Book Review > The Intelligent Portfolio

The Intelligent Portfolio sets out to help investors question their assumptions about investment risk and to build knowledge to make informed choices. The author, Christopher Jones, works his way through a broad body of theory as gently as he can. The book is quite technical at times but is clearly explained through practical examples. I found it a very rewarding and empowering learning experience. His explanations of the difference between forward-thinking and backward-thinking risk assessment left me a little stunned by my own ignorance. He uses these concepts to comprehensively explain not only why past results are a very poor predictor of future performance, but how outperformance is often actually due to chance. In this way of thinking, past performance represents only one of many possible outcomes that could have occurred. In many cases weighting a portfolio with asset classes that have performed well in the past, overweights it with those that may not do well in the future.

Jones is the CIO of Financial Engines, a company that popularised the use of the Monte Carlo Simulation (MCS) in portfolio design. Financial Engines uses MCS to look past the popular inclination to put ultimate faith in history, to focus on the much more critical question of what is the likelihood of the projected results actually being achieved.

In reading expert reviews of Jones’ work, the main criticism seems to be that his central assumption is based on markets being efficient. The efficient-market hypothesis says that all participants in the market have access to, and act on all the information available as soon as possible. Therefore you can’t outperform the market except through luck. Consequently market prices are always the most accurate measure of the true value of any asset class. Financial Engines portfolio modelling is based on this premise, so if you are not a believer in efficient markets you will not agree with much of what follows.

The Intelligent Portfolio also comes with a 12 month subscription to Financial Engines’ “Online Personal Advisor” investment advisory service. This should help you work out how to apply these principles to your own portfolio.

Michael Stearn is a member of the AIA.