It’s been said physics explains 99% of the world with three laws, while economics explains 3% of the world with 99 laws. We found the data in the table interesting for a number of reasons, but namely for the fact that it would be nearly impossible for a trained economist to make sense of the past five or so years given these snapshots in time.

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The professional investor who is benchmark agnostic, who doesn’t seek to eke out every penny of return at the expense of risk, who focuses on downside protection, and who is not handcuffed by a certain business model – be it active, passive or otherwise – has better odds of controlling for volatility.

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Of all the experts that we would expect to undermine the basis of passive (index) investing, Standard and Poor’s, the creator of the widely-followed S&P 500 Index, was not high on our list. However, in a recent piece The Low-Volatility Effect: A Comprehensive Look, the company inadvertently does just that.

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Indexing has always been peddled as a cheap, tax-efficient and safe way to get market returns. While it is unquestionably the cheapest and among the most tax-efficient ways to invest, safe it is not, the research shows.

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Because of their formulaic nature, many indexes are prone to distortions over time (as we saw in the late 90’s, valuations on tech stocks drove up their market capitalizations and caused the tech weighting of the Russell 1000 Growth Index to hit 50% by 2000. Again in 2007, high flying financials rose to 36% of the Russell 1000 Value Index the year before delivering crushing losses).

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We seem to live in a world where the markets believe bad news is good news. The worse things get, the more excited markets become about yet another round of stimulus by the Federal Reserve. Whether it’s uncertainty around Greek elections or weak economic data, markets have supreme confidence in the willingness of the Fed to support financial markets during economic weakness.

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During market turmoil, traditional portfolios often decline more than investors expect, due to different, seemingly unrelated, asset classes moving in unison. As Ben Levisohn and Joe Light of the Wall Street Journal write, traditional asset allocation fails to achieve stable and robust diversification.

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Today, the Fed has engineered a situation in which the really unattractive asset classes are the ones we have always thought of as low risk: government bonds and cash. And unlike the internet and housing bubbles, this time it isn’t a quasi-inadvertent side effect of Fed policies, but a basic aim of them.

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Our goal is to grow your wealth with the most robust and stable diversification possible. Risk limits, stress testing and so on may be very useful tools, but can’t overcome fundamentally flawed portfolio construction any more than a seatbelt can solve the problems inherent in reckless driving.

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