The part of the book that interests me the most is the discussion of investing, and how it is an endeavor that involves a high degree of luck. So much so, in fact, that the influence of events outside of our control (luck) can overshadow skill, good processes and past strings of either good or bad results.
In such a situation, the author recommends following checklists and ensuring that a solid, repeatable process is followed. Before we can even begin to consider evaluating investments for implementation, we have to establish our goals.
How do we do that? I propose the following procedure:
1. Determine the appropriate allocation (or diversification strategy) for your portfolio. My firm does this by evaluating a client's sensitivity to volatility (risk tolerance), using a state of the art tool called Riskalyze.
2. After getting a feel for your risk tolerance, consider other aspects of your life, such as career stability, stage of life (growth years, retirement, distribution, etc.), financial situation in terms of emergency funds, savings, debt, need to pay for education, etc. Then, make a determination about what your expected return needs to be. Should it be 6%, 8%, 11%?
3. A rate of return can be backfitted into your portfolio by using the latest estimates of what different asset classes have returned over a period of time, as well as inflation expectations and other factors.
To give you an idea of how subjective this is, and how a qualified fiduciary adviser can earn his or her keep, here's an excerpt from Dimensional Fund Advisors latest "Matrix Book," an invaluable resource for making informed decisions of this type:
As a back-of-the envelope estimate, let's go with the most recent 20 years and the following basic asset classes:
U.S. Stocks – S&P 500: 8.2%
International – MSCI EAFE: 4.4%
U.S. Small Cap – Dimensional US Small Cap Index: 11.5%
Bonds – Barclays US Aggregate Bond Index: 5.3%
Your expected return is going to equal the sum of the returns of each of the above benchmarks multiplied by its expected weight in your portfolio. For example, let's say your risk tolerance score recommends you build a balanced portfolio of 60% stocks and 40% bonds. Also, let's say that you've decided that 10% of the portfolio should be in small company stocks and 10% in international. Your expected overall return should be: 8.2% x 0.4 + 4.4% x 0.1 + 11.5% x 0.1 + 5.3% x 0.4 = 6.99%. That's before inflation, money management fees, etc.
Now we have a decision point. Is 6.99% appropriate for you? Or do you need more of a return? A case can be made that if you are in the growth stage of your career and income, the entire portfolio should be weighted toward large and small domestic stocks, which should significantly impact your returns (and also the volatility of the portfolio). Realize too, that there are many other asset classes we can consider&mdsah;emerging market stocks, different classifications such as growth, value, or blend, mid-cap stocks, commodities, real estate, "smart beta", etc. These may add incremental returns to our portfolio, depending on the type of asset.
If you're happy with the return expectations using only indexes and benchmarks to guide you, a passive indexing approach may suit your needs just fine. You will minimize one component of portfolio drag—expenses, as most index funds and exchange-traded funds will have overall expense ratios of 0.5% or less.
Whatever your needs, this process can help you make better decisions when choosing mutual funds and ETFs. You can even crunch your own numbers, using the Portfolio Expected Returns Calculator I've created.