Nobel Prize Winning Investing Advice

I was fortunate to have a couple professors back in my college days who instilled in me the lesson that it is nearly impossible to beat the market over the long term. Investors are best served when they simply own the market.
Since college I have been a passionate student of this idea. I have observed this in academic studies and in my own experiences.
Last week Eugene Fama was awarded a Nobel prize for the underlying theory supporting investing in the market vs. stock picking.
Below is a link to a short article and video interview with David Booth who has turned Fama's research into one of the most successful mutual fund companies in the nation - Dimensional Fund Advisers (DFA).
I am proud to say that I am an approved DFA adviser and through that process was fortunate to be lectured by Eugene Fama at DFA's headquarters.

http://www.cnbc.com/id/101160690?__source=pulse&par=pulse&utm_medium=referral&utm_source=pulsenews

Eugene Fama's Contribution to the 2013 Nobel Prize in Economics

What does the Eugene Fama part of the 2013 Nobel Prize in Economics tell us?

This years prize went to Eugene Fama, Lars Hansen and Robert Shiller. All have done work on asset prices - think stock prices.

Fama is the father of the efficient market hypothesis - which states that without consistent inside information it is difficult to determine a better price for a stock other than the current price of that stock.

The argument is that stock prices incorporate all known information into the price of the stock at any given time. Which means that prices will react to new news as it becomes available. That is why they appear to bounce around in a random pattern. Thus the  term "random walk" of stock prices. There are so many people analyzing so much data that it is hard to find an edge. A 7/11/2013 Business Week story on hedge funds says it all:

" In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost."

This means that it is hard to pick stocks that will give you market beating returns. When an investor purchases a stock that he thinks is a good buy, there is a seller who is selling for some reason. What do they know that you dont?

After 2008 many liked to say that the efficient market was dead. Those that said that didnt understand the nuances of Fama's argument:

Fama says that markets dont always get prices correct, sometimes they get prices terribly wrong, but in a random, unpredictable manner, and therefore investors cannot develop systems to consistently outperform the market.

What should an investor do? The answer has been: dont try to time the market or outsmart the market, rather simply own the whole market. By doing so an investor owns the return on capital markets over time. The US stock market has returned around 10% since 1926. Not too bad.

This insight has lead to the growth of index funds over the last 40 years. Index funds allow investors to own the whole market at a very low cost. The lesson for the average investor is to just own the market and stop trying to outsmart all the other smart people. There is not a system to date that has figured out how to outperform the market over the long run (net of fees and taxes).

Note: the stock market fluctuates wildly at times, investors in the market need to understand that point and plan accordingly.

An Example Of Why Many In The Industry Opposing The Fiduciary Standard?

Many in the financial industry are opposing the DOL's push to require financial advisers of retirement plans (401K, IRAs) to act as a fiduciary when advising their clients. Recently, the CEO of Raymond James issued a call to arms:

http://wealthmanagement.com/raymond-james-national-conference/opposition-dol-fiduciary-gains-ground

A fiduciary standard would require the adviser to put the clients needs above their own. How is this a bad thing? Why would those who earn commissions or annual fees on investment products oppose this.

The answer is made clear in a prior blog post of mine reproduced below:

How was an adviser, who placed their client in the Highland Small-Cap investment shown above, acting in their clients best interest?

Recently, I have taken on 3 new clients. All 3 were with commission or fee based advisers prior to asking me for advice.

The chart above, produced by Morningstar, is representative of at least 10 of the funds that the new clients owned.

In this case, the client's adviser invested the clients money in the Highland Small Cap Equity fund in 2011. Highland invests in small company growth stocks.

The chart shows the following;

1. Highland's performance over the last 10 years in blue.
2. The performance of all small cap growth funds in orange.
3. The performance of the Vanguard small cap index in yellow.

The Vanguard Index is simply a fund that holds all stocks that meet the definition of small cap growth - this is known as an index fund. The fee for this particular index fund is .08%

The other funds are known as actively managed funds - which means the funds employ managers who pick stocks in an effort to outperform a benchmark (or index). In this case the managers are trying to outperform the small cap growth sector.

A review of the chart shows that the Vanguard index fund clearly was a better choice in 2011 based on a visual look at the performance.

So why would an adviser NOT place their client in the Vanguard?

A look at the the top of the chart shows that there is a 4% load on the fund and an annual expense of 2.75%. This means that for every $1,000 initially invested the adviser gets an initial fee of $40. In addition, the fund takes 2.75% off of the balance every year. In fact, of that 2.75%, 1% goes to the adviser on an annual basis.

The adviser had a choice, he could have recommended the no load, .08% annual fee Vanguard fund, yet they placed their client in the Highland fund which rewarded him a 4% initial fee + 1% of the balance annually.
How was that good for the client. It seems it was good for the adviser.

In my opinion, this is what is wrong with this industry. It is based on a system where brokers and fee based advisers earn income off of recommended investments.

One way to combat this is too work with a fee-only adviser who doesnt accept commissions or fees from products they recommend. Dont confuse fee-only with fee based. fee based can receive fees from products they recommend to you. A fee-only adviser will generally charge an hourly rate or base the fee on the dollar amount of assets managed.

Note: Michael Angelucci MBA, CFP is a fee-only adviser.

Student Loan Debt - How $50,000 in loans could cost you over $750,000

Here is how $50,000 in student loan debt could really cost you $753,206.

It is not out of the ordinary for many college graduates to have $50,000 in student loans.
With current student loan rates at 6.8% and with a 10 year payback of the loan, a student could have a monthly payment of $575.40/month. This will amount to $69,048 in payments over 10 years. But that is not where it ends.

If the graduate did not have the loan, that student could theoretically save that amount every month in a in an investment account or their company 401K.

Lets assume the graduate saves the $575.40 every month and the money earns 6.8% on average - not an unlikely scenario if the funds are invested in a 60% stock/40% bond portfolio. After 10 years that money would grow to $98,504. It doesn't end here!

If the Graduate lets the $98,504 continue to grow in the account for the next 30 years, and the money continues to earn an average return of 6.8%, the account will grow to $753,206! That is without adding another penny to the balance.

I call the $753,206 the real cost of borrowing.

This does not mean that college degrees should not be pursued and debt not incurred. This cannot be avoided for many professional programs - medical, law.

But, many attend private and out of state universities to pursue degrees in accounting engineering and liberal arts that may not result in higher life time pay than a local state university.

When it comes down to making a college decision, a young person must ask: "if I have to borrow to attend this school will the degree result in more lifetime income than the real cost of borrowing?"

An Instructive Sunday read as told by Malcom Gladwell: Black Swans and the Difficulty of Beating Markets

Last fall, Niederhoffer sold a large number of options, betting that the markets would be quiet, and they were, until out of nowhere two planes crashed into the World Trade Center. "I was exposed. It was nip and tuck." Niederhoffer shook his head, because there was no way to have anticipated September 11th. "That was a totally unexpected event."

The above is the last paragraph from a great New Yorker piece by Malcom Gladwell. I have read dozens of books, articles, and studies on he difficulty of beating the market. For me, this story is one of the most telling: Since nobody can know the future how can you outperform the market over time - no matter how smart you are. A great lesson, I re-read this often.

Spend less than an hour with this well told, instructive story

http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm

Efficient Markets: Markets are not perfect but neither are really smart guys

Next time you think you, your mutual fund, your broker, your stock picking software can beat the market; scan the graphic below and read this short excerpt from Business Week July 16-21, 2013, "The Hedge Fund Myth"

"Hedge funds are built on the idea that a smarter guy (and they are almost all guys; only 16.8 percent of managers are women) with a better computer can make miracles possible by uncovering inefficiencies in the market or predicting the future. In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost."

Full Article: http://www.businessweek.com/articles/2013-07-11/why-hedge-funds-glory-days-may-be-gone-for-good#p2

What if You Paid Your Doctor Like You Pay Your Financial Adviser?

There would be moral outrage if we lived in a world where doctors didn't directly charge patients, but earned all their income from the pharmacy companies for the prescription drugs they prescribed. We would ask "how can the doctor be objective?"

Reality: We live in a world where the vast majority of financial advisors dont directly charge the client a penny, but receive commissions and fees from the investments and insurance products they sell clients. This is how brokers and many fee based advisors earn their fees. There is no moral outrage, no cry of "how can they be objective?"

This year the UK, Netherlands, and Australia have made commissions in financial products illegal, see Jason Zweig's WSJ blog:

http://blogs.wsj.com/moneybeat/2013/06/21/the-intelligent-investor-going-dutch-could-fee-hurdles-come-down-everywhere/

A fee only advisor charges a client directly. The charge is generally based on time spent or on the amount of money managed. The client receives an invoice and pays directly or may pay directly from the investment portfolio.

Ask your advisor how they get paid and then ask whether they can be objective in their advice.

Full Disclosure: AWM is a fee only advisor.

Advice to those attempting to manage their own stock portfolio.

A short quote from  Satyajit Das's excellent book:  Extreme Money: Masters of the Universe and the Cult of Risk.  Excellent advice for those who attempt to own individual stocks and manage their own stock portfolios.

"Bernard Baruch, the famous financier and investor, once offered the following guide to investment success:
If you are ready and able to give up everything else, to study the whole history and background of the market and all the principal companies whose stocks are on the board as carefully as a medical student studies anatomy, to glue your nose at the tape at the opening of every day of the year and never take it off till night; if you can do all that and in addition you have the cool nerves of a great gambler, the sixth sense of a kind of clairvoyant, and the courage of a lion, you have a chance."

Das, Satyajit (2011-08-04). Extreme Money: Masters of the Universe and the Cult of Risk (p. 98). Pearson Education. Kindle Edition.

You Don't Need To Invest In Hedge Funds To Have Investing Success

This chart shows the return of a simple portfolio that holds 60% in a simple S&P 500 index fund and 40% in a global bond index fund vs. the returns of the hedge fund industry over the last 10 years.

What this tells you is that it is hard to beat the market. Hedge funds hire some of the sharpest minds on Wall Street and charge a fee of 2% per year plus 20% of the return they make. If they can't beat the market, what makes you think that you can, or your broker, or the neighbor who tells you he is making money hand over foot?

The lesson for most investors is to hold stocks that look very much like that of the overall stock market (the S&P 500 or a Total Market index fund will do) + a portion of bonds that look like the overall bond market. Hold these in a proportion that is right for your risk tolerance, minimize taxes (holding a stock index does this very efficiently), keep fees low (index funds do this better than any other funds) and you will have a high probability of outperforming the average investor over time.

Gatsby and Investor Behavior

"Gatsby believed in the green light, the orgiastic future that year by year recedes before us. It eluded us then, but that's no matter - tomorrow we will run faster, stretch out our arms farther.... And one fine morning-- So we beat on, boats against the current, borne back ceaselessly into the past."

The above quote from the final page of F. Scott Fitzgerald's The Great Gatsby is a beautifully written description of the American psyche. It can also be read as an insight to investor behavior as it relates to the stock market. That is because we believe in the endless possibilities that the market can bring to us. Our dream is the hope that a person can choose the right investment and get rich. This hope has been ingrained in our American DNA through literature, movies and television. 

Wall St can be the place of fortunes and when its not, it can destroy financial lives if we take risks we dont understand or cannot afford. Yet we keep going back and we continue to believe that if we pick the right stock, mutual fund or adviser we can achieve the elusive - consistent market beating returns that will result in easy financial wealth.

We believe in the dream and ignore the academic research that says: over time, an investor has a very low probability of beating the market; and that holding a portfolio of simple index funds, that represent the overall market, outperforms almost all other strategies. Yet "we beat on, boats against the current"  trying to beat the market. Unfortunately, there are really no shortcuts. That is the tragedy of Gatsby. He tried to achieve his dream through shortcuts. It cost him his life. 

There are no shortcuts when it comes to investing success. Occasionally, some get lucky and get rich on a small investment. Those are the rare exception. The secret to successful investing is a disciplined commitment to saving, managing our get rich quick emotions by holding a risk appropriate, well diversified portfolio of various asset classes, rebalancing, and keeping costs low through the use of index funds.

PBS Frontline (4/23/2013) - Powerful evidence in support of indexing

"The evidence is overwhelming. Year after year, actively managed mutual funds fail to beat index funds. Studies have born this out repeatedly over various periods in bull and bear markets"

The quote is from the April 23, 2013 PBS Frontline documentary on the 401K industry, link below:

http://www.pbs.org/wgbh/pages/frontline/retirement-gamble/

It is one hour and it is excellent - especially the last 1/2 hour which focuses on fees and index funds.

Bad Investor Behavior: A Graph

This simple graph, produced by BlackRock, shows mutual fund money flows (blue bars) vs. the return of the S&P 500 (US Market). 

The graph demonstrates how investors pull money out of the market when stocks are low and buy into the market when the stock market is high. Investors do the opposite of buy low and sell high. It is no wonder the average investor underperforms the market. Investors act on fear and not rational analysis.

Ideally inflows would have been up in 2002 and 2009/2010.

Great Literature/2013 Pulitzer Prize/N. Korea

The recent drama in N. Korea lead me to pick up The Orphan Master's Son.
I had heard many say that it was one of the best works of fiction of 2012 and two days ago it was awarded the pulitzer prize.

I am only 1/3 through this novel. But it does what all great literature does for me. It opens doors into places and cultures I will never experience first hand. But more than that, it explores what it means to be human -  mans longing for love and meaning, and in this book, the sad contrast between the evil of a totalitarian regime and its repression of this base human need.

The novel will also give you insight into the total control that the N. Korean government has over their people and their focus on a common enemy, the United States, in order to keep their people focused on something other than their horrible lives.

If you love great literature and you want to gain an understanding of a strange and scary place that exists in our lives today, then pick up this novel.

If You Read This and Dont Index Your Portfolio ....?

Over the past week I have come across powerful evidence for abandoning active management of your investment portfolio. The first, comes from Daniel Kahneman's brilliant Thinking Fast and Slow. Kahneman is a psychologist, who by his own admission, knew nothing of finance prior to studying investor success. 
The book is so much more than a book on investing. It is a book on how humans make decisions and it should be on the top of everyones reading list.

But dont take my word for it, look at the accolades below:

Winner of the National Academy of Sciences Best Book Award in 2012

Selected by the New York Times Book Review as one of the best books of 2011

A Globe and Mail Best Books of the Year 2011 Title

One of The Economist’s 2011 Books of the Year

One of The Wall Steet Journal's Best Nonfiction Books of the Year 2011

“Brilliant . . . It is impossible to exaggerate the importance of Daniel Kahneman’s contribution to the understanding of the way we think and choose. He stands among the giants, a weaver of the threads of Charles Darwin, Adam Smith and Sigmund Freud. Arguably the most important psychologist in history, Kahneman has reshaped cognitive psychology, the analysis of rationality and reason, the understanding of risk and the study of happiness and well-being . . . A magisterial work, stunning in its ambition, infused with knowledge, laced with wisdom, informed by modesty and deeply humane. If you can read only one book this year, read this one.”— Janice Gross Stein, The Globe and Mail 

The quote  I copy below is part of a larger chapter on "The Illusion of Validity." Kahneman uses the lack of persistant success in stock picking to demonstrate an area where this cognitive illusion exists. Remember, this is a guy just studying the facts. No bias to sell you his skill in finance:

“In 1984, Amos (Kahneman research partner) and I and our friend Richard Thaler visited a Wall Street firm. Our host, a senior investment manager, had invited us to discuss the role of judgment biases in investing. I knew so little about finance that I did not even know what to ask him, but I remember one exchange. “When you sell a stock,” I asked, “who buys it?” He answered with a wave in the vague direction of the window, indicating that he expected the buyer to be someone else very much like him. That was odd: What made one person buy and the other sell? What did the sellers think they knew that the buyers did not?

Since then, my questions about the stock market have hardened into a larger puzzle: a major industry appears to be built largely on an illusion of skill. Billions of shares are traded every day, with many people buying each stock and others selling it to them. It is not unusual for more than 100 million shares of a single stock to change hands in one day. Most of the buyers and sellers know that they have the same information; they exchange the stocks primarily because they have different opinions. The buyers think the price is too low and likely to rise, while the sellers think the price is high and likely to drop. The puzzle is why buyers and sellers alike think that the current price is wrong. What makes them believe they know more about what the price should be than the market does? For most of them, that belief is an illusion.

“In its broad outlines, the standard theory of how the stock market works is accepted by all the participants in the industry. Everybody in the investment business has read Burton Malkiel’s wonderful book A Random Walk Down Wall Street. Malkiel’s central idea is that a stock’s price incorporates all the available knowledge about the value of the company and the best predictions about the future of the stock. If some people believe that the price of a stock will be higher tomorrow, they will buy more of it today. This, in turn, will cause its price to rise. If all assets in a market are correctly priced, no one can expect either to gain or to lose by trading. Perfect prices leave no scope for cleverness, but they also protect fools from their own folly. We now know, however, that the theory is not quite right. Many individual investors lose consistently by trading, an achievement that a dart-throwing chimp could not match. ......

“Although professionals are able to extract a considerable amount of wealth from amateurs, few stock pickers, if any, have the skill needed to beat the market consistently, year after year. Professional investors, including fund managers, fail a basic test of skill: persistent achievement. The diagnostic for the existence of any skill is the consistency of individual differences in achievement. The logic is simple: if individual differences in any one year are due entirely to luck, the ranking of investors and funds will vary erratically and the year-to-year correlation will be zero. Where there is skill, however, the rankings will be more stable. The persistence of individual differences is the measure by which we confirm the existence of skill among golfers, car salespeople, orthodontists, or speedy toll collectors on the turnpike.

Mutual funds are run by highly experienced and hardworking professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than fifty years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. Typically at least two out of every three mutual funds underperform the overall market in any given year.

More important, the year-to-year correlation between the outcomes of mutual funds is very small, barely higher than zero. The successful funds in any given year are mostly lucky; they

have a good roll of the dice. There is general agreement among researchers that nearly all stock pickers, whether they know it or not—and few of them do—are playing a game of chance. The subjective experience of traders is that they are making sensible educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are no more accurate than blind guesses" (the bold is mine).

Then after reading this section in Kahneman's book, I read in Forbes that it was announced that the largest pension fund in the country is coming to the same conclusion. The following is from Forbes:

PERSONAL FINANCE 

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3/21/2013 @ 10:00AM |490 views

Nation's Largest Pension Considers More Indexing

"The country’s largest public pension fund may shift more assets into passive indexing if the pension committee takes the advice of their consultant. The California Public Employees’ Retirement System (CalPERS) is considering the move because external active managers have failed to keep pace with the markets.  This news is nothing new to people who closely track active management performance.

CalPERS invests the retirement savings for over 1.6 million public employees, retirees, and their families and more than 3,000 public employers. Assets total more than $256 billion, making it the largest public pension fund in the country.

The fund currently allocates about 50 percent of assets to the global public equity markets. Approximately 60 percent of the allocation is already managed in passive index-tracking portfolios and the remaining 40 percent is managed externally by active investment management firms.

Pension & Investing reported this week that the CalPERs investment committee is considering putting more into indexing after investment consultant Allan Emkin of Pension Consulting Alliance showed that at any given time, only about one-quarter of the fund’s external active managers are outperforming their benchmarks. Further, the results of the winning managers may not be high enough to cancel out the underperformance by the losing managers. He also noted that winning active managers change over time, which complicates the selection process.

Allan’s observations are nothing new to astute investors who track active management performance. It has been know in academia and in the consulting industry that a majority of active managers underperform the indexes they are trying to beat. It’s also known that choosing a winning manager is extremely difficult because there is so much noise in the data. The most interesting point that Allan makes is that losing managers more than cancel the winning managers’ gains, and this leaves a portfolio in a net loss position."

This is profound. It is the a validation of the research findings being born out in real world experience!

If the 256 Billion dollar pension fund cant beat the market, can you?

The beauty is that being the market year after year you will do better than 2/3 of active management each year and by some account 90% of active management over 10 years. 

Finally: If the above has triggered your interest, I highly recommend the short 7 minute videos from Sensible Investing. Although the producers advocate passive (index) investing. The presentation and evidence presented are compelling and worth your time:

http://www.sensibleinvesting.tv/ViewAll.aspx?id=566C2B1B-DEBA-4F6E-BDC8-9BD066F071B3  

A Must Read

Whether your interest is in marketing, education, social welfare, investing or politics, I highly recommend Daniel Kahneman's Thinking Fast and Slow.
The insights into human decision making are profound. Kahneman may be the most important psychologist of the last 40 years. he is also the winner of the noble prize in economics for his work in behavioral finance.

I will be blogging insights found in this book over the coming weeks.

A Simple Rule To Follow When Picking a Mutual Fund

Advice from Carl Richards (Bucks Blog).
Carl is highlighting studies that show that the higher the mutual fund fee the lower its performance relative to its peers.

The best predictor of mutual fund success is a mutual funds expense ratio.

Diversification 101 from Larry Swedroe. A Must Read for the Average Investor

12 years ago while preparing a presentation, I was looking for a source that could clearly explain and demonstrate the ideas behind diversifying an investment portfolio. I wanted examples that could be understood by the average investor. That is when I discovered Larry Swedroe's What Wall Street Doesnt Want You Too Know. I have been a fan of his writing ever since.

What follows is from Larry Swedroe's Wise Investing blog. It is an excellent description of the power of diversifying across asset classes. It is a must read for anyone who invests their money in the markets:

(MoneyWatch) This post is based on chapter 6 of Larry Swedroe's new book Think, Act, and Invest Like Warren Buffett. The data for today's post and the associated text have been updated through the end of 2012.

Because most investors have not studied financial economics and don't read financial economic journals or  books on modern portfolio theory, they don't have an understanding of how many stocks are needed to build a truly diversified portfolio. To effectively diversify the risks of just the asset class of U.S. large-cap stocks, you would have to hold a minimum of 50 stocks. For U.S. small-cap stocks, the figure is much higher. Once you expand your investment universe to include international stocks, it becomes obvious that the only way to effectively diversify a portfolio is through the use of mutual funds.

However, even when individuals invest in mutual funds, they typically don't diversify effectively because they make the mistake of thinking that diversification is about the number of funds you own. Instead, it's about how well your investments are spread across different asset classes. For example, an investor who owns 10 different actively managed U.S. large-cap funds may believe that he is effectively diversified. While it's true that each fund will likely have some differentiation in its holdings from the others, collectively, all the investor has done has been to create an expensive "closet" index fund. The reason is that it's likely that the return of his portfolio, before expenses, will approximate the return of an S&P 500 Index fund. After expenses, the odds are great it will underperform.

Even many individuals who invest in index funds get it wrong because they limit themselves to funds that mimic either the S&P 500 Index or a total U.S. market index. At the very least, they should also include a significant allocation (30 percent to 50 percent) to a fund such as Vanguard's Total International Stock Index Fund.

The next step is to show you how simple it is to build a more effective, globally diversified portfolio. Many investors think that diversification means owning enough mutual funds. However, the key is spreading them across asset classes. After all, 10 different large-cap growth funds still means you only have exposure to one asset class.

The Basic Portfolio

We will begin with a portfolio that has a conventional asset allocation of 60 percent stocks and 40 percent bonds. The time frame will be the 38-year period, 1975-2012. This period was chosen because it's the longest for which we have data on the indexes we need. While maintaining the same 60 percent stock/40 percent bond allocation, we'll then expand our investment universe to include other stock asset classes.

We begin with a portfolio that consists of just two investments:

• The S&P 500 Index for the stock allocation
• Five-year Treasury notes for the bond portion

We'll see how the portfolio performed if one had the patience to stay with this allocation from 1975 through 2011 and rebalanced annually. We will then demonstrate how the portfolio's performance could have been made more efficient by increasing its diversification across asset classes. We do so in four simple steps.

Portfolio 1

• 60 percent S&P 500 Index
• 40 percent five-year Treasury notes

By changing the composition of the control portfolio, we will see how we can improve the efficiency of our portfolio. To avoid being accused of data mining, we will alter our allocations by arbitrarily "cutting things in half."

Small-Cap Stocks

The first step is to diversify our stock holdings to include an allocation to U.S. small-cap stocks. Therefore, we reduce our allocation to the S&P 500 Index from 60 percent to 30 percent and allocate 30 percent to the Fama/French Small Cap Index. (The Fama-French indexes measure returns using the academic definitions of asset classes. Note that utilities have been excluded from the data.)

Portfolio 2

• 30 percent S&P 500 Index
• 30 percent Fama/French Small Cap Index
• 40 percent five-year Treasury notes

Value Stocks

Our next step is to diversify our domestic stock holdings to include value stocks. We shift half of our 30 percent allocation in the S&P 500 Index to a large-cap value index and half of our 30 percent allocation of small-cap stocks to a small-cap value index.

Portfolio 3

• 15 percent S&P 500 Index
• 15 percent Fama/French US Large Value Index (ex utilities)
• 15 percent Fama/French US Small Cap Index
• 15 percent Fama/French US Small Value Index (ex utilities)
• 40 percent five-year Treasury notes

International Stocks

Our next step is to shift half of our stock allocation to international stocks. For exposure to international value and international small-cap stocks we will add a 15 percent allocation to both the MSCI EAFE Value Index and the Dimensional International Small Cap Index.

Portfolio 4

• 7.5 percent S&P 500 Index
• 7.5 percent Fama/French US Large Value Index (ex utilities)
• 7.5 percent Fama/French US Small Cap Index
• 7.5 percent Fama/French US Small Value Index (ex utilities)
• 15 percent MSCI EAFE Value Index
• 15 percent Dimensional International Small Cap Index
• 40 percent five-year Treasury notes

The effect of the changes has been to increase the return on the portfolio from 10.5 percent to 12.3 percent -- an increase of 17 percent in relative terms. This outcome is what we should have expected to see as we added riskier small-cap and value stocks to our portfolio. Thus, we also need to consider how the risk of the portfolio was impacted by the changes. The standard deviation (a measure of volatility, or risk) of the portfolio increased from 10.6 percent to 11.6 percent -- an increase of 9 percent in relative terms. While returns increased 17 percent, volatility increased just 9 percent.

Commodities

There's one more asset class we want to consider including in a portfolio. As we discussed earlier, commodities diversify some of the risks of investing in stocks. They also diversify the risks of investing in bonds. Therefore, we'll add a 4 percent allocation to the Goldman Sachs Commodity Index, reducing each of our four domestic stock allocations by 0.5 percent and both the international stock allocations by 1 percent.

Portfolio 5

• 7 percent S&P 500 Index
• 7 percent Fama/French US Large Value Index (ex utilities)
• 7 percent Fama/French US Small Cap Index
• 7 percent Fama/French US Small Value Index (ex utilities)
• 14 percent Dimensional International Small Cap Index
• 14 percent MSCI EAFE Value Index
• 4 percent Goldman Sachs Commodity Index
• 40 percent Five-Year Treasury Notes

Most investors think of commodities as risky investments. However, you'll note that the addition of commodities to the portfolio actually reduced the volatility of the portfolio, and reduced it by three times the reduction in the portfolio's return. While the portfolio's return fell by 0.2 percent, its standard deviation fell by 0.6 percent. Relatively speaking, the portfolio's return fell 2 percent while its volatility fell by 5 percent. This "diversification benefit" is why you should consider including a small allocation to commodities in your portfolio.

The net result of all of our changes is that we increased the return of the portfolio by 1.6 percent, from 10.5 percent to 12.1 percent -- an increase of 15 percent in relative terms. At the same time, the volatility of the portfolio increased just 0.4 percent, a relative increase of 4 percent.

Reducing Risk

You have now seen the power of modern portfolio theory at work. You saw how you can add risky (and, therefore, higher expected returning) assets to a portfolio and increase the returns more than the risks were increased. That's the benefit of diversification. However, there's another way to consider using this knowledge. Instead of trying to increase returns without proportionally increasing risk, we can try to achieve the same return while lowering the risk of the portfolio. To try and achieve this goal, we increase the bond allocation to 60 percent from 40 percent and decrease the allocations to each of the stock asset classes and to commodities.

Portfolio 6

• 4.5 percent S&P 500 Index
• 4.5 percent Fama/French US Large Value Index (ex utilities)
• 4.5 percent Fama/French US Small Cap Index
• 4.5 percent Fama/French US Small Value Index (ex utilities)
• 9.5 percent Dimensional International Small Cap Index
• 9.5 percent MSCI EAFE Value Index
• 3 percent Goldman Sachs Commodity Index
• 60 percent Five-Year Treasury Notes

Compared with Portfolio 1, Portfolio 6 achieved a higher return with far less risk. Portfolio 6 provided a 0.3 percent higher return, 10.8 percent versus 10.5 percent -- a relative increase of 3 percent. It did so while experiencing 2.8 percent lower volatility, 7.8 percent versus 10.6 percent -- a relative decrease of 27 percent.

Through the step-by-step process described above, it becomes clear that one of the major criticisms of passive portfolio management -- that it produces average returns -- is wrong. There was nothing "average" about the returns of any of the portfolios. Certainly the returns were greater than those of the average investor with a similar stock allocation, be it individual or institutional.

Passive investing delivers market, not average, returns. And it does so in a relatively low-cost and tax-efficient manner. The average actively managed fund produces below market results, does so with great persistency, and does so in a tax-inefficient manner.

By playing the winner's game of accepting market returns, you'll almost certainly outperform the vast majority of both individual and institutional investors who choose to play the active game.