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In his book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” Larry Swedroe has a detailed discussion on how investors can choose the right asset allocation for them, with the focus being on determining one’s ability (capacity), willingness (tolerance) and need (the rate of return required to achieve a goal) to take risk.
To help with issues surrounding the willingness to take risk, risk tolerance questionnaires have become a very popular. Unfortunately, as Joachim Klement showed in his article, “Investor Risk Profiling: An Overview,” published in the June 2018 CFA Institute Research Foundation brief “Risk Profiling and Tolerance: Insights for the Private Wealth Manager,” the “current standard process of risk profiling through questionnaires is found to be highly unreliable and typically explains less than 15% of the variation in risky assets between investors. The cause is primarily the design of the questionnaires, which focus on socioeconomic variables and hypothetical scenarios to elicit the investor’s behavior.”
He went on to explain that there are three problems questionnaires typically fail to address: Our genetic predisposition affects our willingness to take on financial risks, the people we interact with shape our views, and the circumstances we experience in our lifetimes—in particular, > SEE MORE
The evidence is clear that investors are waking up to the fact that, while the past performance of actively managed mutual funds has no value as a predictor of future performance, expense ratios do—lower-cost funds persistently outperform higher-cost ones in the same asset class.
That has led many to choose passive strategies, such as indexing, when implementing investment plans because passive funds tend to have lower expense ratios. Within the broad category of passive investment strategies, index funds and ETFs tend to have the lowest expenses.
Based on my experience, most investors tend to believe that all passively managed funds in the same asset class are virtual substitutes for one another (meaning > SEE MORE
It’s impossible to prudently build an investment plan without estimating the return to stocks (and bonds), making such estimates a central component of the process. This estimate will determine your need to take risk—how high an allocation to equities you will need to reach your goal.
If your estimate is too high, it’s likely you won’t have sufficient assets to reach your retirement goal. If it’s too low, it could lead you to allocate more to equities, which means taking more risk than necessary. Alternatively, it could lead you to lower your goal, save more, or plan on working longer.
Despite its importance, there is much disagreement about how to estimate stock returns. As is always the case, we rely on academic evidence.
Research on the expected equity premium, including Aswath Damodaran’s 2017 paper, “Equity Risk Premiums (ERP): Determinants, Estimation and Implications,” has found that the best predictor of future equity returns is current valuations—whether using measures such as the earnings yield (E/P) derived from the Shiller CAPE 10 (or, for that matter, the CAPE 7, 8 or 9) or the current E/P—not historical returns.
There are two big, ongoing debates relative to index (or, more broadly, passive) investing. The first is whether active or passive (which I define as neither market timing nor individual security selection) management is the winner’s game (the one most likely to allow you to achieve your goals). The overwhelming evidence shows that passive investing is the prudent choice.
The other debate that rages on is if a total-market approach (with John Bogle often seen as the standard-bearer) is “best,” or whether “titling” a portfolio to well-documented factors is likely to produce higher returns, and perhaps higher risk-adjusted returns.
During discussion about this second issue, perhaps the most-asked question I hear goes something like this: We know the historical evidence shows premiums for these factors, but how can you be confident that factor premiums will persist after research about them is published and everyone knows about them? After all, we are all familiar with the phrase “past performance does not guarantee future results.” I thought it worth sharing my answer.
Argument For Persistence
The first thing I point out is that we live in a world of uncertainty. There is simply no way to know for certain whether a factor premium will persist in the future; that goes for all factors, including market beta.
It’s a great tragedy that despite its obvious importance to everyone, our educational system almost totally ignores the field of finance and investments. This is true unless you go to an undergraduate business school or pursue an MBA in finance.
Eighteenth-century English poet Thomas Gray wrote, “Where ignorance is bliss, Tis folly to be wise.” When it comes to investing, ignorance certainly is not bliss—it pays to be wise. Just ask investors who lost tens of billions of dollars in the Bernard Madoff scandal. Without a basic understanding of how capital markets work, there is no way individuals can make prudent investment decisions.
The sad fact is that surveys have shown fewer than half of U.S. workers have even attempted to estimate how much money they might need in retirement, and many older adults face significant retirement shortfalls. While educational achievement is strongly > SEE MORE