Rational Expectations: Advanced, Specific, Practical Portfolio Advice

The fourth and final book in the “Investing for Adults” series by William Bernstein is Rational Expectations: Asset Allocation for Investing Adults. In Book 1: The Ages of the Investor, I learned to take advantage of a lucky streak in stocks and stop when I’ve won the game. In Book 2: Skating Where the Puck Was, I learned why it’s so hard to find any “new and improved” asset classes. In Book 3: Deep Risk, I learned about the scenarios that have led to permanent capital loss.

This final book includes the most specific advice about constructing your retirement portfolio. The entire series is great (and honestly not very long even read back-to-back), but this final book is especially dense with additional practical ideas for those that are already comfortable with investing basics. This isn’t at all scientific, but upon counting my Kindle highlights, Book 4 had 75 highlighted passages vs. 33, 25, and 36 respectively for Books 1-3. I’m only going to touch on the few that directly impacted my own portfolio construction.

Stocks. Here is an excerpt regarding how much of your portfolio should be allocated to international stocks.

Deployment among stock asset classes is relatively easier. The obvious place to start is with the total world stock market, as mirrored reasonably well by the FTSE Global All Cap Index, which in early 2014 was split 48/52 between U.S. and foreign equities. From there, we make three adjustments to the foreign allocation, two down and one up. First, the downs: if you’re like most people, your retirement liabilities will be in dollars, so a 52% foreign allocation is inappropriately high. Second, foreign stocks not only are slightly more difficult and expensive to trade but also are subject to foreign tax withholding. This presents no problem in taxable accounts, since those taxes will offset your liability to the IRS, but you lose that deduction if you hold foreign stocks in a sheltered account.

The up adjustment is a temporary one, since foreign stocks, as was discussed in chapter 1, currently have higher expected returns. So at the time of this writing, a foreign stock allocation somewhere in the 30% to 45% region seems reasonable.

Simplifying all that, as of early 2014, the middle recommendation would be roughly 60/40 US/international while the world market cap weighting was roughly 50/50. A little home bias is recommended for US investors.

As of mid-2020, the world market cap weighting is 57% US and 43% International (source), which you might round to 60/40. The adjustments are mostly the same, except that foreign stocks probably have even slightly higher future expected returns as the US stocks keep climbing. If you want to maintain a slight home bias, I would speculate this might change the recommended range closer to 65/35 or 70/30?

Bonds. The recommended list includes short-term US Treasuries/TIPS, bank CDs, and investment-grade municipal bonds. Bernstein is not a fan of corporate bonds.

Sooner or later, we’re going to have an inflationary crisis, and in such an environment, long duration will be a killer. Stick to short Treasuries, CDs, and munis.

Own municipal bonds via a low-cost Vanguard open-ended mutual fund for the diversification. Own Treasury bonds and TIPS directly, as there is no need for mutual funds or ETFs since they all have the same level of risk. Own bank CDs and credit union certificates under the FDIC and NCUA insurance deposit limits.

Asset location. I found this advice about spreading your holdings across Traditional IRAs, Roth IRAs, and taxable accounts to be very useful and practical. Importantly, this may be somewhat different that what you have read elsewhere. I don’t want to summarize incorrectly, so I will just use the excerpts:

To the extent that you wish to rebalance the asset classes in your portfolio, all sales should be done within a sheltered account. If possible, you should house enough of each stock asset class in a sheltered account so that sales may be accomplished free from capital gains taxes. Next, all of the REIT allocation certainly belongs in the sheltered portfolio, since the lion’s share of their long-term returns come from nonqualified dividends.

The real difference made by location occurs at the level of overall account returns. In terms of tax liability, Traditional IRA/Defined Contribution > Taxable > Roth IRA. This means that, optimally, you’d like to arrange the expected returns of each account accordingly, with the highest returns (i.e., highest equity allocation) optimally occurring in the Roth, and the lowest returns (i.e., lowest stock allocation) in your Traditional IRA/Defined Contribution pool. To the extent that this is true, it conforms with the stocks-in-the-taxable-side argument. That said, for optimal tax-free rebalancing, unless your Roth IRA is much bigger than your traditional IRA, you’re still going to want some stock assets in the latter.

It is definitely nice to be able to rebalance and not have to worry about picking stock lots, making sure you have the right cost basis at tax time, and paying capital gains taxes.