Mark Cuban recently had a post on his blog called Wall Street’s new lie to Main Street – Asset Allocation. In it, he quotes a recent newspaper article that presents this model asset allocation:
15% in an S&P 500 index fund
5% in a small-capitalization value fund
20% in a diversified international stock fund
5% in an emerging markets international fund
5% in Real Estate Investment Trusts
10% in stocks with a history of paying competitive and increasing dividends
10% in a diversified portfolio of convertible securities
5% in a U.S. Treasury inflation-indexed bonds and notes
15% in an international bond fund with traditional fixed coupon bonds
5% in an international bond fund for inflation-indexed bonds
5% in cash equivalents.
To which he translates as:
I want you to invest 5pct in cash and the rest in 10 different funds about which you know absolutely nothing. I want you to make this investment knowing that even if there were 128 hours in a day and you had a year long vacation, you could not possibly begin to understand all of these products. In fact, I don’t understand them either, but because I know it sounds good and everyone is making the same kind of recommendations, we all can pretend we are smart and going to make a lot of money. Until we don’t
Now, I don’t rely on Cuban for investing advice, but I do think he has a point. Over the past couple of years, I have to come value simplicity and also belief in investing. Now, I think asset allocation is important. To me, asset allocation is owning different assets that (1) all have good prospects for long-term returns above inflation, and (2) don’t necessarily move in the same direction. This allows you to reduce volatility when one things zigs while the other zags.
However, this also means you have to own said assets both when they are up and down. If the only reason you own something is because it’s in some financial newspaper article, then you’ll just sell it when the same newspaper starts touting the next new thing. This will likely lead to worse returns than just holding cash. You should only invest in asset classes that you understand and have strong reasons to hold in both good times and bad.
Here are the asset classes that I have strong beliefs in. This is of course my own personal opinion, but I’ll try to share my reasoning as well.
US Stocks
I believe in US stocks as a way to own domestic companies that are creating value and making money. I like to own a “total market” fund that owns essentially every stock in proportion to their value. I own big companies to small companies. If a certain small company turns into a big company, I’ll own it. Instead of searching for a needle in a haystack, I just buy the haystack. More in-depth explanation here. Stocks should expected to give you a bumpy ride. But I believe that in the long-term, they will provide a decent return.
I try not to split this class up too much into value or growth, or micro-cap/small-cap/mid-cap/large-cap. It just gets confusing to me. I do have a small addition of a small-cap value index fund, because these companies are such a small part of the “total market” that I figure a little extra can’t hurt.
International Stocks
I also believe in international stocks. Other developed countries also have smart people making innovative products. Many US companies make a lot of their money internationally, and many international companies make a lot of money from US consumers. International stock funds are usually in their own currency, which provides some currency hedging when the dollar is weaker. Again, I like to own a low-cost, passive fund that owns the entire market in proportion to their values.
I believe in holding domestic and foreign stocks nearly in proportion to their world market cap. Currently that is about 45% US and 55% foreign. I think it’s fine to add a slight bias to domestic stocks so that you are less affected by currency swings – this is assuming you are still spending US dollars.
High Quality Bonds
I was swayed by the arguments of David Swensen in his book Unconventional Success, which argued that alignment of interests is important. With stocks, they want to make profits, and you want them to make profits. In contrast, the job of bond issuers is to look as creditworthy as possible, even if they are not. This keeps the interest rates they pay lower. The safety ratings of bonds usually only get worse – usually quickly and unexpectedly as we saw with subprime mortgages. Ratings agencies are not very good at their jobs, mostly in a reactionary role, and are paid by the same people they rate.
Therefore, I only hold bonds with the highest safety ratings. This means primarily US Treasury bonds, inflation-linked TIPS, and FDIC-insured cash equivalents. In limited cases, I might break this rule slightly with high quality, short-term municipal bonds and insured stable value funds. I don’t invest in corporate bonds, high-yield bonds, mortgage bonds, or bonds in emerging markets.
Real Estate Investment Trusts
I believe that real estate is a different type of investment with unique characteristics, and Real Estate Investment Trusts (REITs) are an easy and relatively direct way of owning real estate. REITs own and operate income-producing real estate such as apartments, shopping centers, office buildings, hotels and warehouses. They are required to distribute at least 90% of their taxable income to shareholders. More on REITs here. I don’t have to collect rent, screen tenants, or fix anything. Over the long-term, the returns should outpace inflation.
For all of these asset classes, I can see past a long period of low returns, because I feel confident in their structure and reasons for long-term solid returns. Who knows, I may be wrong, but I’m willing to bet my hard-earned money on them. Next up, I’ll talk about asset classes that I may like at times, but am either not educated enough about or just not convinced by their proponents.
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The American Association of Individual Investors (AAII) recently did an analysis demonstrating that even in last crappy decade for investing (the period 2000-2009 to be exact), that an investor with with just two funds — Vanguards 500 Index and Total Bond Market Index — who rebalanced to a 50/50 allocation every year would have had a decent positive return over that time period. I think the retail brokerage industry fears average investors getting the message that asset allocation can be quite simple — and profitable. Hence the bizzare recommendations such as that in the pie chart in the article. I dare say that the only reason for such an approach is to generate trading commissions for rebalancing the portfolio accross so many asset classes every year.
I am a firm believer in a proper asset allocated portfolio. Due to my age I do not hold any bond instruments in my portfolio, I prefer a pedal to the metal approach at this time. As I get older I will start to create a position in bonds. If one decides to go the index, asset allocated portfolio then the question is how much risk do you want to add to the portfolio by having a larger percentage in lets say small caps. After loosing a lot of money in the ’90s using high growth active managed funds I decided it was not worth the extra expense & worry of having to keep track of active managed funds which overall have underperformed a asset allocated index folio. I have read David Swenson and others and most highly successful managers suggest the typical retail investor keep it simple. It is impossible to compete with the big firms and all their research teams & HFT. Now with that said I still think once you have your asset allocated portfolio to go outside of that and buy some individual stocks is fine providing it does not throw the allocation out of whack.
I believe in simplicity too, and I am very risk averse hence I like to keep my allocation as 25% stock ETFs (including total us, international and social index fund of the largest 400 companies (equivalent to S&P)); 25% non-government bonds ETFs (inncluding total us, international and peer to peer A and AA notes of $25 increments(using Lendingclub and Prosper); 25% I-Bond index fund ETF (hate when pundits scare risk adverse people that too keep up with inflation you NEED to invest in stock market, what about I bonds ? ); and finally 25% cash (and mine earn at least 4% interest if you factor reward checking and non reward checking with up to $350 one time bonus per as liittle as $100 initial deposit)
Mark Cuban has a short attention span. You’ll excuse me if I stick with David Swensen on this one.
I agree that an overly complicated asset allocation is not really necessary. BUT diversifying your assets is certainly a good idea in general.
Cuban says asset allocation is bad and a rip off. But what exactly does he think is the preferable alternative??
Actually Cuban believes you should build up a cash hoard, sit down, learn a business or area that you are interested in really deeply, wait for an opportunity, and then use your cash to either go into business or similar. Final step: get rich. 🙂
http://blogmaverick.com/2008/09/08/talking-stocks-and-money/
I thought the idea of asset allocation started with “modern portfolio theory”. A study was done showing for a given return of a mixture of US stocks and bonds would reduce volatility. I haven’t seen any other study since then. The original study emphasized the reduction of volatility, not the guarantee of a good return.
Did you see the article in the NY Times today called “A Retirement Program for the Risk-Averse”. It was an interesting point of view.
My newly simplified asset allocation added a new rule:
no categories at or below 5% of the total
This eliminates a lot of the “tweaking” that created tons of busy work for myself for very little (if any) additional return.
My current allocation uses 6 categories and I gave serious consideration to just using two.
I think the point he’s making is don’t invest in something you don’t understand. On that, I’d have to agree.
Unfortunately people do it all the time. It’s how people like Bernie Madoff can rip off millions of dollars from ordinary folks. He just had to sound like enough of an expert and convince people that they were going to make money whether they understood the investment or not.
Swensen is a smart guy… I’d be curious to see how the Lazy Swensen portfolio based on the allocation in Unconventional Success held up with rebalancing over the last few years. I imagine it would have done pretty well all things considered.
Earlier this decade there was a study done (it’s called the CDS study based on the last names of the researchers) based on actual mutual fund holdings that showed individual investors averaged 3% more per year than those investors using an advisor. 3% a year!
As a 15 year veteran of the financial services industry I can tell you that I’m not surprised by their findings! Investors are slowly learning that there is a big difference between someone who ‘manages money’ versus and advisor that just allocates it.
I’m not a fan of asset allocation as it is defined, but then again, I’m an individual investment picker. While the argument against owning bond investments sound persuasive, I find that a blanket statement means that you may miss some opportunities.
If you stay away from bonds, then you will avoid the current muni bond mess where some professionals are making the case that these bonds are not as credit worthy as they are sold. But, you will also miss out on other good opportunities that are worthy.
Mike
Actually Cuban believes you should build up a cash hoard, sit down, learn a business or area that you are interested in really deeply, wait for an opportunity, and then use your cash to either go into business or similar. Final step: get rich.
OK, well, that’s idiotic. If everyone could do that….well, everyone would do that. Most people have lives — jobs, families, etc. — and so don’t have the time, energy, or safety net to go out on a limb like that.
I generally agree with your post and reader comments. Portfolio mgmt should be kept simple and the investor should now how and why a vehicle compliments a portfolio. If they do not they should either gain that understanding or not own it.
I’m also an indexer and keep fees as low as possible. Some games we win by not losing and I believe investing is one of those.
This said, a few comments regarding your asset class discussion:
US Stocks – I personally put more emphasis on Small Cap Value stocks simply because they tend to outperform over long periods of time. I weight Small Cap Value as 1/3 of my total US market target.
Foreign Stocks – Similar to US stocks I overweight Foreign Small Caps. The reasoning being these Small Cap stocks provide more economy diversfication since these companies tend to be local while Foreign Developed Large Cap companies are global. Purchasing the global companies is essentially a hedge against currency risk.
Emerging Mkts – you don’t specifically mention these, but given your allocation they are implied. I don’t go crazy with these, but they are definately targeted in my portfolios.
Bonds – I’m on the fence with Foriegn Bond Funds. They typically nuetralize currency risk, so I’m not sure exactly what added benefit they bring. I do target High Yield bonds, however. Only a small fraction of the overall bond allocation, but they do tend to boost performance over time. Once the risk premium on High Yield bonds falls below 500 Bps, I don’t think investors are properly compensated for the additional risk, however.
US vs Foreign – I too tend to market weight US v. Foreign, but most US investors are very US biased since they are fed daily doses of what the DOW is doing. These investors simply hate underperforming the DOW more than they like beating it. This bias may cause an undisciplined investor to bail on their strategy, which is obviously not good. I think this is why most asset managers overweight US Stocks in their allocation models. Thoughts?
All this said, if the average investor simply bought Vanguard’s World Index + Vanguard Total Bond Fund, then occasssionally rebalanced, they would be much much better off.
Keep up the good work!
What do you think of …Select one of the Vanguard life strategy funds ..at ones risk level for 50% of a portfolio
and the remainder 50% in only FDIC insured options.. live within ones means..and then leave it as is ….and go live ones life?