Know-nothing Investor

Q&A for chinwhisker's 4Pillars Vanguard portfolio

2008-09-14T12:53:58Z

Ask questions related to the "4Pillars Vanguard" Portfolio here.

Q&A for chinwhisker's Lionheart portfolio

2008-09-07T17:25:39Z

Ask questions related to the "Lionheart" Portfolio here.

Q&A for chinwhisker's Endowment Imitator portfolio

2008-09-07T17:23:08Z

Ask questions related to the "Endowment Imitator" Portfolio here.

Q&A for chinwhisker's Cowardly Lion portfolio

2008-09-07T17:18:38Z

Ask questions related to the "Cowardly Lion" Portfolio here.

The Know-Nothing Portfolio

2008-02-02T18:33:42Z

I'm going to do this a little different than those who write the books that move Wall Street. I am going to offer the portfolio in advance, then explain it.

This is the Know-Nothing Portfolio;

Vanguard 500 Index (VFINX)
Vanguard Mid-Cap Value Index (VMVIX)
Vanguard Small Cap Index (NAESX)
Vanguard Small Cap Value Index (VISVX)
Vanguard Developed Markets Index Fund (VDMIX)
Vanguard Emerging Market Index (VEIEX)
Vanguard International Value (VTRIX)
Vanguard International Explorer Fund (VINEX)
Vanguard REIT Index (VGSIX)
Vanguard Precious Metals (VGPMX)
Vanguard Energy Fund (VGENX)
Vanguard Inflation-Protected Securities Fund (VIPSX)
Vanguard Short-Term Investment-Grade Fund Investor Shares (VFSTX)

For the Bogleheads, I came up with what I call the Compromised Know-nothing Portfolio, in that it offers more in large caps per Bogle's wishes and also holds Total Stock Market and a few less funds to try to woo Taylor. ;o),

The Compromised Know-Nothing Portfolio;

35% Vanguard Total Stock Market Index (VTSMX)
5% Vanguard Mid-Cap Value Index (VMVIX)
5% Vanguard Small Cap Value Index (VISVX)
5% Vanguard Emerging Market Index (VEIEX)
5% Vanguard International Explorer (VINEX)
5% Vanguard REIT Index (VGSIX)
20% Vanguard Total bond index (VBMFX)
10% Vanguard Inflation-Protected Securities (VIPSX)
10% Vanguard Short-Term Investment-Grade Fund (VFSTX)

This is a little simpler, fitting a bit closer, but probably not close enough to Taylor's Four Fund Portfolio, his KISS rule, (Keep It Simple Stupid).

Taylor's Four Fund Portfolio;

Vanguard Total Stock Market Index (VTSMX)
Vanguard Total International Stock Index Fund (VGTSX)
Vanguard Total bond index (VBMFX)
Vanguard Inflation-Protected Securities (VIPSX)

Equal percentages will work well with Taylor's 4fund as with my Know-nothing Portfolio, but of course you will want to adjust up as you see fit with my fixed income, and Taylor does not suggest equal percentages in his portfolio.

Another simple portfolio would be the Coffeehouse portfolio;

http://coffeehouseinvestor.com/

10% Vanguard 500 Index (VFINX)
10% Vanguard Value Index (VIVAX)
10% Vanguard Small Cap Index (NAESX)
10% Vanguard Small Cap Value Index (VISVX)
10% Vanguard Inflation-Protected Securities (VIPSX)
10% Vanguard REIT Index (VGSIX)
40% Vanguard Total bond index (VBMFX)

If CRS memory does not fail me, I remember Bill speaking favorably about adding TIPS to the portfolio, and he also offers it is not so much the portfolio as his 3 principles;

http://coffeehouseinvestor.com/Principles.htm

Three Principles of Investing;

1) Don't put all your eggs in one basket.

2) There is not such thing as a free lunch.

3) Save for a rainy day.

Under #3, he suggests "Invest your raise," along with more, but I have had more positive feedback on this one suggestion than any I have offered my friends and coworkers. Investing your raise is one of the easiest and least painful ways of not only increasing the size of your portfolio, but also learning to live below your means. You invest more while reducing how much of your income you use to live. This is an excellent way to reduce the amount of time it takes to build a portfolio you can retire on early.

One more portfolio I should give mention of is William Bernstein's Vanguard portfolio from "The Four Pillars of Investing."

The percentages may be a little off, but I think this is fairly close;

12% Vanguard 500 Index (VFINX)
15% Vanguard Value Index (VIVAX)
3% Vanguard Small Cap Index (NAESX)
9% Vanguard Small Cap Value Index (VISVX)
6% Vanguard REIT Index (VGSIX)
2% Vanguard Precious Metals (VGPMX)
3% Vanguard European Stock Index (VEURX)
3% Vanguard Pacific Index (VPACX)
3% Vanguard Emerging Market Index (VEIEX)
4% Vanguard International Value (VTRIX)
15% Vanguard Inflation-Protected Securities (VIPSX)
25% Vanguard Short-Term Investment-Grade (VFSTX)

His portfolio is based on risk/return per historic returns and correlations and the best guess of the Efficient Frontier. Other than keeping track of the percentages, I have no problem with this portfolio and actually think risk-adjusted it should do better than my Know-nothing Portfolio. The percentages should be easily enough adjusted to where you could more easy keep up with them, or you could set up a spreadsheet to keep up with them.

In fact, I see no problem with any of the above portfolios. Like Bill Schultheis said, "Don't put all your eggs in one basket."

As a side note, these portfolios work best tax-advantaged account.

As for the taxable account, you could use something to the nature of;

Taxable;

Vanguard Total Stock Market Index (VTSMX)
Vanguard FTSE All-World ex-US Index (VFWIX)
Vanguard Tax-Managed Small-Cap Fund (VTMSX)
Vanguard Variable Annuity - REIT Index Portfolio

The REIT annuity has an expense ration (ER) of 0.61% which is high per index investor standards, but the benefits of REITs in diversification warrant having some of this for asset allocation reasons in your portfolio. Maybe keeping it at around 10% of the total portfolio might be wise.

Also as far as stocks go, you might want to add a small percentage, maybe 5% each;

Vanguard Precious Metals (VGPMX)
Vanguard Energy Fund (VGENX)

Though not perfect, energy and metals are the two book ends of commodities. A small percentage of these two should offer some commodities effects in diversifying your portfolio.

Rebalancing in a non-tax advantaged account should be done by adding to the funds that are below your set asset allocation percentages in the nest egg building years (buying into value), and selling the funds that are above your set asset allocation percentages in retirement years (selling growth). Keeping perfect asset allocation percentages are not that important.

As far as fixed income, munis and I-bonds will help the high income investor, and as much as I might be concerned about mentioning it, you may want to reduce your percentages, risk tolerance considered, in fixed income in a taxable account. Taxes eat through the risk/return benefits of most fixed income products. In nominal bonds short-terms offer the best diversification.

I-bonds may be different, as long as I-bonds do not offer too much lower a real coupon rate than other fixed income investments. But for the older investor, building I-bonds over time offer an excellent opportunity as they offer positive correlation to inflation and the lowest correlation to stocks and long-term bonds as inflation is the strongest economic risk to stocks and long-term bonds.

Mainly, you just don't want to go overboard with fixed income in a taxable account, but you do need to know your risk tolerance and how much volatility you can stand.

Chin

Choosing funds, stocks,

2008-04-13T20:42:17Z

This is a continuance of the earlier thoughts on "Asset Allocation,"

and "Choosing funds, fixed and taxable,"

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

As I offered earlier, I don't expect anyone to agree with what I am offering here, or take anything I offer as a quick fix to asset allocation. All I am offering is my reasoning, so take it with however many grains of salt you feel worthy.

This is where I may get a bit unconventional. As I offered earlier, I may have taken William Bernstein's statement about anyone claiming to be on the efficient frontier as frolicking with the Easter Bunny and talking to Elvis a little further than he intended. However, after reading all I have read on the Efficient Frontier, and setting a portfolio up per historic returns, correlations, &c., it is my opinion there is no such thing as the ‘Optimal Portfolio'. My only concern over anyone trying to asset allocate on the Efficient Frontier, is their chasing after the most recent data, which would favor the most recent high performers. Even this is no huge concern, as it still leaves the investor diversified. However, it may not work out as well as setting the percentages and sticking with them. Bernstein's Vanguard Portfolio offered in his "The Four Pillars of Investing" may offer an allocation set in percentages that will be as, or even more efficient today, as one that takes into consideration the returns since 2002 might lean more toward the higher returning asset classes for this period which would more likely than not be the lower returning, and more volatile asset classes going forward.

For reasons such as this, setting the percentages requiring you make judgments as to what would be better served with because of more recent returns, valuations and such, as well as many studies that have shown holding equal percentages in the asset classes you choose to invest in offers nearly as efficient an asset allocation as the hindsight 20/20 allocation, I chose equal percentages in my basic model portfolio.

For the stock allocation for this portfolio, I simply went with historic data which shows the benefits of holding a 4x25 portfolio, equal percentages of large blend, large value, small blend and small value as opposed to 100% S&P 500, and extended this out as far as I could using Vanguard funds. I also accepted this historic data showing the blends offer better returns than the growth indexes, especially in small caps, without question -- and possibly even with a little bias, as I have always been more a value type investor.

For the US and using Vanguard funds only, this is fairly straight forward. However, as opposed to going with large value, I chose mid-cap value as the newer offering for mid-cap value more closely represents Fama/French large value. Fama/French large value is both more valuey, as it reaches for the 30% highest value of large-caps, and smaller than Vanguard's Large Value fund;

Vanguard 500 Index (VFINX)
Vanguard Mid-Cap Value Index (VMVIX)
Vanguard Small Cap Index (NAESX)
Vanguard Small Cap Value Index (VISVX)

The small-cap funds Vanguard offers are not as small as the Fama/French indices. The small value index fund is however as valuey as DFA's Small Value and around the same size and close to as valuey as DFA's Small XM Value;

http://www.ifa.com/Media/Images/PDF%20files/Vanguard_vs_msci%20(2).pdf

If you would like to take a bit more risk, and go with micro caps for the small blend portion, Bridgeway offers a micro-cap fund, and at least as we have discussed here in the past, good management;

Bridgeway Micro-Cap Limited (BRMCX)

The expense ratio for this fund is kinda high, 0.84, but for those looking at add the meat of micro-caps, and believe the higher ER and trading expenses worth it, I personally think this is a good way to go.

As far as international funds, I just simply went with what I could find using Vanguard, and still using equal percentages and carrying this out to domestic/international as well, as I do not think I could guess the Efficient Frontier going forward. And, like I said, I think the major risk reductions, as far as volatility risks go, come from fixed income and possibly commodities.

My old friend raddr had something to say about how internationals helped to diversify a portfolio as well;

http://raddr-pages.com/research/InternationalDiversificationImprovesSWR.htm

As I offered earlier, it may seem odd to look at the Safe Withdrawal Rate (SWR) to determine risks for a nest egg builder, but you have to recognize the need that might arise from losing your income and need to depend on your savings to get you through.

An equal allocation to internationals makes sense as best as I can tell;

Vanguard Developed Markets Index Fund (VDMIX)
Vanguard Emerging Market Index (VEIEX)
Vanguard International Value (VTRIX)
Vanguard International Explorer Fund (VINEX)

I haven't explored other fund families to find better small cap exposure in internationals than Vanguard's International Explorer. It may be possible there are low cost funds out there from dependable fund families that reach smaller of more valuey than Vanguard's. And, of course there are always DFA's if you really feel the need to invest what turns out to be extremely small percentages in international and emerging markets small value on the Efficient Frontier most DFA advisors follow.

My total portfolio using Vanguard funds only comes out to;

Vanguard 500 Index (VFINX)
Vanguard Mid-Cap Value Index (VMVIX)
Vanguard Small Cap Index (NAESX)
Vanguard Small Cap Value Index (VISVX)
Vanguard Developed Markets Index Fund (VDMIX)
Vanguard Emerging Market Index (VEIEX)
Vanguard International Value (VTRIX)
Vanguard International Explorer Fund (VINEX)
Vanguard REIT Index (VGSIX)
Vanguard Precious Metals (VGPMX)
Vanguard Energy Fund (VGENX)
Vanguard Inflation-Protected Securities Fund (VIPSX)
Vanguard Short-Term Investment-Grade Fund Investor Shares (VFSTX)

As I offered, these are my thoughts. The percentages you would hold, not only fixed income, stocks and commodities, but also the different stock asset classes would depend on your personal beliefs and comfort levels, as I showed with the ‘Compromised Know Nothing Portfolio‘;

35% Vanguard Total Stock Market Index (VTSMX)
5% Vanguard Mid-Cap Value Index (VMVIX)
5% Vanguard Small Cap Value Index (VISVX)
5% Vanguard Emerging Market Index (VEIEX)
5% Vanguard International Explorer (VINEX)
5% Vanguard REIT Index (VGSIX)
20% Vanguard Total bond index (VBMFX)
10% Vanguard Inflation-Protected Securities (VIPSX)
10% Vanguard Short-Term Investment-Grade Fund (VFSTX)

The same would hold true for choosing managed funds over index funds in these offerings. Each person has their own reality. If you feel you can choose a managed fund in advance that will beat or increase the risk/return of any of the Vanguard index or managed funds offered here, that is a personal choice we must make -- the same as holds true with these portfolios -- nothing is written in stone.

Chin

originally posted here;

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

Introduction

2008-01-28T00:32:15Z

As far as my background, I don’t claim any expertise in investing, or any financial field. Earlier on, I did some studying with friends called the Foolish Collective at the Motley Fool, including taking a course on line from Dr. Aswath Damodaran of Stern U, NY. It was quite enlightening and enjoyable, and I still miss my friends from way back then.

I guess I might identify with the Black Sheep, as I have yet to fit in with any group politics, philosophy or religion. The irony with my experience with the Foolish Collective was a statement Dr. D made during the course came true. He said that before the end of the course, we would believe more strongly in EMH. By the end of the course I did, in fact so strongly, I decided to pass on individual equities in favor of buying and selling index funds.

To cut to the chase, as I can get long winded, I will offer the more I studied index funds as well as later ETFs, the more I came to the conclusion a fairly sharp economist, John Maynard Keynes knew what he was talking about when he said; “The market can stay irrational longer than you can stay solvent.”

Over the years and mega-arguments with saintly patient, heavy hitters at the Vanguard Diehard forum, I came to the conclusion trading index and low cost managed funds and/or ETFs offered no more opportunity than trading individual equities.

Pretty much what I am trying to say in this long-winded introduction is, I came to believe;

Asset allocation is the only control you have over your investment risks and returns.

Chin

Choosing funds, fixed and taxable,

2008-04-13T20:39:42Z

This is a continuance of my thoughts from ‘Asset Allocation'

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

In what I offer as a ‘Know-nothing Portfolio', all I am concentrating on is diversification with the possibility of some higher returns. The forward market could offer higher returns for large caps again as it did in the 80s and 90s, and components such as precious metals and energy will most likely see more periods of underperformance of the market as I mentioned with commodities earlier. It is not my intention to offer this fund up as an optimal portfolio, or anything of the nature. All I really want to do is offer my thoughts on asset allocation, and allow the reader to consider them, reject them, or possibly begin a conversation in which we can learn a little something together. It is only this, my thoughts -- no expert opinion here.

Before getting into the stock asset allocation, I'd like to say a quick word for my reasoning on the fixed income allocation. In the fixed income, the focus is more on safety than returns, but safety in the sense of the highest risk I see, and I think most see in a portfolio going forward, and that is ‘Inflation'. Historically, if you look at the periods when stocks suffer short-term and even longer term losses, such as 1973 - 1982, it is due to inflation. The more recent bear market, 2000 - 2002 was not an inflation bear market, but the threat of tightening by the Fed did offer the catalyst needed for the correction. Even though it was not an inflation bear market, TIPS proved to offer comparable diversification to longer-term bonds in the Flight to Safety effects of pretty much any bear markets. Though we do not have actual long-term data for TIPS, I think most accept the idea that when the market goes down, the available coupon for TIPS is going to go down with it, offering a more diluted commodities effect from TIPS.

In line with the same concern over inflation, I personally chose to take the advice of Larry Swedroe and William Bernstein to shorten the duration of fixed income. The longer the maturity of a bond fund, the higher the inflation risks and correlation to stocks. I have no problem with Taylor's 4fund portfolio for an individual who does not hold high percentages in stocks, as the long-term bonds and mortgage backed securities in the Total Bond Market (TBM) would not matter as much if you only held 25% or 30% stocks. For others such as myself who might be a little more lion-hearted in their stock allocations, it makes sense to keep durations short. The 5 yr. T-bond offers the sweet spot in treasuries, but you can go shorter with investment grade corporate bonds and match the coupon rate for the treasuries while accepting minimal default risks, and lower term risks.

The fixed income portion of your portfolio, like the commodities I mentioned earlier should be focused on protecting from the risks you face investing in equities, where taking risks make more sense -- offer more reward.

I see no reason to go outside Vanguard for these funds, as Vanguard offers low expense ratios, and any higher expected returns you would get from going with a managed fund can take you out of your preferred asset allocation and offer higher risks. For the fixed income portion of the Know-nothing Portfolio, I went with;

Vanguard Inflation-Protected Securities Fund (VIPSX)
Vanguard Short-Term Investment-Grade Fund Investor Shares (VFSTX)

These, of course, like the commodities I mentioned earlier need be held in a tax advantaged account. If you do not have room in your tax advantaged account for both, you can go with I-bonds, built over time in place of the TIPS. If you do not have room for either in a tax advantaged account, you can go with munis or a low cost Vanguard annuity;

Vanguard Variable Annuity - Short-Term Investment-Grade Portfolio

The expense of 0.45 is more than reasonable for someone wishing to defer taxes IMHO.

As I mentioned earlier, the more risk you take in stocks in your portfolio, the higher the need for fixed income. The Total US Market (TSM) makes more sense here, as it offers both less tax consequences and less risk offering an ability to reduce the percentages of less tax efficient fixed income such as TIPS while you are building your I-bond allocation. You might also want to go with a Developed Markets International Fund, with some Emerging Markets and Tax Managed Small Caps;

Vanguard Total Stock Market Index (VTSMX)
Vanguard Developed Markets Index Fund (VDMIX)
Vanguard Emerging Market Index (VEIEX)
Vanguard Tax-Managed Small-Cap Fund (VTMSX)

The small caps fund is about the only tax managed fund worth considering, once again IMHO, Vanguard offers. DFA offers more tax advantaged funds than Vanguard, but if you have a balance high enough to go with DFA, it might be questionable as to whether it would be advantageous to take the immediate tax hit to switch if you are now in fairly tax efficient funds.

Another annuity that makes sense in a taxable account is REITs. REITs have proven to be excellent diversifiers, offering returns similar to the S&P 500, while offering excellent diversification. Just a quick look found this;

http://www.nareit.com/epubs/2006_Ibbotson.pdf

The Vanguard REIT annuity offers an expense ratio of 0.6%, a little high, but the diversification benefits of holding something like 7% to 10% REITs in a portfolio should offset the small difference this is going to make in the overall total expense ratio;

Vanguard Variable Annuity - REIT Index Portfolio.

As I offered earlier, the commodities funds are not tax efficient. Though possibly not as effective as adding commodities to a portfolio, precious metals and energy equities represent the two bookends of commodities and offer returns closer to that you might expect from businesses dealing in these commodities. In a taxable account, this is about all you have to choose from;

Vanguard Precious Metals (VGPMX)
Vanguard Energy Fund (VGENX)

So, I guess now, as opposed to sticking with fixed income only, I have gotten into talking about investing in a taxable portfolio as well, huh?

Our taxable portfolio looks something like this;

Stocks

35% Vanguard Total Stock Market Index (VTSMX)
25% Vanguard Developed Markets Index Fund (VDMIX)
10% Vanguard Emerging Market Index (VEIEX)
10% Vanguard Tax-Managed Small-Cap Fund (VTMSX)
10% Vanguard Variable Annuity - REIT Index Portfolio
5% Vanguard Precious Metals (VGPMX)
5% Vanguard Energy Fund (VGENX)

Fixed Income

50% Vanguard Variable Annuity - Short-Term Investment-Grade Portfolio
50% I-bonds (built over time)

The percentages, or even funds I have chosen are not written in stone. Like I said, this is just offerings of my ideas. Choose your own reality. And, as it should go without saying, if you cannot build the 50% allocation in I-bonds over the time you are allowed, the 50% is not written in stone either.

Chin

originally posted here;

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

Asset Allocation,

2008-04-13T20:36:25Z

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;

http://socialize.morningstar.com/NewSocialize/blogs/chinwhisker/2481580/post.aspx

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;

http://hardassetsinvestor.com/index.php?option=com_content&task=view&id=526&Itemid=4

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

http://raddr-pages.com/research/CommodityFutures.htm

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

Why indexing?

2008-03-23T23:47:02Z

To begin with, I am not trying to offer a statement "Managed funds are the devil!" I know there are times when managed funds offer something to be considered, such as a few of my friends recently offered, that sometimes the psychological factor alone is enough to hold a managed fund. Funds such as have been offered such as Wellington and Wellesley offer benefits of less risky stocks and shorter term bonds for a 'One stop' fund for the investor who does not care to study investing, and wants a little less volatility than they might find in a balanced index fund -- and quite possibly some superior returns per the asset allocation due to stocks focused more toward the giant value side and the bonds the shorter corporate side.

I also have already asked the question "Why managed funds?" to get a better idea as to why folks insist on investing in managed funds, and agree with what Petrocelli had to say, in that when selecting managed funds, select them as you would an index funds.

Some of the most obvious answers to this question were offered by Taylor in the Active -vs.- Managed thread;

http://socialize.morningstar.com/NewSocialize/forums/post/2485483.aspx

I have already offered what Jack Bogle offered when studying all managed funds;

http://www.vanguard.com/bogle_site/sp20040413.html

This is of course only one of his numerous speeches showing the advantages of the index fund, and while Jack Bogle was doing this, another, Burton Malkiel was doing the same as evidenced in his "Random Walk" books.

Vanguard offers a little something on this;

https://institutional.vanguard.com/iip/pdf/Case_Indexing.pdf

Here is the executive summary for those who don't care to read the whole thing;

https://institutional.vanguard.com/iip/pdf/ICRPIS.pdf

Vanguard uses this knowledge to better not only their index funds, but managed funds as well.

It has been said a few times here, " . . . but this is long-term!" -- True. In some short periods higher percentages of the managed funds will perform better than the so-called ‘Market‘, but this is due to one of the factors besides costs that drag down the returns over time -- cash drag. Cash (and/or bonds) offer better returns and less volatility in the periods when the market as a hole, or large caps do not do well. In other periods even those without the cash drag will perform better than the market. This is due to taking value, size and sector risks the market does not. These risks do not show up in all periods.

Eugene Fama and Kenneth French developed a Three Factor Model to study the returns of managed funds compared to an indexed portfolio built on their observed factors of risk/return, which boils down to how much alpha the manager actually gains considering they could have invested in a portfolio of funds with DFA indexed toward the sectors of the market based on Fama/French small/value indices. To cover bonds and cash in the managed funds, they developed a four factor and five factor model. Using the Fama/French models show 95% of the returns of a mutual fund can be explained by the markets in which they invest. It can explain the returns of the funds in the short periods;

http://www.ifa.com/12steps/step8/step8page4.asp

All-in-all, it doesn't appear managed funds are capable of beating the index funds, even in the short-term, unless of course the managed fund invests outside the market you can reach with index funds. When looking at stand alone managed funds and their performance, their success should be considered using the Fama/French 3Factor (or 4 or 5). Possibly what will explain beyond the 95% this model covers is the sector weightings of the fund, such as healthcare, REITs, metals, energy, &c. when these sectors are returning higher than historic returns.

The often looked at 10 year period compared to the S&P 500 in a period when the S&P 500 has offered poor returns does nothing to explain the returns of managed funds. A simple way to compare the managed fund would be to compare it against something like the Four Pillars Vanguard Portfolio as offered in William Bernstein's "The Four Pillars of Investing" (or if you prefer "The Intelligent Asset Allocator" which the portfolio can be dated back 10 nearly 10 years ago now).

The portfolio can be found here;

http://socialize.morningstar.com/NewSocialize/blogs/chinwhisker/archive/2008/02/02/The-Know_2D00_Nothing-Portfolio-.aspx

If you just want to see how managed funds have done against index funds, look at the simple Coffeehouse portfolio which can be found in the above link or here;

http://coffeehouseinvestor.com/

Bill Schultheis offers his own reasons to "Why indexing?"

Once again, this is not meant to be focused on the superiority of index funds, or to say do not invest in managed funds, but maybe as Petrocelli offered, look at managed funds the same as you do index funds. As opposed to the claims of Efficient Market Hypothesis (EMH), Jack Bogle's Cost Matters Hypothesis (CMH ;) is difficult to argue.

Maybe the question should have been "Why Vanguard?", as over the years, Vanguard has been concentrating on lowering costs by not trying to beat the market or their prospective benchmarks through managers trying to beat the millions of other stock traders, but by reducing the costs of their funds by not trading and paying analysts high wages for a "Zero sum" game.

As offered in EMH, any anomaly that can be exploited can be quickly recognized, copied, and taken advantage of to the point the anomaly disappears. It appears other fund companies have noticed what Vanguard is doing, and trying to copy their model.

Will the Vanguard advantage disappear? We can only hope for the good of those who have not discovered low cost investing.

Originally posted here;

http://socialize.morningstar.com/NewSocialize/forums/1/2493113/ShowThread.aspx?mrr=1204482905

Chin

Active -vs.- Passive

2008-02-05T23:28:56Z

I don't care to join in on the arguments over Weiner, and don't care to argue with Petrocelli, as I consider Petro a friend. We have differing views, and I see that as healthy when it comes to developing an investment philosophy. The problem as I see it is, one is not developing an investment philosophy when following a newsletter and/or chasing after the hot managed funds.

I don't know Weiner's record, as I do not receive the newsletter, but I have honest doubts Weiner or anyone else can accomplish any more than a Do It Yourself (DIY) passive investor can on their own with a little help from their friends.

I understand the complaints of the Diehards offering their short little "parables and platitudes" in answer to the managed funds postings here, and I have tried to not do so in my answers to the managed -vs.- indexing debate.

In my view, it is not a matter of Weiner being able to beat the market, as beating the market is easy through asset allocation, especially in a period when pretty much every other market has beaten the S&P 500. It is also not a matter of whether managed funds offer a better risk/return than index funds, as neither of these address what the Diehards is/was about.

In what is often called indexing, and is so often misidentified as the S&P 500 or Total Stock Market (TSM), managed funds do have their place. As a general rule, you choose managed funds where index funds are not available. As my friend Petro offered, when he looks at managed funds, he looks at them in a way indexers look at index funds. If I may expand on this as I think he would, he looks at managed funds with low expenses he feels fits in the market in which he invests in with a proven management record.

If I may offer without overstepping my boundaries in the way Larry Swedroe might also look at this, he has offered Bridgeway fills a need in the small cap area of asset allocation Vanguard does not, while offering proven management and low costs, but costs that would send a index only Boglehead spinning. ;),

What many see as the stogy limits to Vanguard Diehard or Boglehead investing, as many of the Diehards, or Bogleheads may have misinterpreted, Bogle stands for only TSM/TSB in his investing suggestions. I think this holds true as he has spoken out against Slice-n-Dice, but I think his words are generally pointed at those who use S&D, or the Efficient Frontier, as a selling point to rob investors of their investment earnings through unneeded advisory fees and/or confusion over the simple rules of investing. In fact, I have a little something stuck back Dr. Aswath Damodaran of Stern U, NY offers his students where Bogle offers some guidelines to selecting managed funds;

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/bogleonfunds.htm

Sometimes, in a well diversified portfolio, it is not even possible to use only index funds. In my Know-nothing Portfolio, I use;

Vanguard International Value (VTRIX)
Vanguard International Explorer Fund (VINEX)
Vanguard Precious Metals (VGPMX)
Vanguard Energy Fund (VGENX)
Vanguard Inflation-Protected Securities Fund (VIPSX)

There are no index funds that fit into these markets, and I personally feel these markets offer excellent diversification that exceeds the total market or index only approach of investing.

However, I know there are always going to be those who believe fund managers can beat the index fund, but I would suggest if you are looking for a managed fund, look at the long record. Funds have done well for 5 to 10 years, just to go by the wayside, or get sucked up by another fund, because the manager failed to succeed in what the Fly by the seat of their pants 5* investors consider the long term.

When looking at managed funds or the success of a newsletter portfolio, it is best not to fall into the trap of comparing apples-to-oranges. For instance, don't look at a managed fund that has the opportunity to invest in mid caps and compare it to large caps in a period when mid caps, or a combination of large/mid caps have exceeded the returns and/or risk/returns of large caps. If the fund manager is any good, they should know when to be in mid, and when to be in large to the point they would have beaten a mid cap index fund. The same would hold true with newsletters. Don't fall into the trap of thinking the portfolio of a newsletter succeeded because it beat the S&P 500 or TSM over a period when the S&P 500 and TSM underperformed all other areas of the market.

Also, don't confuse balanced portfolios with Slice-n-Dice portfolios. When comparing portfolios, you must look at the international, value and size weightings of the portfolios; risk/return. As a for instance, my Know-nothing Portfolio invests heavily in value and internationals, including emerging markets. A 60/40 TSM/TSB would offer risks closer to a 50/50 blend in my Know-nothing Portfolio, or a 40/60 blend in a DFA portfolio. (I only bring up DFA for comparison)

Pretty much, the bottom line statement I am trying to make here is, Don't confuse a fund manager's or a portfolio manager's record to that of the S&P 500 or blend if they invest outside the S&P 500. Compare their success to Larry Swedroe's portfolio, or William Bernstein's, or even Bill Schultheis' simple little Coffeehouse Portfolio. Both Bernstein's and Schultheis' are based purely on Vanguard funds, and Schultheis' purely index funds. Larry Swedroe has offered here in the past, and now over at the Bogleheads, what I might consider the ultimate of both passive and ‘Beat the market' portfolios.

All this is free. If it's too complicated, look at what Bogle offered in the link above. I don't think you can get much simpler.

The greatest control you have over your portfolio is your asset allocation.

If you want to be dependent on newsletters and fund managers for the rest of your life, I must ask the question, Why are you here? Why did you come to an investment board focused on DIY if you want to stay dependent on someone else?

I'm not denying anyone's right, or need to discuss newsletters and/or managed funds. I am not even saying there are not superior newsletters or managed funds, but I personally would demand one that bettered the market for a period of 30 years or more before I would take the risk of investing in a manager that cannot do what a simple 4x25 strategy has done for as long as we have data for; back to 1927. This has not proven an easy task;

http://www.vanguard.com/bogle_site/sp20040413.html

<SNIP>

So today, three decades later, let's examine some brute evidence. Let's go back to the era in which the Samuelson article was published, and see what lessons we can learn by examining the evidence on the ability of mutual fund managers to provide market-beating returns. In 1970, there were 355 equity mutual funds, and we have now had more than three decades over which to measure their success. We're first confronted with an astonishing-and important-revelation: Only 147 funds survived the period. Fully 208 of those funds vanished from the scene, an astonishing 60% failure rate.
Now let's look at the records of the survivors-doubtless the superior funds of the initial group. Yet fully 104 of them fell short of the 11.3% average annual return achieved by the unmanaged S&P 500 Index. Just 43 funds that exceeded the index return. If, reasonably enough, we describe a return that comes within plus or minus a single percentage point of the market as statistical noise, 52 of the surviving funds provided a return roughly equivalent to that of the market. A total of 72 funds, then, were clear losers (i.e., by more than a percentage point), with only 23 clear winners above that threshold.
If we widen the "noise" threshold to plus or minus two percentage points, we find that 43 of the 50 funds outside that range were inferior and only seven superior-a tiny 2% of the 355 funds that began the period, and an astonishing piece of the brute evidence that Dr. Samuelson demanded. The verdict, then, is here, and it is clear. The jury has spoken. But its verdict is not "unproved." It is "guilty." Fund managers are systematically guilty of the failure to add shareholder value.
But I believe the evidence actually over-rates the long-term achievements of the seven putatively successful funds. Is the obvious creditability of those superior records in fact credible? I'm not so sure. Those winning funds have much in common. First, each was relatively unknown (and relatively unowned by investors) at the start of the period. Their assets were tiny, with the smallest at $1.9 million, the median at $9.8 million, and the largest at $59 million. Second, their best returns were achieved during their first decade, and resulted in enormous asset growth, typically from those little widows' mites at the start of the period to $5 billion or so at the peak, before performance started to deteriorate. (One fund actually peaked at $105 billion!) Third, despite their glowing early records, most have lagged the market fairly consistently during the past decade, sometimes by a substantial amount.
The pattern for five of the seven funds is remarkably consistent: A peak in relative return in the early 1990s, followed by annual returns of the next decade that lagged the market's return by about three percentage points per year-roughly, S&P 500 +12%, mutual fund +9%.
In the field of fund management it seems apparent that "nothing fails like success"-the reverse of the threadbare convention that "nothing succeeds like success." For the vicious circle of investing-good past performance draws large dollars of inflow, and having large dollars to manage crimps the very ingredients that were largely responsible for the good performance-is almost inevitable in any winning fund. So even if an investor was smart enough or lucky enough to have selected one of the few winning funds at the outset, selecting such funds by hindsight-after their early success-was also largely a loser's game. Whatever the case, the brute evidence of the past three decades makes a powerful case against the quest to find the needle in the haystack. Investors would clearly be better served by simply owning, through an index fund, the market haystack itself.

</SNIP>

There is much more in this ‘One' of his many speeches worthy of a read, and yes, I know it's long, but he had a lot to say, just as must have had a lot to say, huh? ;o),

originally posted here;

http://socialize.morningstar.com/NewSocialize/forums/thread/2483662.aspx