A Review of The Intelligent Asset Allocator: Portfolio Theory for the Small Investor

This article appeared in the December 1997 CAMITalk (Chinese Alumni/ae of MIT newsletter).

Future investment returns depend mainly on how you allocate your assets among stocks, bonds, and cash reserves such as money market funds. The Intelligent Asset Allocator, by William J. Bernstein, is an excellent and comprehensive text for those of us who have never taken a course on asset allocation. It covers the key issues without complex mathematics so anyone who has had high school algebra, will be able to understand the concepts and work through the examples. (In the preface to his second book, Bernstein said that “the dividing line seemed to be slightly north of Statistics 101.”) One should expect however, to spend a decent amount of time and effort learning the material. As the author says, “this is not a Grisham novel.” The package consists of a 120+ page “book” file and accompanying spreadsheet.

Bernstein clearly illustrates the importance of diversification by using a coin toss model. In his example, a head represents a 30% investment gain during the year and a tail represents a 10% loss. If you were to flip one coin, your result would be 30% (heads) or -10% (tails). However, when tossing two coins together, you have the possibility of getting a head and tail together, which results in a 10% gain [(30% + -10%)/2]. This is analogous to investing in two types of assets which do not necessarily increase or decrease at the same time. Your chance of having a loss has been reduced and your long-run annualized (compound) rate of return increases due to less variability from the average return of 10%.

The spreadsheet “backtester” allows you to specify the percentage of your funds to invest in various asset classes that do not always move in the same direction or by the same amount. These include US large company stocks, US small company stocks, European large company stocks, US 20 year Treasury bonds, etc. The model calculates the annualized return and standard deviation (a measure of variability) of your asset allocation using historical values during the 1970 – 1996 period. This is a very useful tool to see how various asset allocations would have performed during a period of time that included the severe downturn of 1973-74.

The spreadsheet portfolio is “rebalanced” annually to your original percentages. Rebalancing involves selling the assets which have appreciated more than the others, while using the proceeds to buy more of the latter. You are selling relatively expensive assets and buying relatively inexpensive ones. Bernstein estimates that periodic rebalancing’s “buy low, sell high” bias results in a 1% – 2% increase in annualized return compared to a “buy-and-hold” strategy.

He also addresses the use of extremely complex mathematics (“mean variance optimization” or MVO) to find the “best” asset allocation for the next period. Fortunately, this is done without the details of the mathematics. MVO software is available which does not require an extensive mathematical background, though Bernstein’s opinion might be summarized as “garbage in, garbage out.” Based on historical inputs, the “best” allocation yields the highest return for a given level of risk (standard deviation) or the lowest risk for a given return. These inputs include returns, standard deviations, and correlations between the different assets’ returns. If future values of the inputs differ even slightly from past values, extremely sub-optimal results can occur. It therefore, makes more sense to create a balanced portfolio which does well under a variety of scenarios, and the portfolio returns of MVO do not take into account the 1% – 2% rebalancing “bonus.”

Bernstein suggests a “Coward’s Portfolio” comprised of eight mutual funds, but the “Simpleton’s Portfolio” described in the preface might be a nice compromise. It is equal amounts of US large company stocks, US small company stocks, foreign stocks, and US short-term bonds with annual rebalancing. A chart in the last chapter provides guidelines regarding increasing or decreasing the bond portion depending on your time horizon and risk tolerance. Bernstein estimates this simplification will cost between .5% and 1% of annualized return in the long run compared to his more elaborate Coward’s Portfolio.

I highly recommend The Intelligent Asset Allocator for those who would enjoy the equivalent of a self-study course on asset allocation. My only minor complaint is that a table of contents and index were not included with the book file. Before ordering, you might wish to view the free 1995 online version, which is virtually identical to the 1997 book file. After downloading the book file from Bernstein’s Web site and paying $13, you will receive its password by e-mail, along with the accompanying spreadsheet. The book file is in Adobe Acrobat format and the spreadsheet is in Excel format. The free software needed to read the book file is available by following a link at the bottom of Bernstein’s download page.

The Adobe Acrobat and free 1995 online versions are no longer available. You’ll find links to part of the 2000 McGraw-Hill book at the bottom of Bernstein’s ordering information page.

McGraw-Hill published Bernstein’s second book, The Four Pillars of Investing, in 2002. This book was written for a general audience’s “accessibility and enjoyment.”

The Investor’s Manifesto was published in 2009. “I think that most of my old readers, and perhaps some new ones as well, will find the contents of this work even more readable than the last two.”

Regardless of age, most investors should start by reading his free 2014 booklet, If You Can: How Millennials Can Get Rich Slowly.

Rational Expectations (paperback / Kindle), “a clean sheet of paper in the wonky world of quantitatively based asset allocation aimed at small investors,” was published in 2014.

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