ITA Wealth Management

“Beating the Market, 3 Months as a Time” is the title of Gerald and Marvin Appel’s new book. The thesis of the book can be explained in a few paragraphs and it goes like this.

“Once every three months, you should select from among the best-performing ETFs from the last quarter to hold in your portfolio for the coming quarter.” That is the key Appel & Appel idea. One selects two ETFs from five basic equity investment styles and they are as follows. I am including the Vanguard equivalent.

• U.S. large-cap value (VTV)
• U.S large-cap growth (VUG)
• U.S. small-cap value (VBR)
• U.S. small-cap growth (VBK)
• International (VEU)

Of interest would be data that included mid-cap value and mid-cap growth, REITs, and emerging markets. Then invest in three or four of the nine best performing ETFs. Yes, it is a little more complicated, but not a significant complication.

Lowell Herr

Photograph: Overlooking the Sacred Valley of Peru out to the Andes to the west.

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In the forward of Robert Arnott’s new book, “The Fundamental Index: A Better Way to Invest,” Harry Markowitz poses this argument.

“Suppose we have four companies, each with $1 in reported earnings. Suppose two of these have ample future growth prospect that would justify a price 20 times the current profits, or $20, and the other two have less impressive prospects and fully deserve $10 — 10 times the current earnings. But, no one can have a clear view of the future prospects of our companies, so the market merely guesses at these fair values. Suppose the market does a pretty good job, but misjudges those prospects by 20 percent in each of the four cases, with one growth stock priced 20 percent too high and one 20 percent too low, and likewise for the value stocks. So, we have two stocks with a true value of $20 each, priced at $24 and $16, and two stocks with a true value of $10, priced at $12 and $8.”

This is not hard to follow so far. Markowitz goes on to make the argument as to why value portfolios perform better than cap-weighted portfolios.

“Suppose prices revert to fair value in the next year. The “cap-weighted” portfolio produces zero return; since the prices are symmetric around value, the errors cancel. If we could construct a fair-value-weighted portfolio, few would disagree that it should be better than capitalization weighting. It is. Half of our portfolio rises 25 percent in value, and half loses 16.7%, for an average of 4.2 percent return. Why? Because the fair value portfolio puts equal amounts in over- and undervalued stocks, while capitalization weighting put 60 percent of our money in the overvalued and 40 percent in the undervalued companies.”

“Since we have no idea what the fair value is for each company, and so there’s no way for us to construct this fair-value-weighted portfolio, why should we care that fair value weighting beats capitalization weighting? What of the other construction methods? The portfolios weighted equally and by company profits (efficiency -weighted), which lead to the same weighting in this example, produce a return of 4.2 percent also, identically the same as the fair-value-weighted portfolio!”

Take time to pencil out the Markowitz argument above.

Lowell Herr

Photograph: Lightening over Portland, OR — Image by David Vernier

Investors interested in digging deeper into the nuances of asset allocation will find the following five books of interest. Here is my list of the five best books on asset allocation.

• The Four Pillars of Investing: Lessons for Building a Winning Portfolio
• Asset Allocation: Balancing Financial Risk
• Index Funds: The 12-Step Program for Active Investors
• All About Asset Allocation: The Easy Way To Get Started
• The Intelligent Asset Allocator

William Bernstein, of Oregon, is the author of my number one and number five picks. Actually, The Intelligent Asset Allocator is my favorite, but I would not recommend it as the first to read as the others are better for readers not as familiar with the asset allocation language. Begin your journey with The Four Pillars.

Roger C. Gibson, in his Asset Allocation (number two pick) book does a remarkable job of showing why one should build a diversified portfolio. However, I am still waiting for an author who will provide compelling data for using over ten different asset classes.

Mark T. Hebner provides one of the best overviews for passive or index investing. In his Index Funds book, Hebner goes into the history and research for this approach to investing. If cost is an issue, this book is a best buy. I also recommend visiting the IFA web site as it is one of the very best available. I provide a link off to the right under “Links.”

Richard A. Ferri, in his All About Asset Allocation book, fulfills the goals of the book title. Ferri supports our contention that a portfolio should be tilted toward the value side of the market spectrum. In this book you will learn why asset allocation is the most important investment decision you will make.

The Intelligent Asset Allocator is one of my all-time favorite investing books. Complete your summer, fall, and winter reading with this book. Bernstein has a writing style that will leave you smiling despite the challenging material.

If anyone has a favorite book on asset allocation, please add it to this list under the comments section. Your contributions are most welcome.

Lowell Herr

Photograph: Lima, Peru students taking a snack break.

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