The point is not that VT was not efficient. Its not possible to have a fully efficient portfolio, but this is not due to the point observed in the misleading paper stated above but simply a matter of information and timing challenges. The point is two-fold:
- assuming efficient markets, its impossible to systematically beat the market; BUT
- the market doesnt consist of shares only but all liquid assets with a risk premium
=> An efficient Portfolio consists of an unknown blend of risky asset classes; a shares only investment introduces inefficiencies
When we go into details, we need to consider that the paper is flawed. Whilst an assets with marginal zero weight may be hardly imagined, a negative weight one could only be explained with an asset that is either about to go bust; or that will experience a material de-valuation. In any other scenario, a negative weight does not make sense. In such scenario (bust or de-valuation) where assets risk or return would go belly up; such assuming efficient markets implied an immediate reduction / voiding of the assets market cap to adjust to the change in return/risk. A negative weight therefore only makes sense for a i) marginally small amount of time required for Mr Market to absorb the information, ii) in case of a market inefficiency or iii) asymetric information.
This actually highlights the underlying issue which is that both return and risk may not be determined but only retrospectively observed and approximated. Hence, its impossible to establish an ideal portfolio as such would need to be based on unknown risk and return data. Assuming efficient markets however, the market will constantly translate retrospectively observed data and resulting adjustment to approximate risk/return into a change in the assets market cap; leading to a situation where a market cap represents the best possible proxy to an efficient portfolio given „known“ data. Indexing is therefore the best alternative to beeing the allknowing Mr. Market himself.
What puzzles me is that many investors in this forum go all-in on shares only. Going 100% in shares is simply a speculation on a certain market segment (shares) of the entire market (risk carying assets). The rationale behind 100% assets is maximized return but not a maximized risk weighted return. The same logic could be applied further by cutting shares into additional segments that historically warrant higher returns like small caps or Nasdaq. Whilst small cap premium might (depending on the research) be historically observed, they are not guaranteed as there is no undisputed fundamental reason for the premium to prevail. Same applies to Shares vs. e.g. Real Estate returns. What if Mr. market at any given point in time and after centuries decides that RE shall have the higher return?
Taking the Shares vs. Small Caps example to showcase the point. Whilst many investors probably agree that Small Caps might imply higher prospect returns than All Shares. Who would dare to claim that their risk weighted return was higher? Hard to do… right? Even if currently observed (which is not the case) its even harder to claim that such was just given and prevailed. The exact same thought could be applied on Shares vs. All Risky Assets. Would anyone dare to claim that shares had a higher risk weighted return than e.g. 25% Shares, 25% Real Estate, 25% Bonds and 25% Gold? We could still claim so but huh… just looking at recovery time from max drawdowns; that might be bold. And even if we could claim so… how could we justify that this overperformance prevailed?
Why not simply going even more „passive“ than just shares only? Clearly… its impossible to establish a market cap global allocation over all risky assets. Besides, such would be screwed given market unequalities and incentives, e.g. tax relieve on real estate. So the second best to an all passive global allocation is probably to use observed, estimated risk/return as well as correlation figures from investable asset classes and to build a corresponding portfolio that gets close to the desired target return yet optimizes risk and return.
And what if you not just want to get close to but actually the maximum return? Well… its still more efficient to use such optimal risk/return portfolio that is somewhat close to the desired target return… and then simply leverage or de-leverage accordingly. Leverage doesnt need to imply debt, hefty interest or margin calls (dont do that) but can be self-funded. Latest beyond the first 10 years of work, most people establish both an investment portfolio as well as a fairly moderate safety cushion that within reason could be used for „self funded leverage“.
If you still insist on max return and don‘t have such safety cushion for self leverage… in my experience you then either are at the beginnig of your investment journey where future investments compared to current investments are major… aka your future income constitutes kind of a low risk asset that you use to re-balance against (so you follow a ballanced approach without noticing as your alternative otherwise would have been to on day 1 take a loan equivalent to your next 10 years savings and immediately invested all). Or if you already had certain wealth where your future investments p.a. did not exceed e.g. 10% of your current investments and you still invested 100% on shares… well then good luck with your investment strategy and I wouldnt want to comment on what I thought of such approach. But just remember that max returns of shares over all risky assets are observed but not guaranteed and you highly likely experience a worse risk weighted return than possible.
Or in simple words… do never go 100% all in on shares; unless you anual new investments materially exceed 10% of your current investments.
The Tea Lover