The Perfect Portfolio
In the early months of the COVID-19 Pandemic, I engaged in many of the same diversions as many of you such as binge watching Netflix shows and surfing YouTube. One of my favorite discoveries was a series of interviews by the MIT Laboratory for Financial Engineering called In “Pursuit of the Perfect Portfolio.” The program’s interviewers were Andrew W. Lo and Stephan R. Foerster, who have also co-written a book by the same title.
These in-depth interviews were with some of the pioneers of finance who developed the academic work of modern portfolio theory in the 1950’s, 60’s and 70’s, which underpin the entire field of finance today. The series included Harry Markowitcz, Eugene Fama, William Sharpe, Robert Merton and Myron Scholes. These are the names I remember from my text books in graduate school and also in trade papers known for their seminal work in the emerging field of financial economics. In watching the series, I liked being able to put faces to the names and hear the stories of how they developed the models of how investments and portfolios behave. They discussed the origins of the Efficient Market Hypothesis and the Capital Asset Pricing Model and other concepts that make up Modern Portfolio Theory.
Some like Paul Samuelson and Fisher Black were no longer living to give firsthand accounts, but clearly it was a small community centered mostly on a few graduate business schools like the Chicago School of Business, MIT and Princeton. They all seemed to have known each other and could tell the stories of the early days of financial theory.
You might recognize the names of some of the other people interviewed: Jack Bogle, Jeremy Siegel, Charles Ellis and Robert Schiller. They were either colleagues or students during that time period and have gone on to publish many bestselling books that have brought important knowledge to the masses. Many of the interviewees have won the Nobel Prize for their work. This was an enormous amount of brain power assembled for one series of videos.
Each interview ended with a question asking the featured person to describe The Perfect Portfolio. Each time I knew the answer before the question was asked. Nobody could offer The Perfect Portfolio because of course no such thing exists. The future is uncertain, so there is no way to know with foresight the outcome of future events. I would contend that we can’t even know The Perfect Portfolio in hindsight because any assessment made at a single point in time could be rendered premature by subsequent events. Besides, what is good for one person is not necessarily appropriate for another.
If they can’t tell you what constitutes The Perfect Portfolio, I certainly can’t either. Based on the interviews of the great scholars, I can tell you that if there was such a thing as a perfect portfolio, what characteristics it would have.
The Perfect Portfolio should not try to beat the market. Markets are not perfectly efficient, but they are efficient enough that it is highly unlikely that anyone can outperform the market after adjusting for risk and transaction costs. I don’t think any of these great minds would say otherwise. They created models to describe the way security prices behave. They are by definition estimates, not actual results. There is always unexplained variation – especially when you are dealing with human behavior. In hindsight, the models are not always accurate. The world is too complex with far too many variables to quantify in a few formulas. That said, the efficient market hypothesis does say that security prices encapsulate all known information. Without a crystal ball, there is no reason to think that assets are mispriced.
For example, a common stock is always priced based on all known information. Therefore, it represents the consensus view of its intrinsic value – encompassing the opinions of potentially millions of investors, many of whom are full time professional analysts. There is no reason to think a stock is anything other than fairly valued at any point in time. The price will not change unless new information becomes available. New information is the future, which we cannot know. The price already includes all of the positive things known about a company as well as all the risks. There is no objective reason to think that you can profit by finding undervalued stocks.
Attempting to beat the market entails effort, costs and potentially taxes. It doesn’t make sense to expend these resources if the markets are efficient. So, The Perfect Portfolio will not even attempt to beat the market - it will simply own the market. The best way to own the market is with index funds and passive exchange traded funds (ETFs). In doing so, you get the market return with minimal drag from the friction of expenses and taxes. You also save the anxiety of trying to guess the future – or worse yet – hiring someone to guess the future for you.
A corollary is that The Perfect Portfolio keeps expenses as low as possible. If no person can be expected to beat the market, it doesn’t make sense to spend money trying to do so. Again, index funds and ETFs provide access to the markets with minimal cost, thereby giving you almost all of the return that is available from the market. The Perfect Portfolio avoids giving a cut of the action unnecessarily to a middle man.
The Perfect Portfolio must be diversified. Diversification cannot eliminate market risk – which is the tendency for most stocks to go up and down together. However, diversification can eliminate single company risk. It would not make sense for the market to reward a single security risk, when it can be so easily eliminated through diversification. Sure, a person can get lucky and buy the right stock at the right time and look like a genius. In doing so at the time of purchase, they were taking on more risk than the asset was likely to return in benefits. In retrospect, a single bet might have worked out well, but it does not represent a good strategy.
Once again, the better strategy is to use index funds to diversify away all single security risk and garner the market return with an acceptable level of market risk. I would argue that diversification is an exception to the axiom in economics that there is no such thing as a “free lunch.” If you can get the same expected return with lower risk by using diversification, you are getting a free benefit.
The Perfect Portfolio should also be well balanced. This concept is similar to diversified, but not quite the same. Both relate to the concept of risk. Different asset classes carry different types of risk. For example, high beta stocks like technology and small cap stocks are considered to have greater volatility than defensive stocks like large consumer goods stocks or utilities. International stocks are pretty similar to US stocks in the aggregate, but their returns will vary quite a bit in any given time period. Ideally, an investor will build a portfolio by starting with well-balanced and diversified broad-based market exposure, and then adjust the weight of the asset classes based on their own fondness for the characteristics of each group. Judgements must be made by each investor in selecting types of assets to include in the portfolio and the amount of each. The Perfect Portfolio will embody good judgements by the individual based on their own personal circumstances and preferences.
Ultimately, The Perfect Portfolio must match the needs and risk preference of the investor. A portfolio that is right for a 25-year old investor just starting an investment program is probably not going to be suitable for a 65-year old near retirement. This is obvious, but even two different 65-year olds can have greatly different investment objectives and risk profiles. Some people want to draw more income, some prefer more growth. The ability to handle the inherent volatility is also quite personal. Some folks have more appetite for risk than others. To even approach being The Perfect Portfolio, each portfolio should be uniquely suited to the individual investor.
If you ask me to describe The Perfect Portfolio, my answer will be similar to those expressed by the pioneers of financial economics. I can’t tell you The Perfect Portfolio, but I can tell you the things that it would include. It should be low-cost, diversified, and well-balanced and match the individual’s personal situation. You aren’t likely to ever achieve The Perfect Portfolio, but if you learn these lessons you will certainly be much closer.