses so that there actually is no tax. 

“Actively managed mutual funds turn over at 40% a year, and the gains are taxable at ordinary income rates,” he points out. Obviously, he feels that index funds have big tax advantages; so always consider taxes, correct? 

Yes. He and a number of our luminaries as well stress attention paid to taxes.

If you have high turnover, which will create capital gains, then there could be tax implications versus the typical index fund, for example, which has a much lower turnover, and which could help you from a tax deferral perspective.

Part of Ellis’ philosophy is: “Don’t think of your house as an investment or treat it like a bank from which you can borrow.” How does that compare with the philosophy of the others you’ve profiled?

It’s a different perspective from Shiller, for example. Ellis’s perspective goes back to [ideas in] his book “Winning the Loser’s Game.”

I’ll use the financial crisis as an example: A lot of individuals were very highly leveraged in terms of mortgages on their homes. The lenders made the assumption that house prices always go up and that being highly leveraged didn’t matter because the price will go up. 

But clearly, we know that didn’t end well. Many people at the time were treating their homes as a financial investment, which they never [really] were. 

With all the research that Professor Lo and you conducted for the book, did you uncover anything surprising?

One of the endowment funds that Bogle oversaw didn’t only have passive index funds. He had a component with an investment in gold. That was a surprise! 

Why do you suppose he made the decision to buy gold?

He felt that it was a small hedge against some major catastrophe — a major risk — and that it might balance things out a bit. 


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