A few years ago David Swensen lectured on the three basic tools that every investor has to manage and grow their portfolio.
So, I’d like to talk about how it is that we got from where we were in the mid-80s to where we ended up in the early- to mid-90s, and where we remain today. And to do that, I’d like to put it in the context of the basic tools that we have available to us as investors. And these tools are the tools that you can employ if you’re managing your portfolio as an individual, or the tools that I have to employ when I’m managing Yale’s portfolio as an institutional investor. And there are basically three things that you can do to affect your returns. First of all, you can decide what assets you’re going to have in the portfolio and in which proportions you’ll hold those assets. So, that’s the asset allocation decision. How much in domestic stocks, how much in foreign stocks, how much in real estate. If you’re an institutional investor, how much in timber, how much in leveraged buyouts, how much in venture capital. The fundamental decision of how it is that the portfolio assets are allocated.
The second thing that you can do is make a market timing decision. So, if you establish targets for your portfolio–targets with respect to how much in domestic socks, how much in domestic bonds, how much in foreign stocks. And then, because in the short run, you think that–let’s say domestic stocks are expensive and foreign stocks are cheap–you decide to hold more foreign stocks and less in domestic stocks. That bet, that short-term bet against your long-term targets, is a market timing decision. And the returns that are attributable to that deviation from your long-term targets are the returns that would be attributable to market timing.
And the third source of returns has to do with security selection. So, you’ve got your allocation to domestic equities. If you buy the market–and the way that you buy the market is to buy an index fund that holds all of the securities in the market in the proportions that they exist in the market–if you buy the market, then your returns to security selection are zero, because your portfolio is going to perform in line with the market. But if you make security selection bets, if you decide that you want to try and beat the market, then that bet or that series of bets will define your returns attributable to security selection.
If you are on campus today, you can listen to Swensen speak at Linsly-Chittenden Hall.
Post by Marcelino Pantoja