Any investor with even minimal experience in the market will tell you the “golden rule” is right: when investing in securities, you must always diversify your risks. Even the old proverb says “don’t put all your eggs in one basket…”
However, we are not going to prove the obvious: clearly, an investment portfolio consisting of many different stocks will be more stable and resilient against adverse changes in market conditions than, say, a bunch of shares in a single company worth the same money. The question is how can you construct a portfolio that will maximize profits with minimal risk.
Old University secret
Most likely, there is no universal formula for building an investment portfolio. Even the most successful institutional organizations frequently change their strategies, redistributing their funds to reflect changes in the market. On the other hand, it’s been a long time since any systems have been invented that left top hedge funds jealous for their profits – and most importantly their stability. We are talking about so-called endowments – particularly the special-purpose capital of the oldest American universities.
Educational institutions established these foundations using funds raised through donations. The money is then invested, and the profits are typically spent on the university’s needs. According to Forbes, the Yale University endowment earned an average of 16% per year from 1985 to 2008. A similar foundation in Harvard earned 15%. This may not sound like a lot compared to what some financial institutions promise. But in this case, we are talking about results demonstrated over more than 20 years.
A five-part portfolio
Maben Faber, owner of the Cambria Investment Management company in the United States, spent a lot of time studying this phenomenon. The study resulted in a book entitled The Ivy Portfolio, which is definitely worth your attention if you are serious about investing. Why ivy? It’s really simple: the American universities that Faber studied are all part of the so-called “Ivy League.” All of the institutions in this old organization essentially have the same investment rules.
So, what is the secret of portfolio management according to Faber? Of course, it’s all about diversification – and the relative shares in endowment portfolios of all the Ivy League institutions are basically the same. The rule of thumb is simple: the investment capital is divided into five parts of more or less the same size. Each part is invested into US stocks, foreign company shares, goods (commodities, as a rule), bonds and real estate.
Sounds simple so far, doesn’t it? But then here comes the most important part: how do you choose the specific securities for the portfolio? Faber studied the theory and practice around his fund’s operations and came up with a simple formula that shows the suitability of a specific financial asset. Just calculate the arithmetic average of the asset prices over the last nine months (taking end-of-month prices) – and compare this to the current value. If the price is above average – buy the asset. If it’s below average – sell it.
Faber recommends conducting a monthly review of your investment portfolio using the same, or nearly the same, formula, which he describes in detail in his book. This makes the investor avoid undue concerns related to short-term market fluctuations. Another important secret of the “ivy portfolio” is that investment is performed through an ETF, not directly. These index funds help reduce both risks and costs of investment, thanks to lower commissions.
Faber claims that the “ivy rules” work with absolutely any market and any security. However, you can try improving performance by changing the period for recalculating averages. On the other hand, American universities have been investing using this formula for decades with the results we described above.