The Quiet Millionaire: Part 7 - Give Me Investment Gains, Hold The Losses
“Win by not losing” or rather win by minimizing losses during market downturns is the ticket to being an investment champion according to The Quiet Millionaire author and Certified Financial Planner Brett Wilder.
Here are the players in his investment strategy based on economic research that won The 1990 Alfred Nobel Memorial Prize in Economic Sciences (awarded to Harry Markowitz, Merton Miller, and William Sharpe):
- Modern Portfolio Theory (MPT): “how wealth can be optimally invested in assets which differ in regard to their expected return and risk, and thereby also how risks can be reduced” developed by Harry Markowitz and the Capital Asset Pricing Model developed by William Sharpe. (Source: Nobel Prize website; see also Money Chimp's discussion of MPT)
- Asset Classes: Bonds, Domestic Equities (Large Cap-Growth, Large Cap-Value, Mid-Cap, Small Cap), International Equities. Mr. Sharpe’s list of asset classes deviates slightly from Mr. Wilder’s list. For example, Mr. Sharpe has two asset classes for non-USA stocks (European Stocks and Japanese Stocks) whereas Mr. Wilder lists International Equities; Sharpe has Small Cap only but Mr. Wilder separates Small-Cap Growth from Small-Cap Value. (Learn about growth vs. value).
- Reasonable Average Rate of Return (% annual growth desired) as defined by the individual investor.
- Acceptable Volatility (see The Honest Dollar’s discussion of volatility) or how much you can stand to lose in portfolio value in any given year. Mr. Wilder recommends that risk tolerance of the individual investor be defined as a % of acceptable loss (e.g., would you go crazy if your investments declined 15% in one year?) rather than vague terms such as conservative, moderate, or aggressive.
- Time Horizon or the years from now to when you will be using investments to fund a major purchase, college education of your children, retirement, or whatever you are saving for.
- Portfolio Structure or Allocation Among Asset Classes is based on MPT and your investment profile (desired rate of return, risk tolerance, time horizon). A sample allocation from The Quiet Millionaire:
- Domestic Bonds 13%
- International Bonds 7%
- Domestic Equities Large Cap Growth 16%
- Domestic Equities Large Cap Value 16%
- Domestic Equities Mid-Cap Growth 4%
- Domestic Equities Mid-Cap Value 4%
- Domestic Equities Small-Cap Growth 6%
- Domestic Equities Small-Cap Value 6%
- International Equities 14%
- Specialty Sector Equities 14%
- Investments That Match Asset Allocations. Mr. Wilder recommends “low-cost mutual funds that are expected to perform better than their competitors categorized in the same asset class.” Choose between actively managed mutual funds (which are managed by a financial pro in hopes of outperforming the market index) or passive funds (index funds).
- Performance Monitoring. Check your performance to see that you are on track with your investment goals but checking every day is not productive.
- Portfolio Rebalancing. When growth occurs in an asset class, it becomes overweighted and not in line with your desired portfolio structure; so, periodically, you need to rebalance your portfolio. Mr. Wilder advises "Rebalancing should not be considered an automatic activity when the out-of-balance situation occurs because, strategically, it may be advantageous or prudent to delay or accelerate making shifts in certain asset classes."
In summary, from the book:
“The Modern Portfolio Approach to investing assures that more predictable performance results will occur during both the good and not so good investment environments. This is because a well-structured portfolio accesses multiple global economies for more investment diversification than can be accomplished with an unstructured portfolio consisting of too few asset classes and a limited number of individual holdings. The individual holdings within an undiversified portfolio typically have too high a degree of investment correlation, which means that all of the holdings go up or down in value at the same time.”
and from me (based on the book):
- Investments increase in value over time.
- If your time horizon is finite (and it is always finite, whether you are saving for a down payment on a house in 5 years or for retirement in 30 years), some of your investments will not reflect their true value at some point in time.
- Certain asset classes will outperform other asset classes in a given time period.
- Certain asset classes will under-perform other asset classes in a given time period.
- You never know for sure which of these asset classes are going to perform better than average or lower than average.
- If you spread out your investments in various asset classes, you will minimize (not eliminate) the fluctuations in your portfolio value while capturing market gains that occur over time.
- When one asset class does well, it is likely that this performance will not continue indefinitely so it is best to rebalance your portfolio structure every once in a while.
Additional items of interest from Chapter 7:
- Realize that media outlets promoting individual stocks, mutual funds, etc. are unregulated.
- Understand that a negative investment environment can be positive, because you can buy stocks at relatively low prices especially if you continue automatic or regular contributions to your investments.
and from me:
- Morningstar mutual fund ratings are based primarily on past performance and a risk factor so choose investments carefully and don't rely too heavily on one source of information.
- The Vanguard 500 Index Fund is a Domestic Equities Large Cap fund (growth/value blend).
Using the right pick of investments, the MPT approach gives a structure to investing that yields gains, over time: “While investing may seem exciting when the investment environment is productive, it is when the going gets tough that uncertainty and fear set in, and it becomes more difficult to make smart decisions.” Being a champion doesn't mean never having a setback or loss but pressing forward with a winning game plan.
Note: I have received a copy of The Quiet Millionaire in exchange for a book review.