The following is an excerpt from The Investment Answer
Once you and your advisor have decided on the general asset class mix of stocks, bonds, and cash that is right for you, it is time to focus on the specific asset class building blocks to include in your portfolio. While many people understand the idea of “not putting all your eggs in one basket,” most do not understand the concept of effective diversification.
To illustrate, here is a typical situation that we saw during the technology bubble of the late 1990s. A technology executive, in an effort to diversify his large holding of one technology company, bought 10 other technology companies. He thought he was diversifying and was smart to stay with an industry he knew well. Unfortunately, when technology stocks crashed as a group (because they share many common risk factors) his wealth was severely damaged.
The true benefits of diversification are realized when an investor considers the relationship of each asset class to that of every other asset class in his portfolio. It turns out that some asset classes tend to increase in value when others go down (or at least they don’t go down as much). Asset classes that tend to move in tandem, such as companies in the same industry group or those that share similar risk factors, are said to be positively correlated.
Assets that move independently are uncorrelated, and those that move inversely are called negatively correlated.
Figure 3-1 (not shown here) illustrates the benefit of blending two hypothetical asset classes that are negatively correlated. Asset A has different risk and return characteristics than asset B and, therefore, their prices move in opposite directions (when A declines then B rises, and vice versa).
The line labeled AB that runs down the center illustrates a blended portfolio that holds both of these assets equally. The blended portfolio has lower volatility (i.e., lower standard deviation) than either individual asset.
This is an important component of what financial economists call Modern Portfolio Theory. The concept was introduced in 1952 by the Nobel Laureate economist Harry Markowitz. Markowitz first described this idea using individual stocks, but the concept works equally well with mutual funds or entire asset classes.
This concept underscores another very important tenet of investing: focus on the performance of your portfolio as a whole, rather than the returns of its individual components. Do not be discouraged that in any given period some asset classes will not do as well as others.
Domestic Stocks
As a U.S. investor, which specific asset classes should be included in your mix? While this important topic should lend itself to a much broader discussion with your advisor, a reasonable place to start would be to allocate some of your money to domestic large cap stocks, such as the stocks included in the S&P 500 index. After all, these 500 companies account for about 70% of the market capitalization of the entire U.S. stock market.
You can then work with your advisor to identify other domestic equity asset classes that would complement and provide diversification benefits to U.S. large company stocks. We recommend including exposure to U.S. small cap and value stocks, as they can increase your portfolio’s expected return and broaden its diversification. Likewise, real estate investment trusts can serve as a useful diversifier when blended with traditional equity asset classes.
International Stocks
No discussion about investing would be complete without mentioning the benefits of diversifying internationally. Many investors are surprised to discover that the U.S. stock market currently accounts for less than half of the market value of the world’s equity markets. There are many investment and diversification opportunities outside our borders. In addition, with the advances in technology, professional money managers now have upto-the-minute information about developments in countries all over the world, and the ability to move billions from market to market nearly instantaneously. As a result, the long-term expected returns of international asset classes are similar to those of comparable domestic asset classes.
In the short run, the performance of international asset classes can be very different from domestic asset classes. Sometimes international outperforms the U.S., and sometimes the U.S. does better. This is due largely to countries and regions being at different points in their economic cycles, having fluctuating exchange rates, and exercising independent fiscal and monetary policies.
The diversification benefits of international investing are stronger when you include international small-cap and value stocks, as well as emerging market securities (stocks of companies in developing countries). Stocks of these developing countries are especially valuable for diversification because their prices tend to be more closely related to their local economies than to the global economy. By way of contrast, a large international company such as Nestle has operations all over the world, and thus is likely to have a higher correlation with other large companies in the U.S. and abroad.
Domestic Bonds
Remember that the role of fixed income is to reduce the overall volatility of your portfolio. When including bonds in your mix, we recommend using higher quality issues (bonds with higher credit ratings) and those with shorter maturities (less than five years) reduce risk most effectively. These types of bonds are safer, more liquid, and less volatile.
International Bonds
Like international stocks, international bonds can be excellent diversifiers for your portfolio. As with domestic fixed income, consider using shorter maturities and higher-quality issues. An international bond portfolio that blends U.S. bonds with those from other developed countries can have lower risk and greater expected returns than a comparable all-U.S. bond portfolio.
Use Asset Classes
With the help of today’s sophisticated computer programs, an advisor can access the historical risk and return data of different asset classes and construct a portfolio that maximizes expected returns for any given level of risk. Figure 3-2 demonstrates this concept. Higher risk/return portfolios usually have greater percentages in stocks.
Notice that the risk level reduces as the initial stock market exposure (up to about 20 percent) is added to the 100 percent bond portfolio. This is caused by the diversification benefits available from adding riskier assets that do not move in perfect unison with the other assets in your portfolio.
It’s up to you and your advisor to determine how much risk is appropriate for you.
IF FMF HADN'T CLOSED THE "ACTIVE VS PASSIVE" THREAD, AFTER I SPENT SO MUCH TIME WITH MY CONTRIBUTION, I WOULD HAVE POSTED MY RESPONSE THERE
You all make it sound so complicated, when it's quite simple. What no one is stating is a reasonable rate of return over the long term. What is your expectation with a Buy and Hold strategy, versus a Market Timing one, or a regular quarterly Rebalancing strategy based on age and risk?
I've been investing for over 25 years. I don't use Buy and Hold, except for a few stocks that pay high dividend yields, which make up about 10-15% of my total holdings. The only thing I hold at all times is Fixed Income Funds, which are now returning about 4.5%. I utilize market timing based on day to day volatility, but only with 10% of my fixed income fund at a time. When the market makes sharp moves, I go in and out of the index fund at 10% of the total value of my account. The strategy is based on the odds of the market going up or down 10 times in a row, which it rarely does. If the index is down over 1.0%, I buy. If the market is up the next day 0.25%, I sell. If it goes up the next few days, I might miss out on higher short term returns, but I make money. If the volatility is decent, I can make money as the index goes up or down on a weekly basis. The only time I don't trade, is when the market is flat, as it was this last week. Whatever I have in the index fund won't get sold until there's a good UP day. Whatever I have left in fixed income, I don't buy until there's a good DOWN day.
It makes not difference to me over the long term if a short spate of market timing is put on hold when I run out of stocks, or whether I my cost basis of all my index fund is higher than any present value. I just stop, wait, collect dividends, and put all monthly contributions into fixed income. After all, you never lose money until you sell.
History has proven over and over, that the short term (2 years or less) is very volatile, while the long term (20 years or more) is stable and based on growth of GDP and population. Who cares about the Dot.com bubble? Who cares about the latest Great Recession? It's all short term. The goal should be to trade or re-balance actively enough to get that few extra percent return off of a fixed income fund (conservative), or a few extra percent off an index or stock fund (aggressive). If the overall performance of an index over the last 50 years was 9-10%, you could conceivably get a stable, year after year, return of 12-15%. You wouldn't participate in any "good" year like 1999, or lose anything in a "bad" year like 2001. In fact, short term political, economic, and social upheavals would have very little impact on your annual returns.
Losing less money is the same thing as making more money. Risking 10% of your cash on any one day to buy some fund, leaves 90% in the box to earn interest and dividends. It leave NINE more days to sell the rest of your cash, assuming there are nine down days in a row. That rarely happens, as does NINE up days in a row. If there's ONE day where the market is higher than the last 10% lot of fund you bought, you SELL it!. What happens is that the cost basis of your more expensive lots goes down, and you have 10% more cash to buy the fund back on a down day. I caution that you only make money when you can buy the fund back lower than the price of the last lot you sell. If you run out of cash and the market continues to go down...YOU DO NOTHING! If you sell all your lots at a small profit and you run out of index fund...YOU DO NOTHING! The fixed income cash at 100% is now earning interest, or the index fund (with a higher cost basis) is earning something and losing nothing unless you panic and sell. You could be out of the market for a YEAR, missing out 1999---but also taking profit in 2000, and missing out on 2001. Remember what you define as short and long term. I don't care what the market does between recessions. Recessions and Irrational Exuberance happen as a fact of life, usually a few years in between. I'm interested in my overall average ROI from age 25 to age 70. THAT's long term!
Furthermore, the global economy is changing, as Warren Buffet recently warned that investors going forward should reasonably expect 6-7% annual returns over the LONG term, rather than the historical 9-10%. If you are an extreme saver, your annual contributions early on in life will make the difference in returns insignificant (if you consider there's really any difference in happiness between having $2 million in retirement, or $3 million) I just want to retire early, and since I didn't get a good start, I'm having to catch up with some risky market timing combined with a mitigated risk of never going all in at any one time, and neither panicking or getting greedy with the rest of the "Greater Fools" I make money off of. All I want to do is make a few more percent than the historical average of the S&P500 over 50 years.
My annualized return in 1999-2000 was 12.6%
My annualized return in 2000-2001 was 11.5%
My annualized return from Sep 2009-present day is around 10%. I'm doing a little better year to date, but this flat market bothers me now.
No year I lost money in a panic. No year I made more than 15% trying to ride the rocket. It all averages out as I said over the long term.
People are right that Buy & Hold doesn't work, as are those that Market Timing doesn't work. You have to use a bit of both strategies to make more money than the average, but not much more. To me, making 3% more in a year on a balance of $1.7 millions is better than the 6-7% we are told to expect. Even a 50 year outlook is worth a little risk and daily attention.
Posted by: Todd on The Active versus Passive Decision | September 17, 2010 at 08:23 PM
"People are right that Buy & Hold doesn't work, as are those that Market Timing doesn't work."
I view these words as intelligent words.
The big picture here is that mankind's knowledge of how stock investing works is primitive today. We know some thing well, some things sorta/kinda and some things not at all. I love much of what the Buy-and-Holders contributed but I very much do not believe that they have it all figured out today. So I believe that we need to put aside dogmatism and listen to different people with different points of view.
Does timing work? Let's talk about it. Are stocks best? Let's talk about it. Do the conventional retirement planning rules work? Let's talk about it. Do the conventional asset allocation rules still make sense? Let's talk about it. Are stocks as risky as generally claimed, or less so, or more so? Let's talk about it.
We learn by talking things over. We need a national debate on this stuff. We shouldn't let a misplaced belief in things we thought we had settled in the past block us from learning new and important things on a going-forward basis.
Rob
Posted by: Rob Bennett | September 19, 2010 at 02:12 PM