On Investing: Thoughts for Now

Here’s what has been on my mind of late.

Asset allocation models too often are naïve about price.  Entry price affects both the potential for returns and the potential for risk.   A model that suggests a portfolio weight with no regard for current valuation might have no relation to past patterns of risk or return.  In that case a high risk asset might be low risk and a low risk asset might be high risk.  Models too often don’t capture this.

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Geographic allocation approaches, especially for developed market equities, don’t represent the real world of modern commerce.   A world benchmark aligns much better with the world we live in today.  Asset allocation practices have a certain path dependency to them.  We are, in large part based on where we’ve been.    Geography was much more significant in a more walled off economic era.   These days it has the logic of thinking of the difference between investing east or west of the Mississippi River.  Good companies can be found all over the place. 

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A now famous study of the returns of endowment and pension portfolios concluded that 90% of their returns were derived from asset allocation.  The results have been broadly misunderstood.  This study merely concluded that based on how these investors behaved, 90% of their returns were derived from their asset allocations.   It has come to be wrongly understood that that asset allocation determines nearly all of investment returns.  Not so.   

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Indexing clusters investment assets in securities which represent past success, are widely owned, and often fully valued.  Investing is about the future.  Good active investors are adept at uncovering future success.   Compounded over a long time horizons, the difference in so called “terminal wealth” can be very large between passive approaches, average active approaches, and above average active approaches.    

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Dividend yield is a popular idea these days for both individual securities, and mutual funds.  I’ve no issue with that.  However, just because the yield is low doesn’t make an individual stock or fund unattractive.   For example some companies have well above average returns to capital employed.  This means that they can earn high returns on monies re-invested into their own businesses.  Usually (but not always) this means that they show a lower than average dividend yield.   Don’t take this as an unattractive trait.  The returns on the re-invested cash might be far higher than you could find elsewhere. 

Mutual funds may not show a high dividend yield, and there may be little to glean from it.  If you held a portfolio of companies that earn high returns on capital it makes sense to re-invest dividend proceeds into them.   Some portfolio managers do this instead of distributing cash.  This can be a logical and wise choice, but it means the dividend yield may not be particularly high.  Before I went for the yield strategy I might ask the question about what the yield on the portfolio is, and not simply assume that the dividend payout represents the portfolio’s dividend stream. 

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I believe that if more investors thought about their investment lives from an asset and liability standpoint they may arrive at different conclusions about how to arrange their investment portfolios.  Insurance companies operate this way.  Most people, like insurance companies, have varying liability streams , and need assets which adequately fund them.  Long-term liabilities should be funded with long-term assets.  Equities are perpetual instruments designed to generate high real returns compared to other financial assets, and are a good choice for this.  

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