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Portfolio Design: A Modern Approach to Asset Allocation by R. Marston

asset allocation, Bob Litterman, book value, Bretton Woods, business cycle, capital asset pricing model, capital controls, carried interest, commodity trading advisor, correlation coefficient, currency risk, diversification, diversified portfolio, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, family office, financial engineering, financial innovation, fixed income, German hyperinflation, global macro, high net worth, hiring and firing, housing crisis, income per capita, index fund, inventory management, junk bonds, Long Term Capital Management, low interest rates, managed futures, mortgage debt, Nixon triggered the end of the Bretton Woods system, passive investing, purchasing power parity, risk free rate, risk-adjusted returns, Robert Shiller, Ronald Reagan, Sharpe ratio, Silicon Valley, stocks for the long run, superstar cities, survivorship bias, transaction costs, Vanguard fund

This low correlation meant that the risk of an internationally diversified portfolio could be lower than that of an all-U.S. portfolio. Over the period from 1970 (when the EAFE index begins) and 2009, for example, the correlation between EAFE and the S&P 500 index is only 0.60. The effects of this low correlation have often been illustrated using a horseshoe diagram like that found in Figure 5.8. The horseshoe shows various portfolios of U.S. and foreign stocks ranging from an all-S&P 500 portfolio (at the lower right end) to an all EAFE portfolio (at the higher right end). The powerful message of this chart is that diversified portfolios of foreign and domestic stocks have the dual benefit of lower risk and higher return.

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There is an all-American portfolio consisting of 75 percent invested in the S&P 500 and 25 percent in the medium-term Treasury bond. The diversified portfolio replaces one third of the stock allocation, 25 percent of the whole portfolio, with foreign stocks. The portfolio containing EAFE has a higher return and lower standard deviation. So the Sharpe ratio is also higher at 0.41 as opposed to 0.37 for the all-American portfolio. That is not much of a difference, but it translates into 0.4 percent excess return for the diversified portfolio.12 The second set of portfolios is for a shorter period beginning in 1979. This set of portfolios replaces the S&P 500 with the Russell 3000 all-cap P1: a/b c05 P2: c/d QC: e/f JWBT412-Marston T1: g December 8, 2010 17:36 Printer: Courier Westford 87 Foreign Stocks TABLE 5.5 Performance of Portfolio with EAFE Added Portfolio A (1970–2009) Without EAFE 25% EAFE Portfolio B (1979–2009) Without EAFE 25% EAFE Geometric Average Arithmetic Average Standard Deviation Sharpe Ratio 9.7% 9.9% 10.0% 10.1% 12.0% 11.2% 0.37 0.41 11.0% 10.8% 11.2% 11.0% 12.2% 11.6% 0.47 0.47 Portfolio A: Portfolio without EAFE consists of 25 percent in medium-term U.S.

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What if foreign stocks were constrained in the internationally diversified portfolio? Suppose that foreign stocks are constrained to be only 40 percent of the total stock allocation so foreign stocks are 28 percent (i.e., 40 percent of 70 percent) of the overall portfolio allocation. The result is reported in the top half of Table 8.1. Investing 40 percent of the stocks in the EAFE index, the average return rises from 10.1 percent to 10.3 percent, while the standard deviation drops from 12.0 percent to 11.3 percent. The higher Sharpe ratio of the internationally diversified portfolio adds an extra 0.4 percent to the risk-adjusted return.

The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi

asset allocation, backtesting, Bear Stearns, behavioural economics, Bernie Madoff, Black Swan, book value, business cycle, buy and hold, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, diversification, diversified portfolio, financial engineering, fixed income, global macro, high net worth, implied volatility, index fund, interest rate swap, invisible hand, managed futures, market microstructure, merger arbitrage, moral hazard, Myron Scholes, passive investing, Richard Feynman, Richard Feynman: Challenger O-ring, risk free rate, risk tolerance, risk-adjusted returns, risk/return, search costs, selection bias, Sharpe ratio, short selling, statistical model, stocks for the long run, survivorship bias, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve, zero-sum game

., m = 2), the investor can have a great deal of confidence that the bond floor will not be violated. In this case, the portfolio manager will invest the following amount in the diversified portfolio: 66 = 2 × (100 − 67 ) The remaining 34 will be invested in Treasuries. Suppose the bond floor increases to 70, the investment in Treasuries grows 36 and the investment in diversified portfolio grows to 73. The reallocation is determined as follows: 78 = 2 × (36 + 73 − 70) This means that the total investment in diversified portfolio should increase from 73 to 78. The net investment in Treasuries will be 31 = 36 + 73 − 78. This procedure is followed until the note matures.

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As an alternative, the number of calculations can be significantly reduced if it is assumed that returns are driven by only one factor (e.g., the market portfolio). Note that this does not assume that CAPM holds. In other words, suppose we use a simple linear regression to estimate the beta of an asset with respect to a well diversified portfolio. Rit = α i + βi Rmt + eit The rate of return on the asset at time t is given by Rit, the rate of return on the diversified portfolio is given by Rmt, the intercept and the slope (beta) are given by αi and βi respectively. Finally, the error term for asset i is given by eit. Suppose we run the same regression for another asset, denoted asset j. If the error term for asset j is uncorrelated with the error term for asset i, then the covariance between the two assets is given by Cov (Ri , Rj ) = βi β jVar (Rm ) Notice that to estimate covariance between the two assets, we need an estimate of the variance of the market portfolio as well (Var(Rm)).

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ASSET ALLOCATION IN TRADITIONAL AND ALTERNATIVE INVESTMENTS: A ROAD MAP A seminal study by Brinson, Hood, and Beebower (1986) demonstrated that as much as 93.6% of variation in returns in quarterly performance of professionally managed diversified portfolios could be explained by the mix of the asset classes (security selection explains the rest).5 Recent research however, has also shown, that while over 90% of the return volatility of a diversified portfolio through time is explained by its allocation to broad asset classes, a somewhat smaller portion of that portfolio’s total return over the same time period is explained by its allocation to various asset classes.

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing by Burton G. Malkiel

accounting loophole / creative accounting, Alan Greenspan, Albert Einstein, asset allocation, asset-backed security, backtesting, Bear Stearns, beat the dealer, Bernie Madoff, book value, BRICs, butter production in bangladesh, buy and hold, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dogs of the Dow, Edward Thorp, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial engineering, financial innovation, fixed income, framing effect, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Japanese asset price bubble, John Bogle, junk bonds, Long Term Capital Management, loss aversion, low interest rates, margin call, market bubble, Mary Meeker, money market fund, mortgage tax deduction, new economy, Own Your Own Home, PalmPilot, passive investing, Paul Samuelson, pets.com, Ponzi scheme, price stability, profit maximization, publish or perish, purchasing power parity, RAND corporation, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, stock buybacks, stocks for the long run, sugar pill, survivorship bias, The Myth of the Rational Market, the rule of 72, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond

In 2010 investment-grade bonds yielded about 6 percent, whereas “junk” bonds often yielded 8 percent. Thus, even if 2 percent of the lower-grade bonds defaulted on their interest and principal payments and produced a total loss, a diversified portfolio of low-quality bonds would still produce net returns comparable to those available from a high-quality bond portfolio. Thus, many investment advisers have recommended well-diversified portfolios of high-yield bonds as sensible investments. There is, however, another school of thought that advises investors to “just say no” to junk bonds. Most junk bonds have been issued as a result of a massive wave of corporate mergers, acquisitions, and leveraged (mainly debt-financed) buyouts.

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There were many villains in this morality tale: the fee-obsessed underwriters who should have known better than to peddle all of the crap they brought to market; the research analysts who were the cheerleaders for the banking departments and who were eager to recommend Net stocks that could be pushed by commission-hungry brokers; corporate executives using “creative accounting” to inflate their profits. But it was the infectious greed of individual investors and their susceptibility to get-rich-quick schemes that allowed the bubble to expand. And yet the melody lingers on. I have a friend who built a modest investment stake into a small fortune with a diversified portfolio of bonds, real estate funds, and stock funds that owned a broad selection of blue-chip companies. But he was restless. At cocktail parties he kept running into people boasting about this Net stock that tripled or that telecom chipmaker that doubled. He wanted some of the action. Along came a stock called Boo.com, an Internet retailer that planned to sell with no discounts “urban chic clothing—that was so cool it wasn’t even cool yet.”

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Buying and selling, to the extent that it is profitable at all, tends to generate capital gains, which are subject to tax. Buying and holding enables you to postpone or avoid gains taxes. By following any technical strategy, you are likely to realize short-term capital gains and pay larger taxes (as well as paying them sooner) than you would under a buy-and-hold strategy. Thus, simply buying and holding a diversified portfolio suited to your objectives will enable you to save on investment expense, brokerage charges, and taxes; and, at the same time, to achieve an overall performance record at least as good as that obtainable using technical methods. HOW GOOD IS FUNDAMENTAL ANALYSIS? How could I have been so mistaken as to have trusted the experts?

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Eleventh Edition) by Burton G. Malkiel

accounting loophole / creative accounting, Alan Greenspan, Albert Einstein, asset allocation, asset-backed security, beat the dealer, Bernie Madoff, bitcoin, book value, butter production in bangladesh, buttonwood tree, buy and hold, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, Detroit bankruptcy, diversification, diversified portfolio, dogs of the Dow, Edward Thorp, Elliott wave, equity risk premium, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial engineering, financial innovation, financial repression, fixed income, framing effect, George Santayana, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Japanese asset price bubble, John Bogle, junk bonds, Long Term Capital Management, loss aversion, low interest rates, margin call, market bubble, Mary Meeker, money market fund, mortgage tax deduction, new economy, Own Your Own Home, PalmPilot, passive investing, Paul Samuelson, pets.com, Ponzi scheme, price stability, profit maximization, publish or perish, purchasing power parity, RAND corporation, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Salesforce, short selling, Silicon Valley, South Sea Bubble, stock buybacks, stocks for the long run, sugar pill, survivorship bias, Teledyne, the rule of 72, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond, zero-sum game

In 2014 investment-grade bonds yielded about 4½ percent, whereas “junk” bonds often yielded 5 to 6 percent. Thus, even if 1 percent of the lower-grade bonds defaulted on their interest and principal payments and produced a total loss, a diversified portfolio of low-quality bonds would still produce net returns comparable to those available from a high-quality bond portfolio. Many investment advisers have therefore recommended well-diversified portfolios of high-yield bonds as sensible investments. There is, however, another school of thought that advises investors to “just say no” to junk bonds. Most junk bonds have been issued as a result of a massive wave of corporate mergers, acquisitions, and leveraged (mainly debt-financed) buyouts.

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There were many villains in this morality tale: the fee-obsessed underwriters who should have known better than to peddle all of the crap they brought to market; the research analysts who were the cheerleaders for the banking departments and who were eager to recommend Net stocks that could be pushed by commission-hungry brokers; corporate executives using “creative accounting” to inflate their profits. But it was the infectious greed of individual investors and their susceptibility to get-rich-quick schemes that allowed the bubble to expand. And yet the melody lingers on. I have a friend who built a modest investment stake into a small fortune with a diversified portfolio of bonds, real estate funds, and stock funds that owned a broad selection of blue-chip companies. But he was restless. At cocktail parties he kept running into people boasting about this Internet stock that tripled or that telecom chipmaker that doubled. He wanted some of the action. Along came a stock called Boo.com, an Internet retailer that planned to sell with no discounts “urban chic clothing—that was so cool it wasn’t even cool yet.”

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Moreover, buying and selling, to the extent that it is profitable at all, tends to generate capital gains, which are subject to tax. By following any technical strategy, you are likely to realize short-term capital gains and pay larger taxes (as well as paying them sooner) than you would under a buy-and-hold strategy. Thus, simply buying and holding a diversified portfolio suited to your objectives will enable you to save on investment expense, brokerage charges, and taxes. *Edward O. Thorp actually did find a method to win at blackjack. Thorp wrote it all up in Beat the Dealer. Since then, casinos switched to the use of several decks of cards to make it more difficult for card counters and, as a last resort, they banished the counters from the gaming tables.

A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan by Ben Carlson

Albert Einstein, asset allocation, backtesting, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, book value, business cycle, buy and hold, buy low sell high, commodity super cycle, corporate governance, delayed gratification, discounted cash flows, diversification, diversified portfolio, do what you love, endowment effect, family office, financial independence, fixed income, Gordon Gekko, high net worth, index fund, John Bogle, junk bonds, loss aversion, market bubble, medical residency, Occam's razor, paper trading, passive investing, Ponzi scheme, price anchoring, Reminiscences of a Stock Operator, Richard Thaler, risk tolerance, Robert Shiller, robo advisor, South Sea Bubble, sovereign wealth fund, stocks for the long run, technology bubble, Ted Nelson, transaction costs, Vanguard fund, Vilfredo Pareto

Maybe emerging markets continue to grow and develop their markets at a rapid rate and they're the big winners in the coming years. The best allocation will always be the one you're most comfortable with, which allows you to stick with it over time. It's going to be impossible for a diversified portfolio to completely sidestep the pain when we experience periods like the great financial crisis from 2007 to 2009. Diversification isn't about the short term. It's about the long term. It requires patience, because building a diversified portfolio means that there are going to be times that pieces of your portfolio are going to drive you mad. Always remember that it's the performance of your entire portfolio that matters, not the individual parts.

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Their performance has been much worse than the precious metals stocks. From 1991 to 2014, a diversified index of commodities only slightly outpaced the return of cash (Treasury bills), but with much higher risk.12 Unless we see a return to the highly inflationary decade of the 1970s, it's unlikely that commodities deserve a place in a diversified portfolio. Only those who can handle bone-crushing volatility and returns that are less than the stock market should apply. Generally, commodities are better suited as vehicles for short-term traders, not long-term investors. Myth 12: Housing Is a Good Long-Term Investment From 1930 to 2013, according to the Case–Shiller Index, housing in the United States returned 3.8 percent per year, just over the 3.5 percent rate of inflation in that time.

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Because there were so many different factors included in these portfolios, less than one in five said that they were confident of the various risk factor exposures included across the fund. So many different risk factors were in these portfolios that they ended up offsetting one another, leaving the funds with a neutral or market risk profile. All that work to put together a widely diversified portfolio and they still ended up looking like the overall market, but at a much higher cost. This is what we call overdiversification and all it does is bring unnecessary complexity and costs to a portfolio.9 The art of doing nothing most of the time doesn't mean you can simply set your portfolio and forget it.

All About Asset Allocation, Second Edition by Richard Ferri

activist fund / activist shareholder / activist investor, Alan Greenspan, asset allocation, asset-backed security, barriers to entry, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, book value, buy and hold, capital controls, commoditize, commodity trading advisor, correlation coefficient, currency risk, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, equity premium, equity risk premium, estate planning, financial independence, fixed income, full employment, high net worth, Home mortgage interest deduction, implied volatility, index fund, intangible asset, inverted yield curve, John Bogle, junk bonds, Long Term Capital Management, low interest rates, managed futures, Mason jar, money market fund, mortgage tax deduction, passive income, pattern recognition, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, selection bias, Sharpe ratio, stock buybacks, stocks for the long run, survivorship bias, too big to fail, transaction costs, Vanguard fund, yield curve

Which one best describes you today? ● ● Plan A. Buy investments that I expect will perform well over the next few years. If an investment performs poorly or the prospects change, switch to another investment or go to cash and wait for a better opportunity. Plan B. Buy and hold different types of investments in a diversified portfolio regardless of their near-term prospects. If an investment performs poorly, buy more of that investment to put my portfolio back in balance. If you are like most investors, Plan A looks familiar. People tend to put their money into investments that they believe will lead to profitable results in the near term and sell those that do not perform.

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Sectors can be of different types. Stocks can be divided by industry sectors, such as industrial stocks, technology stocks, bank stocks, and so on; or they can be geographically divided, such as Pacific Rim and European stocks. Bonds can be divided by issuer, such as mortgages, corporate bonds, and Treasury bonds. A well-diversified portfolio may hold several asset classes, categories, styles, and sectors. Successful investors study all asset classes and their various components in order to understand the differences among them. They estimate the long-term expectations of risk and return, and they study how the returns on one asset class may move in relation to other classes.

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No investor who had money in a diversified stock portfolio for the entire year in 1987 lost money, but that is not what people remember. We only remember how bad it felt to lose money on Black Monday. Everyone wants to earn a fair return on his or her investments after inflation and taxes. This will require risk and probably losing money on occasion. All the broadly diversified portfolios introduced in this book have inherent risk and will go down in value periodically. It would be nice to know when these losses will occur so that we can sell beforehand, but that is simply not possible. No one can predict with any consistency when the markets will go up or down. If a person tells you she has found the secret to the markets, she is either naive or she is trying to steal your money.

Market Sense and Nonsense by Jack D. Schwager

3Com Palm IPO, asset allocation, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Brownian motion, buy and hold, collateralized debt obligation, commodity trading advisor, computerized trading, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, global macro, high net worth, implied volatility, index arbitrage, index fund, Jim Simons, junk bonds, London Interbank Offered Rate, Long Term Capital Management, low interest rates, managed futures, margin call, market bubble, market fundamentalism, Market Wizards by Jack D. Schwager, merger arbitrage, negative equity, pattern recognition, performance metric, pets.com, Ponzi scheme, proprietary trading, quantitative trading / quantitative finance, random walk, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, selection bias, Sharpe ratio, short selling, statistical arbitrage, statistical model, subprime mortgage crisis, survivorship bias, tail risk, transaction costs, two-sided market, value at risk, yield curve

An investor would be better off allocating to multiple investments, each with the same expected average return, than to just one of those investments, not only because of lower risk (the well-understood rationale) but also because the lower volatility of the diversified portfolio will yield a higher compounded return. In fact, a diversified portfolio will often yield a higher compounded return than at least some of its components with returns above the portfolio average. The implication is that unless you are confident that you can pick a significantly above-average investment, you are better off with a diversified portfolio, even for return reasons alone, not to mention the risk-reduction benefits. The impact of volatility on compounding is one of the reasons why in Chapter 3 the past best-performing sector or fund yielded a lower cumulative return than the average (in addition to having much higher risk).

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Thus such pro forma results will be highly biased because, although the portfolio results are constructed from actual return data for the underlying funds, the composition of the portfolio itself is hypothetical. Another example of misleading pro forma numbers would be a manager who after trading a diversified portfolio decides to create a new specialized program that trades only one sector in the portfolio. One can safely assume that such a carve-out portfolio will be based on a market sector subset of the whole portfolio that has done particularly well. Once again, the pro forma results are based on actual returns, a factor that seems to lend credibility.

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Even if individual hedge funds, on average, had the same return/risk characteristics as mutual funds or equity indexes, it would still be possible to create a portfolio with significantly better return/risk characteristics by utilizing hedge funds because of their heterogeneous nature. The fact that there are so many different types of hedge fund strategies, some with moderate to low correlation with each other, makes it possible to create a portfolio that has much greater diversification and hence lower risk. Consequently, a diversified portfolio of hedge funds has an intrinsic important advantage over traditional mutual fund investments simply because there are so many more tools to work with. Advantages of Incorporating Hedge Funds in a Portfolio There are two key reasons why a hedge fund allocation should be added to traditional long-only investment portfolios: 1.

Commodity Trading Advisors: Risk, Performance Analysis, and Selection by Greg N. Gregoriou, Vassilios Karavas, François-Serge Lhabitant, Fabrice Douglas Rouah

Asian financial crisis, asset allocation, backtesting, buy and hold, capital asset pricing model, collateralized debt obligation, commodity trading advisor, compound rate of return, constrained optimization, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, discrete time, distributed generation, diversification, diversified portfolio, dividend-yielding stocks, financial engineering, fixed income, global macro, high net worth, implied volatility, index arbitrage, index fund, interest rate swap, iterative process, linear programming, London Interbank Offered Rate, Long Term Capital Management, managed futures, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, p-value, Pareto efficiency, Performance of Mutual Funds in the Period, Ponzi scheme, proprietary trading, quantitative trading / quantitative finance, random walk, risk free rate, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, stochastic process, survivorship bias, systematic trading, tail risk, technology bubble, transaction costs, value at risk, zero-sum game

M = minimum-risk portfolio. 15.6 illustrates, an index of managed futures returns is most strongly related to investment strategies focused on currencies, interest rates, and stocks. Commodities are in fourth place. One way of demonstrating that a commodity investment strategy is of benefit to a diversified portfolio of CTAs is to calculate how the Sharpe ratio (excess return divided by standard deviation) would change once the new investment is added to the portfolio. Table 15.7 shows how the addition of a particular commodity manager to three diversified portfolios increases the Sharpe ratio of each portfolio. The three diversified portfolios are represented by CTA indices provided by Daniel B. Stark & Co. Figure 15.8 illustrates another way of confirming that a futures trading program would be a diversifier for an existing investment in a basket of futures traders.

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However, a pair where both funds were classified as systematic trend followers had a correlation of 0.47. As expected, the discretionary funds had low correlations. Given the diversity of the funds classified as currency, the correlation patterns of risk measures are along expected lines. Diversified Portfolios Table 10.5 presents the summary statistics for the diversified portfolios; Table 10.6 presents the correlations among the portfolios. For the period of our study, 107 diversified CTAs had complete data. One interesting result in the case of diversified CTAs is that no portfolios are perfectly correlated with each other. However, a majority of portfolios had high correlations, a few had moderate correlations, and none had low correlations.

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Of these 5 were discretionary, 21 were systematic, 10 were trend based, and 3 were trend identifiers. Clearly the systematic or trend-based funds dominated the portfolios. The return patterns of these portfolios suggest that they have similar risk characteristics. The Interdependence of Managed Futures Risk Measures TABLE 10.5 Summary Statistics for Diversified Portfolios 213 214 TABLE 10.6 Correlations for Diversified Portfolios The Interdependence of Managed Futures Risk Measures TABLE 10.7 Summary Statistics for Financial Portfolios 215 216 TABLE 10.8 Correlations for Financial Portfolios The Interdependence of Managed Futures Risk Measures TABLE 10.9 Summary Statistics for Stock Portfolios 217 218 TABLE 10.10 Correlations for Stock Portfolios The Interdependence of Managed Futures Risk Measures 219 Stock Portfolios Table 10.9 presents the summary characteristics of the stock portfolios; Table 10.10 presents the correlations.

Unconventional Success: A Fundamental Approach to Personal Investment by David F. Swensen

asset allocation, asset-backed security, Benchmark Capital, book value, buy and hold, capital controls, classic study, cognitive dissonance, corporate governance, deal flow, diversification, diversified portfolio, equity risk premium, financial engineering, fixed income, index fund, junk bonds, law of one price, Long Term Capital Management, low interest rates, market bubble, market clearing, market fundamentalism, money market fund, passive investing, Paul Samuelson, pez dispenser, price mechanism, profit maximization, profit motive, risk tolerance, risk-adjusted returns, Robert Shiller, Savings and loan crisis, shareholder value, Silicon Valley, Steve Ballmer, stocks for the long run, survivorship bias, technology bubble, the market place, transaction costs, Vanguard fund, yield curve, zero-sum game

SECURITY SELECTION Security selection plays a minor role in investment returns, because investors tend to hold broadly diversified portfolios that correlate reasonably strongly with the overall market. The high degree of association between investor security holdings and the market reduces the importance of security-specific influences, causing portfolio returns to mirror market returns. Consider the security selection alternative to the generally sensible investor behavior of holding broadly diversified portfolios. If an investor were to hold a single stock instead of a diverse portfolio of stocks, the idiosyncratic character of that particular security would drive equity portfolio performance.

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As I gathered information for my new book, the data clearly pointed to the failure of active management by profit-seeking mutual-fund managers to produce satisfactory results for individual investors. Following the evidence, I concluded that individuals fare best by constructing equity-oriented, broadly diversified portfolios without the active management component. Instead of pursuing ephemeral promises of market-beating strategies, individuals benefit from adopting the ironclad reality of market-mimicking portfolios managed by not-for-profit investment organizations. The colossal failure of the mutual-fund industry carries serious implications for society, particularly regarding retirement security for American workers.

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The investment management world includes a very small number of not-for-profit money management firms, allowing investors the opportunity to invest with organizations devoted exclusively to fulfilling fiduciary obligations. Moreover, the market contains a number of attractively structured, passively managed investment alternatives, affording investors the opportunity to create equity-oriented, broadly diversified portfolios. In spite of the massive failure of the mutual-fund industry, investors willing to take an unconventional approach to portfolio management enjoy the opportunity to achieve financial success. David Swensen New Haven, Connecticut March 2005 OVERVIEW 1 Sources of Return Capital markets provide three tools for investors to employ in generating investment returns: asset allocation, market timing, and security selection.

Principles of Corporate Finance by Richard A. Brealey, Stewart C. Myers, Franklin Allen

3Com Palm IPO, accelerated depreciation, accounting loophole / creative accounting, Airbus A320, Alan Greenspan, AOL-Time Warner, Asian financial crisis, asset allocation, asset-backed security, banking crisis, Bear Stearns, Bernie Madoff, big-box store, Black Monday: stock market crash in 1987, Black-Scholes formula, Boeing 747, book value, break the buck, Brownian motion, business cycle, buy and hold, buy low sell high, California energy crisis, capital asset pricing model, capital controls, Carl Icahn, Carmen Reinhart, carried interest, collateralized debt obligation, compound rate of return, computerized trading, conceptual framework, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cross-border payments, cross-subsidies, currency risk, discounted cash flows, disintermediation, diversified portfolio, Dutch auction, equity premium, equity risk premium, eurozone crisis, fear index, financial engineering, financial innovation, financial intermediation, fixed income, frictionless, fudge factor, German hyperinflation, implied volatility, index fund, information asymmetry, intangible asset, interest rate swap, inventory management, Iridium satellite, James Webb Space Telescope, junk bonds, Kenneth Rogoff, Larry Ellison, law of one price, linear programming, Livingstone, I presume, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, low interest rates, market bubble, market friction, money market fund, moral hazard, Myron Scholes, new economy, Nick Leeson, Northern Rock, offshore financial centre, PalmPilot, Ponzi scheme, prediction markets, price discrimination, principal–agent problem, profit maximization, purchasing power parity, QR code, quantitative trading / quantitative finance, random walk, Real Time Gross Settlement, risk free rate, risk tolerance, risk/return, Robert Shiller, Scaled Composites, shareholder value, Sharpe ratio, short selling, short squeeze, Silicon Valley, Skype, SpaceShipOne, Steve Jobs, subprime mortgage crisis, sunk-cost fallacy, systematic bias, Tax Reform Act of 1986, The Nature of the Firm, the payments system, the rule of 72, time value of money, too big to fail, transaction costs, University of East Anglia, urban renewal, VA Linux, value at risk, Vanguard fund, vertical integration, yield curve, zero-coupon bond, zero-sum game, Zipcar

Investors can eliminate specific risk by holding a well-diversified portfolio, but they cannot eliminate market risk. All the risk of a fully diversified portfolio is market risk. A stock’s contribution to the risk of a fully diversified portfolio depends on its sensitivity to market changes. This sensitivity is generally known as beta. A security with a beta of 1.0 has average market risk—a well-diversified portfolio of such securities has the same standard deviation as the market index. A security with a beta of .5 has below-average market risk—a well-diversified portfolio of these securities tends to move half as far as the market moves and has half the market’s standard deviation.

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Portfolio risk To calculate the variance of a three-stock portfolio, you need to add nine boxes: Use the same symbols that we used in this chapter; for example, x1 = proportion invested in stock 1 and σ12 = covariance between stocks 1 and 2. Now complete the nine boxes. 7. Portfolio risk Suppose the standard deviation of the market return is 20%. a. What is the standard deviation of returns on a well-diversified portfolio with a beta of 1.3? b. What is the standard deviation of returns on a well-diversified portfolio with a beta of 0? c. A well-diversified portfolio has a standard deviation of 15%. What is its beta? d. A poorly diversified portfolio has a standard deviation of 20%. What can you say about its beta? 8. Portfolio beta A portfolio contains equal investments in 10 stocks. Five have a beta of 1.2; the remainder have a beta of 1.4.

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If the standard deviation of the market were 20% (roughly its average for 1900–2011), then the portfolio standard deviation would also be 20%. This is shown by the green line in Figure 7.15. FIGURE 7.15 The green line shows that a well diversified portfolio of randomly selected stocks ends up with β = 1 and a standard deviation equal to the market’s—in this case 20%. The upper red line shows that a well diversified portfolio with β = 1.5 has a standard deviation of about 30%—1.5 times that of the market. The lower brown line shows that a well-diversified portfolio with β = .5 has a standard deviation of about 10%—half that of the market. But suppose we constructed the portfolio from a large group of stocks with an average beta of 1.5.

Stocks for the Long Run 5/E: the Definitive Guide to Financial Market Returns & Long-Term Investment Strategies by Jeremy Siegel

Alan Greenspan, AOL-Time Warner, Asian financial crisis, asset allocation, backtesting, banking crisis, Bear Stearns, behavioural economics, Black Monday: stock market crash in 1987, Black-Scholes formula, book value, break the buck, Bretton Woods, business cycle, buy and hold, buy low sell high, California gold rush, capital asset pricing model, carried interest, central bank independence, cognitive dissonance, compound rate of return, computer age, computerized trading, corporate governance, correlation coefficient, Credit Default Swap, currency risk, Daniel Kahneman / Amos Tversky, Deng Xiaoping, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Financial Instability Hypothesis, fixed income, Flash crash, forward guidance, fundamental attribution error, Glass-Steagall Act, housing crisis, Hyman Minsky, implied volatility, income inequality, index arbitrage, index fund, indoor plumbing, inflation targeting, invention of the printing press, Isaac Newton, it's over 9,000, John Bogle, joint-stock company, London Interbank Offered Rate, Long Term Capital Management, loss aversion, machine readable, market bubble, mental accounting, Minsky moment, Money creation, money market fund, mortgage debt, Myron Scholes, new economy, Northern Rock, oil shock, passive investing, Paul Samuelson, Peter Thiel, Ponzi scheme, prediction markets, price anchoring, price stability, proprietary trading, purchasing power parity, quantitative easing, random walk, Richard Thaler, risk free rate, risk tolerance, risk/return, Robert Gordon, Robert Shiller, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, stocks for the long run, survivorship bias, technology bubble, The Great Moderation, the payments system, The Wisdom of Crowds, transaction costs, tulip mania, Tyler Cowen, Tyler Cowen: Great Stagnation, uptick rule, Vanguard fund

This is not because the conclusions of the earlier editions needed to be changed. Indeed the rise of U.S. equity markets to new all-time highs in 2013 only reinforces the central tenet of this book: that stocks are indeed the best long-term investment for those who learn to weather their short-term volatility. In fact, the long-term real return on a diversified portfolio of common stocks has remained virtually identical to the 6.7 percent reported in the first edition of Stocks for the Long Run, which examined returns through 1992. CONFRONTING THE FINANCIAL CRISIS Because of the severe impact of the crisis, I felt that what transpired over the last several years had to be addressed front and center in this edition.

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Economists use this scale to depict long-term data since the same vertical distance anywhere on the chart represents the same percentage change. On a logarithmic scale the slope of a trendline represents a constant after-inflation rate of return. The compound annual real returns for these asset classes are also listed in the figure. Over the 210 years I have examined stock returns, the real return on a broadly diversified portfolio of stocks has averaged 6.6 percent per year. This means that, on average, a diversified stock portfolio, such as an index fund, has nearly doubled in purchasing power every decade over the past two centuries. The real return on fixed-income investments has averaged far less; on long-term government bonds the average real return has been 3.6 percent per year and on short-term bonds only 2.7 percent per year.

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In the first half of the twentieth century, the great U.S. economist Irving Fisher, a professor at Yale University and an extremely successful investor, believed that stocks were superior to bonds during inflationary times but that common shares would likely underperform bonds during periods of deflation, a view that became the conventional wisdom during that time.7 Edgar Lawrence Smith, a financial analyst and investment manager of the 1920s, researched historical stock prices and demolished this conventional wisdom. Smith was the first to demonstrate that accumulations in a diversified portfolio of common stocks outperformed bonds not only when commodity prices were rising but also when prices were falling. Smith published his studies in 1925 in a book entitled Common Stocks as Long-Term Investments. In the introduction he stated: These studies are a record of a failure—the failure of facts to sustain a preconceived theory, . . .

In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest by Andrew W. Lo, Stephen R. Foerster

Alan Greenspan, Albert Einstein, AOL-Time Warner, asset allocation, backtesting, behavioural economics, Benoit Mandelbrot, Black Monday: stock market crash in 1987, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, buy and hold, capital asset pricing model, Charles Babbage, Charles Lindbergh, compound rate of return, corporate governance, COVID-19, credit crunch, currency risk, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, Edward Glaeser, equity premium, equity risk premium, estate planning, Eugene Fama: efficient market hypothesis, fake news, family office, fear index, fiat currency, financial engineering, financial innovation, financial intermediation, fixed income, hiring and firing, Hyman Minsky, implied volatility, index fund, interest rate swap, Internet Archive, invention of the wheel, Isaac Newton, Jim Simons, John Bogle, John Meriwether, John von Neumann, joint-stock company, junk bonds, Kenneth Arrow, linear programming, Long Term Capital Management, loss aversion, Louis Bachelier, low interest rates, managed futures, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, money market fund, money: store of value / unit of account / medium of exchange, Myron Scholes, new economy, New Journalism, Own Your Own Home, passive investing, Paul Samuelson, Performance of Mutual Funds in the Period, prediction markets, price stability, profit maximization, quantitative trading / quantitative finance, RAND corporation, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Solow, Ronald Reagan, Savings and loan crisis, selection bias, seminal paper, shareholder value, Sharpe ratio, short selling, South Sea Bubble, stochastic process, stocks for the long run, survivorship bias, tail risk, Thales and the olive presses, Thales of Miletus, The Myth of the Rational Market, The Wisdom of Crowds, Thomas Bayes, time value of money, transaction costs, transfer pricing, tulip mania, Vanguard fund, yield curve, zero-coupon bond, zero-sum game

This state of affairs changed permanently in 1952. 2 Harry Markowitz and Portfolio Selection THE COMMON PHRASE “don’t put all your eggs in one basket” is thought to have originated in the seventeenth century, but the notion of diversification dates back at least to the works of William Shakespeare and can even be found in the Bible. While it’s commonplace now to think of creating a diversified portfolio rather than investing in a collection of securities that each on their own look promising, that wasn’t always the case. It was Harry Markowitz who provided a theory and a process to the notion of diversification. He helped to create the industry of portfolio management. Before his seminal “Portfolio Selection” article in 1952, Markowitz recalled, there was no “notion that you should have a theory about what makes a well-diversified portfolio and what is the trade-off between risk and return. It’s surprising that the human race went so long to leave me to discover that.”1 In the search for the Perfect Portfolio, investors everywhere should applaud his discovery.

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It turned out that in Sharpe’s CAPM world, investors would be rewarded for bearing risk but only for risk that couldn’t be diversified away—the reason why all investors held a diversified portfolio. In Sharpe’s model, the price one paid for a particular stock didn’t depend on how volatile that stock’s return was expected to be in isolation. All that mattered was the relative riskiness of that stock as part of a broad and diversified portfolio. Given these assumptions, Sharpe was able to derive a linear relationship between a stock’s expected return and its riskiness, what is now referred to as the security market line.

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The equation for the security market line is also the now-famous CAPM equation: E(R) = Rf + β × (Rm − Rf), where E(R) is a stock’s expected return, Rf is the risk-free rate of return, β is a stock’s riskiness relative to the overall market, and (Rm − Rf) is the expected return on the market in excess of the risk-free rate of return, also known as the market risk premium, or MRP.29 FIGURE 3.4: The security market line compares a stock’s expected return with its risk as measured by beta (β). According to the CAPM, all stocks (held in a diversified portfolio) should fall along the security market line. Although at first glance simple, on further examination this model has a deep sense of both beauty and complexity. It shows why some securities have higher returns than others but only as compensation for risk. As long as an investor holds a diversified portfolio, the only measure of risk that matters is beta, the covariance of a security’s return with the market portfolio. Nothing else matters.

The Gone Fishin' Portfolio: Get Wise, Get Wealthy...and Get on With Your Life by Alexander Green

Alan Greenspan, Albert Einstein, asset allocation, asset-backed security, backtesting, behavioural economics, borderless world, buy and hold, buy low sell high, cognitive dissonance, diversification, diversified portfolio, Elliott wave, endowment effect, Everybody Ought to Be Rich, financial independence, fixed income, framing effect, hedonic treadmill, high net worth, hindsight bias, impulse control, index fund, interest rate swap, Johann Wolfgang von Goethe, John Bogle, junk bonds, Long Term Capital Management, means of production, mental accounting, Michael Milken, money market fund, Paul Samuelson, Ponzi scheme, risk tolerance, risk-adjusted returns, short selling, statistical model, stocks for the long run, sunk-cost fallacy, transaction costs, Vanguard fund, yield curve

Most investors are already familiar with them. As you may know, they offer several important advantages:1. Diversification. The risk of owning a whole portfolio of stocks is considerably less than the risk of holding any one of the individual stocks in it. But it can take quite a bit of money to build a diversified portfolio of stocks or bonds. You get instant diversification with each mutual-fund share. 2. Professional management. Whether you own an index fund or an actively managed fund, there is a professional manager overseeing the portfolio. 3. Low minimums. Each fund establishes its own investment minimum.

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These results—which have been confirmed by many other studies—are startling. It means that over the long term, your chosen asset allocation is 10 times as important as security selection and market timing combined. HIGHER RETURNS WITH LESS VOLATILITY The goal of asset allocation is to create a diversified portfolio with the highest possible return within an acceptable level of risk. You achieve this by combining noncorrelated assets, like stocks, bonds, and real estate investment trusts (REITs). Academics call it building an efficient portfolio. When I talk to investors about asset allocation, they are often dismissive.

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High-yield bonds, also called non- investment-grade bonds, are also corporate bonds. These are bonds rated BBB- or lower by the rating agency Standard & Poor’s. They are issued by companies less creditworthy than those that issue investment-grade bonds and are considered speculative. But don’t let the name junk bond throw you. A diversified portfolio of these bonds, even after accounting for defaults, has returned more than either Treasuries or high-grade corporates. And while they do tend to be more highly correlated with the stock market than other bonds, they do not move in lock step with equities, giving you some diversification advantage. 3.

Reset: How to Restart Your Life and Get F.U. Money: The Unconventional Early Retirement Plan for Midlife Careerists Who Want to Be Happy by David Sawyer

"World Economic Forum" Davos, Abraham Maslow, Airbnb, Albert Einstein, asset allocation, beat the dealer, bitcoin, Black Monday: stock market crash in 1987, Cal Newport, cloud computing, cognitive dissonance, content marketing, crowdsourcing, cryptocurrency, currency risk, David Attenborough, David Heinemeier Hansson, Desert Island Discs, diversification, diversified portfolio, Edward Thorp, Elon Musk, fake it until you make it, fake news, financial independence, follow your passion, gig economy, Great Leap Forward, hiring and firing, imposter syndrome, index card, index fund, invention of the wheel, John Bogle, knowledge worker, loadsamoney, low skilled workers, Mahatma Gandhi, Mark Zuckerberg, meta-analysis, mortgage debt, Mr. Money Mustache, passive income, passive investing, Paul Samuelson, pension reform, risk tolerance, Robert Shiller, Ronald Reagan, Silicon Valley, Skype, smart meter, Snapchat, stakhanovite, Steve Jobs, sunk-cost fallacy, TED Talk, The 4% rule, Tim Cook: Apple, Vanguard fund, William Bengen, work culture , Y Combinator

No active funds lurk in this portfolio, so no inefficient humans dabbling with your hard-earned money. The funds offer a simple, globally diversified portfolio, with a weighting to the home (UK) market, in line with Vanguard’s approach[384]. From a UK investor’s perspective, a diversified global portfolio is the way to go if you want to guard against underperformance of a particular index, maximise returns and minimise risk[385]. The asset allocation (before you reach FIRE) is 100% equities for reasons already covered. If you piece together a globally diversified portfolio of funds, it will cost you slightly less than, for instance, buying a one-world equity fund.

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[385] maximise returns and minimize risk: “Does International Diversification Improve Safe Withdrawal Rates...” 4 Mar. 2014, toreset.me/385a. The article also finds that for UK investors between 1900 and 2012 a globally diversified portfolio performed better in 78.6% of the cases versus 21.4% for domestic portfolios. Nobel prize-winning economist Harry Markowitz’s modern portfolio theory was the first to show that a diversified portfolio can improve performance and decrease risk over long periods: “Modern Portfolio Theory (MPT) – Investopedia.” toreset.me/385b. [386] one-stop options: figures correct as of 7th June 2018. [387] helps with currency risk: “Currency risk – Monevator.” 4 Jul. 2013, toreset.me/387

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But during that time, the Dow Jones has risen from 1,000 to its present 25,108 while the FTSE All Share Index has moved from 218.18 to its current 4,225 (gains of 2,411% and 1,836%[348]). While there are exceptions (the freak case of Japan since 1989, for instance), typically whenever stock markets have crashed, they’ve recovered. Always in the US and UK. This is why (as we’ll see later in Part IV), wherever you live in the world, you need to form an internationally diversified portfolio, keep your emotions in check and be in it for the long-term. 6. Good if it goes up, good if it goes down It’s easy looking at the long-term when times are good. But what about when you’re mired in the daily 2% hits to your life savings that are commonplace when the market gets the jitters?

Rigged Money: Beating Wall Street at Its Own Game by Lee Munson

affirmative action, Alan Greenspan, asset allocation, backtesting, barriers to entry, Bear Stearns, Bernie Madoff, Bretton Woods, business cycle, buy and hold, buy low sell high, California gold rush, call centre, Credit Default Swap, diversification, diversified portfolio, estate planning, fear index, fiat currency, financial engineering, financial innovation, fixed income, Flash crash, follow your passion, German hyperinflation, Glass-Steagall Act, global macro, High speed trading, housing crisis, index fund, joint-stock company, junk bonds, managed futures, Market Wizards by Jack D. Schwager, Michael Milken, military-industrial complex, money market fund, moral hazard, Myron Scholes, National best bid and offer, off-the-grid, passive investing, Ponzi scheme, power law, price discovery process, proprietary trading, random walk, Reminiscences of a Stock Operator, risk tolerance, risk-adjusted returns, risk/return, Savings and loan crisis, short squeeze, stocks for the long run, stocks for the long term, too big to fail, trade route, Vanguard fund, walking around money

In order to gather more money under our control, the wholesaler suggested we start selling mutual funds. They were marketed as less risky because they invested in lots of stocks. But, we told him, we invested in lots of stocks too! He agreed, with a puzzled stare, but continued to extol the virtues of a diversified portfolio as defined by many funds, not many stocks. To be fair, a diversified portfolio for us was 5 to 10 stocks, which is still considered fairly focused. While we didn’t care or get it at the time, the bottom line was that his pitch was all about getting the safe money. Needless to say, we didn’t much care for what the funds did, as they all looked the same.

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After looking back at the performance of both groups of stocks, the conclusion was not what some had expected: “First, dividend yield does not have a consistent impact on expected return . . . second . . . expected return on the [higher yielding] portfolio, given its level of risk, will be lower than it might be with a better diversified portfolio.” Let me put this into plain English. A stock’s performance wasn’t determined by how much a corporation paid as a dividend, if it all. Sometimes higher dividend-paying stocks performed better, and other times they did not, compared to lower-paying stocks. There was not a clear pattern you could take to the bank. Their second point is critical. Trying to put together a high-yielding portfolio would get you a similar result to the broad market, but increase your risk. Why? You simply had a smaller, less diversified portfolio that in the end would have the same performance as a more diversified portfolio.

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You wouldn’t buy something if it wasn’t designed to make a profit, right? Because they don’t move together, one asset will surely be moving up while another moves down. Thus, we have a group of different assets that all go up in the long run, but their random movement allows us to sleep at night knowing we have constructed a diversified portfolio. All you need is a professional adviser that can lead you to the Promised Land by telling you how much of each asset you should have based on the level of risk appropriate. The Original Pie Crust Where did this idea of diversification come from? In 1952 an American economist named Harry Markowitz wrote an article describing “Portfolio Theory.”

Toward Rational Exuberance: The Evolution of the Modern Stock Market by B. Mark Smith

Alan Greenspan, bank run, banking crisis, book value, business climate, business cycle, buy and hold, capital asset pricing model, compound rate of return, computerized trading, Cornelius Vanderbilt, credit crunch, cuban missile crisis, discounted cash flows, diversified portfolio, Donald Trump, equity risk premium, Eugene Fama: efficient market hypothesis, financial independence, financial innovation, fixed income, full employment, Glass-Steagall Act, income inequality, index arbitrage, index fund, joint-stock company, junk bonds, locking in a profit, Long Term Capital Management, Louis Bachelier, low interest rates, margin call, market clearing, merger arbitrage, Michael Milken, money market fund, Myron Scholes, Paul Samuelson, price stability, prudent man rule, random walk, Richard Thaler, risk free rate, risk tolerance, Robert Bork, Robert Shiller, Ronald Reagan, scientific management, shareholder value, short selling, stocks for the long run, the market place, transaction costs

Even if they did occasionally add common stocks to the portfolios they managed, they invariably chose only the most stable, dividend-paying shares, which often had less growth potential than stocks that might be defined as speculative. It was this approach that Markowitz attacked broadside. He showed that a diversified portfolio of stocks, even one that included more “speculative” shares, could actually be no more risky than some of the “prudent” portfolios, if the stocks included in the diversified portfolio were carefully selected to minimize covariance. He even found that some portfolios of so-called safe securities could actually be quite risky because the securities had high covariances, meaning that they could move together adversely under certain circumstances.

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Sharpe found that about one-third of the movement of an average stock was a reflection of the movement of the overall market, while the rest was explained by the stock’s relationship to other stocks in similar industries, or by the unique characteristics of the stock itself. Significantly, however, he found that in a properly diversified portfolio the non-market-related factors cancelled each other out, leaving the influence of the market as the primary factor affecting the value of the entire portfolio. Sharpe’s ideas were published in Management Science magazine in January 1963. In the article, Sharpe estimated that by using his approach, the mainframe computer time required to select a “Markowitz” diversified portfolio from a hypothetical universe of 100 stocks would be cut from 33 minutes to 30 seconds. It was now possible for virtually any investment manager to put together a “risk efficient” portfolio that would maximize expected return for a given level of risk.

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In effect, Barron was claiming that the market was less risky in the long run than it appeared to be in the short run. An empirical basis for this important conclusion was provided by the publication in 1924 of Common Stocks as Long Term Investments by Edgar Lawrence Smith. The thesis of the book, unremarkable from today’s perspective but revolutionary in the early 1920s, was that a diversified portfolio of common stocks would consistently outperform bonds over long time horizons. Smith argued that the increasingly common practice of retaining earnings to finance future expansion created a “compounding effect” that gave the stocks of modern corporations an “upward bias.” His book caused something of a sensation, both among academics and the financial press.

The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein

Alan Greenspan, asset allocation, behavioural economics, book value, Bretton Woods, British Empire, business cycle, butter production in bangladesh, buy and hold, buy low sell high, carried interest, corporate governance, cuban missile crisis, Daniel Kahneman / Amos Tversky, Dava Sobel, diversification, diversified portfolio, Edmond Halley, equity premium, estate planning, Eugene Fama: efficient market hypothesis, financial engineering, financial independence, financial innovation, fixed income, George Santayana, German hyperinflation, Glass-Steagall Act, high net worth, hindsight bias, Hyman Minsky, index fund, invention of the telegraph, Isaac Newton, John Bogle, John Harrison: Longitude, junk bonds, Long Term Capital Management, loss aversion, low interest rates, market bubble, mental accounting, money market fund, mortgage debt, new economy, pattern recognition, Paul Samuelson, Performance of Mutual Funds in the Period, quantitative easing, railway mania, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Savings and loan crisis, South Sea Bubble, stock buybacks, stocks for the long run, stocks for the long term, survivorship bias, Teledyne, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, the rule of 72, transaction costs, Vanguard fund, yield curve, zero-sum game

If it returns, say, 10% in a given year, does it bother you that some of the stocks in it may have lost more than 80% of their value, as will happen to a few each year? Of course not. A globally diversified portfolio behaves the same way, except that the performance of each component is now more visible to you in the form of returns data in the daily paper and your quarterly statements. As an example, I’ve listed the returns for 1998, 1999, and 2000 for some of the most commonly used stock asset classes: This three-year sequence is a pretty typical one. Let’s start with 1998. In the first place, a diversified portfolio did reasonably well in that year. U.S. large stocks did the best, but REITs lost a lot of money.

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If you can live on 3.5% of your savings and you can shelter almost all of your retirement money in a Roth IRA (which does not require mandatory distributions after age 70 1/2), then you are guaranteed success for up to 30 years, which is the current maturity of the longest bond. For devout believers in the value of a well-diversified portfolio, this option is profoundly unappealing, as this is a poorly diversified portfolio—the financial equivalent of Eden’s snake. (Although it’s a very secure basket!) At a minimum, however, some commitment to TIPS in your sheltered accounts is probably not a bad idea. At the end of the day, you can never be completely certain that your retirement will be a financial success.

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Another way of putting this is that rebalancing forces you to be a contrarian—someone who does the opposite of what everyone else is doing. Financial contrarians tend to be wealthier than folks who like to simply follow the crowd. This concept also reveals the major benefit of a diversified portfolio: the advantage of “making small bets with dry hands.” In poker, the player who is least concerned about the size of the pot has the advantage, because he is much less likely to lose his nerve than his opponents. If you have a properly diversified portfolio, you are in effect making many small bets, none of which should ruin you if they go bad. When the chips are down, it will not bother you too much to toss a few more coins into the pot when everyone around you is folding his hand.

The Bogleheads' Guide to Investing by Taylor Larimore, Michael Leboeuf, Mel Lindauer

asset allocation, behavioural economics, book value, buy and hold, buy low sell high, corporate governance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, endowment effect, estate planning, financial engineering, financial independence, financial innovation, high net worth, index fund, John Bogle, junk bonds, late fees, Long Term Capital Management, loss aversion, Louis Bachelier, low interest rates, margin call, market bubble, mental accounting, money market fund, passive investing, Paul Samuelson, random walk, risk tolerance, risk/return, Sharpe ratio, statistical model, stocks for the long run, survivorship bias, the rule of 72, transaction costs, Vanguard fund, yield curve, zero-sum game

, reading a prospectus and understanding what you're investing in will be well worth the time and effort. We can't emphasize it enough: Read the fund's prospectus and understand what you re investing in! There are at least 10 advantages of investing in mutual funds: 1. Diversification. The costs involved in purchasing a diversified portfolio of individual stocks and bonds could be prohibitive for most investors. However, since each mutual fund invests in a large number of stocks, bonds, or both, you get instant diversification when you buy a mutual fund. 2. Professional management. Whether your fund is an index fund or an actively managed one, there are professional managers at the helm. 3.

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Finally, because of the wide selection of funds available, you can probably find a fund to fit just about any investment needs you might have. So, as we've seen, mutual funds have a lot to offer. We feel strongly that they should be the investment of choice for most individual investors. Funds of Funds In an attempt to simply investing, a recent trend has developed that allows investors to obtain a nicely diversified portfolio by choosing a single mutual fund that meets their desired asset allocation. These offerings invest in other mutual funds, normally from the same company, and usually include stock, bond, and money market mutual funds-thus the name funds of funds. Some of these funds maintain a fairly stable ratio of stocks, bonds, and cash at all times, so it's up to investors to switch to a more conservative fund as they get older and closer to retirement.

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Sharpe, Nobel Laureate, STANCO 25 Professor of Finance, Emeritus, Stanford University Graduate School of Business and Chairman, Financial Engines, Inc.: "I love index funds." Rex Sinquefield, co-chairman of Dimensional Fund Advisors: "The only consistent superior performer is the market itself, and the only way to capture that superior consistency is to invest in a properly diversified portfolio of index funds." Larry E. Swedroe, author of The Successful Investor Today: "Despite the superior returns generated by passively managed funds, financial publications are dominated by forecasts from so-called gurus and the latest hot fund managers. I believe that there is a simple explanation for the misinformation: it's just not in the interests of the Wall Street establishment or the financial press to inform investors of the failure of active managers."

The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money by Steven Drobny

Albert Einstein, AOL-Time Warner, Asian financial crisis, asset allocation, asset-backed security, backtesting, banking crisis, Bear Stearns, Bernie Madoff, Black Swan, bond market vigilante , book value, Bretton Woods, BRICs, British Empire, business cycle, business process, buy and hold, capital asset pricing model, capital controls, central bank independence, collateralized debt obligation, commoditize, commodity super cycle, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, diversification, diversified portfolio, equity premium, equity risk premium, family office, fiat currency, fixed income, follow your passion, full employment, George Santayana, global macro, Greenspan put, Hyman Minsky, implied volatility, index fund, inflation targeting, interest rate swap, inventory management, inverted yield curve, invisible hand, junk bonds, Kickstarter, London Interbank Offered Rate, Long Term Capital Management, low interest rates, market bubble, market fundamentalism, market microstructure, Minsky moment, moral hazard, Myron Scholes, North Sea oil, open economy, peak oil, pension reform, Ponzi scheme, prediction markets, price discovery process, price stability, private sector deleveraging, profit motive, proprietary trading, purchasing power parity, quantitative easing, random walk, Reminiscences of a Stock Operator, reserve currency, risk free rate, risk tolerance, risk-adjusted returns, risk/return, savings glut, selection bias, Sharpe ratio, short selling, SoftBank, sovereign wealth fund, special drawing rights, statistical arbitrage, stochastic volatility, stocks for the long run, stocks for the long term, survivorship bias, tail risk, The Great Moderation, Thomas Bayes, time value of money, too big to fail, Tragedy of the Commons, transaction costs, two and twenty, unbiased observer, value at risk, Vanguard fund, yield curve, zero-sum game

., stocks and bonds have had pretty much the same return on risk for the last 80 years, during which time they have been uncorrelated, on average. A diversified portfolio would ideally have an equal risk allocation to stocks and bonds, which would suggest an allocation of about 20-80 stocks-bonds. International diversification is also very important. Within reasonable capacity constraints, I would suggest trying to equal weight most things by risk. Once you have a diversified portfolio with stocks and bonds, your next concern should be inflation. Over the long term all assets respond to inflation. However, over the short- to medium-term many of the assets traditionally included as inflation hedges are anything but.

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Soon after its publication, investors from family offices to pensions and foundations began trying to emulate Yale by creating their own endowment-style portfolios. The “Yale Model” soon came to be known as the “Endowment Model” as the portfolio management style became pervasive among university endowment portfolios. The Endowment Model, as it was popularly interpreted, is a broadly diversified portfolio, though with a heavy equity orientation, which seeks to earn a premium for taking on illiquidity risk. The argument behind the equity and “equity-like” orientation is that stocks produce the highest returns over time. This fundamental concept has roots in the very foundations of capitalism: risky equity capital should earn more than less risky bonds.

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Views sometimes count very little, whereas good risk management always counts a lot. The top performers in 2008 were able to put on good risk-versus-reward bets at the right time, and had the liquidity to do so due to good risk management. The old style of risk management suggests establishing a “diversified” portfolio with different asset weightings based on risk tolerance and time profile, which does not really work in this environment. If you are 60 years old, you are theoretically supposed to increase your bond weighting. But if you did that at the beginning of 2009—decreased your equities and increased your bonds—you virtually committed suicide.

The Permanent Portfolio by Craig Rowland, J. M. Lawson

Alan Greenspan, Andrei Shleifer, asset allocation, automated trading system, backtesting, bank run, banking crisis, Bear Stearns, Bernie Madoff, buy and hold, capital controls, correlation does not imply causation, Credit Default Swap, currency risk, diversification, diversified portfolio, en.wikipedia.org, fixed income, Flash crash, high net worth, High speed trading, index fund, inflation targeting, junk bonds, low interest rates, margin call, market bubble, money market fund, new economy, passive investing, Ponzi scheme, prediction markets, risk tolerance, stocks for the long run, survivorship bias, technology bubble, transaction costs, Vanguard fund

A Different Way to Diversify Given the problems with conventional beliefs about diversification discussed above, there is a better way to look at the challenge of achieving strong diversification within a portfolio. A diversified portfolio only works when the assets you own are not all moving in lockstep. A portfolio where everything is going up at the same time can also turn into a portfolio where everything is going down at the same time. A diversified portfolio only works when the assets you own are not all moving in lockstep. A portfolio where everything is going up at the same time can also turn into a portfolio where everything is going down at the same time.

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Some funds also have front end loads and other fees. 4. William F. Sharpe, “The Arithmetic of Active Management,” Financial Analyst's Journal, January/February 1991: 7–9. Chapter 5 Investing Based on Economic Conditions The Illusion of Diversification The notion that investors should build diversified portfolios is based on the idea that by allocating funds among different investments no single catastrophic event can inflict too much damage on the whole portfolio. The idea itself is simple, but achieving strong diversification in a portfolio actually takes quite a bit of thought to make sure that it will really work when needed.

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The point above applies to other assets as well, whether it is gold, bonds, real estate, or anything else an investor may purchase. Any one of them can go into a bad market for extended periods and stay there for years or even decades. And yes, at different points in time all of these assets have done exactly that. When it comes to investing, there are just no guarantees. A strongly diversified portfolio should not overweight any particular asset. Instead, it should assume that the future might not resemble the past and hold a balanced allocation that will position the portfolio well for whatever the future may bring. The purpose of a balanced allocation is so that when one asset unexpectedly begins performing poorly there will be other assets to take up the slack and protect against serious losses.

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein

Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black Monday: stock market crash in 1987, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, corporate raider, debt deflation, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, full employment, Glass-Steagall Act, Great Leap Forward, guns versus butter model, implied volatility, index arbitrage, index fund, interest rate swap, invisible hand, John von Neumann, Joseph Schumpeter, junk bonds, Kenneth Arrow, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, Michael Milken, money market fund, Myron Scholes, new economy, New Journalism, Paul Samuelson, Performance of Mutual Funds in the Period, profit maximization, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk free rate, risk/return, Robert Shiller, Robert Solow, Ronald Reagan, stochastic process, Thales and the olive presses, the market place, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, transfer pricing, zero-coupon bond, zero-sum game

If the price of a security is more volatile than the movements of the dominant factor, that security will make the portfolio more variable, and therefore more risky, than it would have been otherwise; if the price of the security is less volatile, it will make the portfolio less risky. In well-diversified portfolios, the simple average of these relationships will then serve as an estimate of the volatility of the portfolio as a whole. What is the “basic underlying factor” to which Sharpe refers? There is no doubt that individual stocks respond most directly to the stock market as a whole. About one-third of the variability of the average stock is simply a reflection of moves in the “index”—or “the most important single influence.”

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I had never even set my fingers onto a computer keyboard until I attended a 1969 summer workshop at Harvard Business School. PCs with video screens were not yet a gleam in an inventor’s eye; we sat at terminals hooked into a mainframe located somewhere else and waited patiently while a clattering printer produced our results in hard copy. I now realize that we were using the computer to compose diversified portfolios, but I had little idea at the time of what that clattering was all about. ••• Only two analyses of any note had appeared during the twenty years following Cowles’s 1933 article, one in 1934 and the other long afterward in 1953. Neither paper was by an economist. The authors in each case were statisticians who used the data base of the financial markets to prove a point about statistical methods.

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Profitable trading depends on imperfections, which develop only when other investors are slower than the swinger to receive information, draw erroneous conclusions from it, or delay acting on it. Gradual recognition and understanding of the facts is what makes for trends instead of bedlam. Professionals insist that they can win when they invest actively, as opposed to buying and holding a broadly diversified portfolio, because they can distinguish trends from noise and make better sense than amateurs out of new information. Moreover, because they are full-time players tuned in to all the smart brokers and analysts, professionals are confident that they can act fast enough to beat the others to the gun. Alexander contrasts this view with the view of the academics who hold that the best way to anticipate future price movements is to toss a coin.

Work Less, Live More: The Way to Semi-Retirement by Robert Clyatt

asset allocation, backtesting, buy and hold, currency risk, death from overwork, delayed gratification, diversification, diversified portfolio, do what you love, eat what you kill, employer provided health coverage, estate planning, Eugene Fama: efficient market hypothesis, financial independence, fixed income, future of work, independent contractor, index arbitrage, index fund, John Bogle, junk bonds, karōshi / gwarosa / guolaosi, lateral thinking, Mahatma Gandhi, McMansion, merger arbitrage, money market fund, mortgage tax deduction, passive income, rising living standards, risk/return, Silicon Valley, The 4% rule, The Theory of the Leisure Class by Thorstein Veblen, Thorstein Veblen, transaction costs, unpaid internship, upwardly mobile, Vanguard fund, work culture , working poor, zero-sum game

Similarly, for the 30-year and 40-year periods, using The 95% Rule generated a 2% to 5% drop-off in success rates. For the target of 4.3% withdrawal level, assume that success rates would fall by a few percent in about half the cases going forward, a modest drop in security for the much-needed additional income during poor market conditions. Diversified portfolios survive best A simple portfolio of stocks and bonds will not survive nearly as well as a diversified portfolio with small and value tilts and international stocks. To see the impact of the portfolio composition on success rates, compare the columns in the chart above. The first is the success rate data already seen above for the standard withdrawals from the Rational Investing portfolio (labeled RIP).

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Unless you have a sizable pension, these assets will become a major focus as you plan and work to save enough to safely semi-retire. By projecting a reasonable rate of growth, you can see how the combination of fresh annual savings and portfolio earnings can work together to bring you to your goal. A reasonable assumption would be that the earnings in a diversified portfolio would grow by 8% a year, or 5% per year in real terms—that is, after subtracting 3% average inflation. While you have little control over how your assets perform, 2004 13,000 9,000 181,342 65,637 315,709 229,408 792,096 12,000 8,000 164,135 62,512 294,485 212,294 733,425 12,000 8,000 148,700 59,535 274,748 196,470 679,453 10,000 8,000 134,000 56,700 255,950 181,400 628,050 8,000 TOTAL SAVINGS 79,000 98,000 120,000 54,000 239,000 168,000 581,000 8,000 52,000 6,000 47,000 207,000 229,000 147,000 161,000 480,000 540,000 6,000 55,000 39,000 151,000 104,000 349,000 6,000 48,000 46,000 164,000 112,000 370,000 6,000 35,000 48,000 187,000 124,000 394,000 IRA/401(k) Contributions This Year Regular IRA/401(k) Roth IRAs Taxable Accounts A Taxable Accounts B Sum of Taxable and Tax-Advantaged Financial Assets 2009 Projected 10,000 2008 Projected 8,000 2007 2006 Projected Projected 8,000 2005 Taxable Savings This Year ANNUAL SAVINGS 2003 7,000 2002 7,000 2001 7,000 2000 Total Savings Worksheet chapter 2 | Live Below Your Means | 99 100 | Work Less, Live More you do have control over your annual savings—and you should commit yourself to make them as large as reasonably possible.

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You can find data on each of your fund’s fees and expenses in its prospectus or by entering the ticker symbol at www. morningstar.com. The Rational Investing portfolio has average annual fees and expenses of about .35%, though internal fund trading costs and brokerage expenses might push that closer to .5%. For investment mix detail, choose the second option, and enter a diversified portfolio that uses FireCalc’s available historical data to approximate the Rational Investing portfolio introduced in Chapter 3: U.S. MicroCap 11%, U.S. Small 10%, U.S. Small Value 9%, S&P 500 11%, U.S. Large Value 9%, U.S. Long Term Treasury 18%, Long-Term Corporate Bond 30%, 1-month Treasury 2%. Overall, this portfolio will be invested 50% in stocks and 50% in bonds.

The New Depression: The Breakdown of the Paper Money Economy by Richard Duncan

Alan Greenspan, asset-backed security, bank run, banking crisis, banks create money, Bear Stearns, Ben Bernanke: helicopter money, Bretton Woods, business cycle, currency manipulation / currency intervention, debt deflation, deindustrialization, diversification, diversified portfolio, fiat currency, financial innovation, Flash crash, Fractional reserve banking, Glass-Steagall Act, income inequality, inflation targeting, It's morning again in America, Joseph Schumpeter, laissez-faire capitalism, liquidity trap, low interest rates, market bubble, market fundamentalism, mass immigration, megaproject, Mexican peso crisis / tequila crisis, Money creation, money market fund, money: store of value / unit of account / medium of exchange, mortgage debt, Nixon triggered the end of the Bretton Woods system, private sector deleveraging, quantitative easing, reserve currency, risk free rate, Ronald Reagan, savings glut, special drawing rights, The Great Moderation, too big to fail, trade liberalization

Balance of payments: asset prices and currencies and foreign central banks’ creation of fiat money and foreign exchange reserves global imbalances government finance and quantitative easing and U.S. and foreign exchange reserves Banking sector: commercial banks, credit creation, and decline in liquidity reserves commercial banks’ credit structure current financial health of in Mitchell’s theory of business cycles New Great Depression scenarios and Bank of America Baruch, Bernard Bear Stearns Bernanke, Ben: global savings glut theory of on Milton Friedman policy responses to credit expansion and New Depression Bodin, Jean Bonds: in diversified portfolio effect of stimulus on quantitative easing and Bush, George W. Business cycles, theories of Business Cycles: The Problem and Its Setting (Mitchell) Capital adequacy ratio (CAR) Capitalism, evolution to credit-based, government-directed economic system China: fiat money creation and foreign exchange reserves New Great Depression scenarios and possibility of end to buying of U.S. debt Citibank Commercial banks. See Banking sector Commercial Paper Funding Facility (CPFF) Commodities: in diversified portfolio inflation and quantitative easing and regulation of derivatives market and Congressional Budget Office (CBO): budget outlook scenarios government debt estimates Construction sector, in Mitchell’s theory of business cycles Consumer price inflation Corporate sector: inflation and deflation’s effects on share of U.S. debt Corruption of Capitalism, The (Duncan) Credit creation and expansion: credit structure of U.S., 1945 and 2007 economic growth and essential to booms foreign causes transformation of U.S. economy by U.S. domestic causes “Crowding in” “Crowding out” Currencies, trade balances and Current account balances.

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solar initiative example Reagan, Ronald Rental property, in diversified portfolio Republican Party Reserve requirements: asset-based securities and government-sponsored entities and commercial banks and current Roosevelt, Franklin D. Rothbard, Murray Russia Saving and investment, in Mitchell’s theory of business cycles Savings and loan companies, credit supply and Schumpeter, Joseph Schwartz, Anna Jacobson Solar initiative, proposed Spain Special Drawing Rights (SDRs) Special purpose vehicles (SPVs), credit creation and Status quo option, for U.S. Stocks: in diversified portfolio quantitative easing and Switzerland Taiwan Tariffs: inflation and New Great Depression scenarios and Tax revenues: credit expansion’s effect on during Great Depression New Great Depression consequences and Theory of Money and Credit, The (von Mises) Time deposits, commercial bank funding and Total credit market debt (TCMD): contraction of by economic sector foreign central banks’ creation of fiat money and foreign exchange reserves in 2011 likely for 2012 major categories of sectors and changing percentages of debt Trade, generally.

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Those unable to devote all their time and energy to deciphering the kaleidoscopic changes in the politics and policies of Washington have the option of constructing a broadly diversified investment portfolio that would ensure significant wealth preservation regardless of whether the price level moves up or down. The following are five components of a diversified portfolio: 1. Commodities generally perform well in an inflationary environment and suffer in times of disinflation or deflation. Gold and silver benefit most from quantitative easing, which undermines public confidence in the national currency. 2. Stocks tend to rise (1) in a healthy economic environment, (2) when central banks create money and pump it into the financial markets (so long as they don’t cause too much inflation), (3) when the government runs a budget surplus and crowds in the private sector, and (4) when the trade deficit is larger than the budget deficit.

The Power of Passive Investing: More Wealth With Less Work by Richard A. Ferri

Alan Greenspan, asset allocation, backtesting, Benchmark Capital, Bernie Madoff, book value, buy and hold, capital asset pricing model, cognitive dissonance, correlation coefficient, currency risk, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, endowment effect, estate planning, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, index fund, intangible asset, John Bogle, junk bonds, Long Term Capital Management, money market fund, passive investing, Paul Samuelson, Performance of Mutual Funds in the Period, Ponzi scheme, prediction markets, proprietary trading, prudent man rule, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, survivorship bias, Tax Reform Act of 1986, too big to fail, transaction costs, Vanguard fund, yield curve, zero-sum game

One use for the model is to compare a mutual fund performance to three distinct risks factors and isolate how much of a fund’s return was due to these three factors and how much was due to the fund manager. Fama and French found that, on average, beta alone explained about 70 percent of a diversified portfolio’s performance. When they measured how much exposure that randomly created portfolios were influenced by the three risk factors of beta, size, and BtM, they could explain within about 95 percent accuracy how a diversified portfolio should have performed in relation to the stock market without knowing the actual return of the portfolio. All they needed to know was the amount in each risk factor. The results were a blow to active portfolio managers, who until this time touted their stock-picking prowess as the primary reason for generating alpha.

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Index Funds Make Most Active Funds Obsolete It wasn’t necessary for actively managed mutual funds to beat the market prior to the introduction of index funds because they were the only game in town. They were the only option available. Mutual fund companies fulfilled their obligation to investors by offering a broadly diversified portfolio of securities that individuals could not replicate on their own at the same cost. In this regard, actively managed funds were a good deal for investors. But that era has passed. Today, actively managed funds aren’t needed to gain broad diversification in an asset class. Index funds and ETFs perform that function much more efficiently.

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For the small investor to make an intelligent selection from these—indeed, to pass an intelligent judgment on a single one—is ordinarily impossible. He lacks the ability, the facilities, the training, and the time essential to a proper investigation.3 The mutual fund system worked for the industry and for investors for many years because it was a win-win situation. Investors bought into a diversified portfolio of securities through mutual funds, and the fund companies didn’t need to be concerned about losing assets when their managers underperformed the markets because few people monitored the returns that closely. Passive Investing Makes Its Case The cozy relationship between Wall Street and Main Street lasted for several decades.

The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk by William J. Bernstein

asset allocation, backtesting, book value, buy and hold, capital asset pricing model, commoditize, computer age, correlation coefficient, currency risk, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial engineering, fixed income, index arbitrage, index fund, intangible asset, John Bogle, junk bonds, Long Term Capital Management, p-value, passive investing, prediction markets, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, South Sea Bubble, stocks for the long run, survivorship bias, the rule of 72, the scientific method, time value of money, transaction costs, Vanguard fund, Wayback Machine, Yogi Berra, zero-coupon bond

You have the rest of your life to get your affairs in order; the time you take learning and planning will be time well-spent. 2. Acquire an appreciation of the nature of and fundamental relationship between risk and reward in the financial markets. 3. Learn about the risk/reward characteristics of various specific investment types. 4. Appreciate that diversified portfolios behave very differently than the individual assets in them, in much the same way that a cake tastes different from shortening, flour, butter, and sugar. This is called portfolio theory and is critical to your future success. 5. Estimate how much risk you can tolerate; then learn how to use portfolio theory to construct a portfolio tailored to produce the most return for that amount of risk. 6.

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Dealing with More Than Two Imperfectly Correlated Assets The above models have been quite useful for demonstrating the effect of diversification on risk and return of two similar assets (Example 2) and two different assets (Example 1) with zero correlation. Unfortunately, the above examples are no more than useful illustrations of the theoretical benefits of diversified portfolios. In the real world of investing, we must deal with mixes of dozens of asset types, each with a different return and risk. Even worse, the returns of these assets are only rarely completely uncorrelated. Worse still, the risks, returns, and correlations of these assets fluctuate considerably over time.

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We can’t predict returns, SDs, and correlations accurately enough. If we could, we wouldn’t need the optimizer in the first place. And optimizing raw historical returns is a one-way ticket to the poor house. So, forget about getting the answer from a magic black box. We’ll have to look elsewhere for a coherent allocation strategy. More Bad News A well-diversified portfolio is not a free lunch. It does not come anywhere near eliminating risk; economic catastrophes do not respect national borders. The events of 1929–1932 and 1973–1974 involved all markets, and the damage varied only in degree among national markets. Markowitz mean-variance analysis tells us that if one asset has an SD of 20%, then two completely uncorrelated assets 72 The Intelligent Asset Allocator (zero correlation) will have an SD of 14.1%, and four mutually uncorrelated assets, an SD of 10%.

Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies by Jeremy J. Siegel

addicted to oil, Alan Greenspan, asset allocation, backtesting, behavioural economics, Black-Scholes formula, book value, Bretton Woods, business cycle, buy and hold, buy low sell high, California gold rush, capital asset pricing model, cognitive dissonance, compound rate of return, correlation coefficient, currency risk, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, Everybody Ought to Be Rich, fixed income, German hyperinflation, implied volatility, index arbitrage, index fund, Isaac Newton, it's over 9,000, John Bogle, joint-stock company, Long Term Capital Management, loss aversion, machine readable, market bubble, mental accounting, Money creation, Myron Scholes, new economy, oil shock, passive investing, Paul Samuelson, popular capitalism, prediction markets, price anchoring, price stability, proprietary trading, purchasing power parity, random walk, Richard Thaler, risk free rate, risk tolerance, risk/return, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, stock buybacks, stocks for the long run, subprime mortgage crisis, survivorship bias, technology bubble, The Great Moderation, The Wisdom of Crowds, transaction costs, tulip mania, uptick rule, Vanguard fund, vertical integration

The superior performance of U.S. equities over the past two centuries is not a special case. Stocks have outperformed fixed-income assets in every country examined and often by an overwhelming margin. International studies have reinforced, not diminished, the case for equities. CONCLUSION: STOCKS FOR THE LONG RUN Over the past 200 years the compound annual real return on a diversified portfolio of common stock is nearly 7 percent in the United States, and it has displayed a remarkable constancy over time. The reasons for the persistence and long-term stability of stock returns are not well understood. Certainly the returns on stocks are dependent on the quantity and quality of capital, productivity, and the return to risk taking.

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CHAPTER 2 Risk, Return, and Portfolio Allocation FIGURE 25 2–1 Maximum and Minimum Real Holding Period Returns, 1802 through December 2006 It is very significant that stocks, in contrast to bonds or bills, have never delivered to investors a negative real return over periods of 17 years or more. Although it might appear to be riskier to accumulate wealth in stocks rather than in bonds over long periods of time, precisely the opposite is true: the safest long-term investment for the preservation of purchasing power has clearly been a diversified portfolio of equities. Some investors question whether holding periods of 10 or 20 or more years are relevant to their planning horizon. But one of the greatest mistakes that investors make is to underestimate their holding period. This is because many investors think about the holding periods of a particular stock, bond, or mutual fund.

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As noted in the last chapter, the last 30-year period in which bonds beat stocks ended in 1861, at the onset of the U.S. Civil War. This is a point worth remembering: never in any of the past 175 years would a buyer of newly issued 30-year government bonds (had they been issued on an annual basis) have outperformed an investor in a diversified portfolio of common stocks held over the same period. Although the dominance of stocks over bonds is readily apparent in the long run, it is also important to note that over one- and even twoyear periods, stocks outperform bonds or bills only about three out of every five years. This means that nearly two out of every five years a CHAPTER 2 Risk, Return, and Portfolio Allocation 27 stockholder’s return will fall behind the return he or she would get on Treasury bills or bank certificates.

Investing Demystified: How to Invest Without Speculation and Sleepless Nights by Lars Kroijer

Andrei Shleifer, asset allocation, asset-backed security, Bernie Madoff, bitcoin, Black Swan, BRICs, Carmen Reinhart, clean tech, compound rate of return, credit crunch, currency risk, diversification, diversified portfolio, equity premium, equity risk premium, estate planning, fixed income, high net worth, implied volatility, index fund, intangible asset, invisible hand, John Bogle, Kenneth Rogoff, low interest rates, market bubble, money market fund, passive investing, pattern recognition, prediction markets, risk tolerance, risk/return, Robert Shiller, selection bias, sovereign wealth fund, too big to fail, transaction costs, Vanguard fund, yield curve, zero-coupon bond

It is a major evolution in the investing world that products tracking these indices are now readily available: just 15 years ago they were not. Some books on investing involve intricate arguments about why certain geographical areas or sectors of the equity markets will outperform and provide a safe haven for the investor. On the contrary, the most diversified portfolio you can find offers the greatest protection against regional declines. Also, since we are simply saying ‘buy the world’, the product is very simple and should be super cheap. Over the long run that will matter greatly. Someone willing to add a bit of complexity to the very simple portfolio of world equities and minimal-risk government bonds could add other government and corporate bonds (see Figure 3.2).

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You may have a diversified rational portfolio with your investments, but you are still taking a large concentration risk in your overall economic life. If the UK property market went down the drain you would be in a rough spot, despite having done the right things in your investment portfolio. It could well be that the diversification benefits you gained from having a broadly diversified portfolio were dwarfed by the fact that the rest of your assets were so concentrated. You might be losing your job and any potential future job prospects, your house may decline in value and your inheritance be worth less, all for the same reason. As unpleasant as the plight of the UK investor would be in the above scenario, compare it to the situation of an investment portfolio composed exclusively of UK property stocks.

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But in a case like that you can take solace from the fact that while this hurts you locally your rational portfolio is broadly diversified and perhaps not declining at the same time as everything else in your life is going wrong. There is no generalised way to reduce the concentration risk outlined above. If you find yourself with too great a concentration risk try to find ways to divest some of the assets that add to this risk and re-invest those in a more diversified portfolio like the rational one. Unfortunately many people only worry about these issues after misfortune has hit. Not just geography I had a friend who was a successful internet entrepreneur. He had made some money from selling his internet business and was now launching the next one. Because of the risk he perceived in his own business he did not invest too much of his money into the new venture.

Personal Investing: The Missing Manual by Bonnie Biafore, Amy E. Buttell, Carol Fabbri

asset allocation, asset-backed security, book value, business cycle, buy and hold, currency risk, diversification, diversified portfolio, Donald Trump, employer provided health coverage, estate planning, fixed income, Home mortgage interest deduction, index fund, John Bogle, Kickstarter, low interest rates, money market fund, mortgage tax deduction, risk tolerance, risk-adjusted returns, Rubik’s Cube, Sharpe ratio, stocks for the long run, Vanguard fund, Yogi Berra, zero-coupon bond

But this technique really shines when you earn higher returns, like the 7% from a diversified portfolio, and give your portfolio time to mature. The graph below shows how a $10,000 nest egg grows when you put your money in diversified investments, bonds, money market funds, and savings accounts. Compare the line for inflation to see how investing can help you beat the steady rise in prices. You can see below how investments start to take off after 15 years. That’s compounding at work, and that’s why it’s important to start investing for long-term goals as early as you can. $160,000 $140,000 Diversified portfolio $120,000 Bonds Inflation Dollars $100,000 Money Market $80,000 Savings $60,000 $40,000 $20,000 $0 0 5 10 15 25 20 Years 30 35 40 Investing for the Long Term Although well-diversified investing works like magic when you give it time, it doesn’t make sense for short-term goals.

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The returns from savings accounts, certificates of deposit, and other savings options rarely beat inflation, so you simply can’t save enough to pay for everything you need or want. What can you do? Fight back by investing your money instead of stashing it in your mattress. When you invest your money, your savings work harder. The return on a diversified portfolio of stocks and bonds averages about 7%. That not only beats inflation, it shoots growth hormones (all organic) into your nest egg. Invest that $10,000 savings per year and earn 7%, and you’ll have almost a million dollars after 30 years, instead of $300,000. Still not as much as you need, but you’ll learn how to make ends meet by the time you finish reading this book.

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During recessions, the stock market can really tank, like the almost 50% drop it suffered in 2001. You wouldn’t want to see half your nest egg go away the year before you retire. However, since 1929, the average annual return on stocks is more than 10% despite battering from the Great Depression and several recessions. Why Should You Invest? 19 Besides, a diversified portfolio isn’t invested solely in the stock market, as you’ll learn in Chapter 9. By investing in stocks, bonds, and real estate, you won’t see drops as big as the ones for stocks alone. Chapters 9, 10, and 11 also tell you how to move money that you need in the next few years into ultra-safe savings so it’s around when you need it.

Triumph of the Optimists: 101 Years of Global Investment Returns by Elroy Dimson, Paul Marsh, Mike Staunton

asset allocation, banking crisis, Berlin Wall, Black Monday: stock market crash in 1987, book value, Bretton Woods, British Empire, buy and hold, capital asset pricing model, capital controls, central bank independence, classic study, colonial rule, corporate governance, correlation coefficient, cuban missile crisis, currency risk, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, European colonialism, fixed income, floating exchange rates, German hyperinflation, index fund, information asymmetry, joint-stock company, junk bonds, negative equity, new economy, oil shock, passive investing, purchasing power parity, random walk, risk free rate, risk tolerance, risk/return, selection bias, shareholder value, Sharpe ratio, stocks for the long run, survivorship bias, Tax Reform Act of 1986, technology bubble, transaction costs, yield curve

Investment is as much about risk as return, so in sections 4.5 to 4.7 we turn our attention to risk. In section 4.5, we examine the distribution of annual real asset returns for the United States from 1900–2000, and document the risk of US equities, bonds, and bills. Our figures for equity risk are based exclusively on market indexes that represent highly diversified portfolios. Section 4.6 shows that individual stocks tend to be much riskier than this, and demonstrates the importance and power of diversification for equity investors. Finally, in section 4.7 we present risk comparisons both across asset classes and countries. We show that over the long haul, risk and return have gone hand-in-hand.

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For our purposes— emphasizing comparisons between assets and countries—greater precision is not needed. 4.6 Risk, diversification, and market risk The risk figure cited in the previous section, namely, a standard deviation of 20.2 percent, was for real returns on the overall US market. This would be the risk level experienced by an investor who purchased a US index fund, or who held a very well diversified portfolio of US stocks. Individual stocks will typically have standard deviations much higher than this. The lower risk for the overall market is attributable to the power of diversification. 57 Chapter 4 International capital market history Most finance textbooks have a diagram showing how rapidly diversification reduces the risk of an equity portfolio because the returns on different stocks are less than perfectly correlated.

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Figure 4-11 shows how quickly risk is reduced as the number of (randomly chosen) stocks rises from one to fifty, when equal amounts are invested in each. The vertical axis shows the “excess standard deviation,” which is the difference between the portfolio’s risk and the risk of investing in an equally weighted index of all stocks. “Excess standard deviation” thus measures diversifiable risk, which is zero for a fully diversified portfolio. Diversifiable risk clearly falls off rapidly. Many textbooks state that most of the benefits are achieved with just twenty stocks. This is potentially misleading as a twenty-stock portfolio still has an appreciable level of diversifiable risk, and also because Campbell, Lettau, Malkiel, and Xu found that the number of stocks needed to achieve a given level of diversification has increased in recent years.

The Big Secret for the Small Investor: A New Route to Long-Term Investment Success by Joel Greenblatt

backtesting, book value, discounted cash flows, diversified portfolio, hiring and firing, index fund, risk free rate, Sharpe ratio, time value of money, Vanguard fund

Since it’s so difficult to find even a few companies that can be both accurately valued and available at a good price, one thing seems pretty clear: once a fund gets to its twentieth or fiftieth favorite pick, it’s not likely that very much extra value is being added to the portfolio. But there are a number of reasons why most funds still own so many stocks. First, they view having a diversified portfolio of many stocks as an advantage. It’s difficult for individual investors to purchase and keep track of a portfolio of fifty to two hundred stocks. A mutual fund with a professionally managed, widely diversified portfolio provides a service that most individuals have difficulty replicating on their own. This diversification helps make sure that a handful of bad stock choices don’t have an outsized negative influence on overall investment returns.

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Over the long term, managing a concentrated portfolio may be a great way to beat the market averages, but over shorter time horizons it’s also a great way to risk your business and your career. As a result, only a few brave souls choose this route in the mutual fund world. It’s just much safer for most managers to buy a widely diversified portfolio of many stocks that are more likely to closely mirror the major market averages and much less likely to fall significantly behind. As you might suspect, special situation investing follows pretty much the same story line. By definition, each of these special situations, in which a company is going through some sort of extraordinary change, is unique.

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In general, our emotions tell us to shy away from these. On the other hand, everyone already knows the bad news, and on average we don’t have to pay a lot for our purchases. In fact, on average, people overreact and we get to own a portfolio filled with bargains! The important thing is that we do this systematically. By buying a diversified portfolio based on just the numbers, not emotions, we’ve taken our first step. But here’s the big problem. While our value strategy makes sense and seems to work over long periods of time, unfortunately, it doesn’t always work. In Chapter 6 we learned that if you follow a strategy that differs from market-cap-weighted indexes like the S&P 500 or the Russell 1000, there can be long periods of underperformance.

The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns by John C. Bogle

asset allocation, backtesting, buy and hold, creative destruction, currency risk, diversification, diversified portfolio, financial intermediation, fixed income, index fund, invention of the wheel, Isaac Newton, John Bogle, junk bonds, low interest rates, new economy, passive investing, Paul Samuelson, random walk, risk tolerance, risk-adjusted returns, Sharpe ratio, stocks for the long run, survivorship bias, transaction costs, Upton Sinclair, Vanguard fund, William of Occam, yield management, zero-sum game

I wouldn’t dream of consuming valuable pages in this small book with a weighty bibliography, so please don’t hesitate to visit my website. Notes 1 Keep in mind that an index may also be constructed around the bond market, or even “road less traveled” asset classes such as commodities or real estate. Today, if you wish, you could literally hold all your wealth in a diversified portfolio of low-cost traditional index funds representing every asset class and every market sector within the United States or around the globe. 2 Over the past century, the average nominal return on U.S. stocks was 10.1 percent per year. In real terms (after 3.4 percent inflation) the real annual return was 6.7 percent.

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But buoyed by abundant self-confidence, these folks aren’t about to give up on actively managed funds themselves. A tad delusional? I think so. Picking the best-performing funds is ‘like trying to predict the dice before you roll them down the craps table,’ says an investment adviser in Boca Raton, FL. ‘I can’t do it. The public can’t do it.’ “To build a well-diversified portfolio, you might stash 70 percent of your stock portfolio into a [total stock market] index fund and the remaining 30 percent in an international-index fund.” If these comments by a great money manager, a brilliant academic, and a straight-thinking journalist don’t persuade you about the hazards of focusing on past returns of mutual funds, just believe what fund organizations tell you.

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You’ll note that the fundamental index fund earned higher returns while assuming higher risk than the S&P 500 fund. The dividend index, on the other hand, earned lower returns and carried lower risk. But when we calculate the risk-adjusted Sharpe ratio, the S&P 500 Index fund wins in both comparisons. The similarity of returns and risks in all three funds should not be surprising. Each holds a diversified portfolio with similar stocks—simply weighted differently. In fact, given the remarkably high correlation of 0.97 of both smart beta ETFs with the returns earned by the S&P 500, both could easily be classified as high-priced “closet index funds.” What the S&P 500 index portfolio offers is the certainty that its investors will earn nearly the entire return of the stock market index.

Red-Blooded Risk: The Secret History of Wall Street by Aaron Brown, Eric Kim

Abraham Wald, activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, Asian financial crisis, Atul Gawande, backtesting, Basel III, Bayesian statistics, Bear Stearns, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Black Swan, book value, business cycle, capital asset pricing model, carbon tax, central bank independence, Checklist Manifesto, corporate governance, creative destruction, credit crunch, Credit Default Swap, currency risk, disintermediation, distributed generation, diversification, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, experimental subject, fail fast, fear index, financial engineering, financial innovation, global macro, illegal immigration, implied volatility, independent contractor, index fund, John Bogle, junk bonds, Long Term Capital Management, loss aversion, low interest rates, managed futures, margin call, market clearing, market fundamentalism, market microstructure, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, natural language processing, open economy, Pierre-Simon Laplace, power law, pre–internet, proprietary trading, quantitative trading / quantitative finance, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, shareholder value, Sharpe ratio, special drawing rights, statistical arbitrage, stochastic volatility, stock buybacks, stocks for the long run, tail risk, The Myth of the Rational Market, Thomas Bayes, too big to fail, transaction costs, value at risk, yield curve

Since this particular stock has the highest expected return, that means you’re going to average in lower expected return investments. Your portfolio expected return is the weighted average of your individual stock expected returns, so a diversified portfolio has to have a lower expected return than the 100 percent you can get with this one stock. But a diversified portfolio can have much lower risk than even the safest component. By spreading your money around, you might end up with a portfolio expected return of 10 percent, instead of the 100 percent you can get with one stock, but with much less probability of losing money.

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You could, of course, put half your portfolio in bonds and the other half in diversified risky assets, but this still makes you a risk taker, seeking out as many risks as possible. You just run a low risk version of the strategy. There’s nothing that says a risk taker has to have a high-risk life. In practice, however, once investors take all the trouble to create a broadly diversified portfolio, or individuals learn to embrace risk, they tend to exploit the investment. It’s good that people make this choice young, because each route requires skills and life attitudes that would be fatal to acquire playing for adult stakes. Risk takers must enjoy the volatility of the ride, because that’s all there is.

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Another very important point is that the average return on the individual investments is 32.9 percent, only a little less than the 35.5 percent from the portfolio, and it is achieved with much less average investment. An investor with even a little faith in her ability to pick the best commodity investment is not crazy to hold a single commodity rather than a diversified portfolio, as long as (and I emphasize how important this is) she knows how to size the bet correctly. Investors with no knowledge should always diversify but for active investors the best portfolio, in my opinion, is usually the one that can be sized most accurately, rather than the most diversified or highest Sharpe ratio or highest expected return one.

Willful: How We Choose What We Do by Richard Robb

activist fund / activist shareholder / activist investor, Alvin Roth, Asian financial crisis, asset-backed security, Bear Stearns, behavioural economics, Bernie Madoff, Brexit referendum, capital asset pricing model, cognitive bias, collapse of Lehman Brothers, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, delayed gratification, diversification, diversified portfolio, effective altruism, endowment effect, Eratosthenes, experimental subject, family office, George Akerlof, index fund, information asymmetry, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, lake wobegon effect, loss aversion, market bubble, market clearing, money market fund, Paradox of Choice, Pareto efficiency, Paul Samuelson, Peter Singer: altruism, Philippa Foot, principal–agent problem, profit maximization, profit motive, Richard Thaler, search costs, Silicon Valley, sovereign wealth fund, survivorship bias, the scientific method, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, transaction costs, trolley problem, ultimatum game

Most of those with for-itself black swanitis will gradually reconstitute their beliefs to fit the new environment, while a few will act despite their uncertainty. Stock-Picking and Identity When I ask my students, “Of those who invest in the stock market, how many pick your own stocks?” hands shoot up. Next, I ask: “How many of you invest in a diversified portfolio, such as the S&P 500?” No hands. Finally, I ask: “How many of you know that a non-diversified portfolio conflicts with economic theory?” They all raise their hands and laugh. My students are not alone in ignoring the precept that they can maximize return and minimize risk by holding a portfolio of assets that is diversified. Investors often diversify far less than the capital asset pricing model advises and overweight their portfolio toward their home country more than transaction costs alone can justify.

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Ricardo made his bet and won big.2 If pressed for a reason, Ricardo might have argued that British government bonds offered a high potential reward for the risk. On the surface, this looks like a clear proposition, similar to “investors can achieve higher expected returns and less risk with a diversified portfolio than with a portfolio of a few randomly selected stocks” or that “stocks that pay high dividends generate, on average, higher total returns than stocks that pay no dividends.” But unlike Ricardo’s proposition, these two statements can be tested against data and proven true or false. Suppose France had won, or Britain had won but the bonds didn’t appreciate as Ricardo expected.

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And since markets are efficient, it was foolish to even entertain the idea that you might beat them. But that argument is too simplistic. It’s possible to hold simultaneously the views that markets are efficient and agents are rational, and that at least some investors can expect returns beyond what they might earn with a diversified portfolio of stocks. To realize these returns, an investor must act out of character on an informed hunch. For-itself trading falls beyond, and so reveals a limit to, market efficiency. Institutional Investing Let’s start by taking a look at credit markets that are the domain of public and private pension funds, sovereign wealth funds, insurance companies, university endowments, and other institutional investors.

Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School by Andrew Hallam

Albert Einstein, asset allocation, Bernie Madoff, buy and hold, diversified portfolio, financial independence, George Gilder, index fund, John Bogle, junk bonds, Long Term Capital Management, low interest rates, Mary Meeker, new economy, passive investing, Paul Samuelson, Ponzi scheme, pre–internet, price stability, random walk, risk tolerance, Silicon Valley, South China Sea, stocks for the long run, survivorship bias, transaction costs, Vanguard fund, yield curve

Table 3.2 The World’s Actively Managed Stock Market Mutual Fund Fees Source: “Mutual Fund Fees Around The World,” Oxford University Press, 200831 Country Total Estimated Expenses, Including Sales Costs Ranking of Least Expensive to Most Expensive Actively Managed Funds Netherlands 0.82% #1 Australia 1.41% #2 Sweden 1.51% #3 United States 1.53% #4 Belgium 1.76% #5 Denmark 1.85% #6 France 1.88% #7 Finland 1.91% #8 Germany 1.97% #9 Switzerland 2.03% #10 Austria 2.26% #11 United Kingdom 2.28% #12 Dublin 2.40% #13 Norway 2.43% #14 Italy 2.44% #15 Luxembourg 2.63% #16 Spain 2.70% #17 Canada 3.00% #18 Who’s Arguing against Indexes? There are three types of people who argue that a portfolio of actively managed funds has a better chance of keeping pace with a diversified portfolio of indexes after taxes and fees over the long term. Introduced first, dancing across the stage of improbability is your friendly neighborhood financial adviser. Pulling all kinds of tricks out of his bag, he needs to convince you that the world is flat, that the sun revolves around the Earth, and that he is better at predicting the future than a gypsy at a carnival.

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They might try telling you that they know when the economy is going to self-destruct, which stock market is going to fly, and whether gold, silver, small stocks, large stocks, oil stocks, or retail stocks are going to do well this quarter, this year, or this decade. But they are full of hot air. Pension fund managers are more likely to know oodles more about making money in the markets than financial advisers or brokers. Knowing that pension fund managers are like the gods of the industry, how do their results stack up against a diversified portfolio of index funds? Most pension funds have their money in a 60/40 split: 60 percent stocks and 40 percent bonds. They also have advantages that retail investors don’t have: large company pension funds pay significantly lower fees than retail investors like you or I would, and they don’t have to pay taxes on capital gains that are incurred.

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After the losses that Gilder’s followers experienced from 2000 to 2002, a gain of 3,400 percent would have his long-term subscribers barely breaking even on their original investment after a decade—and that’s if you didn’t include the ravages of inflation. If there are any long-term subscribers, they’re nowhere near their break-even point. Can you hear his followers scrambling on the lowest slopes of the Grand Canyon? I wonder if they’re thirsty. Where there is a buck to be taken We already know that the odds of beating a diversified portfolio of index funds, after taxes and fees, are slim. But what about investment newsletters? You can find more beautifully marketed newsletter promises than you can find people in a Tokyo subway. They selectively boast returns (like Gilder does), creating mouthwatering temptations for many inexperienced investors: With our special strategy, we’ve made 300 percent over the past 12 months in the stock market, and now, for just $9.99 a month, we’ll share this new wealth-building formula with you!

Concentrated Investing by Allen C. Benello

activist fund / activist shareholder / activist investor, asset allocation, barriers to entry, beat the dealer, Benoit Mandelbrot, Bob Noyce, Boeing 747, book value, business cycle, buy and hold, carried interest, Claude Shannon: information theory, corporate governance, corporate raider, delta neutral, discounted cash flows, diversification, diversified portfolio, Dutch auction, Edward Thorp, family office, fixed income, Henry Singleton, high net worth, index fund, John Bogle, John von Neumann, junk bonds, Louis Bachelier, margin call, merger arbitrage, Paul Samuelson, performance metric, prudent man rule, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, shareholder value, Sharpe ratio, short selling, survivorship bias, technology bubble, Teledyne, transaction costs, zero-sum game

A lightbulb turned on when I realized the investors I admire the most (and this admiration comes only in part from the amazing success they’ve achieved) tend to share one characteristic: They are concentrated value investors. That is, they adhere to a concentrated approach to portfolio construction, holding a small number of securities as opposed to a broadly diversified portfolio. We set out to study the mathematical and statistical research that has been done by various academics on the subject of portfolio concentration, and to chronicle the methods and achievements of some of the people who have benefited from being concentrated value investors. Our first task was to approach Lou Simpson and Kristian Siem, two ultrasuccessful concentrated value investors who had never previously agreed to interviews on the mechanics of their investment style.

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How, then, does a manager add value over the market? In Simpson’s opinion, a “closet indexer”—an investor who closely follows index components to achieve returns in line with the index without disclosing that they are doing so—and who varies from the index “a little bit here and there and everywhere” won’t outperform.159 A broadly diversified portfolio will likely underperform the market after taking out fees. Simpson concluded that one means of outperforming is to hold a concentrated portfolio of securities where an investor has a lot of conviction. He reached his conclusion 28 Concentrated Investing through an application of common sense, by reading the academic literature, and under Munger and Buffett’s influence.

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Full diversification leads to market performance, and minimizes tracking risk. A concentrated holding in a single stock ties the investor’s portfolio wholly to the performance of that stock, and maximizes tracking risk. Modern portfolio theory holds that, as it’s impossible to beat the market other than by chance, the investor’s best option is the most broadly diversified portfolio, perhaps one based on a market index. Value investment theory holds that mispricings do exist, and investors able to identify those mispriced securities can outperform the market to the extent that the portfolio contains proportionately more undervalued securities, and proportionately fewer overvalued securities, than the market.

Advances in Financial Machine Learning by Marcos Lopez de Prado

algorithmic trading, Amazon Web Services, asset allocation, backtesting, behavioural economics, bioinformatics, Brownian motion, business process, Claude Shannon: information theory, cloud computing, complexity theory, correlation coefficient, correlation does not imply causation, data science, diversification, diversified portfolio, en.wikipedia.org, financial engineering, fixed income, Flash crash, G4S, Higgs boson, implied volatility, information asymmetry, latency arbitrage, margin call, market fragmentation, market microstructure, martingale, NP-complete, P = NP, p-value, paper trading, pattern recognition, performance metric, profit maximization, quantitative trading / quantitative finance, RAND corporation, random walk, risk free rate, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, Silicon Valley, smart cities, smart meter, statistical arbitrage, statistical model, stochastic process, survivorship bias, transaction costs, traveling salesman

Graduation: At this stage, the strategy manages a real position, whether in isolation or as part of an ensemble. Performance is evaluated precisely, including attributed risk, returns, and costs. Re-allocation: Based on the production performance, the allocation to graduated strategies is re-assessed frequently and automatically in the context of a diversified portfolio. In general, a strategy's allocation follows a concave function. The initial allocation (at graduation) is small. As time passes, and the strategy performs as expected, the allocation is increased. Over time, performance decays, and allocations become gradually smaller. Decommission: Eventually, all strategies are discontinued.

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López de Prado, M. (2015e): “Why most empirical discoveries in finance are likely wrong, and what can be done about it.” Lecture at University of Pennsylvania. Available at https://ssrn.com/ abstract=2599105. López de Prado, M. (2015f): “Advances in quantitative meta-strategies.” Lecture at Cornell University. Available at https://ssrn.com/abstract=2604812. López de Prado, M. (2016): “Building diversified portfolios that outperform out-of-sample.” Journal of Portfolio Management, Vol. 42, No. 4, pp. 59–69. Available at https://ssrn.com/ abstract=2708678. López de Prado, M. and M. Foreman (2014): “A mixture of Gaussians approach to mathematical portfolio oversight: The EF3M algorithm.” Quantitative Finance, Vol. 14, No. 5, pp. 913–930.

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CHAPTER 16 Machine Learning Asset Allocation 16.1 Motivation This chapter introduces the Hierarchical Risk Parity (HRP) approach.1 HRP portfolios address three major concerns of quadratic optimizers in general and Markowitz's Critical Line Algorithm (CLA) in particular: instability, concentration, and underperformance. HRP applies modern mathematics (graph theory and machine learning techniques) to build a diversified portfolio based on the information contained in the covariance matrix. However, unlike quadratic optimizers, HRP does not require the invertibility of the covariance matrix. In fact, HRP can compute a portfolio on an ill-degenerated or even a singular covariance matrix, an impossible feat for quadratic optimizers.

Systematic Trading: A Unique New Method for Designing Trading and Investing Systems by Robert Carver

asset allocation, automated trading system, backtesting, barriers to entry, Black Swan, buy and hold, cognitive bias, commodity trading advisor, Credit Default Swap, diversification, diversified portfolio, easy for humans, difficult for computers, Edward Thorp, Elliott wave, fear index, fixed income, global macro, implied volatility, index fund, interest rate swap, Long Term Capital Management, low interest rates, margin call, Market Wizards by Jack D. Schwager, merger arbitrage, Nick Leeson, paper trading, performance metric, proprietary trading, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, survivorship bias, systematic trading, technology bubble, transaction costs, Two Sigma, Y Combinator, yield curve

Then in part four I will give some recommended portfolios in each example chapter, which have been constructed to be as diversified as possible given the level of the volatility target and the available instruments. Correlation If you already owned shares in RBS and Barclays then the last thing you would want to add to your portfolio is another UK bank like Lloyd’s. Generally you should want to own or trade the most diversified portfolio possible, where the average correlation between the assets is lower than the alternatives. If there are a limited number of instruments that you can fit in your portfolio then it makes sense to pick those with lower correlations. Costs Given the choice between two otherwise identical instruments you should choose the cheapest to trade.

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If they are perfectly correlated then the portfolio will have a return standard deviation of 10%; the same as the individual assets. But if the correlation between the two assets was 0.5, the portfolio volatility would come out at 8.66%.89 Similarly a correlation of zero gives a volatility of 7.07%. More diversified portfolios have lower volatility. In the framework we are concerned with putting together volatility standardised assets that have the same expected average standard deviation of returns; and to do this we need forecasts to have the same average absolute value. To ensure this is always the case you need to multiply the forecasts or positions you have to account for portfolio diversification, so that your total portfolio also achieves the standard volatility target.

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Instrument diversification multiplier Once you’ve parcelled out your trading capital to each trading subsystem you’re faced with a problem you might have seen before in chapter seven, which is the issue of diversification reducing your risk. If you skipped that chapter please go back and read the concept box on page 129. Diversified portfolios of volatility standardised assets like trading subsystems nearly always have a lower expected standard deviation of returns than the individual assets they are trading. The lower the average correlation, the worse the undershooting of risk will be. You already know that the correlation between the two equity indices and the bond in the simple example is very low (the rule of thumb value from table 50 in appendix C is 0.1, and the estimated value I calculated in chapter four was negative).

Beyond Diversification: What Every Investor Needs to Know About Asset Allocation by Sebastien Page

Andrei Shleifer, asset allocation, backtesting, Bernie Madoff, bitcoin, Black Swan, Bob Litterman, book value, business cycle, buy and hold, Cal Newport, capital asset pricing model, commodity super cycle, coronavirus, corporate governance, COVID-19, cryptocurrency, currency risk, discounted cash flows, diversification, diversified portfolio, en.wikipedia.org, equity risk premium, Eugene Fama: efficient market hypothesis, fixed income, future of work, Future Shock, G4S, global macro, implied volatility, index fund, information asymmetry, iterative process, loss aversion, low interest rates, market friction, mental accounting, merger arbitrage, oil shock, passive investing, prediction markets, publication bias, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Feynman, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, robo advisor, seminal paper, shareholder value, Sharpe ratio, sovereign wealth fund, stochastic process, stochastic volatility, stocks for the long run, systematic bias, systematic trading, tail risk, transaction costs, TSMC, value at risk, yield curve, zero-coupon bond, zero-sum game

It’s hard to refute the argument that risk should be compensated: asset classes with higher risk should have higher expected returns than those with lower risk, as least over a reasonably long time horizon. There’s an appealing notion of equilibrium behind this approach. But there’s an important subtlety: under the CAPM, risk isn’t defined as the asset’s volatility or exposure to loss. It’s defined as its contribution to a diversified portfolio’s volatility. In other words, expected return on a security or asset class is proportional to its sensitivity (beta) to the world market portfolio. Let us briefly get into some technical details. To calculate an asset’s beta, we multiply (a) the ratio of its volatility to the market’s volatility by (b) its correlation with the market.

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It’s also one of the theoretical building blocks of a popular portfolio optimization technique used to avoid counterintuitive optimal weights, called the Black-Litterman model. I’ll discuss this model in Chapter 14. For multi-asset investors, the CAPM is one tool in the return forecasting toolset. Based on a risk model, it gives us an estimate of risk-proportional expected returns, where the only risk that matters is the asset’s contribution to a broadly diversified portfolio’s volatility. At equilibrium, these agnostic estimates make sense, provided we use a good risk model and calibrate the risk-free rate and market risk premium carefully. Still, like a financial law of motion, the model only works in a world without friction. In the real world, markets deviate from equilibrium, sometimes over long periods of time.

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During good times, we should seek to reduce the return drag from diversifiers. In our more recent (2018) paper, Rob Panariello and I insist that despite the wide body of published research, many investors still do not fully appreciate the impact of correlation asymmetries on portfolio efficiency—in particular, on exposure to loss. During left-tail events, diversified portfolios may have greater exposure to loss than more concentrated portfolios. Marty Leibowitz and Anthony Bova (2009) show that during the 2008 global financial crisis, a portfolio diversified across US stocks, US bonds, international stocks, emerging markets stocks, and REITs saw its equity beta rise from 0.65 to 0.95, and the portfolio unexpectedly underperformed a simple 60% US stocks/40% US bonds portfolio by 9 percentage points.

The Art of Execution: How the World's Best Investors Get It Wrong and Still Make Millions by Lee Freeman-Shor

Alan Greenspan, behavioural economics, Black Swan, buy and hold, Carl Icahn, cognitive bias, collapse of Lehman Brothers, credit crunch, Daniel Kahneman / Amos Tversky, diversified portfolio, family office, I think there is a world market for maybe five computers, index fund, Isaac Newton, Jeff Bezos, Long Term Capital Management, loss aversion, Market Wizards by Jack D. Schwager, Pershing Square Capital Management, Richard Thaler, Robert Shiller, rolodex, Skype, South Sea Bubble, Stanford marshmallow experiment, Steve Jobs, technology bubble, The Wisdom of Crowds, too big to fail, tulip mania, world market for maybe five computers, zero-sum game

The shares rebounded and he made a lot of money. The key point here is that although the Hunter invested big in Barclays at the outset, he was prepared to invest a lot more money should it continue to fall, because the odds would have gone from great to extraordinary. If you believe the way to control risk is to have a diversified portfolio, then obviously you have no choice but to invest small stakes in each company. If you are a Hunter, though, you choose not to control risk by diversification but by thoroughly understanding the risk and returns of a particular stock or handful of stocks. Your goal is to find companies that have an unbelievably attractive, asymmetric payoff profile.

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This militates against concentrating investments in potential long-term winners. Secondly, regulators – based on investment theories from the 1970s – have put into place rules that prohibit professional fund managers from holding large positions in just a handful of their very best money-making ideas. Why? Because they believe diversified portfolios represent less risk than a concentrated portfolio of stocks. The reality, however, is that all you are doing is swapping one type of risk for another. You are exchanging company specific risk (idiosyncratic risk), which may be very low depending on the type of company you invest in, for market risk (systematic risk).

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Phrased differently: “the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolios that are not outperformers … [in other words] managers attempt to maximise profits by maximizing assets under management … while investors benefit from concentration … managers under most commonly-used fee structures are better off with a more diversified portfolio.”56 Dangers of being a Connoisseur As the most profitable form of investing, being a Connoisseur is not easy. Not only does it run against some pretty strong impulses, it also comes with some significant dangers that must be watched for. There are three in particular: 1. You can be too late As we covered earlier, Ned Davis, using the Dow Jones Industrial Average Index from 1929 to 1998, showed that the bulk of investors’ returns (more or less half) in bull markets come in the first third of a rally.57 He also showed that the first half of a rally accounts for two-thirds of the overall return in a bull market.

Frequently Asked Questions in Quantitative Finance by Paul Wilmott

Abraham Wald, Albert Einstein, asset allocation, beat the dealer, Black-Scholes formula, Brownian motion, butterfly effect, buy and hold, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, delta neutral, discrete time, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial engineering, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, lateral thinking, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Myron Scholes, Norbert Wiener, Paul Samuelson, power law, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk free rate, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, urban planning, value at risk, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond

We can therefore decompose any portfolio into a linear combination of these five factors, plus some supposedly negligible stock-specific risks. If we are shown six diversified portfolios we can decompose each into the five random factors. Since there are more portfolios than factors we can find a relationship between (some of) these portfolios, effectively relating their values, otherwise there would be an arbitrage. Note that the arbitrage argument is an approximate one, relating diversified portfolios, on the assumption that the stock-specific risks are negligible compared with the factor risks. In practice we can choose the factors to be macro-economic or statistical.

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Treynor Ratio The Treynor or Reward-to-variability Ratio is another Sharpe-like measure, but now the denominator is the systematic risk, measured by the portfolio’s beta, (see Capital Asset Pricing Model), instead of the total risk: In a well-diversified portfolio Sharpe and Treynor are similar, but Treynor is more relevant for less diversified portfolios or individual stocks. Information Ratio The Information ratio is a different type of performance measure in that it uses the idea of tracking error. The numerator is the return in excess of a benchmark again, but the denominator is the standard deviation of the differences between the portfolio returns and the benchmark returns, the tracking error.

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For there to be no arbitrage opportunities there must be restrictions on the investment processes. Example Suppose that there are five dominant causes of randomness across investments. These five factors might be market as a whole, inflation, oil prices, etc. If you are asked to invest in six different, well diversified portfolios then either one of these portfolios will have approximately the same risk and return as a suitable combination of the other five, or there will be an arbitrage opportunity. Long Answer Modern Portfolio Theory represents each asset by its own random return and then links the returns on different assets via a correlation matrix.

DIY Investor: How to Take Control of Your Investments & Plan for a Financially Secure Future by Andy Bell

asset allocation, bank run, Bear Stearns, Black Monday: stock market crash in 1987, buy and hold, collapse of Lehman Brothers, credit crunch, currency risk, diversification, diversified portfolio, estate planning, eurozone crisis, fixed income, high net worth, hiring and firing, Isaac Newton, junk bonds, Kickstarter, lateral thinking, low interest rates, money market fund, Northern Rock, passive investing, place-making, quantitative easing, selection bias, short selling, South Sea Bubble, technology bubble, transaction costs, Vanguard fund

For the novice investor who doesn’t have much time to research individual investments, it is hard to argue against a portfolio of low-cost tracker funds. A well-diversified portfolio for someone investing over the medium/long term for capital growth with a medium-high risk appetite may look something like Table 18.3. table 18.3 A well-diversified portfolio of investments There are, of course, very many variations of the above, but you will see that it is a diversified portfolio that can be put together in literally minutes. Rebalancing your portfolio There are two reasons why you will need to revisit the asset allocation of your portfolio at regular intervals.

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Share prices may fall, dividends may be reduced or stopped altogether, companies may even go bust, leaving investors completely out of pocket. It would be foolish to suggest that buying and selling equities like a day trader is going to make you a million. But, despite their risks, a well diversified portfolio of shares is likely, in the long term, to generate higher returns than you would get from most other asset classes. Top websites www.advfn.com www.fool.co.uk www.investorschronicle.co.uk www.londonstockexchange.com www.moneyam.com www.sharesmagazine.co.uk chapter 13 * * * Corporate bonds and gilts Less risky than equities but usually returning more than a bank or building society, bonds aim to give a steady income through good times and bad.

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But if you are saving to repay a mortgage on your holiday home in Spain, then this is a very real risk. Liquidity risk – this is most relevant when investing in obscure investments. You need to ensure you can easily sell your investment when you need to. Sector risk – one sector may perform very badly, and unless you have a well-diversified portfolio this could really hit your investment return. Tax risk – tax rules will change over time and you need to ensure that you keep abreast of these changes to ensure you maintain a tax-efficient investment strategy. Like you did with your investment objectives, try writing down some of the risks you are worried about, using the examples and the risk-profiling tools mentioned here.

Mastering Private Equity by Zeisberger, Claudia,Prahl, Michael,White, Bowen, Michael Prahl, Bowen White

Alan Greenspan, asset allocation, backtesting, barriers to entry, Basel III, Bear Stearns, book value, business process, buy low sell high, capital controls, carbon credits, carried interest, clean tech, commoditize, corporate governance, corporate raider, correlation coefficient, creative destruction, currency risk, deal flow, discounted cash flows, disintermediation, disruptive innovation, distributed generation, diversification, diversified portfolio, family office, fixed income, high net worth, impact investing, information asymmetry, intangible asset, junk bonds, Lean Startup, low interest rates, market clearing, Michael Milken, passive investing, pattern recognition, performance metric, price mechanism, profit maximization, proprietary trading, risk tolerance, risk-adjusted returns, risk/return, Savings and loan crisis, shareholder value, Sharpe ratio, Silicon Valley, sovereign wealth fund, statistical arbitrage, time value of money, transaction costs, two and twenty

Exhibit 18.4 LP PE Portfolio Evolution TARGET RETURN: An LP’s target return for its PE allocation will have a direct impact on manager selection, portfolio construction and regional allocation. Return expectations for developed markets tend to be lower than those for emerging markets; similar for later stage investment strategies versus early stage investment strategies. The level of diversification in a portfolio also has an impact on its expected return: broadly, diversified portfolios reduce the volatility of returns by smoothing out the impact of individual funds’ outperformance or underperformance, while concentrated portfolios provide a wider range of expected returns (for better or worse) as the impact of an individual fund’s performance will be more pronounced. IN-HOUSE OR OUTSOURCED TEAMS: LPs must decide whether to execute a PE program in-house or outsource the investment function.

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IN-HOUSE OR OUTSOURCED TEAMS: LPs must decide whether to execute a PE program in-house or outsource the investment function. This build or buy decision with regards to investment decision-making defines how much internal resources and know-how are required. In-house programs require a team with investment expertise, skills to construct a well-diversified portfolio, experience in manager selection and a large network to access attractive fund offerings. LPs often start with an allocation to PE through a fund of funds6 or engage advisors to craft custom mandates to PE, then gradually build expertise to allocate directly to PE funds. Even seasoned LPs will at times rely on the selection skills of external managers to access markets outside their expertise (especially emerging markets) or, in the case of large investors, allocate to smaller funds that are unable to accommodate their minimum check size.

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Source for the MSCI World and JP Morgan Global Government Bond Index: Bloomberg. 3 Please refer to Chapter 1 Private Equity Essentials for a clear explanation of the mechanics of PE funds. 4 J-curves were introduced in Chapter 1 Private Equity Essentials; the J-curves in Exhibit 18.4 plot the LP’s cash flows from four separate $10 million commitments to the funds shown in the exhibit. 5 All funds in the hypothetical LP’s portfolio have the cash flow characteristics of the J-curve detailed in Chapter 1 and a steady evolution of fund NAV. Commitments are made to the portfolio on January 1 of each year and the hypothetical LP can allocate the exact amount it desires to the hypothetical fund. 6 Fund of funds aggregate capital from multiple investors and invest in a diversified portfolio of PE funds. They act as a single LP in a fund and may be able to negotiate fee discounts on behalf of their clients. 7 Please refer to Chapter 21 LP Direct Investment for more on LP co-investment and direct strategies. 8 See Chapter 14 Responsible Investment for more on environmental, social and governance considerations. 9 Harris, Jenkinson, Kaplan, and Stucker (2014). 10 The number refers to professional fund management firms; but estimates vary widely on the number of active fund managers (source: Prequin 2016). 11 Please refer to Chapter 23 Risk Management for further discussions on risks and risk mitigants in PE. 12 We assume a fund life of 10 years for all funds in the portfolio, which causes the number of funds and fund manager relationships to flatten from year 10 onwards as new funds replace those funds at the end of their terms. 13 Please refer to Chapter 24 Private Equity Secondaries for additional information. 14 Please refer to Chapter 21 LP Direct Investment for further reading. 19 PERFORMANCE REPORTING Performance reporting is the formal process through which general partners (GPs) communicate a fund’s activity and interim returns to limited partners (LPs) throughout the holding period.

The Smartest Investment Book You'll Ever Read: The Simple, Stress-Free Way to Reach Your Investment Goals by Daniel R. Solin

Alan Greenspan, asset allocation, buy and hold, corporate governance, diversification, diversified portfolio, index fund, John Bogle, market fundamentalism, money market fund, Myron Scholes, PalmPilot, passive investing, prediction markets, prudent man rule, random walk, risk tolerance, risk-adjusted returns, risk/return, transaction costs, Vanguard fund, zero-sum game

Take a look at the chart on page 74, which illustrates this point. 74 Your Broker or Advisor Is Keeping You from Being a Smart Im"eStor RISK RETURN COMPARISON (DitlI'Iri8l: 1911-2005) 11m _ • C*dI Yur lois AmgII AuuaJ II!ln • &1M SIKb 141M iIIJlIk ....... "" .,.. "" ... '" "' "" ,"' "" . . As you can see, if you invested in a diversified portfolio consisting of 100% stocks during the period 1977 to 2005, your average rerum would have been 1 1.7%. Your worst loss in any one calendar year would have been 15.1%. However, if you had a diversified portfolio invested in only 60% stocks and 40% bonds, your average rerum would have been 11.0%--only 0.7% less than the 100% stock portfolio. However, your worst loss in anyone year-instead of bei ng 15. 1% with the 100% stock portfolio-would have been only 6.2%.

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As I have explained, no one can predict which stock or which bond will increase in value, or when it will increase. And no one wi ll know when or by how much the entire market will increase in value. Therefore, investors should own the entire market. By the «entire market," I mean a broadly diversified portfolio of investments in domestic and international markets. Let's take anomer look at (he chart on the following page that I showed you in Chapter 4. It tells you precisely which 180 The Real \vily Smart Im'estors Beat 95%or the "Pros- ETFs to select, and what percentage of your portfolio should be invested in each ETF, depending on the portfolio you have selected.

I Will Teach You To Be Rich by Sethi, Ramit

Albert Einstein, asset allocation, buy and hold, buy low sell high, diversification, diversified portfolio, do what you love, geopolitical risk, index fund, John Bogle, late fees, low interest rates, money market fund, mortgage debt, mortgage tax deduction, Paradox of Choice, prediction markets, random walk, risk tolerance, Robert Shiller, shareholder value, Silicon Valley, survivorship bias, the rule of 72, Vanguard fund

BECAUSE OF INFLATION, YOU’RE ACTUALLY LOSING MONEY EVERY DAY YOUR MONEY IS SITTING IN A BANK ACCOUNT. In 2008, when the global financial crisis really erupted in the stock market, the first thing many people did was pull their money out of the market. That’s almost always a bad move. They compounded one mistake—not having a diversified portfolio—with a second: buying high and selling low. For all the people who blamed the government, CEOs, and evil banks, had any of them read one personal finance book? And yet they expected to get ahead with their money? Let’s put the excuses aside. What if you could consciously decide how to spend your money, rather than say, “I guess that’s how much I spent last month”?

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As Warren Buffett has said, investors should “be fearful when others are greedy and greedy when others are fearful.” For you, it’s different. You understand how investing works, so you can put a long-term perspective into practice. Yes, in theory it’s possible for you to lose all your money, but if you’ve bought different investments to create a balanced (or “diversified”) portfolio, you won’t. You’ll notice that your friends are concerned with the downside: “You could lose everything! How will you have time to learn to invest? There are so many sharks out there to take your money.” What about the downside of the money they’re losing every day by not investing? Ask your friends what the average return of the S&P 500 has been for the past seventy years.

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With their low fees, they are a great choice if you want to create and control the exact makeup of your portfolio. But what if you’re one of those people who knows you’ll just never get around to doing the necessary research to figure out an appropriate asset allocation and which index funds to buy? Let’s be honest: Most people don’t want to construct a diversified portfolio, and they certainly don’t want to rebalance and monitor their funds, even if it’s just once a year. If you fall into this group, there is the option at the very top of the investment pyramid. It’s an investment option that’s drop-dead easy: lifecycle funds. Lifecycle Funds: Investing the Easy Way Whether you’re just arriving here direct from page 165, or you’ve read through the basics of investing and decided you want to take the easy way after all, no problem—lifecycle funds are the easiest investment choice you’ll ever need to make.

How I Invest My Money: Finance Experts Reveal How They Save, Spend, and Invest by Brian Portnoy, Joshua Brown

asset allocation, behavioural economics, bitcoin, blockchain, blue-collar work, buy and hold, coronavirus, COVID-19, cryptocurrency, diversification, diversified portfolio, estate planning, financial independence, fixed income, high net worth, housing crisis, index fund, John Bogle, low interest rates, mental accounting, passive investing, prediction markets, risk tolerance, Salesforce, Sharpe ratio, time value of money, underbanked, Vanguard fund

.), philanthropic Capital (we focus on education, ALS, and helping military families), and our “fun” capital bucket (assets we like to enjoy but where we are not fixated on financial return). With our personal capital Mary Ann and I are still fairly young, and thankfully healthy, so we have a fairly aggressive growth portfolio. We invest in a diversified portfolio consisting of index funds in the core part of portfolio, managed money for small cap and international, and currently have a 10% allocation to both fixed income and cash. I am a believer in investing in things you know with people you know. In the past that drove us to buying other finance stocks of companies that were run by people I knew and respected.

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If all investment research is based on past data (there is no other data), then any portfolio deemed “optimal” is out of date before it even begins because we are investing into the future where everything is unknown. In other words, we can’t know what optimal is until the future gets here, at which point it’s too late. If there are no facts about the future, why bother trying to optimize something that is entirely unoptimizable? I believe being willing to stick to a diversified portfolio of index funds is the closest thing to an investing superpower that exists in the age of shiny object syndrome. Patience seems to be a much simpler and more satisfying road to our financial goals than always trying to find the next best thing. We currently contribute monthly to my Roth 401(k) and our taxable account.

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When I make a charitable donation, Betterment pulls the most highly appreciated shares from any taxable account, and I maximize my impact while minimizing my taxes. The investment portfolio So, here’s the boring part. Pretty much all my money is held at Betterment. They invest me in a low-cost globally diversified portfolio of ETFs. Betterment is responsible for pretty much everything: fund due diligence, rebalancing, managing inflows and outflows, tax loss harvesting, managing the glide path, and asset location. I don’t have to do much besides save and withdraw when needed. The funds tend to be a split between Vanguard and iShares.

Understanding Asset Allocation: An Intuitive Approach to Maximizing Your Portfolio by Victor A. Canto

accounting loophole / creative accounting, airline deregulation, Alan Greenspan, Andrei Shleifer, asset allocation, Bretton Woods, business cycle, buy and hold, buy low sell high, California energy crisis, capital asset pricing model, commodity trading advisor, corporate governance, discounted cash flows, diversification, diversified portfolio, equity risk premium, financial engineering, fixed income, frictionless, global macro, high net worth, index fund, inflation targeting, invisible hand, John Meriwether, junk bonds, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low cost airline, low interest rates, market bubble, merger arbitrage, money market fund, new economy, passive investing, Paul Samuelson, Performance of Mutual Funds in the Period, Phillips curve, price mechanism, purchasing power parity, risk free rate, risk tolerance, risk-adjusted returns, risk/return, rolling blackouts, Ronald Reagan, Savings and loan crisis, selection bias, seminal paper, shareholder value, Sharpe ratio, short selling, statistical arbitrage, stocks for the long run, survivorship bias, systematic bias, Tax Reform Act of 1986, the market place, transaction costs, Y2K, yield curve, zero-sum game

But small-cap stocks offered the most intriguing choice: They delivered a much higher annual rate of return during the sample period—but with greater volatility. So, the question is straightforward: Do higher rates of return compensate an investor for the added risk? Arguably, systematic risk is the most important risk measure for investors who are considering the addition of an asset class to a diversified portfolio.3 According to the capital asset pricing model (CAPM), the only risk priced (that is, a risk that requires a higher rate of return) is risk correlated with the market. This is otherwise known as systematic risk, or market risk. Risk not correlated with the market is not priced because it can be diversified away.

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CAPM Beta Jensen’s Alpha T-Statistics Sharpe Ratio Small Cap 1 5.64% 2.07 0.65 Large Cap 1 0.00% Growth 1.06 –1.46% 1.87 0.43 Value 0.93 0.81% 1.67 0.60 International 0.62 –1.27% 0.04 0.29 0.53 Strategic Asset Allocation Based On… Period Sharpe Ratio 0.66 0.03% 24.09 0.72 Yearly Sharpe Ratio 0.52 0.02% 24.58 0.63 Market Weights 0.54 0.1% 27 0.57 Comparing the Historical- and Market-Based Allocations As I pointed out in Chapter 1, “In Search of the Upside,” financial economics developments over the past three decades provide us with the necessary tools to develop risk-adjusted returns in a rigorous and systematic way. Arguably, systematic risk is the more important risk measure for investors who are considering adding an asset class to a diversified portfolio. According to the capital asset pricing model (CAPM), the only sort of risk priced (that is, risk requiring a higher rate-of-return) is systematic risk, which is correlated with the market. The CAPM offers a way to estimate systematic risk for different asset classes (that is, beta) as well as precisely measure the additional return (that is, alpha) provided by an asset class over that required to compensate for the systematic risk.

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Second, and equally important, is the SAA would have significantly reduced the portfolio’s overall volatility while producing market-like returns. The numbers reported in the previous chapter in fact show the SAA’s great benefit, and the diversification produced by the strategy, are best described in risk reduction terms. But, the data nevertheless clearly show the SAA, as promised, delivers a diversified portfolio producing lower risk without sacrificing returns. That’s a good deal. But, if good in this case only means good enough, the good is the enemy of the best. The challenge now is to develop an allocation strategy that delivers even better risk-adjusted returns than the market SAA. The data reported in Chapter 2, “The Case for Cyclical Asset Allocation,” show for approximately 80 percent of the time during our 30-year sample period, the optimal size, style, location, and equity/fixed-income allocation was a corner solution (that is, a 90 percent or greater allocation to one of the choices).

Capital Without Borders by Brooke Harrington

Alan Greenspan, banking crisis, Big bang: deregulation of the City of London, British Empire, capital controls, Capital in the Twenty-First Century by Thomas Piketty, classic study, complexity theory, corporate governance, corporate social responsibility, diversified portfolio, emotional labour, equity risk premium, estate planning, eurozone crisis, family office, financial innovation, ghettoisation, Great Leap Forward, haute couture, high net worth, income inequality, information asymmetry, Joan Didion, job satisfaction, joint-stock company, Joseph Schumpeter, Kevin Roose, liberal capitalism, mega-rich, mobile money, offshore financial centre, prudent man rule, race to the bottom, regulatory arbitrage, Robert Shiller, South Sea Bubble, subprime mortgage crisis, the market place, The Theory of the Leisure Class by Thorstein Veblen, Thorstein Veblen, transaction costs, upwardly mobile, wealth creators, web of trust, Westphalian system, Wolfgang Streeck, zero-sum game

Indeed, a common denominator of the growth strategies that wealth managers devise for their clients is that they are “deliberately structured to eliminate virtually all investment risk.”74 This flies in the face of the economic theories underpinning modern capitalism, in which financial rewards come only to those who accept risks.75 That is the basis of the entrepreneurial ideal, and of the legitimacy historically accorded to great fortunes. But one of the things the wealthy can do better than others is hedge their risks. This occurs on a number of fronts simultaneously, from the use of legal fig leaves such as opinion letters and the sheltering of assets in judgment-proof Cook Islands trusts, to the choice of a diversified portfolio of investments.76 Having all one’s eggs in a single basket, financially speaking, makes one’s wealth very vulnerable to economic downturns. Those whose wealth is spread among stocks and bonds, real estate, art, and cash are in a much better position to withstand market declines—or even take advantage of them.

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See also asset-holding structures; wealth Austen, Jane, 42 authority: divine, 40; of ecclesiastical courts, 41; feudal, 296; patriarchal, 86, 112–14, 121; professionals invested with, 96; rational-legal form of, 113; respect for, 88; state, 21, 25, 76, 236, 240, 243–52, 253, 268, 269, 289, 292 “Baby Mama Trust,” 159, 260, 268 Bahamas, 157, 167 bankers: family banks, 251, 269; family institutions take on functions of, 250–52; fiduciary responsibility absent for, 63; nineteenth-century growth of trust in, 75; offshore banking, 138, 196, 255; on trusts managers, 62–63; wealth managers compared with, 4, 83 bankruptcy: corporations’ limited liability, 182; discretionary trusts provide protection from, 156; foundations as subject to, 180; in private trust company structure, 190; special-purpose vehicles provide protection from, 19; tightening of laws of, 156–57; trustees as at risk of personal, 49; VISTA structure and, 170 bargaining, 106, 107 barriers to access, 22–27 Bayeux Tapestry, 41 bearer shares, 184, 185 Beckert, Jens, 202 Belize, 157, 301 beneficial owners: in divorce procedures, 162–63; nominee shareholders as, 183–84; registries of, 301; tiered assets and, 189; trustees act as, 49 Bentham, Jeremy, 204 Bermuda, 8, 9, 167, 188, 254 Bessemer Trust, 191, 250 “big government,” 252 Bleak House (Dickens), 1–2 blind trusts, 206 bonds: British trustees prefer to invest in, 49; buying up after financial crisis of 2008, 211; diversified portfolios, 211; wealth managers had to become knowledgeable about, 288 bonuses, 60 borders: abolishing, 293; controls, 239, 247 borrowing, trusts increase cost of, 221 Bourdieu, Pierre, 93, 94, 96, 98, 103, 121, 217 Brazil, 147, 224 bribery, 147, 223 BRICS countries, 107, 161, 178 British Virgin Islands (BVI): as captured state, 262–67; cash flown in to banks in, 139; double-taxation treaty with United States, 262; as former British colony, 254; International Business Corporation Act, 262–63, 265, 267; interviews for this study in, 32; makes itself hospitable to wealth management industry, 264–65; offshore business as mixed blessing for, 253; Payroll Act, 265; Russians and Chinese base offshore corporations in, 146–47; seen as specializing in theft, 296; standard of living in, 265; subsumes its own culture to high-net-worth individuals, 263–64; in typical client scenario, 8, 188; VISTA (Virgin Islands Special Trusts Act) trusts, 57, 114–15, 168, 169–70, 177, 185, 222 Bruce (Geneva-based practitioner), 62, 68–69, 72, 110–11, 112, 116, 147, 148, 178, 234 Bubble Act (1720), 48, 181, 314n44 Buffett, Warren, 18 Burke, Edmund, 238 Bush, George W., 16 BVI.

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See British Virgin Islands (BVI) campaign contributions, 18, 223 Canterbury Tales (Chaucer), 44, 46 capital: circuit between private and corporate wealth, 74; concentration of, 214, 217; cultural, 94, 95, 96, 102, 121, 286, 288; fungibility of, 290; gains, 150, 152, 175, 199; global flows of, 21, 22, 219, 235, 248, 256, 259, 300, 235, 248, 300; human, 60, 218, 220; hypermobile, 12, 126, 236; internationalization of, 53; loosening of controls on, 235; mobility of, 124, 129, 133, 134, 139, 236, 240, 256; reputational, 14–15; surplus, 194; taxes on capital gains, 150, 152, 175; as transnational, 12, 261, 269; wealth shifts from land to, 48 capitalism: fiduciary, 272; income inequality and, 204; industrial, 47, 51, 125; legal powers granted to corporations and modern, 74; professional wealth management emerges with transformation of, 5, 125; risk-reward relationship in, 211; Statute of Elizabeth of 1571 in development of, 155; STEP frames its work as defense of, 226; supersession of nation-state as organizing principle of, 235; transformations in, 5, 51, 74, 125; trust and estate planning’s emergence and transformation of, 51, 125; trustees in institutional integration of stable capitalist class, 51; wealth managers in conflict with dynamics of, 18 Cardozo, Benjamin, 46 care, fiduciary duty of, 45–46, 87 Caribbean: Bahamas, 157, 167, 157, 167; Turks and Caicos, 167, 255. See also British Virgin Islands (BVI); Cayman Islands Carlos (Buenos Aires–based practitioner), 148, 149, 300–301 Carnegie, Andrew, 292 cash: Chinese desire for offshore, 143; diversified portfolios, 211; in high-end real estate transactions, 144–45; transporting to offshore banks, 138–40 cash-for-passports programs, 239–40, 290 Cayman Islands: beneficial ownership registry in, 301; Chinese base offshore firms in, 145, 177; divorce-protection trusts in, 162–63; as former British colony, 254; interviews for this study in, 32; in Iran-Contra affair, 260; legislation to block court control over inheritance in, 167; STAR (Special Trusts Alternative Regime) structure, 168, 169, 170–71, 177, 185, 276; taxation in, 175; in trade-restriction avoidance, 159; in typical client scenario, 7–8, 188 Channel Islands: central location of, 130; feudal remnants in, 37; as former British colony, 254; offshore financial centers in, 129.

The Handbook of Personal Wealth Management by Reuvid, Jonathan.

asset allocation, banking crisis, BRICs, business cycle, buy and hold, carbon credits, collapse of Lehman Brothers, correlation coefficient, credit crunch, cross-subsidies, currency risk, diversification, diversified portfolio, estate planning, financial deregulation, fixed income, global macro, high net worth, income per capita, index fund, interest rate swap, laissez-faire capitalism, land tenure, low interest rates, managed futures, market bubble, merger arbitrage, negative equity, new economy, Northern Rock, pattern recognition, Ponzi scheme, prediction markets, proprietary trading, Right to Buy, risk tolerance, risk-adjusted returns, risk/return, short selling, side project, sovereign wealth fund, statistical arbitrage, systematic trading, transaction costs, yield curve

His previous assignments have included working for the Corporate and Investment Bank in equity derivatives, where he performed diverse roles including senior profit and loss analysis, risk management and warrants trading. 1 Introduction In 2008 conventional private investor thinking was turned upside down following the ‘credit crunch’ and the ensuing stream of dismal revelations of imprudent bank lending, financial products based on the packaging of toxic debt and inadequate financial sector regulation. Previous conceptions of what were safe forms of investment and how diversified portfolios could be structured at acceptable levels of risk were tossed aside. High-net-worth individuals (HNWs) and others with significant capital assets, including pension pots, available for investment have had to rethink their investment strategies. Financial institutions and advisers were caught on the hop too and have had to tighten their investment analysis and due diligence routines.

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There are various return drivers, including sector selection, market capitalization positioning, stock selection, and how managers vary the total amount held in long and short positions. Funds may also use leverage, meaning that portfolios can range from riskier highly leveraged focused portfolios to more diversified portfolios with less or no leverage. Managers can add positions based upon top-down and/or bottom-up fundamentals or technicals. 26 BESTINVEST WEALTH MANAGEMENT SERVICE Investing shouldn’t be a numbers game Bestinvest has been providing investment counsel for over 20 years. We’ve been through five recessions, six Chancellors of the Exchequer, black Monday, black Wednesday and more than a fair share of bleak outlooks.

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Looking at each type of investment we can briefly summarize their characteristics as follows: ឣ Funds – Single or multiple funds. – Tend to be illiquid (unless one of the open-ended variety with short-based redemption periods). – Difficult for investor to see value of single assets. – Well-diversified portfolio. – Single or multiple strategy. – Access to established fund managers with excellent access and expertise to their marketplaces. – Reduced management risk at asset level. – Debt, if used, is accessed via the fund manager; thus the individual investor does not have to acquire his/her own debt.

Inside the House of Money: Top Hedge Fund Traders on Profiting in a Global Market by Steven Drobny

Abraham Maslow, Alan Greenspan, Albert Einstein, asset allocation, Berlin Wall, Bonfire of the Vanities, Bretton Woods, business cycle, buy and hold, buy low sell high, capital controls, central bank independence, commoditize, commodity trading advisor, corporate governance, correlation coefficient, Credit Default Swap, currency risk, diversification, diversified portfolio, family office, financial engineering, fixed income, glass ceiling, Glass-Steagall Act, global macro, Greenspan put, high batting average, implied volatility, index fund, inflation targeting, interest rate derivative, inventory management, inverted yield curve, John Meriwether, junk bonds, land bank, Long Term Capital Management, low interest rates, managed futures, margin call, market bubble, Market Wizards by Jack D. Schwager, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, Nixon triggered the end of the Bretton Woods system, oil shale / tar sands, oil shock, out of africa, panic early, paper trading, Paul Samuelson, Peter Thiel, price anchoring, proprietary trading, purchasing power parity, Reminiscences of a Stock Operator, reserve currency, risk free rate, risk tolerance, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, tail risk, The Wisdom of Crowds, too big to fail, transaction costs, value at risk, Vision Fund, yield curve, zero-coupon bond, zero-sum game

The global macro hedge fund strategy has the widest mandate of all hedge fund strategies whereby managers have the ability to take positions in any market or instrument. Managers usually look to take positions that have limited downside risk and potentially large rewards, opting for either a concentrated risk-taking approach or a more diversified portfolio style of money management. Global macro trades are classified as either outright directional, where a manager bets on discrete price movements, such as long U.S. dollar index or short Japanese bonds, or relative value, where two similar assets are paired T 1 2 INSIDE THE HOUSE OF MONEY on the long and short sides to exploit a perceived relative mispricing, such as long emerging European equities versus short U.S. equities, or long 29year German Bunds versus short 30-year German Bunds.

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The simplest version is you want a carry trader, a fund that earns regular income; and you want a gamma trader, one that looks for the huge move.You want someone who’s going to make you the regular money when things are normal and quiet, and the guy who’s going to make you a lot of money when things really move. That’s how you develop a diversified portfolio. Not by diversifying through markets or by geographic regions but through how they trade. The great trades in global macro are when you combine carry with gamma.When a high yielding currency is cheap, for example, is when you can get tremendous outsized returns. THE RESEARCHER 129 Why do you think asset allocators find global macro the most difficult of the hedge fund strategies to understand?

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It was an outstanding trade. 4.5 4.0 Getting a Bit Hairy Yield (%) 3.5 3.0 Position Entered at 3.4% Yield 2.5 2.0 Exit at Initial 1.5% Yield Target FIGURE 15.1 1997–2003 10-Year Treasury Inflation-Protected Securities (TIPS), Source: Bloomberg. 20 03 2 20 0 01 20 0 20 0 99 19 98 19 19 97 1.5 THE FIXED INCOME SPECIALISTS 319 Were you able to hold on to the position because you were running a broadly diversified portfolio? Gorton: Exactly. We had other trades on that were doing well. We also hung on to that trade for so long because it was so outstandingly good. I have never seen a yield curve that was as mispriced as the yen curve at that time. Other great trades over the years were curvature and conditional steepener type trades on the U.S. yield curve back in 2001 when nobody understood them.

Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever by Robin Wigglesworth

Albert Einstein, algorithmic trading, asset allocation, Bear Stearns, behavioural economics, Benoit Mandelbrot, Big Tech, Black Monday: stock market crash in 1987, Blitzscaling, Brownian motion, buy and hold, California gold rush, capital asset pricing model, Carl Icahn, cloud computing, commoditize, coronavirus, corporate governance, corporate raider, COVID-19, data science, diversification, diversified portfolio, Donald Trump, Elon Musk, Eugene Fama: efficient market hypothesis, fear index, financial engineering, fixed income, Glass-Steagall Act, Henri Poincaré, index fund, industrial robot, invention of the wheel, Japanese asset price bubble, Jeff Bezos, Johannes Kepler, John Bogle, John von Neumann, Kenneth Arrow, lockdown, Louis Bachelier, machine readable, money market fund, Myron Scholes, New Journalism, passive investing, Paul Samuelson, Paul Volcker talking about ATMs, Performance of Mutual Funds in the Period, Peter Thiel, pre–internet, RAND corporation, random walk, risk-adjusted returns, road to serfdom, Robert Shiller, rolodex, seminal paper, Sharpe ratio, short selling, Silicon Valley, sovereign wealth fund, subprime mortgage crisis, the scientific method, transaction costs, uptick rule, Upton Sinclair, Vanguard fund

In the conclusion to his letter to the Post’s owner, Buffett therefore laid out his recommendations: Either stay the course with a bunch of big, mainstream professional fund managers and accept that the newspaper’s pension fund would likely do slightly worse than the market; find smaller, specialized investment managers who were more likely to be able to beat the market; or simply build a broad, diversified portfolio of stocks that mirrored the entire market. Buffett obliquely noted that “several funds have been established fairly recently to duplicate the averages, quite explicitly embodying the principle that no management is cheaper, and slightly better than average paid management after transaction costs.”

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Rex Sinquefield, then a student at Chicago’s business school, noted, somewhat tongue-in-cheek, that “if I had to rank events, I would say CRSP is probably slightly more significant than the creation of the universe.”37 Lorie himself stressed that professional investors “can be and almost certainly are useful.” They performed a valuable service in simply convincing people to invest in stocks—which, as he had shown, offered superior returns to bonds and money deposited in a bank account—and provided a relatively efficient way of gaining a diversified portfolio of them. After all, the cost of bookkeeping and custodial work could be significant, and the service that professionals offered smaller investors in reducing the “agony of choice and responsibility” was valuable, Lorie argued.38 Nonetheless, he took a stab at explaining why the average returns of professional money managers didn’t seem to be able to beat the market.

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The genesis of index funds was the realization that most people—whether experienced professional money managers, a dentist investing for their retirement, or unemployed twentysomethings day-trading to make a quick buck—make terrible investors. The best long-term results come from buying a big, well-diversified portfolio of financial securities, and trading as little as possible. Jack Bogle built a vast financial empire around these two basic principles. Yet there is in practice little meaningful difference between taking a bet on a hot dotcom stock and on a biotech or robotics ETF. The line between “active” and “passive” investing has always been a fuzzy one, given that choosing what index fund to invest in is unavoidably an active choice.

Money Changes Everything: How Finance Made Civilization Possible by William N. Goetzmann

Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, banking crisis, Benoit Mandelbrot, Black Swan, Black-Scholes formula, book value, Bretton Woods, Brownian motion, business cycle, capital asset pricing model, Cass Sunstein, classic study, collective bargaining, colonial exploitation, compound rate of return, conceptual framework, Cornelius Vanderbilt, corporate governance, Credit Default Swap, David Ricardo: comparative advantage, debt deflation, delayed gratification, Detroit bankruptcy, disintermediation, diversified portfolio, double entry bookkeeping, Edmond Halley, en.wikipedia.org, equity premium, equity risk premium, financial engineering, financial independence, financial innovation, financial intermediation, fixed income, frictionless, frictionless market, full employment, high net worth, income inequality, index fund, invention of the steam engine, invention of writing, invisible hand, James Watt: steam engine, joint-stock company, joint-stock limited liability company, laissez-faire capitalism, land bank, Louis Bachelier, low interest rates, mandelbrot fractal, market bubble, means of production, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, new economy, passive investing, Paul Lévy, Ponzi scheme, price stability, principal–agent problem, profit maximization, profit motive, public intellectual, quantitative trading / quantitative finance, random walk, Richard Thaler, Robert Shiller, shareholder value, short selling, South Sea Bubble, sovereign wealth fund, spice trade, stochastic process, subprime mortgage crisis, Suez canal 1869, Suez crisis 1956, the scientific method, The Wealth of Nations by Adam Smith, Thomas Malthus, time value of money, tontine, too big to fail, trade liberalization, trade route, transatlantic slave trade, tulip mania, wage slave

Lowenfeld concentrated on the recent past, the period of intense growth in the world markets. These data, once collected and studied, showed him that spreading investments internationally made the overall portfolio less risky. As a result, he reasoned, a truly diversified portfolio had to be spread over the entire world. And investors needed a convenient exchange to build such an ideal, modern diversified portfolio. Lowenfeld constructed a beautiful example using only railway securities. Bonds from one industry in a single country are usually highly correlated, but the Lowenfeld portfolio invested equally in ten railroad bonds from around the world: British, Canadian, German, Sardinian, Indian, Egyptian, American, Mexican, Argentinean, and Spanish; all with about the same yield.

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It offered its services on a strictly fee basis—eliminating some of the extreme conflicts of interest held by other firms. Unlike big Wall Street companies, Investors Management Company did not underwrite securities and then park the failures in their investment trusts. The firm offered two products: Fund A and Fund B. Both allowed investors to hold a diversified portfolio of common stock, formed chiefly according to the principles outlined in his book. Fund A planned to pay out 5% per year in dividends, which was the rate Smith figured was a sustainable yield based on historical analysis. Fund B allowed investors to plow back all dividends by reinvesting in more common stock shares.

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Although the Investors Management Company Funds A and B were not the very first mutual funds in America, they were very prominent and immediately attracted imitators. Just as suddenly as Americans became infatuated with buying stocks, they fell in love with investment trusts. The simple idea of pooling investor money and buying a diversified portfolio of securities is a great one and is certainly not new. After all, the Dutch invented mutual funds every bit as sophisticated. The British model for American funds—including the famous Foreign and Colonial Government Trust—was widely acknowledged in the 1920s. Trusts were even referred to as a “British” style of investing.

The Little Book of Hedge Funds by Anthony Scaramucci

Alan Greenspan, Andrei Shleifer, asset allocation, Bear Stearns, Bernie Madoff, business process, carried interest, corporate raider, Credit Default Swap, diversification, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, fear of failure, financial engineering, fixed income, follow your passion, global macro, Gordon Gekko, high net worth, index fund, it's over 9,000, John Bogle, John Meriwether, Long Term Capital Management, mail merge, managed futures, margin call, mass immigration, merger arbitrage, Michael Milken, money market fund, Myron Scholes, NetJets, Ponzi scheme, profit motive, proprietary trading, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, risk/return, Ronald Reagan, Saturday Night Live, Sharpe ratio, short selling, short squeeze, Silicon Valley, tail risk, Thales and the olive presses, Thales of Miletus, the new new thing, too big to fail, transaction costs, two and twenty, uptick rule, Vanguard fund, Y2K, Yogi Berra, zero-sum game

So, what is a fund of hedge funds? As the name implies, it is a fund that invests in other hedge funds. In creating and managing a portfolio of various hedge funds, a fund of hedge funds manager thematically blends together funds so as to maximize returns while minimizing risk. To do so, he must create a diversified portfolio that is composed of funds that exhibit low correlations with the overall market, experience solid performance, and have lower volatility. Thus, funds of hedge funds are the ultimate vehicle for investors who want to take advantage of the various benefits of hedge fund investing. If done properly, smaller investors—who historically do not have the sizable minimums required to get access to hall of fame hedge fund managers—allot their capital to this alternative asset, with the capital being stewarded judiciously to an able-minded group that is constantly and dynamically shifting the portfolio.

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For example, for as little as $50,000 a Registered Investment Company (RIC) provides individuals with access through the same aggregation that a fund of funds provides. These types of products put relatively small investors in the catbird seat, benefitting from the aggregation but also from the rigorous analysis and risk management. Diversification = Mitigated Risk As discussed previously, a fund of hedge funds holds a diversified portfolio of various hedge funds that invest in different asset classes, alternative investment styles, and geographic regions. Although there is not a magic number, it is recommended that a fund of hedge funds invest in about 30 to 50 managers, with the typical sweet spot being around 35 to 40 managers.

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How or why did you get started in the industry? My career began in the capital markets focused on sales and trading across currencies, interest rates, equities, and later derivatives. From that I migrated to structured investment products and then to CIO of an asset management business focused on globally diversified portfolios of stocks, bonds, and cash. Around that same time hedge funds were starting to become recognized investment alternatives with attractive risk adjusted returns and correlation characteristics. Therefore, I began to explore how to utilize them within a portfolio of traditional asset classes to create portfolios that would be more efficient.

Smarter Investing by Tim Hale

Albert Einstein, asset allocation, buy and hold, buy low sell high, capital asset pricing model, classic study, collapse of Lehman Brothers, corporate governance, credit crunch, currency risk, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, eurozone crisis, fiat currency, financial engineering, financial independence, financial innovation, fixed income, full employment, Future Shock, implied volatility, index fund, information asymmetry, Isaac Newton, John Bogle, John Meriwether, Long Term Capital Management, low interest rates, managed futures, Northern Rock, passive investing, Ponzi scheme, purchasing power parity, quantitative easing, random walk, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, South Sea Bubble, technology bubble, the rule of 72, time value of money, transaction costs, Vanguard fund, women in the workforce, zero-sum game

What has changed, and changed for the better, since the previous edition is the number and quality of passive fund providers and sensible passive products available to retail investors. The arrival of Vanguard has caused a revolution in product and huge pressure on pricing which is all great from a Smarter Investor’s perspective. It is now easy to construct and administer a robust and well-diversified portfolio using online broker platforms. The implementation section of the book provides insight into some of the funds that investors can research to fill each slice of their portfolio pie. The nature of financial advice has changed too. On 1 January 2013, a new regime came into being that effectively bans all commission payments by providers to advisers.

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This includes regular rebalancing of portfolios back to their original mix on a regular basis, selling out of assets that have performed well and re-investing in assets that have done less well – a systematic, contrarian investment process. Mental tick box 8: Accept that you are prone to emotional pressures that drive you to do the wrong thing at the wrong time. Learn to be comfortable with the diversified portfolio that you own. Lean heavily on your adviser, when you need support at times of emotional, investment-related weakness. Tip 9: There are no perfect answers Let me tell you that there are no perfect answers to investing and this book does not seek to provide any. But there are better and worse solutions.

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At the end of the day, the various decisions we are going to consider making are trying to improve (a) just owning global equities and (b) simply owning cash. That does not mean that these incremental decisions are not of value, they are – just like the time and effort David Brailsford spends with his helmet design and wind tunnel tests. It makes good sense to try to construct more robust and better diversified portfolios based on the evidence we have to hand, a bit of hard thinking and a good dose of common sense. What does not make sense is getting caught up in overcomplicated software models, taking on risks that are not adequately rewarded or the myriad of faddish sectors and market ‘opportunities’ peddled by those who think that complexity justifies their fees.

Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky

algorithmic trading, asset allocation, automated trading system, backpropagation, backtesting, barriers to entry, behavioural economics, book value, business cycle, buy and hold, capital asset pricing model, constrained optimization, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, currency risk, data science, deep learning, discounted cash flows, discrete time, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial engineering, financial intermediation, Flash crash, Geoffrey Hinton, implied volatility, index arbitrage, index fund, intangible asset, iterative process, Long Term Capital Management, loss aversion, low interest rates, machine readable, market design, market microstructure, merger arbitrage, natural language processing, passive investing, pattern recognition, performance metric, Performance of Mutual Funds in the Period, popular capitalism, prediction markets, price discovery process, profit motive, proprietary trading, quantitative trading / quantitative finance, random walk, Reminiscences of a Stock Operator, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, risk/return, selection bias, sentiment analysis, shareholder value, Sharpe ratio, short selling, Silicon Valley, speech recognition, statistical arbitrage, statistical model, stochastic process, survivorship bias, systematic bias, systematic trading, text mining, transaction costs, Vanguard fund, yield curve

As the number of alphas increases, however, different techniques to measure the correlation coefficient among them become more important in helping the investor diversify his or her portfolio. Portfolio managers will want to include relatively uncorrelated alphas in their portfolios because a diversified portfolio helps to reduce risk. A good correlation measure needs to identify the uniqueness of one alpha with respect to other alphas in the pool (a smaller value indicates a good uniqueness). In addition, a good correlation measure has the ability to predict the trend of movement of two alpha PnL vectors (time-series vectors).

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It can also help more-experienced quants, who have the ability to define the entities that constitute each axis and then analyze existing alphas in their portfolios, to target their efforts with greater efficiency. New quants can easily be overwhelmed by the challenge of trying to develop alphas. They ask themselves, “How do I find alphas? How do I start the search?” Even experienced quants working with many alphas can miss key components required to build a robust, diversified portfolio. For instance, one of the most difficult aspects of alpha portfolio construction is the need to optimize the level of diversification of the portfolio. In automated trading systems, decisions on diversification make up a major area of human intervention. It’s not easy to visualize the many pieces of the portfolio, which contain hundreds or thousands of alphas, and their interactions.

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Published 2020 by John Wiley & Sons, Ltd. 84 Finding Alphas diversifying their portfolios, they may just be developing the same kinds of alphas over and over again. Although they may appear to have low correlation, variants of the same alpha types tend to have the same failure modes and do not provide the full benefit of a truly diversified portfolio. Nearly everyone falls into this trap when they begin to research alphas. Every successful quant has a gold mine; he digs deeper and deeper in his mine to extract as much as he can. One person develops a very strong momentum site; another has a very strong fundamental site; a third builds a very strong reversion site.

Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris

active measures, Andrei Shleifer, AOL-Time Warner, asset allocation, automated trading system, barriers to entry, Bernie Madoff, Bob Litterman, book value, business cycle, buttonwood tree, buy and hold, compound rate of return, computerized trading, corporate governance, correlation coefficient, data acquisition, diversified portfolio, equity risk premium, fault tolerance, financial engineering, financial innovation, financial intermediation, fixed income, floating exchange rates, High speed trading, index arbitrage, index fund, information asymmetry, information retrieval, information security, interest rate swap, invention of the telegraph, job automation, junk bonds, law of one price, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market clearing, market design, market fragmentation, market friction, market microstructure, money market fund, Myron Scholes, National best bid and offer, Nick Leeson, open economy, passive investing, pattern recognition, payment for order flow, Ponzi scheme, post-materialism, price discovery process, price discrimination, principal–agent problem, profit motive, proprietary trading, race to the bottom, random walk, Reminiscences of a Stock Operator, rent-seeking, risk free rate, risk tolerance, risk-adjusted returns, search costs, selection bias, shareholder value, short selling, short squeeze, Small Order Execution System, speech recognition, statistical arbitrage, statistical model, survivorship bias, the market place, transaction costs, two-sided market, vertical integration, winner-take-all economy, yield curve, zero-coupon bond, zero-sum game

If you have ever listened to speeches by a Fed chairman or a Fed governor, you know that they rarely say anything interesting about interest rates. They do not want to reveal any information that would allow informed traders to predict the future course of interest rates. ◀ * * * Diversified Portfolios Relative spreads will be smaller for contracts on well-diversified portfolios than for the individual assets in the portfolio. Although traders may have significant material information about individual assets, such information rarely is material to all assets in the portfolio. A large portfolio dilutes the importance of information about any single constituent asset.

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In a symmetric distribution, outcome probabilities depend only on their distance from the median value of the distribution. The probabilities of outcomes at equal distances above and below the median therefore are the same. The returns of well-diversified portfolios are approximately symmetrically distributed. Although there are some systematic departures from symmetry (large negative values are slightly more common than large positive values), these departures usually affect index returns as well. Accordingly, market-adjusted returns tend to be quite symmetric for well-diversified portfolios because the asymmetries in the portfolio and index returns offset each other. Certain portfolio strategies, however, can produce highly asymmetric return distributions.

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Susan needs short-term capital losses to offset her capital gains. Unfortunately—actually fortunately—she does not have any positions with losses that she can sell. To solve her problem, Susan decides to buy the Mexico Fund (MXF) and short sell the Mexico Equity and Income Fund (MXE). These two funds are unrelated closed-end funds that own diversified portfolios of Mexican stocks. Although Mexican stocks are often quite volatile, the combined position is not very risky because the returns to these two funds are very closely correlated. If the Mexican stock market rises before the end of the year, Susan will realize her loss on her short MXE position and carry her gain in MXF over into the next year.

The Automatic Millionaire, Expanded and Updated: A Powerful One-Step Plan to Live and Finish Rich by David Bach

asset allocation, diversified portfolio, financial independence, index fund, job automation, late fees, money market fund, Own Your Own Home, risk tolerance, robo advisor, transaction costs, Vanguard fund

In other words, you’ve got to diversify—which means that instead of investing all of your money in just one or two places, you spread it around. Now spreading your money around does not mean opening up a lot of different retirement accounts in different places. If you do that and then make the same kinds of investments with each of them, all you’ve done is complicate your life. Spreading your money around means building a diversified portfolio of stocks, bonds, and cash investments all done in one retirement account. Many people make this complicated. It doesn’t need to be. THE POWER OF THE PYRAMID On this page is a wonderful tool designed to help you determine where your money should be invested and how much should go in each place.

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As of 2015, according to Morningstar, there are $763 billion invested in these funds. What target dated funds do is help you select an investment fund of funds that will be professionally managed with a “target date of retirement.” Say you want to retire around 2035; you simply select the fund with “2035” in it. Then the fund manager builds a diversified portfolio like the investment pyramid I showed you earlier, broken down between stocks, bonds, cash, global investments, etc. The fund then is automatically rebalanced and the risk is reduced in the portfolio as you get closer to retirement. GET TO KNOW YOUR GLIDE PATH If you already have this type of fund or you’re considering it, it’s critical that you take a look at what is called the “Glide Path” of the fund.

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And the fact is that boring works—according to Morningstar, there’s now more than $650 billion invested in these simple one-stop solution target-dated funds. If you invest your money according to the Automatic Millionaire Investment Pyramid, as I suggest on this page, you will end up with a well-diversified portfolio that is professionally managed. Even better, if you invest in one balanced fund or asset allocation fund that diversifies your portfolio for you AND you automate your contributions—which, after all, is the point of this little book—you’ll have a really boring financial life. The same is true if you use a robo advisory firm or a model portfolio of index funds and ETFs.

Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein

Alan Greenspan, Albert Einstein, Alvin Roth, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, Bayesian statistics, behavioural economics, Big bang: deregulation of the City of London, Bretton Woods, business cycle, buttonwood tree, buy and hold, capital asset pricing model, cognitive dissonance, computerized trading, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Edmond Halley, Edward Lloyd's coffeehouse, endowment effect, experimental economics, fear of failure, Fellow of the Royal Society, Fermat's Last Theorem, financial deregulation, financial engineering, financial innovation, full employment, Great Leap Forward, index fund, invention of movable type, Isaac Newton, John Nash: game theory, John von Neumann, Kenneth Arrow, linear programming, loss aversion, Louis Bachelier, mental accounting, moral hazard, Myron Scholes, Nash equilibrium, Norman Macrae, Paul Samuelson, Philip Mirowski, Post-Keynesian economics, probability theory / Blaise Pascal / Pierre de Fermat, prudent man rule, random walk, Richard Thaler, Robert Shiller, Robert Solow, spectrum auction, statistical model, stocks for the long run, The Bell Curve by Richard Herrnstein and Charles Murray, The Wealth of Nations by Adam Smith, Thomas Bayes, trade route, transaction costs, tulip mania, Vanguard fund, zero-sum game

As Poincare had pointed out, the behavior of a system that consists of only a few parts that interact strongly will be unpredictable. With such a system you can make a fortune or lose your shirt with one big bet. In a diversified portfolio, by contrast, some assets will be rising in price even when other assets are falling in price; at the very least, the rates of return among the assets will differ. The use of diversification to reduce volatility appeals to everyone's natural risk-averse preference for certain rather than uncertain outcomes. Most investors choose the lower expected return on a diversified portfolio instead of betting the ranch, even when the riskier bet might have a chance of generating a larger payoff-if it pans out.

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Improving economic status and opportunity ... is a basic component of increasing freedom. `9 But the fear of loss sometimes constrains our choices. That is why Arrow applauds insurance and risk-sharing devices like commodity futures contracts and public markets for stocks and bonds. Such facilities encourage investors to hold diversified portfolios instead of putting all their eggs in one basket. Arrow warns, however, that a society in which no one fears the consequences of risk-taking may provide fertile ground for antisocial behavior. For example, the availability of deposit insurance to the depositors of savings and loan associations in the 1980s gave the owners a chance to win big if things went right and to lose little if things went wrong.

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Playing to win against such an opponent is likely to be a sure recipe for losing. By making the best of a bad bargain-by diversifying instead of striving to make a killing-the investor at least maximizes the probability of survival. The mathematics of diversification helps to explain its attraction. While the return on a diversified portfolio will be equal to the average of the rates of return on its individual holdings, its volatility will be less than the average volatility of its individual holdings. This means that diversification is a kind of free lunch at which you can combine a group of risky securities with high expected returns into a relatively low-risk portfolio, so long as you minimize the covariances, or correlations, among the returns of the individual securities.

Corporate Finance: Theory and Practice by Pierre Vernimmen, Pascal Quiry, Maurizio Dallocchio, Yann le Fur, Antonio Salvi

"Friedman doctrine" OR "shareholder theory", accelerated depreciation, accounting loophole / creative accounting, active measures, activist fund / activist shareholder / activist investor, AOL-Time Warner, ASML, asset light, bank run, barriers to entry, Basel III, Bear Stearns, Benoit Mandelbrot, bitcoin, Black Swan, Black-Scholes formula, blockchain, book value, business climate, business cycle, buy and hold, buy low sell high, capital asset pricing model, carried interest, collective bargaining, conceptual framework, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, currency risk, delta neutral, dematerialisation, discounted cash flows, discrete time, disintermediation, diversification, diversified portfolio, Dutch auction, electricity market, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, eurozone crisis, financial engineering, financial innovation, fixed income, Flash crash, foreign exchange controls, German hyperinflation, Glass-Steagall Act, high net worth, impact investing, implied volatility, information asymmetry, intangible asset, interest rate swap, Internet of things, inventory management, invisible hand, joint-stock company, joint-stock limited liability company, junk bonds, Kickstarter, lateral thinking, London Interbank Offered Rate, low interest rates, mandelbrot fractal, margin call, means of production, money market fund, moral hazard, Myron Scholes, new economy, New Journalism, Northern Rock, performance metric, Potemkin village, quantitative trading / quantitative finance, random walk, Right to Buy, risk free rate, risk/return, shareholder value, short selling, Social Responsibility of Business Is to Increase Its Profits, sovereign wealth fund, Steve Jobs, stocks for the long run, supply-chain management, survivorship bias, The Myth of the Rational Market, time value of money, too big to fail, transaction costs, value at risk, vertical integration, volatility arbitrage, volatility smile, yield curve, zero-coupon bond, zero-sum game

Remember that this approach applies only if the investor owns a perfectly diversified portfolio. Here is why: the greater the risk assumed by the financial investor, the higher his required rate of return. However, if he makes just one investment and that turns out to be a failure, his required rate of return will matter little, as he will have lost everything. With this in mind, it is easier to understand that the risk premium is relevant only if the financial investor manages not just a single investment, but a diversified portfolio of investments. In this case, the failure of one investment should be offset by the return achieved by other investments, which should thereby produce a suitable return for the portfolio as a whole.

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Better to let a troubled sector rid itself of its lame ducks than to keep them artificially afloat, which in turn creates difficulties for the healthy, efficient firms to the point where they, too, may become financially distressed. For investors with a well-diversified portfolio, the cost of the bankruptcy will theoretically be nil, since when a company is discontinued, its assets (market share, customers, factories, etc.) are taken over by others who will manage them better. One person’s loss is another person’s gain! If the investor has a diversified portfolio, the capital losses will be offset by other capital gains. In practice, however, markets are not perfect and we all know that even if bankruptcies are a means of reallocating resources, they carry a very real cost to those involved.

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Providing part of the financing and providing security to lenders. No, no and no! You forget to take into account the risk (here liquidity risk). “You can’t make money without borrowing money” applies to an investor with a poorly diversified portfolio; it’s all or nothing if he goes into debt to leverage it. “Borrowing can’t create value” applies to a perfectly diversified portfolio. Short-term, so as to be able to refinance on better terms as growth opportunities become profitable investments. Inventory profits and opportunity profits on investment realised sooner than expected. Provided the inflation rate is higher than the interest rate.

Retire Before Mom and Dad by Rob Berger

Airbnb, Albert Einstein, Apollo 13, asset allocation, Black Monday: stock market crash in 1987, buy and hold, car-free, cuban missile crisis, discovery of DNA, diversification, diversified portfolio, en.wikipedia.org, fixed income, hedonic treadmill, index fund, John Bogle, junk bonds, mortgage debt, Mr. Money Mustache, passive investing, Ralph Waldo Emerson, robo advisor, The 4% rule, the rule of 72, transaction costs, Vanguard fund, William Bengen, Yogi Berra, Zipcar

They didn’t really know what they were doing and why, so they had no confidence that they were making the right decision. As you might expect, eventually they failed to press the button and…well, I won’t spoil the show for you. Investing is similar to pressing the button. It is incredibly easy. As you’ll see in later chapters, you can create a well-diversified portfolio of stocks and bonds in about the time it takes to, well, press a button. If you don’t know why you are pressing the button, however, you’ll have no confidence in what you are doing. You’ll be like the Lost survivors debating what to do. During times when market values are falling, and they will fall, your lack of knowledge could cause you to make some serious mistakes.

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These companies typically grow at a slower pace than the typical company. The fund seeks to track a value-style index of small-sized companies. One of the fund’s primary risks is its focus on the small-cap arena, which is an often-volatile segment of the market. Investors looking to add a passively managed, small-cap value allocation to an already diversified portfolio may wish to consider this fund.” Given what we’ve already covered, you should follow this description like a pro. Specialty Some mutual funds invest in specific assets or industries. Two important examples of specialty funds are REITs and Commodity funds. A REIT, or Real Estate Investment Trust, is a mutual fund that invests in real estate.

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He’ll also help you with everything from a budget to retirement projections to insurance to social security. You can get more information on PlanVision here: https://planvisionmn.com/. Robo-Advisors: As we discussed earlier, services such as Betterment offer low cost tools to help you build a solid portfolio. They use automation to help investors build low-cost, diversified portfolios using index ETFs (an ETF is similar to a mutual fund, but it trades like a stock). The typical fee is about 25 to 35 basis points. Some services also provide an advisor you can talk to about your portfolio, although in that case the fee will likely be higher. 3 Key Concepts The best option is to handle your own investments.

Practical Doomsday: A User's Guide to the End of the World by Michal Zalewski

accounting loophole / creative accounting, AI winter, anti-communist, artificial general intelligence, bank run, big-box store, bitcoin, blockchain, book value, Buy land – they’re not making it any more, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carrington event, clean water, coronavirus, corporate governance, COVID-19, cryptocurrency, David Graeber, decentralized internet, deep learning, distributed ledger, diversification, diversified portfolio, Dogecoin, dumpster diving, failed state, fiat currency, financial independence, financial innovation, fixed income, Fractional reserve banking, Francis Fukuyama: the end of history, Haber-Bosch Process, housing crisis, index fund, indoor plumbing, information security, inventory management, Iridium satellite, Joan Didion, John Bogle, large denomination, lifestyle creep, mass immigration, McDonald's hot coffee lawsuit, McMansion, medical bankruptcy, Modern Monetary Theory, money: store of value / unit of account / medium of exchange, moral panic, non-fungible token, nuclear winter, off-the-grid, Oklahoma City bombing, opioid epidemic / opioid crisis, paperclip maximiser, passive investing, peak oil, planetary scale, ransomware, restrictive zoning, ride hailing / ride sharing, risk tolerance, Ronald Reagan, Satoshi Nakamoto, Savings and loan crisis, self-driving car, shareholder value, Silicon Valley, supervolcano, systems thinking, tech worker, Ted Kaczynski, TED Talk, Tunguska event, underbanked, urban sprawl, Wall-E, zero-sum game, zoonotic diseases

Portfolio Design Strategies With the discussion of risks and asset classes out of the way, the final phase of safeguarding wealth is to construct a robust, diversified portfolio that will stand the test of time. The right approach to this problem depends on many factors, including the size of your rainy-day fund, prevailing market conditions, and your familiarity with each of the aforementioned asset classes (heeding the Mr. Market parable from Graham’s book). In normal inflationary environments, a solid starting point may be to keep around three to four months’ worth of savings in cash or in the bank, and then start putting what’s left in a diversified portfolio of around 10 to 20 value stocks, but only up until the equity positions represent about 50 percent of your total emergency funds.

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Cryptocurrencies and NFTs There’s a reason the traditional classes of assets outlined earlier in the chapter are considered the benchmarks for investors: they’re more accessible, safer, cheaper, and more reliable than most alternatives. But there’s no shortage of more exotic choices, and at least two of them deserve some note. The first are cryptocurrencies. We discussed their mechanics before, but the lingering question is whether they have a place in a diversified portfolio. Although some financial advisors are beginning to change their tune, to me, the answer continues to be no. It’s not that cryptocurrencies lack merit or are bound to crash; it’s that their risk profile is difficult to reason about, and the staying power of specific products is far less certain than for many other instruments with good inflation-hedging properties.

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., 196 currencies, history of, 58–68 customer data, 110 cuts, 150 Cypriot debt crisis, 69, 73 D data brokers, 110 Datrex, 143 d-CON, 177 DDT (dichlorodiphenyltrichloroethane), 176 De Waal, Frans, 20 death causes of, 13 planning, 14–15, 124–125 debt, 10–11, 50, 53–54, 59–60 debt crisis, 22 Debt: The First 5000 Years (Graeber), 59 de-escalation skills, 13 defensive driving, 96–98 dehydration, 134 DeleteMe Help Center, 110 deltamethrin, 176 dental care, 151 dental picks, 151 developing countries, 33–34 dextromethorphan, 150 diarrhea, 150 dichlorodiphenyltrichloroethane (DDT), 176 Didion, Joan, 122 dietary supplements, 180 diets, 115–118 digital communications, 188–189 Digital Mobile Radio (DMR), 188 diindolylmethane (DIM), 179 dinosaurs, 34 diseases, 32–33, 173–177 dishwashing, 148 Diversey Oxivir Five 16, 176 Diversey PERdiem, 148 diversified portfolios, 88–-90 divorce, 69–70 documents, 166–167 Dogecoin, 68 dogs as burglary deterrent, 112 domestic terrorism, 26–27 driving habits, 96–98 drowning, 104 drugs, 99–101, 150 D-STAR, 188 “duck and cover,” 39 DuPont Tychem coveralls, 175 dust storms, 18 duty to retreat, 205 Dynarex, 149 E earthquake probabilities, 19 Ebola, 26, 32 economic crises, 22–24 economic hardships, 10–11 economic persecution, 72 ecosystem collapse, 34 Ehrlich, Paul R., 7–8, 30 elastic bandages, 150 electricity, 36, 152–159 electrolyte imbalance, 150 emergency ration bars, 143 emergency repairs, 162–163 EMP (electromagnetic pulse), 40–41 employment, 91–93 encephalitis lethargica, 25 Energizer Ultimate batteries, 155 entertainment, 191–192 epinephrine inhalers, 150 Epsilon Data Management, 110 Equifax, 110 equities, 79–81 escheatment, 77 eugenics, 37 eugenol, 151 evacuation, 165–171 exercise, 117–118 expenses, 51–52 Experian, 110 Expose, 176 extinction, 34 extraterrestrial life, 43 extreme weather, 18, 156–158, 168 F Facebook, 109, 110, 155 fall injuries, 98–99 false vacuum decay, 35 Family Radio Service (FRS), 186–187 farming, 137 Federal Emergency Management Agency (FEMA), 19, 132 fever, 150 fiat money, 64–65 fiction, 29–30 fighting, 113, 206 financial problems, 10–11 firearms, 196–197, 211–219 fires Butte fire complex, 18 house fires, 11, 18, 103–104 wildfires, 18, 44, 124 firewood, 158, 170 first aid, 149–152 fitness, 115–118 fixed-blade knives, 170 flashlights, 154–155 flat tires, 163 floods, 19, 147–148 floss, 151 flu, 25 fluticasone propionate, 150 FMJ (full metal jacket) bullets, 217 food-borne illness, 141–142 food preparation, 158 food security, 137–144 foraging, 168–169 foreclosures, 10–11 foreign currencies, 78–79 Forgey, William W., 152 Forster, E.

The Wisdom of Finance: Discovering Humanity in the World of Risk and Return by Mihir Desai

activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, AOL-Time Warner, assortative mating, Benoit Mandelbrot, book value, Brownian motion, capital asset pricing model, Carl Icahn, carried interest, Charles Lindbergh, collective bargaining, corporate governance, corporate raider, discounted cash flows, diversified portfolio, Eugene Fama: efficient market hypothesis, financial engineering, financial innovation, follow your passion, George Akerlof, Gordon Gekko, greed is good, housing crisis, income inequality, information asymmetry, Isaac Newton, Jony Ive, Kenneth Rogoff, longitudinal study, Louis Bachelier, low interest rates, Monty Hall problem, moral hazard, Myron Scholes, new economy, out of africa, Paul Samuelson, Pierre-Simon Laplace, principal–agent problem, Ralph Waldo Emerson, random walk, risk/return, Robert Shiller, Ronald Coase, short squeeze, Silicon Valley, Steve Jobs, Thales and the olive presses, Thales of Miletus, The Market for Lemons, The Nature of the Firm, The Wealth of Nations by Adam Smith, Tim Cook: Apple, tontine, transaction costs, vertical integration, zero-sum game

Myron Scholes and Robert Merton would win the Nobel Prize in 1997 for a pricing formula that corresponds to (and considerably improves upon) the mostly forgotten logic laid down by Bachelier. And Bachelier’s ability to describe stock prices moving about at random ultimately gave rise to portfolio theory by putting forward the notion that it was hopeless to try to beat the market—the best you could do was hold a diversified portfolio. Perhaps it’s wrong to mock the history of French finance as much as I did in the last chapter. Yes, French public finance schemes were inherently unstable and impractical compared to the English system. But we can thank Parisian financial markets for providing the insights that gave rise to the modern understanding of risk management.

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In fact, the relationships that are most enriching are ones that broaden our perspective beyond our usual experience—those relationships are, in finance terms, “imperfectly correlated assets,” precisely the types of assets that most enhance the portfolios of our lives. Similarly, filling our lives with only those people who think like we do and who experience the same world that we inhabit is not nearly as powerful. Just as Keynes found it hard to intuit diversification, the logic of a diversified portfolio of relationships runs counter to many of our instincts. Homophily, or the desire to surround ourselves with like-minded people, is a common social instinct—and one that finance warns against. Yes, it’s easier to be around like-minded types, but finance recommends the hard work of exposing yourself to differences, not shielding yourself from them.

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The gist of that model is that—given the virtues of diversification—individuals will hold many different investments and, consequently, every investment will be measured on the basis of how different or similar they are to the rest of that portfolio. In short, the risk of any investment can’t be measured in isolation—the risk of an asset can only be measured by understanding how it behaves relative to a diversified portfolio and how it contributes to that portfolio. So, here’s what that model boils down to: assets that fluctuate very much along with your portfolio are “high-beta” assets that are not highly valued because of their limited diversification value. In fact, they make your exposure to the market even more pronounced—when the market goes down, these stocks go down a lot.

Money Moments: Simple Steps to Financial Well-Being by Jason Butler

Albert Einstein, asset allocation, behavioural economics, buy and hold, Cass Sunstein, Cornelius Vanderbilt, diversified portfolio, estate planning, financial independence, fixed income, happiness index / gross national happiness, index fund, intangible asset, John Bogle, longitudinal study, loss aversion, Lyft, Mark Zuckerberg, mortgage debt, Mr. Money Mustache, passive income, placebo effect, Richard Thaler, ride hailing / ride sharing, Steve Jobs, time value of money, traffic fines, Travis Kalanick, Uber and Lyft, uber lyft, Vanguard fund, Yogi Berra

Index funds basically deliver the returns of the overall stockmarket, but at much lower costs than funds managed by clever people who try to outperform the market. Jack Bogle is the founder of Vanguard, which with around £3 trillion is the second-largest mutual fund manager in the world. This is what he has to say about investing: ‘The index fund is a most unlikely hero for the typical investor. It is no more (nor less) than a broadly diversified portfolio, typically run at rock-bottom costs, without the putative benefit of a brilliant, resourceful, and highly skilled portfolio manager. The index fund simply buys and holds the securities in a particular index, in proportion to their weight in the index. The concept is simplicity writ large.’48 So there really is no need to pay high annual charges to have your money managed by a manager who makes decisions on what companies to buy, when and how much.

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However, given that each investor has their own risk preference, they can increase or decrease the equity content within their portfolio. So we end up with five no-brainer portfolios, depending on the risk the investor is prepared to take, as shown below.50 Fund groups like Vanguard with their Lifestrategy range, and Blackrock with their Consensus range, offer very low cost, globally diversified portfolios with a choice of risk and reward profiles, for an annual charge of around 0.25% per annum of the amount you invest. So, in summary, get broad stockmarket exposure that meets your risk/reward profile, keep costs low (I personally use a multi-index portfolio fund) and take a very long-term view, But I’ll leave the last word to Warren Buffett, one of the most successful investors of all time and one of the richest people in the world.

The Clash of the Cultures by John C. Bogle

Alan Greenspan, asset allocation, buy and hold, collateralized debt obligation, commoditize, compensation consultant, corporate governance, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, estate planning, Eugene Fama: efficient market hypothesis, financial engineering, financial innovation, financial intermediation, fixed income, Flash crash, Glass-Steagall Act, Hyman Minsky, income inequality, index fund, interest rate swap, invention of the wheel, John Bogle, junk bonds, low interest rates, market bubble, market clearing, military-industrial complex, money market fund, mortgage debt, new economy, Occupy movement, passive investing, Paul Samuelson, Paul Volcker talking about ATMs, Ponzi scheme, post-work, principal–agent problem, profit motive, proprietary trading, prudent man rule, random walk, rent-seeking, risk tolerance, risk-adjusted returns, Robert Shiller, seminal paper, shareholder value, short selling, South Sea Bubble, statistical arbitrage, stock buybacks, survivorship bias, The Wealth of Nations by Adam Smith, transaction costs, two and twenty, Vanguard fund, William of Occam, zero-sum game

This chapter will likely prove contentious, for I set down my own evaluations—flawed and subjective though they may be—of what I call the “Stewardship Quotient” for Vanguard and for three other fund managers. The Index Fund In 1975, I created the first index mutual fund, now known as Vanguard 500 Index Fund. Then, as now, I considered it the very paradigm of long-term investing, a fully diversified portfolio of U.S. stocks operated at high tax efficiency and rock-bottom costs, and designed to be held, well, “forever.” It is now the world’s largest equity mutual fund. In Chapter 6, I chronicle the Fund’s formation, its investment advantages, its minimal costs, and its remarkable record of performance achievement.

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It seems increasingly apparent, however, that the paradigm of long-term investing represented by the TIF and the paradigm of short-term speculation so often represented by the ETF are, in general, competing only at the margin for the capital of the same investors. The clash of the cultures in the index fund arena, then, is a clash between two very different philosophies. The first philosophy is buy and hold a widely diversified portfolio of stocks and bonds. The second is buy such a portfolio and sell at will, and do the same with narrow portfolios of, well, anything, including heavily levered portfolios through which bets are magnified. Seldom has the choice between investment and speculation been so starkly drawn. To be fair, we must make a distinction between the use of ETFs by individual investors and financial institutions.

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I have earlier explored how mutual fund investors can do so more effectively by seeking out funds that already measure up to essential fiduciary principles, presenting in Chapter 5 a “stewardship quotient” checklist that investors can use to establish guidelines for their selection of a mutual fund family, and choosing among the mutual funds it supervises. Buy Broad Market Index Funds Another major positive step is focusing on index funds as the core of your portfolio. Owning an index fund is simply a decision to buy and hold a diversified portfolio of stocks representing the entire stock market, both U.S. and possibly non-U.S. companies. Such an index fund is the paradigm of long-term investing, and the antithesis of short-term speculation. That was my concept when I created the first index mutual fund way back in 1975, and the growth of indexing over the past 37 years has attested to its soundness—and then some!

Irrational Exuberance: With a New Preface by the Author by Robert J. Shiller

Alan Greenspan, Andrei Shleifer, asset allocation, banking crisis, benefit corporation, Benoit Mandelbrot, book value, business cycle, buy and hold, computer age, correlation does not imply causation, Daniel Kahneman / Amos Tversky, demographic transition, diversification, diversified portfolio, equity premium, Everybody Ought to Be Rich, experimental subject, hindsight bias, income per capita, index fund, Intergovernmental Panel on Climate Change (IPCC), Joseph Schumpeter, Long Term Capital Management, loss aversion, Mahbub ul Haq, mandelbrot fractal, market bubble, market design, market fundamentalism, Mexican peso crisis / tequila crisis, Milgram experiment, money market fund, moral hazard, new economy, open economy, pattern recognition, Phillips curve, Ponzi scheme, price anchoring, random walk, Richard Thaler, risk tolerance, Robert Shiller, Ronald Reagan, Small Order Execution System, spice trade, statistical model, stocks for the long run, Suez crisis 1956, survivorship bias, the market place, Tobin tax, transaction costs, tulip mania, uptick rule, urban decay, Y2K

Stefano Athanasoulis and I have proposed creating first a market for a longterm claim on the combined national incomes of all the nations of the world (“The Significance of the Market Portfolio,” forthcoming in Review of Financial Studies [2000]). By investing in it, one would have a totally diversified portfolio, the socalled true “market portfolio” that finance theorists only dream about. Younger working people and people who are less risk averse may short this market, and elderly people who are no longer working can take long positions, thereby living off a completely diversified portfolio in their retirement. 32. See Marianne Baxter and Urban Jermann, “The International Diversification Puzzle Is Worse Than You Think,” American Economic Review, 87 (1997): 170–80. 33.

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Learning about Mutual Funds, Diversification, and Holding for the Long Run James Glassman and Kevin Hassett, in a pair of influential Wall Street Journal articles in 1998 and 1999, argued that “investors have become better educated about stocks, thanks in large part to mutual funds and the media. They have learned to hold for the long term and to see price declines as transitory—and as buying opportunities.” Thus, they conclude that investors have learned that diversified portfolios of stocks are not risky, that stocks are much more valuable as investments than they had formerly thought. Therefore they are now willing to pay much more for stocks. Because of this increased investor demand for stocks, the stock market will perpetually remain at a higher level in the future.11 Glassman and Hassett followed up these articles with a book, Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market.

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The proposed major international markets I call macro markets would include markets for long-term claims on national incomes for each of the major countries of the world; markets for long-term claims on the incomes of specific occupational groups; and markets for currently illiquid assets, such as single-family homes.29 There are a number of ways to create macro markets, including using perpetual futures or the macro securities that Allan Weiss and I developed.30 If such markets are created, people can take short positions in them corresponding to their own incomes, to protect themselves against fluctuations in the value of their own personal sources of income, and can invest in a truly diversified portfolio around the world. These markets could indeed be vastly larger than any existing market and far more numerous in the risks they allow to be offset. Moreover, retail institutions such as home equity insurance or pension plan options that correlate negatively with labor income or home values will help people make use of such risk management tools.31 I believe that creating such new markets may have, besides their obvious benefits of creating new risk management opportunities, a salutary effect on speculative excesses by broadening the scope of market participation.

Hedge Fund Market Wizards by Jack D. Schwager

asset-backed security, backtesting, banking crisis, barriers to entry, Bear Stearns, beat the dealer, Bernie Madoff, Black-Scholes formula, book value, British Empire, business cycle, buy and hold, buy the rumour, sell the news, Claude Shannon: information theory, clean tech, cloud computing, collateralized debt obligation, commodity trading advisor, computerized trading, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, diversification, diversified portfolio, do what you love, Edward Thorp, family office, financial independence, fixed income, Flash crash, global macro, hindsight bias, implied volatility, index fund, intangible asset, James Dyson, Jones Act, legacy carrier, Long Term Capital Management, managed futures, margin call, market bubble, market fundamentalism, Market Wizards by Jack D. Schwager, merger arbitrage, Michael Milken, money market fund, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, proprietary trading, quantitative easing, quantitative trading / quantitative finance, Reminiscences of a Stock Operator, Right to Buy, risk free rate, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Rubik’s Cube, Savings and loan crisis, Sharpe ratio, short selling, statistical arbitrage, Steve Jobs, systematic trading, technology bubble, transaction costs, value at risk, yield curve

As part of this project, one of the researchers looked at stocks that were most up and stocks that were most down during the recent past. He found that the stocks that were most up tended to underperform the market in the next period, while the stocks that were most down tended to outperform the market. That finding led to a strategy of buying a diversified portfolio of the most down stocks and selling a diversified portfolio of the most up stocks. We called that strategy MUD for most up, most down. My friend UCI mathematician William F. Donoghue used to joke, little realizing how close he was to a deep truth, “Thorp, my advice is to buy low and sell high.” We found that this market neutral strategy had about a 20 percent annual return before costs.

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He states that return/risk can be improved by as much as a factor of 5 to 1 if the assets in the portfolio are truly independent. Most people tend to focus on correlation as a primary tool for determining the relative dependence or independence of two assets. Dalio believes that correlation can be a misleading statistic and poorly suited as a tool for constructing a diversified portfolio. The crux of the problem is that correlations between assets are highly variable and critically dependent on prevailing circumstances. For example, typically, gold and bonds are inversely related because inflation (current or expected) will be bullish for gold and negative for bonds (because higher inflation normally implies higher interest rates).

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In this type of environment, gold and bonds can be positively correlated, which is exactly opposite their normal relationship. Instead of using correlation as a measure of dependence between positions, Dalio focuses on the underlying drivers that are expected to affect those positions. Drivers are the cause; correlations are the consequence. In order to ensure a diversified portfolio, it is necessary to select assets that have different drivers. By determining the future drivers that are likely to impact each market, a forward-looking approach, Dalio can more accurately assess which positions are likely to move in the same direction or inversely—for example, anticipate when gold and bonds are likely to move in the same direction and when they are likely to move in opposite directions.

Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael W. Covel

Albert Einstein, Alvin Toffler, Atul Gawande, backtesting, Bear Stearns, beat the dealer, Bernie Madoff, Black Swan, buy and hold, buy low sell high, California energy crisis, capital asset pricing model, Carl Icahn, Clayton Christensen, commodity trading advisor, computerized trading, correlation coefficient, Daniel Kahneman / Amos Tversky, delayed gratification, deliberate practice, diversification, diversified portfolio, Edward Thorp, Elliott wave, Emanuel Derman, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, fiat currency, fixed income, Future Shock, game design, global macro, hindsight bias, housing crisis, index fund, Isaac Newton, Jim Simons, John Bogle, John Meriwether, John Nash: game theory, linear programming, Long Term Capital Management, managed futures, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, Market Wizards by Jack D. Schwager, mental accounting, money market fund, Myron Scholes, Nash equilibrium, new economy, Nick Leeson, Ponzi scheme, prediction markets, random walk, Reminiscences of a Stock Operator, Renaissance Technologies, Richard Feynman, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, shareholder value, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, survivorship bias, systematic trading, Teledyne, the scientific method, Thomas L Friedman, too big to fail, transaction costs, upwardly mobile, value at risk, Vanguard fund, William of Occam, zero-sum game

., a trend following managed futures firm with almost $3 billion in assets under management, has returned 17.65 percent since its inception in 1972, proving that performance can be sustainable over the long-term.26 The Millburn Diversified Portfolio has a 10 percent allocation which has historically exhibited superior performance characteristics coupled with an almost zero correlation of monthly returns to those of traditional investments. If an investor had invested 10 percent of his or her portfolio in the Millburn Diversified Portfolio from February 1977 through August 2003 he or she would have increased the return on his or her traditional portfolio by 73 basis points (a 6.2 percent increase) and decreased risk (as measured by standard deviation) by 0.26 of a percent (an 8.2 percent decrease). www.millburncorp.com 112 Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets among trend followers.

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Will you trade stocks? Currencies? Futures? Commodities? What markets will you choose? While some people might focus on limited, market-specific portfolios, such as currencies or bonds, others pursue a more widely diversified portfolio of markets. For example, The Adam, Harding, & Lueck (AHL) Diversified Program (the largest trend following fund in the world now run by Man Financial) trades a diversified portfolio of over 100 core markets on 36 exchanges. They trade stock indices, bonds, currencies, shortterm interest rates, and commodities (energy, metal, and agricultural contracts): CHART 10.1: AHL Portfolio Currencies: 24.3% Bonds: 19.8% Energies: 19.2% Stocks: 15.1% Interest rates: 8.5% Metals: 8.2% Agriculturals: 4.9% AHL does not have fundamental expertise in all of these markets.

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Portfolio heat seems to be associated with personality preference; bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances that give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2 percent on each of five instruments has a total heat of 10 percent, as does a portfolio risking 5 percent on each of two instruments.”16 Chauncy DiLaura, a student of Seykota’s, adds to the explanation, “There has to be some governor so I don’t end up with a whole lot of risk. The size of the bet is small around 2 percent.”

Money Mavericks: Confessions of a Hedge Fund Manager by Lars Kroijer

activist fund / activist shareholder / activist investor, Bear Stearns, Bernie Madoff, book value, capital asset pricing model, corporate raider, diversification, diversified portfolio, equity risk premium, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, intangible asset, Jeff Bezos, Just-in-time delivery, Long Term Capital Management, Mary Meeker, merger arbitrage, NetJets, new economy, Ponzi scheme, post-work, proprietary trading, risk free rate, risk-adjusted returns, risk/return, shareholder value, Silicon Valley, six sigma, statistical arbitrage, Vanguard fund, zero-coupon bond

There is more money to be made from active management or convincing people to invest in more fancy products like hedge funds or private equity. The above is highly unsexy as it does not claim to be able to beat the market or be particularly brilliant at financial analysis. Buying protection? The main concern with a broadly diversified portfolio is that diversification can give a false sense of security. When the shit hits the fan, all markets act as one and our fancy charts go out the window, along with correlation assumptions. During the 2008 meltdown, no markets were spared, just as in September 2001 when they all took a hit at the same time.

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Above that implied volatility threshold the options were simply too expensive for it to be a consistently profitable strategy. There is probably an argument to be made that investors who are comfortable trading options could benefit from buying deep out-of-the-money put options on the market when implied volatilities are low and thus be protected against shock events in their diversified portfolio at a manageable cost, but it is clearly not a strategy for everyone. In summary, for those without edge (and that would be most people) we probably have to accept that most our financial investments will correlate in a downturn and we should adjust our risk appetite accordingly. Summary If we have only bought general indices on stocks and bonds, we have not paid anyone a ton of money to be smart about beating the markets (since we don’t think it can consistently be done, after fees).

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Our portfolio consists of a series of index futures, ETFs, and broad indices of corporate and government bonds. Over a five-to-ten-year time horizon, the low cost of the portfolio alone should cause us to outperform the active managers, who are weighed down both by fees and by investing in a narrower subset of the market than our broadly diversified portfolio. A few summarising thoughts: If you accept that market direction can’t be consistently predicted, you should not try to do so or pay anyone a lot of money for trying to do this on your behalf. If you accept active management, you implicitly accept the corresponding high fees and expenses.

The Money Machine: How the City Works by Philip Coggan

activist fund / activist shareholder / activist investor, algorithmic trading, asset-backed security, Bear Stearns, Bernie Madoff, Big bang: deregulation of the City of London, Black Monday: stock market crash in 1987, bond market vigilante , bonus culture, Bretton Woods, call centre, capital controls, carried interest, central bank independence, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, disintermediation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, endowment effect, financial deregulation, financial independence, floating exchange rates, foreign exchange controls, Glass-Steagall Act, guns versus butter model, Hyman Minsky, index fund, intangible asset, interest rate swap, inverted yield curve, Isaac Newton, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", joint-stock company, junk bonds, labour market flexibility, large denomination, London Interbank Offered Rate, Long Term Capital Management, low interest rates, merger arbitrage, Michael Milken, money market fund, moral hazard, mortgage debt, negative equity, Nick Leeson, Northern Rock, pattern recognition, proprietary trading, purchasing power parity, quantitative easing, reserve currency, Right to Buy, Ronald Reagan, shareholder value, South Sea Bubble, sovereign wealth fund, technology bubble, time value of money, too big to fail, tulip mania, Washington Consensus, yield curve, zero-coupon bond

Furthermore, the best hedge funds are often closed to new investors, because the managers worry that having too big a fund will reduce performance. The new investors may end up choosing between smaller managers without a long track record. The biggest problem of all may be the costs. The managers claim superior skills, so they charge higher fees; 2 per cent annually and a fifth (20 per cent) of all returns. Those that want a diversified portfolio of managers may opt for a fund-of-hedge-funds, which will charge another 1 per cent annually (and 10 per cent of performance) on top. That is a big hurdle to overcome. Worse still, the high performance fees may encourage hedge fund managers to take risk. After all, it is the performance fees that have turned some managers into billionaires; if you manage $10 billion of money, and the fund returns 20 per cent in a year, that is a performance fee of $400 million.

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There is also the possibility that the borrower will not repay the loan or bond. In the old days, there was not much that the investor could do about this. Bond investors could at least sell their holdings if they felt bad news was due; loan investors were usually stuck. The best protection was to have a diversified portfolio of bonds or loans and hope that the good payers outweighed the defaulters. But the financial markets are remarkably ingenious at finding ways to insure against risk. The credit default swap is their latest wheeze. It is like an insurance policy against default. One party pays a premium to another; in return, the seller agrees to pay up if the borrower defaults.

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Most private investors only have enough money to buy two or three shares, and are thus very exposed to the risk of one of those companies going bust. Unit and investment trusts (explained in Chapter 8) offer a way round this problem. They each buy a widespread portfolio of shares – private investors then acquire units, or shares, in the trusts. Those with a small sum can thus enjoy the benefits of a diversified portfolio. It is possible to buy units in trusts which specialize in certain geographical areas (such as the US, Japan or Europe) or in commodities like gold. However, the more narrow a trust’s focus, the greater the risk. Investment trusts have shares rather than units. These shares are not directly linked to the value of the fund, but rise and fall according to supply and demand.

Zero to One: Notes on Startups, or How to Build the Future by Peter Thiel, Blake Masters

Airbnb, Alan Greenspan, Albert Einstein, Andrew Wiles, Andy Kessler, Berlin Wall, clean tech, cloud computing, crony capitalism, discounted cash flows, diversified portfolio, do well by doing good, don't be evil, Elon Musk, eurozone crisis, Fairchild Semiconductor, heat death of the universe, income inequality, Jeff Bezos, Larry Ellison, Lean Startup, life extension, lone genius, Long Term Capital Management, Lyft, Marc Andreessen, Mark Zuckerberg, Max Levchin, minimum viable product, Nate Silver, Network effects, new economy, Nick Bostrom, PalmPilot, paypal mafia, Peter Thiel, pets.com, power law, profit motive, Ralph Waldo Emerson, Ray Kurzweil, self-driving car, shareholder value, Sheryl Sandberg, Silicon Valley, Silicon Valley startup, Singularitarianism, software is eating the world, Solyndra, Steve Jobs, strong AI, Suez canal 1869, tech worker, Ted Kaczynski, Tesla Model S, uber lyft, Vilfredo Pareto, working poor

They know companies are different, but they underestimate the degree of difference. The error lies in expecting that venture returns will be normally distributed: that is, bad companies will fail, mediocre ones will stay flat, and good ones will return 2x or even 4x. Assuming this bland pattern, investors assemble a diversified portfolio and hope that winners counterbalance losers. But this “spray and pray” approach usually produces an entire portfolio of flops, with no hits at all. This is because venture returns don’t follow a normal distribution overall. Rather, they follow a power law: a small handful of companies radically outperform all others.

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Therefore every entrepreneur must think about whether her company is going to succeed and become valuable. Every individual is unavoidably an investor, too. When you choose a career, you act on your belief that the kind of work you do will be valuable decades from now. The most common answer to the question of future value is a diversified portfolio: “Don’t put all your eggs in one basket,” everyone has been told. As we said, even the best venture investors have a portfolio, but investors who understand the power law make as few investments as possible. The kind of portfolio thinking embraced by both folk wisdom and financial convention, by contrast, regards diversified betting as a source of strength.

The Dollar Meltdown: Surviving the Coming Currency Crisis With Gold, Oil, and Other Unconventional Investments by Charles Goyette

Alan Greenspan, bank run, banking crisis, Bear Stearns, Ben Bernanke: helicopter money, Berlin Wall, Bernie Madoff, Bretton Woods, British Empire, Buckminster Fuller, business cycle, buy and hold, California gold rush, currency manipulation / currency intervention, Deng Xiaoping, diversified portfolio, Elliott wave, fiat currency, fixed income, Fractional reserve banking, housing crisis, If something cannot go on forever, it will stop - Herbert Stein's Law, index fund, junk bonds, Lao Tzu, low interest rates, margin call, market bubble, McMansion, Money creation, money market fund, money: store of value / unit of account / medium of exchange, mortgage debt, National Debt Clock, oil shock, peak oil, pushing on a string, reserve currency, rising living standards, road to serfdom, Ronald Reagan, Saturday Night Live, short selling, Silicon Valley, transaction costs

If you spend a lot of time behind the wheel and your cost of living will rise sharply as energy prices climb, you may want to hedge that risk by allocating more to the energy component of your portfolio. Someone with a small amount of money may invest the entire amount in gold coins, while an experienced investor with an already diversified portfolio will act on one or two specific recommendations that represent special profit opportunities. Even so, I do recommend that you allot your investments among the four categories to the extent you are able. The four categories represent investments in enduring monetary vehicles (although gold and silver each merit a separate chapter, think of them both as part of this category), in the world’s preeminent form of energy, in the basics of life, and in financial conditions that unfold over time.

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Read the prospectus, available at the same site, unitedstatesoilfund.com, before investing. Because of the political risk it is hard to recommend direct oil investments in much of the world now. Direct investments in kleptocracies like Mexico and Russia are out of the question except as small parts of well-diversified portfolios. Canada is another story. Canada is a rule-of-law nation that operates a fiscal surplus and a balance of trade surplus. It has the world’s second-largest proved reserves and is the United States’ largest supplier of oil. Canadian Royalty Trusts oil and natural gas producers deserve a mention in this section because of their advantageous structure.

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Baytex Energy Trust (Toronto Stock Exchange symbol: BTE.UN; New York Stock Exchange symbol: BTE), an oil and gas investment trust with producing properties in Alberta, British Columbia, and Saskatchewan, produces over 40,000 barrels of oil equivalent per day, weighted about 60 percent to heavy oil. Consult the company’s Web site before investing, baytex.ab.ca, for regulatory filings and more information. Enerplus Resources Fund Trust (Toronto Stock Exchange symbol: ERF.UN; New York Stock Exchange symbol: ERF) is an oil and gas income trust with a diversified portfolio of crude oil and natural gas assets located in western Canada and the United States. Production expectations for 2009 are 91,000 barrels of oil equivalent a day: 58 percent natural gas, 42 percent crude oil and natural gas liquids. Read investor information and regulatory filings before investing at enerplus. com.

The Essays of Warren Buffett: Lessons for Corporate America by Warren E. Buffett, Lawrence A. Cunningham

book value, business logic, buy and hold, compensation consultant, compound rate of return, corporate governance, Dissolution of the Soviet Union, diversified portfolio, dividend-yielding stocks, fixed income, George Santayana, Henry Singleton, index fund, intangible asset, invisible hand, junk bonds, large denomination, low cost airline, Michael Milken, oil shock, passive investing, price stability, Ronald Reagan, stock buybacks, Tax Reform Act of 1986, Teledyne, the market place, transaction costs, Yogi Berra, zero-coupon bond

According to this view, you will do 12 CARDOZO LAW REVIEW [Vol. 19:1 better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense. One of modern finance theory's main tenets is modern portfolio theory. It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio-that is, it formalizes the folk slogan "don't put all your eggs in one basket." The risk that is left over is the only risk for which investors will be compensated, the story goes. This leftover risk can be measured by a simple mathematical term-called beta-that shows how volatile the security is compared to the market.

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A strategy of financial and mental concentration may reduce risk by raising both the intensity of an investor's thinking about a business and the comfort level he must have with its fundamental characteristics before buying it. The fashion of beta, according to Buffett, suffers from inattention to "a fundamental principle: It is better to be approximately right than precisely wrong." Long-term investment success depends not on studying betas and maintaining a diversified portfolio, but on recognizing that as an investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success. Such "flitting from flower to flower" imposes huge transaction costs in the forms of spreads, fees and commissions, not to mention taxes.

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When these misdeeds were done, however, dagger-selling investment bankers pointed to the "scholarly" research of academics, which reported that over the years the higher interest rates received from low-grade bonds had more than compensated for their higher rate of default. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high~grade bonds. (Beware of past-performance "proofs" in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.) There was a flaw in the salesmen's logic-one that a first-year student in statistics is taught to recognize.

Other People's Money: Masters of the Universe or Servants of the People? by John Kay

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, behavioural economics, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Monday: stock market crash in 1987, Black Swan, Bonfire of the Vanities, bonus culture, book value, Bretton Woods, buy and hold, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, Cornelius Vanderbilt, corporate governance, Credit Default Swap, cross-subsidies, currency risk, dematerialisation, disinformation, disruptive innovation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial engineering, financial innovation, financial intermediation, financial thriller, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Greenspan put, Growth in a Time of Debt, Ida Tarbell, income inequality, index fund, inflation targeting, information asymmetry, intangible asset, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, it is difficult to get a man to understand something, when his salary depends on his not understanding it, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", Jim Simons, John Meriwether, junk bonds, light touch regulation, London Whale, Long Term Capital Management, loose coupling, low cost airline, M-Pesa, market design, Mary Meeker, megaproject, Michael Milken, millennium bug, mittelstand, Money creation, money market fund, moral hazard, mortgage debt, Myron Scholes, NetJets, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, Paul Samuelson, Paul Volcker talking about ATMs, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, proprietary trading, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, reality distortion field, regulatory arbitrage, Renaissance Technologies, rent control, risk free rate, risk tolerance, road to serfdom, Robert Shiller, Ronald Reagan, Schrödinger's Cat, seminal paper, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, vertical integration, Washington Consensus, We are the 99%, Yom Kippur War

The CAPM describes them as specific risk and market risk respectively. Specific risk arises when a badly managed business loses share to its competitors, or a major project suffers from cost overruns. A well-diversified portfolio will accumulate a variety of specific risks. (CAPM implies that the lower risk achieved by constructing such a portfolio will be reflected in lower returns: I recommend readers to ignore this advice and build a diversified portfolio anyway.) Market risk is usually measured by β, which measures the correlation between the value of a particular stock and the movement of general share price indexes. I will return to this Greek alphabet soup in Chapter 7.

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For example, the risk that interest rates will rise sharply is unrelated to the risk that a cancer drug will fail its clinical trials, or the risk that Apple’s new product range will flop. A conservative investor – like me – can invest in very risky things so long as the investment is part of a well-diversified portfolio. Correlation is the statistical term for the extent to which two distinct variables – such as the values of Apple shares and those of long-term bonds – move together. Understanding correlation, and judging it, is critical to effective portfolio management by intermediaries. A fairly small number of securities is enough to provide effective diversification if the risks those securities carry are completely different.

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Taken as a whole, although some particular hedge funds have been very successful, the hedge fund industry has been very profitable for hedge fund managers, but not for their investors.8 Diversification by financial intermediaries is nevertheless valuable and cheaper for investors. This was the initially persuasive rationale for pooled investment funds, which enabled small investors to take shares in a diversified fund which they could not possibly have built for themselves. A simple, lazy and therefore inexpensive way of constructing a diversified portfolio is simply to buy all the available stocks. In the 1970s computers made it easy for intermediaries to offer funds that held a proportionate share of every security. Academic research around the efficient market hypothesis – which encouraged scepticism about the reality of manager skill – led to the creation of the first index, or passive, funds.

Market Risk Analysis, Quantitative Methods in Finance by Carol Alexander

asset allocation, backtesting, barriers to entry, Brownian motion, capital asset pricing model, constrained optimization, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, financial engineering, fixed income, implied volatility, interest rate swap, low interest rates, market friction, market microstructure, p-value, performance metric, power law, proprietary trading, quantitative trading / quantitative finance, random walk, risk free rate, risk tolerance, risk-adjusted returns, risk/return, seminal paper, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, systematic bias, Thomas Bayes, transaction costs, two and twenty, value at risk, volatility smile, Wiener process, yield curve, zero-sum game

To derive the CAPM, we consider the conditions under which a risky asset may be added to an already well diversified portfolio. The conditions depend on the systematic risk of the asset, also called the undiversifiable risk of the asset since it cannot be diversified away by holding a large portfolio of different risky assets. We also need to know the risk free rate of return and the expected return on the market portfolio. Then we ask: given the systematic risk of an asset, what should its expected excess return be to justify its addition to our well diversified portfolio?21 The CAPM is based on a concept of market equilibrium in which the expected excess return on any single risky asset is proportional to the expected excess return on the market portfolio.

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So if an estimated coefficient is insignificantly different from 0 then its explanatory variable can be excluded from the regression model. The estimated model can be used to: • predict or forecast values of the dependent variable using scenarios on the independent variables; • test an economic or financial theory; • estimate the quantities of financial assets to buy or sell when forming a diversified portfolio, a hedged portfolio or when implementing a trading strategy. The outline of this chapter is as follows. Section I.4.2 introduces the simplest possible linear regression model, i.e. one with just one explanatory variable. We describe the best method to estimate the model parameters when certain assumptions hold.

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It is the excess of the expected return on an asset (or more generally on an investment portfolio) over the risk free rate divided by the standard deviation of the asset returns distribution, i.e. ER − Rf (I.6.56) = where ER and are the forecasted expected return and standard deviation of the asset or portfolio’s returns. Suppose we forecast an alpha for a risky asset in the CAPM framework (I.6.47) and that this alpha is positive. Then we may wish to add this asset to our well diversified portfolio, but the CAPM does not tell us how much of this asset we should buy. If our holding is too large this will affect the diversification of our portfolio. The asset has a non-zero specific risk , so if we add too much of the asset this will produce a specific risk of the portfolio that is also non-zero.

The Ascent of Money: A Financial History of the World by Niall Ferguson

Admiral Zheng, Alan Greenspan, An Inconvenient Truth, Andrei Shleifer, Asian financial crisis, asset allocation, asset-backed security, Atahualpa, bank run, banking crisis, banks create money, Bear Stearns, Black Monday: stock market crash in 1987, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, BRICs, British Empire, business cycle, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, classic study, collateralized debt obligation, colonial exploitation, commoditize, Corn Laws, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, deglobalization, diversification, diversified portfolio, double entry bookkeeping, Edmond Halley, Edward Glaeser, Edward Lloyd's coffeehouse, equity risk premium, financial engineering, financial innovation, financial intermediation, fixed income, floating exchange rates, Fractional reserve banking, Francisco Pizarro, full employment, Future Shock, German hyperinflation, Greenspan put, Herman Kahn, Hernando de Soto, high net worth, hindsight bias, Home mortgage interest deduction, Hyman Minsky, income inequality, information asymmetry, interest rate swap, Intergovernmental Panel on Climate Change (IPCC), Isaac Newton, iterative process, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", John Meriwether, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, junk bonds, Kenneth Arrow, Kenneth Rogoff, knowledge economy, labour mobility, Landlord’s Game, liberal capitalism, London Interbank Offered Rate, Long Term Capital Management, low interest rates, market bubble, market fundamentalism, means of production, Mikhail Gorbachev, Modern Monetary Theory, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, Naomi Klein, National Debt Clock, negative equity, Nelson Mandela, Nick Bostrom, Nick Leeson, Northern Rock, Parag Khanna, pension reform, price anchoring, price stability, principal–agent problem, probability theory / Blaise Pascal / Pierre de Fermat, profit motive, quantitative hedge fund, RAND corporation, random walk, rent control, rent-seeking, reserve currency, Richard Thaler, risk free rate, Robert Shiller, rolling blackouts, Ronald Reagan, Savings and loan crisis, savings glut, seigniorage, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spice trade, stocks for the long run, structural adjustment programs, subprime mortgage crisis, tail risk, technology bubble, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Bayes, Thomas Malthus, Thorstein Veblen, tontine, too big to fail, transaction costs, two and twenty, undersea cable, value at risk, W. E. B. Du Bois, Washington Consensus, Yom Kippur War

But the real home bias is the tendency to invest nearly all our wealth in our own homes. Housing, after all, represents two thirds of the typical US household’s portfolio, and a higher proportion in other countries.75 From Buckinghamshire to Bolivia, the key to financial security should be a properly diversified portfolio of assets. 76 To acquire that we are well advised to borrow in anticipation of future earnings. But we should not be lured into staking everything on a highly leveraged play on the far from risk-free property market. There has to be a sustainable spread between borrowing costs and returns on investment, and a sustainable balance between debt and income.

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For one thing, they were simultaneously pursuing multiple, uncorrelated trading strategies: around a hundred of them, with a total of 7,600 different positions.82 One might go wrong, or even two. But all these different bets just could not go wrong simultaneously. That was the beauty of a diversified portfolio - another key insight of modern financial theory, which had been formalized by Harry M. Markowitz, a Chicago-trained economist at the Rand Corporation, in the early 1950s, and further developed in William Sharpe’s Capital Asset Pricing Model (CAPM).83 Long-Term made money by exploiting price discrepancies in multiple markets: in the fixed-rate residential mortgage market; in the US, Japanese and European government bond markets; in the more complex market for interest rate swapsbf - anywhere, in fact, where their models spotted a pricing anomaly, whereby two fundamentally identical assets or options had fractionally different prices.

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advertising 196 Afghanistan 6 Africa: aid to 307 British investment in 293 China and 338-9 gold trade 25 slaves from 23 African-American people 249-50 ‘Africas within’ 13 age see pensions agriculture: East-West comparison 285 finance and 2 forward and future contracts 226 ‘improvements’ 235 and migration 110 rising and declining prices 53 and risk 184 Agtmael, Antoine van 288 Aguilera, Jaime Roldós 310-11 aid: conditions on 307 limited usefulness 307 and microfinance 279 to developing countries 274 Aldrich-Vreeland Act 301 Algeria 32 Allende, Salvador 212-13 Allison, Graham 223 All State insurance company 181-2 Al Qaeda 223 Alsace 144 Amboyna 130 American Civil War 91-7 American Dream Downpayment Act 267 American Home Mortgage 272 Americas, conquest of 285 Amsterdam 127 as financial centre 74-5 Amsterdam Exchange Bank (Wisselbank) 48-9 anarchists 17 Andersen (Arthur) 173 Andhra Pradesh 280 Angell, Norman 297 Angola 2 annuities 73-4 anthrax 223 anti-Darwinians 356 Antipodes 293 anti-Semitism 38 Antwerp 52 Applegarth, Adam 7 Arab: mathematics 32 oil 26 Arab-Israeli war 308 arbitrage 83 Argentina 98 British investment in 294 currencies 114 default crisis 110 Enron and 171 inflation 3 past prosperity 3 stock market 125 aristocracy 89 ARMs see mortgages, adjustable-rate arms/defence industry 298 . see also technological innovation art markets 6 Asia: aid and international investment 287 Asian crisis (1997-8) 10 and credit crunch 283 dependence on exports to US 10 dollar pegs 300 European trade 26 industrial growth and commodity prices 10 low-wage economies, production by 116 savings glut 336 sovereign wealth funds 9 asset-backed securities 6 and sub-prime mortgages 9 assets: asset markets 163 need for diversified portfolio 262 new types 353 asymmetric information 122 Atahuallpa 20 Australasia 52 Australia 233 Austria/Austro-Hungarian empire 90 bonds 86 currency collapses 107 and First World War 101 autarky 303 automobiles 160 Avignon 43 Babylonia see Mesopotamia Baer (Julius) bank 322 Bagehot, Walter 55 Baghdad 176 Bahamas see Lyford Cay Bailey, A.

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

activist fund / activist shareholder / activist investor, Alan Greenspan, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Bear Stearns, behavioural economics, Black-Scholes formula, book value, Brownian motion, business cycle, buy and hold, buy low sell high, buy the rumour, sell the news, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, currency risk, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, financial engineering, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, global macro, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, junk bonds, late capitalism, law of one price, Long Term Capital Management, low interest rates, managed futures, margin call, market clearing, market design, market friction, Market Wizards by Jack D. Schwager, merger arbitrage, money market fund, mortgage debt, Myron Scholes, New Journalism, paper trading, passive investing, Phillips curve, price discovery process, price stability, proprietary trading, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Reminiscences of a Stock Operator, Renaissance Technologies, Richard Thaler, risk free rate, risk-adjusted returns, risk/return, Robert Shiller, selection bias, shareholder value, Sharpe ratio, short selling, short squeeze, SoftBank, sovereign wealth fund, statistical arbitrage, statistical model, stocks for the long run, stocks for the long term, survivorship bias, systematic trading, tail risk, technology bubble, time dilation, time value of money, total factor productivity, transaction costs, two and twenty, value at risk, Vanguard fund, yield curve, zero-coupon bond

When a merger has been announced, the target stock jumps up on the announcement, but if the merger deal falls apart, the price will drop back down. Due to this event risk, many mutual funds and other investors sell the target stock, leading to downward pressure on the stock price. In this case, merger arbitrage hedge funds provide liquidity by buying a diversified portfolio of such merger targets. The merger arbitrage hedge funds can therefore be viewed as selling insurance against the event risk that the merger falls apart. Just as insurance companies profit from selling protection against your house burning down, merger arbitrage hedge funds profit from selling insurance against a merger deal failing.

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The standard return-based measure is the market beta, measuring the systematic risk that the stock price will go down when the market is also down. Some equity investors also look at a stock’s total volatility (or even its idiosyncratic volatility). The beta is relevant for measuring the contribution to risk in a very well-diversified portfolio, while the stock’s total volatility is the risk of holding the stock in a concentrated portfolio. Fundamental risk measures are designed to estimate the risk of declining future profits, for instance, by considering the past variation in profitability. Payout and Management Quality A fourth class of quality measures focuses on how shareholder-friendly the firm is and how well managed it is.

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The size of each position is chosen to target an annualized volatility of 40% for that asset.6 Specifically, the number of dollars bought/sold of instrument s at time t is 40%/ so that the time series momentum (TSMOM) strategy realizes the following return during the next week: Here, is the ex ante annualized volatility for each instrument, estimated as an exponentially weighted average of past squared returns. This constant-volatility position-sizing methodology is useful for several reasons: First, it enables us to aggregate the different assets into a diversified portfolio that is not overly dependent on the riskier assets—this is important given the large dispersion in volatility among the assets we trade. Second, this methodology keeps the risk of each asset stable over time, so that the strategy’s performance is not overly dependent on what happens during times of high risk.

Beyond the Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing by Vijay Singal

3Com Palm IPO, Andrei Shleifer, AOL-Time Warner, asset allocation, book value, buy and hold, capital asset pricing model, correlation coefficient, cross-subsidies, currency risk, Daniel Kahneman / Amos Tversky, diversified portfolio, endowment effect, fixed income, index arbitrage, index fund, information asymmetry, information security, junk bonds, liberal capitalism, locking in a profit, Long Term Capital Management, loss aversion, low interest rates, margin call, market friction, market microstructure, mental accounting, merger arbitrage, Myron Scholes, new economy, prediction markets, price stability, profit motive, random walk, Richard Thaler, risk free rate, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, short squeeze, survivorship bias, Tax Reform Act of 1986, transaction costs, uptick rule, Vanguard fund

The foregoing discussion assumes that a valid explanation exists for each anomaly. That is not always the case. There are anomalies, such as the home bias, for which no reasonable explanation exists. Home bias is the tendency of investors to underweight foreign stocks compared to an optimally diversified portfolio. In other cases, the explanation, though supported by empirical evidence, may be incorrect. Whenever explanations are either false or unavailable, the anomaly is likely to disappear without any warning. ANOMALIES MAY BE ARBITRAGED AWAY BY TRADING If markets are efficient and investors are rational, then the more popular this book becomes, the greater the chance that people will trade on these anomalies until they are no longer profitable.

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A simple and commonly used measure of the riskreturn trade-off is the Sharpe ratio.2 The ratio is calculated as: 81 82 Beyond the Random Walk Portfolio return – Return on Treasury bills Standard deviation of portfolio return The Sharpe ratios are reported below based on the average shortterm interest rate and annual returns for two trading strategies and three indexes over the May 1989–April 1999 period. 6-month estimation period, 12-month holding, 3 industries 0.58 12-month estimation period, 12-month holding, 3 industries 0.86 S&P 500 holding return 0.86 Wilshire 5000 holding return 0.78 Russell 2000 holding return 0.35 Sector fund trading strategies do not outperform the S&P 500 after accounting for risk. However, the trading strategies are generally superior when compared with other mutual funds, and other indexes. If only the beta risk (or systematic risk) is considered (assuming the sector funds are held in an otherwise well-diversified portfolio), the sector fund trading strategies are superior, in general, to almost all other mutual funds, including the S&P 500 index funds. All of the data presented in this section for Fidelity sector funds are based on long holding periods. Later in this chapter we will see that Fidelity sector funds perform quite well over shorter holding periods.

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However, if you own only one stock, such as the stock of the company you work for, it is easy to find other stocks that are not well correlated with that stock. Adding more stocks to that one stock will certainly reduce risk. It is estimated that you must invest in thirty to forty randomly picked stocks to get a reasonably diversified portfolio. Did you know that a typical individual invests in less than ten stocks? How many different stocks does your portfolio have? Correlation and risk are important for all financial decisions. For example, you protect your house and car against loss through insurance. Insurance has a negative correlation with your assets.

Taming the Sun: Innovations to Harness Solar Energy and Power the Planet by Varun Sivaram

"World Economic Forum" Davos, accelerated depreciation, addicted to oil, Albert Einstein, An Inconvenient Truth, asset light, asset-backed security, autonomous vehicles, bitcoin, blockchain, carbon footprint, carbon tax, clean tech, collateralized debt obligation, Colonization of Mars, currency risk, decarbonisation, deep learning, demand response, disruptive innovation, distributed generation, diversified portfolio, Donald Trump, electricity market, Elon Musk, energy security, energy transition, financial engineering, financial innovation, fixed income, gigafactory, global supply chain, global village, Google Earth, hive mind, hydrogen economy, index fund, Indoor air pollution, Intergovernmental Panel on Climate Change (IPCC), Internet of things, low interest rates, M-Pesa, market clearing, market design, Masayoshi Son, mass immigration, megacity, Michael Shellenberger, mobile money, Negawatt, ocean acidification, off grid, off-the-grid, oil shock, peer-to-peer lending, performance metric, renewable energy transition, Richard Feynman, ride hailing / ride sharing, rolling blackouts, Ronald Reagan, Silicon Valley, Silicon Valley startup, smart grid, smart meter, SoftBank, Solyndra, sovereign wealth fund, Ted Nordhaus, Tesla Model S, time value of money, undersea cable, vertical integration, wikimedia commons

Two assumptions stand out: One, the world will be able to build over three times as much nuclear capacity as currently exists; and two, every coal-fired power plant that doesn’t get shut down will be retrofitted with equipment to capture and store its carbon emissions. On its face, this plan seems sound in that it is based on a diversified portfolio of zero-carbon resources. Also, because both nuclear and fossil plants are widely used in today’s power sector, building them into the future electricity mix would be least disruptive to the status quo. But it would be very risky to bet on this route to decarbonizing the power sector. Tripling nuclear capacity could be tough, given that nuclear power’s share of global electricity supply actually declined over the last decade as a result of high costs and political opposition.17 Betting that carbon capture and storage from fossil plants can take off is even riskier; only a handful of demonstrations exist around the world—most of them very expensive.

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They work this way because they have the capacity to scrutinize only a limited number of investments. The easiest way to satisfy both stipulations is to invest in listed securities, that is, stocks and bonds listed on public exchanges. This approach offers liquidity—it is straightforward to buy or sell securities on large exchanges—and it is possible to invest large sums in a diversified portfolio. To avoid having to perform due diligence on every stock or bond in which an investor has exposure, investors can invest in index funds, which themselves are listed securities that aggregate lots of individual stocks or bonds. Overall, institutional investors invest 80–90 percent of their portfolios in listed securities.35 For the most part, solar power projects fail to meet either of the criteria that institutional investors demand.

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Perhaps from the ashes of SunEdison’s flameout will emerge a genuine solar supermajor. Toward YieldCo 2.0 The example from the oil and gas industry that inspired renewable energy YieldCos was a decades-old financial vehicle known as the “Master Limited Partnership (MLP).” An MLP pools together a diversified portfolio of oil and gas infrastructure assets, such as pipelines and processing facilities. Investors then can buy shares of MLPs on the stock market. MLPs get special treatment under the U.S. tax code: they pay no corporate tax and can distribute the revenue generated by their oil and gas assets directly to shareholders as dividends.

Financial Independence by John J. Vento

Affordable Care Act / Obamacare, Albert Einstein, asset allocation, diversification, diversified portfolio, estate planning, financial independence, fixed income, high net worth, Home mortgage interest deduction, low interest rates, money market fund, mortgage debt, mortgage tax deduction, oil shock, Own Your Own Home, passive income, retail therapy, risk tolerance, the rule of 72, time value of money, transaction costs, young professional, zero day

When we analyze the risk versus return of cash, bonds, stocks, and alternatives, it has been shown that a properly diversified portfolio that includes these asset classes can minimize risk without sacrificing return. For example, in Exhibit 9.3, Investment Growth Based on Rates of Return 1980 to 2011, you can clearly see that if you invest 20 percent of your portfolio in stocks and 80 percent in bonds (rather than 100 percent in bonds), that can result in less risk with a higher return. The general rule of investing states the higher the risk, the higher the potential rate of return. This Nobel-prizewinning discovery by Harry Markowitz was able to show that with a properly diversified portfolio that included both stocks and bonds, it was actually possible to increase your rate of return and, at the same time, lower the risk of the overall portfolio.

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Company- or industry-specific risk occurs when an event affects only a specific company or industry—for example, if accounting irregularities are discovered during a particular company’s financial statement audit, the value of investment in that company is likely to decrease. These types of events can have a significant effect on a company’s value as well as the confidence investors can place with its management. By far, this is the strongest reason for a well-diversified portfolio and why you should never keep all your eggs in one basket. Stocks, Bonds, Mutual Funds, and Exchange-Traded Funds The most efficient and popular way to invest is by purchasing individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Therefore, I believe that it is essential that I provide you with a description of each of these investment vehicles.

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These investment vehicles may provide the potential for returns that could exceed inflation over the long term. Of course, these growth-oriented investment vehicles also come with a greater risk than other types of investments. As you select your asset allocation model based on your risk tolerance level, never forget that smart investors always focus on a well-diversified portfolio. Taking on too much risk or taking on too little risk can both be equally damaging to your financial success. You must find your own perfect balance in determining your own risk-reward ratio. When investing, you must always consider the tax consequences of your investment when determining your true rate of return.

Capital in the Twenty-First Century by Thomas Piketty

accounting loophole / creative accounting, Asian financial crisis, banking crisis, banks create money, Berlin Wall, book value, Branko Milanovic, British Empire, business cycle, capital controls, Capital in the Twenty-First Century by Thomas Piketty, carbon footprint, carbon tax, central bank independence, centre right, circulation of elites, collapse of Lehman Brothers, conceptual framework, corporate governance, correlation coefficient, David Ricardo: comparative advantage, demographic transition, distributed generation, diversification, diversified portfolio, European colonialism, eurozone crisis, Fall of the Berlin Wall, financial intermediation, full employment, Future Shock, German hyperinflation, Gini coefficient, Great Leap Forward, high net worth, Honoré de Balzac, immigration reform, income inequality, income per capita, index card, inflation targeting, informal economy, invention of the steam engine, invisible hand, joint-stock company, Joseph Schumpeter, Kenneth Arrow, low interest rates, market bubble, means of production, meritocracy, Money creation, mortgage debt, mortgage tax deduction, new economy, New Urbanism, offshore financial centre, open economy, Paul Samuelson, pension reform, power law, purchasing power parity, race to the bottom, randomized controlled trial, refrigerator car, regulatory arbitrage, rent control, rent-seeking, Robert Gordon, Robert Solow, Ronald Reagan, Simon Kuznets, sovereign wealth fund, Steve Jobs, Suez canal 1869, Suez crisis 1956, The Nature of the Firm, the payments system, The Theory of the Leisure Class by Thorstein Veblen, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, trade liberalization, twin studies, very high income, Vilfredo Pareto, We are the 99%, zero-sum game

But this is probably not true at all levels: as we move down the list into the $1–10 billion range (and according to Forbes, several hundred new fortunes appear in this range somewhere in the world almost every year), or even more into the $10–$100 million range, it is likely that many inherited fortunes are held in diversified portfolios, in which case they are difficult for journalists to detect (especially since the individuals involved are generally far less eager to be known publicly than entrepreneurs are). Because of this straightforward statistical bias, wealth rankings inevitably tend to underestimate the size of inherited fortunes. Some magazines, such as Challenges in France, state openly that their goal is simply to catalog so-called business-related fortunes, that is, fortunes consisting primarily of the stock of a particular company. Diversified portfolios do not interest them.

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We cannot rule out the possibility that the pure return on capital will rise to higher levels over the next few decades, especially in view of the growing international competition for capital and the equally increasing sophistication of financial markets and institutions in generating high yields from complex, diversified portfolios. In any case, this virtual stability of the pure return on capital over the very long run (or more likely this slight decrease of about one-quarter to one-fifth, from 4–5 percent in the eighteenth and nineteenth centuries to 3–4 percent today) is a fact of major importance for this study.

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This logical contradiction cannot be resolved by a dose of additional competition. Rent is not an imperfection in the market: it is rather the consequence of a “pure and perfect” market for capital, as economists understand it: a capital market in which each owner of capital, including the least capable of heirs, can obtain the highest possible yield on the most diversified portfolio that can be assembled in the national or global economy. To be sure, there is something astonishing about the notion that capital yields rent, or income that the owner of capital obtains without working. There is something in this notion that is an affront to common sense and that has in fact perturbed any number of civilizations, which have responded in various ways, not always benign, ranging from the prohibition of usury to Soviet-style communism.

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan

Albert Einstein, asset allocation, asset-backed security, book value, Brownian motion, business cycle, business process, buy and hold, capital asset pricing model, clean water, collateralized debt obligation, computerized markets, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, equity risk premium, fear index, financial engineering, fixed income, Glass-Steagall Act, implied volatility, index fund, intangible asset, interest rate swap, inventory management, inverted yield curve, junk bonds, London Interbank Offered Rate, low interest rates, margin call, money market fund, mortgage debt, Myron Scholes, passive investing, performance metric, risk free rate, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, short squeeze, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond

Diversification strives to smooth out unsystematic risk in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not correlated. Investopedia explains Diversification Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction. Investing in more securities will yield further diversification benefits, but to a drastically smaller degree. Further diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated with domestic investments.

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Mutual funds are operated by money managers, who actively manage a fund’s assets in an attempt to produce positive returns for the fund’s investors. A mutual fund’s portfolio strategy is structured and maintained to match the investment objectives stated in its prospectus. Investopedia explains Mutual Fund Mutual funds are popular because they give small investors access to professionally managed, diversified portfolios of stocks, bonds, and other securities that would be quite difficult (if not impossible) for investors to replicate on their own with a small amount of money. Each shareholder participates proportionally in the gain or loss of the fund. Mutual fund units, or shares, are issued and typically can be purchased or redeemed as needed at the fund’s current net asset value (NAV) per share, which sometimes is expressed as NAVPS.

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Passive investors purchase investments with the intention of long-term appreciation and thus have limited portfolio turnover. Index fund investing, in which shares in the fund simply mirror an index, is a form of passive investing. Investopedia explains Passive Investing Also known as a buy-and-hold or couch potato strategy, passive investing requires good initial research, patience, and a well-diversified portfolio. Unlike active investors, passive investors buy a security and typically do not actively attempt to profit from short-term price fluctuations. Passive investors instead rely on their belief that in the long term the investment will be profitable. Related Terms: • Diversification • Index • Mutual Fund • Exchange-Traded Fund • Index Fund Payback Period What Does Payback Period Mean?

Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

Alan Greenspan, Albert Einstein, Alfred Russel Wallace, algorithmic trading, Andrei Shleifer, Arthur Eddington, Asian financial crisis, asset allocation, asset-backed security, backtesting, bank run, barriers to entry, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, bitcoin, Bob Litterman, Bonfire of the Vanities, bonus culture, break the buck, Brexit referendum, Brownian motion, business cycle, business process, butterfly effect, buy and hold, capital asset pricing model, Captain Sullenberger Hudson, carbon tax, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, confounding variable, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Daniel Kahneman / Amos Tversky, delayed gratification, democratizing finance, Diane Coyle, diversification, diversified portfolio, do well by doing good, double helix, easy for humans, difficult for computers, equity risk premium, Ernest Rutherford, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, Fall of the Berlin Wall, financial deregulation, financial engineering, financial innovation, financial intermediation, fixed income, Flash crash, Fractional reserve banking, framing effect, Glass-Steagall Act, global macro, Gordon Gekko, greed is good, Hans Rosling, Henri Poincaré, high net worth, housing crisis, incomplete markets, index fund, information security, interest rate derivative, invention of the telegraph, Isaac Newton, it's over 9,000, James Watt: steam engine, Jeff Hawkins, Jim Simons, job satisfaction, John Bogle, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, language acquisition, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, Louis Pasteur, mandelbrot fractal, margin call, Mark Zuckerberg, market fundamentalism, martingale, megaproject, merger arbitrage, meta-analysis, Milgram experiment, mirror neurons, money market fund, moral hazard, Myron Scholes, Neil Armstrong, Nick Leeson, old-boy network, One Laptop per Child (OLPC), out of africa, p-value, PalmPilot, paper trading, passive investing, Paul Lévy, Paul Samuelson, Paul Volcker talking about ATMs, Phillips curve, Ponzi scheme, predatory finance, prediction markets, price discovery process, profit maximization, profit motive, proprietary trading, public intellectual, quantitative hedge fund, quantitative trading / quantitative finance, RAND corporation, random walk, randomized controlled trial, Renaissance Technologies, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, Robert Shiller, Robert Solow, Sam Peltzman, Savings and loan crisis, seminal paper, Shai Danziger, short selling, sovereign wealth fund, Stanford marshmallow experiment, Stanford prison experiment, statistical arbitrage, Steven Pinker, stochastic process, stocks for the long run, subprime mortgage crisis, survivorship bias, systematic bias, Thales and the olive presses, The Great Moderation, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, Thomas Malthus, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Triangle Shirtwaist Factory, ultimatum game, uptick rule, Upton Sinclair, US Airways Flight 1549, Walter Mischel, Watson beat the top human players on Jeopardy!, WikiLeaks, Yogi Berra, zero-sum game

If the previous sentence sounds like the fine print of an insurance policy, it should; business conditions often shift violently and “long enough” depends on a lot of things. For example, between October 2007 and February 2009, imagine if you had your entire nest egg invested in the S&P 500, a well-diversified portfolio of five hundred of the largest U.S.-based companies. You would have lost about 51 percent of your life savings over those seventeen stressful months. As you watched your retirement evaporate a few percentage points each month, at what point would your “fear factor” have kicked in and caused you to cash out?

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Popular investment gurus told us to forget about trying to beat the market and to forget about relying on our flawed intuition. The price is always right, they said; we might as well throw darts at the financial pages to pick our stocks, because we’d end up doing just about as well as the professionals, if not better. We should buy and hold a passive, well-diversified portfolio of stocks and bonds, they said, preferably through a no-load index mutual fund or an exchange-traded fund, requiring as little thought as possible. The market has already taken everything into account. The market always takes everything into account. This idealistic view of the market still sticks in the craw of professional money managers, but the basic idea is more than forty years old.

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In fact, many economists and prominent investment professionals believe that, on average, mutual fund alphas are either zero or negative after deducting fees, and argue that you should always put all your money in low-cost index funds. Principle 3 follows logically from the CAPM. By estimating the alphas and betas of financial investments, we should be able to construct passive, highly diversified portfolios of stocks weighted by their market capitalization to achieve reasonably attractive returns. (What does “reasonably attractive” mean here? An expected return that’s consistent with the portfolio’s beta.) Alpha seems rare—how many David Shaws do you know, and how easy is it to identify them before they become wildly successful and retire?

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

Alan Greenspan, Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, behavioural economics, Bernie Madoff, Black Swan, Bob Litterman, bond market vigilante , book value, Bretton Woods, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, carbon credits, Carmen Reinhart, central bank independence, classic study, collateralized debt obligation, commoditize, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, deal flow, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, G4S, George Akerlof, global macro, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, information asymmetry, interest rate swap, inverted yield curve, invisible hand, John Bogle, junk bonds, Kenneth Rogoff, laissez-faire capitalism, law of one price, London Interbank Offered Rate, Long Term Capital Management, loss aversion, low interest rates, managed futures, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, Myron Scholes, negative equity, New Journalism, oil shock, p-value, passive investing, Paul Samuelson, pension time bomb, performance metric, Phillips curve, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, proprietary trading, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, savings glut, search costs, selection bias, seminal paper, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, stock buybacks, stocks for the long run, survivorship bias, systematic trading, tail risk, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond, zero-sum game

Thus the goal of HF beta investing is to create a portfolio of alternative betas, while leaving out traditional ones. Capturing HF betas requires skill, both in defining them (identifying smart strategies: inclusion, weighing, rebalancing) and in implementing them cost-effectively and with effective risk management. With HF betas we can structure a diversified portfolio with an especially attractive reward-to-risk ratio (e.g., combining value and momentum strategies that both have a positive alpha but that are often negatively correlated to each other). Truly original proprietary strategies have a special premium in today’s competitive environment where fears of being in overcrowded trades are not unreasonable.

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Over my full sample, an undiversified first–tenth trade (i.e., buying the single highest yielding and shorting the lowest yielding currency) gave a moderately higher excess return (8%) but much higher volatility (16%), resulting in an SR of 0.51—compared with the base case 6%/10%/0.61 noted above. In the other extreme, a diversified portfolio that buys equal amounts of the highest yielding five currencies and that shorts the lowest yielding five currencies earned 4% with a low 7% volatility, resulting in an SR of 0.62. Thus, in risk-adjusted terms, diversification across signals is somewhat more beneficial than exploiting the strongest signal.

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• Momentum strategies can be traded on a single asset (trend following) or across assets (long–short trading). One can use many types of momentum signals (past returns, moving averages, breakout, consistency, etc.) and various lookback window lengths (to capture shorter and longer trends). • For single commodities, the SR of trend-following strategies is typically between 0.0 and 0.5. For a diversified portfolio of them, the SR is between 0.5 and 1.0—at the higher end if volatility weighting is used. However, actual CTAs (commodity trading advisors) rarely have as good SRs as these simulated strategies. • Momentum patterns likely reflect behavioral factors—investor underreaction to news and overreaction to recent returns (extrapolating past returns).

Value Investing: From Graham to Buffett and Beyond by Bruce C. N. Greenwald, Judd Kahn, Paul D. Sonkin, Michael van Biema

Andrei Shleifer, barriers to entry, Berlin Wall, book value, business cycle, business logic, capital asset pricing model, corporate raider, creative destruction, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, Eugene Fama: efficient market hypothesis, Fairchild Semiconductor, financial engineering, fixed income, index fund, intangible asset, junk bonds, Long Term Capital Management, naked short selling, new economy, place-making, price mechanism, quantitative trading / quantitative finance, Richard Thaler, risk free rate, search costs, shareholder value, short selling, Silicon Valley, stocks for the long run, Telecommunications Act of 1996, time value of money, tulip mania, Y2K, zero-sum game

As a group they produced a body of work, sometimes called modern investment theory, that, if accurate, has several inescapable implications for investors: • The market is efficient, and it is not possible to outdo its returns except by accident. • Risk is measured by the contribution of individual securities to the volatility of returns of widely diversified portfolios, rather than the more common-sense understanding of risk as permanent loss of capital. • The best strategy for investors is to buy a broad index of securities and adjust for the desired level of risk by combining investments in this index portfolio with greater or lesser amounts of a risk-free asset, such as cash.

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Because, as the theory holds, it is possible to diversify away the risks of holding only one or a few securities, investors will not be rewarded for those risks that they assume in running narrow portfolios. The only risk that does earn a com mensurate reward is the risk of volatility, or the risk that the diversified portfolio will move up and down at a greater rate than some even more broadly diversified benchmark, like the Standard & Poor's 500 index or the Wilshire 5000. The efficient market hypothesis-the idea that the market always incorporates the best estimate of the true value of a security-is embedded in this conception of risk and diversification; otherwise it might be possible for a clever investor to pick relatively few securities and be rewarded for these selections.

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The thoroughly informed investor, knowledgeable about the industry, the company, and even the economy, can take fewer and larger positions in situations in which he or she is fully informed. Value investors come down on both sides of the question of diversification, although all of them think there is an important role for active stock selection. The Schlosses run a diversified portfolio, but they do it without prescribed limits on the size of a position they will take. Though they may own 100 names, it is typical for the largest 20 positions to account for around 60 per cent of the portfolio. They have occasionally had up to 20 percent of their fund in a single security, but that degree of concentration is a rarity.

Investment: A History by Norton Reamer, Jesse Downing

activist fund / activist shareholder / activist investor, Alan Greenspan, Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, book value, break the buck, Brownian motion, business cycle, buttonwood tree, buy and hold, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, Cornelius Vanderbilt, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, dogs of the Dow, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, flying shuttle, Glass-Steagall Act, Gordon Gekko, Henri Poincaré, Henry Singleton, high net worth, impact investing, index fund, information asymmetry, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, John Bogle, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, low interest rates, managed futures, margin call, means of production, Menlo Park, merger arbitrage, Michael Milken, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Network effects, new economy, Nick Leeson, Own Your Own Home, Paul Samuelson, pension reform, Performance of Mutual Funds in the Period, Ponzi scheme, Post-Keynesian economics, price mechanism, principal–agent problem, profit maximization, proprietary trading, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Sand Hill Road, Savings and loan crisis, seminal paper, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, survivorship bias, tail risk, technology bubble, Teledyne, The Wealth of Nations by Adam Smith, time value of money, tontine, too big to fail, transaction costs, two and twenty, underbanked, Vanguard fund, working poor, yield curve

Alternatives (a class of investments that includes hedge funds, private equity, and venture capital) tend to be high-fee, relatively exclusive, and often institutionally oriented products. Index funds and ETFs, by contrast, are low fee, typically involve passive and rules-based ownership, and are available for retail investors and institutions alike. Debates have raged over the relative superiority of these as well as the ability to combine the two classes in a diversified portfolio. Few examinations, however, have sought to uncover their respective historical developments to unlock meaning and their possible futures. This chapter aims to do precisely that, unearthing the origins and evolution of these investment vehicles. More New Investment Forms 257 ALTERNATIVE INVESTMENTS: HEDGE FUNDS, PRIVATE EQUITY, AND VENTURE CAPITAL The realm of alternative investments is vast and includes not just hedge funds, private equity, and venture capital but also commodities, real estate, and infrastructure.

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Actual investable commodities indices are far more recent, coming into existence in 1991 with the Goldman Sachs 282 Investment: A History Commodity Index (S&P GSCI) and later in 1998 with the Dow Jones UBS Commodity Index.48 Commodities and natural resources investments include both traditional futures and collateralized commodity futures, as well as direct holdings of physical assets such as gold and other natural resources. Mineral rights and the licensing of revenue streams are also examples of real-world commodities and natural resources investments in the alternatives space. Commodity investments are an attractive way to diversify portfolios because they often have high returns and low correlations to equities and other liquid investable assets.49 timber, agriculture, and farmland The Employee Retirement Income Security Act of 1974 was a major catalyst for investment in timberland, since pension funds now had the ability to move into new and more esoteric asset classes.50 Since the mid-1980s, institutional assets invested in timber have grown dramatically, from $1 billion to more than $50 billion.51 Asset returns were strong through the 1980s to the 1990s, resting in part on Japanese demand and pricing.

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Over the period from 1994 to 1996, some 91 percent of managed funds underperformed their index fund counterparts within US equities—a victory for the vehicle that was once derided as a recipe for mediocrity.58 Today there exist nearly 300 distinct stock and bond index mutual funds in the United States and over 1,000 American passive ETFs, and the world of investment has come a very long way toward not only accepting index funds as a fixture of investing but also fully embracing the power of indexing as one component of a strategy to outperform the market in terms of risk-adjusted return.59 The first index funds were meant for passive investors who simply wanted a small piece of the larger pie of the equity markets. Modern index funds, however, cater not only to passive investors who are looking for a broadly diversified portfolio of securities but also to active investors who want to enhance their portfolio returns by investing in particular asset classes through indexing. For instance, there are index funds that specialize in timberland investment, leveraged index funds that attempt to double or triple the return of a common stock index such as the S&P 500 on a daily basis, and index funds that specialize in commodities.

The Intelligent Investor (Collins Business Essentials) by Benjamin Graham, Jason Zweig

3Com Palm IPO, accounting loophole / creative accounting, air freight, Alan Greenspan, Andrei Shleifer, AOL-Time Warner, asset allocation, book value, business cycle, buy and hold, buy low sell high, capital asset pricing model, corporate governance, corporate raider, Daniel Kahneman / Amos Tversky, diversified portfolio, dogs of the Dow, Eugene Fama: efficient market hypothesis, Everybody Ought to Be Rich, George Santayana, hiring and firing, index fund, intangible asset, Isaac Newton, John Bogle, junk bonds, Long Term Capital Management, low interest rates, market bubble, merger arbitrage, Michael Milken, money market fund, new economy, passive investing, price stability, Ralph Waldo Emerson, Richard Thaler, risk tolerance, Robert Shiller, Ronald Reagan, shareholder value, sharing economy, short selling, Silicon Valley, South Sea Bubble, Steve Jobs, stock buybacks, stocks for the long run, survivorship bias, the market place, the rule of 72, transaction costs, tulip mania, VA Linux, Vanguard fund, Y2K, Yogi Berra

(Interestingly, that projection matches the estimate we got earlier when we added together real growth, inflationary growth, and speculative growth.) Compared to the 1990s, 6% is chicken feed. But it’s a whisker better than the gains that bonds are likely to produce—and reason enough for most investors to hang on to stocks as part of a diversified portfolio. But there is a second lesson in Graham’s approach. The only thing you can be confident of while forecasting future stock returns is that you will probably turn out to be wrong. The only indisputable truth that the past teaches us is that the future will always surprise us—always! And the corollary to that law of financial history is that the markets will most brutally surprise the very people who are most certain that their views about the future are right.

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Unlike traditional brokers or mutual funds that won’t let you in the door for less than $2,000 or $3,000, these online firms have no minimum account balances and are tailor-made for beginning investors who want to put fledgling portfolios on autopilot. To be sure, a transaction fee of $4 takes a monstrous 8% bite out of a $50 monthly investment—but if that’s all the money you can spare, then these microinvesting sites are the only game in town for building a diversified portfolio. You can also buy individual stocks straight from the issuing companies. In 1994, the U.S. Securities and Exchange Commission loosened the handcuffs it had long ago clamped onto the direct sale of stocks to the public. Hundreds of companies responded by creating Internet-based programs allowing investors to buy shares without going through a broker.

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I further make a solemn commitment never to invest because the stock market has gone up, and never to sell because it has gone down. Instead, I will invest $______.00 per month, every month, through an automatic investment plan or “dollar-cost averaging program,” into the following mutual fund(s) or diversified portfolio(s): _________________________________, _________________________________, _________________________________. I will also invest additional amounts whenever I can afford to spare the cash (and can afford to lose it in the short run). I hereby declare that I will hold each of these investments continually through at least the following date (which must be a minimum of 10 years after the date of this contact): _________________ _____, 20__.

Trend Commandments: Trading for Exceptional Returns by Michael W. Covel

Alan Greenspan, Albert Einstein, Alvin Toffler, behavioural economics, Bernie Madoff, Black Swan, business cycle, buy and hold, commodity trading advisor, correlation coefficient, delayed gratification, disinformation, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, family office, full employment, global macro, Jim Simons, Lao Tzu, Long Term Capital Management, managed futures, market bubble, market microstructure, Market Wizards by Jack D. Schwager, Mikhail Gorbachev, moral hazard, Myron Scholes, Nick Leeson, oil shock, Ponzi scheme, prediction markets, quantitative trading / quantitative finance, random walk, Reminiscences of a Stock Operator, Sharpe ratio, systematic trading, the scientific method, three-martini lunch, transaction costs, tulip mania, upwardly mobile, Y2K, zero-sum game

They are all the same when you look at price data only. If they are all the same, then an opportunistic strategy that is ready to go when a trend starts can make you serious money. That’s how the fortunes discussed in the earlier chapter “Show Me the Money” were made. The following is an example of a diversified portfolio that you could use as a starting point for assembling your own portfolio (with the exchanges listed where markets are traded): British Pound (CME; www.cmegroup.com) Canadian Dollar (CME) Euro (CME) Swiss Franc (CME) Japanese Yen (CME) Australian Dollar (CME) Mexican Peso (CME) Eurodollar (CME) Euribor (NYSE LIFFE; www.euronext.com) Aussie Bank Bills (ASX; www.asx.com.au) U.S. 10-Year Note (CME) U.S. 30-Year Bond (CME) 66 Tre n d C o m m a n d m e n t s Canadian Gov’t.

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., 223 Commodities Corporation, 69 D commodity trading advisors (CTAs), defined, 11 decisions, immediacy of, 131-132 The Complete TurtleTrader (Covel), 199 compounding, importance of, 22-23 degrees, worth of, 123 delay in decision-making, avoiding, 131-132 Dennis, Richard, 199 computers, role in trend following, 87-88 “Determining Optimal Risk” (Druz and Seykota), 62 consistency, 139 diversified portfolios, example of, 65-67 Contact (film), 4 contradictions in market predictions, 175-178 Donahue, Phil, 113 Donchian, Richard, 230-231, 239 Index Dow Theory, 225-226 fat tails, 137 Dow, Charles H., 225 Faulkner, Charles, 59 drawdowns, 69-70 Field, Jacob, 226 Druz, David, 18, 62 50 Cent, 166 Duchovny, David, 211 financial bubbles, irrational behavior in, 25-26 Dunn, Bill, 15-16, 195 Dunnigan, William, 229-230, 239 E Economic Bill of Rights, 114 economic philosophy, assumptions in, 25 economy, effect on presidential approval ratings, 181-182 Edwards, Robert D., 226 Efficient-Markets Hypothesis, 101-102 Elizabeth II (queen of England), 47 Elliott, R.

The Gig Economy: The Complete Guide to Getting Better Work, Taking More Time Off, and Financing the Life You Want by Diane Mulcahy

Affordable Care Act / Obamacare, Airbnb, Amazon Mechanical Turk, basic income, Clayton Christensen, cognitive bias, collective bargaining, creative destruction, David Brooks, deliberate practice, digital nomad, diversification, diversified portfolio, fear of failure, financial independence, future of work, gig economy, helicopter parent, Home mortgage interest deduction, housing crisis, independent contractor, job satisfaction, Kickstarter, loss aversion, low interest rates, low skilled workers, Lyft, mass immigration, mental accounting, minimum wage unemployment, mortgage tax deduction, negative equity, passive income, Paul Graham, remote working, risk tolerance, Robert Shiller, seminal paper, Silicon Valley, Snapchat, social contagion, TaskRabbit, TED Talk, the strength of weak ties, Uber and Lyft, uber lyft, universal basic income, wage slave, WeWork, Y Combinator, Zipcar

Diversifying our interests brings balance and variety to our lives and gives us a way to explore our passions, nurture new interests, and satisfy our curiosities. Like Allison, we can be the public speaking coach and the folk singer. We have the freedom to have multiple identities and the chance to focus on both personal and professional goals. Management thinker Charles Handy described the idea of a diversified portfolio career as “a portfolio of activities—some we do for money, some for interest, some for pleasure, some for a cause.”1 Portfolio workers were individuals who purposefully chose to build a diversified life of multiple roles and projects, both paid and unpaid. They could accomplish personal and professional goals and achieve a balance between money and love, play and work, passion and pragmatism.

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It turns out that over-diversifying can be just as bad; it may constrain your losses, but it also limits your gains. Excess diversification eliminates the risk that any one company’s poor performance will tank the portfolio but also limits the gain you’ll realize from any outperformance. Over-diversified portfolios generate average returns that mirror, rather than outperform, the general market because the performance of any single stock doesn’t meaningfully impact the performance of the whole portfolio. We risk over-diversification if we spread ourselves too thin and do too much. If we over-diversify, we risk achieving less than we hoped and expected.

Models. Behaving. Badly.: Why Confusing Illusion With Reality Can Lead to Disaster, on Wall Street and in Life by Emanuel Derman

Albert Einstein, Asian financial crisis, Augustin-Louis Cauchy, Black-Scholes formula, British Empire, Brownian motion, capital asset pricing model, Cepheid variable, creative destruction, crony capitalism, currency risk, diversified portfolio, Douglas Hofstadter, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial engineering, Financial Modelers Manifesto, fixed income, Ford Model T, Great Leap Forward, Henri Poincaré, I will remember that I didn’t make the world, and it doesn’t satisfy my equations, Isaac Newton, Johannes Kepler, law of one price, low interest rates, Mikhail Gorbachev, Myron Scholes, quantitative trading / quantitative finance, random walk, Richard Feynman, riskless arbitrage, savings glut, Schrödinger's Cat, Sharpe ratio, stochastic volatility, the scientific method, washing machines reduced drudgery, yield curve

Idiosyncratic risk is avoidable: it can be diminished by diversification, the assembly of a portfolio of many stocks whose idiosyncratic risks are unrelated and therefore tend to cancel each other out. (This tendency to cancel is similar to the tendency of independent random up and down stock price moves in Figure 5.2 to cancel, so that the idiosyncratic risk of a portfolio of n stocks grows only as fast as Vn.) All that afflicts a stock in a (theoretically) diversified portfolio of many stocks is therefore the market risk it carries. CAPM characterizes each stock’s unavoidable market risk by a statistic, β (beta), the ratio of its individual market risk to the risk of the entire market. The β of each stock describes its tendency to herd with the crowd, and different stocks have different measurable betas.13 The greater the beta of a stock, the more it responds to a market move.

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But CAPM has had a beneficial impact, having being responsible for introducing into finance as metaphors the notion of alpha and beta. Alpha and beta represent the sources of return. Beta refers to the return earned for simply entering the market dumbly. Getting beta is easy: all you have to do is buy a diversified portfolio of stocks without worrying about their individual attributes. Alpha, in contrast, represents skill, the return generated by being smarter than the hordes, by picking better-than-average stocks, or picking ordinary stocks at the right time, as with Apple in the example above. Inspired by CAPM, investors now ask themselves whether their manager is providing merely dumb beta or smart alpha.

The Captured Economy: How the Powerful Enrich Themselves, Slow Down Growth, and Increase Inequality by Brink Lindsey

Airbnb, Asian financial crisis, bank run, barriers to entry, Bernie Sanders, Build a better mousetrap, Capital in the Twenty-First Century by Thomas Piketty, carbon tax, Carmen Reinhart, Cass Sunstein, collective bargaining, creative destruction, Credit Default Swap, crony capitalism, Daniel Kahneman / Amos Tversky, David Brooks, diversified portfolio, Donald Trump, Edward Glaeser, endogenous growth, experimental economics, experimental subject, facts on the ground, financial engineering, financial innovation, financial intermediation, financial repression, hiring and firing, Home mortgage interest deduction, housing crisis, income inequality, informal economy, information asymmetry, intangible asset, inventory management, invisible hand, Jones Act, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, knowledge worker, labor-force participation, Long Term Capital Management, low skilled workers, Lyft, Mark Zuckerberg, market fundamentalism, mass immigration, mass incarceration, medical malpractice, Menlo Park, moral hazard, mortgage debt, Network effects, patent troll, plutocrats, principal–agent problem, regulatory arbitrage, rent control, rent-seeking, ride hailing / ride sharing, Robert Metcalfe, Robert Solow, Ronald Reagan, Savings and loan crisis, Silicon Valley, Silicon Valley ideology, smart cities, software patent, subscription business, tail risk, tech bro, too big to fail, total factor productivity, trade liberalization, tragedy of the anticommons, Tragedy of the Commons, transaction costs, tulip mania, Tyler Cowen, Uber and Lyft, uber lyft, Washington Consensus, white picket fence, winner-take-all economy, women in the workforce

And why do banks stoutly resist higher capital requirements on the ground that equity funding is so much more expensive than debt? First, financial firms may be able to rely more on debt because the assets they are borrowing against are much more stable in value than those of nonfinancial firms. As John Cochrane has pointed out, a diversified portfolio of loans and securities just isn’t very risky, certainly not in comparison to the expected future profit flows of a single company.20 Second, beyond the difference in market fundamentals, financial firms’ predilection for debt may also reflect a market failure. Specifically, in judging the trade-off between risk and reward when choosing how much debt to take on, financial firms may look only at their own individual situation and not take account of the destabilizing effects of aggregate leverage in the financial system.21 Given the fact that banks borrow from each other and also considering the risk of contagion during bad times, levels of leverage that might be fine for a single institution become problematic if more widespread.

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As copyright terms have lengthened (and, simultaneously, global markets have grown by leaps and bounds), the industry has become progressively organized around the maximization of returns from the occasional runaway crowd favorite. This task requires large-scale investments in talent search and marketing for success in the long term, which means developing a diversified portfolio of new talent and a growing inventory of cash cows to milk as efficiently and as long as possible. Neither software nor pharmaceuticals can match the entertainment industry for its extremes. On one end, there is an enormous volume of low-selling books, records, and films; at the other end, many blockbusters remain bestsellers for decades.

A Mathematician Plays the Stock Market by John Allen Paulos

Alan Greenspan, AOL-Time Warner, Benoit Mandelbrot, Black-Scholes formula, book value, Brownian motion, business climate, business cycle, butter production in bangladesh, butterfly effect, capital asset pricing model, confounding variable, correlation coefficient, correlation does not imply causation, Daniel Kahneman / Amos Tversky, diversified portfolio, dogs of the Dow, Donald Trump, double entry bookkeeping, Elliott wave, endowment effect, equity risk premium, Erdős number, Eugene Fama: efficient market hypothesis, four colour theorem, George Gilder, global village, greed is good, index fund, intangible asset, invisible hand, Isaac Newton, it's over 9,000, John Bogle, John Nash: game theory, Larry Ellison, Long Term Capital Management, loss aversion, Louis Bachelier, mandelbrot fractal, margin call, mental accounting, Myron Scholes, Nash equilibrium, Network effects, passive investing, Paul Erdős, Paul Samuelson, Plato's cave, Ponzi scheme, power law, price anchoring, Ralph Nelson Elliott, random walk, Reminiscences of a Stock Operator, Richard Thaler, risk free rate, Robert Shiller, short selling, six sigma, Stephen Hawking, stocks for the long run, survivorship bias, transaction costs, two and twenty, ultimatum game, UUNET, Vanguard fund, Yogi Berra

Students who miss a lot of classes generally (although certainly not always) achieve a lower score, so the extremes of the sum, number of classes missed plus exam scores, are going to be considerably less than they would be if number of classes missed and exam scores did not have a negative covariance. When choosing stocks for a diversified portfolio, investors, as noted, generally look for negative covariances. They want to own equities like the Hatfield and the McCoy stocks and not like WCOM, say, and some other telecommunications stock. With three or more stocks in a portfolio, one uses the stocks’ weights in the portfolio as well as the definitions just discussed to compute the portfolio’s variance and standard deviation.

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Brian auditors Aumann, Robert availability error average values compared with distribution of incomes risk as variance from averages average return compared with median return average value compared with distribution of incomes buy-sell rules and outguessing average guess risk as variance from average value averaging down Bachelier, Louis Bak, Per Barabasi, Albert-Lazló Bartiromo, Maria bear markets investor self-descriptions and shorting and distorting strategy in Benford, Frank Benford’s Law applying to corporate fraud background of frequent occurrence of numbers governed by Bernoulli, Daniel Beta (B) values causes of variations in comparing market against individual stocks or funds strengths and weaknesses of technique for finding volatility and Big Bang billiards, as example of nonlinear system binary system biorhythm theory Black, Fischer Black-Scholes option formula blackjack strategies Blackledge, Todd “blow up,” investor blue chip companies, P/E ratio of Bogle, John bonds Greenspan’s impact on bond market history of stocks outperforming will not necessarily continue to be outperformed by stocks Bonds, Barry bookkeeping. see accounting practices bottom-line investing Brock, William brokers. see stock brokers Buffett, Warren bull markets investor self-descriptions and pump and dump strategy in Butterfly Economics (Ormerod) “butterfly effect,” of nonlinear systems buy-sell rules buying on the margin. see also margin investments calendar effects call options. see also stock options covering how they work selling strategies valuation tools campaign contributions Capital Asset Pricing Model capital gains vs. dividends Central Limit Theorem CEOs arrogance of benefits in manipulating stock prices remuneration compared with that of average employee volatility due to malfeasance of chain letters Chaitin, Gregory chance. see also whim trading strategies and as undeniable factor in market chaos theory. see also nonlinear systems charity Clayman, Michelle cognitive illusions availability error confirmation bias heuristics rules of thumb for saving time mental accounts status quo bias Cohen, Abby Joseph coin flipping common knowledge accounting scandals and definition and importance to investors dynamic with private knowledge insider trading and parable illustrating private information becoming companies/corporations adjusting results to meet expectations applying Benford’s Law to corporate fraud comparing corporate and personal accounting financial health and P/E ratio of blue chips competition vs. cooperation, prisoner’s dilemma complexity changing over time horizon of sequences (mathematics) of trading strategies compound interest as basis of wealth doubling time and formulas for future value and present value and confirmation bias definition of investments reflecting stock-picking and connectedness. see also networks European market causing reaction on Wall Street interactions based on whim interactions between technical traders and value traders irrational interactions between traders Wolfram model of interactions between traders Consumer Confidence Index (CCI) contrarian investing dogs of the Dow measures of excellence and rate of return and cooperation vs. competition, prisoner’s dilemma correlation coefficient. see also statistical correlations counter-intuitive investment counterproductive behavior, psychology of covariance calculation of portfolio diversification based on portfolio volatility and stock selection and Cramer, James crowd following or not herd-like nature of price movements dart throwing, stock-picking contest in the Wall Street Journal data mining illustrated by online chatrooms moving averages and survivorship bias and trading strategies and DeBondt, Werner Deciding What’s News (Gans) decimalization reforms decision making minimizing regret selling WCOM depression of derivatives trading, Enron despair and guilt over market losses deviation from the mean. see also mean value covariance standard deviation (d) variance dice, probability and Digex discounting process, present value of future money distribution of incomes distribution of wealth dynamic of concentration UN report on diversified portfolios. see stock portfolios, diversifying dividends earnings and proposals benefitting returns from Dodd, David dogs of the Dow strategy “dominance” principle, game theory dot com IPOs, as a pyramid scheme double-bottom trend reversal “double-dip” recession double entry bookkeeping doubling time, compound interest and Dow dogs of the Dow strategy percentages of gains and losses e (exponential growth) compound interest and higher mathematics and earnings anchoring effect and complications with determination of inflating (WCOM) P/E ratio and stock valuation and East, Steven H.

Early Retirement Guide: 40 is the new 65 by Manish Thakur

Airbnb, diversified portfolio, financial independence, hedonic treadmill, index fund, lifestyle creep, Lyft, passive income, passive investing, risk tolerance, Robert Shiller, side hustle, time value of money, uber lyft, Vanguard fund, William Bengen, Zipcar

There's no hard and fast answer for this since some individuals are very entrepreneurial and want to actively manage where their dollars are put to work, and some individuals are already booked solid and want a more passive approach. The key to this is to simply get started. This section will give you 90% of the knowledge and resources to get started investing today. Invest in an adequately diversified portfolio of low cost passive investments and hold for the long term. That sentence holds all the secrets and techniques needed to invest and thrive. Don't spend a dime on finance gurus and conferences that will teach you "the 5 key techniques to earning millions on stocks" or "the secret to how I made $65,000 in a month."

Stop Saving Start Investing: Ten Simple Rules for Effectively Investing in Funds by Jonathan Hobbs

Albert Einstein, diversified portfolio, en.wikipedia.org, financial independence, low interest rates, selective serotonin reuptake inhibitor (SSRI)

CHAPTER 4 OWNING STOCKS THROUGH FUNDS: THE FUND OF FUNDS STRATEGY “Funds were created to make investing easy, so consumers wouldn’t have to be burdened with picking individual stocks.” Scott Cook It’s fun to pick your own stocks. But it can also be emotionally draining and take up a lot of time, especially if you’re new to stock investing. By investing in funds, it’s easy to own a diversified portfolio of stocks in companies from all over the world. Using the right fund managers will bring you peace of mind that your investments are in good hands. What is a fund? A google search will tell you that a mutual fund is “an investment programme funded by shareholders that trades in diversified holdings and is professionally managed.”

What They Do With Your Money: How the Financial System Fails Us, and How to Fix It by Stephen Davis, Jon Lukomnik, David Pitt-Watson

activist fund / activist shareholder / activist investor, Admiral Zheng, banking crisis, Basel III, Bear Stearns, behavioural economics, Bernie Madoff, Black Swan, buy and hold, Carl Icahn, centralized clearinghouse, clean water, compensation consultant, computerized trading, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, crowdsourcing, David Brooks, Dissolution of the Soviet Union, diversification, diversified portfolio, en.wikipedia.org, financial engineering, financial innovation, financial intermediation, fixed income, Flash crash, Glass-Steagall Act, income inequality, index fund, information asymmetry, invisible hand, John Bogle, Kenneth Arrow, Kickstarter, light touch regulation, London Whale, Long Term Capital Management, moral hazard, Myron Scholes, Northern Rock, passive investing, Paul Volcker talking about ATMs, payment for order flow, performance metric, Ponzi scheme, post-work, principal–agent problem, rent-seeking, Ronald Coase, seminal paper, shareholder value, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, Steve Jobs, the market place, The Wealth of Nations by Adam Smith, transaction costs, Upton Sinclair, value at risk, WikiLeaks

That’s why academics call diversification the “only free lunch” for investors.35 All the free food at the diversification buffet may lead us to ignore a key fact: diversification is no defense against systemic risk, meaning risks to broad swaths of the market. That seems obvious; if the entire market declines, a diversified portfolio will decline, too. What is less obvious is that widespread diversification may actually increase systematic risk. It may even have helped cause the global financial crisis. To understand how, we first need to understand how the financial markets employ diversification. Most people might think that a good investor is someone like Warren Buffett, who identifies good investment opportunities, doesn’t place all his eggs in one basket, and watches those investments closely.

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While individual investors account for 27 percent of the average company’s shareholders, they tend to be more passive than institutional investors in exercising their responsibilities and rights. Individuals vote the proxies for just 29 percent of their shares, while institutions vote 90 percent of theirs.72 One reason is that individuals are daunted by the complexity of voting. The information is often convoluted, and the process time consuming. If you own a diversified portfolio of individual stocks, you may have to do it twenty or thirty times or more. But technology has made it possible for individuals to vote their preferences without the need for individual review of each proxy. “Advance Voting Instructions” (AVI) allow investors to vote automatically with or against management, or with a well-known third party such as the giant pension fund CalPERS, or with the recommendations of a proxy voting agency.

The Predators' Ball: The Inside Story of Drexel Burnham and the Rise of the JunkBond Raiders by Connie Bruck

"RICO laws" OR "Racketeer Influenced and Corrupt Organizations", Alvin Toffler, Bear Stearns, book value, Carl Icahn, corporate raider, diversified portfolio, Edward Thorp, financial independence, fixed income, Future Shock, Glass-Steagall Act, Irwin Jacobs, junk bonds, Michael Milken, mortgage debt, offshore financial centre, Oscar Wyatt, paper trading, profit maximization, Tax Reform Act of 1986, The Predators' Ball, yield management, Yogi Berra, zero-coupon bond

And there were the money managers—people who ran investment portfolios for thrift institutions, insurance companies, public and private pension funds, mutual funds, offshore banks, college endowments, high-yield funds. Many of them had been converted into believers by Milken back in the seventies, when he had begun tirelessly preaching an esoteric gospel: that in a diversified portfolio of high-yield bonds, otherwise known as “junk” bonds, the reward outweighs the risk. This was a proven theory, well documented by academician W. Braddock Hickman in his enormous multivolume tome Corporate Bond Quality and Investor Experience, published in the fifties. All that remained, for everyone to make money, more money probably than they had ever imagined, was to put theory into practice.

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OVER THE NEXT several years, Milken began to cultivate a group of increasingly satisfied customers. There were a handful of institutions, like Massachusetts Mutual, and discount-bond mutual funds, including Keystone B4, Lord Abbott Bond Debenture, and National Bond Fund. These tended to play the market according to Hickman, going for the yield over time in large, diversified portfolios. There was also David Solomon, of First Investors Fund for Income, known as FIFI. FIFI was converting its high-grade-bond fund (with bonds that had suffered in the recession) to a high-yield fund in 1973, at about the time that Solomon was employed to manage it. According to former members of Milken’s group, Milken soon took Solomon in hand, and the returns on Solomon’s portfolio showed the effect.

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Milken had his stable of clients, but if this market was to thrive it would need a much broader base. Milken and Joseph quickly determined, however, that they would not distribute the bonds through Drexel’s retail system. Milken followed the old Hickman credo on diversification. The retail customers with their small holdings would not have diversified portfolios, and without diversification Milken was convinced he would ultimately kill his clients. The way to reach those retail buyers, Milken and Joseph decided, was to invent high-yield-bond funds, where the portfolio would be diversified. First Investors Fund for Income (FIFI) had been operating essentially as a high-yield-bond fund since Milken began tutoring David Solomon, in the midseventies.

Python for Finance by Yuxing Yan

asset-backed security, book value, business cycle, business intelligence, capital asset pricing model, constrained optimization, correlation coefficient, data science, distributed generation, diversified portfolio, financial engineering, functional programming, implied volatility, market microstructure, P = NP, p-value, quantitative trading / quantitative finance, risk free rate, Sharpe ratio, tail risk, time value of money, value at risk, volatility smile, zero-sum game

Number of stocks and portfolio risk We know that when we increase the number of stocks in a portfolio, we would diversify away firm-specific risk. However, how many stocks do we need to diversify away from most of the firm-specific risk? Statman (1987) argues that we need at least 30 stocks. The title of his paper is How Many Stocks Make a Diversified Portfolio? in the Journal of Financial Quantitative Analysis. Based on his relationship between n (number of stocks) and the ratio of the portfolio standard deviation to the standard deviation of a single stock, we have the graph showing the relationship between the two. The values in the following table are from Statman (1987) where n is the number of stocks in a portfolio, V S is the standard deviation of the annual portfolio returns, and V is the average of the standard deviation of a one-stock portfolio: n VS VS V n VS VS V 1 49.236 1.00 45 20.316 0.41 2 37.358 0.76 50 20.203 0.41 4 29.687 0.60 75 19.860 0.40 6 26.643 0.54 100 19.686 0.40 [ 142 ] Chapter 7 n VS VS V n VS VS V 8 24.983 0.51 200 19.432 0.39 10 23.932 0.49 300 19.336 0.39 12 23.204 0.47 400 19.292 0.39 14 22.670 0.46 500 19.265 0.39 16 22.261 0.45 600 19.347 0.39 18 21.939 0.45 700 19.233 0.39 20 21.677 0.44 800 19.224 0.39 25 21.196 0.43 900 19.217 0.39 30 20.870 0.42 1000 19.211 0.39 35 20.634 0.42 f 19.158 0.39 40 20.456 0.42 The following is our program: from matplotlib.pyplot import * n=[1,2,4,6,8,10,12,14,16,18,20,25,30,35,40,45,50,75,100,200,300,400,500,6 00,700,800,900,1000] port_sigma=[0.49236,0.37358,0.29687,0.26643,0.24983,0.23932,0.23204, 0.22670,0.22261,0.21939,0.21677,0.21196,0.20870,0.20634,0.20456,0.20316,0 .20203,0.19860,0.19686,0.19432,0.19336,0.19292,0.19265,0.19347,0.19233,0. 19224,0.19217,0.19211,0.19158] xlim(0,50) ylim(0.1,0.4) hlines(0.19217, 0, 50, colors='r', linestyles='dashed') annotate('', xy=(5, 0.19), xycoords = 'data',xytext = (5, 0.28), textcoords = 'data',arrowprops = {'arrowstyle':'<->'}) annotate('', xy=(30, 0.19), xycoords = 'data',xytext = (30, 0.1), textcoords = 'data',arrowprops = {'arrowstyle':'<->'}) annotate('Total portfolio risk', xy=(5,0.3),xytext=(25,0.35), arrowprops=dict(facecolor='black',shrink=0.02)) figtext(0.15,0.4,"Diversiable risk") figtext(0.65,0.25,"Nondiversifiable risk") plot(n[0:17],port_sigma[0:17]) [ 143 ] Visual Finance via Matplotlib title("Relationship between n and portfolio risk") xlabel("Number of stocks in a portfolio") ylabel("Ratio of Portfolio std to std of one stock") show() In the preceding code, the values for n, that is, the number of stocks in a portfolio, and port_swigma, that is, the portfolio standard deviation, are from Statman (1987).

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You can use the latest five-year data from Yahoo! Finance to support your arguments. 11. What is the Capital Market Line? How do we visualize this concept? 12. What is the Security Market Line? How do we visualize this concept? 13. Could you find empirical evidence to support or dispute the argument made by Statman (1987) that a well-diversifiable portfolio should at least be holding 30 stocks? 14. Construct an efficient frontier with the use of ten stocks from Yahoo! Finance. You can use either monthly or daily data. 15. How do we show the relationship between risk and returns? 16. What is the correlation between the US stock market and the Canadian stock market?

Magic Internet Money: A Book About Bitcoin by Jesse Berger

Alan Greenspan, barriers to entry, bitcoin, blockchain, Bretton Woods, Cambridge Analytica, capital controls, carbon footprint, correlation does not imply causation, cryptocurrency, diversification, diversified portfolio, Ethereum, ethereum blockchain, fiat currency, Firefox, forward guidance, Fractional reserve banking, George Gilder, inflation targeting, invisible hand, Johann Wolfgang von Goethe, liquidity trap, litecoin, low interest rates, Marshall McLuhan, Metcalfe’s law, Money creation, money: store of value / unit of account / medium of exchange, moral hazard, Network effects, Nixon shock, Nixon triggered the end of the Bretton Woods system, oil shale / tar sands, planned obsolescence, price mechanism, Ralph Waldo Emerson, rent-seeking, reserve currency, ride hailing / ride sharing, risk tolerance, Robert Metcalfe, Satoshi Nakamoto, the medium is the message, Vitalik Buterin

Systematic risk, also known as “market risk,” is more comprehensive, with global implications resulting from macro-economic forces such as inflation, interest rates, exchange rates, taxes, or political and social instabilities. To combat unsystematic risks, many investment funds and wealth managers embrace the mantra of not putting all your eggs in one basket, diversifying portfolios by mixing a variety of asset types across different industries and geographies. This allows smaller and confined risk events negatively affecting one investment to be offset by others that react differently to those same events, or that experience unrelated positive effects. Guarding against systematic risk is more difficult.

MONEY Master the Game: 7 Simple Steps to Financial Freedom by Tony Robbins

"World Economic Forum" Davos, 3D printing, active measures, activist fund / activist shareholder / activist investor, addicted to oil, affirmative action, Affordable Care Act / Obamacare, Albert Einstein, asset allocation, backtesting, Bear Stearns, behavioural economics, bitcoin, Black Monday: stock market crash in 1987, buy and hold, Carl Icahn, clean water, cloud computing, corporate governance, corporate raider, correlation does not imply causation, Credit Default Swap, currency risk, Dean Kamen, declining real wages, diversification, diversified portfolio, Donald Trump, estate planning, fear of failure, fiat currency, financial independence, fixed income, forensic accounting, high net worth, index fund, Internet of things, invention of the wheel, it is difficult to get a man to understand something, when his salary depends on his not understanding it, Jeff Bezos, John Bogle, junk bonds, Kenneth Rogoff, lake wobegon effect, Lao Tzu, London Interbank Offered Rate, low interest rates, Marc Benioff, market bubble, Michael Milken, money market fund, mortgage debt, Neil Armstrong, new economy, obamacare, offshore financial centre, oil shock, optical character recognition, Own Your Own Home, passive investing, profit motive, Ralph Waldo Emerson, random walk, Ray Kurzweil, Richard Thaler, risk free rate, risk tolerance, riskless arbitrage, Robert Shiller, Salesforce, San Francisco homelessness, self-driving car, shareholder value, Silicon Valley, Skype, Snapchat, sovereign wealth fund, stem cell, Steve Jobs, subscription business, survivorship bias, tail risk, TED Talk, telerobotics, The 4% rule, The future is already here, the rule of 72, thinkpad, tontine, transaction costs, Upton Sinclair, Vanguard fund, World Values Survey, X Prize, Yogi Berra, young professional, zero-sum game

So it’s totally up to you. Once again, I’m not here to give you my opinion, just the best insights available from the best experts. For most people, lump-sum investing is not an issue because they don’t have a significant sum to invest! If that’s your situation, you’ll still maximize your returns by investing in a diversified portfolio with dollar-cost averaging. * * * 12. If you look on most of today’s stock charts, you may see that Citigroup was selling for $10.50 on March 9, 2009, and $50.50 on August 27, 2009. This is not accurate. These charts have been reformatted to reflect the fact that on May 6, 2011, Citigroup did a reverse stock split.

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Would you have white knuckled it and held on? When Mark asked the newsletter publisher about whether or not investors could actually hang on during the roller coaster ride, he provided quite the understatement by saying, in an email, that his approach isn’t for an investor who “bails out of his/her broadly diversified portfolio the first time a worry arises.” I would call a 66% drop more than “a worry.” He makes it sound like us mere mortals are prone to overreaction, as though I jumped out of a moving car when the check engine light came on. Remember, a 66% loss would require nearly 200% gains just to get back to even—just to recoup the portion of your nest egg that it may have taken your entire life to save!

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PTJ: You can invest for the long term, but you’re not going to necessarily be wealthy for the long term—because everything has a price and a central value over time. But it’s asking a lot, I think, of an average investor to understand valuation metrics all the time. The way that you guard against that—guard against the fact that maybe you’re not the most informed person of every asset class—is you run a diversified portfolio. TR: Of course. PTJ: Here’s a story I’ll never forget. It was 1976, I’d been working for six months, and I went to my boss, cotton trader Eli Tullis, and said, “I’ve got to trade, I’ve got to trade.” And he said, “Son, you’re not going to trade right now. Maybe in another six months I’ll let you.”

Debtor Nation: The History of America in Red Ink (Politics and Society in Modern America) by Louis Hyman

Alan Greenspan, asset-backed security, bank run, barriers to entry, Bretton Woods, business cycle, business logic, card file, central bank independence, computer age, corporate governance, credit crunch, declining real wages, deindustrialization, diversified portfolio, financial independence, financial innovation, fixed income, Gini coefficient, Glass-Steagall Act, Home mortgage interest deduction, housing crisis, income inequality, invisible hand, It's morning again in America, late fees, London Interbank Offered Rate, low interest rates, market fundamentalism, means of production, mortgage debt, mortgage tax deduction, p-value, pattern recognition, post-Fordism, profit maximization, profit motive, risk/return, Ronald Reagan, Savings and loan crisis, Silicon Valley, statistical model, Tax Reform Act of 1986, technological determinism, technology bubble, the built environment, transaction costs, union organizing, white flight, women in the workforce, working poor, zero-sum game

Only the subsidies to GNMA, and not the total mortgages bought, would go on the books as a federal expense.26 Mortgage-backed securities initially came in two forms: the “modified pass-through” security and the “bond-like” security. Both forms gave the investor a claim on the monthly principal and interest payments of a large, diversified portfolio of mortgages. Both forms rendered the investor’s connection to the underlying assets completely anonymous and secondhand. The differences between them initially irked the mortgage banking industry, however. The pass-through security delivered the real monthly principal and interest payments of the portfolio, minus a servicing fee, to the investor.

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More than just standardization, however, conventional mortgages could be traded because they were issued through mortgage-backed securities and not the old assignment system of the 1950s. While the FHA mortgage reduced investors’ risk by homogenizing standards, the FHLMC reduced risk by heterogeneous diversification. The mortgage-backed security came with a pre-diversified portfolio for a given interest rate, so that the investor did not need to cherry-pick mortgages across regions and neighborhoods. The risk of one bad loan could be diluted across many good loans in a mortgage-backed security’s underlying portfolio. Mortgage portfolios backing the securities brought enough diversification, it was believed, to overwhelm any outlying bad loan.

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Investors wanted the reassurance that the unlimited tax-collecting resources of the federal government stood behind the securities, even if, legally, there was not an unlimited backstop. While GNMA and FNMA announced in their publications that the “full faith” of the U.S. government stood behind their issues, the reality fell far short of the promise— but for investors, it was close enough. Dangling promises, diversified portfolios, and foreclosable houses convinced many investors. The mortgage-backed security had come into its own and quickly began to define how mortgage funds flowed in the United States. By 1973, FHLMC was buying three times as many conventional mortgages as federally insured mortgages—nearly $1 billion in conventional mortgages.40 The next year, 1974, FHLMC further doubled its conventional mortgage activity to nearly $2 billion and shrunk its purchases of federally insured mortgages to $261 million.41 This rapid expansion into an uninsured market was made possible through FHLMC’s assiduous mimicry of the debt instruments of GNMA and FNMA, which continued through 1972 to deal primarily in federally insured mortgages.

The Joys of Compounding: The Passionate Pursuit of Lifelong Learning, Revised and Updated by Gautam Baid

Abraham Maslow, activist fund / activist shareholder / activist investor, Airbnb, Alan Greenspan, Albert Einstein, Alvin Toffler, Andrei Shleifer, asset allocation, Atul Gawande, availability heuristic, backtesting, barriers to entry, beat the dealer, Benoit Mandelbrot, Bernie Madoff, bitcoin, Black Swan, book value, business process, buy and hold, Cal Newport, Cass Sunstein, Checklist Manifesto, Clayton Christensen, cognitive dissonance, collapse of Lehman Brothers, commoditize, corporate governance, correlation does not imply causation, creative destruction, cryptocurrency, Daniel Kahneman / Amos Tversky, deep learning, delayed gratification, deliberate practice, discounted cash flows, disintermediation, disruptive innovation, Dissolution of the Soviet Union, diversification, diversified portfolio, dividend-yielding stocks, do what you love, Dunning–Kruger effect, Edward Thorp, Elon Musk, equity risk premium, Everything should be made as simple as possible, fear index, financial independence, financial innovation, fixed income, follow your passion, framing effect, George Santayana, Hans Rosling, hedonic treadmill, Henry Singleton, hindsight bias, Hyman Minsky, index fund, intangible asset, invention of the wheel, invisible hand, Isaac Newton, it is difficult to get a man to understand something, when his salary depends on his not understanding it, Jeff Bezos, John Bogle, Joseph Schumpeter, junk bonds, Kaizen: continuous improvement, Kickstarter, knowledge economy, Lao Tzu, Long Term Capital Management, loss aversion, Louis Pasteur, low interest rates, Mahatma Gandhi, mandelbrot fractal, margin call, Mark Zuckerberg, Market Wizards by Jack D. Schwager, Masayoshi Son, mental accounting, Milgram experiment, moral hazard, Nate Silver, Network effects, Nicholas Carr, offshore financial centre, oil shock, passive income, passive investing, pattern recognition, Peter Thiel, Ponzi scheme, power law, price anchoring, quantitative trading / quantitative finance, Ralph Waldo Emerson, Ray Kurzweil, Reminiscences of a Stock Operator, reserve currency, Richard Feynman, Richard Thaler, risk free rate, risk-adjusted returns, Robert Shiller, Savings and loan crisis, search costs, shareholder value, six sigma, software as a service, software is eating the world, South Sea Bubble, special economic zone, Stanford marshmallow experiment, Steve Jobs, Steven Levy, Steven Pinker, stocks for the long run, subscription business, sunk-cost fallacy, systems thinking, tail risk, Teledyne, the market place, The Signal and the Noise by Nate Silver, The Wisdom of Crowds, time value of money, transaction costs, tulip mania, Upton Sinclair, Walter Mischel, wealth creators, Yogi Berra, zero-sum game

In contrast, even though the plant belonging to one of my portfolio companies, Hester Biosciences, was disrupted by that earthquake, I was able to comfortably weather the storm, because at the time, my portfolio consisted of many other businesses that were not affected at all. Sometimes, factors like currency depreciation or rising interest rates hurt some of our portfolio companies while benefiting others, so that the overall impact is muted. Most notably, if we invest in a diversified portfolio of good businesses, then most of the time the tailwinds pushing a few businesses forward will compensate for the headwinds pushing back the others, thus protecting us from permanent loss of capital. 3. Access to top-notch managers to run the business. When investing in the stock market, an investor gains access to top-notch managerial talent free of cost.

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You are exchanging company-specific risk (unsystematic risk), which may be quite low, depending on the type of company in which you invest, for market risk (systematic risk). Risk hasn’t been reduced, it simply has been transferred from one form to another. Diversification of investments is touted as reducing both risk and volatility. Although a diversified portfolio indeed may reduce your overall level of risk, it also may correspondingly reduce your potential level of reward. The more extensively diversified an investment portfolio, the greater the likelihood is that it, at best, mirrors the performance of the overall market. Because many investors aim for better-than-market-average investment returns, it is important to have a clear understanding of diversification versus concentration in portfolio choices.

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—Lee Ainslie Avoid extreme concentration like Buffett and Munger, unless you have very high expertise… If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. —Warren Buffett A well-diversified portfolio needs just four stocks. —Charlie Munger instead, practice sufficient diversification… For an individual investor you want to own at least ten and probably fifteen and as many as twenty different securities. Many people would consider that to be a relatively highly concentrated portfolio.

The Upside of Inequality by Edward Conard

affirmative action, Affordable Care Act / Obamacare, agricultural Revolution, Alan Greenspan, Albert Einstein, assortative mating, bank run, Berlin Wall, book value, business cycle, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, Climatic Research Unit, cloud computing, corporate governance, creative destruction, Credit Default Swap, crony capitalism, disruptive innovation, diversified portfolio, Donald Trump, en.wikipedia.org, Erik Brynjolfsson, Fall of the Berlin Wall, full employment, future of work, Gini coefficient, illegal immigration, immigration reform, income inequality, informal economy, information asymmetry, intangible asset, Intergovernmental Panel on Climate Change (IPCC), invention of the telephone, invisible hand, Isaac Newton, Jeff Bezos, Joseph Schumpeter, Kenneth Rogoff, Kodak vs Instagram, labor-force participation, Larry Ellison, liquidity trap, longitudinal study, low interest rates, low skilled workers, manufacturing employment, Mark Zuckerberg, Martin Wolf, mass immigration, means of production, meta-analysis, new economy, offshore financial centre, paradox of thrift, Paul Samuelson, pushing on a string, quantitative easing, randomized controlled trial, risk-adjusted returns, Robert Gordon, Ronald Reagan, Second Machine Age, secular stagnation, selection bias, Silicon Valley, Simon Kuznets, Snapchat, Steve Jobs, survivorship bias, The Rise and Fall of American Growth, total factor productivity, twin studies, Tyler Cowen, Tyler Cowen: Great Stagnation, University of East Anglia, upwardly mobile, War on Poverty, winner-take-all economy, women in the workforce, working poor, working-age population, zero-sum game