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This was a re-read for me, with the recent publishing of the fifth edition of this very important book. Roger Gibson has updated his excellent work with the results of his strategies during the Great Recession, up to date as of late 2012.
Advisors have much to learn from Mr. Gibson’s tome regarding the optimal methods for allocating your investment assets. Throughout the first portion of the book, the concepts of market-timing and superior asset selection are summarily debunked, and the benefits of market index investment and diversification are shown to be optimal. The author uses real-world data to underpin his findings. The result is the explanation that, with known investment time horizons, an optimal mix of investments can be determined that will produce superior long-term risk-adjusted results.
Much is written in the book, which is directed primarily to investment advisors, about the mind-set of the investor himself or herself. The point is that, even though as an advisor you develop and implement the best possible investment allocation, if the investor is reluctant to stick with the allocation plan through thick and thin, the benefits of the allocation are lost.
It is important to ensure that the advisor understands where the investor stands on the concepts of market timing and superior investment selection. Mr. Gibson displays this as a matrix as follows:
| Is Successful Market Timing Possible? | |||
| YES | NO | ||
| Is Superior Security Selection Possible? | YES | Quadrant 1 | Quadrant 2 |
| NO | Quadrant 3 | Quadrant 4 | |
| Source: Roger C. Gibson, 1995 | |||
Folks who fall into Quadrant 1 believe that it is possible to choose the best time to enter and exit the market (e.g., buy low, sell high), and that it is possible to choose specific securities that will result in superior returns. This means that one day the investor wakes up and looks at his charts, graphs, and company reports and magically, he’s able to tell the future. He is capable (in his mind) of choosing just the right investment at just the right time, and furthermore he is capable of knowing when to sell that investment to avoid a downturn. Without going into the backing data, hopefully you can see that these folks, while they do exist, their results aren’t as anticipated – if the results were clearly superior, obviously all investable funds would eventually be placed with such a manager. No one has that kind of result.
Quadrant 2 devotees only believe that it is possible to choose superior securities, but that choosing the entry and exit times is not predictable. This investor buys his chosen superior investments and holds them for long periods of time, a true “buy and hold” investor.
Those with a Quadrant 3 worldview are of the belief that superior investment selection is not possible, therefore these investors choose to invest in index mutual funds or other methods of owning a broad basket of securities across various asset classes. However, Q3 folks believe it is possible to determine when is the best time to enter a holding in a particular asset class and when to exit the holding. This investor is constantly choosing between the asset class that he believes is in favor versus the asset class he believes is out of favor. Long-term results have shown that this sort of market timing is similarly unsuccessful as the Q1 worldview. Again, had this ever been the case, the results would speak for themselves.
This leaves us with Quadrant 4 – giving in to the fact that superior asset selection is not predictable, and timing is not possible. This means that we choose index-type broad market investments, and we hold to the investment allocation over long periods of time. This is the only long-term successful method of investment allocation, proven time and again with real world results.
This of course doesn’t mean to just simply determine the asset classes across which your investments should be allocated and split your investments evenly across all chosen asset classes. Time horizon for the investment activity must be known, as the shorter the time horizon, the less risk the portfolio can endure.
In addition, the investor’s appetite for (and tolerance of) risk must be determined. This determination is made by considering the amount of loss that the investor can emotionally withstand – and using knowledge of the risk profile of various mixes of investments to match up with the risk appetite. Naturally this risk appetite is countered by the requirement for returns from the investment – in order to achieve increased returns, generally risk must be increased.
In addition, once the asset class allocations are chosen based on the time horizon, return requirement, and risk appetite of the investor, as investment results occur over time the investment allocation must be re-balanced regularly. This is necessary to maintain the same risk/return profile that was originally selected. As well, over time the time horizon becomes necessarily shorter, so the original asset allocation must be re-aligned to fit the new horizon.
The above is only a brief overview of what I found to be the most important take-aways from this critical book. I highly recommend this book for any advisor who is looking to develop long-lasting superior risk-adjusted returns for his clients. Individual investors can benefit from the book as well, although the much of the book is devoted to working with clients to develop allocation plans.
The above book review is part of a series of reviews that I am doing in an arrangement with McGraw-Hill Professional Publishing, where MH sends me books with the only requirement being that I read the book and write a review – like it or not. If you find the information in this review useful, let me (and McGraw-Hill) know!