I am not going to write a book review for Pioneering Portfolio Management, because many other qualified individuals have already done so, and this book is clearly a worthwhile read. What I am going to do is highlight the main points of the book that would be most applicable to average individual investors.
David Swensen is Yale’s chief investment officer and manages their endowment fund. An individual investor is not too different from an institutional investor, except that he works on a much smaller scale, isn’t sheltered from taxes, and has a finite lifespan. Both types of investors use the same three tools when making financial decisions: asset allocation, market timing, and security selection.
In allocating assets, diversification is key. Diversification is only meant to control risk, not increase return. Investing in multiple uncorrelated asset classes, each with the same risk factor and expected return, will decrease the collective risk factor while maintaining the same expected return.
This is Swensen’s basic formula for an individual investment portfolio:
- Domestic Equity 30%
- Emerging Market Equity 5%
- Foreign Developed Equity 15%
- Real Estate Investment Trusts 20%
- U.S. Treasury Notes and Bonds 15%
- U.S. Treasury Inflation-Protection Securities 15%
After choosing asset allocations, it is important to constantly rebalance your portfolio to maintain these allocations. Swensen recommends rebalancing more frequently with higher volatility assets. For stocks, rebalance daily (but remember that Swensen does not have to worry about tax liabilities). This emphasizes the contrarian approach to investing. Swensen strongly discourages momentum investing.
Where the market is efficient, there are no mispricings for active managers to exploit. Swensen asserts that in such markets, “Good results stem from luck, not skill.” Index funds historically offer better returns than mutual funds simply because they don’t have the active management costs.
Swensen does advocate some allocation into real estate and private and foreign equity. This is more difficult for an individual to directly access, but there are ETFs that track alternative investments.
Finally, trying to time the market is futile.