Studies show that portfolio policy and more specifically how an investor allocates their portfolio across stocks, bonds, and cash can be responsible for up to 90% of the volatility experienced and returns earned by an investor relative to things like individual stock selection and market timing. The big picture point is that investors should be thinking about why they own certain investment assets at all and how they fit together to support reaching their goals. As Bogleheads investment philosophy would posit, when preparing to invest, one should never bear too much or too little risk. Given, as we just said, a majority of the risk an investor can experience is tied to how they allocate their assets across stocks and bonds, this concept of portfolio construction becomes crucial to investing intelligently. Security selection sits downstream from the asset allocation decision.
Commenting on Commentary on Chapter 4
As Zweig reminds us, portfolio construction / asset allocation policies are not solely about the investments, it is very much about you, the investor. There is a financial mantra that is a riff on Socrates, that says ‘investor, know thyself’, hitting straight to the heart of one of the most overlooked areas of building an investment portfolio, you first have to understand what kind of investor you are, to better understand your own ability to stick to a plan when financial conditions and markets get difficult.
Before digging into thoughts on how an investor should determine the proportion of stocks, bonds, and cash they hold, Zweig via Graham detour slightly into what they see as the two main types of investors based more on personality traits than prowess. They offer up two ways to be an intelligent investor based on who you are, the first is what is called ‘enterprising’, this is the investor who does his own research, selection, monitoring to build up a portfolio, while the second he calls ‘defensive’, the investor who owns portfolios of funds that largely can run on autopilot. In short the distinction is about effort and emotion.
The rest of the chapter focuses on the concept of ‘defensive’ or ‘passive’ investing, beginning with the decision of how much you should invest in stocks. If you were hoping for a quick answer to this question, you won’t get it. Instead of providing an answer Zweig reviews several leading heuristics commonly discussed in investing circles, one being that investors should invest a percentage of their portfolio in stocks equal to 100 minus their age. Overall Zweig cautions that relying on factors like age misses the bigger picture Graham is trying to discuss, which is it’s about your financial and emotional ability to bear risk, to survive volatility, and the unexpected based on your needs.
Graham had suggested that an investor should never hold more than 75% of their portfolio in stocks and never less than 25% in stocks, with the driver being factors specific to your ability to control yourself during the inevitable vagaries of the market, or as Bogleheads would say: “Aim to select an asset allocation that lets you sleep at night, and avoid the destructive urge to sell out in a panic the next time the market plummets, then having to worry over when is the time to get back in. This leads to selling low and buying high, the exact opposite of prudent investing.” The more risk you can tolerate, the higher percentage of your portfolio can be allocated to stocks.
The rest of Zweig’s commentary on the chapter is devoted to providing the reader with an overview of some fixed-income securities, which I won’t cover here as I feel like it takes away from the central point of this chapter. The real wisdom Zweig leaves us with in this chapter is that “Graham’s distinction between active and passive investors is another of his reminders that financial risk lies not only where most of us look for it - in the economy or in our investments - but also within ourselves.”
When we return we turn to how the defensive or passive investors should think about filling up the equity/stock portion of their portfolio.
Until then:
“When you leave it to chance, then all of a sudden you don’t have any more luck.” - Pat Riley
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