longinvest wrote:Bonds and stocks are two fundamentally different asset classes. It is perfectly justifiable for an investor not to consider them part of a single market.
I consider, in my portfolio, domestic stocks and international stocks as two distinct markets. Why? Because international stocks have fundamentally different risks: currency risk on each dividend payment, higher costs, political risks (confiscation of assets by a foreign government), foreign withholding taxes, etc.
So, yes I can agree that the choice of a specific asset allocation that is different from the relative weighing of domestic stocks, domestic bonds, and international stocks relative to one another could be interpreted as active, if one defined a single market for the three assets. But, there are good reasons not to do so.
In particular, as a Canadian, if I considered these 3 assets as a single market, my portfolio would have to be something like 95% international stocks, 2% Canadian stocks, and 3% Canadian bonds.
You'll tell me to add international bonds? Hedged or not?
Do you see what I mean when I say that it can make sense to passively invest in three distinct markets?
Whether you call all this passive or not, passive within distinct markets, or whatever, you're making asset allocation decisions, and that's the point. You have to consider all the risks and the returns of different assets, whatever they are, and what they mean for you.
If you're consciously loading up on stocks, somebody's doing the opposite. But why? And why invest in bonds instead of holding cash? We have some ideas about the historical track records and the properties of these investments, including risk and return. By integrating knowledge and some level of prediction ("I think stocks go up in the long run" is a prediction, just one that is defined in a different way and less specific than "I think stocks will return 2.6% real as the most likely outcome with anything from -3% to 9% being somewhat likely for the next ten years"—and both predictions can be meaningfully wrong in different ways), we decide on an appropriate asset allocation.
Some investors may for example look at current yields of bonds and realize this means something about the future risk and return of this asset class. Other investors look at stock valuations, current dividend yields and buyback yields and whatnot, and decide if that means anything about the risk and return in the future for the asset class. Some investors may think that such things tell us nothing about the future and not use them as inputs when deciding on asset allocations. Others will keep these things in mind to some limited degree, while yet others will hop around investments aggressively as a result.
lack_ey wrote:I still don't understand where this says that beta is the worst factor and that it should be avoided.
OK, maybe I'm wrong, but I thought that the idea of the Larry Portfolio, for example, was to avoid exposure to beta, to minimize the left tail.
I think there are two main ways to analyze this.
(1) Factor thinking
By reducing market beta exposure while increasing loadings on size and value, equivalent expected return can be achieved without relying so much on just beta. Value and size won't necessarily do poorly when beta does (actually, value does, to a certain extent), so this concentrated position in small value means perhaps less pain when the market falls.
(2) More traditional alternative
By reducing the amount of stocks in the portfolio, there's a higher floor of safer assets, less potential losses to sustain.
In any case, the Larry Portfolio is not avoiding beta. It is reducing exposure relative to what many people own. In fact, it has more market beta than value. You can avoid beta if you want (and pick up other factor exposure) by going long-short, say with equity market neutral funds.
IIRC market beta has been better in most markets than value and size.