Altruist Financial Advisors LLC

Fee-Only Investment Management

Reading Room - Articles/Papers

"The mark of a well educated person is not necessarily in knowing all the answers, but in knowing where to find them."

—Douglas Everett (1916–2002)

Here you will find relatively brief articles and papers, each of which focuses on a fairly narrow topic. For more broad coverage of investing issues, see our Reading Room for Books.

We've listed herein a mix of good articles from the popular press (intended for lay people) and highly technical academic papers. Hopefully, these materials will elucidate more than they confuse. We've included links to full text for many of the entries. Note that some of the papers are quite lengthy and may take a fair amount of time to download.

Unfortunately, some papers aren't freely available on the Internet at this time (to the best of our knowledge). You may be able to find them at large public libraries. You almost certainly will be able to locate them at most business school libraries. For those papers which aren't freely available online, we've tried to include brief summaries.

Articles written in a fashion such that laypeople can probably understand them are colored blue—most people should be able to comprehend them. Technical articles and papers intended for professionals/academics are colored red.

If you have questions or comments about any of the materials referenced here, contact us—we love talking about this stuff!

Asset Allocation

Asset allocation refers to the division of one's investment portfolio across the various asset classes. At the highest level, this refers to a split between stocks and bonds. Many more finely defined sub-asset allocations are also common. Also, see Modern Portfolio Theory, Rebalancing and Tax-Managed Investing.

Bid-Ask Spreads

All securities bought or sold on exchanges have a bid-ask spread. This is the difference between the security's selling price and its buying price. The difference covers the costs and profits of the market maker. Whenever you buy or sell a security on an exchange, you implicitly incur one-half of the bid-ask spread as a transaction cost. Also, see Illiquidity Premium.

Bonds

Fixed income assets (e.g., bonds) are often added to a portfolio to lessen its volatility. Another benefit from including bonds in a (otherwise all equity) portfolio is the improved risk/return characteristics resulting from the less than perfect correlation of bonds with equities and other assets. Also, see Inflation-Indexed Bonds and High-Yield Bonds (Junk Bonds).

Broker/Dealers

Broker/Dealers are involved with selling financial products and executing brokerage transactions (as opposed to providing objective advice as a fiduciary). Sadly, the public is ill-informed about the conflicts of interest exhibited by Broker/Dealers and subsequently tend to accept sales-pitches masquerading as objective financial advice as such objective financial advice.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model was developed in the mid-60s by William Sharpe, John Lintner, and Jan Mossin (independently). Some believe that its utility has largely been eclipsed by the introduction of the Fama/French Three-Factor Model.

Charitable Giving

Charitable Giving has several benefits. First, of course, it is good for the soul. But many don't realize how it can have enormously beneficial tax effects as well. For example, if, instead of donating cash, you donate highly appreciated securities, you can avoid paying capital gains taxes on those securities (and the charity wouldn't have to pay them either). This is in addition, of course, to the benefit of the tax-deduction you get for charitable gifts of any kind.

There are at least three means for implementing a long-term giving program: Donor-Advised Funds, Qualified Charitable Distributions, and Charitable Remainder Trusts. Of the three, Donor-Advised Funds are the simplest to set up and administer. The Vanguard Charitable Endowment Program and the Fidelity Charitable Gift Fund are generally our most preferred DAFs due to their exceptionally low fees.

Closed-End Funds

Closed End Funds are mutual funds which are bought and sold on exchanges (i.e., like you buy and sell stocks). Interestingly, the share price, determined by the market, can dramatically differ from the share price determined by the current value of the securities a closed end fund holds (i.e., its NAV). This gives an investor the opportunity to get exposure to securities at a deep discount. Whether or not it is prudent to do so is a different story. Before going out and buying discounted closed-end funds, be sure to read the Pontiff and Reichert/Timmons papers below.

College Planning

There are several tax-advantaged means of saving for college. For most people, 529 savings plans are the best choice. If your state offers tax-deductions for contributions to your state's plan, you should consider (the direct purchased version of) that plan (i.e., don't buy it through a financial adviser). Otherwise, you should consider one of the low-cost alternatives (e.g., Utah’s, Ohio’s, or Vanguard’s plan). For information on all 529 plans, see SavingforCollege.com. Note that, if you choose another state's plan, it may be necessary to transfer it back to your state's plan immediately before college in order to avoid taxation of withdrawals by your state.

Commodity Futures

Commodities refers to real assets such as energy, agriculture, livestock, industrial metals, and precious metals. The below papers make a compelling case for the diversification benefits of collateralized commodities index futures contracts (i.e., they have a very low correlation with other asset classes). Unfortunately, there are few practical means for retail investors to prudently expose themselves to this asset class. We currently recommend the Vanguard Commodity Strategy Fund Admiral Shares (VCMDX) as the preferred means of implementing this asset class in retirement accounts. In taxable accounts, you might consider the Invesco DB Commodity Index Tracking Fund (DBC).

In general, we would recommend only a fairly small fraction of any portfolio be allocated to this asset class. Further, since futures contracts (and derivatives thereof) tend to be quite tax-inefficient, these investments are generally best held in tax-exempt accounts.

Currency Hedging

When investing in foreign investments, an investor subjects herself to currency risk (i.e., the changes in the value of the investment due solely to changes in the exchange rate between the investor's native currency and that of the country where the investment is domiciled). Some investors choose to hedge (i.e., eliminate) this risk by buying currency futures for the investment's currency. Also, see Foreign Investing.

Data Mining

Data Mining (a.k.a., "Data Snooping") refers to the practice of searching through data looking for patterns. Of course, there isn't anything wrong with that, in general. However, many make the mistake of finding apparent patterns in the sample (which may be due to chance) and inappropriately extrapolating them from the sample to the data universe. That's a fancy way of saying that if you find a pattern in past financial data, it may be that the pattern existed solely due to chance, even if it strongly appears otherwise.

Defined Benefit Pension Plans

This section addresses issues related to use of Defined Benefit Pension Plans. Also, see Retirement Investing, Defined Contribution Pension Plan Design, and Pension Fund Management.

Defined Contribution Pension Plans

This section addresses issues related to design of defined contribution pension plans (e.g., 401(k), 403(b), etc.). Also, see Retirement Investing and Pension Fund Management.

Dimensional Fund Advisors (DFA)

Many of our recommended mutual funds come from DFA. However, you may never have heard of them because they do no advertising to the public. Here are some good articles on DFA.

Diversification

Diversification refers to the idea that your investments ought to be spread out amongst many investments. On average, a diversified portfolio will have the same expected return (but less risk/volatility) as a less diversified portfolio with similar characteristics. When put that way, it is easy to see why diversification is beneficial—why have a more risky portfolio if you can't expect higher returns in exchange for taking on that additional risk? Also, see the section on Modern Portfolio Theory.

"Diversification is your buddy." —Merton Miller, winner of the 1990 Nobel Memorial Prize in Economic Sciences

Diversification of Concentrated Positions

For various reasons, many investors find themselves overconcentrated in a single stock (or very few stocks). Most often, this is the stock of their employer. What can such a person do to prudently diversify? In addition to the articles listed here, see the articles on NUA by Bradley and by Herbers in the "Retirement Investing" section below.

Dividends

With the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, certain stock dividends are taxed at the same low rate as long-term capital gains. Some see this as making dividend paying stocks preferred to non-dividend paying stocks. In fact, nothing can be further from the truth, at least in taxable accounts. Also see Tax-Managed Investing.

Dollar Cost Averaging

Dollar Cost Averaging refers to a procedure whereby an equal amount is invested each period on an ongoing basis. For the purpose of deploying a stream of cash-flows (e.g., the residue of your take-home pay after subtracting expenses), this basically just means investing what you have to invest when you have it available to invest. There are few other good choices in such a situation. However, for those who are making changes in their portfolios, this might mean spreading out the change over a period of time rather than making the change all at once. The below articles address this aspect of Dollar Cost Averaging. Also see Market Timing.

Efficient Market Hypothesis

This is a large part of the theoretical argument for passive management and against persistence of mutual fund returns. The developed world's equity and bond markets are quite efficient. This means that there are many intelligent rational people trying to maximize their wealth and that relevant information about securities travels extremely quickly. In other words, everybody else already knows everything you think you know about a particular security and they have already taken advantage of that information (and eliminated any opportunity that may have briefly existed to take advantage of that information) before you (and I) get a chance to.

"THE INFLUENCES which determine fluctuations on the Exchange are innumerable; past, present, and even discounted future events are [all] reflected in market price … At a given instant, the market believes in neither a rise nor a fall of true prices." —Louis Bachelier, Theory of Speculation, 1900

Emerging Markets

Emerging markets refers to stock markets of economies which are developing (e.g., China, Russia, Argentina, Mexico, etc.). Investing in emerging markets is often done with a small portion of one's portfolio in order to get the diversification benefits offered by this asset class. Also, see Foreign Investing and Currency Hedging. Also, see Frontier Markets.

Endowment Fund Management

Also, see Pension Fund Management.

Equity Premium

The "Equity Premium" refers to how much stock returns are higher than bond returns. It is prudent to have realistic expectations of what stock returns are likely to be in the future. Therefore, macroscopic estimates thereof are quite important for investors.

Estate Planning

Estate planning is extremely important for wealthy individuals who wish to maximize the amount of assets passed on to heirs. In general, it is important that estate planning be done by an expert—usually a lawyer who specializes in this area. The below articles discuss investment aspects of estate planning. Also, see Charitable Giving.

Exchange Traded Funds

Exchange Traded Funds are similar to conventional index mutual funds, but they are bought and sold on an exchange, like a stock.

Fama/French Three-Factor Model

These papers explore the intellectual underpinnings for the idea that tilting a stock portfolio towards small and value stocks will tend to result in higher long-term expected returns (at the expense of somewhat higher short-term volatility).

Foreign Investing

Investing internationally with a portion of one's portfolio is often recommended in order to achieve diversification benefits. Also, see Emerging Markets and Currency Hedging.

Frontier Markets

Frontier Markets are countries that aren't developed enough to be considered "Emerging Markets." Conceptually, whatever makes Emerging Markets desirable (e.g., low correlation with other stuff) should apply even moreso with Frontier Markets. Also, see Emerging Markets.

Hedge Funds

Some very wealthy investors invest in Hedge Funds. Hedge Funds are similar to mutual funds, but they are more risky, less regulated, less liquid, and dramatically more expensive (not only may they have annual expense ratios of about 2%, but they may take 20% or more of all gains as well). We discourage use of Hedge Funds because they are so very expensive and because virtually all of them are actively managed.

"If you want to waste your money, it's a good way to do it." "If you want to invest in something where they steal your money and don't tell you what they're doing, be my guest." —Dr. Eugene Fama, commenting on the prudence of investing in hedge funds

"If there's a license to steal, it's in the hedge fund arena." —Dr. Burton Malkiel, commenting on the high costs of hedge funds

"It takes about 35 years of returns to say with any statistical confidence that stocks have a higher expected return than the risk-free rate. Think about a hedge fund that has equity-like volatility. If the manager’s alpha was as large as the market risk premium—which would be huge—it would also take about 35 years to be confident the manager has any value added—and that’s before his fees of '2 and 20.' Even if that phenomenal manager is out there, is he likely to stick around long enough for us to be able to figure out he wasn’t just lucky?" —Dr. Kenneth French, commenting on the probability of being able to determine that any particular hedge fund manager had ANY skill

High-Yield Bonds (Junk Bonds)

High-yield bonds (a.k.a., "junk bonds") are any bonds issued by companies which are judged to be poor credit risks (i.e., they may default on their debt). Because the value of these bonds is so dependent on the likelihood of default (which in turn is linked with the well-being of the company), they behave both like conventional investment-grade bonds and like stocks. Also, see Bonds.

Illiquidity Premium

There is reason to believe that investing in relatively illiquid investments will, in the long run and on average, yield higher expected returns than a more liquid investment of similar risk. If this weren't true, then nobody would buy them, which would tend to drive down their price, which would tend to increase the expected returns until it was true. Also, see Bid-Ask Spreads and Private Equity.

Index Weighting

Index weighting refers to how a securities index weights the constituent securities in its index. Virtually all indexes weight their constituent securities by market capitalization (notable exception: the Dow Jones Industrial Average). This makes a certain amount of sense. For example, if you assume that the market in aggregate is capable of optimizing its allocation, then a market-cap weighted index makes sense. However, some have pointed out that the market doesn't price ANYTHING "right" all the time. Some securities end up being overpriced and some being underpriced at all times. Unfortunately, the ones that are most overpriced would tend to be the largest constituents of market-cap-weighted indexes, while the ones that are most underpriced would tend to be the smallest constituents. Of course, if you could, you would prefer to concentrate your investments in those securities which are underpriced, rather than those that are overpriced. This is the qualitative argument for considering alternative weighting schemes. Note that equal weighting is perhaps the simplest of the infinitely many possible alternative (i.e., non-market-cap) weighting schemes.

Inflation-Indexed Bonds (TIPS and I-Bonds)

There are many well-documented behavioral phenomena which often conspire to rob investors of investment performance. Being aware of them may help you to steer clear of them.

Investor Psychology/Behavioral Finance

There are many well-documented behavioral phenomena which often conspire to rob investors of investment performance. Being aware of them may help you to steer clear of them.

Life Insurance

Long Term Care Insurance

Market Timing

Market timing refers to an attempt to time investing decisions so as to invest in assets which are expected to go up in the near term and divest from assets which are expected to go down in the near term. The most simple implementation may be to shift one's assets between cash and stocks in order to take advantage of anticipated stock market movements. As you can see from the below studies, attempts at market timing are only likely to work spuriously, due to occasional good fortune. We strongly advocate against market timing in all its various forms. Also, see Dollar Cost Averaging.

"The long, sad history of market timing is clear: Virtually nobody gets it right even half the time. And the cost of getting it wrong wipes out the occasional gain of getting it right. So the average investor's experience with market timing is costly. Remember, every time you decide to get out of the market (or get in), the investors you buy from and sell to are the best of the big professionals. (Of course, they're not always right, but how confident are you that you will be 'more right' more often than they will be?) What's more, you will incur trading costs or mutual fund sales charges with each move—and, unless you are managing a tax-sheltered retirement account, you will have to pay taxes every time you take a profit." —Charles Ellis, Winning the Loser's Game

"The mathematical expectation of the speculator is zero. … The expectation of an operation can be positive or negative only if a price fluctuation occurs—a priori it is zero." —Louis Bachelier, Theory of Speculation, 1900

Modern Portfolio Theory

Modern Portfolio Theory refers to the idea that each investment ought to be selected in consideration of how it will interact with other assets in one's portfolio. Modern Portfolio Theory is the basis for Mean Variance Optimization.

You should also read about Modern Portfolio Theory Using Downside Risk, which is a definite improvement on traditional MPT. Also, see the sections on Asset Allocation and Diversification.

Modern Portfolio Theory using Downside Risk

This refers to an improvement on Modern Portfolio Theory. MPT suggests using volatility as the measure of an investment's risk. The problem is that this suggests that abnormally high returns are as much "risk" as abnormally low returns. Most investors welcome high returns and are only sensitive to low returns. This inspires the idea of considering risk only to be related to abnormal low returns and ignoring abnormal high returns. The most useful such measure of risk would be to consider only abnormal returns below some customized "minimum acceptable return" to be "risk." This section contains papers which develop this idea.

While traditional MPT suggests optimizing a portfolio on two statistics—return and volatility, this "Improved" Modern Portfolio Theory suggests optimizing a portfolio on return and some measure of downside risk. Also, see the sections on Asset Allocation, Diversification, Risk Measures, and especially, Modern Portfolio Theory.

Momentum Investing

Momentum refers to the phenomenon whereby stocks that have done well (poorly) recently tend to continue to do well (poorly) for a short period. This suggests a strategy of buying (selling) stocks which have performed well (poorly) recently, holding those positions for a short-period, then repeating the process.

Mortgage Refinancing

Mortgage refinancing is largely an investing issue. Homeowners are always wondering whether they should refinance, whether they should take additional cash out of their homes, what term of mortgage should they get, what points should they pay, etc.

Multi-Factor Investing

The Fama-French work on the small and value premiums, complemented by the Jegadeesh/Titman work on the momentum premium, has led many to implement portfolios that attempt to take advantage of those effects. What is the best way to do so if one desires to capture the beneficial effects of several of these factor premiums within a portfolio?

Mutual Fund Fees

Fees should be one of the primary considerations when selecting a mutual fund. Much of investing requires dealing with uncertainties. Fees, however, are one of the few important factors that you have complete control over. It is almost always prudent to minimize fees, unless you have a compelling reason not to.

"Beware of small expenses; a small leak will sink a great ship." —Benjamin Franklin

Mutual Fund Persistence

Mutual Fund Persistence refers to the question of whether past performance of a mutual fund has any positive correlation with future performance. The lack of persistence in mutual funds (and pension funds, etc.) is a large part of the empirical argument for passive management.

The root of this issue is whether it is possible for ANY actively-managed mutual fund to consistently achieve superior risk-adjusted returns. This is an important question. If the answer is no, then it implies that actively managed funds should be avoided (because they tend to be more expensive). If the answer is yes, then it inspires a separate, but equally important, question of whether it is possible to identify the few funds which will consistently outperform in advance. We believe that, while it is possible for an actively managed fund to occasionally achieve superior returns through good luck, it is impossible to identify those lucky mutual fund managers in advance. The majority of well-done studies tend to support a lack of persistence for all but the worst performing equity mutual funds.

Passive vs. Active Management

The question of whether to invest in actively or passively managed mutual funds is an important one. Both theoretical arguments (see Efficient Market Hypothesis) and empirical evidence (see Mutual Fund Persistence) suggests that passive management (e.g., investing in index mutual funds) is usually prudent.

Pension Fund Management

This section addresses how a corporation should invest its pension assets. Note that what is appropriate for a corporation is not necessarily also appropriate for individuals trying to fund their own retirements.

Performance Evaluation

Is it possible to evaluate the relative "goodness" of an investment manager? If so, how should one go about it? What should be avoided? The concern here is to avoid evaluation strategies which might tend to cause one to embrace unskilled managers and/or to exclude skilled managers. Also, see the section on Risk Measures and Performance Measurement.

"Good clients will, if they decide to use active managers, insist that their managers adhere to the discipline of following through on agreed-upon investment policy. In other words, the investor client will be equally justified and reasonable to terminate a manager for out-of-control results above the market as for out-of-control results below the market. Staying with a manager who is not conforming his or her portfolio performance [to agreed-upon investment policy] or to prior promises is speculation—and ultimately will be 'punished.' But staying with the competent investment manager who is conforming to his or her own promises—particularly when out of phase with the current market environment—shows real 'client prudence' in investing and ultimately will be well rewarded." —Charles Ellis, Winning the Loser's Game

Performance Measurement

When evaluating the performance of a mutual fund or other investment, one must somehow adjust it for the relative riskiness inherent therein. There are three primary means of doing so: the Jensen index, the Treynor index, and the Sharpe Ratio. More recent, but less well known and used, are the Sortino Ratio and the Upside Potential Ratio. Also, see the section on Risk Measures and Performance Evaluation.

Portfolio Insurance

"Portfolio Insurance" refers to a strategy for ensuring that a portfolio's value never falls below some "floor" value. Among the approaches are Options-Based Portfolio Insurance (OBPI) and Constant Proportion Portfolio Insurance (CPPI).

Private Equity

Also, see the section on the Illiquidity Premium.

Profitability Investing

There is reason to believe that stocks of currently profitable companies tend to have higher subsequent returns than stocks of less profitable companies, all else being equal.

Prudent Investor Rule

In addition to the articles below, for a good introduction to the Prudent Investor Rule, see here.

Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (REITs) are basically companies whose business is to own and operate Real Estate (at least that is what equity REITs do—there are other types). The company stock trades just like any other stock. Equity REITs are an excellent means to get exposure to the Real Estate asset class.

Rebalancing

Rebalancing refers to periodically restoring a portfolio's asset allocation to its target proportions. If you don't rebalance, the portfolio naturally drifts from its target allocation. This either increases or decreases your portfolio's risk profile, neither of which is desirable (assuming that the risk profile is appropriate for the investor in the first place).

Retirement Investing

Also, see Social Security Retirement Benefits and Variable Annuities.

Reversion to the Mean

Reversion to the mean is the phenomenon (discovered by Charles Darwin's cousin, Sir Francis Galton (1822–1911)) whereby a stock's average performance (or a mutual fund's, or many other non-investing statistics) tend to become more average (i.e., less extreme) over time. If true, this implies that recent good performers are perhaps somewhat more likely than average to be below-average performers in the future (and vice-versa). This idea is supported by much of the research. Also, see Mutual Fund Persistence.

Risk Measures

Social Security Retirement Benefits

Most US workers are entitled to Social Security Retirement Benefits when they get old enough. This benefit can be substantial and should be considered as part of retirement planning. A strong case can be made not only to include the income in future cash-flow plans, but to include the present value of future Social Security benefits as a current asset in your portfolio when doing asset allocation (it is closer to an inflation protected bond than anything else).

Survivorship Bias

Survivorship bias refers to the phenomena whereby the past records of existing mutual funds are examined to determine various trends. The problem lies in the fact that you are only examining the past records of currently existing funds—funds which ceased existence in the past are not included in your data. This tends to cause one to (falsely) conclude that the average mutual fund has performed better than is actually the case (because the funds which cease to exist and are therefore removed from the sample universe tend to be the poor performers). Due to survivorship bias, it is actually possible to (falsely) conclude that the average dollar invested in mutual funds performed better than average! Also, see mutual fund persistence.

Synthetic/Enhanced Indexing

Synthetic indexing refers to a strategy of replicating an index by buying futures (or derivatives) on an index, rather than buying the underlying securities making up the index. Implicit in the price of a futures contract is an assumed interest rate covering the period from purchase of the contract to the contract expiration date. The futures themselves are typically a relatively small portion of the portfolio (enough futures are bought to simulate full investment in the index). An even smaller portion of the portfolio is set aside in very short-term treasuries as collateral. The remaining cash is typically invested in a bond portfolio with a goal of trying to exceed the interest rate assumed in the pricing of the futures contract. If the bond portfolio can earn a better risk-adjusted return than the interest rate implicit in the futures price, it is possible to have better risk-adjusted returns than the index (before fees).

The above discussion describes synthetic indexing. There are several other means of "enhanced" indexing.

Tax Loss Harvesting

Anybody who has investments in a taxable account (i.e., stocks, bonds, or mutual funds that are NOT in an IRA, Roth IRA, 403(b), 401(k), etc.) should be concerned about minimizing their tax burden. Tax loss harvesting is an important means of doing so. Also, see the section on Tax Managed Investing.

Tax Managed Investing

Anybody who has investments in a taxable account (i.e., stocks, bonds, or mutual funds that are NOT in an IRA, Roth IRA, 403(b), 401(k), etc.) should be concerned about minimizing their tax burden. Taxes are just another type of investing expense that ought to be prudently minimized. Also, see the sections on Dividends and Tax Loss Harvesting.

Variable Annuities

Variable Annuities are appropriate for almost nobody. Their high costs generally dramatically outweigh the potential benefit of tax deferral except for the lowest cost annuities for persons with investment time horizons of many decades. However, if you are stuck in one, you ought to consider getting out of your high cost VA by doing a tax-free 1035 exchange into one of the excellent low-cost options at TIAA-CREF.

Miscellaneous Other