[Book Summary] A Fundamental Approach to Personal Investment by David Swensen

Overview: Sources of Return

• Capital markets provide three tools for investors to generate returns: asset allocation, market timing, and security selection.
  • Asset Allocation: long-term decision regarding the proportion of assets that an investor chooses to place in particular asset classes.
  • Market Timing: deviations from the long-term asset-allocation targets. It represents a purposeful attempt to generate short-term, superior returns based on insights regarding relative asset class valuations.
  • Security Selection: the method of construction of portfolios for each of the individual asset classes.

Fundamental Investment Principles

Equity Bias, Diversification and Tax Sensitivity.

Equity Bias

• Equity investors rightly expect returns superior to those expected by holders of less risky financial assets, albeit at the cost of higher levels of risk.
  • The book mentions a study conducted by Ibbotson Associates that shows that the average annual return on equities from 1926 to 2003 was 10.4%, compared to 5.4% for long-term government bonds and 3.7% for Treasury bills. Compounded over time, the difference in returns is staggering. (The Stocks, Bonds, Bills, and Inflation (SBBI) dataset was discontinued in 2024.)
• However, the author argues that investors should not pull all of their eggs in the equity market basket.

Small Reflection: To check the latest data. I believe it is still true.

Comparing returns between stocks and bonds, stocks have outperformed bonds in the last ten years (up to 2024). [^4]

Diversification

• Diversification improves portfolio characteristics by allowing investors to achieve higher returns for a given level of risk. Nobel laureate Harry Markowitz called diversification "the only free lunch in finance."
• The author provides examples of the stock market crash in 1929 and 1970s. From the peak of small company stock prices in November 1928 to the trough in 1932, small company stocks lost 90% of their value. In the 1970s, the small stocks fell by nearly 60 by the time they reached the bottom in 1974. Inflation reduced the dollar's purchasing power to just 68% six years later. The combination of market action and inflation erosion produced a 70% loss in real terms.

Small Reflection: I remember Warren Buffet being against diversification. I need to check his arguments. However, Buffet recommends purchasing a diversified index fund for an average investor. I believe security selection is hard.

"Diversification is protection against ignorance. It makes little sense if you know what you are doing."

"If you know how to analyze businesses and value businesses, it's crazy to own 50 stocks or 40 stocks or 30 stocks probably because there aren't that many wonderful businesses that are understandable to a single human being in all likelihood." [^2]

"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” [^3]

Tax Sensitivity

• The author mentions a study conducted by James Porterba at MIT that shows that the gap between pre-tax and after-tax returns deferred by 3.5% per year from 1926 to 1996, in the context of a pre-tax return of 12.7% per year.
• The current (2003) tax system is currently favour long-term gains over dividend and interest income. Short-term gains, currently defined as gains from positions held less than a year and a day, received the same harsh treatment as dividend and interest income.
• However, investors should avoid "tax-related exotica" and focus on investments that have sound economic foundations rather than being driven by tax considerations.
• Unrealised capital gains are not taxed until taxed until the asset is sold. Also, unrealised losses can be used to offset realised gains. Thus, tax-sensitive investors show a bias toward low turnover of holdings with gains and high turnover of holdings with losses.
• However, investors should expect to deal predominantly with taxes on gains, not benefits from losses, because the equity markets tend to produce positive results over a long period of time.

Discussion on Market Timing

• For institutional investors, market timing fails to make an important contribution because:
  • they understand the inconsistency inherent in making a speculative short-term bet
  • they recognise the futility of consistently making assessments necessary for market-timing success.
• For individual investors, the impact generally falls into the negative category because:
  • Allocation to recent strong performers or allowing inertia to drive portfolio allocation overlooked the mean-reverting behaviour of asset classes.
  • failure to rebalance the portfolio to the target asset allocation.

Discussion on Security Selection

• Security selection is a zero-sum game because the active investor can overweight a stock only if other market players take offsetting underweight positions.
• Taking commissions to trade and security selection is a negative sum game.
• Security selection may provide substantial excess returns to skilled investors.

Common Mistakes

• Focus on unproductive diversions of security selection and market timing instead of constructing equity-oriented, well-diversified, tax-sensitive portfolios.
• Unable to withstand the inevitable market traumas. Investors ultimately reap the rewards only if they maintain positions in the face of market woes.

Reflections

I agree with the author's argument that individual investors should focus on asset allocation, diversification, and tax sensitivity. If it takes the expertise of someone like Warren Buffett to consistently beat the market through security selection, then it’s more prudent for the average investor to concentrate on asset allocation and diversification—approaches that offer a higher likelihood of success. A passive investment strategy that emphasizes an equity bias, diversification, and periodic rebalancing seems like a sound approach. This strategy aligns the investor's returns with the market's performance, which is ultimately driven by human ingenuity and productivity. Given the difficulty of betting against humanity’s long-term progress, this strategy offers a strong probability of success (unless AI dooms day comes) . Additionally, it’s a low-cost, low-effort approach, making it particularly well-suited for the average investor.

The most challenging aspect of adopting this strategy is acknowledging that I am, indeed, just an average investor. But realistically, how can an individual expect to outperform institutional investors who possess greater resources, information, and expertise? The best part is that if we start early, time becomes our ally.

References

• Swensen, David F. Unconventional Success: A Fundamental Approach to Personal Investment. New York: Free Press, 2005.
• [^2] Warren Buffett: Why Diversification Is Bullsh*t (youtube.com)
• [^3] How To Invest Money Based On Advice From Warren Buffett (forbes.com)
• [^4] Stocks vs. Bonds - Updated Chart | Longtermtrends