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Course 501
Why Bother with Investment Theory?

Introduction

Theory. We hated it in college. What practical use would the Pythagorean Theorem or Deconstructionism have in our lives?

Many feel the same way about investment theory. Explaining modern portfolio theory to your colleagues at a cocktail party may make you seem erudite, but will understanding it make you a better investor? Yes, it can. The trick is putting the theory in context.

The 500 Level of the Investing Classroom will explore some of the major topics in portfolio theory, those ideas that form the basis of how people invest and build portfolios. We'll also summarize some ongoing investment debates. By questioning many of the old rules and offering their theories, today's financial scholars and observers prove that investing is a learning experience that never ends.

Efficient Markets Theory

Burton Malkiel's A Random Walk Down Wall Street, first published in 1973, popularized this theory, which says that stock prices reflect all the publicly available information about the companies. Stock prices may not be "right," but they're as correct as they possibly can be.

There's no point in trying to beat the market, suggests the theory. Just index it.

Some, including most mutual fund managers, disagree. They feel that they can find mispriced securities, or opportunities where a stock's price does not accurately reflect everything about the company.

We'll explore both sides of the issue in Portfolio 502.

Modern Portfolio Theory

Just call Harry Markowitz the Dean of Diversification. Back in the 1950s, Markowitz pointed out what is now obvious: The more return you can expect from an investment, the greater the risk inherent in that investment. Modern Portfolio Theory says that you can limit your volatility by spreading your risk among different types of investments.

We'll detail the ins and outs of MPT in Portfolio 503.

The Investing Pyramid

For some, investing is a hobby. That’s right, some folks enjoy visiting financial web sites daily, watching financial news – they even subscribe to financial newsletters and attend financial conferences.

For most, however, investing isn’t a hobby. It’s drudgery. It’s overwhelming. And it’s impossible to imagine how to squeeze it in one’s busy life.

The Investing Pyramid is a framework that non-hobbyists can use to frame the investing process. If you have a finite amount of time to devote to (or a finite interest in) your investment activities, this can help guide the way.

Learn about pyramid in Portfolio 504.

What Goes Where: The Art of Asset Location

“Don’t let the tail wag the dog.”

That well-worn expression applies to so many things in life – including investing. Specifically, you’ll hear some investing “experts” say that you shouldn’t let taxes drive your investment decisions. Others, meanwhile, will argue the exact opposite.

Portfolio 505offers some guidelines for how to think about tax matters in the investment process.

Factor Investing

Most investors have heard of factor investing, but just may not know it. If you've ever favored smaller companies to larger companies, you've engaged in factor investing.

Portfolio 506traces the history of factor investing.

Behavioral Pitfalls

Psychological factors--such as the tendency to feel particularly risk-averse following a bear market or a proclivity to follow the crowd--can play enormous roles in our investment outcomes, and often they are not positive ones.

Portfolio 507and 508 outline 10 of the most common behavioral pitfalls that investors make.

The Bucket Approach to Retirement Allocation

Here's your assignment: Gather up all of your retirement accounts and shape them into a portfolio that will supply you with the income you'll need during your retirement years. Oh, and one other tiny to-do: You'll also need to make sure you never run out of money, even though you don't know exactly how long you'll need it.

In the past, one simple and elegant solution to the above problem was to buy an immediate annuity that would pay you a stream of income for the rest of your life. But many investors don't like the loss of control that accompanies annuities. One other intuitively appealing idea is to sink your portfolio into income-producing investments such as bonds and dividend-paying stocks and live off whatever yield they generate. That way you might never have to tap your principal at all. The big drawback, however, is that you're buffeted around by whatever the interest-rate gods serve up. When yields are up, you're living high off the hog; when they're miserly, you have the unappetizing choice of scaling your spending way back or venturing into riskier income-producing securities to get the yield you need.

It’s no wonder that so many retirees and pre-retirees have been receptive to another strategy: "bucketing" their portfolio for retirement. At its core, bucketing is a total-return approach in which you segment your portfolio based on when you expect to need your money. Money for near-term income needs is parked in cash and short-term bonds, while money needed for longer-range income needs remains in bonds and stocks.

Portfolio 509details how the bucket approach to retirement allocation works.

What’s the Right Foreign Allocation?

U.S.-based investors keep hearing that it’s a small world, and they should therefore globalize their portfolios in an effort to maximize their return opportunity. But how should investors decide how much foreign exposure is too much and how much is not enough?Portfolio 510sorts through the issues.

Quiz 501
There is only one correct answer to each question.

1 1. What investment theory suggests that investors cannot beat the market, so they should index it?
a. Efficient market theory
b. Modern portfolio theory
c. Factor investing
2 What investment theory says that you can limit your volatility by spreading your risk among different types of investments?
a. Efficient market theory
b. Modern portfolio theory
c. Factor investing
3 Favoring smaller companies over larger ones is an example of
a. Efficient market theory
b. Modern portfolio theory
c. Factor investing
4 What is a total-return approach in which a retiree segments a portfolio based on when the retiree expects to need the money?
a. Asset location
b. Bucketing
c. A behavioral pitfall
5 What practice is related to tax planning?
a. Asset location
b. Bucketing
c. Behavioral finance
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the quiz page.
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