Book Summary — Unconventional Success
A Fundamental Approach to Personal Investment
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1 paragraph summary:
What to look out for when you construct your investment portfolio.
Individuals fare best by constructing equity-oriented, broadly diversified portfolios without the active management component.
John Maynard Keynes: Worldly wisdom teaches that is is better for reputation to fail conventionally than to succeed unconventionally.
Human nature prefers the comfort that comes with pursuing a time-honored strategy. Sharing a common outcome with large numbers of fellow citizens creates a mutually reinforcing social bond. Unfortunately, the comfortable rarely produces success.
Sources of Return
Capital markets provide three tools for investors to employ in generating investment returns: asset allocation, market timing, and security selection.
1. Asset Allocation
Three basic principles inform asset-allocation decisions in well-constructed portfolios.
First, long-term investors build portfolios with a pronounced equity bias.
Second, careful investors fashion portfolios with substantial diversification.
Third, sensible investors create portfolios with concern to tax considerations.
- Wealth creating equity bias
- Risk-reducing portfolio diversification
- Return-enhancing tax sensitivity
Six asset classes provide exposure to well-defined investment attributes. Proper portfolio construction requires each asset class to be at least 5–10 percent of assets, each class no more than 25–30 percent.
- Core asset class — stock, bond, real estate
- domestic, foreign and emerging markets equities
- treasury bonds and inflation-protected securities
Treasury Bonds
US treasury bonds provide a unique form of diversification for investor portfolios, protecting against financial crisis and economic distress.
In terms of crisis, gov bonds provide the greatest degree of protection to investor portfolios.
The purity of noncollable, long-term, default-free Treasury bonds provides the most powerful diversification to investor portfolios.
Foreign Developed Equity
Overseas investments exhibit two critical differentiating characteristics relative to domestic holdings.
- different markets respond differently to economic forces
- exposes investors to foreign currency fluctuations
Sensible investors pursue diversification as a policy to reduce risk, not as a tactic to chase performance. By following a disciplined policy of maintaining a well-diversified set of portfolio exposures, regardless of market zigs and zags, investors establish the conditions for long-run success.
Foreign equities provide an important tool for reducing portfolio risk without sacrificing expected returns.
Emerging Markets Equity
High risk, high return segment of marketable equities.
Risk and Return Characteristics
Real estate returns and risks fall between those of bonds and equities. With bond-like rental streams and equity-like residual values, investors expect real estate to produce results somewhere between the results expected from the bond market and those from the stock market.
Publicly Traded Real Estate Securities
Vanguard stands atop the industry in terms of excellence in tracking a wide variety of markets. Along with its market-replicating record of low-tracking-error products comes a well-deserved reputation for low fees. Like all of Vanguard’s index products, the Vanguard REIT index fund provides high-quality, low-cost exposure to its target market.
Portfolio Construction
Unless an investor embraces wholeheartedly a particular portfolio structure, failure awaits. Lightly held positions invite casual reversal, exposing vacillating investors to the costly consequences of market whipsaw.
The Science
Diversification demands that each asset class receive a weighting large enough to matter, but small enough not to matter too much. Equity orientation requires that high-expected-return asset classes dominate the portfolio.
The necessity that each asset class matter indicates a minimum of a 5 or 10 percent allocation. The requirement that no asset class matter too much dictates a maximum of a 25 to 30 percent allocation.
Adjustment of portfolio allocations for personal preferences leads to greater likelihood of maintaining asset-class exposure though thick and thin. Consideration of personal circumstances produces financial asset exposures that complement an investor’s overall asset and liability profile.
Non-Core Asset Classes
Corporate Bonds
The holder of corporate bonds faces a “heads you win, tails I lose” situation. IF rates decline, the investor loses the no high-coupon bond through a call at a fixed price. If rates rise, the investor holds a no low-coupon bond that shows mark-to-market losses. The lack of parallelism in a callable corporate bond’s response to rising and falling rates factors the corporate issuer over the bond investor.
As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run.
2. Market Timing
Overweighting assets that produced strong past performance and underwriting assets that produce weak past performance provides a poor recipe for pleasing prospective results. Strong evidence exists that markets exhibit mean-reverting behaviour, a tendency for food performance to follow bad and bad performance to follow good.
In markets characterized by mean reversion, investors who fairly to rebalance portfolio to long-term targets end up with outsized exposure to recently appreciated assets that prove most vulnerable to poor future results.
Active market times usually fail. Market timing requires taking relatively few, generally undiversifiable positions.
Avoiding bull market purchases and forsaking bear market sales constitute first steps in sensible implementation of a reasonable investment program.
Rebalancing
As market forces cause various assets to rise and fall in value, proportions of portfolios allocated to the various assets rise and fall concurrently. To maintain desired allocations, investors sell assets that appreciate in relative terms and buy assets that depreciate in relative terms.
When markets make radical moves, investors demonstrate either the courage or the cowardice of their convictions.
Depending on the circumstances, losses generated from security sales may provide and offset to gains realized elsewhere, thereby enabling tax-free rebalancing.
Psychology of Rebalancing
Contrarian behaviour lies at the heart of most successful investment strategies. Unfortunately for investors, human nature craves the positive reinforcement that comes from running with the crowd.
Contrarian investment behaviour requires shunning the loved and embracing the unloved. Most people do the opposite.
3. Security Selection
Security selection plays a minor role in investment returns, because investors tend to hold broadly diversified portfolios to correlate reasonably strongly with the overall market.
Research shows that to achieve the same reduction in nonmarket risk, investors required a portfolio of fifty securities.
Before considering transaction costs, active management appears to be a zero-sum game, a contest in which the winners’ games exactly offset the losers’ losses.
The leakage of fees from the system causes active management to turn into a negative-sum game.
Mutual Funds
Actively managed mutual funds consistently fail to produce superior returns. Pre-tax returns fall short of the market-mimicking, passively managed alternative by a substantial margin. Taxes cause actively managed portfolios to produce even more dismal shortfalls. When taking sales charges into consideration, the failure of actively managed mutual funds reaches staggering proportions.
On the one hand, mutual fund managers take on fiduciary responsibility to provide high-quality investment management services to investors. On the other hand, the overwhelming number of mutual-fund org exist to generate profits, either for public shareholders, private owners, or corporate parents. Conflicts of interest abound.
Investors require low fees. Profit seekers demand high fiees.
Taxable investors prefer low turnover investment strategies that defer taxable gains. Profit seekers revel in the money and influence that accompany high trading volume.
Investors benefit from limits of assets under management. Profit seekers gather assets.
Investors seek for fair, transparent fee arrangements. Profit seekers thrive under complex, opaque transaction structures.
Note: half the book is about why not to invest in Mutual Funds because of opaque fees and misaligned incentives.
Exchange-Traded Fund Alternative
Well structured ETFs share with standard index funds the benefits of diversification, low cost, and tax efficiency.
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