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Investment Advice
(Updated 5/23/08)
Previous Strategy My previous strategy for investing in the stock market was influenced by John Bogle, the founder and former chairman of Vanguard mutual funds. Bogle recommends the Total Stock Market index fund (TSM). The advantages of TSM are its simplicity and low cost. With one fund, you get stock market diversification by owning virtually all U.S. stocks. This diversified fund gets you large-cap, mid-cap and small-cap stocks. Plus, you’re diversified by style by owning both growth and value stocks. And since it’s an index fund, its cost is low with an expense ratio down around 0.20%. Shortcomings Upon closer examination, I discovered that TSM doesn’t give enough diversification. You see, TSM is a market-cap weighted index. So, stocks of larger companies dominate the index. In fact, TSM behaves much like a large-cap fund. Why is this not the best choice? Well, when we study the history of the stock market, we notice that different areas of the market will have long periods of above-trend returns (secular bull markets) and long periods of below-trend returns (secular bear markets). To cope with secular bear markets, investors may attempt to time the market -- a difficult strategy to be successful at over the long-term. Another problem with TSM comes during retirement. If the retiree has the misfortune of making withdrawals during bear markets, secular or otherwise, their nest egg can be in jeopardy of early depletion. A better diversification strategy is to own separate funds for specific areas of the market:
Large This strategy, which slices TSM into its component parts (asset classes), is called ‘slice and dice’. Slice and Dice Advantages There are three advantages of a ‘slice and dice’ strategy (S&D). 1) By slicing TSM into separate areas of the market (large-growth, large-value, small-growth, small-value), the risk to one’s portfolio from bubbles or below-trend returns in any one area of the market is reduced. As an example, did you know that during the large-cap secular bear market of 1966-1982, small-caps enjoyed their best secular bull market? That fact gets little mention from market timers. 2) With an S&D portfolio, there are now opportunities for rebalancing. This gives an automatic method to ‘buy-low’ and ‘sell-high’. So when one area of the market becomes dominant, the rebalancing discipline will force you to take profits and ‘sell-high’ -- thereby averting damage from the occasional asset class bubble and subsequent bursting. Plus, the rebalancing discipline will force you to ‘buy-low’ into the lagging area of the market. 3) Since one or more asset classes are likely to show a profit each year, an S&D portfolio will allow the retiree a greater choice of funds to withdraw those profits for current living expenses. This is important because withdrawing funds during down markets can cause one’s retirement nest egg to deplete sooner. Tracking Error If there is one disadvantage to S&D, it is psychological. You see, an S&D portfolio will perform differently, sometimes much differently, than TSM. This performance difference is called ‘tracking error’. So while in most years an S&D portfolio will beat TSM, there will be some years when TSM will beat S&D. It is when S&D lags that one has to revisit the reasons why a more diversified S&D portfolio will better serve you over the long term. Core and Explore Some investors might get restless and try ways to ‘beat the market’. It’s human nature to try to improve things. However, many studies of active investors have shown that only a minority are able to beat the market. Still, if you just have to make the attempt, a good recommendation is to invest the ‘core’ of your funds in S&D and then use the rest to ‘explore’ in active strategies. I recommend a modest portion of your funds to explore with -- perhaps 10 to 20 percent. If you’re successful with your explore strategies, great! If not, the ‘core’ of your portfolio is still intact. Sleep Factor It goes without saying that investing in stocks involves risk -- meaning that at some point your stock funds will decline. However, it is due to their higher risk (among other reasons) that have made stocks more rewarding than lower risk investments such as bonds, Certificates of Deposit (CDs) and money market accounts. So investors have to take on some stock market risk in order to reap the potential of higher returns. The question each investor then has to ask is, “How much risk can I take?” Too little risk and your portfolio might not grow large enough to meet your retirement goals. Too much risk and you might panic and sell during a severe market decline. So how do you know the ‘right’ amount? One way to find out is to imagine the maximum decline of your portfolio that you’re willing to bear. And then multiply that number by 2. Put that amount into stocks and the rest into fixed income (bonds and CDs). So for example, if you cannot bear the thought of your portfolio experiencing more than a 20% decline, then put only 40% in stocks. For those who may be able to tolerate more risk and think they can withstand a 30% decline to their portfolio, then put 60% in stocks. As a gut check, convert the percentages into dollar amounts. Sometimes, percentages are a bit abstract. But, dollar amounts may be more tangible. Fixed Income If we assume a 60% stock allocation, then the other 40% will go into fixed income. However, I would suggest keeping an emergency stash in money market that is separate from your investment portfolio. This emergency stash should be enough to cover 6 to 12 months of living expenses. So for example, if you average $2000 a month in living expenses and you have $124,000, then you can divide your funds like this:
$24,000 emergency funds in money market The goal of your fixed income portfolio should be the highest yield while maintaining a stable value. For this reason, I would limit bond funds -- whose principal value (NAV) fluctuates with changes in interest rates -- to a small portion of your fixed income portfolio. To avoid the NAV fluctuations associated with bond funds, an alternative strategy would be to construct a ladder of CDs. To build a ladder, you would start with five CDs with these maturities: 1-year, 2-year, 3-year, 4-year and 5-year. Every year, a CD will mature and you would replace it by buying another 5-year CD. In this way, your fixed income portfolio will maintain a stable value and generate a high yield. Alternatively, some 401(k) plans offer nice yielding stable value funds. If your 401(k) plan offers one, that would also be a good choice. Create your Plan and Put it Down on Paper The best way to stick to an investment plan is to write it down. Your plan should include your asset allocation and trigger points when you would rebalance. It’s probably only necessary to rebalance just once a year -- and only if one or more stock funds leads or lags too far from their original allocation. The asset allocation that I like looks like this:
10% Large (VFINX) This portfolio is the brainchild of Bill Schultheis, author of The Coffeehouse Investor. Bill has an excellent website www.coffeehouseinvestor.com where he explains in greater detail the advantages of ‘slice and dice’ and investing in index funds. A Word of Caution Regarding Actively Managed Mutual Funds At first glance, it would make sense that mutual funds employing an expert manager to pick stocks of good companies and avoiding stocks of lousy companies would provide fund owners with superior returns. Unfortunately, many academic studies demonstrate the opposite is true. Their conclusion? A passively managed index fund that owns all stocks -- both of the good companies and the lousy companies -- outperforms the majority of actively managed funds with similar style objectives. Even if you find an actively managed mutual fund that outperformed its benchmark index during the past 3 to 5 years, the odds of continued outperformance for the next 3 to 5 years are quite small. The list of winning funds often contains different names every year. Finally, there’s one possible drawback of actively managed funds when you consider them for inclusion in a ‘slice and dice’ strategy. This drawback is called ‘style drift’. For example, if you own an actively managed fund that started out as a small-cap value fund, it may evolve over time to be a mid-cap growth fund. So even if the returns are still good, your objective to own a small-value fund is now compromised. Index funds, on the other hand, do not employ an active manager to find the next hot sector. Index funds just own the stocks within their particular area of the market. Now you may ask, “Bob, index funds sound well and good. I even think your ‘slice and dice’ strategy will probably work better for me. However, my 401(k) plan only has actively managed mutual funds. What should I do?” There are two things I can suggest. First, you may try to lobby your Human Resources department to include index funds in their 401(k) offerings. And if you need supporting evidence, books by Larry Swedroe offer compelling evidence. His book What Wall Street Doesn't Want You to Know is a good choice. If no changes to your 401(k) plan take place, you may have no other choice than to make the best of what you have. Select only those actively managed funds that stay true to their style objective and that keep their expense ratios and turnover (buying and selling of stocks) to a minimum. And substitute your 401(k)’s least desirable actively managed funds with an index fund in your Roth IRA account. Conclusion Saving and investing for retirement is one of the biggest challenges facing many working Americans. The decisions we make today could have a big impact on the lifestyle we can afford in our Golden Years. Fortunately, strategies for successful investing are simple and straightforward. 1) Don’t spend more than you earn – save. 2) Don’t put all your eggs in one basket – diversify. And 3) It’s hard to beat the market – so use index funds. |
Index Fund - A fund that seeks to only mimic a particular index. It is considered passively managed by owning the stocks in direct proportion to those that compose the index itself. This is in contrast with actively managed funds whose objectives are either to earn a higher return than its benchmark index or a similar return with lower volatility.
Large-cap - Stocks of large companies such as General Electric, Microsoft and Wal-Mart. Larger companies are considered less risky than smaller companies. Because smaller companies are considered more risky, they have offered investors higher historical returns. ‘Cap’ is shorthand for capitalization – a measure of the size of a company.
Value Stocks - Stocks of companies considered cheap because they are either growing slowly or are in distress. In contrast, growth stocks are considered expensive because investors anticipate faster growth. Because companies in distress are considered more risky, value stocks have offered investors higher historical returns.
Expense Ratio - The cost of operating a mutual fund. Mutual funds with higher expense ratios cost more to operate and thus typically offer their owners with lower returns than similar funds with lower expense ratios.
Rebalancing - Over time, a portfolio’s allocation might change because some funds outperformed while other funds underperformed. Rebalancing simply means selling some shares of the outperforming fund and then using the proceeds to buy some shares of the underperforming fund. This process should bring the portfolio back to the original allocation.
Money Market Account - Invests in very short-term bonds. So the yield is usually very low. However, the advantage of a money market account is that the fund sponsor maintains the fund at a stable value of one dollar. While the stable value is not a guarantee, it has been very rare for a money market account to lose money.
Stable Value Fund - These funds are only available through retirement plans such as 401(k)’s and IRA’s. These funds offer higher rates by investing in short and intermediate-term high quality government and corporate bonds. As with money market accounts, the fund sponsor maintains the fund at a stable value. While the principal value is not a guarantee, it has been very rare for a stable value fund to lose money.
Asset Allocation - This is diversification in action. It is the decision on how to slice the pie (your portfolio) and what ingredients (asset classes) your pie will consist of.
REITs - Short for Real Estate Investment Trust. REITs are companies that hold a portfolio of income producing properties. There are different categories of REITs which include apartment REITs, office REITs, shopping REITs and others. REITs typically pay much higher dividends than other kinds of stocks.
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