Introduction to Stocks Decal
Lecture 11: Active & Passive Management, Indexing, and
Portfolio Construction
Spring 2008
Lawrence Wu
April 15, 2008 – April 22, 2008
CURRENT EVENTS
Quote of the Week

"The takeaway from that is that the news
is still bad, but it's not catastrophic," said
Claire Gruppo, the co-founder of the
boutique investment bank Gruppo, Levey
& Co. "There's an underlying fear factor
that it's going to be an unmitigated
disaster. So when it just continued to be
pretty bad, there's a 'phew' factor."
LECTURE
Outline
Simulation winner
 Risk
 Index funds
 The Experts
 Investing Principles
 Portfolio Considerations

Risk

Two kinds of risk
◦ Systematic and Idiosyncratic or…
◦ Market risk vs. diversifiable risk

Market risk cannot be eliminated (otherwise you wouldn’t be
in the market)
◦ You are compensated for taking on this kind of risk

Diversifiable risk
◦ Company, sector, political, currency etc.
◦ Company risk can be eliminated by investing in a large number
of companies
Groups of stocks provide the same expected return
with lower risk
 Rational investors: Reject individual stocks in favor of a welldiversified group of stocks (unless you feel like you can pick
the right individual stocks)

What does history tell us
Source: Berk and DeMarzo. Corporate Finance.
INDEXING
Introduction to indexing
An index is a group of securities chosen
to represent a market
 An index fund mimics an index
 Try to minimize expected tracking error
 Best indexes don’t necessarily provide the
highest return but the one that tracks
closest to the benchmark

Positive-sum game
Investing is a positive sum game
 Compounded annual return of U.S. large
cap stocks since 1926 has been 11%
 Long-run return > time value of money
(interest rates) is a reward for risk –
represents the new wealth in society
created by investment in infrastructure,
research, buildings, technology etc…

Zero-sum game
A game in which all profits sum to zero
Holdings of all investors in a market (i.e. US)
aggregates to form the market (Sharpe, 1991)
 Active investing is zero-sum game
 Because all investors’ holdings are represented, if
one investor’s dollars outperform the aggregate
market, another investor’s dollars must
underperform so that the sum equal the
performance of the market (which historically is a
positive sum)
 Sports betting and gambling are also zero-sum
games


Passive vs. Active Management

Passive investor – Bob – hold every security
in the market
◦ If Security B represents 5% of the market, John
will hold 5% of his portfolio in B

Active investor – Harry – his portfolio will
be different than John’s at some or all times
◦ The active managers act on “perceptions of
mispricing,” and these perceptions change
relatively often, these managers trade often,
“hence the term ‘active’”
*Source: Sharpe, The Arithmetic of Active Management
Distribution of Market Returns
Blue bell curve – all
investors’ returns
 Blue dotted line –
average market
return
 Gray and red – after
impact of expenses
and taxes
 White area – fewer
dollars exceed
benchmark

Source: The Case for Indexing,Vanguard Investment
Counseling & Research, pg. 4
After cost distribution of mutual
fund returns
Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 6
Useful terminology
Alpha - portfolio’s risk-adjusted excess
return vs. it’s benchmark
 Beta - measure of magnitude of a
portfolio’s past share price fluctuations in
relation to the market’s volatility

Indexing’s advantage
Lower costs
More tax efficient – IRS defines a trade as a
“taxable event” – capital gains taxes are due every
year stocks are bought and sold
 Minimizing costs is the key to achieving long-term
success


◦ Every dollar paid for management fees means $1 less
in returns
Research done on best predictor of fund
performance: past performance, Morningstar
rating, alpha, and beta.*
 Expense ratio was the most reliable predictor!
 One of the few factors known in advance

Source: Financial Research Corporation, 2002, Predicting Mutual Fund Performance II: After the Bear
Returns vs. cost – inversely related
Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 8
Active what?
Source: The Case for Indexing, Vanguard Investment Counseling & Research, pg. 10
Individual investors

If the professionals (who spend their
livelihood) have a hard time beating the
market…
◦ Keep in mind they don’t have to beat the
market to still make a good living because of
FEES

If they can’t do it… how can you expect
do it as an individual investing part-time?
We’re not that old to think about retirement
TAX & RETIREMENT
CONCERNS
Traditional vs. Retirement Accounts
To help us in retirement, we have the
option of investing in special tax-deferred
accounts
 Grows absolutely tax free
 Don’t owe Uncle Sam a dime!
 Depending on the tax bracket, we’re
talking about serious money here

Roth vs. Traditional IRAs

Traditional – take tax deduction up front,
earnings aren’t taxed until its distribution
after retirement
◦ Pay taxes when you withdraw it

Roth – contribute after-tax money, the
money grows tax-free
◦ Pay taxes today
Roth > Traditional
You will likely be in a higher tax bracket when
you retire than right now as a student
2. More flexible – can withdraw early at anytime
without penalty (NOT recommended – can’t
put them back in later!)
3. No mandatory age-based distribution schedule
– manage your own income stream after
retirement
4. You contribute more with Roth - $4,000 in a
Roth is worth more than pre-tax in a traditional
IRA
1.
An Example

25 year old, contributes $5,000 each year
into a Roth IRA until she retires, makes
an annual return of 8%

She will have $1.4 million at age 65
An Example with tax

25 year old, contributes $5,000 each year
into a regular taxable account until
she retires, makes an annual return of 8%

Taxed at 15% (assume no state tax)

She will have $1 million at age 65,
$400,000 less than if she chose the Roth,
down even more if there was state tax
Roth IRA Contribution Limits
Starting 2008, you can contribute $5,000
per year if you earn less than $99,000
(single) or $156,000 (married filing
jointly)
 If you are 56 years old, you can contribute
$6,000 per year.
 Can contribute for 2007 up tax day the
following year: April 15, 2008

Roth IRA drawbacks

Need taxable income to contribute to a
Roth IRA
◦ Can’t be income from babysitting for mowing
your neighbor’s lawn unless they reported
taxes

If you wait too long, you may start earning
too much making you ineligible for a Roth
The Experts
The pros weigh in.
What does Swenson say?
He says it is fruitless for individual investors to
Davidpick
Swenson,
ofno
theway
Yalethat
endowment
since
stocks.manager
“There is
an individual
Don’t
be distracted
by market
forecasts,
he said. in its last
1988.
The
endowment
earned
28
percent
Regarding
market
declines
like
the
can go out there and compete with all these
“You
have
towe’re
diversify
against
the
collective
fiscal
year,
which
ended
June
30, beating
all other
current
one
experiencing,
Swenson
highly qualified and compensated
professionals,”
ignorance,”
hejust
said.
think
is in with
a position
endowments.
It“Ifinished
the year
$22.5 billion
recommends
ignore
it. nobody
Mr. Swensen
said.
to react to these big macro-issues. Where is the
dollar going to be or what is G.D.P. growth going to
be in China? For every “Let
smartyourself
personoff
onthe
onehook,”
side of
the question, there is another
he said.smart
“If youperson
pursueon
thethe
other side.” (Swenson quoted
the NY Times
sensibleinlong-term
policy,Feb
17, 2008)
look at it over a 5- to 10-year
period. Don’t look at five
months.”
What does Buffett say?
In April 2008, at a talk with 150 Wharton
students…
Buffet
asked:
Whenbusiness
asked about
the health
of was
the US
economy…
What still
advice
would
you give
to someone
who
But you're
bullish
about
the makes
U.S.
forits
the
long on
“Wall
Street
money
investor? Where should
term?is not a professional
activity. You make your money on
they
their money?
“We think
weput
[Berkshire
inactivity. If everybody in this room
“The American economy
is going
to portfolio
do fine. Butaround
it won'tevery
do
trades
their
day
Hathaway]
can
do
better
than
the
“Well,
if
they're
not
going
to
be
an
active
fine every year and every
week
andother
every person,
month. I mean,
if all
with
every
you’re
investor
fewabout
shouldbuying
tostocks
do that
S&P.you
I would
be- and
disappointed
iftry
don't
believe
that,very
forget
anyway.
But
going
to end
up broke.
The
intermediary
then
should
just
stay
with index
funds. Any
it stands
to they
reason.
I mean,
get
productive
our portfolio
didn't
do
awe
couple
is going
tomore
end up
with allevery
the money.
low-cost
index
fund. And they
should
buy
it over
year, you
know. It's
a positive-sum
game,
long
term.
And
the stock
On
the other
hand, if you all own
of percentage
points
better.
I
time.
notget
going
be able
to pick
only way
an They're
investor can
killedtois
high fees
or by trying and
in a group
ofby
average
businesses
right
price
the
right time. What
would
bethe
amazed
if just
itand
did
better.”
to outsmart
the market.”
sit here for fifty years, you’ll end up
want to do is avoid the wrong price
– Warrenthey
Buffett
with a fair amount of money and your
and wrong stock.You just make sure you own
broker will be broke.” – Warren Buffett
a piece of American business, and you don't buy
all at one time. ”
“I believe
thatthe
98greatest
or 99 percent
—
Warren
Buffett,
investor
maybe
than 99 percent
that
ever more
lived, supports
indexing.— of
people who invest should extensively
diversify and not trade.That leads
them to an index fund with very low
costs.” – Warren Buffett
Investing
Principles
Time-tested investment principles to live by.
Some Investing Principles

Wall Street will spend over $10B in
advertising revenue to focus on buying the
latest hot stock or the best mutual fund and
ignore these 3 principles
1. Don’t
put all your eggs in one basket.
2. There
is no such thing as a free lunch.
3. Save.
1. Don’t Put all your Eggs in One Basket
Diversify into different asset classes
 Top 10 funds in the hottest 2 sectors
does not mean diversification
 Instead of trying to time the hot sectors,
own ALL of them

2. There’s no such thing as a free lunch





Wall Street will try to get you to “beat the
market” – more trades, transactions and profits
for them, not you
Capturing more than the entire return of an asset
class (what Wall street wants you to think)
Capturing the entire return of the market using
low cost, tax efficient index funds
Extremely difficult to beat the market in the long
term
For serious investors, the question is not, "Can I
beat the market?", but rather, "How can I limit if
not totally eliminate the risk of 'underperforming'
the market?"
3. Save
Develop a long-term financial plan
 Ignore the things outside our control
(stock prices, earnings reports etc.) and
focus on what you can control: saving and
spending habits
 Rule of thumb: save 10% of what you earn

Portfolio
Considerations
Things to consider when building your first portfolio.
Asset Allocation

Once you’ve determined
your split between
stocks/bonds…
◦ Pick broadly diversified
funds (Total Market funds)
– easier to manage
◦ “Slice and Dice” using subasset class funds (Large
Cap Growth, Small Cap
Value…)

International exposure
◦ Experts recommend 2040% of your equity
holdings in international
A 60/40 asset allocation example
Stocks & Bonds





Max Equity - Exposure Max loss
20%..............................5%
30%.............................10%
40%.............................15%
50%.............................20%
60%.............................25%
70%.............................30%
80%.............................35%
90%.............................40%
100%...........................50%
Other ways of determining asset allocation:
Your age in bonds. So, if you are 40 years old, then use a 60/40
(equity/bond) allocation.
110 minus your age = equities (110-40 yrs old=70/30 asset
allocation)
120 minus your age = equities (120-40 yrs old = 80/20 asset
allocation)
How much International exposure?
70% U.S./30% Int = highest return
 80% U.S./20% Int = lowest standard
deviation
 1% to 40% = Int allocations that have
historically increased return over an all
U.S. portfolio without increasing standard
deviation

Portfolio Construction
1.
2.
3.

Basically, you want to invest as much as
possible in tax-deferred accounts
Put the most tax-inefficient investment
products in tax-deferred accounts
Use only tax-efficient funds in taxable
accounts
Open a Roth IRA now!
Mock Portfolio #1
For us 20+ year olds:
 100% - Vanguard 2050 Target Retirement
Fund

◦ 72% - Total stock market
◦ 10% - Bonds
◦ 18% - International
Auto-rebalancing as you age – shift from
stocks to bonds as you grow older
 Boring but simple and it works

Portfolio Considerations



Total stock market index provides maximum
diversification and tax-efficiency – should
make up the core of portfolio (50%)
Add foreign stocks for international
exposure (10-40%)
Small-cap value stocks have historically
outperformed, very tax-inefficient (5-10%)
◦ Keep it in a tax-deferred account (Roth IRA)

Add other asset classes like real estate or
commodities (5%)
Index funds or ETFs
You can either buy index funds directly
from the mutual fund company or open a
brokerage at Zecco and buy ETFs
 Vanguard generally has the lowest fees,
Fidelity is okay
 I’d recommend index funds only because
you’re more likely to stick to the plan…
with Zecco you might be tempted to
overtrade (free trades!)

Mock Portfolio #2

50% Total Stock Market
◦ VTI, IWV,VTSMX

30% Total International
◦ EFA, EEM,VEU,VGTSX

10% Bonds
◦ VBMFX, BND

5% Small-cap value
◦ IJS,VBR,VISVX

5% REIT
◦ RWR,VGSIX,VNQ

Compare expense ratios on prospective funds
SOME LAST MINUTE
ADMINISTRATIVE
POINTS
Extra reading
Research papers on this subject if you’re
interested:
 Sharpe – The Arithmetic of Active
Management

◦ Won the 1990 Nobel Prize in Economics for
developing CAPM

Thorley – The Inefficient Market
Argument for Passive Investing
Feedback

Please take the time to fill out this
anonymous course feedback form:
◦ http://spreadsheets.google.com/viewform?key=pt5fXqd0_YmOQNjbOdBCKg&email=true

I appreciate your comments!
“Office Hours”
Portfolio help
 Analyzing your current holdings
 E-mail me if you have any questions, I’ll
hold “office hours” at 4:00pm at Café
Strada next Wednesday (4/29)
