ITA Wealth Management

Photograph:  Mykonos Island, Greece

In 1992, Fama and French broke out their three-factor and changed the way we construct portfolios.  Again, quoting from Hebner as to how the three-factor model advanced the relationship between return and risk as it relates to a portfolio.  While the Sharpe model argues the amount of a portfolio invested in stocks accounts for the greatest return, their are still missing factors.  F&F filled in some of the gaps.

“The Fama/French model added two other fundamental determinants.  Fama and French sought to determine the factors that best describe why there are differences among the returns of stock asset classes over long periods of time.  They first studied the period starting in 1964, the year that reliable computer data was available.  It was later updated and confirmed with data dating back to 1926.  In short they tried to identify the factors that explained the remaining 30% of returns left unexplained by Sharpe.”

If you have been reading this blog, you now know what two additional factors F&F studied to account for most of the “missing 30%.”

“Fama and French concluded that exposure to three risk factors–market, size, and value (book-to-market)–collectively do the best job pinpointing the sources of investment risk that account for stock market returns.  Risk factors are sources of risk that the stock market seems to reward over the long run.  Based on the Fama/French findings, these three risk factors constitute the dimensions of stock returns.”

Construction of the AA-Mosaic Portfolio is following the F&F research in that we skew the portfolio toward value and also toward small-cap equities.

Photograph: Just shy of being Sampson. Ephesus, Turkey

Why include bonds in a portfolio? I think I asked this question before, but it is worth reviewing. After reading a blog moments ago where a CFA was recommending a proper blend of stocks and bonds, what came to mind was a spreadsheet of stock and bond performances beginning in 1929. Using five-year rolling performance periods, only four times from 1929 through 2007 have bonds added value to the portfolio. Several of those alpha adding periods by bonds came in the 1970s when stocks suffered. Are we entering another such period? That is impossible to say, but I am betting bonds are not going to be the place to invest money over the next ten years. Instead, I will go with higher risk small-cap stocks, commodities, international developed countries, and emerging markets. It even looks like REITs may soon turn the corner. REITs tend to provide a good yield as well as some growth.

In the Mean Variance Optimization (MVO) database, I do have bond data included. Right now, if I move down the efficient frontier graph toward a lower return, lower risk option, the MVO software shows or recommends a minimum investment of 5% in bonds. However, if I move up the efficient frontier graph and ask for a little higher return, the bond request goes to 0%. Under current market conditions, I am requesting a little higher return and sacrificing risk.