In the Introduction, I presented the justification for this book: the conver- gence of the personal computer (PC), the Internet, and exchange-traded funds (ETFs). The tools that the trio offers must be applied to a process to be valid. For despite all their wonderful advantages and benefits, personal computers and the Internet, on their own, cannot enable an investor of av- erage or modest means to construct and maintain an effective portfolio.
Yes, as noted in the Introduction, the PC and the Net do make investment research easier, more efficient, and far more cost-effective. Yes, the PC and the Net do make managing and monitoring a portfolio far more easy and productive. And yes, the PC and the Net do enable investors to get to that all-important asset allocation decision more efficiently. But, there is some- thing that the PC and the Net cannot do: enable an investor to properly di- versify his/her assets. To take investment matters to the next step, we need an investment vehicle that will enable us to construct and manage portfo- lios effectively. That’s where exchange-traded funds (ETFs) come into the picture.
ETFs TO THE RESCUE
An effective portfolio is one that seeks to minimize risk and maximize op- portunities through the intelligent use of the all-important principle of di- versification. An effective portfolio is a portfolio designed to give an investor the edge—the competitive advantage—he/she needs to produce consistent investment results. An effective portfolio employs the principles of diversification to its advantage.
Portfolio diversification is an underappreciated aspect of successful in- vesting that most individual and many professional investors fail to fully appreciate. In fact, diversifying within an asset class comes second to the single most important factor in achieving consistent investment perfor- mance—the asset allocation decision.
As for diversification, some might ask why it is necessary. Why is it best to build and maintain a well-diversified portfolio? The answer to that question lies in another proven fact: Diversification decreases portfolio volatility while enabling an equal or greater return. Because of the mathe- matical facts of correlation (the price movement of one asset vis-à-vis an- other), a well-diversified portfolio is a less volatile and therefore a less risky portfolio. Additionally, a well-diversified portfolio enjoys a rate of return that is often equal to or greater than the return an investor might receive from a less diversified, more concentrated portfolio. Finally, portfolios that are more concentrated and therefore less diversified are destined to be sub- ject to the mercy of overconcentration in sectors, in industries, geographi- cally, and from an investment style perspective, and, therefore, subject to its consequences. As a result, there are two points to make:
1. A less diversified portfolio is almost always a more volatile one than a well-diversified one. (The exception would be a heavy concentration in sectors, styles, and stocks that individually have very low volatilities.) 2. Overconcentration almost always leads to greater risk that hopefully
will be rewarded with a greater return—with hopefullybeing the oper- ative word.
The final point I wish to make on the issue of diversification is the issue of playing not to lose. We all want to win, and win consistently. A major part of winning is minimizing the risk it takes to win, and to do that it is most important that investors consider that playing not to lose is an impor- tant part of winning. For there are times when the unknowable becomes even more unknowable. That is to say, despite our best efforts to analyze the economic and investment world we live in, there is much that we just don’t know. Events occur that are wholly unexpected; exogenous events such as terrorism or natural disasters or uncontrollable circumstances brought about by the lack of transparency of financial instruments, to name a few, produce a situation of making investment decisions with less than perfect information in a highly uncertain environment. Then there is the added issue of human nature.
Buy low, sell high is a wonderful idea but one that human nature often gets in the way of. Many times fear and greed run rampant. And investors, being the less than perfectly rational human beings that they are, become even less rational and often get swept up in the emotion of the moment.
That is how bubbles and panics are formed. Moreover, as investors try to outsmart each other, issues like justification for extreme overvaluation or undervaluation get wrapped in phrases like “liquidity-driven markets.” Di- versification helps counteract the failings of human nature by insisting that
no one area is overexposed and, therefore, the risk of being economically adversely impacted is minimized.
Bottom line: A well-diversified portfolio is vital to your financial health. Exchange-traded funds are the everyman’s tool for achieving that goal.
Exchange-traded funds, by their very nature, provide the most cost- effective and performance-effective way of constructing and maintaining an effective—that is, diversified—portfolio by enabling an investor to do what heretofore only a person with a considerable amount of money anda considerable amount of resources could do. Here’s why:
In the time before ETFs, to achieve the all-important diversification necessary for sustainable investment performance, an investor had to mimic professional investors—build and maintain fairly large portfolios with lots of stocks, lots of sector exposure, and lots of style exposure. To achieve this required a considerable amount of money (both within a port- folio and for research services) and the time and skill necessary to monitor the myriad of companies and stocks to make the right portfolio decisions.
Few investors and financial managers of more modest means have such time and resources to, in effect, do the right portfolio thing. In other words, creating and maintaining a properly diversified portfolio is a hard, but necessary, thing to do. Exchange-traded funds make this possible.
Exchange-traded funds are simple yet powerful investment tools that, above all else, provide investors with the wherewithal to cost-effectively build a portfolio designed to maximize return and minimize risk through diversification. ETFs are the intelligent investor’s investment instrument upon which an effective portfolio can become a cost-effective reality. As a recent Merrill Lynch report so aptly describes it:
ETFs give investors access to entire portfolios of stocks or bonds through a single exchange-traded instrument. Within the equity universe, ETFs offer investors a wide array of investment choices including the ability to invest based on sector, size & style, as well as a vehicle to easily invest in international equities. While they may be less attractive for investors with strong stock-specific views, ETFs are convenient for implementing diversified top-down investment decisions for investors not wanting to manage large portfolios of individual stocks.1
Therefore, unless an investor can spend a lot of time and money mim- icking professional money managers monitoring hundreds of individual companies and their stocks, the ability to benefit from an effective portfo- lio is beyond their means. That is, until now.
The real power of an ETF-built portfolio rests in the ability of an in- vestor to cost-effectively create a portfolio that provides exposure to the broad economic sectors and styles that comprise the equity markets. But there is something else, something that unfortunately far too many investors often lose sight of, that using ETFs to achieve an efficient port- folio helps to emphasize: placing the investment focus where it be- longs—on strategy.
In my 30-plus years on Wall Street, I have consistently been amazed at how few investors, mostly nonprofessionals, truly understand the impor- tance of asset allocation and diversification and how they, and not the indi- vidual stocks, are the primary forces of investment results. The data I noted earlier on asset allocation is a well-documented fact and speaks vol- umes for itself. It is where I spend the majority of my research time and ef- fort—focused on the macro and micro environments, from a top-down and bottom-up perspective, from a real economy and a financial economy perspective. When 85 to 90 percent explains anything, it warrants 85 to 90 percent of my time. The side benefit of using ETFs as the core of your in- vestment portfolio (see the next section, “Core Plus”) is that it literally forces an investor to focus on strategy and away from the nonproductive exercise of trying to outsmart and outperform the market through stock picking. Stock picking may be good for television ratings and it certainly is a lot of fun when you get it right, but it should not be the center of an in- vestor’s attention. When it comes to making money consistently, asset allo- cation followed by a well-diversified portfolio is the means to that end.
If you have accepted what I have presented thus far, then you are prob- ably now ready to better understand the portfolio construction process I advocate and offer for your consideration. Therefore, let me describe to you my version of the core of effective portfolio managers—overweight or underweight the sectors of the market. I call it “Core Plus.”