Skip to main content

In any walk of life, the participants can be divided into two distinct camps: the individuals with the ability to see clearly and apply logic to their endeavors, and the other 99% of us who thrash about trying to figure out what the heck to do.

In the investing world, James O'Shaughnessy is one of those rare birds in the former camp.

Fortunately, O'Shaughnessy is willing to share his insights on asset allocation and long-term investing with the masses. If you put money to work with Bear Stearns Asset Management, where O'Shaughnessy is senior managing director, you can benefit from his experience. You can also invest in the


Bear Stearns Alpha Growth Portfolio fund, which has returned 6.65% a year over the past five years -- placing the fund in the top 2% of all large growth funds, according to Morningstar. Or, for about $35, you can purchase O'Shaughnessy's

How to Retire Rich


What Works on Wall Street

, two epics of investing strategy that are easy to read and endlessly useful.

For this week's

10 Questions

, we caught up with O'Shaughnessy to discuss the markets, the "very boring" virtues of diversification and the perils of the "Four Horsemen of the Investing Apocalypse," as he says.

1. Does the market's rally of the past few months have any bearing on your long-term outlook for investing and asset allocation?

That's one of the classic questions, really. And I don't mean to offend, but it's also one of the wrong questions. That's the reason Dalbar results are what they are

Editor's note: Studies by Dalbar show that the average investor's returns trail the market significantly, primarily because of short-term trading activity.

When people focus too much on the short-term moves in the market and try to chase performance, they lose the forest from the trees. They are forever chasing the dot.

Scroll to Continue

TheStreet Recommends

The behavioral finance experts have a lot to say about the perils of applying short-term thinking to long-term investing. It doesn't matter what the market is doing in a given year; there are better questions to ask. How old am I? What are my investment goals and how can I achieve those goals? If I'm 30 years old with no dependents and have a great job, it's a little easier to answer than if I'm 45 years old with two kids and a 401(k) that hasn't done well the past few years.

Nonetheless, people have to define their long-term goals and set up a diversified portfolio that they are comfortable with. That's the problem in these markets. If I want to sleep well, I'll never retire.

Rather than ask, what do the past three months teach us we should ask, long term, what asset classes offer the best returns? What are the best asset classes and how do I blend them in to my portfolio?

The only time we at Bear Stearns Asset Management make strategic calls on asset allocation are after evaluating historical returns of asset classes. We might want to overweight large-cap value because historically they have offered better returns than large growth.

2. One asset allocation subject that's a source of debate is the role of international assets in your portfolio. Vanguard founder John Bogle and others say individuals can get their international exposure by holding U.S. multinationals. In your opinion, do investors need to get overseas exposure?

I just gave a speech in London to a group of executives called Inspired Leaders; essentially they were executives at FTSE-100 companies. To prepare for the speech, I wanted to look at how similar the U.S. and U.K. markets were. I was really struck by the absolute similarity.

When we were in a bear market, they were in a bear market. When we were in a bull market, so were they. The U.K. has had the same number of bull markets and bear markets that we have had. These markets have a very high correlation.

If you're an alpha hunter, you shouldn't exclude overseas companies. If you have the resources, you should go global to find the best companies.

On the other hand, if you are using mutual funds for your portfolio, the Bogle camp is broadly correct. The biggest companies domiciled in the U.S. draw the majority of the revenue from overseas operations. It's better for the average investor to have good domestic exposure, which will take care of the international exposure as well.

3. The high correlation level with Western European markets is understandable. What about developing countries in Asia, say, where burgeoning domestic economics may spell great growth over the next few decades?

OK, now we're talking specifically about emerging markets. Emerging markets definitely have a very low correlation to the U.S.

The caution I would add to a discussion of emerging markets investing is this: They have low correlation and great potential because they also have a very high risk level. So my first piece of advice is caution; emerging markets may be a wild ride that you find you can't stay on for, in which case you end up selling at what might be the worst possible time.

But if you are going to invest in emerging markets, one of the best strategies I have been able to find is using a group of ETFs

exchange traded funds that mirror specific markets.

However, if you do, you have got to rebalance your portfolio. Failing to rebalance is even more damaging in emerging markets. Let's say you have Taiwan, China, Russia and a few other countries in your emerging market ETF portfolio. What we've historically seen with emerging markets is that there is no rhyme or reason to return patterns. Transylvania may be up 100% on year and Bulgaria is down 80%. The next year, Bulgaria may be up 100% and Transylvania is down 80%. If you haven't rebalanced, you had entirely too much exposure to Transylvania.

So: Equal weight emerging market ETFs, hold them and rebalance to equal weight them each year. That allows you to harvest the gains that have done well and add to the groups that have underperformed.

One final point to underline: Emerging markets are not something we recommend for nonsophisticated investors.

4. This raises an important question. What do you recommend for the nonsophisticated investor? There is so much information -- often times, bad information -- that gets disseminated that it's hard for the average investor to know what to do.

For most investors, the best thing is to hire Bear Stearns Asset Management and let us assist you. (Laughs.) Of course, if you don't have the resources to hire us, I would still recommend that you outsource the management of your portfolio because you will be outsourcing the emotion.

But if you really want to do it yourself, find an investment strategy, make sure it matches your psyche and comfort level and let it run. I tried to detail investment strategies for independent-minded investors in

What Works on Wall Street


How to Retire Rich


Let's take Dogs of the


, for instance.

Editor's note: The Dogs of the Dow is an investment strategy in which investors buy the 10 stocks on the Dow Jones Industrial Average with the highest dividend yields.

See this story for more information. In rolling 10-year periods back to 1928, there are only two periods where the Dogs of the Dow didn't beat the

S&P 500

: 1968 and 1999, at the end of two speculative manias.

Bet where there's a long history of proven performance, and ensure that you are using a strategy that is married to your risk-tolerance level.

A lot of investors don't really understand the notion of their risk-tolerance level, although after having lived through this bear market many people have learned. (Laughs.) Your behavior during the past few years may teach valuable lessons. Did you sell out near the bottom of 2002? You can do better the next time by just letting the strategy work.

You're right, there is a ton of information out there. There are innumerable sites, and some do have some bad information. Trust, but verify, as Reagan said.

Unfortunately, investors are too guided by emotions. Sadly, that will always be the case. The four horsemen of the investing apocalypse are fear, greed, hope and ignorance. And ignorance is the only one that's not an emotion.

5. At Ibbotson Associates' Asset Allocation conference in February, you discussed the various asset classes and how you thought they would perform over the next 20 years. Would you discuss what asset classes are important for investors, and how they should use them to build a diversified portfolio?

Asset allocation and style diversification are bedrock principles of investing. One of the biggest mistakes people made was jettisoning every asset class that wasn't large growth because they were weighing down their returns.

And this was easy to do in the late 1990s, when you had people -- including many experts and media pundits -- saying, it's a new era! It's different this time! They repealed the business cycle! (Laughs.)

It's never different this time. Now that we have once again learned this lesson, a lot of investors have to start over. Asset allocation and style diversification are the starting points.

Look at your portfolio and then go on Morningstar, Smart Money or any place that explains style attributions of your mutual funds. Make certain that you have exposure to the following asset classes: large growth, large value, small growth and value and mid-cap growth and value.

Now, how should you allocate those assets? You should have at least a market weighting in small-cap stocks. The unequivocal proof for the last 75 years is that in any 20-year period small-cap stocks have done better. I'm not saying bet the farm on small-caps, but you have to have them included in your portfolio.

So, about 25% of the market according to capitalization weighting is smaller-cap stocks. You should have at least 25% of your portfolio in smaller growth and value.

That leaves 75% for large-cap stocks. How should you allocate between large growth and large value? If you look at the Fama-French historical data, large value outperforms large growth. This is consistent with the data I used for

What Works on Wall Street


You could put 45% in large value, and 30% in large growth. Now, if you are comfortable with a little additional risk, you can tilt your portfolio more toward small-cap, maybe a little more growth. If you are more conservative, you can tilt it more toward large value.

Whatever you decide to do with your asset allocation, you must remember to rebalance. One of the biggest mistakes investors make is that they fail to harvest gains. At the end of the first year, one of those asset classes is going to be overweight. If small-caps rise, you may have 38% instead of 25%.

Bring it back to the target


Take money off the table in the classes that did well, and put it back in the classes that have underperformed. People normally do it the other way around, throwing more money into hot asset classes. This is what leads us to the Dalbar results.

6. How about on the fixed-income side of the portfolio?

We remain unequivocal in our advice on fixed income:

avoid long bonds

. Long bonds are not in a position to do well in the next long while. To quote Floyd Norris, we're going from a period of risk-free return to a period of return-free risk.

Use intermediate-term bonds as your longest bonds. Bring your durations in shorter, to about three years. Interest rates are going to go up, and bonds are going to go down. They will not give you protection. Stick with intermediate-term bonds and lower.

Besides, intermediate-term bonds offer better diversification. When equities have been negative, intermediate bonds have done better. So the historical numbers would say that intermediate-term bonds are better anyway.

7. In writing about mutual funds, you have said, "It's not a perfect world, and mutual funds are not a perfect investment." Yet they remain one of the primary vehicles for individuals to invest in the market. What are the pitfalls and rewards of mutual funds, and how should investors navigate them?

In the interest of full disclosure, I should mention that I run the Bear Stearns Alpha Growth mutual fund.

There are a few things investors need to consider. Investors should look for funds that have easy-to-understand strategies that they can adhere to. E.B. White said, if your thinking is clear, your writing will be clear. Well, if an investment firm's thinking is clear, its strategy will be clear.

That's sounds great, right, but how can investors tell? Look at a fund's prospectus; the more disciplined the fund's strategy sounds, the better. A clearly defined strategy is a plus. Look to see if there is great style consistency as well as great performance consistency.

The other advice is more general:

don't chase performance


As was the case in the late 1990s, investors often throw all of their money in hot asset classes -- and it's the worst thing you can do. Go look for a large value fund that has a consistent performance record and few changes in its style box.

Editor's note: Morningstar's Web site tracks style box changes. Do the same thing with large growth, small growth and your other asset classes.

As you'll see with the advice, all roads lead back to Bear Stearns Alpha Growth. (Laughs.)

8. Let's talk a bit about your fund. The fund relies on quantitative research models, but I see you have large holdings in some heady growth stocks such as Citrix Systems (CTXS) - Get Citrix Systems Inc. Report, eBay (EBAY) - Get eBay Inc. Report and Cisco (CSCO) - Get Cisco Systems Inc. Report. Would you explain how your models lead you to the stocks in the fund?

We use four separate models in our stock selection. We are always looking for underlying factors that have proven themselves over many market cycles to be successful strategies.

It's very similar to some of the methods I discuss in

What Works on Wall Street


How to Retire Rich

, the difference being the focus solely on large growth. In terms of the human factor, we don't override the models. We let the underlying discoveries work.

With the Alpha fund, we search for good stock-price appreciation over the previous one- and six-month periods, positive earnings momentum and a strong projected earnings model -- with earnings projections over three to five years. We also look at price persistence. We use valuation metrics, primarily a low price-to-sales ratio, to find reasonably valued stocks. And then we use a multifactor model to sum up our findings.

9. The price appreciation model -- buying stocks that have already risen -- may come as a surprise to some of our readers. Would you explain a little further why it works and how you apply it with the other metrics?

All of the empirical analysis that has been done demonstrates that it is the only model that works. It is the only single growth variable to beat the market going back five decades. At least six studies confirm this evidence.

The reason we marry in projected earnings into our model is that it has a low correlation with price appreciation. By marrying together strategies that have low correlation to one another you reduced your risks. This is an important point: When you add security selection models that have a high correlation with each other, you get the same results. We've put together a selection methodology without taking huge levels of risks.

10. Any final thoughts for our readers?

We should paraphrase Woody Allen's line about 80% is just showing up. Well, 99% of long-term investing is just building a diversified portfolio and rebalancing every year. It's very boring, very dry and very rewarding over the long run.

For years after the 1987 crash I would get asked the question, aren't you terrified by the 1987 crash? No. And in 2017, you aren't going to be terrified of the crash of 2002. Don't let all of your todays ruin your tomorrows. Every day you are closer to your final goal. As Albert Einstein said, compounding is one of the most miraculous mathematical discoveries of all time.

This advice may seem dry. It's very dull for cocktail party chatter, but it's the most important thing investors need to know.