Personal Financial Management Library

Modern Portfolio Theory

Efficient Market Hypothesis

Diversification

Passive vs. Active Management

Mutual Fund Fees

Retirement Investing

Tax Loss Harvesting

Rebalancing

Reversion to the Mean

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Modern Portfolio Theory

Harry Markowitz, “Portfolio Selection,” Journal of Finance, March 1952 Vol 7, pp. 77-91(603kb). This paper laid the groundwork for Modern Portfolio Theory, which earned Dr. Markowitz a Nobel Prize. The paper suggests that, instead of asking the question, “What is a good investment?” you ought to be asking, “What is a good investment for my portfolio?” It turns out that the answer is heavily dependent on what else happens to be in your portfolio. All else being equal, it is more beneficial (from the standpoint of maximizing your risk-adjusted return) to take on an investment which is likely to have low correlations with other elements of your portfolio than to take on an investment which is likely to have high correlations with other elements of your portfolio. Thus, investment selection should involve getting maximum diversification benefit (with respect to the rest of the portfolio) from each investment.

William J. Bernstein, “The Appropriate Use of the Mean Variance Optimizer,” Efficient Frontier, January 1998. ”Can you use an MVO to help you shape your portfolio? Yes, but you’ve got to be very careful. An MVO is like a chainsaw. Used appropriately, it is a powerful tool for clearing your backyard. Used inappropriately it will send your local surgeon’s kids to college. Same thing with MVOs. Want to wind up in the financial version of intensive care? Just throw in some historical (or even plausible) returns and believe what comes out the other end.” “So, what use is the thing? Well, first and foremost an MVO is a superb teaching tool. Play around with one for a few hours and you will begin to acquire a grasp of the rather counterintuitive way in which real portfolios behave.” “… You have to realize that the chances of your allocation, no matter how skillfully chosen, winding up exactly on the future efficient frontier are zero.”

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Efficient Market Hypothesis

Morningstar Investing Glossary, Efficient Market Hypothesis definition, Efficient Market Hypothesis (EMH) definition and explained briefly

Burton G. Malkiel, The Efficient Market Hypothesis and Its Critics, 24 pages, The guru writes about efficient market hypothesis.

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Diversification

Daniel J. Burnside, Donald R. Chambers, and John S. Zdanowicz, “How Many Stocks Do You Need to be Diversified?” AAII Journal, July 2004.

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Passive vs. Active Management

William F. Sharpe, “The Arithmetic of Active Management” Financial Analysts Journal, January/February 1991, pp. 7-9. “If ‘active’ and ‘passive’ management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. These assertions will hold for any time period.” This brief, lucidly written article is perhaps the simplest and most persuasive theoretical case ever made for passive management.

Anna Bernasek, “The Man Your Fund Manager Hates” Fortune, December 1999. An interview with Burton Malkiel, author of A Random Walk Down Wall Street: The Best Investment Advice for the New Century.

John C. Bogle, “Equity Fund Selection: The Needle or the Haystack?” a speech presented before the Philadelphia Chapter of the American Association of Individual Investors, November 23 1999.

John C. Bogle, “Three Challenges of Investing: Active Management, Market Efficiency, and Selecting Managers” a speech given in Boston on October 21 2001.

Eric Brandhorst, “Problems with Manager Universe Data” State Street Global Advisors, November 22 2002. “Even the two asset classes (international equity and U.S. small cap) that are often held up as examples of arenas where active managers can consistently add value lose their active management luster when appropriate adjustments are made to the median manager data.”

Anthony W. Brown, “Why Indexing Makes Sense” Hammond Associates, June 1999.

Warren E. Buffet, “How to Minimize Investment Returns” Berkshire Hathaway 2005 Annual Report, 2005.

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Mutual Fund Fees

John C. Bogle, “What Can Active Managers Learn from Index Funds?”, Lecture delivered on December 4 2000.

John Markese, “How Much Are You Really Paying For Your Mutual Funds?”, AAII Journal, February 1999. “Loads and expenses decrease your mutual fund return dollar-for-dollar. Looking forward—the best direction in which to look to make judgments—loads and expenses are predictable; returns are not. Loads are sales commissions paid to sales personnel and have only a negative impact on fund performance. Fund expenses that are significantly higher than the average for a category are difficult for fund managers to overcome.”

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Retirement Investing

Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz, Retirement Savings: Choosing a Withdrawal Rate that is Sustainable”, AAII Journal, February 1998.

William Reichenstein, “Savings Vehicles and the Taxation of Individual Investors”, Journal of Private Portfolio Management, Winter 1999 (88kb). ”When saving for retirement, the most important consideration is the tax structure. In this case, the better choice between two savings vehicles is the one that produces the greater after-tax ending wealth.”

Portfolio Withdrawals
Colleen M. Jaconetti, CPA, CFP, Vanguard Investment Counseling & Research, (09/12/2007)
Spending From a Portfolio: Implications of a Total-Return Approach Versus an Income Approach for Taxable Investors Executive summary. During the accumulation years, many investors build retirement savings in both tax-advantaged accounts, such as IRAs or 401(k)s, and regular taxable accounts. When these investors reach retirement, they face decisions about how to spend from their investment portfolios—how much to spend yearly, which accounts to draw from, and how to keep the balance of the assets invested. In this paper, we explore the most common spending strategies, review best practices, and discuss some pitfalls that investors should avoid. Investors spending from a retirement portfolio typically employ one of two well known methods: the total return approach or the income approach. Historically these approaches have been discussed as mutually exclusive—an investor follows either one or the other. In reality, the two approaches are similar in many ways, and in fact operate identically up to a point. Using the total-return approach, the investor spends from both the principal and income components of his or her portfolio. Under the income approach, the investor typically spends only the income generated by the portfolio, which often is not sufficient to meet spending needs. To make up for the shortfall, many investors elect to either increase their allocation to bonds, tilt their bond holdings toward high-yield bonds, or tilt their equity holdings toward higher-dividend-paying stocks—none of which are preferred strategies for maintaining inflation-adjusted spending over long periods. Because the decision regarding a withdrawal strategy depends upon the investor’s spending goals, as well as upon his or her asset allocation, we have included an appendix that provides general spending guidelines based on various allocations, time horizons, and success rates.

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Tax Loss Harvesting

Robert D. Arnott, Andrew L. Berkin, and Jia Ye, “Loss Harvesting: What’s It Worth To The Taxable Investor?”, Journal of Wealth Management, Spring 2001 (170kb).

Andrew L. Berkin and Jia Ye, “Tax Management, “Loss Harvesting, and HIFO Accounting”, Financial Analysts Journal, July/August 2003 pp. 91-102. “Our findings show that no matter what market environment occurs in the future, managing a portfolio in a tax-efficient manner gives substantially better after-tax performance than a simple index fund, both before and after liquidation of the portfolio.”

Donald Jay Korn, “Bummer Crop” While fall turns to winter on Wall Street, clients who harvest losses may reap rich rewards when the stock market springs back,” Financial Planning, September 2002, pp. 63-69.

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Rebalancing

Gobind Daryanani, “Opportunistic Rebalancing: A New Paradigm for Wealth Managers”, Journal of Financial Planning, January 2008, pp. 48-61. An outstanding discussion of the rebalancing routine we’ve been using since 2001, which we call “Opportunistic Partial Rebalancing.”

Robert D. Arnott and Robert M. Lovell, Jr., “Rebalancing: Why? When? How Often?”, Journal of Investing, Spring 1993, pp. 5-10 (52kb). An excellent discussion of the benefits of rebalancing and a comparison of various rebalancing routines.

William J. Bernstein, “The Rebalancing Bonus”, Efficient Frontier, Fall 1996.

William J. Bernstein, “Case Studies in Rebalancing”, Efficient Frontier, Fall 2000. “The returns differences among various rebalancing strategies are quite small in the long run.”

Robert M. Dammon, Chester S. Spatt, and Harold H. Zhang, “Capital Gains Taxes and Portfolio Rebalancing”, TIAA-CREF Institute research dialogue, March 2003, pp. 1-15 (192kb). The authors capture the trade-off over the investor’s lifetime between the tax costs and diversification benefits of trading. They find that the investor’s incentive to re-diversify the portfolio declines with the size of the capital gain and the investor’s age. Unlike conventional financial advice, the reset of the capital gains tax basis and the resulting elimination of the capital gains tax liability at death, suggests that the optimal equity proportion of the investor’s portfolio increases as he ages.

Hayne E. Leland, “Optimal Portfolio Implementation with Transactions Costs and Capital Gains Taxes”, Haas School of Business Working Paper, December 20 2000 (247kb).

Seth J. Masters, “Rules for Rebalancing”, Financial Planning, December 2002, pp. 89-93.

Yesim Tokat, “Portfolio Rebalancing in Theory and Practice”, Vanguard Investment Counseling & Research, February 15, 2006.

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Reversion to the Mean

John C. Bogle, “Bogle on Investment Performance and the Law of Gravity: Reversion to the Mean—Sir Isaac Newton Comes to Wall Street,” Speech given at MIT Lincoln Laboratory on January 29 1998. “… RTM is a rule of life in the world of investing—in the relative returns of equity mutual funds, in the relative returns of a whole range of stock market sectors, and, over the long-term, in the absolute returns earned by common stocks as a group.”

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For more information or to schedule a complimentary initial consultation, call Alan Markell at 256-881-9637 or email Alan@Discover-FP.com.

113 Misty Hollow Way
Huntsville AL 35806
256-881-9637
Alan@Discover-FP.com
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