Investment Management: Portfolio Diversification, …

1 Investment management Portfolio Diversi cation, Risk, and Timing Fact and Fiction ROBERT L. HAGIN. John Wiley & Sons, Inc. More Praise for Investment management Makes serious learning fun again for any serious, contemporary investor.. Charles D. Ellis, Director Greenwich Associates With unusual clarity and originality, Bob Hagin exposes a variety of in- vestment myths that have long confounded experienced professionals as well as novice investors. The invaluable lessons offered in this entertaining book will serve you well again and again as you navigate the mysterious maze of investing.. Mark P. Kritzman, Managing Partner Windham Capital management Boston, LLC. Bob Hagin's investing insights are informative and refreshingly easy to di- gest. The elements of sound nancial decision making take shape as sources of awed Investment reasoning are exposed concisely and simply. Practical takeaways abound in this book that will make anyone a more successful in- vestor or duciary.

2 Brian E. Hersey, Investment Director Watson Wyatt Investment Consulting At last, a book for duciaries and consultants that translates the often complex body of nancial theory into understandable and imminently practical Investment advice. Hagin, without the use of the jargon and equa- tions of the quantitative world, presents an integrated road map of the in- vestment process coupled with an insightful history of the major contributors to modern nancial theory.. Robert E. Shultz, Partner TSW Associates With the skill of a respected and deft surgeon, quantitative investor Bob Hagin expertly dissects the case for active Investment management . Chap- ter after pungent chapter, the myths that most investors hold as dogma are laid to rest with simple, sometimes obvious, facts and gures. If you don't believe index funds work, read this book. If you do believe, revel in it.. John C. Bogle, Founder and former CEO.

3 The Vanguard Group This book is a wonderful collection of compasses that steer investors and duciaries in the right direction. It is an Investment gyroscope since you not only get your bearings, but also never lose your balance. I am making my kids read it! Hagin changes the odds for most of us who think we know ourselves well enough to invest in the stock market. Read this book before you discover you didn't know yourself as well as you thought.. Arnold S. Wood, President and CEO. Martingale Asset management Investment management Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With of ces in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding. The Wiley Finance series contains books written speci cally for nance and Investment professionals as well as sophisticated individual investors and their nancial advisors.

4 Book topics range from Portfolio management to e-commerce, risk management , nancial engineering, valuation, and - nancial instrument analysis, as well as much more. For a list of available titles, visit our Web site at Investment management Portfolio Diversi cation, Risk, and Timing Fact and Fiction ROBERT L. HAGIN. John Wiley & Sons, Inc. Copyright 2004 by Robert L. Hagin. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc.

5 , 222 Rosewood Drive, Danvers, MA. 01923, 978-750-8400, fax 978-646-8600, or on the web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and speci cally disclaim any implied warranties of merchantability or tness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of pro t or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

6 For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at Library of Congress Cataloging-in-Publication Data: Hagin, Robert L. Investment management : Portfolio diversi cation, risk, and timing fact and ction / by Robert L. Hagin. p. cm. ISBN 0-471-46920-3 (CLOTH). 1. Investments. 2. Portfolio management . 3. Investment analysis. I. Title. HG4521 .H2247 2003. dc21 200314215. Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1. To my wife Susie and our daughters KC and Tory Acknowledgments aving spent a long and rewarding career in the Investment man- H agement business, I am indebted to many people.

7 The rst is my father. Many years ago, with my junior driver's license in hand, I. bought a 1929 Model A Ford. (At the time the car was 19 years old;. I was 14 and a half.) My father's admonition was that I could drive the car only after I had taken it completely apart and put it back to- gether. My father's lesson that whatever I do I should take apart and put back together before I drive it has served me well. In the early 1960s I was fortunate to be awarded a fellowship from IBM to pursue doctoral studies at UCLA. My thanks to IBM for nd- ing my proposal to use computers to study nancial markets worthy of funding and launching me in a career no one could have imagined. At UCLA I had an opportunity to work with many distin- guished scholars. I owe a debt of gratitude to all of them. One per- son who stands out from this elite group is Benjamin Graham (considered to this day to be the father of security analysis ).

8 He remained a mentor, friend, and frequent luncheon companion until his death in 1976. His legacy to me was, No beliefs particularly those that are most strongly held about the proper' ways to in- vest should be safe from inquiry. Never let what you think you know get in the way of learning.. After graduation and a teaching stint at UCLA, I joined the fac- ulty of the Wharton School at the University of Pennsylvania. Of my many colleagues at Wharton the person who was the invisible hand on this book was the late Chris Mader with whom I collab- orated in writing three earlier books. Moving from Wharton to Wall Street in the early 1970s was eye- opening to say the least. Armed with my rst book, The New Sci- ence of Investing, I quickly discovered the chasm that to this day separates science from seat-of-the-pants guesswork in most rms. Bridging this gap has been an almost lifelong crusade.

9 Vii viii ACKNOWLEDGMENTS. I am by no means alone in this quest. There is an invaluable network of colleagues, many of whom are cited in the following chapters. Over the years we have gathered at Center for Research into Security Prices (CRSP) seminars at the University of Chicago (now effectively replaced by the Chicago Quantitative Alliance);. Barra research seminars in Pebble Beach; Berkeley Program in Fi- nance conferences in California; Cambridge Center for Behavioral Studies seminars at Harvard; meetings at the Society of Quantita- tive Analysts in New York (where I have served as president and remain a board member); and last, but by no measure least, the In- stitute for Quantitative Research in Finance (Q-Group) seminars. The interactions and friendships afforded me by my membership in the Q-Group (where I am privileged to be a board member and serve on the program committee) have been particularly valuable.

10 I owe particular thanks to Jim Farrell, Bill Fouse, and Dale Berman, whose combination of commitment and exibility has al- lowed the Q-Group to evolve into a premier organization dedi- cated to the discussion and dissemination of the most recent quantitative research. I owe a special thanks to Jon Jankus at Guardian Life Insurance Company of America and Wayne Wagner at Plexus Group, Inc., who helped me with certain chapters as well as offered helpful sug- gestions on the entire manuscript. I received invaluable suggestions on early drafts of this book from Ted Aronson at Aronson + Johnson + Ortiz, LP; Jack Bogle at Bogle Financial Markets Research; Charley Ellis at Greenwich Asso- ciates; Jon Ender at ABN AMRO Asset management ; Brian Hersey at Watson Wyatt Worldwide; Marty Hertzberg at Spring Mountain Capital; Frank Jones at San Jose State University; Mark Kritzman at Windham Capital management ; Marty Liebowitz at TIAA-CREF.