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With so many different investments, how should you choose what to include in your portfolio?
Listen now and learn:
- The tradeoffs between implementing a bad idea and missing out on a good one
- A framework for determining whether higher performance is the result of chance
- A process for making choices about adding a new position to your portfolio
Show Notes
When the FDA evaluates a new drug, they seek to minimize the chance of approving a drug that is not beneficial to people’s health or causes bad side effects. In doing so, they increase the probability of failing to approve a drug that would improve people’s health. This is a tradeoff between minimizing Type I and Type II error.
The same tradeoff occurs when evaluating which exposures to include in your portfolio. You can minimize Type I error by owning a couple broad market index funds and never seeking further enhancements to your portfolio. Minimizing Type II error, on the other hand, means setting a very low bar for implementing a new strategy.
The tricky part? Minimizing one error leads to a higher chance of realizing the other error.
The key is to strike a good balance. But the thing I find fascinating about evidence-based investing is that people can look at the same data and come to different conclusions depending on their preference for minimizing Type I or Type II error.
For me, I know that each additional strategy has a diminishing marginal benefit. In addition, the costs of implementing additional exposures at the portfolio level (not just the fund level) increases the uncertainty regarding the net benefit from inclusion.
For these reasons, I tend to be more concerned with implementing a bad idea than missing out on a good one. In other words, I prefer to minimize Type I error.
In Practice
So what exactly does this mean?
Let’s take factor investing as an example.
A factor is a characteristic or trait that explains portfolio returns. Implementing a factor investing strategy means targeting securities with characteristics that you would expect to generate different returns than you would earn from owning the entire market.
For example, the value factor uses fundamental measures such as the book value to find relatively cheap stocks to buy and relatively expensive stocks to short. Eugene Fama and Kenneth French first identified the value factor in 1992 as a dimension of return in their three-factor model, which also identified a premium for owning small companies versus large companies.
Since the publication of the Fama French three-factor model, there has been an explosion in the number of academics and practitioners seeking additional factors that explain portfolio return, with over 600 different factors now published in academic and practitioner literature.
Sorting Through the Factor Zoo
But most of these factors don’t hold up to rigorous standards, and remember, I’m more concerned about implementing a bad idea than missing out on a good one:
For me to consider a factor to include in a portfolio, there are a number of things I’m looking for.
For starters, it must provide explanatory power to portfolio returns and have delivered a premium (a fancy word for higher returns). Additionally, the factor must:
- holds across long periods of time and different economic regimes.
- Work across countries, regions, sectors, and even asset classes.
- Apply for various definitions (for example, there is a value premium whether it is measured by price-to-book, earnings, cash flow, or sales).
- It holds up not just on paper, but also after considering actual implementation issues, such as trading costs.
- Intuitive – There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.
What you’re seeking to do with this framework is identify the drivers of expected returns that are unlikely to be the result of chance. But it doesn’t mean you should include everything that meets these criteria to your portfolio.
As I mentioned before, each additional exposure you add to a portfolio comes with a diminishing marginal benefit, which lowers the probability that the benefits will outweigh the costs. As a result, you must carefully weigh the expected net benefits versus the degree of uncertainty.
The other consideration that I think a lot of practitioners fail to think about is investor behavior. You can build the best portfolio in the world on paper, but living with that portfolio is a different challenge.
Whether we are talking about factor investing or the use of non-correlated assets such as alternatives, I believe it’s important to think about the frequency and methods with which the portfolio is going to be monitored.
The less frequently a portfolio is reviewed, the more likely long-term strategies will be given the space to let financial theory play out.
On the other hand, if a portfolio is being reviewed frequently — and maybe you think I’m talking about daily or weekly, but really I think reviewing a portfolio quarterly is a lot — then you’re opening yourself up for more behavioral mistakes, whether those are cognitive or emotional errors. Because so many people check their portfolios on a quarterly basis, if not more frequently, that impacts the way I think about portfolio construction.
And when I talk about method of review, I’m talking about whether where someone is monitoring the portfolio:
- From their phone on their custodial app or statement, which typically just shows a position’s gains and losses that don’t account for income? These reporting methods also exclude any insight for how positions that are no longer held have impacted their performance.
- Or are they looking at a statement from an advisor that typically incorporates more comprehensive portfolio level performance?
- Are they looking at money weighted returns or internal rates of return? And if they’re looking at both, will they know the difference?
- Will someone with a deep understanding of the various holdings be present when the portfolio is being reviewed.
As you might expect, given my role, I’m thinking about the choice to add or not to add positions to a portfolio on behalf of others.
To Add or Not To Add? That Is The Question
But when it comes to making your own decisions, here are a few things to keep in mind when evaluating what to include in your portfolio:
- Every potential change to your portfolio should start with a written hypothesis that can be tested using evidence. This helps protect ourselves from a tendency to seek out confirming information or being swayed by narrative.
- Slow down your process. Real long-term investors shouldn’t be in any hurry to include something in a portfolio. Don’t be afraid to lay out a timeline that spans 12 to 24 months for your research phase and hypothesis testing. If you truly have a multi-decade horizon, taking this time won’t penalize you. If anything, it will help you uncover more things you didn’t think about initially.
- Understand how product methodology differs from the methodology in the underlying research. It’s one thing to find research that you believe in. It’s another thing to find a product that captures a given exposure in a way that aligns with the methodology from the research. Similarly, you ought to understand the weaknesses of the models and their underlying assumptions. It’s easy to find a strategy that works in hindsight
- Diversification and return benefits must always be considered in light of expenses and taxes. Extra fees can offset the benefits of otherwise attractive investments. Most published research focuses on cost at the fund level, but doesn’t consider the portfolio level or unique end-user experience. Running simulations to evaluate trading costs and tax impact of including a new fund or exposure can help you better understand the true impact to your end user.
And although it seems obvious, don’t invest in something you couldn’t live with for multiple decades. There isn’t a strategy that always works. Most financial theory tends to play out in the long-term, but investors often find sitting through the day-in-and-day-out experience to be more stressful.
Until next time, to long-term investing.
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About the Podcast
Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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