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Asset Allocation,

chinwhisker

04-13-2008, 3:13 PM | Post #2508002 | 60 Replies

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

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Choosing funds, fixed and taxable,

chinwhisker

04-13-2008, 3:15 PM | Post #2508003

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

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

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Choosing funds, stocks,

chinwhisker

04-13-2008, 3:17 PM | Post #2508004

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

and “Choosing funds, fixed and taxable,”

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 [MSCI US Small Cap Value Index] 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

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Re: Choosing funds, stocks,

tar42 04-13-2008, 6:33 PM | Post #2508062

I truely attempted to read and comprehend all you wrote, Chin, but.....................Some how I think too much is made of investing. Taylor has four funds and most of us keep it simple.

Take care

Tim