I thought maybe it time to offer a little something on my reasons for setting up the ‘Know-nothing Portfolio' the way I do.

Thanks to the 2000 - 2002 adjustment, most now see a need to be more diversified than just simply throwing a blanket over the US market, holding the Vanguard Total Stock Market Index Fund (VTSMX). Due to this same bear market, most would also question holding a simple balanced fund such as Vanguard Balanced Index Fund (VBINX).

There is no easy answer to the decision as to how far you would choose to enhance or diversify a portfolio for returns over risks. Looking at the past 10 years, including the bubble created by tech stocks bursting, it would seem evident adding small, value, international and specialty funds is an easy way to protect against the short-falls of the total US market and the S&P 500, but you have to ask, Is it all this evident?

2000 - 2002 was not like previous bear markets we can use to make comparisons. What is called the ‘Slice-n-Dice' portfolio, such as the Coffeehouse has gained notoriety, but if you look back to 1973 - 74, the volatility of this portfolio would have looked a bit worse than holding the total US market, as even REITs and small caps lost more than the S&P 500. REITS are generally touted as a great diversifier, but this period showed this not always to be the case. Going back to the ‘29 Crash, value, both large and small, and small caps in general as well as international lost more than the S&P 500. More recently, since Oct. of last year, the small and value risks have shown up as well.

Larry Swedroe and William Bernstein offer some portfolios more based on the Efficient Frontier, or historic returns and correlations that should reduce the tracking error of the market and the severity of volatility in the stocks in bear markets in such periods as 1929 - 1932 and 1973 - 1974. My Know-nothing Portfolio does not concern as much with this short-term volatility, but more the long-term volatility such as 1973 - 1982, or in the examples Bernstein uses in his book 1966 - 1981. In my Know-nothing Portfolio, you would depend more on higher fixed income and maybe commodities to reduce the risks. This is where I see the higher certainty of reducing risks. As William Bernstein offered in "The Intelligent Asset Allocator," ".....next year's efficient frontier will be nowhere near last year's. Anybody who tells you that their portfolio recommendations are "on the efficient frontier" also talks to Elvis and frolics with the Easter Bunny." I don't think he meant this as strongly as I take it, but you do need to be a bit reserved when looking at historic data, which he and Larry have proven to accomplished.

All-in-all, there is no answer as to what is best for all investors as far as stock diversification goes in the portfolio. The greatest, and only dependable diversification you will gain in reducing volatility of a portfolio will come from the stocks/fixed income allocations, and possibly commodities.

When you small, value and international tilt a portfolio, the best you can hope for is to increase long-term diversification and added returns to help get through the long-term periods that threaten the worst risk you can face, the risk the money will not be there when you need it. It is a matter of setting up your portfolio in both stocks and fixed income to allow a safe withdrawal rate as best as we can estimate it, as well as short-term volatility that will allow one to "Stay the course."

A general rule to how to adjust your stock/fixed allocations would be how much volatility you can accept in the short-term in hopes of longer-term gains. The rule of thumb comes out close to the highest short-term loss you can expect is around half the stock allocation to your portfolio. For instance, a portfolio of 60% stocks and 40% fixed would offer a highest expected loss of 30%. This is however, the highest ‘Expected' loss only. There are no guarantees that investing in stocks will not offer volatility similar to that we saw in 1929.

For most, it would pay to be a little conservative in your stock/fixed allocations. The additional returns might not be worth the loss of sleep you would experience in hard times, or the possibility you will not be able to ‘Stay the course', and sell out at exactly the worst time to do so.

As an example only of how going down from 70/30 to 60/40 in your stock/fixed allocations, using the 40 year period 1964 - 2003 [convenient data without updating], including two recent bear markets, you would have gained a little less than 0.3% additional return 70/30 over 60/40. In the 1973 - 1974, this would have cost you a loss of 24.9% for the 70/30 portfolio, but only 20.8% for the 60/40. For 2000 -2002, this would have come out to a 17.9% loss for the 70/30 portfolio and only 10.6% for the 60/40 portfolio.

Whether it be while building your portfolio and risking losing your income depending on your portfolio to help, or in retirement when drawing from the portfolio would magnify these losses, you would have to ask if less than a third of a percent additional return is going to warrant the additional losses.

The losses above are for the S&P 500 and intermediate term bonds. When this is extended out beyond the S&P 500 it will take higher percentages of fixed income to reduce the volatility of a portfolio, such as with my Know-nothing Portfolio;

Finding a sweet spot between higher risk and higher security using fixed is not something I think most have considered when they look at something like the Coffeehouse portfolio I mentioned earlier, the Four Pillars or the DFA portfolios.

Larry Swedroe offered this idea in how he personally invests, with an allocation 80% fixed income, and putting the 20% equities in the highest risk stocks such as DFA's US small value, International small value and emerging markets small value. Looking at the difference in expected returns of these over something like the S&P 500 would put you in around the same expected risk/return as maybe a 60/40 allocation of stocks/bonds using the total US stock market (TSM) and total US bond market (TBM). The biggest risk you would face in this particular portfolio would be the possibility your stocks didn't offer the small/value and international risk premiums going forward. One plus of this portfolio though, you could use the 80% fixed to determine your basic needs, and use the 20% equities to pay a bonus in retirement, of course sticking some of the excess returns back for hard times.

The other asset class I mentioned just briefly earlier, commodities, can make a huge difference in the reduction of volatility as they have a negative correlation to stocks and nominal bonds. At least historically, commodities have offered high returns in the years when stocks and even bonds offer negative returns.

In this, I am not talking about betting commodities themselves as this is extremely dangerous, but holding them in an ETF or fund -- in particular PIMCO's fund makes a good choice as it collateralizes the commodities with Treasury Inflation Protected Securities (TIPS). PIMCO is a managed fund, and does make some small bets on their trades, but is mostly a long-only fund, meaning they just go long on the commodities and allow rebalancing to cover these bets. If you want to go with a more index type commodities fund, Larry suggests iPath Dow Jones AIG ETN, but favors PIMCO;

Another friend, raddr, offers a good look at commodities here;

I would warn, raddr's is a look at historic returns and correlations of commodities, and as he warns, "Certainly no rational person would retire with a portfolio split roughly equally between ScV and a commodity . . . "

Commodities do offer excellent diversification, but this diversification can come with long periods of lower returns. The most extreme example of this would have been the great bull market of 1982 - 1999.

More recently commodities have proven their worth, but this also means commodities have attracted more investors running up the price. I personally think 20% is the maximum anyone should hold in commodities, with maybe 5% being the minimum. If I were to make a guess, for most 10% would prove about right for now anyway.

Whew! This has gotten long, huh? I haven't even gotten to my thoughts on asset allocation within stocks and bonds, but maybe it is time to take a break.

Chin

originally posted here;

http://socialize.morningstar.com/NewSocialize/forums/1/2508002/ShowThread.aspx?mrr=1208117890