In Search of the Perfect Portfolio: The Stories, Voices and Key Insights of the Pioneers Who Shaped the Way We Invest. 2021. Andrew W. Lo and Stephen R. Foerster. Princeton University Press.
Between the introductory and concluding chapters of this book, each of the 10 famous superstars of finance receives a chapter of its own.
In the order in which they appear and with their main contribution to what we know about investing, they are Harry Markowitz and portfolio selection, William Sharpe and the capital asset pricing model (CAPM), Eugene Fama and efficient markets , John Bogle and index investing. , Myron Scholes and option pricing, Robert C. Merton and option pricing, Martin Leibowitz and the bond market; Robert Shiller and market irrationality, Charles Ellis and index mutual funds, and Jeremy Siegel and the long-term stability of real stock returns.
Two names, however, are notable for their omission: the Omaha, Neb.-based value investing team of Warren Buffett and Charlie Munger. Munger’s name is absent, and Buffett’s gets only five brief mentions, perhaps because of his directive to the receiver of his estate: “Put 10% of your cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”
In light of this counsel, it is worth noting that an investor who bought 100 shares of Berkshire Hathaway at $15 a share after Buffett gained control in 1965 and still holds it would have a stake that, in as of this writing, it is worth just under $56.4 million. This represents a compounded annual rate of return of 20.3%. If that same investor had bought 100 shares of an S&P 500 index fund at $173 a share in January 1965, that investment would be worth about $469,000 today for a compounded annual rate of return of just under 6%.
I emailed Lo and Foerster to ask about the omission of Buffett and Munger. Each responded quickly. One wrote that the reason they were excluded is that so much had already been written about them. The other noted that “the purpose of our book was to help readers understand the March to think about portfolio construction” and that “most of these highly successful investors have spent very little time and effort educating investors on how to invest.”
The book’s opening chapter, “A Brief History of Investments,” begins with an extremely useful chart that shows the connections between the superstars, such as whether they were fellow PhD students, whether they extended or started teaching the work of another, they received the Nobel Prize in the same year. , etc. The chapter includes short sections on the evolution of investing, as well as sections titled “Early Diversification” and “The Science of Investing in the Twentieth Century.”
Three chapters in particular, two focusing on investment pioneers Sharpe and Bogle, and the final chapter, “What’s the Perfect Portfolio?” are particularly convincing.
The capital asset pricing model
The opening paragraph of Sharpe’s profile rightly notes that CAPM was “an idea that forever changed the way portfolio managers approach their trading.” And that “Sharpe narrowed the focus of Markowitz’s portfolio idea and did more than any other financial economist to make the investment process more accessible to all of us.”
After earning his bachelor’s degree in economics in 1955, Sharpe applied for jobs in banks. They all turned him down because, he believed, they wanted B students, not straight As. He stayed in school, earned a master’s degree in 1956, and joined the RAND think tank that same year.
Sharpe discovered that he had a knack for programming, which he really enjoyed. While at RAND, he took night courses to earn a doctorate in economics, which he received in 1958. Professor Fred Weston hired him as a research assistant and became one of his mentors. A second, Armen Alchian (later of “Alchian and Demsetz” fame), “taught Sharpe to question everything and to analyze a problem from first principles.” This, in turn, allowed him to “criticize his own work and play devil’s advocate when necessary.”
“Portfolio Analysis Based on a Simplified Model of Securities Relations” was the title of Sharpe’s 1961 thesis. The final chapter of this paper, “A Positive Theory of Security Market Behavior,” eventually led to the CAPM development. This, in turn, gave rise to the market portfolio, which we know today in the form of index funds. In September 1964, the Finance magazine published his paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Risk Conditions.” By 2021, the paper had generated more than 26,000 citations.
Index investment
Most investors who try to “beat the market” don’t. This failure eventually gave rise to index funds or “passive investing.”1 The idea for an index fund came from a three-page article by Paul Samuelson in 1974. Bogle subsequently launched the first index mutual fund, First Index Investment Trust, in 1975. It started with assets of $11.3 million, a far cry from $160. million that Bogle hoped to raise. The first index and a second fund became Vanguard Group.
When Bogle died in 2019, the two funds had more than $5 trillion under management.
So what is the perfect wallet?
After sections devoted to each luminary’s notion of the “perfect portfolio,” Lo and Foerster state the obvious: There is no such thing. They note that perfect health is the parallel of this portfolio: there is no such thing, only degrees.
The authors, however, offer a list of seven principles by which investors can build their own “perfect portfolios.” These include such sound recommendations as determining the extent of financial planning expertise and the amount of time and energy one is willing to devote to managing a portfolio, defining a comfort zone in terms of profit and loss, and avoid mistakes like paying unnecessarily high commissions and invest with active managers based on friendship.
Lo and Foerster also summarize the book in a table of 16 investor archetypes that categorizes people based on their risk tolerance, income and spending habits, while taking into account the economic environment. Depending on the category that best applies to them, individuals should take courses ranging from investing primarily in equities and staying the course to reducing spending and immediately consulting a financial advisor.
All in all, I highly recommend this book. I think it’s worth the time of both neophytes and experienced investors.
1.The topic was first published in 2004 as “The Case for Indexing” by Nelson Wicas and Christopher B. Philips. Unfortunately, the original version is no longer available. However, an excellent explanation of index funds, their origins, etc., is accessible via Investopedia.
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Warren D. Miller, CFA, CPA
