Morningstar Advisor - August/September 2009 - 32

Gray Matters The minute you say that return to asset class X is going to be 10%, as a forecaster, I know that’s going to be wrong. The beauty of MPT is that I have some idea about how much uncertainty there is around the expectation of that forecast. Steven Fox Fox: Suppose for a moment that, in fact, the world is not normal. It has slightly fatter tails than standard deviation would allow you to believe. Question: How much weight do you want to put to that part of the outcome space in your portfolio decision, if instead of a one over six chance of there being a minus 8% return, it’s one in four? given a certain set of assumptions. Nobody knows what’s going to happen in the future. But I think we can make some fairly educated guesses and form some expectations based on good information. They may not always come true, but in the absence of anything else, I think we have to do that. Kaplan: Michael, with the models that Steven works with, asset-allocation weights explicitly come out of assumptions about expected returns, standard deviations, and correlations. You have a very different point of view on how to come up with asset-allocation weights. Falk: I’ve learned that the only thing forecasts do for you is that they make you wrong. So why not just avoid forecasting? Let’s start with diversification and the building blocks of a portfolio. We could all probably agree that there are six to 12 basic asset classes. Which ones you choose is the investment diversification selection. What’s the allocation or weighting of those selections? One choice would be to market-weight them, and another is one-over-N. People may know this as the “naïve diversification theory.” Equal-weight asset classes? You’re probably thinking, how did this guy get on this panel? reality is, I do not know which one is going to perform better in the future, and I do not want to regret making the wrong choice.” The man whose theory so many are following was a one-over-N man. That’s how I got on this panel! Kaplan: So Steven, what is it that you’re doing at Russell again? Fox: I’d argue that Michael is also doing forecasts. There is a view embedded in one-over-N that in the MPT space would come out as: Every asset class has the same marginal contribution to total portfolio risk. So you’d allocate equally across all those assets. The alternative to using MPT is not well specified. So you have to be very careful with assuming that, well, the model offers a horrible approximation. But it may be that it’s good enough, in the sense that you don’t want to strongly overweight low probability events. You might want to take a different approach to mitigating that type of risk. Falk: Which really goes to the other side of the one-over-N, which is it doesn’t have to be the complete portfolio. It can be within a core/ explore framework. In 1988, in an interivew for Money magazine, Jason Zweig asked Dr. Markowitz how he invested his retirement dollars. His answer was, “I have half of my money in stocks, and I’ve got half of my money in bonds.” Sounds like one-over-N to me. Zweig then asked Dr. Markowitz how he came to that allocation. Was it through a quadratic calculation? He said, “Jason, I probably should have done some form of calculation to decide my weights. But the But I also have to acknowledge that forecasts can be wildly wrong. The minute you say that return to asset class X is going to be 10%, as a forecaster, I know that’s going to be wrong. The beauty of MPT is that I have some idea about how much uncertainty there is around the expectation of that forecast. That’s where the concept of risk gets introduced in MPT. It’s standard-deviation proxies, both investor preference for risk and my uncertainty surrounding what I think the future is going to hold. You’re really a forecaster, Michael. Just admit it. Falk: As long as you remember that the standard deviation—which is a measure of uncertainty, not a measure of risk—only fits in if it’s a normal distribution. If it’s not a normal distribution, standard deviation has no merit in terms of the calculus. The core, 60% to 80% of the portfolio, is the one-over-N, or market. These are liquid, typical asset classes. Let’s start with the macros: domestic equities, foreign equities, U.S. Treasuries, U.S. corporate bonds, foreign bonds, commodities, and cash. If you want to throw real estate in there, feel free. But if you’re going to use active management instead of passive in the portfolio, just know your active managers are buying REITs at times, hopefully the right times. On the equity side, you can get more granular. U.S. equity can be large, mid, small. On the foreign side, you could do large and “smid”—because we don’t have a well-defined mid and small—and if you want to, throw in emerging markets. But if you’re using active managers, again, know they may use emerging in their portfolios. What we’re really talking about is six to 12 asset classes for core. The reason why I go a little more granular myself is because I do still hold regression to the mean near and dear, and I want a little bit more to rebalance with. The 20% to 40% explore is what I refer to as the TAIL: Tactical. Active risk tilting. Insurance. 32 Morningstar Advisor August /September 2009

Morningstar Advisor - August/September 2009

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2009

Morningstar Advisor - August/September 2009
New on MorninstarAdvisor.com
Letter from the Editor
Contributors
Are We at the Beginning of a New Small-Cap Era?
At Home Around the World
Staying Nimble
Investment Briefs
Asia's Way Forward
MPT Put Through the Wringer
Recession Rallies' Sweet Spot
What Makes Small Caps Tick
The Trick to Small Caps
Value Hound
Four Picks for the Present
Signs of Stabilization in the Housing Industry
The Not-Ready-for-High-Yield Players
Moats Around Small Castles
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks
Most Popular Variable Annuities
New at Morningstar
The No in Innovation
Morningstar Advisor - August/September 2009 - Morningstar Advisor - August/September 2009
Morningstar Advisor - August/September 2009 - Cover2
Morningstar Advisor - August/September 2009 - 1
Morningstar Advisor - August/September 2009 - 2
Morningstar Advisor - August/September 2009 - 3
Morningstar Advisor - August/September 2009 - 4
Morningstar Advisor - August/September 2009 - 5
Morningstar Advisor - August/September 2009 - New on MorninstarAdvisor.com
Morningstar Advisor - August/September 2009 - 7
Morningstar Advisor - August/September 2009 - 8
Morningstar Advisor - August/September 2009 - Letter from the Editor
Morningstar Advisor - August/September 2009 - Contributors
Morningstar Advisor - August/September 2009 - 11
Morningstar Advisor - August/September 2009 - Are We at the Beginning of a New Small-Cap Era?
Morningstar Advisor - August/September 2009 - 13
Morningstar Advisor - August/September 2009 - At Home Around the World
Morningstar Advisor - August/September 2009 - 15
Morningstar Advisor - August/September 2009 - 16
Morningstar Advisor - August/September 2009 - Staying Nimble
Morningstar Advisor - August/September 2009 - 18
Morningstar Advisor - August/September 2009 - 19
Morningstar Advisor - August/September 2009 - Investment Briefs
Morningstar Advisor - August/September 2009 - 21
Morningstar Advisor - August/September 2009 - 22
Morningstar Advisor - August/September 2009 - 23
Morningstar Advisor - August/September 2009 - Asia's Way Forward
Morningstar Advisor - August/September 2009 - 25
Morningstar Advisor - August/September 2009 - 26
Morningstar Advisor - August/September 2009 - 27
Morningstar Advisor - August/September 2009 - 28
Morningstar Advisor - August/September 2009 - MPT Put Through the Wringer
Morningstar Advisor - August/September 2009 - 30
Morningstar Advisor - August/September 2009 - 31
Morningstar Advisor - August/September 2009 - 32
Morningstar Advisor - August/September 2009 - 33
Morningstar Advisor - August/September 2009 - 34
Morningstar Advisor - August/September 2009 - 35
Morningstar Advisor - August/September 2009 - Recession Rallies' Sweet Spot
Morningstar Advisor - August/September 2009 - 37
Morningstar Advisor - August/September 2009 - 38
Morningstar Advisor - August/September 2009 - 39
Morningstar Advisor - August/September 2009 - 40
Morningstar Advisor - August/September 2009 - 41
Morningstar Advisor - August/September 2009 - What Makes Small Caps Tick
Morningstar Advisor - August/September 2009 - 43
Morningstar Advisor - August/September 2009 - 44
Morningstar Advisor - August/September 2009 - 45
Morningstar Advisor - August/September 2009 - The Trick to Small Caps
Morningstar Advisor - August/September 2009 - 47
Morningstar Advisor - August/September 2009 - 48
Morningstar Advisor - August/September 2009 - 49
Morningstar Advisor - August/September 2009 - 50
Morningstar Advisor - August/September 2009 - 51
Morningstar Advisor - August/September 2009 - 52
Morningstar Advisor - August/September 2009 - Value Hound
Morningstar Advisor - August/September 2009 - 54
Morningstar Advisor - August/September 2009 - 55
Morningstar Advisor - August/September 2009 - Four Picks for the Present
Morningstar Advisor - August/September 2009 - 57
Morningstar Advisor - August/September 2009 - Signs of Stabilization in the Housing Industry
Morningstar Advisor - August/September 2009 - 59
Morningstar Advisor - August/September 2009 - 60
Morningstar Advisor - August/September 2009 - 61
Morningstar Advisor - August/September 2009 - The Not-Ready-for-High-Yield Players
Morningstar Advisor - August/September 2009 - 63
Morningstar Advisor - August/September 2009 - Moats Around Small Castles
Morningstar Advisor - August/September 2009 - 65
Morningstar Advisor - August/September 2009 - Mutual Fund Analyst Picks
Morningstar Advisor - August/September 2009 - 67
Morningstar Advisor - August/September 2009 - 68
Morningstar Advisor - August/September 2009 - 69
Morningstar Advisor - August/September 2009 - 50 Most Popular Equity ETFs
Morningstar Advisor - August/September 2009 - 71
Morningstar Advisor - August/September 2009 - Undervalued Stocks
Morningstar Advisor - August/September 2009 - 73
Morningstar Advisor - August/September 2009 - 74
Morningstar Advisor - August/September 2009 - 75
Morningstar Advisor - August/September 2009 - Most Popular Variable Annuities
Morningstar Advisor - August/September 2009 - 77
Morningstar Advisor - August/September 2009 - 78
Morningstar Advisor - August/September 2009 - New at Morningstar
Morningstar Advisor - August/September 2009 - The No in Innovation
Morningstar Advisor - August/September 2009 - Cover3
Morningstar Advisor - August/September 2009 - Cover4
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