Market Portfolio Strategy
Key Lessons from Research
Diversification: The key idea from MPT is that diversification among uncorrelated assets with similar mean returns can greatly reduce the risk of your portfolio. The investor should use diversification to create smaller swings in the performance of their portfolio.
Market efficiency: It remains extremely difficult for a professional investor to consistently beat the market. An additional challenge as an individual investor is to identify the fund managers who actually have the skill to beat the market (rather than the luck to have beaten it for a few years). Our research leads us to believe that the individual investor would be better served using index funds rather than looking for the best active managers. He will be better off about 90+% percent of the time.
Fund expenses: There is a general negative correlation between fund expense ratio and post-expense performance. Surprisingly, funds with the highest expenses seem to under-perform the market by an amount larger than their expenses. Thus, despite the fact that they can spend more on research, these high cost funds perform poorly even before expenses are considered.
Asset allocation: Your returns will be determined by your asset allocation (how you allocate your money to the various asset classes), market timing (when you choose to buy and sell) and security selection (which individual securities you purchase within each asset class). The bottom line is that it is difficult to time the market and select securities. Asset allocation matters most in determining eventual returns of a portfolio.
Elements of the Sigma Investing Strategy
It’s hard to beat the market in any case but when you add on the additional high management fees and trading expenses of actively managed funds, you’re fighting too much of an uphill battle.
Use index funds or ETFs (exchange traded funds) instead of actively managed mutual funds (or stocks) that try to beat the market.
Remember total costs include management fees, 12b-1 fees, purchase/redemption fees, trading expenses and tax drag from distributions.
Vanguard is great for providing low cost funds — their index funds have really low management fees and the company is a non-profit so their interests are aligned with yours.
Some ETFs also have really low management fees and track the same indices as Vanguard’s funds.
Index funds and ETFs will pay dividends and realize capital gains during the year that are passed onto you — you will be taxed for this.
If possible, keep your funds that will pay higher dividends (like REITs, treasuries) or cap gains (value and emerging market funds) in tax-free accounts (IRA accounts if you have them).
Consider ETFs more strongly because they have an arbitrage mechanism that reduces the amount of cap gains that will be realized while you hold them. Vanguard’s ETFs are a bit different and don’t fully realize this benefit.