|Investment Philosophy and Beliefs
American Reliance Group arguably provides the most advanced investment strategies and money management available. We combine several methodologies in order to achieve this goal. These methodologies include Modern Portfolio Theory, the Three-Factor Model, Fixed-Income Strategies, and the Institutional Approach. Together these strategies help form our overall investment philosophy.
Modern Portfolio Theory
In 1990, Harry Markowitz, William Sharpe, and Merton Miller, three noted financial economists won the Nobel Memorial Prize for Economics for their work in developing Modern Portfolio Theory as a portfolio management technique. Modern Portfolio Theory has been used to develop and manage investment portfolios for large institutions, as well as individual investors. There are four related components to Modern Portfolio Theory.
- Investors inherently avoid risk.
Summary: Don't take more risk than necessary to achieve your goals.
Investors are often more concerned with risk than they are with reward. Rational investors are not willing to accept risk unless the level of return compensates them for it.
- Securities markets are efficient.
Summary: We don't try to beat the market, instead seek marekt returns at the lowest possible cost.
The "Efficient Market Hypothesis" states that while the returns of different securities may vary as new information becomes available, these variations are inherently random and unpredictable. Assets are re-priced every minute of the day according current events and news. As new information enters the market, it is quickly absorbed into the price of securities, and thus hard to capitalize on. In fact, advancing information technology and increased sophistication on the part of investors are causing the markets to become even more efficient.
The implications of the Efficient Market Hypothesis are far-reaching for investors.
It implies that one should be deeply skeptical of anyone who claims to know how to "beat the market." One cannot expect to consistently beat the market by picking individual securities or by "timing the market."
The Efficient Market Hypothesis is at odds with traditional investment strategies. It has, however, been supported by numerous academic studies, both theoretical and empirical. These studies show, among other things, that the risk-adjusted returns achieved by professional investment managers are no better than those of the market as a whole. This was primarily due to the expenses and taxes incurred with active management. That's the bad news. The good news is that the rate of return of the capital markets is good.
- Focus on the portfolio as a whole and not on individual securities.
Summary: Best returns come from diversification and kind of stock, rather than "picking the best stocks."
The risk and reward characteristics of all of the portfolio's holdings should be analyzed as one, not separately. An efficient allocation of capital to specific asset classes is far more important than selecting the individual investments.
96% Structured Exposure to Factors
As the pie chart shows, your asset allocation can determine about 96% of the performance variation of your investment portfolio. How your investment dollars are allocated far outweighs the potential effects of individual security selection and market timing.
See the three-factor model below
1Source: Dimensional study (2002) of forty-four institutional equity pension plans with $452 billion total assets. Factor analysis ran over various time periods, averaging nine years. Total assets based on total plan dollar amounts as of December 31, 2001. Average explanatory power (R2) is for the Fama/French equity benchmark universe.
- Every risk level has a corresponding optimal combination of asset classes that maximizes returns.
Summary: There is a portfolio that will give the best returns for the amount of risk you wish to take.
This is called the "Efficient Frontier." Portfolio diversification is not so much a function of how many individual stocks or bonds are involved, but the relationship of one asset to another. We call this relationship "correlation." The higher a correlation between two investments, the more likely they are to move in the same direction.
The efficient frontier represents the range of hypothetical portfolios that offer the maximum return for any given level of risk. Portfolios positioned above the range are unachievable on a consistent basis. Portfolios below the efficient frontier are inefficient portfolios (too much risk, not enough reward). The ideal portfolio exists somewhere along the efficient frontier.
The portfolio represented by point A is inefficient because portfolios exist with the same value but less risk (Portfolio B) and portfolios with the same risk but more value (Portfolio C) as well as portfolios with a combination of these two conditions. The Efficient Frontier, as originally defined in Modern Portfolio Theory, is a line that represents the continuum of all efficient portfolios.
The Three-Factor Model
Most finance academics and investment professionals acknowledge that there are three primary factors influencing equity portfolio returns:
- Exposure to the overall market (Diversify your investments).
- The percentage invested in large company stocks versus small company stocks. Over time, small company stocks have higher expected returns than large company stocks. This is because stocks of small companies are riskier than those of large companies and investors demand a premium for this risk.
- The percentage invested in growth stocks versus value stocks. Over time, value stocks have higher expected returns than growth stocks. Value stocks are those that sell at lower prices relative to their earnings and book values. They are perceived by investors to be riskier than growth stocks and investors demand a premium for this risk as well.
Portfolios Volatility Reduction
Market volatility can be reduced by reducing your exposure to equities through increased exposure to fixed instruments such as bonds and treasuries. We use high quality fixed instruments with maturities under five years to accomplish this goal.
From time to time we recommend fixed instruments such as fixed annuities to remove risk and volatility of some portion of your investment portfolio altogether.