I loved Wes Gray’s book with Tobias Carlyle: Quantitative Value. I have been thinking about becoming a financial advisor and have been fooling around with different asset allocation models. Imagine my surprise and delight when I found out he had another book (with Jack Vogel and David Foulke) combining the three.
The book is a very easy read (especially when you skip over the all the studies/back testing) and the authors do a great job simplifying complex strategies and creating solutions for investors at various skill and risk levels.
While this post will serve as notes for me to return to, I always recommend reading the book yourself, which you can do here.
Problems with The Experts
- Successful experts must constantly acknowledge the potential for them to be wrong – this is very hard to do in practice.
- Experts typically focus on short-term results and complexity when they should focus on long-term results and simplicity.
- Simple models will typically defeat experts who are slaves to emotional issues. Human decisions are instinctual and heuristic-based whereas processes are calculated and analytical.
- The three main reasons experts fail in this way are: coming to different decisions with the same facts as the model, being overconfident and using story-based and not evidence-based decisions.
- Anchoring – Humans tend to rely too heavily on an eventually irrelevant piece of information, which is referred to as an anchor.
- Framing – The way information is presented (or framed) can evoke emotional responses that lead to different decisions.
- Availability Bias – The mind overvalues recent or easily recalled information.
- Physical State – Physical factors like if the expert is a morning or night person (or if they’ve had their coffee) affect decisions.
- Overconfidence – self-explanatory, this leads to experts using far more leverage or participating in far more risk than is appropriate.
How to Choose an Expert if you Must
- Fees – Find the effective all-in fee number and assure it is based on a percent of assets managed – not commissions on investment products purchased. Don’t pay more than 1% per year and lean toward not paying for investing prowess. Instead, pay for things like insurance, wealth planning and other bonus features.
- Access – Find out what the liquidity provisions are with the investment (is there a lock-up period, are there fees to get your money back) and lean toward more liquidity.
- Complexity – The more complex, the more opportunities to potentially screw up.
- Taxes – Look for advisers and instruments that are good at tax efficiency.
- Search – Consider the time and cost of identifying and monitoring managers.
Asset Allocation allows investors to gain exposure to different asset classes and reduce volatility and drawdowns. The book covers three different approaches and recommends the third:
- Yale Endowment model from David Swensen’s book Unconventional Success: 30% US stocks, 20% foreign stocks, 20% real estate, 15% inflation-protected bonds and 15% treasury bonds.
- William Bernstein’s portfolio from The Intelligent Asset Allocator: 25% domestic equity, 25% foreign equity, 25% small caps and 25% bonds.
- Meb Faber and Eric Richardson’s Ivy Portfolio: 20% US stocks, 20% foreign stocks, 20% real estate, 20% commodities and 20% treasuries.
There are five main buckets of techniques for risk management:
The book recommends using a simple moving average (buy when the price is higher than it has averaged over the past one year) and time series momentum (buy when the asset’s 12-month return is higher than a risk-free asset’s).
There are two simple models to pick securities: value and momentum. For value, pick stocks with a high EBIT/TEV yield (EBIT is earnings before interest and taxes, TEV is the amount it would take to purchase the entire company). For momentum, buy the top decile of stocks based on the past 6 or 12 months of returns.
To combine the two, either buy the top decile of high EBIT/TEV firms each month or split a stock portfolio 50/50 between the two strategies.
The DIY Solution
Start with the Ivy Portfolio, use the security selection tools for the stock portions and apply the risk management tools to each portion, holding cash when necessary.
Last note: Wes’s site Alpha Architect assists with all components of the strategy and is great for both financial advisors and individual investors.