DeMuth:  The book describes a series of stages that investors might go through, starting with the usual portfolio of cats and dogs, going from there to a global portfolio of market index funds, to a portfolio of index funds with small additions to individual stocks and/or sector ETFs, and finally back to a portfolio of all individual stocks, but this time each chosen for its contribution to the total portfolio.  If done correctly, each of these can represent a progression over the preceding stage.  Our feeling is that most investors – including many professional investors – are not taking full advantage of Modern Portfolio Theory effects to increase risk-adjusted returns on a portfolio-wide basis.  Since Modern Portfolio Theory is usually dated to Markowitz’s dissertation in 1952, we talk about bringing people’s portfolios into the rock’n’roll era. 

One of the topics you discuss is that indexed investors are often not as diversified as they think.  Can you give some examples of how this happens?

DeMuth:  The book is about capturing the diversification benefit.  This is a free lunch, and most people leave it on the table.  Geoff Considine – a name I think advisors are going to get to know better – estimates that the diversification benefit is 2-3% annually on top of what is available even using market-wide index funds. 

My epiphany came when I was looking at a number of highly-regarded investment portfolios through the lens of the QPP Monte Carlo simulator (www.quantext.com).  This simulator lays out the inter-correlations among the component assets in a table.  What jumped out at me was that these portfolios all sounded diversified – they held things like total stock market index funds, foreign market index funds, emerging market index funds, small cap funds, value funds, etc. – but that in the end all these asset classes had correlations in the 0.80 range or higher with the underlying portfolios.  They held thousands of securities, but for all that – they were behaving as homogenous lumps.  They were, in fact, significantly under-diversified.  We called these the “glob” portfolios – shorthand for a great global glob of stocks.

With this as a starting point, we set out on a quest for assets that we could add that had much lower correlations, such that adding them in small quantities served to improve the portfolio’s risk-adjusted returns.  We didn’t foresee that the book would come out in the middle of a major market downturn, but we were pleased at how the portfolios held up.

I have posted two articles documenting the process: A Practical Demonstration of the Value of Portfolio Theory  and Global Giants and Diversifiers to Supercharge a Portfolio.

I should add that if advisors are going to get out in front of their clients in this regard, they will need to use a tool like QPP that offers forward-looking risk and return parameters.  It’s not going to happen by picking 5-star funds or stocks off some list.

Based on your experience in your investment advisory business, what are key risks with employing the supercharging strategy you advocate?  What are some of the issues you encounter when presenting this to your clients?

DeMuth: Honestly, I think the main risk is that an advisor might not implement this strategy and thereby saddle his clients with sub-par risk-adjusted returns.  I’m very fortunate in that my clients are a pretty sophisticated group so they got it right away.  I suppose they took it on faith initially, based on my track record, and then the results started to speak for themselves. I core out my client’s portfolios with Dimensional Funds, giving them a small/value tilt, and then add diversifiers to these. Certainly you would have to explain to clients how holding small quantities of riskier assets can actually lower the risk of a portfolio overall.    

Another risk is, as Korzybski said, the map is not the territory.  Monte Carlo models are not the same thing as getting next year’s Wall Street Journal today.  They can easily be over-tuned and used as magic number machines. “Instead of engaging in largely futile behaviors like judging risk tolerance, stock picking, frequent rebalancing, and market timing, advisors should focus their exertions where they add value: matching client investments to client goals, seeking low-expense investment solutions, maximizing diversification, and talking clients out of their own bad investment ideas (like selling out at a market bottom or chasing performance).“ Common sense has to prevail at all times in deciding investment allocations.  Instead of engaging in largely futile behaviors like judging risk tolerance, stock picking, frequent rebalancing, and market timing, advisors should focus their exertions where they add value: matching client investments to client goals, seeking low-expense investment solutions, maximizing diversification, and talking clients out of their own bad investment ideas (like selling out at a market bottom or chasing performance). 

All of this has implications for the investment advisor profession.  Instead of engaging in largely futile behaviors like judging risk tolerance, stock picking, frequent rebalancing, and market timing, advisors should focus their exertions where they add value: matching client investments to client goals, seeking low-expense investment solutions, maximizing diversification, and talking clients out of their own bad investment ideas (like selling out at a market bottom or chasing performance).  Ben [Stein] once thought to start a company where, for a mere 10 percent of the amount you were going to invest, he would talk you out of whatever you were planning to do.  Advisors who work in areas where they add utility will reward their clients many, many times over for the fees they have charged.

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