Prudent investing entails maximizing expected return for the risk incurred. In constructing portfolios we seek to optimize performance by allocating risk to asset classes with higher expected returns while limiting the amount of risk taken in asset classes with lower expected returns. Risk can never be eliminated in an investment portfolio but it can be managed to ensure that the level of risk that is incurred is appropriately rewarded.
Prudent investing also requires that a portfolio be comprised of a variety of asset classes that respond differently to similar economic conditions. In this way, overall volatility is lowered while long term average compound return is increased. Rational investors readily partake of this “free lunch” given that the market does not reward investors who choose to retain diversifiable risk by holding concentrated positions.
The role of stocks in a portfolio is to provide growth to fund long term goals and objectives. Investors hoping to achieve these long term goals must invest in stocks and accept the increased risk this entails in exchange for a higher potential reward. The role of bonds in long term portfolios is primarily to dampen the risk incurred in the equity component resulting in an acceptable overall level of volatility. Given the lower expected return of bonds relative to stocks, it is more efficient to limit risk exposure in the bond component by investing in high quality, shorter maturity bonds thereby freeing investors to take on greater risk in stocks, whose potential return is higher.
We construct portfolios using passively managed no-load equity and bond mutual funds. Our equity funds invest in domestic and international stocks in both developed and emerging markets. In the fixed income portion of the portfolio, we invest in no-load bond mutual funds with average durations of less than five years and with credit ratings of AA or higher. In order to increase tax efficiency, we hold taxable bond funds whenever possible in tax deferred accounts.
Client portfolios will typically be constructed of institutional class, no-load, passively invested mutual funds from Dimensional Fund Advisors (DFA). We are a DFA Approved Advisor. See DFA and Aegis Financial Advisory. On occasion, we may also utilize no-load index funds and ETFs from the Vanguard Group.
Eugene Fama, Nobel Laureate and Developer of the Efficient Markets Hypothesis: