Efficient Frontier

William J. Bernstein
The Basics of Investing and Portfolio Theory
Efficient Frontier is aimed at investors who are familiar with the basics of finance
and portofolio theory. For those who are not, and wish to prse this area frther, the
following sggestions are offered!
Investing competence does not come withot some sweat. E"pect to pt at least as
mch time, effort and intellectal energy into this tas# as yo wold for a difficlt
college corse. For basic areas mst be mastered, in the following order!
$. %o mst ac&ire a wor#ing #nowledge of the natre, retrns, and ris# of varios
asset classes.
B. %o mst then ac&ire an appreciation of how varios assets behave in diversified
portfolios. This is called portfolio theory. The central concept of portfolio theory is
that of the 'efficient frontier.' This involves identifying the portfolio composition(s)
that provide one with the ma"imm retrn for a given degree of ris# (or alternatively,
the least amont of ris# for a given retrn).
*. %o mst then develop a coherent and well+defined personal strategy for the
allocation of yor assets among broad asset classes (i.e., foreign and domestic stoc#s
and bonds, small verss large, growth verss vale stoc#s, cash, real estate, precios
metals, etc.).
,. Finally, yo mst implement this strategy throgh the proper choice of investment
vehicles (individal stoc#s and bonds, mtal fnds). -ere are some simple portfolio
illstrations. They are not intended as recommendations!
.. /tone simple! 012 /3P 011 (4angard inde" trst 011) and 012 bonds (4angard
Bond Inde" Fnd.)
5. /lightly more comple" and diversified! 502 each /3P 011, bonds, small stoc#s
(4angard small stoc# inde"), and foreign stoc#s (one third each 4angard Eropean,
Pacific, and Emerging 6ar#ets Inde" fnds).
7. -ighly comple" and diversified! $ fi"ed mi" of 8./. stoc#s, bonds, and foreign
stoc#s from 95 above, pls foreign bonds, foreign small stoc#s, 8/ small vale
stoc#s, :EITs, precios metals, natral resorces, tilities, ;n# bonds, etc.
The following bibliography provides a start towards accomplishing the above goals.
These for boo#s shold be read in order!
.. A Random Walk Down Wall Street, Brton 6al#iel, <orton Pbl. (abot =.0 in
paperbac#).
5. Asset Allocation, :oger >ibson, Bsiness ?ne Irwin (abot =70).
7. Global Investing, :oger Ibbotson and >ary Brinson, 6c>raw -ill (abot =@1, also
available throgh Ibbotson $ssociates).
@. Value Averaging, 6ichael Edleson, IP* (=55.A0).
If yor time and resorces are limited, yo can 'get by' with the >ibson boo# alone.
8nfortnately, this is also the driest and least well written of the for. The other three
boo#s are actally &ite pleasant and interesting reads. There is alot of math in all
for, which can be discoraging. /imply ignore what yo do not nderstand. The
remainder will reward yo. $n appreciation of the dangers of growth stoc#s is
essential. $ good start can be had from a pamphlet from the Tweedy Browne mtal
fnd grop, What Has Worked in Investing. Those whose appetites have been whetted
can proceed to The Intelligent Investor (-arper and :ow) by Ben;amin >raham. If
yo wish a lcid e"planation of the mathematics of mean variance optimiBation, try
-arrry 6ar#owitBCPortolio Selection.
Investment competence is a lifelong learning process. It helps to sbscribe to some
periodicals. I highly recommend The Wall Street !ournal. This is a lot of reading, so
pic# and choose only what interests yo. The first section is an e"cellent national
newspaper, and the "our #one$ #atters wee#ly featre in the last section provides an
e"cellent review of investment techni&e. $lso, ;oin the $merican $ssociation of
Individal Investors and get a free sbscription to the AAII !ournal, which is another
valable sorce of general investment info.
$ few words are necessary concerning Do :#eyserCs Wall Street Week, the most
widely followed piece of financial media. To &ote Bernard Barch, 'something that
everyone #nows isnCt worth #nowing.' /tdies show that yor long term investment
retrns will be almost entirely dependent on yor allocation of assets among broad
asset categories. 6r. :#eyser instead concentrates almost e"clsively on stoc#
pic#ing and mar#et timing. To the nsophisticated investor this may seem sefl. In
fact, however, long term sccess in the former is rare, in the latter none"istent. It is
mathematically impossible for the thirty million viewers of this show to beat the
mar#et, since they are the mar#et. The same applies to %arrons& 'orbes& #one$&
(i)linger*s, and all newsletters. It goes doble for ,an ,orfman. ($s an
e"ample, 'orbes has a highly respected mtal fnd ran#ing system. 8nfortnately,
academic analysis has shown that the ftre performance of its best rated 'honor roll'
fnds is slightly less than average. To cite another remar#able e"ample, a recent
<ational Brea of Economic :esearch wor#ing paper analyBed the performance of
over 511 newsletters, and fond that none reliably beat the mar#et on a ris# ad;sted
basis, althogh many nderperformed it with astonishing reglarity, inclding one
which lost money at a 02 componded rate for over 51 years. This is a remar#able
accomplishment for the .AE@+A@ period.)
There is a wealth of ine"pensive and powerfl investment software available. For =AA
per year 6orningstar will provide yo with &arterly pdates of a program which will
allow yo to screen, sort, compare, ran#, and display mtal fnds sing doBens of
criteria. This program also provides a &ic# and easy way to follow the valations of
many foreign and domestic sectors, i.e, to determine whatCs cheap and whatCs
overpriced. (This is accomplished by loo#ing at the priceFboo# and priceFearnings
ratios of the 4angard Inde", ,reyfs Wilshire Target, and ,F$ foreign and domestic
small cap inde" fnds.) For a few dollars more they will also sell yo a program to do
the same with individal stoc#s. Dast, and most certainly least, is the web. It is
difficlt to comprehend how so mch garbage has fond its way into sch a small
corner of cyberspace. ,o not waste yor time. To be sre, there is a great wealth of
data ot there, bt this is not of mch se to the novice investor. ?ne of the fonding
fathers of modern portfolio theory, William /harpe, has both a fascinating homepage
and a nearly impenetrable te"tboo# in progress on the web. The only worthwhile
edcational piece ICve fond is Fran# $rmstrongCs Investing for the 21st Century.
This is a well written, highly entertaining, bt somewhat sperficial tor of basic
finance, portfolio theory, and in particlar the pitfalls of modern investing. It will
reinforce what yo get from the above sorces.