The Intelligent Portfolio: Book Notes/Summary

This post contains the key ideas from the book The Intelligent Portfolio by Christopher Jones.

  • Take control of your future. Be realistic about your ability and interest in managing your investments on your own. Decide whether you are willing to spend the time to educate yourself on how to be a savvy investor, or find a qualified and fee-only( no commissions) advisor to help you at a reasonable fee. But most importantly don’t make the mistake of just sitting there and procrastinating.
  • Always maintain a skeptical attitude about your investments. Don’t be led astray by unrealistic performance claims and sloppy analysis. There is a lot of foolish advice out there. Think critically about your investments all the time.
  • Take advantage of the institutional tools of the trade. Simulation and optimisation techniques are very helpful in building high quality investment portfolios. Be a more informed investor by taking advantage of these tool, just like the big institutional investors do.
  • There is no free lunch. Risk and returns are always related. You won’t find higher investment returns without assuming higher risk. Moreover, risk has a way of catching up with you whether you expect it or not.
  • Not all risk comes with expected reward. In general, only risks correlated with the overall market are compensated with higher expected returns. Risks that are easily diversified away generally do not result in higher expected returns.
  • Not all risk is visible in historical returns. Be careful of investment strategies with small probabilities of very bad outcomes( doing very badly in bad times). With such strategies, the historical record can be a poor guide to the future risks. Hedge funds are notorious for having such risks.
  • Use realistic investment simulations to understand your range of possible portfolio outcomes. Sophisticated investment simulation models can give a realistic view of your future outcomes and help you make better decisions. Don’t pay too much attention to the expected outcome –  chances are you will experience something different.
  • Bonds are more risky than cash, and equities are more risky than bonds. But with this risk comes higher expected returns. The higher the risk, the higher the range of possible outcomes. Over a 5 year holding period, bonds have a range of outcomes that is three times bigger than cash( adjusted for inflation), while equities have a range that is eight times larger. These ratios go up even more with longer term horizons. Make sure you understand the range of possible outcomes when you invest.The inflation adjusted portfolio values of various asset classes are as follows( with no fees)

Cash: 1 year(95%-105%) 5 years(95%-115%)
Long term bonds: 1 year(90%-115%) 5 years(80%-145%)
Large cap US equities: 1 year(80%-135%) 5 years(70%-235%)

  • Don’t fall into the trap of picking the portfolio with the highest historical return. Always consider the risk of future returns.
  • Past performance is a poor guide for future expected returns. This is true for both asset classes and investment funds. Just because a manager did well in the past does not mean that such performance will be repeated. Past returns hold little information about the future.
  • History is only one observation from a range of possible but unseen outcomes. Most of what is possible in investment performance is never actually observed. Don’t get too fixated on what happened historically, as the future will almost certainly be different.
  • Don’t be misled by a strong historical record. There are many reasons why historical records may not be representative of the future. Be skeptical, especially about newer investment funds with limited histories.
  • Manager performance is only a weak predictor of future performance. The predictive value of manager track records is weak. Even great track records may be due to good luck as much as investment skill. Don’t make big bets on managers being able to repeat their historical performance.
  • The market is very difficult to consistently beat. This does not mean it is impossible to beat, but consistently outperforming the market is highly challenging, even for the most experienced and sophisticated investors. Don’t base your financial plan on being able to beat the market.
  • The market portfolio is a good benchmark for the average investor. It is also an excellent source of information about future expected returns.
  • Don’t try to time the market. market timing assumes that many other investors in the market are making a big mistake – a costly assumption if you are wrong. You are better off sticking with a consistent diversified strategy over time.
  • Avoid investment strategies that rebalance to fixed proportions. They are actually contrarian bets against the market. You should use strategies that adjust with the market portfolio to avoid market timing bets.
  • Higher expected return classes have more market risk. To get higher expected returns, you need to be willing to take more market risk. Equities have higher expected returns than bonds.
  • International assets are a desirable part of your portfolio. Their relatively low correlations with the rest of your portfolio make them desirable holdings in a diversified strategy.
  • Risk means different things to different people. Make sure you focus on the risks that are most important to you. Evaluate the trade-offs between short-term and long-term risks.
  • The most important factors in selecting an appropriate risk level are time horizon and your tolerance for downside outcomes, both short and long-term. Make sure your investment allocation is consistent with your time horizon.
  • There is a trade-off between long-term expected returns and short-term volatility. Higher median portfolio outcomes come with more short-term volatility. In order to achieve higher expected returns, you must be willing to endure more volatility in the short-term.
  • Don’t make the mistake of investing very conservatively for long periods of time. You give up substantial expected growth over longer horizons by investing in very conservative assets like money market or stable value funds.
  • Even with relatively short horizons, it will often make sense to have significant equity exposure. If your horizon is more than ten years, consider having at least 60% of your assets devoted to diversified equities. Longer-term investors should consider placing 80% or more of their assets into equities. Remember that your retirement horizon is generally not the date when you will need to liquidate your assets.
  • Investing in individual stocks is an unnecessary gamble. You can do better, on average, by using more diversified instruments like mutual funds or exchange traded funds for your core investments.
  • Individual stocks have much higher volatility than funds.The risk of individual stocks varies significantly across industries and companies, but downside values for stocks are much lower than the values for equity funds. Companies can easily go bankrupt, but mutual funds do not.
  • The higher volatility of individual stocks implies much lower expected growth rates. For many individual stocks, the expected growth rate is aero or even negative for multiyear horizons. Higher volatility is a major drag of portfolio growth rates.
  • When you invest in a diversified portfolio instead of a single stock, you give up a small probability of doing very well, but your overall chances of coming out ahead improve dramatically. The performance of a broad-based equity index will exceed the returns of a single stock strategy about 60%-75% of the time over a multiyear period. Don’t bet the farm on a stock doing much better than expected.
  • The costs of trading a stock portfolio are much higher than most mutual funds. The costs associated with even moderate levels of stock trading can be a substantial drag on your expected returns, particularly in a taxable account. Don’t succumb to the siren song of the active stock trader.
  • Never make the critical mistake of being too concentrated in your employer’s stock. If your company gets into trouble, you could lose your job and your retirement savings if you are too concentrated. Do not put more than 20% of your retirement portfolio into your employer’s stock, and most investors should consider an even lower percentage.
  • The average index fund outperforms the average active fund. Only a subset of actively managed funds can beat their benchmark, and this subset changes from year to year. The average dollar invested in an index fund is mathematically guaranteed to beat the average dollar invested in an actively manged fund.
  • Don’t buy funds with high expenses. Avoid equity funds with expense ratios above 1% per year, bond funds with expense ratios of above 0.75% and money market funds with expense ratios of more than 0.5% and index funds with expense ratios of more than 0.4%
  • Avoid equity funds with high turnover( more than 150% per year).  The high turnover increases the total costs of the fund through brokerage commissions and trading costs.
  • Don’t purchase funds with front-end or back-end investment loads. Particularly if you don’t plan to hold the fund for at least 10 years, you are generally better off selecting comparable no load funds. Try to invest in low cost no load funds when possible.
  • Don’t pay your advisor with loads or commissions.
  • Take advantage of institutionally priced products if you can get them through your employer retirement plan.
  • Try to avoid purchases of transaction fee funds.
  • Diversification is important, it does not get rid of market risk. A diversified portfolio may still have considerable risk, depending on the amount of exposure to the overall market. A properly diversified portfolio means only taking risks for which you are likely to be rewarded. A diversified portfolio is still risky.
  • Evaluate diversification at the household level, not at the individual account level. consider the impact of all your assets on your overall investment allocation. make sure your overall household portfolio is diversified.
  • Asset class diversification has significant but finite economic value. The cost of not being to invest in a single asset class is typically less than 0.50% on a forward-looking basis. Asset allocation explains much of the variation in returns for a portfolio, but may not explain much about the mean level of returns
  • Don’t overpay for asset class diversification. If it costs more than about 1% in additional fees to get exposure to a given asset class, you will usually be better off dropping it from your allocation so as to maximise your portfolio expected return.
  • Keep alternative investments to a small part of your portfolio. If you do choose to invest in alternative investments like real estate, commodities or hedge funds, keep the allocation to a small part of your portfolio and be very wary of high fees and unobserved risks.
  • Fund expenses are important predictors of future investment performance. These expenses include annual expense ratios, loads, and costs due to portfolio turnover.
  • Stick with low-cost investments. Generally you should avoid bond funds with expense ratios more than 0.75%, large cap equity funds with expense ratios above 0.75% and small/midcap and international funds with expense ratios above 1%.
  • Compare the performance of funds against peers with similar investment styles.
  • Managers with good historical performance are not guaranteed to repeat such results.
  • Picking good active funds is difficult. Therefore consider index funds as your choice.
  • Get started early. Time is your friend when funding future goals. The earlier you start, the less you will have to save.
  • Realistically estimate your retirement income needs. You will usually need 60-80% of your final year’s income to maintain your standard of living during retirement. Women will need higher savings because they live longer on average.
  • Determine your odds of success. use investment simulation methods to determine your odds of success.
  • Confidence costs money. If you want to very confident of reaching a goal, you will need to save more of your current income and invest more conservatively.
  • Adjust your risk level to be consistent with your time horizons. For longer time horizons, invest in portfolios with higher allocations to equities.
  • The more flexible your goal is, the more risk you can assume in your investment strategy. If a financial goal can be delayed or reduced in size if markets perform poorly, then you have more flexibility with your investment risk level.
  • Take full advantage of your retirement plan employer match. This is free money- take as much as you can get.
  • Revisit your savings plan periodically. Life changes, so be sure your savings plan changes with it. You may need to change your savings rate over time to stay on track.
  • Focus on maximizing after tax returns than minimizing taxes. Your goal should be to maximize your after tax wealth, not to avoid taxes at all costs.
  • Tax-efficient investing means paying lower taxes and deferring taxes into the future where possible. Try to avoid short-term capital gains and interest income from your investments in taxable accounts.
  • The higher your income tax rate, the more important is tax efficiency to your investment success.
  • Equity funds are generally more tax efficient than bond funds. Among bond funds, municipal bonds are most tax-efficient.
  • Hold less tax efficient assets( eg. taxable bonds) in tax-deferred account and more tax efficient assets in your taxable accounts.
  • Index funds are generally more tax-efficient than actively managed funds.
  • Avoid equity mutual funds with large short-term capital gains distributions.
  • High income investors should consider municipal bonds for bond exposure in taxable accounts. Never hold municipal bonds in a tax deferred account.
  • Remember that tax efficiency is only one factor in selecting funds. You also need to consider investment style, fees and manager performance to build good portfolios.
  • Finally, use your common sense. If something sounds too good to be true, it almost certainly is. Don’t be suckered in by a slick sales pitch if the promises don’t make sense.

The above principles can be distilled into 10 basic concepts:

  1. Recognize the linkage between risk and reward
  2. Avoid being deceived by history
  3. Leverage the wisdom of the market
  4. Select an appropriate risk level
  5. Avoid the perils of stock picking
  6. Don’t spend too much on investment fees
  7. Diversify intelligently
  8. Select funds using relevant forward-looking criteria
  9. Understand how to realistically fund financial goals
  10. Invest tax-efficiently.