Investment Philosophy and Beliefs
Allied provides an advanced level of investment strategy and management. We combine several methodologies in order to offer what we feel is a "best of breed" approach. These methodologies include Modern Portfolio Theory, the Three-Factor Model, Fixed-Income Strategies, and the Institutional Approach. Together these four strategies help form our overall investment philosophy.
Modern Portfolio Theory
In 1990, Harry Markowitz, William Sharpe, and Merton Miller, three noted financial economists, who won the Nobel Memorial Prize in Economic Sciences for their work in developing Modern Portfolio Theory as a portfolio management technique. Modern Portfolio Theory has been successfully used to develop and manage investment portfolios for large institutions, as well as individual investors. There are four components to Modern Portfolio Theory.
- Investors inherently avoid risk. Investors are often more concerned with risk than they are with reward. Rational investors are not willing to accept risk unless the level of return compensates them for that risk.
- Securities markets are efficient. The "Efficient Market Hypothesis" states that financial markets are “informationally efficient”, or that the prices on traded assets already reflect all known information. Assets are re-priced every minute of the day according to the latest news. As new information enters the market, it is quickly absorbed into the prices of securities, and thus hard to capitalize on. Information technology advancements and increased investor sophistication will cause the markets to become routinely more efficient over time.
The implications of the Efficient Market Hypothesis are significant for investors. It implies that one should be deeply skeptical of anyone who claims to know how to "beat the market." One cannot expect to consistently beat the market by picking individual securities or by "timing the market".
The Efficient Market Hypothesis contradicts many traditional investment strategies. It has, however, been supported by numerous academic studies, both theoretical and empirical. These studies show, among other things, that the risk-adjusted returns achieved by professional investment managers do not outperform the market as a whole. This was primarily due to the expenses and taxes incurred with active management. That's the bad news. The good news is that the rate of return of the capital markets is relatively good (10%+ over time) - Focus on the portfolio as a whole and not on individual securities. The risk and reward characteristics of all of the portfolio's holdings should be analyzed as one, not separately. An efficient allocation of capital to specific asset classes is far more important than selecting the individual investments.
As the pie chart shows, your asset allocation can determine over 90% of the performance variation of your investment portfolio. How your investment dollars are allocated significantly outweighs the potential effects from individual security selection or market timing.
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Every risk level has a corresponding optimal combination of asset classes that have the highest expected returns possible. This is called the "Efficient Frontier". Portfolio diversification is not so much a function of how many individual stocks or bonds are involved, but the relationship of one asset’s behavior to another. We call this relationship "correlation". The higher a correlation between two investments, the more likely they are to perform in a similar fashion.
The efficient frontier represents the range of hypothetical portfolios that offer the maximum return for any given level of risk. Portfolios positioned above the range are unachievable on a consistent basis. Portfolios below the efficient frontier are inefficient portfolios, because for the same risk one could achieve a greater return. The ideal portfolios exists somewhere along the efficient frontier.
The portfolio represented by point A is inefficient because portfolios exist with the same value but less risk (Portfolio B) and portfolios with the same risk but more value (Portfolio C). The Efficient Frontier, as originally defined in Modern Portfolio Theory, is a line that represents the continuum of all efficient portfolios.
The Three-Factor Model
Most finance academics and the informed investment professionals acknowledge that there are three primary factors influencing equity portfolio returns:
- The exposure to the overall market (beta).
- The percentage invested in large company stocks versus small company stocks. Over time, small company stocks have higher expected returns than large company stocks. Since stocks of small companies are riskier than those of large companies, investors demand a premium for this additional risk.
- The percentage invested in growth stocks versus value stocks. Over time, value stocks have higher expected returns than growth stocks. Value stocks are those that sell at lower prices relative to their earnings and book values. They are perceived by investors to be riskier than growth stocks so investors demand a premium for this risk as well.
Fixed Income
Our firm believes that the role of fixed income in a portfolio is not to produce income, but to reduce volatility. Although there are exceptions, the best way to accomplish this is to employ the following strategies:
- Use shorter maturities (we prefer maturities under five years)
- Use high quality issues
- Use a variable maturity approach
- Use a diversified global approach while hedging currencies
Institutional Approach
Institutions have out-performed the average investor for a variety of reasons.
| Institutions Outperform The Average Investor | |
|---|---|
| Institutional | Average Retail Investor |
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These four methodologies combine to form our firm's "best of breed" investment philosophy. This philosophy shapes our asset allocation decisions, our fund choices, and the overall management of our clients’ portfolios.