Thursday, 5 April 2007
Author Richard Ferri delivers what the subtitle of this compact (300 pages fairly large typeface) book promises: "the easy way to get started". It's a fine introduction that explains what asset allocation is and why it is so important to investment success for the average individual investor. It then shows in straightforward, practical terms exactly what to do, right down to listing the funds that one can choose to form a portfolio according to the asset allocation principles. The words I use to describe this book - "simple, practical and introductory" do not mean this is a dumbed down version or lacking in the theoretical grounding of modern finance.
Asset allocation is a very sure method for an average investor to ensure unspectacular but steady investment results with risk that is well managed through effective diversification. And it requires a minimum of time to maintain once the initial set up is done. As Ferri says: "Asset allocation eliminates the need to predict the future direction of the markets and eliminates the risk of being in the wrong market at the wrong time." (think technology stocks in 2001/2002) The fundamental concept of asset allocation is that different sorts of investment assets do not go up or down in sync. That property, and that property alone, allows one to combine those unconnected types of investments into a portfolio that both raises investment returns and reduces risk. That is true diversification, as opposed to the common misconception that merely having many stocks accomplishes diversification. The holdings required for real diversification and asset allocation, as it turns out according to Ferri, should include European stocks, Far East and Asian stocks, Canadian stocks (for natural resources), Emerging market stocks, US small company stocks, US total stock market, US value stocks, real estate and fixed income. Within the fixed income part of the portfolio, he recommends diversification as well, noting that this is often overlooked by financial advisers. Accordingly, he advises holding a combination of a total US bond market fund, US Treasury inflation-protected, US high-yield corporate bonds, Emerging market bonds and US municipal bonds. All of these stock and bond holdings he says are best obtained through low-cost index funds or ETFs, because of their market representativeness of the asset class, their savings on fees and their ease of re-balancing. What is reassuring is that in each case, he establishes through a review of the correlation of returns that there is indeed worthwhile non-correlation with other classes which creates a diversification benefit.
The book is structured into thirds. The first part lays the foundations and the principles that serve throughout - how risk works, how asset classes are determined, how diversification results from non- or negative-correlation, the importance of re-balancing. The second part examines each asset class mentioned above in turn, analyzes the correlation characteristics of each, including the possibility of alternative investments such as fine art, wine, collectibles. I very much like the fact that he addresses home ownership and finds it to be a worthwhile investment though he concludes that it cannot practically be part of an asset allocation investment strategy since one cannot re-balance when necessary by selling a part of one's house. The final third is devoted to discussing historical rates of return and variability/risk, building a portfolio adapted to one's real risk tolerance (as opposed to the over-estimate of risk tolerance most people apparently display when encountering a market downturn), dealing effectively with taxes, investment fees and financial advisers.
This is quite a complete book ... for US investors, for that is his audience. Canadian and UK or other non-US investors have to take the principles in hand and assume that the same kind of asset class relationships exist elsewhere. If I were to adopt his actual recommendations and invest mostly in US holdings, I would be incurring significant exchange rate risk of the Canadian dollar versus the US dollar. Mr Ferri only briefly notes the existence of such risk but does not recommend doing anything about it. Will re-balancing fix that problem? It would be better to see an explicit discussion and recommendation within the book.
Another recommendation that Mr Ferri does justify in a bit more detail but it could still do with more in my opinion is that re-balancing of the portfolio be done annually, as opposed to more or less often, or according to thresholds of departure from the target allocation percentages.
The presentation of the book is excellent. There are lots of helpful tables and charts, there are chapter summaries and key points, there are references and extra readings and a glossary of terms. The writing is clear, grammatical and engaging. Most useful of all and a great time saver, is a list of potential funds (from among the thousands available), at the end of each chapter.
Overall, this book could do the job perfectly well for a US investor. For Canadians and others, we need a "foreign" version, Mr Ferri but I still recommend it to everyone.
You can find another review of this book at the Chartered Financial Analysts Institute.
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