Annual Review of Portfolio Weights

As regular readers know, we have built seven model portfolios with two types of investor in mind. The first type of investor in principally concerned with beating the return on some type of index, while taking on no additional risk. Call this the "competitive type" of investor. With him or her in mind, we have built three model portfolios, called high, medium, and low risk. The objective of the first portfolio is to deliver more return than a benchmark comprised 80% of the S&P 500 index, and 20% of the Lehman Brothers Aggregate Bond Market Index, while taking on no additional risk. The medium risk portfolio’s objective is to deliver more return than a 60% S&P 500/40% Lehman Aggregate Bond benchmark, while the low risk’s objective is to better a 20% S&P 500/80% Lehman Aggregate Bond benchmark.

The second type of investor has a clear understanding of the minimum rate of return he or she must achieve on his/her portfolio to fully fund his/her future liabilities (e.g., for college education and/or retirement). This investor’s principal goal is to allocate his/her assets to maximize the probability of achieving this "threshold" or minimum required return, while taking on as little risk as possible. Call this the "cautious type" of investor.

We have reviewed the performance of our model portfolios over the past year, as well as the underlying composition of many indexes. Based on this review, we have decided to keep our recommended portfolio weights unchanged for the next twelve months. Undoubtedly, some people will criticize us for this decision, and wonder why we have not increased our weightings for large cap growth stocks, or even introduced the use of more narrowly defined technology indexes into our model portfolios. Let us explain.

There is an old saying that the way to get rich fast is to concentrate, while the way to get rich slowly is to diversify. All around us, the press is full of stories about people who have successfully done the former. Clearly, if someone had invested all of their assets last year in a company like Qualcomm, they would be much wealthier today. On the other hand, if they had invested all their assets in, for example, e-Toys or iVillage, they would be considerably poorer today. The point is clear – investing a substantial portion of your assets in a single stock can make you both wealthier and poorer very quickly. It is almost inevitable that people who invest this way are going to generate widely varying returns from year to year.

This is clearly not the case for an investor with a well-diversified portfolio of index funds, who can generally count on a steady stream of lower, but far less variable returns (because the returns on the asset classes in the portfolio have low correlations with each other). However, the difference between the two investors comes down to more than a question of emotional preference or personal style. There are also real economic consequences involved. Consider a simple example: Harry the High Flyer and Irving the Indexer both have $100,000 to invest. Harry invests in technology stocks, and earns returns of 25%, (20%) and 42% over the next three years. During the same period, Irving’s portfolio returns 17%, 16%, and 15%. Who comes out ahead?

In percentage terms, they end up dead even, as they both have average three-year returns of 16% per year. In wealth terms, however, Harry ends up with $142,000, while Irving ends up with $156,078 – 10% ahead of Harry, Master of the Technology Universe.

Finally, this simple example may be too kind to Harry. Why? Because active investors are particularly exposed to two natural biases that frequently cause human beings to make less than perfectly rational decisions. The first of these has been summed up in the phrase "losing hurts twice as bad as winning feels good" (the fancy name is prospect theory). Because of this bias, we are prone to taking on much more risk when attempting to avoid a loss, and much less risk when it comes to keeping our gains. In investment terms, most active investors have a tendency to ride their losses too long, and take their gains too soon. The problems this causes for one’s portfolio are only made worse by our second natural bias: overconfidence. Not only do we ride our losses too long, but we’re usually too sure that it’s the right thing to do!

This is not to say that Harry was necessarily wrong to take an active approach to investing. Perhaps his future liabilities are all fully funded, and his $100,000 was money he could afford to lose. Perhaps Harry cares more about short-term bragging rights at the club than he does about ensuring his long-term financial security. Or perhaps Harry believed he had access to superior information about the companies in which he invested (and in at least one case, this proved to be true!). Whatever the reasoning behind Harry’s choices, Irving’s portfolio has created more wealth – and undoubtedly less stress in the process. It is for the Irvings of this world that we created Index Investor, and it is with them we look forward to enjoying the coming year, whatever it may bring.