Last week, we introduced you to our weekly Investment Committee meetings. When we met for class on 4/27/18, we began our discussion on the subject of an “optimal portfolio.”

The centerpiece of investment management is portfolio construction. Alongside financial planning, the manner in which one’s money is invested is critical to meeting one’s financial goals.

Before attempting to construct the best portfolio possible, it is important to identify some core beliefs when it comes to investing. There are many, but a few we would like to highlight are:

  • Markets are efficient: By and large, the best estimate of the true intrinsic value of a stock or bond is whatever price the security is currently trading at. Free lunches almost never exist, though in hindsight may seem obvious. No one really knows what will happen to the market tomorrow or the next day.
  • Only take systematic risk: When you own the broad stock market, you are exposed to variability in the value of your investment (risk). When the economy is good, a diversified stock portfolio will go up, and when recessions hit, it will go down. The investor is rewarded for taking that risk. Over time markets go up, but the ride is bumpy. When one owns individual stocks, they are still exposed to that same economic risk. However, they are also exposed to company specific risk. The company specific risk associated with each individual stock averages together to get the broader market, meaning on it’s whole provides no additional return. By concentrating your investments into specific holdings, you are exposing yourself to increased risk without improving expected returns.
  • Risk and return are highly correlated: As markets are efficient, and assuming only systematic risk is being taken, the more (less) risk you are taking the higher (lower) your return should be over long periods of time. Since 1926, U.S. stocks have averaged a 10% return. If you were told going forward you’d get 10% every year, everyone would sign up, driving the price up until the expected return was lower. The fact that the market can be up or down 40% in a year is what makes it risky and along with that comes a return.

Keeping these “truths” in mind, we construct an optimal portfolio with the goal of achieving the following things:

  • Achieve the highest risk-adjusted return: Through the application of modern portfolio theory, we want every portfolio to deliver the largest return for a given level of risk. Financial advisors and investors together are responsible for determining how much risk the investor can and should take. At that point, we find the combinations of investments that deliver the highest expected return.
  • Keep costs low: Research shows that paying too much in fees and commissions eats into returns. Keeping costs low and achieving market returns in the most efficient manner is the proven way to build wealth.
  • Simple and customizable: Research has shown a few factors drive returns. Introducing a multitude of strategies and products generally complicates things, often driving costs up without improving returns. Additionally, every client is unique and an optimal portfolio must be customizable to their specific situation. Whether it’s a legacy stock position with large capital gains, or an employer sponsored retirement account with poor/limited investment choices, an optimal portfolio needs to be able to be customized. Simplicity meshes better with customization than complexity.

Having a plan and sticking with it is critical when it comes to investing. Cognitive and behavioral biases cause people to make emotional decisions which harm their financial well being. Understanding and buying into the investment management piece of one’s finances, helps the investor and the advisor stick to the plan and avoid the mistakes that harm most investors.


People from all across the world look forward to Friday.  Friday marks the end of a (usually long) work week and the start of what is supposed to be a relaxing weekend.  At Rockbridge, we look forward to Friday’s, particularly Friday mornings, for a different reason.

Friday mornings have become a tradition, some say a “tradition unlike any other” (not the masters), where great minds (some) sit around our conference room table and discuss the core principles of our investment philosophy and what, if any, changes should be made to our portfolios.  These meeting are led by Bob Ryan, Rockbridge’s Chief Investment Officer, and topics include anything and everything investment management related.

The purpose of these weekly articles is to inform clients what we are discussing each week and how it relates to their wealth at Rockbridge.  Our investment philosophy is proven in academia and the ideas we implement in our portfolios have been around for several years.  It’s important to us to not have a “whimsical” approach to managing wealth; something we see all too often in the investment management world.  Although we are seen as a financial planning/wealth management firm in the eyes of our clients, investment management and portfolio construction is the backbone of this process.

We hope to provide valuable insight on our Friday meetings; what some have coined “Bob’s Investment Class.”  This marks the beginning of a series of weekly posts sharing some of these ideas with you.

Thoughts from Friday 4/20/18

Mike, Ethan, and Claire, attended the Dimensional Fund Advisors (DFA) conference in New York City this week and came away with some interesting ideas for our Friday discussion.

Topic: Corporate Bond Credit Risk Premium

There are risks to consider when investing in the bond market, one being credit risk.  Credit risk is the risk of a bond “defaulting”, and in a normal market riskier bonds will have to entice investors by providing higher coupon payments.  We ran across data suggesting that bonds with lower credit quality have similar default rates to similar bonds with higher credit quality.  This begged the question of “why not invest in riskier bonds and pocket the higher coupon payment if said bonds have the same default rate as  similar higher quality bonds?”

One of our core rules is to be suspicious of any “free lunches” when it comes to investing; achieving a higher return without enduring additional risk, which is what we see here.    This situation is no exception to our core beliefs.

We discussed that although increasing credit risk in the bond portfolio might not result in a higher default rate, it would actually increase the correlation to the equity portfolio.  Bonds should be inversely correlated with equities, and increasing credit quality too much creates positive correlation to equities; meaning equities and fixed income would behave similarly, something we don’t want to happen.  Bonds provide a “buffer” in the portfolio, helping to “smooth out the ride.”  For example, in 2008 the Barclay’s Aggregate Bond Index finished the year earning 5.24% while the S&P 500 Index finished losing nearly 37%.

In summary, the role of bonds is much more than the eye sees.  Sure, we could increase expected bond returns by exposing portfolios to more credit risk, but we would increase the correlation between the stock and bond components of the portfolio as well.