November 2009

8 Simple Portfolios

I recently came across an interesting question on the Boglehead forum:

If you could only own one fund, what would you own?

That question got me thinking about one aspect of investing that doesn’t often get discussed: desire for simplicity. While some investors don’t mind managing a portfolio of ten different funds, other investors would never consider anything so complex.

Generally speaking, the more asset classes you include in your portfolio, the better diversification you’ll achieve, but it begins to require more work to manage the portfolio. Also, the additional diversification derived from adding each asset class is less than the diversification gained by adding the prior asset class.

I thought it would be fun (and perhaps helpful to investors reworking their portfolios) to put together a list of portfolios sorted by complexity. The following are my recommended one-fund portfolio, two-fund portfolio, and so on (followed by some additional thoughts). Please feel free to share your own suggestions. :)

For each fund, the first ticker is the open-end version of the fund, and the second ticker is the ETF version of the fund.

One-Fund Portfolio

  • 100% Vanguard Target Retirement Fund of your choice.

Two-Fund Portfolio

  • 70% Vanguard Total World Stock Index (VTWSX, VT)
  • 30% Vanguard Total Bond Market Index (VBMFX, BND)

Three-Fund Portfolio

  • 35% Vanguard Total Stock Market Index (VTSMX, VTI)
  • 35% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 30% Vanguard Total Bond Market Index (VBMFX, BND)

Four-Fund Portfolio

  • 30% Vanguard Total Stock Market Index (VTSMX, VTI)
  • 10% Vanguard REIT Index Fund (VGSIX, VNQ)
  • 30% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 30% Vanguard Total Bond Market Index (VBMFX, BND)

Five-Fund Portfolio

  • 30% Vanguard Total Stock Market Index (VTSMX, VTI)
  • 10% Vanguard REIT Index Fund (VGSIX, VNQ)
  • 30% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 15% Vanguard Total Bond Market Index (VBMFX, BND)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

Six-Fund Portfolio

  • 20% Vanguard 500 Index (VFINX, VOO)
  • 10% Vanguard Small-Cap Value Index (VISVX, VBR)
  • 10% Vanguard REIT Index (VGSIX, VNQ)
  • 30% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 15% Vanguard Total Bond Market Index (VBMFX, BND)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

Seven-Fund Portfolio

  • 20% Vanguard 500 Index (VFINX, VOO)
  • 10% Vanguard Small-Cap Value Index (VISVX, VBR)
  • 10% Vanguard REIT Index (VGSIX, VNQ)
  • 20% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 10% Vanguard FTSE All-World Ex-US Small-Cap Index (VFSVX, VSS)
  • 15% Vanguard Total Bond Market Index (VBMFX, BND)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

Eight-Fund Portfolio

  • 20% Vanguard 500 Index (VFINX, VOO)
  • 10% Vanguard Small-Cap Value Index (VISVX, VBR)
  • 10% Vanguard REIT Index (VGSIX, VNQ)
  • 10% Vanguard Total International Stock Index (VGTSX, VXUS)
  • 10% Vanguard FTSE All-World Ex-US Small-Cap Index (VFSVX, VSS)
  • 10% Vanguard International Value (VTRIX, n/a)
  • 15% Vanguard Total Bond Market Index (VBMFX, BND)
  • 15% Vanguard Inflation-Protected Securities Fund (VIPSX, TIP*)

*Vanguard’s TIPS fund does not have an ETF version. As such, I’ve included iShares Barclays TIPS Bond Fund (TIP) as the comparable ETF.

Regarding Stock/Bond Allocations

In order to make comparisons easy, each of the above portfolios is built using a 70/30 stock/bond allocation. There’s no particular reason that a 70/30 split was chosen over any other stock/bond split.

Any of the above portfolios can be adjusted to fit your ideal stock/bond allocation. Simply increase (or decrease) the allocation to the bond fund(s) and decrease (or increase) the allocation to each stock fund in proportion to its original allocation.

Regarding U.S. vs. International Allocations

Each of the above portfolios is built using roughly a 50/50 split between U.S. and international stocks. Many investors and investment professionals would view this as too heavy an international allocation. You can see my reasoning here and decide for yourself whether to adjust the international allocations downward.

ETFs or Index Funds?

These portfolios could be implemented at Vanguard via traditional open-end index funds or at an online brokerage of your choice using ETFs. If you do opt to use ETFs, you have an additional motivation to keep things simple: Fewer funds means less commissions paid. (Unless you’re using a brokerage firm that offers commission-free trades, that is.)

November 30, 2009 13 comments

Marginal Tax Rates and Mortgage Prepayments: Weekend Reading

Happy Friday, everybody. I hope you enjoyed your Thanksgiving celebrations yesterday. :)

My favorite articles from this week:

Investing Articles

Other Money-Related Articles

Blog Carnivals

Have a great weekend, and thanks for reading!

November 27, 2009 2 comments

Diversification and Correlation

Administrative note: There will be no new post tomorrow–taking the day off for Thanksgiving. And on that note, thanks to each of you for the roles you play here (whether buying one of my books, sharing the blog with others, or participating in the discussion). Being able to do this full-time is literally a dream come true for me. So, thanks. :D

There appears to be a prevailing sentiment that diversification failed in 2008 because U.S. stocks, international stocks, and REITs all went down at the same time.

The thing is, that’s what usually happens when one of them goes down. They are, after all, positively correlated.

In fact, even bonds–the asset class most frequently used as a diversifier for an otherwise stock portfolio–have a historically positive correlation with the U.S. stock market. If stocks go down in a given year, more likely that not, bonds went down also.

Does this mean bonds are ineffective as a diversifier? Of course not. They’re a helpful diversifier because their correlation to U.S. stocks, while positive, is quite low.

Math Refresher: Correlation Coefficient

In case it’s been a while since you studied correlations, here’s a refresher:

  • If two variables have a correlation coefficient of 1, they move in perfect lockstep. One goes up, so does the other.
  • If two variables have a correlation coefficient of 0, they’re completely independent. The movement of one has no value for predicting the movement of the other.
  • If two variables have a correlation coefficient of -1, they’re perfectly negatively correlated. When one goes up, the other goes down.

Negative Correlations: Dream On.

The dream asset class is one that would have a long-term expected return similar to stocks as well as a negative correlation to stocks (such that when one has a bad year, the other usually has a good year).

However, it’s rare that you’ll find asset classes with negative correlation to the stock market (aside from asset classes with negative expected returns). In fact, even looking for a zero correlation is quite difficult. In most cases, a low positive correlation is all we can hope for.

Seeking Low Correlations

You benefit any time you add an asset class to your portfolio that has:

  • A correlation (to the rest of your portfolio) of less than 1, and
  • A similar expected return to the rest of your portfolio.

That’s why international stocks make a worthwhile diversifier to U.S. stocks even though their correlation is quite high. When one has a bad year, there’s at least a chance that the other had a good year. Or, more likely, when one has a truly terrible year, the other may only have a “sorta bad” year.

And with bonds, even if they lose money in 2/3 years in which stocks lose money, they still provide a diversification benefit because:

  • In the other 1/3 bad years, they must have gone up, and
  • Even in the 2/3  bad years in which bonds also went down, they likely went down less than stocks.

In other words, all we’re looking for when we diversify is asset classes that will behave differently from stocks (without sacrificing too much expected return), not asset classes that always go up when stocks go down.

So did diversification fail us?

Just because U.S. stocks, international stocks, and REITs all went down in 2008 doesn’t mean “diversification failed us.” They did, in fact, all perform differently from each other–exactly what we’d hope they would do. And bonds had a great year, with many bond funds putting up double-digit returns.

It seems to me that diversification didn’t fail at all. It worked perfectly according to plan–practically a banner year for the “here’s why you should diversify” message. So what failed? The general public’s expectations and understanding of diversification.

November 25, 2009 7 comments

International Allocation: Maximum and Minimum

What percentage of the stock portion of your portfolio should be invested internationally? Vanguard’s website (in a section only accessible if you’re logged in) contains this statement:

“Investing up to 20% of your stock portfolio in international stocks can help you diversify. Between 20% and 40%, your diversification improves, but at a lower rate. And because of the risks of international investing, an upper limit of 40% is wise.”

20-40%. That’s more or less in keeping with conventional wisdom.

But conventional wisdom seems to gloss over something here: Having 80% of your portfolio (more than 80% if we assume that the entire bond portion is invested in U.S. bonds) invested in one country is not diversified–especially for anybody whose income is largely dependent upon the U.S. economy.

Past and Future

I assume Vanguard’s statement is based on an analysis of historical returns. I can only guess which exact period(s) they’re looking at, but surely it’s limited to the 20th century plus the first decade of this century–a period during which the United States went from being a young upstart nation to being the world’s largest economic superpower.

It’s hardly a surprise that based on an analysis of that period, a U.S.-heavy portfolio looks pretty darned good. What I’m not so sure we can expect is for the next 10, 20, 30, or 60 years to look the same.

Starting Point: Market-Weighted Portfolio

To me, it seems that the starting point for discussion should be a market-weighted portfolio. At the moment, such a portfolio would be invested approximately 40% in the U.S. and 60% internationally.

From there, you can make adjustments to cater to your specific needs. For example, if you’re in (or close to) retirement, it could makes sense to decrease your international allocation for two reasons:

  • First, you’re going to be spending down your investments soon, which means that it would be good to minimize currency risk (the risk caused by fluctuations in exchange rates that comes with owning non-U.S. investments).
  • Second, you have fewer years remaining in the workforce, meaning that you’re less dependent upon the U.S. economy that somebody who is, say, 25 or 30.

Alternatively, if you’re in your 20s or early 30s, it could make sense to increase your international allocation relative to a market-weighted portfolio for precisely the opposite reasons.

Avoiding the “Growth Trap”

What I’d caution against, however, is falling into the growth trap–overweighting emerging markets (China or India, for instance) simply because you know they’re going to grow at a faster rate than the U.S. over the next couple decades.

When it’s obvious that a country’s economy will be growing quickly, that growth should already be reflected in the price of their stocks. To earn above-market returns, you need to invest not in countries (or companies) that grow quickly, but in countries (or companies) that grow more quickly than expected.

If you’re going to invest more of your portfolio in non-U.S. investments than conventional wisdom would suggest, do it with the goal of diversification, not with the goal of earning superstar returns.

November 24, 2009 12 comments

Testing EMH: The Joint Hypothesis Problem

Hypotheses cannot be proven. They can only be disproved. As Taleb reminds us, even with hundreds of thousands of white swan sightings and no black swan sightings, it was never possible to prove the statement “all swans are white.” Yet one single sighting of a black swan could (and did) immediately disprove the statement.

In finance, people often seek to disprove the efficient market hypothesis (and thereby give hope to active fund managers, active fund investors, stock pickers, market timers, and stock newsletter publishers that their efforts aren’t doomed to failure). The trick is that EMH is an incomplete hypothesis, and it cannot be disproved.

Testing EMH

We can say “markets are efficient” and “an efficient market would look like X.” But if we test, and find that markets don’t look like X, we don’t know whether:

  • Markets are not efficient, or
  • Our description of what an efficient market looks like is inaccurate/incomplete.

This is what’s known as the joint hypothesis problem. When we attempt to test EMH, we’re automatically testing two hypotheses:

  1. “Market’s are efficient” <— the efficient markets hypothesis, and
  2. “Efficient markets look like X.” <—the secondary hypothesis.

If the joint hypotheses are proven false, it’s impossible to know which one was proven false.

For example, we might describe an efficient market as one in which asset classes have expected returns proportional to their risk (as measured by volatility of returns). And if we found two asset classes with equal volatility where one reliably outperformed the other, we might be tempted to say that markets are not efficient.

But that’s not necessarily the case. Perhaps the market is smarter than our description of it, and there are other factors at work. For example, there may be forms of risk other than volatility (illiquidity for instance) that would cause an efficient market to allow one asset class to have higher expected returns than the other.

The Takeaway for Investors

So what’s the point of all this? The point is that you should be extremely leery anytime you see somebody claiming that:

  1. “Markets are not efficient, and I have proof!” or
  2. “I can help you increase your return without increasing risk.” (which, by the way, is just the I’m-about-to-sell-you-something version of claim #1).

Of course, for precisely the same reason EMH can’t be proven false, it can’t be proven true either. EMH’s value lies, in my opinion, not in our ability to prove or disprove it but rather in its usefulness as a lens through which we can examine market phenomena and perhaps come to a better understanding of why the market does what it does.

November 23, 2009 7 comments

Weekend Reading, Boglehead Interview Edition

It’s no secret that I’m not a fan of The Motley Fool. In short, I think investors would be better off if the entire stock-picking newsletter industry just disappeared. That said, this Robert Brokamp fellow who’s been writing guest posts at Get Rich Slowly seems to have his head on straight.

Rather than writing articles about “3 ETFs Ready to Soar!” (an actual Fool headline, shown in an ad in my gmail this week), he writes helpful articles such as How Much Is Your 401k Costing You? and Investing 101: How Diversification Reduces Risk.

Brokamp recently interviewed Taylor Larimore, one of the authors of the Bogleheads’ Guide to Retirement Planning. The interview was posted here on the Bogleheads’ Forum. I suggest checking it out.

My other favorites from this week:

Investing Articles

Other Money-Related Articles

Blog Carnivals

As always, thanks for reading. I hope you all enjoy your respective weekends. :)

November 20, 2009 2 comments

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