other funds can also be used.
Let’s start on the passive side of the street. Look at figure 1 (a Tableof DFA Strategies). Here we have stocks and bonds broken down bysize (large-cap versus small-cap) and style (growth versus value) goingback a full 20 years - a good sample. Also included in this table areinternational funds and bond funds. Now suppose you built yourportfolio by buying index funds representing these different classesof securities. Look at the 4 strategies (plus the S&P 500 index as abenchmark) and breakdowns here and you will see how your invest-ments might have performed using these different combinations ofpassive strategies. Note that the different portfolios are in order ofascending return. (Annualized compound return, at the bottom of thetable.)
Remembering what we learned about standard deviation (whichrepresents the risk of a particular grouping of securities), you mightexpect that the standard deviation would tend to be higher as the re-turn increases because we know that to get higher returns we generallyhave to incur higher risk. But wait a second. Look at Strategy #3, adiversified portfolio that is 80% stocks and 20% bonds. Those resultsare very good at 17.50% annualized with a standard deviation of only10.40! Remember: the S&P 500 over the same 20-year time periodhad a return of 14.59%, and a standard deviation of 13.65. Hmm.Let’s see. If this diversified portfolio gave me a return of over 17% ayear, which was more than the stock market as a whole returned, and
355PETER J. TANOUS
it did it with less risk, (i.e., lower standard deviation), that’s startingto sound an awful lot like a free lunch to me! Look at Strategy #4.Here we have a high annualized return of 19.52% and a standarddeviation about the same as the S&P 500. (But stay skeptical a littlelonger. Hindsight is wonderful.)
Now look at figure 2. Column 1 shows our benchmark, the S&P500, over a 10-year period from 1986 to 1995. As you will see, duringthat period of time, the stock index returned 14.84% annually, onedollar invested grew to $3.99, and the annualized standard deviationwas 13.83. So this will be our return and risk benchmark when wecompare different strategies to the market as a whole. Now let’s lookat some different allocations during the same period.INVESTMENT GURUS
PEFORMANCE FOR SALANCED STRATEGIESAnnualized Compound Percentage Returns
 
January 1976-December 1995DEA 60440Normal
sup StvaregyPor tlalio Sthdex 1 2 5 4SEP 500 (U.S. Large Stocks} wo 6O 0 4 vvUS. Large Valve Gtocks w 14 v?US. Small Stocks 6 14 7U.S. Small Value Stocks 5 1 7EAFE \ciew (Int'l. latge stocks)Internatonal large welea 1 12 6International small stocks: wv 12 16Long term gov't /corp. bonds aShort term corporate bands “0 20Anruollzed compound renann (%) 1456 1269 1601 1750 19.52Growth of $1 16.23 11.31 1950 25.14 M38Annus standard devistion 13966 We B47 1040 13.08
US. Largs Value, US. Smal Value and U.S. Smal Slerke couleey Fama-Tiench amd CREP
EAFE courtesy Morg on Stontey.
Int'l Large Vale" ve and simulated DFA Inter national High BiM,
Int'l Small Stocks: Eve and simulated DFA iniormolienal Smel-Cop Stratogy
Long-Tenn Comporate!Govermment Bonds courtesy Letiman Brothers.
Short-Term Comorate Bonde: OFA One-Toar Fried income Stratagy,
DFA 60/40 Morind Strategy Inewete 10% tn Five-Year locos, 20%, In One-Year FinedIncome and 10% In Global Fixed Income.
Courtesy: Dimensional Fund Advisors.
Figure 1
At this point, we’re going “active/passive,” choosing Guru-managedfunds, and passive funds, both intelligently diversified. We will nowzero in on several strategies from figure 2.PETER J. TANOUS
PERFORMANCE FOR EQUITY MIXES
Annualized Compound ReturnsJanuary 1980-Decamber 1995
 
 
StrategiesPorttallo 1 2 a 16 Sk Fo ie oSBeamdiporiree 20 Ss 0 86 SSOF Normal Balanced Strategy so 4Gened Yalu n» SsLinder Dividend! oa Mm MWMPS Emerging Growth » Ww HM ao BsMutuni Sheses 3 a woRSP 500 index 100 wDVengusd Crowlts Indes 22 6 20Vsnquand Vatue Incex 20 30 2Asewnl ized compound retuan (4.84 14.53 15.64 16.15 16.16 16.42 16.39 17.47 17.55Growth of $1 30% 3.68 4.26 447 GAT 458 4.56 500 507Annunl stendart davintion 12,83 684 10.42 14,53 14.97 12.87 15.54 14,05 14.22Gabeli Value Data trom 1/98.
MFS Emerging Growth data fron v7,Vaeqead Growlh & Valuw indwade Irure 12/82.
 
Courtesy: Dimensional Fund Advisors.INVESTMENT GURUS
Figure 2
After doing the requisite homework, our investor decided to investthe portfolio into three funds (Strategy 2). First, DFA Normal BalancedStrategy (a diversified, passive allocation all by itself) for 60%, andthen add The Brandywine Fund for growth and as a more aggressiveinvestment (20%), and Lindner Dividend Fund, for income and stability(20%). This investor has put most of his assets into a balanced, passivestrategy, but added growth and balance with an income and value-oriented fund, plus a growth investment. We'll call this ModerateStrategy “A”. How did he do? His overall return for the 10 years wasabout the same as the Sé€P 500, but his standard deviation was only8.54 compared to 13.83 for the S&P 500. That tells us that this strategygave us the same return as the market, but with considerably lowerrisk than we would have incurred just by investing in the market asa whole!
MODERATE STRATEGY “A”(anuay L986- Decerben 1992)
Portro ia ALLOCATION 3
DFA Nema: Balanced Strategy OOS,Brandywine Fund 20Lindner Dividend Fund
S&P 500
ANNUALUZEC GomPounc Returns 14.53 Fo 14.849Growth of $1 3.88 3,59AMM. Sranoarc Deviation 854 13.83
 
Suppose instead we wanted higher returns with lower risks. (Remem-ber the northwest quadrant?) Now we need a combination of theGurus. Look at Figure 2, Strategy #3, which we will highlight asModerate Strategy “B” in the chart below: 40% DFA Balanced, 30%MFS Emerging Growth, and 30% Lindner Dividend Fund. This alloc-ation returned somewhat more than the market (15.64% versus14.84%). And what about the standard deviation? With a standarddeviation of only 10.42, this allocation was about 25% less risky thanthe market.PETER J. TANOUS
MOCERATE STRATEGY “B”(Tanvary (9246 - December 1995)
 
Portro wc ALLOCATION %
DPA Nerma! Balanced Strategy 40%,
MPFE Emerging Growth 30%
Lindner Dividend Fund 20%,
S&P 500
ANNUALIZEC Gomrounc Retury 1564% 1484%Crowtr of $i 4.28 3.09
ANN. STANDARC DEVIATION 10.42 13.83
 
Okay. Let’s get more aggressive. Perhaps you are relatively young,and your investment time horizon is years in the future. You also arethe kind of person who is comfortable with greater than averagemarket fluctuations. Here is a more aggressive strategy from figure2, Strategy #9.
AGGRESSIVE ETRATHOY(Vanuary 1886 - December 195)
Portrouioa ALLOGATION
Brandywine >and 2596MF Errerging Groveh 25%Mutaal Shares 50%Sar s30
ANPUALIZED Comrouno ReTURH 1755S 14.8496ISROWTH OF $1 S044 3.9Anh STANDARO DevLATION 14,22 13.83
 
360INVESTMENT GURUS
Note that in our Aggressive Strategy, we have significantly outper-formed the S&P 500 (17.55% versus 14.84% over ten years) and, in-terestingly enough, we did not assume a great deal more risk asmeasured by the standard deviation values (14.22 versus 13.83 forthe S&P 500). In the process, we also retained both style and size di-versification by splitting the portfolio 50/50 between growth andvalue strategies. MFS offers us exposure to small to mid-cap stocks,and to some extent, Brandywine does as well. Our value componentis represented by Michael Price’s Mutual Shares.
Now it is your turn.
Using what we have learned, you should now be prepared to con-struct an intelligent portfolio for your own use, one which reflectsyour personal risk tolerances, goals, expected returns, and time hori-zon. Your portfolio should also reflect the latest advances in academictechniques to make money in the stock market, and the wisdom ofthe Gurus.
Before building your personal portfolio, we need to review and es-tablish the criteria upon which our investment foundation will bebuilt. Let’s quickly review a checklist of desirable features for our in-telligent investment portfolio.
© Choose both active and passive investment strategies to in-crease the likelihood of consistent investment performance
® Use non-correlating asset classes to reduce volatility:
Use both growth and value stocks or funds
Use both large and small-caps in all but conservative strategiesUse international stocks, emphasizing funds for this purpose, toget geographic diversification
© For the active portion of the portfolio, use the Gurus, or thebest talent available to you, or even your own stock picks, byapplying the criteria we used to select Gurus in the introduction.© Consider your time objective to be a minimum of 5 years andpreferably 10 or more.
Remember: Our strategy is to use passive and active allocations toincrease the odds of success and to maximize our returns. We expectexcess profits from the active managers, but since we know how hardthat is to do, we want to use only the finest talent available (or yourvery best stock picks using the Guru methods) for the active portionof the portfolio.
361PETER J. TANOUS
Let’s consider three basic strategies, conservative, moderate, andaggressive. These will be generic in nature, allowing you to selectyour own stocks, funds, or managers, within the defined categories.We will “fine tune” your portfolio with a few subsequent adjustmentsto match your personal criteria as perfectly as possible.
First decision: Which strategy is right for you, conservative, mod-erate, or aggressive? Perhaps you already know. The answer is afunction of your time horizon and risk tolerance. Look, if you have15-to-20 years to go to retirement, you should lean toward the ag-gressive approach with your 401(k) and IRA strategy. On the otherhand, what is your emotional tolerance for market swings? Will adecline in your portfolio gnaw at you mercilessly? The reason this isimportant goes beyond concern for your emotional well-being. Thedanger is that if you get upset about market swings, you may makesome untimely, and possibly very bad, investment decisions. Of course,you, and perhaps your spouse, are in the best position to evaluateyour risk tolerance. Be very realistic about it. I can’t second guessyou on this subject.
On the other hand, if you have some gambling instincts, and youelect a super aggressive strategy even though your time investmenthorizon is only a few short years, take a deep breath and count toten. It is just plain foolish to try for aggressive growth, with its accom-panying risk, unless the odds are in your favor. It is time that tilts theodds in your favor. And, at the risk of beating this point to death, Iwant to instill in you that we are stacking the odds in our favor withour approach to wealth. We know what works and we know whatdoesn’t. By taking the known factors and the latest academic advanceson historic stock performance and combining that information withoutstanding Guru performance and strategies you can use, we willdo as much as we can to tilt the odds our way.
Here are the three basic strategies you can use:
362INVESTMENT GURUS
CONSERVATIVE &TRATEGY
Portro.ic ALLOCATION 3Passive
30% Yanguad Ghoywlh, 20% VYaluz,
40% Short term Bond Index
or 100% DFA Normal Balanced
Grow tt stacks
or Crowth stock candValue stocks
or “value stock fuidinieniucfioaal stoetcs
or International stock fund
 
This allocation will have the highest percentage of passive fundsand will include some short term bonds to reduce volatility. Thepassive funds give us the highest degree of confidence that our per-formance there will be in line with the historic performance of themarkets we are trying to clone.
363PETER J. TANOUS
MODERATE &8TR ATESY
Portroiic ALLS ETI RL BE
Passive
40% Vanguard Growsh 40% Value
2076 Short term Gond Index
or 120% DFA Strategy #2 40%
Grow th stocks
or Growth stock fund 20%,
Swialh Cep (diversified growth and value} 1098
Value stocks
or Value stock fund 20%
Intemational stocks
or Internaticnal stock fund 109510096
 
 
The differences between the conservative and moderate portfoliosare subtle. You will quickly see that the principal difference is theintroduction of the small-cap style. For our purpose, we will not tryto allocate the small-cap portion by value and growth as that is hardto do, since most small-cap managers are, in fact, growth managers.A diversified small-cap fund, or your own small-cap picks, will dofine. We also lowered the passive allocation in the moderate strategyas we will be trying for higher than market returns to a greater extentthan with the conservative strategy.
The aggressive strategy reduces the passive allocation to 25% ofthe portfolio. Even so, note the DFA passive Strategy #4 (figure 1) isactually quite aggressive, having shown returns over 19% for 20years. (This is not your father’s passive strategy!) We’ve also doneaway with the bond portion altogether. It’s not stability we’re after,it’s high octane performance. Our small-cap allocation is up to 30%of the portfolio. And note the subtle tilt toward value stocks (valueallocation is 15% versus growth 10%), since we know that valueoutperforms growth over time. Whether or not it does so with moretisk is still controversial. This portfolio will provide an intelligenthigher risk, higher reward trade-off.
364INVESTMENT GURUS
 
 
AGGRESSI V2 STRATEGY
Portro io ALLOGATION 96
Passive
o0% Yanguad Growth, 299) Yalus
or 100% DFA Strategy #4 25%
Grow th siooks
or Crovwth stock tand Lads
Svail- Cup (diversified gt ovth and value} 30%
Value stocks
or value stock fund 15%
Ditentational stects
or International stock fund 20%100%
 
 
Now we must tinker with our basic portfolios to adapt them to yourpersonal circumstances. You say, look, I know I want the conservativestrategy, so what else do I need. What’s to tinker with?
Here’s what I mean. We need to fine-tune the allocations withinthe strategies to adapt not only to your risk tolerance, but also toyour age, the time frame of your expected returns, and even the pur-pose of the funds. (Some things are postponable, i.e. that Ferrari youthink you need for your midlife crisis; others are not, like the kid’scollege education.)
365PETER J. TANOUS
CHANGE ADILETMENT*Consemvarve Mecoerate  AgsRessiveTime frame objective 3-5 yeas = 1 3 ZorTime frame obj. over 10 peass 2 dor5 Na chengeGreater usk tolerance 2 4 7Lesser rick tolerance 1 3 Zor 8
* ADJUSTMENT Revs
1 Inctease passive allosation Oy 10% te 15%. Reduce small-eap allocation by came amourt.
2 Consider basic moderate strategy.
3 Consider basic conservative stratezy,
4 Decrease passive allecation bry 10%, Increase small<ap alea-cation by 10%.
§ Consider basic aggressive strategy,
6 Inclease passive allocation by 10 ta 1o%, Add shert termbond allecation of same ameunt.
7 Decrease pressive allocation by 5%. Decrease value sockallecation by 595, Increase small-cap allocation by Is,
S 0 Inetease passive allecation hy 109. Mretease smali-cap alle-
cation by 10%,
 
 
Rebalancing v In any portfolio, the asset allocation is likely tochange over time. That’s because each of the asset classes you chosewill perform differently over time. For example, if the small-capportion of your portfolio has a terrific run, your allocation will tilttoward small-cap because there are now more dollars in small-capas a result of your gains. Your original 10% allocation may now be16% because it has gone up so much in value. What should you do?
What most portfolio managers do to correct these situations is thatthey periodically “rebalance” their portfolios. You should do this too.The process is simple enough. You sell the asset classes that haveperformed too well and increase those that have underperformed.Huh? You mean, we’re selling our winners and putting the moneywith the losers? It seems counterintuitive, doesn’t it? Well, maybe.
366INVESTMENT GURUS
But if your original asset allocation had a purpose, and it did, youshould stick to it.
How often should you rebalance? Most portfolio managers setparameters. For example, whenever your allocation changes by morethan 5% of the total portfolio, you rebalance. For example, if yourgrowth allocation is 20% of your portfolio, you would rebalance ifgrowth got to 25% or more of the portfolio. That could be becauseyour growth stocks did very well or your passive stocks did poorly.It could also result from another allocation doing particularly badly.In the latter case, the first thing you want to do is make sure that theunderperformance wasn’t due to a problem with the fund manageror with your particular stocks. If that is the case, first take care of theproblem. If the underperformance is simply due to a group being outof favor, then you proceed with the rebalancing by selling growthstocks, or shares in your growth fund, until the percentage is back to20%, the original allocation. The money from the sale would be addedto those areas where the percentage allocation had declined, and thereason for the decline was explainable and acceptable.
Semi-Annual Review v At least twice a year, look at your portfoliocritically. Perform the sort of review we investment consultants do.Ask these questions:
© Have my investments performed in a satisfactory manner?
© Were the appropriate benchmarks matched or exceeded? (Inother words, did my equity portfolio match the performance ofthe S&P 500? Or did my small-cap portfolio keep pace with anappropriate benchmark, like the Russell 20007)
¢ If an investment underperformed, what was the reason? If itis a mutual fund, was there a change in fund managers or fundobjective?
© Does the portfolio need rebalancing?
These portfolios show how combinations of excellence can resultin superior performance. What’s more, you don’t have to rely exclus-ively on the Gurus. A combination of intelligently chosen passiveand active strategies can do the job, too.
To construct your own portfolio, you need to follow some of thebasic guidelines we learned from the Gurus. By all means, use thefunds managed by the Gurus we interviewed. They have been around
367PETER J. TANOUS
and they will continue to be around, God willing. They have passedthe test of time.
Here’s the bottom line. Since you and I know that we can’t predictthe future, and since we also know that most superior investmentperformance occurs by luck, not skill, we must learn to distinguishtrue investment genius, the Gurus, from the rest. Our conversationswith the Gurus gave us insight into the qualities that set the Gurusapart. These are valuable lessons to learn.
In real estate, they speak of location, location, location. The invest-ment equivalent is persistence, persistence, persistence. In the absenceof a working crystal ball, we must make use of what has worked inthe past. Persistence means track record, and with track records, thelonger the better. Three, four, or five years of good performance maynot be enough. Ten years gets interesting, and twenty years evenbetter. The Gurus have passed the test of time. Passive strategies havealso passed the test of time, and, as we have seen together, the aca-demic advances in this area have been impressive. We can capitalizeon this knowledge by using combinations of active and passivestrategies, tailored to our specific circumstances and risk profiles.
Using these examples as guidelines, you can see how it is possibleto tailor a specific portfolio to your individual circumstances. Nowthat you know about style and size diversification, and the importanceof standard deviation to measure risk, you can confidently constructa personal portfolio. You know how to measure return against thetisk you are willing to take. So, having determined all these paramet-ers, you can start the building process by style, size, geography (inter-national versus domestic) and risk. Armed with this knowledge, youmay wish to seek the help of a financial advisor or broker to assistyou. Among other services, these individuals can help you withstandard deviation data, which is not easy to calculate and often notreadily available.
For my part, I truly hope you enjoyed and profited from the timewe spent together and especially our visits with the Gurus. There wereno secret recipes, no magic formulas, no miracle 10-step plans, justsound advice from the greatest minds in the investment business.What more could we ask?
Thanks for coming along. J hope our paths cross again.
368<|end|>