Asset Classes It is useful to think of three major asset classes - - PDF document

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Winning Investment Strategies

A Global Vision

Javier Estrada Winter, 2014

• 1. A Look Back
• Bringing it all together
• 2. A Look Ahead
• Some final thoughts

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Asset Classes

• It is useful to think of three major asset classes
• Stocks
• Essential in almost all portfolios / Provide upside
• It may be best to invest in diversified groups of stocks
• Bonds
• Essential in almost all portfolios / Provide protection
• Risk and return are relatively easy to assess
• Can also be invested in diversified groups
• Alternatives (Others)
• Do not use them for short‐term speculative bets
• Use them for their diversification benefits
• The strategic decision determines most of the

portfolio’s risk and return

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Financial Products

• Important distinctions
• Absolute performance (No benchmark)
• Active management (Absolute return funds / HFs)
• Higher costs than relative performance
• Their benefits for investors are far from clear
• Relative performance (There is a benchmark)
• Active management (Mutual funds)

 It is far from clear that they reach their goal consistently

• Passive management (Index funds / ETFs)

 Largely achieve their goal  Lower costs than active management

• It is critical to think about (the absolute/relative

performance and) the active/passive management proportions in the portfolio

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Essential/Underrated Issues

• Costs
• The most underrated variable in investing
• They can be visible or ‘hidden’
• Determine observed and expected return
• Lower costs are tied to higher return and lower risk
• Should be a top criteria when choosing funds
• The holding period
• Determines the risk of the assets in the portfolio
• All else equal, the longer the holding period, the

more likely is that a higher exposure to risk will turn into a higher return

• All else equal, the longer the holding period, the

higher should be the exposure to risk

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Complementary/Important Issues

• Alpha and beta
• Alpha is what active managers should deliver
• Alpha is elusive and expensive, beta is cheap
• Pay very little for beta, only pay for alpha
• The fallacy of growth
• Growth is only part of the investment story
• Valuation plays a critical role in this story
• High (low) growth may result in a bad (good)

investment (Focus on how much you pay for growth)

• Two well‐known (aggressive) tilts
• The size and value effects are pervasive
• Size and value tilts can be used to increase a

portfolio’s expected return (and risk)

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Portfolio Choice & Rebalancing

• Focus on two/three major asset classes
• The allocation to stocks and bonds is critical
• Liquidity decisions are ‘exogenous’
• Key variables
• Holding period and risk tolerance
• Tools
• Assess your ability to tolerate losses
• Asset allocation table
• Performance of some benchmark portfolios
• Online questionnaires
• Rebalancing
• A way to control the risk of the portfolio
• Rebalancing once or twice a year with a 5%

tolerance band is enough

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Reference Portfolios

• Some well‐known, easy‐to‐implement portfolios
• Discussion of observed performance
• No specific recommendation to invest in them
• Why, then?
• To consider possible, easy‐to‐implement portfolios
• To raise the issue of whether that (observed and

expected) performance is appropriate for you

• All model portfolios are not only easy to implement

but also have low costs

• Fees: They can be implemented with ETFs
• Time: Annual rebalancing
• Q: Does my portfolio have to be ‘complicated’? If so,

why? How is it better than a simple(r) portfolio?

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Behavioral Insights

• The bottom line
• We make mistakes both in life and when investing
• Those mistakes can be identified (Psychology)
• The negative consequences of those mistakes can

be predicted (Finance)

• Strategies can be devised to overcome the negative

impact on performance of those mistakes

• In short
• Know that you are not wired to be a good investor
• Know that you can (and will) make mistakes
• Put yourself on a leash!
• And remember, pick up a Behavioral Finance book

to learn more about this issue

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts

Managing your savings requires …

common sense and even ‘folk wisdom’

Set realistic goals Observe deviations and correct Be patient Be disciplined

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts – Warren Buffett

“If they’re not going to be an active investor, and very few should try that, then they should just stay with index

• funds. Any low-cost index fund. And

they should buy it over time. They’re not going to be able to pick the right price and the right time.”

(Fortune, 2008)

What advice would you give to individual investors?

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts – Warren Buffett

“By periodically investing in an

index fund … the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

(Letter to Shareholders, 1993)

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts

Professional athletes …

have two critical lessons for investors

The road to success can be pretty bumpy, pretty often, and for a pretty long time Losing is an inevitable part

• f investing

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts

The ‘sad truths’ of financial markets

(1) The higher the required return, the higher should be the exposure to risk (2) The higher the exposure to risk, the longer should be the holding period

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts – Carl Richards

“When it comes to investing, risk and reward are related. It’s as close as we get to a fundamental law in finance. If you want or need a greater expected return, you’ll have to accept more risk.”

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts

Implications (More ‘sad truths’)

(1) The higher the exposure to risk, the more patience the investor should have (2) The higher the exposure to risk, the more discipline the investor should have

Think how you seriously get healthy and in good shape

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts – Carl Richards

“We often resist simple solutions because they require us to change our behavior. And so we spend $40 billion a year on weight-loss programs and products rather than take the simple, do-it-yourself approach: consume fewer calories, burn more calories with exercise, or do both. We'd rather look for the magic bullet: something to save us from the day-to-day grind of simply doing the work that needs doing.”

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts

A Checklist

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts

The 8 Essential Steps

• 1. Define your goal
• 2. Determine your holding period
• 3. Assess your risk tolerance
• 4. Choose your asset allocation
• 5. Target annual fees
• 6. Choose active/passive proportions
• 7. Select financial products
• 8. Forget until periodic rebalancing

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts – Richard Branson

“There’s really nothing to it.

Start as a billionaire and then buy an airline.”

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts – John Bogle

“I wish I could assure you that

the investment strategy outlined ... is the best strategy ever devised ... I can't promise that. But I can assure you that the number of strategies that are worse is infinite.”

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Final Thoughts

Good Bad Good Bad

Outcome Process

Deserved Success Bad Break Dumb Luck Poetic Justice Deserved Success

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Javier Estrada Winter, 2014

Winning Investment Strategies Thank you!