Yes, You Can Supercharge Your Portfolio!

Review of the book by Geoff Considine

Ben Stein and Phil DeMuth have published a new title called Yes, You Can Supercharge Your Portfolio (Hay House, January 2008).  The book is aimed at individual investors who do not understand the practical application of portfolio theory to their own investments.  The book is an easy read for more experienced investors, but I have been hearing from some longtime investors that it is worthwhile and made them think about some concepts in different ways.

Before I go into a review of the book, I will note in the spirit of full disclosure that the book uses my firm’s software (Quantext Portfolio Planner) throughout, so I have a personal interest in seeing this book do well.  Fair enough.

The book is laid out as a series of six steps.  The process starts with an analysis of what you are trying to accomplish with your portfolio, through portfolio construction, testing, and how to use quantitative methods to improve your portfolio.  Perhaps the most similar book on my shelf (thematically) is William Bernstein’s The Intelligent Asset Allocator.  While Dr. Bernstein’s book explains portfolio theory, it ends up with similar portfolios to many investing books, with ‘pie chart’ allocations to major asset classes.  The Stein-DeMuth book explains how to go a step beyond by using portfolio theory to modify and improve portfolio allocations beyond basic ‘pie chart’ portfolios.

Do you have any objective benchmark for how volatile your portfolio is?  Do you have an objective sense of how volatile your portfolio will get in the higher volatility environment that we have entered?  Do you have any reason to believe that you have really exploited the available diversification benefits in your portfolio?  Most individual investors answer ‘no’ to all of these questions.  This book explains portfolio theory and how to answer all of these questions in a consistent and objective framework.

Many individual investors buy some of everything via index funds, thinking that this means that they are well diversified, but this is often not the case.  Other investors try to improve their returns by holding concentrated positions in individual stocks, but often end up with portfolios that are far riskier (and less diversified) than they should be.  Retail investors also tend to chase the asset classes that have recently out-performed, and avoid those that have not been great performers.  Thinking in terms of portfolio theory helps investors to generate portfolios that avoid these potentially costly mistakes.  A portfolio with concentrations of individual stocks can provide as much or more diversification benefit as one that invests in a set of funds.  You can’t ‘see’ diversification without looking under the hood, however.  This book explains how investors can look at their portfolios through the lens of portfolio theory and, thereby, find ways to improve it.  A good portfolio model helps to shape expectations for future returns, reducing the tendency to chase the hot asset classes.  Portfolios that are too concentrated will show up as unacceptably risky, because of the high correlations between portfolio components: when one goes bad, others go bad at the same time.

A central theme of this book—and one that will surprise many investors—is that holding individual stocks can add value to a portfolio of broad index funds.  There are two clear schools of thought on this issue.  One is John Bogle, who believes that individual investors should only by traditional index funds.  On the other side of the debate are Warren Buffett and Charlie Munger.  Berkshire Hathaway’s long market-beating performance has been driven by portfolios that have substantial concentrations in individual stocks and they have been famously critical of simply buying some of everything via buying the indices.  Stein and DeMuth explain this apparent paradox---and this is a very important idea.  If you choose individual stocks carefully and know what you are doing, you can build a well diversified portfolio with a fairly small number of individual stocks.  If you don’t know how to analyze companies, buying a thoughtful allocation to index funds provides a way to protect against that lack of knowledge and you can still do better than the vast majority of individual investors.  Portfolio theory provides the tools to compare the diversification benefits between portfolios.  Stein and DeMuth show that Berkshire Hathaway’s famously concentrated portfolio is actually very well diversified—more than many portfolio of index funds which hold thousands of individual securities.  This is the most valuable lesson of the book, as far as I am concerned.  You are not necessarily well-diversified if you buy a bunch of funds.

Better diversification allows a portfolio to generate more return without increasing risk, so investors should work to make sure that they exploit all of the available diversification benefits that the market provides.  While most investors spend their time trying to pick individual stocks or sectors based on analysis of what will do well, they miss the most basic source of better performance: diversification benefits.  If you look at the most successful long-term investors of our time, it is clear that they do exploit diversification very effectively when you look at their investment choices through portfolio theory (think of Warren Buffett and Yale’s David Swensen).

What makes this book most useful is that it brings ‘portfolio thinking’ to the masses, providing a powerful tool that is routinely used in the professionals community.  When I worked on a trading floor at Aquila Energy (then second only to Enron in trading power and gas), portfolio analysis tools were used to analyze every position we made.  Our goal was to see how each position shaped the overall risk/return profile of the portfolio.  Major financial houses, banks, and trading operations use portfolio analysis to see the cumulative interactions of all of their positions.  The companies that produce the analytical tools and data used at these firms are probably unknown to most investors (RiskMetrics, Barra, Sungard, SAS)—but these are very well-known firms in the world of professional finance.  From my perspective, it is crucial for individual investors to understand the objective measures and tools that are available to help them improve their portfolios—and this book is the first to being this knowledge base to a wide audience.

There are a range of other topics in the book that are important.  The presentation of how to think about re-balancing is very good and is quite different from other treatments you will see.  This section explains that re-balancing shifts the risk and return of your portfolio—you can choose the re-balancing criteria based on your risk tolerance and in light of what else is in your portfolio.  This is clearly a better way to think about re-balancing.

The book also deals with an issue that is important but not properly appreciated by most investors: how to think about bonds as a portfolio component.  Bonds have low volatility and a low correlation to equities, but they are something of a blunt instrument in terms of getting the most return for the risk that you bear.  You can often manage risk quite effectively with careful selection of higher-return assets, before resorting to bonds.  The benefit of this approach is that it is possible to get more return at a given level of portfolio risk.  This is a theme that is not properly understood, although Rob Arnott discussed this in an interview in 2007.

In summary, I believe that this book has the potential to improve the investing performance of many, if not most, investors.  Most investors and even advisors think about their investment selections in a framework that pre-dates portfolio theory.  I often read analysis in which a portfolio is said to be risky because it is ‘over weight’ in an asset class, which simply means that the portfolio higher allocation than some broad market index.  From my perspective, this is not very meaningful.  A portfolio with substantially more of a sector than the S&P500, for example, may be more risky or less risky than that index.  Portfolio theory allows portfolios to be compared on a more meaningful basis and provides investors with tools to objectively improve their portfolios.

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(Official) Book Description

Most investors spend their time worrying about selecting individual stocks and mutual funds: big mistake! Modern Portfolio Theory—developed in 1952 by economics Nobel Prize winner Harry Markowitz—shows that it’s more important to focus on how our securities interact as a whole. Astonishingly, most investors—including many professionals—still run their investment accounts the same way people did back when “How Much Is That Doggie In the Window” played on the Hit Parade. It’s time to apply what we’ve learned in financial economics over the past 50 years to bring your portfolio into the rock-’n-roll era. Armed with a computer, you, the investor, can use sophisticated tools to analyze your holdings—tools that would have been the envy of the biggest money managers only a decade ago. First among these is the Monte Carlo simulator: the better mousetrap that investors have been waiting for. With their trademark wit, Ben Stein and Phil DeMuth show you how your current portfolio is radically under diversified, costing you money. They offer step-by-step instructions to supercharge it across a variety of investment situations to get you the best risk-adjusted returns.

About the Authors

Ben Stein can be seen talking about finance on Fox TV news every week. He has written about finance for Barron’s and The Wall Street Journal for decades and contributes regularly to the AARP’s Modern Maturity (now AARP: The Magazine). He was one of the chief busters of the junk bond frauds of the 1980s, has been a long-time critic of corporate executives’ self-dealing, and has written several self-help books about personal finance.

Phil DeMuth is an investment psychologist with a longstanding interest in the stock market. He has written for The Wall Street Journal and Barron’s, as well as Human Behavior and Psychology Today. His opinions have been quoted on theStreet.com and Fortune Magazine. He is president of Conservative Wealth Management in Los Angeles.

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