ffirs.qxd 11/3/03 10:38 AM Page iii Investment Management Portfolio Diversification, Risk, and Timing—Fact and Fiction ROBERT L. HAGIN John Wiley & Sons, Inc. ffirs.qxd 11/3/03 10:38 AM Page a 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 financial decision making take shape as sources of flawed investment reasoning are exposed concisely and simply. Practical takeaways abound in this book that will make anyone a more successful in- vestor or fiduciary.” —Brian E. Hersey, Investment Director Watson Wyatt Investment Consulting “At last, a book for fiduciaries and consultants that translates the often complex body of financial 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 financial 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 figures. If you don’t believe index funds work, read this book. If you dobelieve, revel in it.” —John C. Bogle, Founder and former CEO The Vanguard Group “This book is a wonderful collection of compasses that steer investors and fiduciaries 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 ffirs.qxd 11/3/03 10:38 AM Page i Investment Management ffirs.qxd 11/3/03 10:38 AM Page ii Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices 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 specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and fi- nancial instrument analysis, as well as much more. For a list of available titles, visit our Web site at www.WileyFinance.com. ffirs.qxd 11/3/03 10:38 AM Page iii Investment Management Portfolio Diversification, Risk, and Timing—Fact and Fiction ROBERT L. HAGIN John Wiley & Sons, Inc. ffirs.qxd 11/3/03 10:38 AM Page iv Copyright © 2004 by Robert L. Hagin. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. 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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 www.wiley.com. Library of Congress Cataloging-in-Publication Data: Hagin, Robert L. Investment management : portfolio diversification, risk, and timing—fact and fiction / 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 332.6—dc21 200314215 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 ffirs.qxd 11/3/03 10:38 AM Page v To my wife Susie and our daughters KC and Tory ffirs.qxd 11/3/03 10:38 AM Page vi ffirs.qxd 11/3/03 10:38 AM Page vii Acknowledgments H aving spent a long and rewarding career in the investment man- agement business, I am indebted to many people. The first 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 find- ing my proposal to use computers to study financial 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”). 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 first 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 firms. Bridging this gap has been an almost lifelong crusade. vii