The Four Pillars Of Investing Part 12

Finally, when the $50,000 level is reached, she'll split her Total International Fund into the Pacific, European, Emerging Markets, and International Value funds and arrive at a retirement fund composition looking like the allocation shown above. The above process is complex. For the sake of clarity, in Table 13-9 Table 13-9 I've outlined what it looks like in actual practice, as the account grows in size. Funds are added from left to right, one at a time, for each $5,000 increment in portfolio growth. I've outlined what it looks like in actual practice, as the account grows in size. Funds are added from left to right, one at a time, for each $5,000 increment in portfolio growth.

Teach Your Children Well The primary object of investing for the very young is not simply the management of cold, hard a.s.sets, but rather financial education. financial education. Instilling fiscal responsibility into the young is well beyond the scope of this book, but it is a fact that the way we handle financial risk and loss is probably determined at an early age. The sooner your children become acquainted with the risk/return nexus and the benefits of diversification, and the earlier they experience financial loss in a protective, supportive environment, the better. Instilling fiscal responsibility into the young is well beyond the scope of this book, but it is a fact that the way we handle financial risk and loss is probably determined at an early age. The sooner your children become acquainted with the risk/return nexus and the benefits of diversification, and the earlier they experience financial loss in a protective, supportive environment, the better.

I suggest that at approximately age ten you set up a small portfolio with two or three a.s.set cla.s.ses, as well as a money market fund in the child's name. Have him or her learn how to sort and file the statements properly as they arrive in the mail and teach the child how to track the value of each fund. Every quarter, sit down with all involved siblings and have an "investment conference" during which the performance of each account is discussed. Their reward for these ch.o.r.es will be the dividends from the stock and money market funds, as well as half of the remaining increase in investment value, if any, each December 31.

Table 13-9. "Young Yvonne's" Investment Path: Vanguard Funds. "Young Yvonne's" Investment Path: Vanguard Funds.

Note: Funds are added from left to right, in $5,000 increments. See text.

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The most valuable part of the process comes during market declines, when they will suffer paper losses amounting to several months' or years' allowance in one fell swoop. The message during these periods should be as clear as it is gentle and kind: It is all right to lose significant amounts of money in stocks as long as it is due to the vicissitudes of the overall stock market. Do not be afraid to do so and do not feel badly when it happens. This is the inevitable price you pay for the long-term superiority of stocks. In fact, a very famous investor once said that from time to time it was the duty of an investor to lose money. (Don't tell your children it was Keynes.) (Don't tell your children it was Keynes.) By imparting this invaluable lesson to your offspring at an early age, you will have gone most of the way towards making them competent investors. And in the process, you just might learn a few things yourself.

One Size Doesn't Fit All Ted, Sam, Ida, and Yvonne are purely ill.u.s.trative cases. It's a mistake to take a cookie-cutter approach to the allocation process-the above portfolios are only starting points. There are several factors that would cause you to modify the above recommendations. Among them: * Your personal a.s.set cla.s.s preferences. The precious metals equity cla.s.s is a good example of this. Some investors are deathly afraid of inflation and get a warm fuzzy feeling from having this ultimate hard a.s.set in their portfolio. Others find it silly to hold a component with low expected return and high volatility. Still others find it emotionally difficult to perform the rebalancing operations necessary to extract its maximum return-buying low and selling high requires an iron discipline that not everyone possesses. Emerging markets investing is another frequent problem. Some investors are uncomfortable owning stocks in countries where the water is not safe to drink or where shareholder protection is not quite the priority it is in the developed world, despite knowing that such risk is often generously rewarded by the capital markets. Although you should not let your emotional responses dictate your allocation, you do need to sleep at night, and your personal preferences are an important part of your a.s.set cla.s.s structure.* Your tolerance for "tracking error"-that is, the difference between the performance of your portfolio and that of the market. I'm reminded of Mencken's definition of a wealthy man as one who makes more money than his wife's brother-in-law. The same is true of portfolio performance. Whether you like it or not, you cannot help but compare the return of your equity portfolio to the market, by which most investors mean the S&P 500. The period from 1995 to 1999, when this index outperformed every other a.s.set cla.s.s, provided a powerful reality check in this regard. As already mentioned, diversification works whether we want it to or not. During those five years, the diversified investor felt pain as his stock portfolio lagged those of his family, friends, and neighbors by a large amount. If this tracking error doesn't irk you, then by all means, diversify away. But it's a fact that many investors find lagging the S&P 500 for a three or four years highly unpleasant, even if the long-term return of their stock a.s.sets is higher than that benchmark. As one of a.s.set allocation guru Roger Gibson's clients put it, "I would rather follow an inferior strategy that wins when my friends are winning and loses when my friends are losing than follow a superior long-term strategy that at times results in my losing when my friends are winning." If such underperformance relative to the market, which can last up to a decade, bothers you, perhaps you should weight your portfolio more towards the S&P 500 and go lighter on the REITs, small, value, and international stocks than Sam, Ted, Ida, and Yvonne.* Lastly, whether you know it or not, you are likely the proud owner of quite a lot of "human capital" that needs to be integrated into the rest of your portfolio. What this recently fashionable term refers to is the fact that you are probably the recipient of a steady salary, Social Security, or fixed pension payments that can be "capitalized" to their present value as we did in Chapter 2 Chapter 2. Let's consider each of these in turn. Let's say you are an employee of General Motors. In this case, you are working for a "value company" and are vulnerable in rough economic times, just as are value stocks. In this case, it would not be a good idea to overweight your portfolio with value stocks, as in a severe economic slump you may lose both your job as well as a fair chunk of your portfolio. Similarly, if you work in high tech, it would be foolish to overweight growth stocks in your portfolio. This highlights the most common investment mistake made by corporate employees-owning company stock in their personal and retirement portfolios, as was recently demonstrated by the Enron debacle. If the company gets into trouble, the risk of losing everything is high. There are also people who should should own value stocks. These are employees of companies in "countercyclical" industries that do well even when times are bad, such as food and drug companies. The ultimate countercyclical jobs are in the p.a.w.n and repo business, which boom during economic slumps. If you work in either of these industries, you can knock yourself out and load up on value stocks if you so wish. Finally, if you are one of the vanishing number of individuals lucky enough to be getting a regular fixed pension, then you own, in essence, a bond issued by your former employer. If that employer was the government, you can capitalize (that is, discount) its payments by a low rate-say 6%. So, if you are relatively young, you essentially own a perpetual annuity, similar to prest.i.ti and consols. If your payments are $30,000 per year, this is the same as owning a long bond with a value of $30,000/0.06 = $500,000. If you are older, its value will be commensurately less. Your Social Security payments should be capitalized in the same way. If your pension comes from Trump Casinos, I'd capitalize it at much higher rate-say 12%-making its present value only $250,000 ($30,000/0.12 = $250,000). In any case, it would not be a bad idea to increase your stock holdings to reflect the "bonds" you effectively own via your pension and Social Security. own value stocks. These are employees of companies in "countercyclical" industries that do well even when times are bad, such as food and drug companies. The ultimate countercyclical jobs are in the p.a.w.n and repo business, which boom during economic slumps. If you work in either of these industries, you can knock yourself out and load up on value stocks if you so wish. Finally, if you are one of the vanishing number of individuals lucky enough to be getting a regular fixed pension, then you own, in essence, a bond issued by your former employer. If that employer was the government, you can capitalize (that is, discount) its payments by a low rate-say 6%. So, if you are relatively young, you essentially own a perpetual annuity, similar to prest.i.ti and consols. If your payments are $30,000 per year, this is the same as owning a long bond with a value of $30,000/0.06 = $500,000. If you are older, its value will be commensurately less. Your Social Security payments should be capitalized in the same way. If your pension comes from Trump Casinos, I'd capitalize it at much higher rate-say 12%-making its present value only $250,000 ($30,000/0.12 = $250,000). In any case, it would not be a bad idea to increase your stock holdings to reflect the "bonds" you effectively own via your pension and Social Security.

Finally, never forget that stocks can have zero real return for periods as long as 20 years. We design our portfolios for the long term, not for emergencies, college, or even a home. This is not to say that a solid allocation does not have room in it for these expenses, but that is not its primary purpose. Obviously, if you have an adequate nest egg to which you've allocated 40% in bonds, there will be more than enough available for emergencies (as long as the "emergency money" is in a taxable account) or for a house down payment, as long as enough of the bonds are in a taxable account.

Although the central tenet of a.s.set allocation is to consider the performance of your portfolio as a whole, it is psychologically comforting to occasionally backslide into what investment advisors call "two-bucket mode." This means envisioning your bonds as providing living expenses during the bad times and your stocks as providing support during the good times.

No matter what portfolio you choose, realize that looking back, you will always wish that you had allocated more to what turned out, retrospectively, to be the best a.s.sets. But since no one knows in advance what these will be, you should own as many as your circ.u.mstances allow. By indexing and diversifying, you are giving up bragging rights with the neighbors and the country club gang. But you are also minimizing the chances of impoverishing yourself and the ones you love.

CHAPTER 13 SUMMARY.

1. The major stock a.s.set cla.s.ses you should own are domestic, foreign, and REITs. You may further break the domestic portion into the "four corners": large market, small market, large value, and small value.2. Your overall stock/bond allocation is determined by your time horizon, risk tolerance, and tax structure. Since stock and bond returns may be quite similar in the future, you should hold at least 20% in bonds, no matter how risk tolerant you think you are.3. The stock and bond a.s.set cla.s.ses you employ are primarily dictated by the percentage of your portfolio that is tax-sheltered.4. The easiest a.s.set structures to design are those where more than half of a.s.sets are tax-sheltered.5. If you have less than 50% of your a.s.sets in sheltered vehicles, you should place value stocks and REITs in them. If you have room left over, you should break your foreign a.s.sets into regions (European, Pacific, and emerging markets) to benefit from rebalancing.6. The present value of your Social Security and fixed pension payments should be factored into your a.s.set allocation.

14.

Getting Started, Keeping It Going You are now, metaphorically speaking, a construction engineer. By this point, you should have a working set of blueprints (your allocation), and you should also have selected your building materials (mutual funds and Treasury securities). In what sequence do you begin to erect the structure?

Broadly speaking, your situation will fall into one of two categories: * You are an investing novice with relatively little experience in the markets, with only a small amount of your a.s.sets in stocks.* You are experienced with the ups and downs of the market. And since you are familiar with the markets and your own risk tolerance, your planned stock/bond allocation should thus be roughly the same as your current overall stock/bond mix. All you need to do is convert over to an indexed investment plan.

If you fall into the second category, then your task is relatively simple. If your stocks and funds do not carry a large amount of capital gains, all you will need to do is to sell them all and on the same day, if possible, purchase all of your new stock-index funds and bond funds/Treasuries. If you intend to use ETFs, then you can accomplish this from your existing brokerage account, a.s.suming its fees will not be onerous.

If you decide to use Vanguard's, Fidelity's, or Schwab's index funds, then things get a little more complex. If you are selling individual stock positions, then I'd transfer the whole shooting match over to a brokerage account at Vanguard, Fido, or Schwab so that you can sell your individual stock and bond positions and establish your new fund positions at the same time. If at all possible, you should keep a cash buffer large enough so that you do not run into problems caused by settlement delays on your sales proceeds.

Things will be even more complicated if you have individual mutual fund accounts. Depending on your situation, you may be able to exchange your stock and bond fund shares to a money market account with check writing privileges that you can then deposit in your new fund accounts. Ideally, you should have already set up an account at Vanguard/Fido/Schwab so that your checks can be directly deposited. Conversely, it may be easier simply to transfer all of your old fund shares over to a brokerage account with Vanguard/Fido/Schwab, then sell them. In most cases, this will incur commissions.

If you hold a substantial amount of stocks and mutual funds that have appreciated significantly, then switching to the kind of a.s.set-cla.s.s-based indexed approach we've outlined may entail a large capital-gains jolt, and it may not be worth the cost, particularly if you already own a well-diversified portfolio of individual stocks. This represents a very difficult problem, and if you find yourself in this predicament, it would be well worth your while to engage the services of an accountant or tax attorney.

Getting Used to the Long Run The beginning of this chapter is aimed at the first kind of investor-the novice whose current stock exposure is low. From a purely financial point of view, it is usually better to put your funds to work right away. However, if you are not used to owning risky a.s.sets, then getting started is a little like getting in shape to run a marathon. It is not a good idea to try to run 26 miles on the first day of training. Similarly, it takes a while to accommodate yourself to the ups and downs of the market. If your allocation to stocks has been low in the past and the allocation process we've described calls for a significant increase, then this is best done gradually, over a few years.

Once you've arrived at your target stock allocation, you are faced with a second problem-that of portfolio rebalancing. In the normal course of the capital markets, a.s.set cla.s.ses have different returns-sometimes radically different-and your portfolio composition will drift away from its planned percentages. It then becomes necessary to buy more of the losers and sell some of the winners-in other words, to rebalance it-to bring things back into line. It takes some time to convince yourself that rebalancing your portfolio is a good idea in the long run, particularly as you find yourself pouring cash into a prolonged bear market for one, several, or all of your a.s.sets.

Traditionally, investors working to acc.u.mulate stock shares use dollar cost averaging, dollar cost averaging, or "DCA," to achieve their objectives. This involves investing the same amount of money regularly in a given fund or stock. The advantages of this approach are several-fold: a.s.sume that a mutual fund fluctuates in value between $5 and $15 during the course of a year, and that $100 is invested monthly in the fund, allowing shares to be purchased at prices of $10, $5, and $15. The average price of the fund over the purchase period is $10, but through the magic of financial mathematics, using DCA in this manner gives you a lower average price. Here's how: we purchased 10 shares at $10, 20 shares at $5, and 6.67 shares at $15, for a total of 36.67 shares. The overall price per share was thus $8.18 ($300/36.67), even though the average of the three prices was $10. This is because we purchased more shares at the lower than at the higher price. or "DCA," to achieve their objectives. This involves investing the same amount of money regularly in a given fund or stock. The advantages of this approach are several-fold: a.s.sume that a mutual fund fluctuates in value between $5 and $15 during the course of a year, and that $100 is invested monthly in the fund, allowing shares to be purchased at prices of $10, $5, and $15. The average price of the fund over the purchase period is $10, but through the magic of financial mathematics, using DCA in this manner gives you a lower average price. Here's how: we purchased 10 shares at $10, 20 shares at $5, and 6.67 shares at $15, for a total of 36.67 shares. The overall price per share was thus $8.18 ($300/36.67), even though the average of the three prices was $10. This is because we purchased more shares at the lower than at the higher price.

DCA is a wonderful technique, but it is not a free lunch. Purchasing those 20 shares at $5 took great fort.i.tude because you were buying at John Templeton's "point of maximum pessimism." Security prices do not get to bargain levels without a great deal of negative sentiment and publicity. Imagine what it felt like to be buying stocks in October 1987, junk bonds in January 1991, or emerging markets stocks in October 1998, and you'll understand what I mean. Do not underestimate the discipline that is sometimes necessary to carry out a successful DCA program. DCA does entail risk; your entire buy-in period may occur during a powerful bull market and be immediately followed by a prolonged drop in prices.

Such are the uncertainties of equity investing. Always remember that you are compensated for bearing risk, and buying during a prolonged bull market is certainly a risk. If you've never invested in a bear market before, recall author Fred Schwed's warning that there are some things that cannot be explained to a virgin using words and pictures. For most investors, a prolonged down market is an experience unlike any other. Your first few forays into bear territory should be done with a relatively small portion of your capital.

There is an even better method than DCA, known as "value averaging," described by Michael Edleson in a book by the same t.i.tle. A simplified version of his technique is as follows. Instead of blindly investing, say, $100 per month, you draw a "value averaging path," consisting of a target amount that increases by the same amount each month, $100 in this example. In other words, you aim at having $100 in the account in January, $200 in February, and so forth, on out to $1,200 by December of the first year and $2,400 by the end of the second year. In this case, you are not simply investing $100 per month. If the fund value declines, more more than $100 will be required to reach the desired total each month. If the fund goes up, less will be required. It is even possible that if the fund value goes up a great deal, no money at all will have to be added in some months. than $100 will be required to reach the desired total each month. If the fund goes up, less will be required. It is even possible that if the fund value goes up a great deal, no money at all will have to be added in some months.

Further, a.s.sume that we plan an investment of $3,600 over three years. We will probably not complete our $3,600 investment in exactly 36 months. If, in general, the markets are up, it may require another three, six, or nine months to complete the program. If, on the other hand, there is a bear market, then we will run out of cash reserves long before 36 months are up. To show you how this works, let's start with Taxable Ted's allocation at the 50/50 stock/bond level (Table 13-6). I've a.s.sumed that Ted has a total portfolio size of $1 million and that he has finally decided that he wants a 50/50 portfolio, with $500,000 each in bonds and stocks. There is no reason why he should not invest all of his bond money immediately. Yes, there is a risk that he could be investing at a high point in the bond market and that he could lose some money, but bond bear markets are relatively painless affairs at the short maturities used in his portfolio.

That leaves $500,000 allocated to stocks. In Table 14-1 Table 14-1, I've established a three-year "value averaging path" for his four stock a.s.sets at the Vanguard Group. The path consists of target amounts for each quarter that will be met with periodic investments. I've started at the fund minimum for each a.s.set-$10,000 for all but the Total Stock Market Index Fund, which has a $3,000 minimum.

Table 14-1. "Taxable Ted's" Value Averaging Path (for $500,000 Stock Allocation) "Taxable Ted's" Value Averaging Path (for $500,000 Stock Allocation) [image]

A few fine points should be mentioned. This is a somewhat simplified version of Edleson's method. In addition to increasing the target value for each quarter by a fixed amount, he also "builds in" further growth into the path. For ease of understanding, I have not done so. His book, by the way, is extremely hard to find. At the time of this writing, Fourstar Books, http://www.fourstarbooks.com, still has copies in stock.

It should be obvious that value averaging should not not be done with exchange-traded funds, as doing so would incur a separate fee for each transaction. In the above example, it would cost Ted several hundred dollars each year. be done with exchange-traded funds, as doing so would incur a separate fee for each transaction. In the above example, it would cost Ted several hundred dollars each year.

There is nothing magic about quarterly investments or a three-year overall plan. Professor Edleson does recommend a quarterly investment program, but you can tailor the length of your plan to suit your tastes. I suggest a minimum of two to three years for funding; if market history is any guide, you should have an authentic bear market (or at least a correction) during this time. This will enable you to test your resolve with the relatively small mandated infusions and to ultimately convince yourself of the value of rebalancing.

Last, there will be some months when the market is doing very well, and you may actually be above the target for a given a.s.set for that month on the path. Theoretically, you should sell some of the a.s.set to get back down to the target amount. Don't do it, particularly in a taxable account, as this will incur unnecessary capital gains.

This method is about the best technique available, in my opinion, for establishing a balanced allocation. But it is not perfect. As already pointed out, if there is a global bear market, you will run out of cash long before three years is up. The opposite will happen if stock prices rise dramatically. If you are value averaging into both taxable and sheltered accounts, as In-Between Ida would have to do, it is likely that after a time the taxable and sheltered halves of the allocation will get out of kilter. Consider Ida's portfolio, which split the 10% of her portfolio that was sheltered between U.S. large-value and small-value stocks. What would happen if these a.s.sets did very poorly during the value averaging period? She would run out of sheltered money before she had reached her targets for those two a.s.sets.

In that case, she would have to compromise, either by stopping at that point, or perhaps putting more of her money into an a.s.set with similar behavior-the "large market" and "small market" funds in her taxable accounts. If the opposite happens, the problem is less severe. If she is still in the value averaging phase and building up a position in these a.s.sets, then she will simply have to wait a few months before the "value path" eventually rises above her a.s.set level, requiring additional purchases.

Value averaging has many strengths as an investment strategy. First and foremost, it forces the investor to invest more at market lows than at market highs, producing significantly higher returns. Second, it gives the investor the experience of investing regularly during times of market pessimism and fear-a very useful skill indeed. Value averaging is very similar to DCA, with one important difference; it mandates investing larger amounts of money at market bottoms than at market tops. You can think of value averaging as a combination of DCA and rebalancing. (Value averaging works just as well in reverse. If you are retired and in the distribution phase of your financial life cycle, you will be selling more of your a.s.sets at market tops than at bottoms, stretching your a.s.sets further.) Playing the Long Game Once you've established your allocation, you are left with the financial equivalent of gardening-maintaining the policy allocation you decided on in the last chapter. Mind you, this is very important work, from a number of perspectives. First, it keeps your portfolio's risk within tolerable limits. Second, it generates a bit of excess return. And third, and perhaps most important, it will instill the discipline and mental toughness essential to investment success.

In order to understand rebalancing, let's consider a model consisting of two risky a.s.sets; call them A and B. In a given year, each a.s.set is capable of having only two returns: a gain of 30% or a loss of 10%, each with a probability of 50%. You can simulate the return for each simply by flipping a coin. Half the time you'll get a return of +30%, and half the time you'll get 10%.

The expected return of this "investment" is 8.17% per year. That's because, on average, you'll get one year of +30% for every year of 10%: 0.9 1.3 = 1.17, or a two-year return of 17%. If you annualize this out, you get 8.17% per year. (In other words, a return of +30% the first year and 10% the second is the same as a return of 8.17% in both.) Of course, you only get this 8.17% "expected return" if you flip the coin millions of times, so that the heads/tails ratio comes out very close to 50/50.

Now, imagine that you construct a portfolio of 50% A and 50% B. You thus have four possible situations: [image]

One-quarter of the time, we flip two heads resulting in a +30% return. One-quarter of the time, we flip two tails, and the portfolio returns 10%. And one-half the time, we get one of each, and the return is the average of +30% and 10%, or +10%. The expected four-year return is thus 1.3 1.1 1.1 0.9 = 1.4157. This annualizes out to a return of 9.08%. (That is, had we gotten a return of 9.08% all four years, our final wealth would be the same 1.4157 we got from the above 30%/10%/10%/10% sequence.) The key point is this: we got almost 1% more return (9.08%, versus 8.17%) simply by keeping our portfolio composition at 50/50. we got almost 1% more return (9.08%, versus 8.17%) simply by keeping our portfolio composition at 50/50. Take a look at Year 2. If we started out that year with equal amounts of a.s.set A and a.s.set B, by the end, we would have had much more of A because of its higher return. In order to get back to 50/50, we sold some of a.s.set A and with the proceeds bought some a.s.set B. The next year, a.s.set B did better than a.s.set A, so we turned a profit with this maneuver. Had we not rebalanced, we simply would have gotten the 8.17% return of each a.s.set. Take a look at Year 2. If we started out that year with equal amounts of a.s.set A and a.s.set B, by the end, we would have had much more of A because of its higher return. In order to get back to 50/50, we sold some of a.s.set A and with the proceeds bought some a.s.set B. The next year, a.s.set B did better than a.s.set A, so we turned a profit with this maneuver. Had we not rebalanced, we simply would have gotten the 8.17% return of each a.s.set.

But that's not all. Notice that instead of getting a return of 10% half of the time, as with a single a.s.set, we now only get it one quarter of the time. We have reduced risk by diversifying. We have reduced risk by diversifying.

This formulation, which I call the "two-coin toss" model of diversification and rebalancing, does overstate the benefits of diversification/rebalancing a bit. It is very unusual to find two a.s.sets with returns as independent as those of A and B and that have such a tendency to "mean revert"-that is, to have low returns followed by high returns, and vice versa. But to a certain extent, all diversified and rebalanced portfolios do benefit from this phenomenon. In real-life portfolios, the benefit of rebalancing stock portfolios is closer to 0.5%, and not the nearly 1% shown in this example.

Beyond risk control and extra return, there is yet a third benefit to rebalancing, and that is psychological conditioning. In order to make a profit on any investment, you must buy low and sell high. Both of these, particularly the former, are extraordinarily difficult to do. Buying low means doing so when the a.s.set has been falling rapidly with poorer recent returns than other a.s.set cla.s.ses, generally accompanied by negative commentary from the experts. This is as it should be-you don't get low prices any other way. Selling high means just the opposite. The a.s.set has had high recent returns and is outperforming other investments; it is the general consensus that it is the "wave of the future." This is also as it should be-you don't get very high prices in any other way.

Rebalancing forces you to buy low and sell high. It takes many years and many cycles of rebalancing before you realize that bucking conventional wisdom is a profitable activity. I like to refer to bucking the conventional wisdom as your "financial condition." By this, I don't mean how flush you are, but rather how strong your discipline and emotional balance are when it comes to investing. Like physical conditioning, "financial condition" requires constant exercise and activity to maintain. Periodically rebalancing your portfolio is a superb way of staying "in shape."

Another way of putting this is that rebalancing forces you to be a contrarian-someone who does the opposite of what everyone else is doing. Financial contrarians tend to be wealthier than folks who like to simply follow the crowd.

This concept also reveals the major benefit of a diversified portfolio: the advantage of "making small bets with dry hands." In poker, the player who is least concerned about the size of the pot has the advantage, because he is much less likely to lose his nerve than his opponents. If you have a properly diversified portfolio, you are in effect making many small bets, none of which should ruin you if they go bad. When the chips are down, it will not bother you too much to toss a few more coins into the pot when everyone around you is folding his hand. That's how you win at poker, and that's how you win the long game of investing.

It is often said that the small investor is at an unfair disadvantage to the professional, because of the latter's superior information and trading ability. This is certainly true of trading in individual stocks. It is even more true in the trading of futures and options, where more than 80% of small investors lose money, mainly to the brokerage firms and market makers. But when it comes to investing in entire a.s.set cla.s.ses, it is really the small investor who possesses an unfair advantage. Why? For two reasons.

First, because sudden market downturns affect smaller investors less, because they have a smaller portion of their portfolio invested in any one a.s.set cla.s.s. I came smack up against this at a recent conference of inst.i.tutional bond investors. The junk-bond money managers at the meeting were easy to pick out-they were the ones with a vacant, deer-in-the-headlights stare. Not only were junk bonds falling rapidly in price, but in most cases, market conditions were so bad that they could not even find someone to trade with. In other words, they did not even know what the bonds in their portfolios were worth. they did not even know what the bonds in their portfolios were worth. Remember, the world of inst.i.tutional investing is highly specialized-junk was most of what these poor folks traded, and my guess is that many of them had recently been on the phone to Momma inquiring about the availability of their old room. On the other hand, if only 2% of your portfolio was in junk, you didn't even notice the loss. And since prices were dirt cheap, why not rebalance or even increase your exposure a tad? Often, the small investor is the only player at the table with dry hands. Remember, the world of inst.i.tutional investing is highly specialized-junk was most of what these poor folks traded, and my guess is that many of them had recently been on the phone to Momma inquiring about the availability of their old room. On the other hand, if only 2% of your portfolio was in junk, you didn't even notice the loss. And since prices were dirt cheap, why not rebalance or even increase your exposure a tad? Often, the small investor is the only player at the table with dry hands.

The second advantage of the small investor is more subtle-you have only your own gut reactions to worry about. The inst.i.tutional manager, on the other hand, constantly has to worry about the emotions of clients, who likely will be annoyed with the purchase of poorly performing a.s.sets. In such a situation, rebalancing into a poorly performing a.s.set may be an impossibility. An oft-quoted a.n.a.logy likens successful investing to driving the wrong way up a one-way street. This is difficult enough with your own vehicle, but nearly impossible when you are a chauffeur piloting a Rolls Royce whose owner is in the back seat, squawking at every pothole and potential collision.

Let's take a look at how rebalancing works in the real world. Consider the four a.s.sets we examined from 1998 to 2000 in Chapter 4 Chapter 4: [image]

a.s.sume for the sake of argument that we have decided on a portfolio holding 25% of each of these a.s.sets. In 1998, U.S. large stocks and foreign stocks did well, and U.S. small stocks and REITs did poorly. So at the end of that year, to get back to equal weighting, we'd have sold some U.S. large stocks and foreign stocks, and bought more small stocks and REITs. As you can see, this was a wash. In 1998 as in 1999, small stocks did better than the portfolio, but REITs did much worse. But at the end of 1999, we'd have sold some of the best performers-U.S. small stocks and foreign stocks-and tossed all of the proceeds into REITs, which were the runaway winner in 2000. The three-year return of the rebalanced portfolio was 8.48%. Had you not rebalanced back to equal weighting at the end of 1998 and 1999, your return would have been only 7.41%.1 This little exercise points out two things. First, rebalancing does not work all of the time-obviously, selling some foreign stocks at the end of 1998 was a bad move. But more often than not, it is beneficial. Second, although it doesn't always work, it always feels awful. Note that we had to endure two solid years of miserable REIT performance before we were finally paid off for our patience. It can be much worse than this-precious metals equity has had low returns for more than a decade, as have j.a.panese stocks.

How Often?

The question of how often to rebalance is one of the th.o.r.n.i.e.s.t in investing. When you try to answer this question using historical data, the answer you get is "rebalance about every two to five years," depending on what a.s.sets and what time period you look at. But you have to be very careful in interpreting this data, because the optimal rebalancing interval is exquisitely sensitive to what a.s.sets you use and what years you study.

Personally, I think that about once every few years is the right answer for one good reason. If the markets were truly efficient, then you shouldn't be able to make any money rebalancing. After all, rebalancing is a bet that some a.s.sets (the worst performing ones) will have higher returns than others (the best performing ones). Research has shown that this tendency for the prior best-performers to do worse in the future and vice versa (which we saw in Chapter 7 Chapter 7 in our survey of five-year regional stock performance) seems to be strongest over about two to three years. In fact, over periods of one year or less, the reverse seems to be true-the best performers tend to persist, as do the worst. in our survey of five-year regional stock performance) seems to be strongest over about two to three years. In fact, over periods of one year or less, the reverse seems to be true-the best performers tend to persist, as do the worst.

Thus, you should not rebalance too often. The most extreme example of the advantage of waiting comes when you consider the behavior of the U.S. and j.a.panese markets in the 1990s. During this period, the U.S. market did almost nothing but go up, whereas the j.a.panese did almost nothing but go down. The longer you waited before selling U.S. stocks and buying j.a.panese ones, the better.

The above considerations apply only in the sheltered environment, where there are no tax consequences to rebalancing. In the example shown above-where we rebalanced a 25/25/25/25 mix of U.S. large and small, foreign and REITs-about 6.5% of the portfolio was traded each year. In a taxable account, rebalancing results in capital gains, which reduce your after-tax return. Although this does not trigger much in capital gains taxes in the early years, as time goes on most of the acc.u.mulated value in the funds would be subject to capital gains. In the example shown above-where we rebalanced a 25/25/25/25 mix of U.S. large and small, foreign and REITs-about 6.5% of the portfolio was traded each year. In a taxable account, rebalancing results in capital gains, which reduce your after-tax return. Although this does not trigger much in capital gains taxes in the early years, as time goes on most of the acc.u.mulated value in the funds would be subject to capital gains.

If, over the years, an average of 50% of the fund value consisted of unrealized capital gains, then this would cause about 3% of the portfolio value each year to be subject to capital gains taxes. At a combined federal/state rate of 25%, this would cost about 0.75% per year, wiping out the rebalancing benefit. Admittedly, you'd get some of this back in the form of a higher cost basis for the rebalanced shares, but it is still quite likely that rebalancing might put you behind the tax eight-ball. Thus, in taxable accounts, it makes sense to rebalance only with mandatory fund distributions (fund capital gains and dividends), inflows (that is, value averaging), and outflows.

Rebalancing in Retirement Retirement is simply value averaging/rebalancing in reverse. Once again, sheltered accounts are easiest to deal with. Since the tax consequences of selling stocks and bonds are equivalent-everything gets taxed at the ordinary rate when you withdraw it from a retirement account-you sell enough of your best-performing a.s.sets to meet your living expenses so as to bring them back to their policy composition. If you are withdrawing only a small percent of your nest egg each year, you may not even notice the difference, and you will go on rebalancing every few years as if nothing has happened. On the other hand, if you are withdrawing a large percentage of your sheltered accounts each year, you may even have to sell some of your poorly performing a.s.sets to make ends meet.2 What this means, in general, is that during the good years, you will be selling stocks, and during the bad years you'll be living off your bonds-the two-warehouse psychology.

If you are going to be living on taxable a.s.sets, at least in part, then things can get extremely messy. For starters, let's think about Taxable Ted's 50/50 portfolio, with no sheltered a.s.sets at all. a.s.sume he doesn't spend any money for a decade or two. (Ted just can't seem to slow down after all. He's taken up consulting and has yet to learn how to say no.) The stock portion of his portfolio has grown faster than the bond portion, and his portfolio is now 70/30 stocks/bonds. When he finally needs to tap his portfolio for cash, he's faced with an unpalatable choice. The "proper" way to do it would be to sell some of his stocks. But this will incur capital gains taxes-if there has been a doubling of his fund share price, then he'll pay about 10% on his total withdrawals. Spending down his bonds would be a real temptation, since this would avoid most capital gains, but would make the portfolio even more top-heavy with stocks.

There is no "right" answer to this dilemma. In most circ.u.mstances, a fully-taxable investor such as Ted should probably bite the bullet and spend down the stocks first, as slowly drifting towards a 100% stock allocation may put him at undue risk in the event of a serious and prolonged market decline. However, if Ted had so much money that he could comfortably get by on his bond holdings alone, then there would be nothing wrong with doing so and allowing his heirs to inherit his tax-efficient stock funds on a stepped-up basis. If you're Bill Gates, you don't need to own bonds.

Things get even more complex when investors have substantial amounts of both sheltered and taxable a.s.sets. The decision of how much to withdraw from each is one best left to an accountant and tax attorney. However, a few general statements are possible. If you have no other source of income, it is often advantageous to make at least some withdrawals from your retirement accounts if these can be made at a relatively low marginal rate. On the other hand, the compounding and rebalancing advantages of a sheltered account are considerable, particularly over long time horizons, so you should also be trying to preserve these as much as possible.

For Those in Need of Help Investment planning and execution are two completely different animals. It is one thing to plan periodic portfolio rebalancing and another to sell a.s.sets that have been doing extremely well so that you can purchase ones that have been falling for years. It is also one thing to calmly look at a graph, table, or spreadsheet and imagine losing 30% of your money. And it is most emphatically another to actually have it happen.

I thought long and hard before including these last few paragraphs, since I am an investment advisor and have no desire to appear self-serving.

I do believe that most investors are capable of investing competently on their own without any professional help whatsoever. But I have also learned from hard experience that a significant number of investors will never be able to do so. Most of the time, this is due to lack of knowledge of investment theory and practice. If you have gotten this far, however, you certainly should not be suffering any shortcomings in these departments!

But it is not uncommon to meet extremely intelligent and financially sophisticated people, oftentimes finance professionals, who are still emotionally incapable of executing a plan properly-they can talk the talk, but they cannot walk the walk, no matter how hard they try.

The most common reason for the "failure to execute" shortcoming is the emotional inability to go against the market and buy a.s.sets that are not doing well. Almost as common is an inability to get off the dime and commit hard cash to a perfectly good investment blueprint, also called "commitment paralysis."

But whatever the reason, a significant number of investors do require professional management. For those who do, I offer this advice: * The biggest pitfall is the conflict of interest arising from fees and commissions, paid indirectly by you. But rest a.s.sured that you will pay these costs just as surely as if they had been lifted directly from your wallet. You will want to ensure that your advisor is choosing your investments purely on their investment merit and not on the basis of how the vehicles reward him. The warning signs here are recommendations of load funds, insurance products, limited partnerships, or separate accounts. The best, and only, way to make sure that you and your advisor are on the same team is to make sure that he is "fee-only," that is, that he receives no remuneration from any other source besides you. Otherwise, you will wind up paying, and paying, and paying, and paying. . .* "Fee-only" is not without pitfalls, however. Your advisor's fees should be reasonable. It is simply not worth paying anybody more than 1% to manage your money. Above $1 million, you should be paying no more than 0.75%, and above $5 million, no more than 0.5%. Vanguard does offer personal advisory services, providing a useful benchmark for comparison: 0.65% from their $500,000 minimum to $1 million, 0.35% for the next $1 million, and 0.20% above $2 million. (Be aware, however, that Vanguard's advisory service will usually recommend some of their actively managed stock funds. If you do use them, insist on an indexed-only stock allocation.)* Your advisor should use index/pa.s.sive stock funds wherever possible. If he tells you that he is able to find managers who can beat the indexes, he is fooling both you and himself. I refer to a commitment to pa.s.sive indexing as "a.s.set-cla.s.s religion." Don't hire anyone without it.

CHAPTER 14 SUMMARY.

1. Only if you are an experienced investor who already has significant stock exposure should you switch rapidly from your current investment plan to one that is index/a.s.set-cla.s.s based.2. If you are a relatively inexperienced investor or do not have significant stock exposure, you should build it up slowly using a value averaging approach.3. Value averaging is a superb method of building up an equity position over time. This technique combines dollar cost averaging and rebalancing. a.s.set allocation in retirement is the mirror image of value averaging-you are rebalancing with withdrawals.4. Rebalance your sheltered accounts once every few years.5. Do not actively rebalance your taxable accounts except with mandatory withdrawals, distributions, and new savings.6. Rebalancing provides many benefits, including higher return and lower risk. But its biggest reward is that it keeps you in "good financial shape" by helping maintain a healthy disdain for conventional financial wisdom.

15.

A Final Word We've surveyed a much wider swath of territory than is usually covered in the field of personal finance in one book, and I hope that you have found the journey rewarding. While each of the four overarching stories I've told (the theory, history, psychology, and business of investing), are worthwhile in their own right, they also form an essential part of an investor's repertoire. Let's recap what we've learned.

Pillar One: Investment Theory * Risk and return are inextricably enmeshed. Do not expect high returns without frightening risks, and if you desire safety, you must accept low returns. The stocks of unattractive companies must, of necessity, offer higher returns than those of attractive ones; otherwise, no one would buy them. For the same reason, it is also likely that the stock returns of less developed and unstable nations are higher than those of developed nations. Anyone promising high returns with low risk is guilty of fraud.* It is relatively easy to estimate the long-term return of a stock market simply by adding its long-term per-share earnings growth to its dividend yield. The long-term return of high-grade bonds is essentially the same as the dividend yield, since bond coupon payments do not grow.* The market is brutally efficient and can be thought of as being smarter than even its wisest individual partic.i.p.ants. Stock picking and market timing are expensive, risky, and ultimately futile exercises. Harness the power of the market by owning all of it-that is, by indexing.* It is not possible to predict what portfolio compositions will perform best in the future. A prudent course is to make the broad market (Wilshire 5000) and a lesser amount of small U.S. and large foreign stocks your core stock holdings. Depending on your tax and employment situation, as well as your tolerance to tracking error (performing differently from the broad market), you may also wish to add small and large value stocks and REITs to your portfolio as well.

Pillar Two: Investment History * You simply cannot learn enough about this topic. The more you know, the better you will be prepared for the shocks regularly hurled at investors by the capital markets.* Be aware that the markets make regular trips to the loony bin in both directions. There will be times when new technologies promise to remake our economy and culture and that by getting in on the ground floor, you will profit greatly. When this happens, hold on tight to your wallet. There will also be times when the sky seems to be falling. These are usually good times to buy.

Pillar Three: Investment Psychology * You are your own worst enemy. It is likely that you are more confident of your ability to pick stocks and mutual fund managers than is realistic. Remember that the market is an 800-pound gorilla whose only pleasure is to make as many investors look as foolish as possible.* If you are invested in the same a.s.sets as your neighbors and friends, it is likely that you will experience low returns. Your social instincts will corrode your wealth by persuading you to own what everyone else in the market owns. Successful investing is a profoundly solitary activity.* Try to ignore the last five or ten years of investment returns and focus on the longer-term data as best you can. Yes, large growth stocks have had very high returns in recent years (and, until 2001, the very highest), but history shows that they still underperform both large and small value stocks. While there are no guarantees that this will be true going forward, the odds always favor data gathered over the longest time periods.* Resist the human temptation to imagine patterns where there are none. a.s.set cla.s.s returns are essentially random, and patterns apparent in retrospect almost never repeat going forward.

Pillar Four: Investment Business * The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks. A broker's only hope of making a good living is to milk your account dry with commissions and spreads. He also occupies the lowest rung in the hierarchy of investment knowledge. The simple fact that you have finished this book means that you know far more about investing than he ever will.* The primary business of most mutual-fund companies is collecting a.s.sets, not managing money. Pay close attention to the ownership structure of your fund company and of the fees it charges, but also realize that the expense ratio of a fund is just the tip of the iceberg.* Ninety-nine percent of what you read about investing in magazines and newspapers, and 100% of what you hear on television is worse than worthless. Most financial journalists quickly learn that it is much easier to turn out a stream of articles about strategists- and fund managers-of-the-month rather than do serious a.n.a.lysis.

In the last section, we synthesized the knowledge in these four areas into a basic investment strategy that any investor should be able to employ. While it is possible to manage your finances with just the knowledge contained herein, you'd be foolish to do so. This book should be seen as a framework to which you'll be continuously adding knowledge, starting with the sources mentioned at the end of Chapter 11 Chapter 11.

The overarching message of this book is at once powerful and simple: With relatively little effort, you can design and a.s.semble an investment portfolio that, because of its wide diversification and minimal expense, will prove superior to most professionally managed accounts. With relatively little effort, you can design and a.s.semble an investment portfolio that, because of its wide diversification and minimal expense, will prove superior to most professionally managed accounts. Great intelligence and good luck are not required. The essential characteristics of the successful investor are the discipline and stamina to, in the words of John Bogle, "stay the course." Great intelligence and good luck are not required. The essential characteristics of the successful investor are the discipline and stamina to, in the words of John Bogle, "stay the course."

Investing is not a destination. It is an ongoing journey through its four continents-theory, history, psychology, and business. Bon voyage Bon voyage

Bibliography

Introduction.

Lowenstein, Roger, When Genius Failed. When Genius Failed. Random House, 2000. Random House, 2000.

Chapter 1.