Who Should NOT Invest in Total Market Index Funds?

I have told you in many of my videos that low-cost total market index funds are the most sensible Investments for most people just own the market I stand by that statement but as true as it is there's a lot more Nuance to making good asset allocation decisions how do you know if you like most people and if you're not like most people how should your portfolio be different from the market I'm Ben Felix portfolio manager at pwl Capital and I'm going to tell you based on portfolio Theory who should not invest in total market index

funds Harry Markowitz developed modern portfolio theory in the 1950s on the basis that investors seek to minimize the variance in their portfolios for a given level of expected return or maximize their expected return for a given level of variance the optimal set of risky portfolios are mean variants efficient and the risky portfolio with the highest sharp ratio is called the tangency portfolio in this Theory all investors optimally hold the tangency portfolio combined with a long or short position in the risk-free asset Bill Sharp's 1964 Capital asset pricing model the cap M turns Markowitz Theory into

a testable prediction about the relationship between risk and expected return in the cap M each asset's price is based on its contribution to the risk and expected Return of the market portfolio in an efficient market with cap M pricing all assets must be priced such that the market portfolio is the tangency portfolio this is a huge Insight with cap M pricing the market portfolio is the mean variance optimal portfolio if we stop here a portfolio of market cap weighted index funds which are a proxy for the market portfolio is optimal for all investors but the

cap m is not perfect investors don't only care about portfolio variants they care about how their portfolio behaves relative to all of the other stuff going on in their lives sure they don't want variants but they especially don't want bad returns and bad times to address this Robert Merton's 1973 inter-temporal cap M or icap M considers a multi-period investor who in addition to mean and variance is concerned with the covariance of their portfolio with things like their labor income the prices of consumption goods and their future expected returns icap M investors are still concerned with

optimizing mean and variance but they're willing to make trade-offs like accepting lower expected returns for a portfolio that is less sensitive to the states of the world that they are concerned about which also means that the Securities that most investors want to avoid must have higher expected returns this materially changes the logic of market cap weighted index funds being universally optimal for all investors in the icap M the marketplace portfolio is no longer the tangency portfolio it is the multi-factor efficient portfolio I know that's some Next Level jargon but let me try and break it

down rather than a single theoretically optimal portfolio for all investors there are infinite optimal portfolios where optimal is different for each investor based on what they have going on outside of their portfolios the market portfolio Aggregates all of these optimal portfolios which is called multi-factor efficient because it is efficient for the average investors mean variance and covariance preferences but all investors are different the market portfolio is still optimal for the average investor but it is sub-optimal for everyone who is different from average this is important if you resemble the average investor you should hold the

market portfolio through low-cost index funds but if you have more or less sensitivity to the risk that the average investor is worried about your portfolio should be different from the market portfolio at least in theory if you are not exposed to any common risks outside of your portfolio that is you don't depend on labor income own a business or otherwise have sensitivity to economic risk outside of your portfolio a retiree might be a good example or if you're willing to load up on more risk than the average investor you might want your portfolio to look

different from the average investors portfolio exactly how a portfolio should look different to account for investor differences is the next question this is where Fama in French's 1993 paper common risk factors in the Returns on stocks and bonds is important they take the empirical evidence that small cap and low priced or value stock returns are not explained by market risk and suggest that these stocks May reflect sensitivity to commoner risks that investors care about empirically value stocks do tend to be under distress have high financial leverage and face substantial uncertainty in future earnings they tend

to be much riskier than growth stocks and bad Economic Times and only slightly less risky and good times they deliver low Returns on labor income and consumption fall and they're more sensitive to Market cash flow shocks than growth stocks based on this we would expect investors with low Financial wealth and high exposure to macroeconomic risk to tilt their portfolios toward growth stocks which act as hedge portfolios interestingly but perhaps not surprisingly the theory does seem to hold up empirically based on the way that investors shift their portfolios from growth to Value over time one of

the big takeaways is that if you are not the average investor the market portfolio which we can easily proxy with low-cost total market index funds is not fear critically optimal for you investors who are more able or willing to take on the risks that the average investor wants to avoid should tilt their portfolios away from the multi-factor Hedge portfolios and toward the portfolios more exposed to priced risks like value stocks they should not just sit back and buy the market there are practical challenges though farm and French have put forward a model of common risk

factors but there is no consensus on what the true pricing factors are there are literally hundreds of documented factors in the academic literature given this uncertainty one of the challenges with being different from the market is that each time you trade you might be trading against a skilled active manager who knows more than you do owning the market is a hedge against being misinformed you buy it once and forget it tilting toward riskier stocks requires more Trading I think this is an important counter argument to deviating from the market portfolio but while it is true

there are hundreds of documented risk factors they all kind of boil down to 13 main themes the majority of which form significant parts of the tangency portfolio we don't have perfect information about differences and expects of returns but we do have pretty good information being different from the market also introduces monitoring costs the market portfolio is what it is it's easy to see if you're getting what you paid for when you invest in a total Market ETF tilting toward riskier stocks like value stocks requires more oversight to know whether the portfolio is delivering what you

expected and doing so efficiently your life is a lot easier when you just own the market through low-cost total market index funds even if it is theoretically sub-optimal for you to do so so who should not sit back relax and invest in total market index funds the market portfolio which we can proxy with total market index funds is optimal for the average investor if you are different from the average investor or are comfortable assuming you're different from the average investor you may want to tilt your portfolio toward or away from riskier stocks if you're willing

to take on the risks that most investors want to avoid and earn higher expected returns for doing so tilting toward portfolio is exposed to priced risks like value stocks can make a lot of sense value stocks have historically outperformed growth stocks and the market over most time periods around the world which is consistent with what the theory would predict but remember it's not a free lunch you need to be willing and able to take on the risk if you're a skeptic about all this stuff and want to minimize the risk of trading on bad information

owning the market portfolio accomplishes that I think there are worse positions to take but we do have Decades of theory evidence and practical implementation supporting the existence of differences and expected returns and the ability to capture them in portfolios finally if you don't want to spend any time monitoring your portfolio total market index funds are hard to argue against even if they are theoretically sub-optimal on other measures thanks for watching I'm Ben Felix portfolio manager at pwl Capital if you enjoyed this video please share it with someone who you think could benefit from the information

we discussed the benefits and trade-offs of Simply owning the market portfolio through low-cost index funds with John Cochran in episode 169 Gene Fama in episode 200 Jonathan Burke and Jules van binsbergen in episode 220 and Robert Merton at episode 234 of the rational reminder podcast these are some of the best Minds in financial economics including two Nobel laureates it's worth hearing what they have to say on this topic I learned the information presented in this video by preparing for and having those conversations with them we put together a short video on the rational Miner Channel

with the relevant Clips to accompany this video [Music] where are you