Spotlight: Walt Woerheide

It turns out that rumors of the death of buy-and-hold investing strategies have been greatly exaggerated. At least that’s what Walt Woerheide believes when it comes to long-term strategies for individual investors who lack a crystal ball or other prognostication skills.

The professor of investments at American College and co-author of the financial professionals’ textbook “Fundamentals of Investments for Financial Planning” believes most people can best benefit from a passive investing strategy, and that modern portfolio theory leads to the efficient frontier, that virtual place where investment return potential is maximized and risk is minimized. He defends the theory against naysayers who found fault with it in the recent bear market.

Bankrate asked the professor to explain modern portfolio theory and to clear up a few questions on asset allocation and rebalancing your portfolio.

At a glance
Name: Walt Woerheide, Ph.D., CFP

Hometown: Bryn Mawr, Penn.

Education: BA from Brown University and Ph.D. and M.B.A. from Washington University

Career highlights:
  • Vice president of Academic Affairs, Dean, at American College.
  • Holder of the Frank M. Engle Distinguished Chair in Economic Security Research and a professor of investments.
  • Oversees the content development of The American College’s Certified Financial Planner (CFP) certification curriculum.
  • Author of “Introducing Personal Finance” and co-author of “Fundamentals of Investments for Financial Planning,” textbooks used to educate financial services industry professionals.
  • Worked for a year as a visiting scholar at the Federal Home Loan Bank Board.
  • Serves as an associate editor for the “Journal of Financial Service Professionals” and serves on the editorial board of the “Financial Services Review and Business Quest” and the “Journal of Financial Planning.”

What is modern portfolio theory?

When we talk about modern portfolio theory, we’re talking about the idea of dividing investments into categories and then we’re talking about estimating several statistics for each category of investment.

You think of each category as a single investment so you might have a category like small-cap value stocks, large-cap growth stocks and so on. So you think of all the different investments and categories and then you estimate three statistics — sort of three, it’s actually a ton more.

You estimate the expected return on each category of investments, the standard deviation of return for that category, and then you estimate the correlation coefficient between the returns on that particular category and every other category of asset classes.

Then you use a very elaborate mathematical model called linear programming that allows you to estimate optimal combinations of the different categories. And those optimal combinations are what we call the efficient frontier.

So in modern portfolio theory, you’re trying to construct the efficient frontier and then figure out which portfolio in that efficient frontier is the one that best serves your needs in terms of your desire for return and your desire to minimize risk.

Even if you and I agreed what the efficient frontier looked like, we still may end up with different portfolios because my optimal risk-return trade-off is different than your optimal risk-return trade-off.

And so you identify the optimal portfolio and pick the one that is best for a particular client and then engage in asset allocation or divide the portfolio into those asset classes.

And that is, in a nutshell, modern portfolio theory.

Not everyone thinks asset allocation is the most efficient way to invest, particularly given the volatility of the past year. What are some of the other theories that people subscribe to when it comes to investing?

Asset allocation is a very passive strategy. It says you pick the optimal portfolio, you allocate your assets and you hold them.

It’s also a buy-and-hold strategy. Everybody who has followed a buy-and-hold strategy over the last year and a half saw about 30 (percent) to 40 percent of their portfolio value knocked out over the past year. So that leads people to say, “This is a dumb strategy.”

Then what are you going to do? The alternative has to be simply that you start trying to anticipate the market and start dynamically moving your money around the various categories.

I think a lot of the people that are poo-pooing modern portfolio theory or asset allocation are also advocating much more allocation to what we call the alternative investments. In truth, alternative investments could very well be a legitimate asset category within the modern portfolio theory context.

Modern portfolio theory does not say the asset categories must be limited to stocks or stocks and bonds, but most of the time when people do it, they do limit their allocation to stock and bond portfolios. But that is not what the basic theory says.

Anybody who says that asset allocation failed because my stock and bond portfolio didn’t do very well is unfairly criticizing the basic theory.

I’ve read some discussions of people poo-pooing modern portfolio theory and asset allocation and they still end up presenting ideas consistent with the theory — that is, you get more diversification by going to these alternative investments.

But if you just define your population of investments to begin with as including these alternative investments, it is perfectly consistent with modern portfolio theory.

And what do you think about the ubiquitous question, is buy-and-hold dead?

No, absolutely not, and it never will be. It comes back to the fact that anybody who thinks they are going to outguess the market is going to be wrong as often as they are right.

There is one study I remember that set up something like, at the start of each quarter you could peek ahead and see if stocks went up or down. If they went up, you put your money into stocks and if they went down you put your money into T-bills for that quarter.

If you had 100 percent perfect forecasting, you did better than a buy-and-hold strategy.

Then they came back and said, “What percentage of the time do you have to be correct in order to beat buy-and-hold?”

They found you had to be correct about 80 percent of the time to beat a buy-and-hold strategy. That is a lot.

It’s really tough, then, to correctly guess looking ahead for the coming quarter to see if the market is going to be up or down 80 percent of the time.

And also let me point out that it turns out that over the course of a year, there are about 20 days in which most of the big moves occur. And if you are out of the market when those big moves occur, you’re really going to underperform that year.

The biggest danger in trying to guess the market is being out when the market makes a big jump.

When the S&P fell to 1,500 two years ago, down to about 700 last March, everybody that guessed that it was going to go down still further and got out at 700 have now missed an incredible run-up of nearly 50 percent.

So the frustrating thing is that you can always look back and say: If only I could have gotten out here or gotten in here. And if you try to translate that into the future and say, I’ll just figure out what the market is going to do — people can’t do it.

And every time you are jumping in and out, you’re paying commissions. If you’re a taxable entity — to the extent you have capital gains taxes — you’re producing some taxes that you have to pay which reduces the size of your portfolio.

And so there is a very real cost to trying to be an active portfolio manager.

So would you recommend a passive approach for individual investors?

Absolutely. Individual investors need to understand what their investment horizon is. They need to figure out the asset allocation categories, and that may include some alternative investments. I don’t oppose them.

For instance, REITs (Real Estate Investment Trusts) as a vehicle for real estate investments, TIPS (Treasury Inflation-Protected Securities) for inflation protection. A lot of nontraditional stock and bond holdings can make sense. They just have to figure out what that optimal allocation is.

The only caveat about buy-and-hold: If you have an asset allocation strategy, over time as different assets go up and go down, your actual allocation will change from your optimal allocation.

In a bull market, let’s say that you decided that your optimal allocation was 60 percent stocks and 40 percent bonds, then suddenly stocks are 75 percent of your portfolio.

A simple buy-and-hold strategy would say, I’m not at the optimal allocation, but I’ll leave it. True portfolio theory would say sell stock and put more money in bonds.

Complete buy-and-hold may make sense if your portfolio is something like 100 percent stocks.

But as soon as you start defining your optimal portfolio in terms of asset categories, buy-and-hold doesn’t mean buy-and-hold.

There have been several studies that have actually shown that if you do rebalance on a regular schedule, you end up with better performance in terms of return and risk exposure.

That would seem to be counterintuitive.

I can say that although I consider myself to be somewhat of an expert in investments, I wish I had followed that advice myself.

You get into behavioral finance. Your stocks start doing incredibly well and you get blinded by that and say, “I’m going to ride this one out.”

We all hope to get the Walmart in its infancy or Google or things like that — you buy them and they go up and if you sell, you’re missing out on incredible price appreciation.

When you have something that does incredibly well, you think it’s going to be the next Google or Walmart. But it probably won’t and that means you need to rebalance and go back to your classical asset allocation.

So have a plan and stick to it.

Yes. But it’s painful to stick to the plan when your stocks start going through the roof.

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