The Intelligent Portfolio E-Book

Christopher L. Jones

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 669

Veröffentlichungsjahr: 2010

Beschreibung

The Intelligent Portfolio draws upon the extensive insights of Financial Engines--a leading provider of investment advisory and management services founded by Nobel Prize-winning economist William F. Sharpe--to reveal the time-tested institutional investing techniques that you can use to help improve your investment performance. Throughout these pages, Financial Engines' CIO, Christopher Jones, uses state-of-the-art simulation and optimization methods to demonstrate the often-surprising results of applying modern financial economics to personal investment decisions.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Foreword

Preface

Acknowledgments

Introduction

CHAPTER 1 - Now It’s Personal

A CHANGING WORLD

THE GRAND SOCIAL EXPERIMENT: 401 (k)

THE KNOWLEDGE GAP

THE TRADITIONAL ADVICE MODEL

INSTITUTIONAL TOOLS OF THE TRADE

CHAPTER 2 - No Free Lunch

I’LL TAKE THE ONE WITH THE HIGHEST RETURN. . .

A LITTLE BIT OF LATIN: EX-ANTE AND EX-POST

HOW ARE THE PRICES OF RISKY ASSETS SET?

THE LINK BETWEEN RISK AND RETURN

WHEN HIGH RISK DOES NOT MEAN HIGH RETURN

HIDDEN RISKS AND THE PESO PROBLEM

HOW MUCH RISK AM I TAKING?

RISKS AND RETURNS OF DIFFERENT ASSETS

DOES IT PASS THE BLUSH TEST?

CHAPTER 3 - History Is Bunk

HISTORY AND EXPECTED RETURNS

THE PAST IS NOT THE FUTURE

HISTORY IS SOMETIMES NOT WHAT IT SEEMS

INVESTING WITH PERFECT HINDSIGHT

THE LUCKY AND THE SKILLFUL

CHAPTER 4 - The Wisdom of the Market

THE EFFICIENT MARKET?

WHAT IS THE MARKET PORTFOLIO?

WHAT DOES THE MARKET PORTFOLIO LOOK LIKE?

THERE’S NO PLACE LIKE HOME

HISTORY OF THE MARKET PORTFOLIO

BETTING AGAINST THE MARKET

AVOIDING UNINTENTIONAL BETS

RISK AND THE MARKET PORTFOLIO

THE MARKET’S VIEW OF FUTURE RETURNS

MARKET PORTFOLIO SIMULATIONS

FINAL THOUGHTS

CHAPTER 5 - Getting the Risk Right

HOW TO MEASURE RISK

ASSET MIX AND SHORT-TERM LOSS

RISK AND PORTFOLIO OUTCOMES

RISK AND TIME HORIZON

FACTORS TO CONSIDER IN SELECTING A RISK LEVEL

EXAMPLES OF INFORMED INVESTOR BEHAVIOR

CHAPTER 6 - An Unnecessary Gamble

A DIFFERENT SORT OF BEAST

THE RISK OF INDIVIDUAL STOCKS

THE IMPLICATIONS OF INDIVIDUAL STOCK RISK

EXPECTED GROWTH RATES

THE BIGGEST MISTAKE IN RETIREMENT INVESTING

WHAT ABOUT MORE THAN ONE?

DO YOU FEEL LUCKY?

HOW TO INVEST IN STOCKS SAFELY

HIDDEN COSTS

DEALING WITH UNWANTED STOCK RISK

CHAPTER 7 - How Fees Eat Your Lunch

IT’S BASIC ARITHMETIC

BIG BUSINESS

FOR EVERY WINNER THERE HAS TO BE A LOSER

IT STILL ADDS UP TO DOLLARS

A WIDE, WIDE WORLD

HOW FEES EAT YOUR LUNCH

IT’S A HEAVY LOAD TO BEAR

FEES AND THE BIGGER PICTURE

PRACTICAL CONSIDERATIONS

CHAPTER 8 - Smart Diversification

THE GOALS OF DIVERSIFICATION

THE BIG PICTURE

WHY HIERARCHY IS BAD FOR PORTFOLIOS

THE VALUE OF ASSET CLASS DIVERSIFICATION

DIVERSIFICATION AIN’T WHAT IT USED TO BE

DIVERSIFICATION AND INVESTMENT CHOICES

THE BIG PICTURE: PART II

THE SEARCH FOR BETTER DIVERSIFICATION

CHAPTER 9 - Picking the Good Ones

THE STUFF THAT MATTERS

IT’S ABOUT THE FUTURE

RISK TOLERANCE AND FUND CHOICE

INVESTMENT STYLE

FUND EXPENSES

PREDICTING MUTUAL FUND PERFORMANCE

RATING FUNDS

PUTTING THE PIECES TOGETHER

WHAT IT TAKES TO RANK AMONG THE BEST

CHAPTER 10 - Funding the Future

THE BENEFITS OF BEING FLEXIBLE

TAXABLE AND TAX-DEFERRED SAVINGS

HOW MUCH DO YOU NEED?

FROM WEALTH TO INCOME

THE MYTH OF ABSOLUTES

RISK, TIME, AND SAVINGS

WHAT IT TAKES TO GET THERE

CHAPTER 11 - Investing and Uncle Sam

WHY YOU DON’T WANT TO MINIMIZE TAXES

HOW TAXES IMPACT INVESTMENT RETURNS

THE IMPACT OF PERSONAL TAX RATES

TAX EFFICIENCY OF ASSET CLASSES

ASSET PLACEMENT

MUTUAL FUND TAX EFFICIENCY

MUNICIPAL BONDS

CAPITAL GAINS AND LOSSES

PUTTING IT ALL TOGETHER

CHAPTER 12 - Wrapping it Up

CHAPTER 1: NOW IT’S PERSONAL

CHAPTER 2: NO FREE LUNCH

CHAPTER 3: HISTORY IS BUNK

CHAPTER 4: THE WISDOM OF THE MARKET

CHAPTER 5: GETTING THE RISK RIGHT

CHAPTER 6: AN UNNECESSARY GAMBLE

CHAPTER 7: HOW FEES EAT YOUR LUNCH

CHAPTER 8: SMART DIVERSIFICATION

CHAPTER 9: PICKING THE GOOD ONES

CHAPTER 10: FUNDING THE FUTURE

CHAPTER 11: INVESTING AND UNCLE SAM

Appendix - The Personal Online Advisor

Notes

Glossary

About the Author

Index

Copyright © 2008 by Christopher L. Jones. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

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Certain materials contained herein are covered by copyrights owned by Financial Engines, Inc. Additionally, certain methodologies described herein may be covered by patents held by Financial Engines, Inc. FINANCIAL ENGINES® and WE MAKE IT PERSONAL® are trademarks owned by Financial Engines, Inc., registered in the United States and other countries. All rights reserved. This publication does not constitute a license of or confer any rights to any intellectual property owned by Financial Engines, Inc., John Wiley & Sons, Inc., or the author, including but not limited to patents, trademarks, or copyrights. Third party marks are owned by their respective companies and no affiliation with Financial Engines, Inc., John Wiley & Sons, Inc., or the author is intended or implied. This publication is not intended to provide specific investment advice to any individual. Financial Engines Advisors L.L.C. is a registered investment advisor and subsidiary of Financial Engines, Inc. Investment results are not guaranteed by any party and liability is not assumed for any losses from the use of this publication.

Library of Congress Cataloging-in-Publication Data:

Jones, Christopher L., 1967-

The intelligent portfolio : practical wisdom on personal investing from Financial Engines / Christopher L. Jones.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-470-22804-3 (cloth)

1. Investments. 2. Portfolio management. 3. Investment analysis. 4. Risk management. I. Financial Engines (Firm) II. Title.

HG4521.J6632 2008

332.6-dc22 2007052402

For Barbara and our two wonderful kids (the best investments I’ve ever made), and to my parents for always providing a steady tailwind.

Foreword

When the idea of a personal investment book based on Financial Engines’ ideas and experience was first broached, the reaction was enthusiastic but guarded. Who could do the project justice? And who could find the time to produce a book that would be practical, approachable and sufficiently broad?

There was no question concerning the best choice. Christopher Jones has been the leader of the finance team at Financial Engines since the firm was founded. His ability to explain the most complex investment ideas and bring them down to earth was well-established. But what about the time required to complete such a project? “Not to worry,” he said. “That is the reason that we have evenings and weekends.”

The result—The Intelligent Portfolio—is before you now. And I am sure that the effort required many late nights.

His style is engaging. His thoughts are richly practical but firmly based in financial economic theory and rigorous empirical work. And most importantly, Chris dives deeply into the lessons learned over more than a decade by a large group of talented people dedicated to helping individuals make better financial decisions.

The investment world has changed—and keeps evolving—in a way that makes more and more people responsible for their own financial destiny. While defined benefit plans (DBs) once managed retirement savings for you, the new reality is that defined contribution plans (DCs) such as 401(k) are rapidly becoming our primary savings vehicles. The decisions you make with your DC plan can thus have a profound impact on your life.

Fortunately for you, the reader, this is not a book written by committee. Nor does it reflect a singular “official” position of Financial Engines. Rather it is the work of an experienced and talented investment professional, distilling his views of the key ideas and facts that any intelligent investor should know in order to invest and save sensibly. And is it a great read! Chris has managed to convey the essence of financial economics with nary an equation and to make the experience both fun and educational.

The Intelligent Portfolio emphasizes the lessons learned over decades based on financial research in both academic institutions and financial firms. But there is so much more here. The book draws heavily on insights gained by working with hundreds of thousands of individual investors struggling with important lifetime financial decisions. Financial Engines was founded to serve literally millions of people at a small fraction of the cost of existing comprehensive approaches. This ruled out consideration of any process in which key investment decisions are made by highly paid advisors based on instincts or gut feelings. Instead, it required a new and systematic approach to investment advice-one in which expertise is captured in algorithms used to generate personalized recommendations for investors. In pursuing this goal, tens of thousands of mutual funds and stocks have been analyzed in great detail, millions of portfolios have been simulated, and investment performance over time analyzed in exquisite detail. The book capitalizes on all this experience, bringing to the reader much that is new as well as much that is old.

Alright. But do you need to use the Financial Engines service to gain from reading this book? Of course not. The lessons it contains are fundamental principles of personal investing. One way or another, either you or your financial advisor need to know them, and there is a great deal to be said for plenty of overlap. It is, after all, your financial life.

If you are inclined to use the Financial Engines’ service, this book will equip you to get far more from the experience. It will explain why Financial Engines recommends diversification, lower cost investments, adequate savings rates, and how it offers you a personalized approach to reaching your own financial goals. It will also illustrate the tradeoffs between risk and return, the importance of making long-term financial decisions taking both risk and return into account, and the nature of the opportunities available to investors in financial markets. Finally, it will insulate you from those in the financial community who are eager to take your hard-earned money in return for promises that are literally too good to be true.

Read on and you will certainly become a more realistic and intelligent investor. Then you can get back to enjoying the rest of your life.

William F. Sharpe Palo Alto, California February 13, 2008

Preface

Investors should start with a view of skepticism.

—Arthur Levitt, former Chairman of the United States Securities and Exchange Commission (SEC)

When I was in high school, I had a rather colorful American history teacher. A compact man with closely cropped gray hair and a decidedly Hemingway-esque demeanor, Mr. Ryan was, in the best sense of the word, a skeptic. In our classroom discussions, he quickly established a reputation for questioning assumptions and challenging conventional wisdom. He pushed us to expose sloppy thinking—especially our own—and not be afraid of challenging views that were widely held and espoused. Though I picked up a good bit of history in that class, the most vivid lesson had nothing to do with the Founding Fathers or the Louisiana Purchase. Mr. Ryan’s passionate belief was that the most important skill in life you can develop is the ability to think critically, though in truth he had a slightly less genteel way of phrasing the point.

Mr. Ryan’s lesson has stuck with me through the years and remains one of the most important things I learned in school. Time and time again in my career I have been reminded of the merits of a healthy dose of skepticism when it comes to evaluating financial decisions. Whether in the boardroom or around the kitchen table, being willing to question assumptions and not be distracted by irrelevant or misleading information is a highly valuable skill, and sadly one that is not developed often enough in our schools. Far too often, we fall prey to having our attention focused on the inconsequential rather than the essential. Through modern media and advertising, we face a veritable blizzard of useless information vying for our attention. Keeping track of the truth through such a haze of falsehoods, minutia, pretensions, and misdirection requires considerable energy and diligence. And nowhere is the impact of critical thinking more pronounced than in the investing world, where it can make the difference between success and outright disaster.

Since most of us do not try to become self-educated authorities in every aspect of our lives, we seek advice from experts. In working with such experts, including those who fix our teeth, service our cars, and prepare our taxes, we walk the fine line between knowing enough to stay out of trouble, and wasting time and energy on things that we don’t really need to learn. However, the perils of making big mistakes or being led astray by phony wisdom are particularly vivid when dealing with decisions about your money.

If you spend any time at all on the subject of personal finance, your skeptical eye will have noticed the deluge of claims that you can beat the market, generate millions of dollars in quick rewards, impress friends, and look better in a bathing suit, all by following a few simple investing rules. Most would correctly view such claims with a healthy dose of doubt, if not outright derision. Putting it mildly, there is a lot of dumb advice out there when it comes to investing. If fact, many of the most important ideas from financial economics, promoted by popular media and advertised by financial services firms, are distorted or misused in order to sell more products and services. Things that you hear about the most (such as past performance) are often among the least important factors in making good investment decisions, while aspects that are crucially important (like fees and expenses) are often hidden from view.

As with many things in life, a good strategy to use when you lack experience is imitation. Want to learn how to make better investment decisions? Look at how the most skilled and experienced professionals invest the billions of dollars in their care. Methods used by multibillion-dollar institutional investors are directly applicable to the decisions faced by individual investors (albeit with differences in the way the problems are framed). Moreover, so are the results. Today the technology exists to perform the same analyses on your investments that institutional investors used to pay hundreds of thousands of dollars to carry out—and accomplish the task in a few minutes. What does this analysis do for you? It helps you understand how different decisions affect possible future outcomes and how to structure portfolios that will improve your odds of success. So-called outcomes-based investing can be a revelation for those faced with difficult choices. The key to good investment decisions is making informed choices. Life is unpredictable. That might sound like a cliché tagline from an insurance commercial, but it really is true. We do not get to pick which future we will live through, but we can structure investment strategies that contemplate the full range of possible outcomes.

For the past 11 years, as a founding employee and head of investment management for Financial Engines, I have been in the unique position to both witness and participate in the migration of institutional investing techniques to the world of individual investors. Financial Engines has been a pioneer in bringing the best of financial economics and institutional money management to everyday investors through independent and personalized advisory and investment management services. The creation of these services required significant insights into how the best practices from academic and institutional finance could be applied to the needs of individual investors—insights that I will now share with you.

What you need to know to make good investment decisions can be distilled down into 10 basic concepts:

• Recognize the linkage between risk and reward

• Avoid being deceived by history

• Leverage the wisdom of the market

• Select an appropriate risk level

• Avoid the perils of stock picking

• Don’t spend too much on investment fees

• Diversify intelligently

• Select funds using relevant forward-looking criteria

• Understand how to realistically fund financial goals

• Invest tax-efficiently

Each of these concepts is explored in the chapters that follow. Some of these ideas will seem like common sense, some will seem counterintuitive and surprising; all of them are important in making good investment decisions. This book builds from some basic intuition on how financial markets function, to practical tips on evaluating trade-offs, to real-world advice on selecting investments, building portfolios, and maximizing the chance of reaching your financial goals. If you learn and follow these principles, you will become a better investor as well as a better judge of whether you are getting good advice. The half-truths, shoddy thinking, and bad advice you regularly encounter in the investing world will become that much more apparent—and that much easier to avoid.

I first began mentioning to friends and family that I was considering writing a book on personal investing in the winter of 2006. The reaction was usually an enthusiastic thumbs up, but I could not help wondering if they were secretly harboring thoughts more along the lines of “Oh boy, another personal finance book . . .” By my informal count, there have been about a million books published on the topic of investing. Second only to cooking and getting men and women talking to each other, few subjects seem to enthrall prospective authors like investing. When I began my research for this book, I went out to my local bookstores and surveyed the genre. With a few notable exceptions, what I found was that most personal finance books come in one of three basic flavors. First there are the engaging concept books—filled with witty anecdotes about people using the concept (such as value investing, commodities trading, or real estate speculation) to get rich and achieve Zen-like peace. While this category of book can be a fun read, like a meal of stir-fry vegetables, you often find yourself hungry again after only a few hours. When you are done, there remains that disquieting feeling of “what did I really get from this?”

Next are the personal finance potpourri books, filled with every manner of charts, tables, statistics, and investing minutia you can imagine. These volumes take a throw-the-spaghetti-against-the-wall-and-see-what-sticks approach to financial education. The appeal here is to the hard-core do-it-yourself investors; those who find comfort in memorizing IRS contribution limits and understanding the finer points of municipal bond credit ratings. Although chock full of information, drawing actionable advice from the pages of such books is left as an exercise for the reader.

Finally there are the academic books, which contain interesting and valuable information, but where the use of advanced math and financial jargon put the conclusions out of reach for all but the most determined readers. Reminiscent of a formal 10-course French dinner, it takes an adventurous palette, a big appetite, and considerable endurance to get the most from the experience. Unless financial economics is your passion, chances are most of these books never make it to your nightstand.

What seemed to be missing from the personal investing genre was a book that distilled the most important intuition from modern financial economics down to a few key ideas and then combined it with practical advice on how to make better investment decisions. How do you identify the most important factors in determining investment success? How do you judge what is valuable advice and what is pure baloney? And how do you come up with a successful investment strategy when the future is uncertain?

Another profound frustration with the personal finance genre is that all too often the material stops just short of giving people the information they need to make actual decisions. Generalities are all good and fine, but what should you actually do? Investment advice, like finding your significant other, is a highly personal affair. Differences between individuals matter a lot. With this truism in mind, Financial Engines has agreed to waive the fees for a 12-month subscription to its award-winning Personal Online Advisor service for purchasers of this book, so that you can apply the ideas presented here to your own personal circumstances. Any book, with its limited length and static content, can only go so far, but an interactive investment advisory service can provide that final crucial step of connecting abstract ideas with real-world circumstances. While you don’t need to use the Personal Online Advisor service to get value from this book, I hope that you will find it to be a helpful and enlightening resource.

My goal in writing this book was to provide you with the literary equivalent of meatloaf—a compact, but rewarding meal that sticks to your ribs (apologies to vegetarians for the choice of metaphor). I will illustrate what really counts in making personal investment decisions through simple explanation of powerful ideas and bringing them to life with real-world examples from my experience with Financial Engines clients. I’ll introduce you to some of the secrets that institutional investors have known for decades, but where most individual investors are still in the dark. Consider it a crash course in financial critical thinking.

Writing a book that imparts useful knowledge in an easily digested manner is difficult. Accomplishing this goal while creating an engaging read that you would not be embarrassed to be seen reading on the beach is a daunting goal indeed. I hope that you find this book to be interesting, enlightening, provocative, and at least occasionally entertaining.

To paraphrase the famous satirist Ambrose Bierce, I trust that you will not find that the “covers of this book are too far apart.”

Acknowledgments

With any project of this magnitude, the list of people who contributed in meaningful ways becomes rather lengthy. Certainly this book was no exception. I could not have completed this work without the noteworthy efforts and support of many friends and colleagues.

I owe a great debt of gratitude to William Sharpe, whose mentorship over the last 11 years has been a profound learning experience. Bill’s insights and practical wisdom are well represented throughout the pages of this book, though I must take sole responsibility for any errors or omissions. In addition to Bill, I have had the good fortune to work with an amazing team of colleagues who have helped build Financial Engines over the last decade. I owe special thanks to the Financial Engines Executive and Investment Management teams for providing me with the flexibility to complete the book in a timely manner, despite the many demands of a challenging day job.

Many people contributed their time, analysis, suggestions, and ideas to the material found here. In particular I would like to single out Brenda Ayres, Geert Bekaert, Scott Campbell, John Choi, Peter Cohn, Melinda Deutch, Asma Emneina, Kenneth Fine, Tim Gallagher, Irene Gitin, Steven Grenadier, Joseph Grundfest, Michael Hahn, Garry Hallee, Wei Hu, Brandon Kirkham, Helen Kuo, Sylvia Kwan, Richard Lipes, Jeff Maggioncalda, Gavin Noronha, Greg Pallas, David Ramirez, Jason Scott, Jim Shearer, Ray Sims, Gregory Stein, Anne Tuttle, Patricia Wang, John Watson, Robert Young, and my parents Douglas and Jerilyn Jones for their contributions, counsel, encouragement, and assistance of many kinds.

I would also like to thank Bill Falloon and the team at John Wiley & Sons, including Emilie Herman, Kevin Holm, and Michelle Fitzgerald, for their help in making this book a reality. Bill’s persistence and energy in bringing the project to fruition were extremely helpful, and his good-natured badgering to keep things clear and simple was sound advice (hopefully largely successful). Caroline Pincus also provided very helpful copyediting assistance throughout the project.

Finally, I would like to thank my wife Barbara and our two incredible kids for putting up with the enormous amount of time and energy devoted to this project. Their unending support and generous patience made this book possible. And my wife’s careful and diligent editing made it a much better book than it would have otherwise been.

I hope that this book provides a measure of illumination to those who find themselves traveling the often poorly lit road to financial security.

Introduction to Financial Engines

Spring comes suddenly to the campus of Stanford University, located about 30 miles south of San Francisco, as the lingering rains and chill of winter suddenly give way to a seemingly unending string of sunny warm days. The spring of 1996 was a particularly auspicious time in the Silicon Valley. Just six months earlier, a little-known start-up company named Netscape had burst into the public consciousness with a record-setting initial public offering, igniting a digital gold rush like the world had never seen. Everywhere new Internet companies and business plans were sprouting like weeds. Where previously students at Stanford competed for high-paying consulting and investment banking jobs, attention now focused on which Internet start-up to join. The arrival of the Internet, it seemed, had changed everything. In the midst of all this frenetic commotion, two friends met, as they often did, in the faculty lounge on the Stanford campus. Bill Sharpe is a kindly, some say grandfatherly man with a trademark goatee and lively eyes. Bill won the Nobel Prize in economics in 1990 for his pioneering work on the theory of financial economics, including how prices of financial assets are determined and the link between risk and return. Unlike a number of similarly accomplished Nobel laureates, Bill gracefully avoids the problem of too much ego for one person. But Bill’s ability to intuit simple solutions to complex problems and then explain them in plain language is unparalleled in financial economics. Far from being unapproachable, Bill has always worked hard to make sure his ideas are both practical and useful in the real world. In the spring of 1996, Bill was looking for a way to apply his ideas, developed over decades of working with institutional investors, to the increasingly large group of individual investors in need of help with their retirement investments. The catalyst for moving these ideas from the academic world to the realm of individual investors came in the form of a one-man dynamo named Joseph Grundfest. Joe is a good friend of Bill’s, a professor of law at Stanford University and a former commissioner of the Securities Exchange Commission (SEC). Joe is also widely regarded as one of the nation’s top experts on securities law. He is also one of the most energetic guys you will ever meet—ideas don’t just trickle out of Joe, they burst forth like a broken fire hydrant.

The topics of conversation that morning were some tools that Bill had recently posted to his personal web site. Bill, a lifelong computer enthusiast, had immediately been struck by the opportunities afforded by the Internet to make information easily available to people all over the world. In the spirit of helping teach others about his passion, he had recently been adapting programs from his work in helping pension funds with their asset allocation decisions to allow individuals to experiment with the techniques on his personal web site. As Bill related the capabilities of these simple but powerful programs, it became clear that many people could benefit from access to such financial tools. Bill was initially planning to put the models up on a free web site where anyone could access them. The problem was that few people were comfortable enough with the technology to get very far on their own. Reaching a broader audience would require a different approach.

Rather than being content to pursue the project as a purely academic exercise, Joe began to sell Bill on the idea of starting a company to develop and promote the tools so that they could be used by average investors to make better investment decisions. At first, Bill was reluctant to seriously consider the idea, as his passion is academic research, not the grind of daily business management. But Joe is a very persuasive guy, and soon convinced Bill to meet with another friend, Craig Johnson, a well-known lawyer and venture capitalist to discuss the possibility. Craig immediately perceived the opportunity to leverage Bill’s work to help the growing tens of millions of individual investors who were struggling with investment decisions in corporate retirement plans.

In the conversations that followed, the three men decided that a company was needed to take the best practices from the institutional world and academic finance and make them widely available to individual investors facing the ever-increasing burdens of managing their own investments. A few months later, in May of 1996, a new company was born—Financial Engines—with the goal of bringing the benefits of modern financial economics through personalized advisory and management services to everyone, regardless of their wealth. Soon the three cofounders hired a CEO for the new firm in the form of an energetic Stanford MBA graduate named Jeff Maggioncalda. A couple of months later, Jeff hired me to build and manage the team of financial experts needed to develop Bill’s ideas into tangible products. Delivering on Bill’s vision would take the enormous efforts of hundreds of talented employees in the years that followed.

Today, Financial Engines is a leading provider of independent investment advice and portfolio management services to millions of individual investors at hundreds of America’s largest companies. The company provides services to more than 6.8 million employees, including workers at more than a hundred Fortune 500 companies. In addition, as of December 31, 2007, Financial Engines managed more than $16 billion in defined contribution assets on a discretionary basis for individual investors in defined contribution plans. The company works with many of the nation’s largest 401(k) providers, including Vanguard, Fidelity, JPMorgan, T. Rowe Price, ACS, Mercer, Hewitt, and CitiStreet.

Financial Engines pioneered the use of sophisticated Monte Carlo simulation with individual investors by building advanced financial expertise into software so that high-quality, personalized analysis could be provided to individual investors at a tiny fraction of the costs that institutional investors pay. The company was also the first to offer comprehensive taxable investment advice online to individual investors. Through its award-winning Personal Online Advisor service, the company has brought institutional-quality investment advice to investors of all wealth levels. Beginning in late 2004, Financial Engines introduced a discretionary portfolio management service, the Personal Asset Manager program, for those investors who wish to delegate the responsibility for managing their 401(k) plan to an independent expert. As of the end of 2007, the company managed portfolios for more than 225,000 investors representing more than $16 billion in assets.

From its inception, Financial Engines has been an independent, federally Registered Investment Adviser and does not receive compensation based on the investments it recommends. The company only receives fees from the advice it renders, and is free from conflicts of interest with the customers it serves. This independence ensures that its recommendations are in the best interests of each investor. Today, more than a decade after the founding of Financial Engines, Bill Sharpe’s vision of providing independent, high-quality investment advice and portfolio management to millions of investors is well on its way to being fully realized.

CHAPTER 1

Now It’s Personal

The future ain’t what it used to be.

—Yogi Berra (1925-)

Over the last few decades, there has been a profound shift in investment responsibility - away from the professional institutions that traditionally manage financial assets and right into your lap. Today, tens of millions of people are faced with making personal investment decisions that will have a big impact on their future quality of life - but only a few feel like they know what they are doing. This shift in responsibility is not simply the result of some cyclical government policy change or a conspiracy among big corporations to avoid funding retirement for their employees, but rather it is a necessary response to a global population that is rapidly aging. In the future, whether you like it or not, you are going to be responsible for managing your retirement investments. The good news is that within the last 10 years, changes in technology have opened the door to the widespread use of modern financial economic methods in personal investing. For the first time, it is possible to apply the same rigorous techniques used by the largest institutional investors to personal investment choices. In this chapter I explore these techniques, how they became available to individual investors, and how they enable a powerful new way of looking at personal investment decisions—outcomes-based investing.

How the heck did we end up here?

Since when did it become accepted that truck drivers, marketing analysts, lawyers, bakers, computer programmers, dentists, and teachers should all become expert investment managers? Who decided that we all need to become well-versed in mutual fund selection and dealing with the impact of investment risk? I don’t recall voting on this, do you?

If you are reading this book, chances are that you have at least a passing interest in becoming a better investor. For some people, the subject of investing is a passion or a hobby, for others it is more of a reluctant obligation - like cleaning the house. The reality is that we now live in a world that expects everyday people to understand a great deal about investing. Expectations go far beyond how to balance a checkbook or apply for a credit card. Today, virtually everyone over the age of 18 is expected to understand concepts such as the value of compounding, progressive tax rates, the differences between equities and bonds, and the benefits of tax-deferred savings. Those who do not bother to acquire this knowledge are roundly criticized by TV commentators, newspaper editors, and personal finance gurus for being dangerously out of touch. The era of the self-directed investor has truly arrived - even if most of us were not ready for it.

Unfortunately, investing is a sprawling and complicated subject, rich with intimidating jargon and numerous conflicts of interest thrown in for good measure. It is no surprise that many people approach investing decisions with a sense of dread, or at least acute anxiety. Why do I have to make all these investment decisions? Generally speaking, I am not expected to diagnose the strange knocking sound coming from the hood of my car on my own, nor am I presumed to figure out the origin of a blotchy rash on my son’s back without expert help. Somehow, when it comes to investing, the prevailing opinion seems to be that you need to be educated enough to make good decisions on your own. But most people have better things to do with their lives than to become self-educated investment experts. And so, here we are, with tens of millions of individual investors directing how trillions of dollars of retirement money is invested, and bearing the consequences of those decisions for better or worse.

But why? Is this really the best way to make sure that we retire comfortably? It turns out that the dramatic movement towards more individual responsibility in retirement investing has its roots in a more fundamental and irreversible trend - we are all living quite a bit longer than we used to.

A CHANGING WORLD

Sixty years ago in the United States, things were a bit different. Back then, there were fewer decisions left to individuals. Mostly such choices were out of your hands. In the past, retirement was based on the concept of a three-legged stool, represented by family, government, and the employer. For much of recorded history, the most important leg of the stool (and often the only one) was your family. It was generally accepted that when you got old, your kids or extended family would take care of you (assuming you had any and that you had been nice to them). This was generally not an undue burden, as families were larger and most relatives tended to live in close proximity to one another. Moreover, retired people did not typically live that long after they stopped working. You might find it hard to believe, but for a male born in 1900, the National Center for Health Statistics reports that the average expected life span was only 48 years. Often, people would simply work until they were no longer able to continue on. Of course, things are a bit different today. Families are smaller and often spread out across large geographic distances. We are also living much longer. By 2003, the average 65 year-old woman in the United States could expect to live an additional 20 years. Moreover, steady advances in medical technology continue to increase average life spans. With earlier retirement dates, and longer life spans, retirement is now often measured in terms of several decades, not years.

In the summer of 1935, another leg of the stool was added—Social Security . With Franklin Roosevelt’s signing of the Social Security Act, the U.S. government would provide a safety net for those in retirement of a lifetime guarantee of income. Social Security was a monumental change in public policy, and is one of the enduring legacies of the modern welfare state. When the system was created, however, there was a large working population paying into the system to support a relatively small retired population. Now, with the aging of the baby boomer population, the system’s finances are under strain. Under current course and speed, either benefits will have to be reduced or payroll taxes will have to be significantly increased (or both) in order to fund the promised benefits, due to the growing population of retirees. Reaching such a political compromise has proven to be a difficult task in recent years, and so the magnitude of the funding problem continues to grow. Of course, this stalemate has potential serious consequences for taxpayers like you and me.

The third leg of the retirement security stool (at least in the last 50 years or so) was the employer. For those lucky enough to work for large companies, defined benefit (DB) plans often provided generous guarantees of retirement income, if you stuck with your employer sufficiently long. A DB plan provided employees with a guarantee of future retirement income funded from a pool of assets managed by the employer (usually without any input from the employees). The money was professionally managed on the employees’ behalf, and if the markets went down, the company made contributions to the plan to insure the benefits were appropriately funded. If you were part of such a plan, all you had to do was show up to work each day for 30 years or so, and you were often comfortably set for retirement. However, even in their heyday, defined benefit plans were not available to everyone. It is estimated that only about a third of people over the age of 55 receive any form of pension income.1 In many situations, employees failed to qualify for any DB income because they changed jobs before they became eligible for the plan, or the companies they worked for simply did not offer such pension benefits. In the most recent generations, the availability of DB pension plans for new employees has declined dramatically.

Why are DB plans going away? One significant factor is the fact that people in today’s economy tend to change jobs frequently. Under a traditional defined benefit plan (which provides guaranteed benefits), an employee must stay with a single employer for more than 10 years or more to accumulate significant retirement benefits. When the concept of “employment for life” was more popular, these restrictions were not as big a problem. However, today, most people change jobs multiple times during their careers, and hence would not accumulate significant benefits under the traditional defined benefit structure. But the biggest reason for the demise of DB plans is cost. It is increasingly expensive to run a defined benefit plan.

Most companies invest their defined benefit plan assets in a broadly diversified portfolio of stocks and bonds that is used to pay the future income of retired workers. If the market goes down, the company is obligated to make additional payments into the plan to ensure that it can pay out its promised retirement benefits. However, this creates a potential problem for companies such as General Motors and Ford, with large retired populations relative to their current workforce. With a DB plan, the company may have to come up with more money to fund the plan at precisely the time when money is scarce. When stock market returns are poor, chances are that the company is also feeling the pinch from a downturn in its business. The need to make payments into the plan when markets are down and when the cost of those payments to the company is highest (more on this concept later) makes DB plans a potentially expensive and risky proposition.

The magnitude of this cost problem is further accentuated when we take into account the impact of an aging population. Because we are all living longer, on average, the number of older retired people has grown dramatically over time, while, at the same time, birth rates have declined significantly. The following figure is an example of a population pyramid chart using 1950 data from the United States Census Bureau.2 Such graphics are called pyramid charts due to their distinctive shape, consistent with the distribution of age groups in a growing population. Historically, in most societies, there have been a large number of young people relative to the population of older persons. If the age of the population is plotted on the vertical axis, and the length of the bars represent the proportion of the population in that age group, you get a distinctive triangle shape. In the United States of 1950, this pattern was clearly evident, as shown in Figure 1.1.

FIGURE 1.1 U.S. Population by Age Group in 1950

Source: U.S. Census Bureau.

In 1950, the U.S. population was growing fast, and while life spans were gradually increasing, the proportion of older people had not yet begun to grow disproportionately. Now contrast this with the picture in 2006 (Figure 1.2).

The combination of lower average birth rates and greatly increased longevity has dramatically changed the relative proportions of active workers supporting retirees. For instance, in 1950, there were 47 people in their prime working years (between the ages of 20 and 59) for every person age 80 or older. By 2006, this ratio dropped to only 15—a decline of 68 percent. By 2050, there will be only 6 employees in their prime working years for every person age 80 or older. This implies a very different division of resources between generations than what has been historically observed.

The net effect of this demographic shift is that companies (and many governments) are increasingly unable to afford guaranteed income for life to the growing retiree population. If you guarantee income for retirees, it means working employees must fund this income with increasingly high taxes, or they must be willing to assume the financial risk of pension assets falling short when markets turn sour. When there are only a small number of retirees for each worker, as was historically the case, this is not such a big problem. But when the retiree population gets large, look out. The burden on the working population becomes too onerous. Just as a company that takes on too much debt greatly increases the risk to stockholders and employees, guaranteeing retirement income for an ever-increasing retiree population is not an economically sustainable proposition. If retirees don’t have any risk in their retirement income, then existing workers must assume all the risk. But now there are simply too many retirees to support—something has to give. The only way out of this predicament is to have the retired population share the risk of market downturns with the working population—that is, to make individual retirement income dependent on market performance. Enter the 401(k).

FIGURE 1.2 U.S. Population by Age Group in 2006

Source: U.S. Census Bureau.

THE GRAND SOCIAL EXPERIMENT: 401 (k)

In the last 20 years, the United States has seen enormous growth in Defined Contribution (DC) plans such as the 401(k). What was once an obscure part of the tax code, the 401(k) plan is now the primary retirement vehicle for most U.S. workers. In fact, DC plan assets now exceed the total value of DB plans by a wide margin. In 2006, according to the Federal Reserve, DB plans totaled $2.3 trillion, while DC plan assets totaled more than $3.3 trillion.3 Defined contribution plans differ from DB plans in that the individual is responsible for making the investment decisions and for bearing investment risk, not the employer. With the rising prevalence of 401 (k) plans, Individual Retirement Accounts (IRAs), Health Savings Accounts (HSAs), 529 Plans, and other plans where individuals must manage their assets, more and more financial responsibility is being placed squarely on the shoulders of everyday people.

In many ways this is a grand social experiment—never before has so much financial responsibility been in the hands of so many nonexperts. We do not yet know what the results of the experiment will be for the United States. If financial markets perform well in the coming decades, people save aggressively and invest prudently, the experiment will likely be successful. However, if this rosy state of the world does not come to pass—there are going to be a lot of grumpy and cash-strapped retirees wondering how all this came to be.

The rise of defined contribution plans like the 401(k) has dramatically altered the landscape for individual investors. As of 2006, there are now more than 55 million individuals managing trillions of dollars of defined contribution assets.4 For most employees hired in the last decade or so, the defined contribution plan is their principal (and often only) retirement benefit. In fact, DC assets now account for 61 percent of overall retirement assets in the United States. Importantly, there is no turning back from this trend. Since the economic need for defined contribution plans like the 401(k) is based on long-term demographic trends, there is no going back to the days of guaranteed retirement benefits. In the future, your retirement paycheck will depend to some extent on market performance and how you choose to allocate your investments. Put another way, if markets decline, you will be the one holding the bag—not your employer.

THE KNOWLEDGE GAP

Sadly, our educational system has been woefully behind the curve in preparing people for the heavy new financial responsibilities of a self-directed investment world. Unless you happen to work in financial services, what you know about these subjects is likely to have come from friends, family, and the media, not from high school or college coursework in economics and finance. Relatively few people have any significant exposure to academic finance or economics, and hence many of the important concepts that govern good decision-making are unknown to those who could benefit from them. Much of what we do learn is incomplete and reduced to three bullet-point sound bites on talk radio or cable TV shows. Most people rely on a haphazard mix of conventional wisdom, rules of thumb, and outright dart-throwing to manage their personal investments. The predictable result is that most investors are not doing a very good job of managing their assets. Unfortunately, most of us are flying by the seat of our pants.

To successfully navigate the waters of modern financial life, you have to make a basic choice. You can educate yourself so that you are able to make informed decisions on your own, or you can hire a competent and objective financial professional to help you (the third option of avoiding the subject, though immensely popular, is generally ill advised). The do-it-yourself approach has several advantages. You are in control, you do not have to delegate decisions to other parties, and you develop first-hand experience with the process of portfolio management. The downside is that it takes a lot of time and energy to become well educated on investments, and a comparable amount of time to monitor your portfolio on an ongoing basis. Also, if things go wrong, you have no one to blame but yourself (don’t laugh; this is a major element of stress for many investors). In fact, most surveys on the subject, including those conducted by Financial Engines, estimate that only 10 to 20 percent of the population is truly comfortable with the do-it-yourself approach. The vast majority of people are looking for help, either to validate their own decisions, or to delegate the responsibilities to a professional who they can trust. Of course, finding an honest, qualified, and reasonably priced investment advisor can be a challenge.

THE TRADITIONAL ADVICE MODEL

It is true that many, if not most, individuals can use help with making investment decisions. What is less clear is how to get objective, personalized advice at a reasonable cost. If you are lucky enough to be wealthy—say, financial assets of a few million dollars or more—there are thousands of advisors eager to work with you. Of course, not all of these eager advisors know what they are doing, but nonetheless, there is a big pool to choose from. If your means are more modest, sources for high quality and objective investment advice can be particularly difficult to find. Like many aspects of life, the caveat emptor proverb applies to investment advice as well. As we will see, a big part of being an informed consumer of investment advice is being able to detect when your advisor may be making claims that don’t stand up to scrutiny.

Up until a few decades ago, people with modest assets generally did not have a need for personalized investment advice. Most personal savings were simply kept in the bank. Few middle class individuals had reason to own mutual funds or even individual stocks until the early 1980s, with the rise of 401(k) plans. Since most clients for investment advice were wealthy, the advice model that developed was based on the concept of one or more expert advisors personally interacting with each client and developing a customized investment strategy. Generally advisors were expected to have high levels of expertise (often across multiple domains), and as a part of their services spent substantial time interacting with each client. The costs of providing such investment advisory services are considerable, typically paid as an annual percentage of client’s assets. Fees for traditional investment advisory services generally range from 75 basis points (0.75 percent) to more than 200 basis points (2.00 percent) of assets under management, depending on the types of services provided and the size of the client account. For the process to be profitable for the advisor, the client account must generate sufficient fees to cover the overhead and compensation for the experts, who are typically paid handsomely. This model works well for high-net-worth individuals or families with big assets who can afford to pay for the personalized attention. But the reality of the advice business is that people with a limited number of zeros at the end of their account balance are simply left out. It is not economically feasible for well-paid experts to spend tens of hours putting together a financial plan for an individual investor with only $50,000 in financial assets.

To service the needs of investors who fall short of the high-net-worth benchmark, financial services firms have typically relied upon the structure of product-based compensation, or commissions. Rather than charging an explicit hourly or asset-based fee for advice, the compensation of the advisor or broker is structured in the form of commissions on the sales of investment products. However, this approach suffers from a big conflict of interest, as some products invariably result in larger commissions for the broker or advisor than others. The result is that the advisor may have a vested interest in selling certain products (such as the funds of their own firm), even if it is not necessarily in your best interests. This fundamental conflict of interest between commission-based brokers or advisors and the clients they serve is at the heart of many lawsuits and arbitrations that occur in the industry each year. Actually, it gets a little worse. Since commission-based compensation is triggered by transactions (buying and selling of products), the commission model also creates incentives for excessive trading. All of a sudden you find out from your broker that the great fund you bought 18 months ago no longer makes the cut.

Fundamentally, the commission-based structure does not alter the basic economics of providing advice—it merely changes (and conceals) the form of payment. Since the costs of the commissions are often built into the financial products (through expense ratios and loads), they are not as visible to the investor as in the case of an explicit advisory fee. However, the impact is the same—lower overall investment returns for the investor, and higher compensation for the broker or advisor. As we will see in Chapter 7, it is critically important to understand how fees impact the value of your investments.

INSTITUTIONAL TOOLS OF THE TRADE

Successfully addressing the needs of average investors requires a different type of advice model—one that leverages technology to change the economics of providing personalized investment advice. By using technology to automate much of the investment analysis process, it is now possible to provide high-quality advice at a much lower cost than was historically the case. The basic idea behind Financial Engines’ advisory services is to emulate how the big guys manage investments using state of the art financial technology, but do it for millions of individual investors instead of a handful of giant funds. Want to know how to best invest your money? Apply the same techniques used by the largest institutional investors investing hundreds of billions of dollars.

For instance, consider the problems faced by pension funds. Putting together well-structured portfolios to fund future pension liabilities is not a particularly easy task, and usually requires significant expertise and analysis. Pension funds use advanced techniques to evaluate risk, forecast possible investment outcomes, value future liabilities, structure portfolios, and evaluate the performance of investment managers. While such techniques might seem intimidating to most investors, these same ideas are directly relevant for your personal retirement investing.

Albeit on a smaller scale, individuals face many of the same problems as institutional money managers like pension funds and university endowments. The biggest difference is that institutional money managers are able to apply much greater resources in evaluating these questions than most individuals (unless your last name happens to be Buffett or Gates). Large institutional investors such as the General Motors pension plan and the Stanford University endowment fund have benefited from the tools of modern financial economics for decades. But it has been only recently that comparable techniques have been applied to the needs of average individual investors. The reasons for this are myriad, but the biggest factor has been cost. Up until the last ten years or so, it has simply been too expensive to rigorously apply the techniques of modern financial economics to individual investment problems. In the mid-1990’s, contemporaneous with the rise of the Internet, technology began to make possible a new approach to personal investment advice. A key development in this process was giving individual investors the ability to realistically view how their investments might perform in the future.

To understand how such techniques can be used to make better investment decisions, it is helpful to introduce some of the most important tools used by institutional investors. In later chapters, I will use these tools to illustrate important concepts with some real-world examples. It is not crucial that you understand the details of such methods, but having some basic understanding of what they are and how they work is very useful, whether you make your own decisions, or use the services of an investment advisor.

As a first step, when choosing an investment strategy, you want to develop a realistic view of the potential future outcomes associated with your investment choices. With knowledge of the possible range of outcomes, you can make an informed choice about the appropriate level of risk and savings to construct an investment strategy that will have a high probability of success. The methods for making such financial projections run the gamut from simplistic calculations based on a constant rate of return to sophisticated simulations that take into account the complex relationships among economic variables and asset returns. Among institutional investors, the most utilized method for understanding the range of possible investment outcomes is a technique called Monte Carlo simulation.

What Might the Future Hold?: Monte Carlo Simulation

Monte Carlo simulation provides a powerful way to analyze problems that involve uncertainty. The formal development of the Monte Carlo method dates from the Manhattan Project to develop the atom bomb during World War II and is based on the work of two famous mathematicians, Stanislaus Ulam and John von Neumann. At the time, they were focused on random neutron diffusion in fissile material—how far little atomic particles, called neutrons, could penetrate into various types of metal. Solving this problem experimentally was expensive and dangerous (neutrons can give you cancer by damaging your DNA, not to mention they make your eyebrows fall out). While they had developed good theoretical models for the behavior of a single neutron, summarizing the interactions between large numbers of neutrons was so complex that it was analytically intractable (they could not even write down the equations, much less solve them). Their solution was to perform a large number of random hypothetical experiments simulating the paths of individual neutrons through various materials and then add them up. By averaging the behavior of individual particles over enough such simulations, the mathematicians could accurately estimate how far neutrons would penetrate different types of materials (they purportedly chose the name Monte Carlo after its namesake in Monaco in honor of Stanislaus’s gambler uncle).

From its early use in nuclear physics, Monte Carlo simulation made its way into other fields of study and is now used in a wide range of domains, including weather forecasting, traffic analysis, chemistry, genetics, statistics, and investment analysis. The method is particularly useful in solving problems where the probabilistic behavior of a system is very complex. The probabilistic behavior of an investment portfolio consisting of a mix of different securities represents one such complex system. That is why institutional investors such as defined benefit pension managers have used Monte Carlo simulation for more than two decades to evaluate the likelihood of meeting future liabilities. More recently, Monte Carlo simulation has rapidly evolved from a mathematical curiosity into something of a marketing buzzword in the financial services industry. The purpose of Monte Carlo investment simulation is to provide a better understanding of the range of possible outcomes when the future values of the assets in the portfolio are uncertain. That is, Monte Carlo simulation can’t help you predict the future (unfortunately no one can do that), but it can show you the range of possible future outcomes you might expect with different market performance.

These simulation tools provide important benefits for investors, including the ability to:

• Calculate the probability of reaching investment objectives

• Provide forward-looking measures of investment risk

• Test drive investment strategies prior to implementation