Investing Rule 1: Know Thyself

By on Nov 21, 2011 in Asset Allocation, Investing | 7 comments

What’s Your Asset Allocation?

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I was fascinated by an article at Oblivious Investor entitled,  Why I Don’t Overweight Small Cap or Value Stocks. Mike cogently laid out the research that over time, value and small cap stocks have ourtperformed a broad based index fund. This is widely accepted information from Modern Portfolio Theory and is considered one of the market anomalies of the efficient market hypothesis. The efficient market theory purports that over time the stock market is generally efficient and that prices reflect all available information and revert to their fair value. This Efficient Market theory is the basis of the indexing approach to investing and states it is very difficult t beat the overall market returns.

Yet, the anomaly rebuffs the efficient market theory and shows that small cap stocks and value stocks, over decades, tend to outperform the overall stock market. Although this is so, there are long periods of underperformane of these asset classes as well. In spite of awareness of this research, Mike decides not to act on the overperformance of value and small cap stocks.

How the Small Cap and Value Stock Outperformance Impacts My Investing

Personally, after studying this research in my MBA program, I added an extra bent towards value and small cap ETF’s to my portfolio. I decided to add those asset classes to our asset allocation and purchased two low cost index ETF’s; one specializing in value stocks and the other in small cap stocks. I was well aware that although small and value stocks outperformed in the long term there were also long periods of underperformance. That doesn’t bother me, as I’m quite disciplined and don’t change my well thought out investing strategy easily.

What About Mike?

In his own words,

“If, however, you’re somebody who would start to doubt your choice–and potentially back out on it at the worst time–during a period of relative underperformance, you should think twice about implementing a tilted portfolio. And that’s the boat I’m in. For whatever reason, I’ve come to have a strong suspicion of anything remotely clever when it comes to investing.”

I was completely taken by his rationale.

In lieu of the possibility of a higher long term rate of return, Mike decided to create a portfolio in line with his self knowledge and investing comfort level. He understands his risk tolerance and is interested in sticking with a simple and clear cut investing strategy in line with his personality.

Very wise.

A Favorite Asset Allocation Site

For more ideas on efficient market influenced index fund investing, take a look at the Lazy Portfolio site. Paul B. Farrell of MarketWatch follows several passive asset allocation approaches and aptly names these portfolios the Lazy Portfolios. From the Margaritaville Portfolio with three holdings to the Aronson Family Portfolio of 11 funds, these all index fund strategies are aptly called lazy because once the money is placed in their respective funds, all you do is rebalance every 6 months or yearly and maintain the allocation.

I highly recommend checking out these portfolios if you are looking for an easy way to manage your investment dollars. This set it and forget it strategy beats most actively traded portfolios!

Finally, I was intrigued by Mike’s disclosure and his discipline to act within his own self knowledge.

How do you decide which investment approach to follow?

image credit; posarma

    7 Comments

  1. You make an excellent point Barb! Emotional investing is disastrous.

    During the dotcom boom, I remember one particular guy who refused to invest in the market, his rationale was very simple. He will invest only in what he knows and he said he understands CDs and interest savings better than stocks!

    Not saying one should ignore stocks, but knowing yourself is very important before following advice that’s out there.

    MoneyCone

    November 21, 2011

  2. Aside from trying to use the large asset classes, I include healthcare, biotech, and high tech. The proportions change over time depending on the market.

    krantcents

    November 21, 2011

  3. @Moneycone-If you can’t stand any volatility, then it’s best not to invest in the markets.
    @Krantcents-Sounds like you are targeting some potentially faster growing sectors.

    Barb

    November 22, 2011

  4. I find it interesting how so many people identify themselves as aggressive investors during the good times. Everyone is a “risk” taker when their portfolio is growing at an annual clip of 40%. You see what they’re made of when it drops 50% the next year.

  5. Barb, I range from very volatile (nano-cap resource stocks) to very boring (dividend) to ultra-conservative (cash). So the combination probably puts me somewhere in the middle.

    Good article, resources & commentary, by the way. I took a noodle around Market Watch, I hadn’t been there in some time.

    101 Centavos

    November 23, 2011

  6. Comfort level plays a big role in investing. Kind of like the portfolio that lets you sleep at night. If your money is keeping you up it’s time to change your strategy.

    JP @ Novel Investor

    November 23, 2011

  7. @Shawanda-You hit the nail on the head!!! No one really likes to see their assets decline in value.
    @101-Sounds like you definitely have some broad diversification! Yea, Marketwatch has some great stuff.
    @JP, Hey, I talk about the sleep at night portfolio in my book!!! It’s one way to determine your risk tolerance.

    Barb

    November 24, 2011

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