The Intelligent Portfolio

The Intelligent Portfolio draws upon the extensive insights of Financial Engines—a leading provider of investment advisory and management services founded by Nobel Prize-winning economist William F. Sharpe—to reveal the time-tested institutional investing techniques that you can use to help improve your investment performance. Throughout these pages, Financial Engines’ CIO, Christopher Jones, uses state-of-the-art simulation and optimization methods to demonstrate the often-surprising results of applying modern financial economics to personal investment decisions.

Foreword ix

Preface xi

Acknowledgments xvi

Introduction to Financial Engines xviii

Chapter 1 Now it’s Personal 1

A Changing World 2

The Grand Social Experiment: 401(k) 6

The Knowledge Gap 7

The Traditional Advice Model 8

Institutional Tools of the Trade 10

Chapter 2 No Free Lunch 25

I’ll Take the one with the Highest Return. . . 26

A Little Bit of Latin: Ex-Ante and Ex-Post 28

How are the Prices of Risky Assets Set? 29

The Link Between Risk and Return 31

When High Risk does not Mean High Return 34

Hidden Risks and the Peso Problem 36

How Much Risk Am I Taking? 38

Risks and Returns of Different Assets 42

Does it Pass the Blush Test? 47

Chapter 3 History is Bunk 49

History and Expected Returns 51

The Past is not the Future 52

History is Sometimes not What it Seems 55

Investing with Perfect Hindsight 57

The Lucky and the Skillful 60

Chapter 4 The Wisdom of the Market 73

The Efficient Market? 74

What is the Market Portfolio? 78

What does the Market Portfolio Look Like? 79

There’s no Place Like Home 81

History of the Market Portfolio 83

Betting Against the Market 85

Avoiding Unintentional Bets 87

Risk and the Market Portfolio 89

The Market’s View of Future Returns 91

Market Portfolio Simulations 97

Final Thoughts 98

Chapter 5 Getting the Risk Right 101

How to Measure Risk 103

Asset Mix and Short-Term Loss 106

Risk and Portfolio Outcomes 109

Risk and Time Horizon 113

Factors to Consider in Selecting a Risk Level 120

Examples of Informed Investor Behavior 121

Chapter 6 An Unnecessary Gamble 125

A Different Sort of Beast 128

The Risk of Individual Stocks 130

The Implications of Individual Stock Risk 132

Expected Growth Rates 136

The Biggest Mistake in Retirement Investing 142

What About More Than One? 144

Do You Feel Lucky? 149

How to Invest in Stocks Safely 150

Hidden Costs 152

Dealing with Unwanted Stock Risk 154

Chapter 7 How Fees Eat Your Lunch 157

It’s Basic Arithmetic 158

Big Business 160

For Every Winner there Has to Be a Loser 161

It Still Adds Up to Dollars 164

A Wide, Wide World 167

How Fees Eat Your Lunch 168

It’s a Heavy Load to Bear 175

Fees and the Bigger Picture 176

Practical Considerations 179

Chapter 8 Smart Diversification 183

The Goals of Diversification 184

The Big Picture 185

Why Hierarchy is Bad for Portfolios 189

The Value of Asset Class Diversification 193

Diversification Ain’t What it Used to Be 197

Diversification and Investment Choices 198

The Big Picture: Part II 205

The Search for Better Diversification 211

Chapter 9 Picking the Good Ones 221

The Stuff that Matters 224

It’s About the Future 227

Risk Tolerance and Fund Choice 227

Investment Style 228

Fund Expenses 232

Predicting Mutual Fund Performance 233

Rating Funds 236

Putting the Pieces Together 257

What it Takes to Rank Among the Best 259

Chapter 10 Funding the Future 263

The Benefits of Being Flexible 264

Taxable and Tax-Deferred Savings 266

How Much do you Need? 269

From Wealth to Income 271

The Myth of Absolutes 275

Risk, Time, and Savings 281

What it Takes to Get there 291

Chapter 11 Investing and Uncle Sam 295

Why you don’t Want to Minimize Taxes 297

How Taxes Impact Investment Returns 298

The Impact of Personal Tax Rates 301

Tax Efficiency of Asset Classes 303

Asset Placement 306

Mutual Fund Tax Efficiency 308

Municipal Bonds 312

Capital Gains and Losses 316

Putting it All Together 319

Chapter 12 Wrapping it Up 321

Appendix The Personal Online Advisor 331

Notes 335

Glossary 347

About the Author 357

Index 359

"The irreverence [Jones] displays toward history as a predictor for investment is one of dozens of viewpoints that fly in the face of conventional portfolio-building wisdom." --The Star-Telegram

"A very comprehensive book which covers risk versus rewards, past performance versus future expected returns, market timing versus long term investing, and investing in individual stocks versus investing in mutual funds. He also discusses diversification, fees and expenses, and the tax consequences of investing. All of his recommendations are backed up with extensive research and presented in an easy-to-understand manner."--Stockerblog

CHRISTOPHER L. JONES is Chief Investment Officer and Executive Vice President of Investment Management for Financial Engines. Working closely with founder William F. Sharpe, Jones built and led the team of experts in finance, economics, and mathematics that developed the financial methodology for Financial Engines’ personalized investment advice and management services. Jones has led the investment management function at Financial Engines for more than a decade. He holds an MS in business technology, an MS in engineering-economic systems, and a BA in quantitative economics, all from Stanford University.

FINANCIAL ENGINES, INC., is a leading provider of personalized investment advisory and management services to investors in workplace retirement plans. The company provides advisory services to more than 6.8 million employees, including workers at 109 Fortune 500 companies. In addition, Financial Engines manages more than $16 billion in defined contribution assets for individual employees as of year-end 2007. All advisory services are provided by Financial Engines Advisors L.L.C., an independent registered investment advisor and subsidiary of Financial Engines, Inc. Financial Engines does not receive compensation based on the investments it recommends.

The key to good investment decisions is making informed choices. And while you cannot predict the future, it is possible to create investment strategies that can maximize your chances of success. In The Intelligent Portfolio, author Christopher Jones shows you how this can be accomplished.

Written with the thoughtful investor in mind, The Intelligent Portfolio draws upon the extensive insights of Jones and Financial Engines—a leading provider of investment advisory and management services founded by Nobel Prize-winning economist William F. Sharpe—to reveal the time-tested institutional investing techniques that individuals can use to help improve their investment performance. Throughout these pages, Financial Engines’ Chief Investment Officer, Christopher Jones, uses state-of-the-art simulation and optimization methods to demonstrate the often-surprising results of applying modern financial economics to personal investment decisions. By illustrating the realistic range of possible investment outcomes, Jones skillfully reveals how the decisions you make today can impact your financial future.

Challenging conventional wisdom that often leads both novice and experienced investors astray, The Intelligent Portfolio builds from basic intuition on how financial markets function to practical tips on evaluating investment trade-offs and real-world advice on selecting investments to better reach your goals.

Along the way, you’ll be introduced to the proven principles—a mix of common sense and counterintuitive concepts—that will put you in a better position to succeed, including:

• Recognizing the link between risk and reward
• Leveraging the wisdom of the market
• Minimizing losses due to investment fees
• Avoiding the risks of stock picking
• Selecting funds using relevant forward-looking criteria
• Understanding how to realistically fund financial goals
• Investing tax-efficiently
• And much more …

In addition to the information outlined throughout this book, you’ll also receive a fee waiver for a one-year investment advisory account at FinancialEngines.com, so that you may apply what you’ve learned here to your own investment endeavors.

Through simple explanations of powerful investment ideas and real-world examples that bring them to life, The Intelligent Portfolio reveals what you need to know when making personal investment decisions. With this book as your guide, you’ll quickly discover how you can effectively implement the strategies that institutional investors have known for decades—helping you achieve a brighter financial future.