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The problem with a lot of good advice is that you really don’t understand it without experience. For example, Jack Bogle always says “Stay the course”. I was lucky enough to trust in that advice, but it took me a while to really appreciate the power of investing in productive assets and then treating them with what I call beneficial neglect. That is, I make the most money when I fight off the urge to take action.

I managed again to do as very little during the hiccups, tantrums, seizures, or other bodily functions the markets had in 2015. As the year ends, we all like to take look back and assess the situation. Here are the trailing 1-year returns for select asset classes as benchmarked by passive mutual funds and ETFs. Return data was taken from Morningstar after market close 12/31/15.

Stocks. The Total US Stock Market (VTI) ended up mostly flat, while the rest of the world’s markets (VXUS) dropped a little bit (~4%). Emerging Markets (VWO) did the worst, with a -15% total return. US REITs (VNQ) were up a little bit (~2%). If you were like most people and owned mostly US stocks with perhaps a little international exposure, you were probably close to breaking even.

Bonds. The Total US Bond Market (BND) and short-Term Treasuries (SHY) went up a little bit. Long-Term Treasuries (TLT) and Inflation-linked Treasuries (TIP) went the other way, going down a little bit instead. There were no huge moves, despite all the talk about interest rates.

Gold dropped around 10%, joining the other industrially-useful commodities in having a down year.

Another year, another batch of predictions into the shredder. How many people were saying that oil prices, already said to be “too low” at $50, would drop another 30% in value? Did anyone listen to me when I said not to speculate with the USO ETF? A funny book that came out this year was The Devil’s Financial Dictionary by Jason Zweig. Here’s how he defines forecasting:

Forecasting (n.) The attempt to predict the unknowable by measuring the irrelevant; a task that, in one way or another, employs most people on Wall Street.

Most people who owned a diversified portfolio in 2015 had their money go nowhere or perhaps lost a little bit of money. The 2015 total return of my personal investment portfolio was roughly -1.5%, right in that “meh” range. I imagine the people who like to focus on dividends, interest, and rental income collected them happily and went about their lives. That sort of mental framework is becoming increasingly appealing to me.

SensibleInvesting.tv recently released a free documentary about the fund management industry and the effect of their high fees on the returns of everyday citizens. “How to Win the Loser’s Game” includes interviews with Vanguard founder John Bogle, Nobel Prize-winning economists Eugene Fama and William Sharpe, author and wealth manager Larry Swedroe, amongst many others. While the publisher is UK-based, most of the concepts are widely applicable to all fund management. The film is broken down into 10 different parts, each about 8 minutes long.

If you are a visual learner and rather watch an educational video than read a book, this documentary is definitely for you. The brief episodes gradually cover the benefits of a low-cost, long-term, low-maintenance, diversified investment strategy. Here’s the trailer, which ends with links to all 10 episodes.

Schwab recently announced lowered expenses on all of their 15 Schwab-branded ETFs, undercutting everyone else’s comparable ETFs in every category, including Vanguard. Quite a bold move! Here is a limited comparison of comparable Vanguard and Schwab ETFs. The asset classes are picked to include the common asset classes as mentioned in many passive investing books and articles, but admittedly biased towards the ones that I like to use in my own portfolio. This way, I can also note which asset classes are not covered.

Briefly, an expense ratio of 0.01% means that on $10,000 invested you would be charged $1 a year in fees. The fees are taken out of the ETF’s share price, or net asset value (NAV), a tiny bit each day. So a difference of 0.03% (3 basis points) on a $10,000 investment would add up to just $3 per year.

My comparison differs from the Schwab-provided version in the area of Treasury ETFs, with what I think are more appropriate Vanguard pairings. As Vanguard does not have a TIPS ETF, I should note that the Schwab TIPS ETF compares favorably to the popular iShares TIPS ETF (ticker TIP) with an expense ratio of 0.20%.

If you already have your money with Schwab, this is great news and a good sign for the future that they are committed to building up some decent-sized assets and trading volume on their ETFs. (Vanguard’s higher asset sizes and volumes mean lower bid/ask spreads and smaller NAV deviations, resulting in lower overall trading costs.) In a Schwab brokerage account, you can trade Schwab ETFs commission-free.

However, if you’re already investing with Vanguard, I don’t think these small expense ratio differences are enough to warrant moving assets especially if you have unrealized capital gains. (You can also trade all Vanguard ETFs commission-free inside a Vanguard brokerage account, and also many of them free at TD Ameritrade.) Vanguard has a long-standing commitment to “at-cost” investing and passing their savings onto the retail investor. In contrast, Schwab is almost certainly losing money on many of these ETFs, and thus using the low expense ratios as a temporary loss-leader “sale” to attract assets. For example, their bond ETF (SCHZ) currently has $316.5 million in assets and thus only generates around $158,000 a year in fees. That’s probably less than one employee salary at Schwab. In other words, I don’t think a substantial savings margin is sustainable over the horizon of many decades. I’d still recommend Vanguard for new investors, especially as Vanguard also has cheaper stock commissions for outside ETFs and individual stocks ($7 or less vs. $8.95).

A good point brought up in the Bogleheads forum is the ability of some people to gain access to these Schwab ETFs in their 401(k) retirement plans through the Schwab Personal Choice Retirement Account® (PCRA). If your retirement plan offers such a brokerage window, you may be able to trade these cheap Schwab ETFs for free with your tax-deferred money. Most PCRAs charge an annual fee of around $30-$50. Unfortunately, I found out that due to silly regulations, if you have a 403(b) plan your PCRA account is limited only to mutual funds. However, Schwab does have a small selection of low-cost index mutual funds as well.

Asset allocation (AA) is an important part of portfolio design, and I like pinning down a target asset allocation for personal reference. This helps keep me focused as my portfolio shifts over time and makes it easy to re-balance back. For some educational posts on this topic, please refer to my asset allocation starter guide.

Below is my updated target asset allocation. Here is my target asset allocation from 2008. It’s not dramatically different, but I’ll try to explain the slight changes below. This is just my own AA, and I think everyone should develop their own based on their own beliefs and learning. If you just copy someone else’s without thinking, when things go awry you won’t have the foundation to stick to your guns. I have been strongly influenced by the writings of Jack Bogle, William Bernstein, David Swensen, Rick Ferri, and Larry Swedroe.

Stocks

I separate things out first into stocks and bonds, and then later it’s easy to go 60% stocks/40% bonds and so on. Here’s my stocks-only breakdown:

• I now do a 50/50 split between US and International stocks. In general, I would like to mimic the overall world investment landscape. On a market cap basis, the US stock market is now about 45% of the world, while everyone else takes up 55%. 50/50 is just simpler, with a slight tilt towards domestic stocks.
• I consider REITs a separate real estate asset class. I used to put Real Estate under US stocks since I only held US Real Estate Investment Trusts (REITs), but in the future I would be open to investing in foreign real estate as property laws improve and investing costs drop.
• On the US side, I add some extra small-cap value companies. Historically, adding stocks of smaller companies with value characteristics (as opposed to growth) has improved the returns of portfolios while lowering volatility. There is debate amongst portfolio theories as to why this happened and if it will continue.

  If you buy a “total market” mutual fund or ETF, you’ll already own many of these types of companies (although many will not be held due to their small size relative to the big mega-corporations). I feel this adds a bit of diversification.

• On the international side, I add a little extra exposure to emerging markets. You may be surprised to know that “emerging” countries like China, Brazil, Korea, India, Russia, and Taiwan already make up 26% of the world’s markets when you remove the US. These are countries that have a greater potential for growth, but also lots of ups and downs. I add a little bit more than market weight for these as well.

Bonds

I try to keep things simple for bonds, partially due to the fact that they are currently a smaller portion of my portfolio.

• I like a 50/50 split between inflation-linked bonds and nominal bonds. Inflation-protected bonds provide a yield that is guaranteed to be a certain level above inflation. Nominal bonds pay a stated rate that is not adjusted for inflation. I like to balance the benefits of both.
• Instead of only short-term US Treasuries for nominal bonds, I added some flexibility. I used to invest only in short-term US treasuries, as they provided the best buffer in my portfolio as they were of the highest quality and had a low sensitivity to interest rate fluctuations. Both TIPS and nominal Treasuries did great during the 2009 crash and the subsequent flight-to-quality, but now the yield on Treasuries is just too low in my opinion. There are trillions of dollars from countries and huge institutions around the world that are tucking their money away under the safe Treasury mattress. By venturing into other places they won’t with my tiny portfolio, I feel I can stay relatively safe yet increase my yield significantly. Possibilities include bank CDs, stable value funds, and high-quality municipal bonds.

Want more examples? Here are 8 model portfolios from respected sources, an updated Swensen portfolio, one from PIMCO’s El-Erian, and Ferri’s personal portfolio. Have fun!

In a recent post on the NY Times Bucks blog, portfolio manager and author Richard Ferri shared his own personal portfolio. As a proponent of low-cost, passive investing, it was not surprising to see mostly index funds in his portfolio, but it was interesting to see that his overall asset allocation is 80% stocks and 20% bonds. He is quick to note that he does have a pension and defined-benefit plans which balance out his overall financial picture. Wouldn’t you like to know what all those financial advisors out there actually own?

Asset Allocation

Here is his asset allocation broken down into stocks and bonds separately using pretty pie charts:

Here’s the overall 80/20 breakdown with ticker symbols (based on this Bogleheads post):

34% Vanguard Total Stock Market ETF (VTI)
10% S&P SmallCap 600 Value Index Fund (IJS)
5% Ultra-Small Company Market (BRSIX)
8% Vanguard REIT ETF (VNQ)

6.5% Vanguard Pacific ETF (VPL)
6.5% Vanguard European ETF (VGK)
5% DFA International Small Cap Value
5% DFA Emerging Markets Core
—- [alternative: Vanguard Emerging Markets ETF (VWO)]

12% Vanguard Total Bond Market Index Fund Investor Shares (VBMFX)
4% Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX)
4% Vanguard High-Yield Corporate Fund Investor Shares (VWEHX)

Reading his book All About Asset Allocation was very helpful in creating my own portfolio. (Also see Model Portfolio #3 taken from that book.) I haven’t been updating my own own portfolio asset allocation as diligently as I should, although I have been keeping track of it. Here’s the last snapshot I took:

I’ve had some asset allocation drift for sure, although I have been countering this by rebalancing with new funds. I really need an update…

Emergency Funds

It’s also interesting to note that he keeps an emergency fund of two years’ living expenses, and that he uses the Vanguard Short-Term Bond (BSV) with a current SEC yield of 1.08%. Very simple and almost no-maintenance.

I prefer using a mix of high interest savings accounts and longer-term CDs/rewards-type checking accounts. I figure that index fund investors get so excited by saving 10 basis points (0.10%) on mutual fund, but with a bit of work you could beat a short-term bond fund by 100 basis points (1%) with what I would call less risk.

Bond funds still have risk to principal, meaning you may have to sell for less than you bought in for, while FDIC-insured bank accounts do not. Money market funds are currently averaging less than 0.10% yield.

Another theory of predicting future stock market returns states that there are three main components to long-term stock market performance. Amongst many others, I learned this from authors and investors Jack Bogle and William Bernstein.

Part 1: Dividend Yield
If your stock distributes 2% in dividends each year, then you will have a 2% contribution towards of return. This is what dividend investors love to see coming in each quarter, and is relatively easy to track for a large group of companies. Here it is over time for the S&P 500, courtesy of Multpl.com:

Part 2: Earnings Growth
If earnings stay constant, then all other things equal, one would expect the share price of your company to stay constant as well. If the earnings grow by 5% every year, then your share price will grow by 5% per year. Thus, earnings growth rate is a vital component of total return.

If your portfolio was all of the stocks traded in the United States, like that of a broad-based index fund, this would create a connection between the growth rate of the nation’s Gross Domestic Product and the earnings growth rates of all US companies. In other words, the fundamental return is based on GDP growth. In turn, the GDP growth rate is connected to population growth and productivity per person.

These two parts added to together are coined the fundamental return:

Some bad news: Now, from 1950-2000, fundamental returns were 10%: 4% dividend yield and a 6% earnings growth rate. These days, the S&P 500 has a dividend yield of only about 2%. Earnings growth rate estimates are subject to debate, but they hover around 5-6%.

Part 3: Changes in P/E Ratio
The price-to-earnings (P/E) ratio is the price per share divided by earnings per share. In other words, it is how much investors are willing to pay for each unit of earnings. If they are willing to pay 20 times annual earnings, the share price of the stock will be twice as high as if they only paid 10 times earnings. This part is denoted the speculative return, as it has changed throughout history. Here it is again for the S&P 500:

In 1950, the P/E ratio was less than 10. As of right now in mid-2010, it is 20. It is very unlikely that this more than doubling of price-per-share will happen again, with the historical average being around 15. (During the dot-com bubble, the P/E ratio was over 40. In 2008, it was over 25.) This will lead to a zero, and quite possible negative, future speculative return!

Summary

Source: Little Book of Common Sense Investing, Exhibit 7.1

When predicting future returns, you have to look at all the sources of those expected returns. Fundamental return is still a solid reason why stock prices will go up on the long-term, especially if you are not investing only in one country or economy. Some people call it a belief in capitalism, that economic growth will continue and GDP will continue to increase. I simply believe in the passion and motivation of all the people out there, from Sweden to China to Brazil. However, there is good evidence that you might not be getting 10% historical returns due to P/E ratio contraction.

In a recent column, Larry Swedroe shares that the forecasts that he has read are predicting a 5% total annual growth in earnings and 2% dividends for a total return of 7% (similar to above). Inflation is predicted at 2.5%. However, he points out the current minimal-risk return is pretty low as well, so you need consider the big picture:

The bottom line is that while the expected nominal return to stocks is lower than the historical return, so is the expected return to Treasury bonds. You should decide if the expected risk premium for stocks is sufficient given your unique ability, willingness and need to take risk.

Over at Bogleheads there was an interesting thread which explored how finance professor Moshe Milevsky has been pushing the concept of human capital as an additional variable to the traditional ideas of net worth, portfolio construction, and asset allocation. These are explored in this this trade magazine article for financial advisors, this draft academic paper, and also in his book Are You a Stock or a Bond?.

Human Capital
There are some differing definitions, but below is a brief explanation (taken from the magazine article above) of what is meant by human capital here:

Human capital is a measure of the present value of your client’s future wages, income and salary (net of any future income taxes and expenses). For example, if she is a doctor, lawyer, engineer or even a professor, she has probably invested an enormous amount of time, effort and money to finance her education. That investment will hopefully pay off over many future years of productive labour income in the form of job dividends over the next 10, 20 or even 30 years. Sure, clients can’t really touch, feel or see human capital, but like an oil reserve deep under the sands of Alberta, it will eventually be extracted and so it’s definitely worth something now.

Milevsky likes to talk about people as businesses and thus includes human capital on the balance sheet of “Me, Inc.”:

When you’re young, your human capital may very well dwarf your 401k balance. With this in mind, it may make you feel better about any short-term losses.

Your human capital can be viewed as a hedge against the losses in your financial capital. So, as a 50-, 40-, or especially 30-year old, you should be willing to take more chances with your total portfolio, perhaps even borrow to invest or leverage into the stock market, because you have the ability to mine more human capital if needed.

Am I a Stock or a Bond?
One characteristic of your human capital to think about is if it tends to act like a stock or a bond. As a tenured university professor, Milevsky offers himself up as a good example of a bond that offers a reliable and steady coupon (paycheck). However, an small business owner, investment banker, or even a car salesman would have an income that is much more correlated with current economic conditions – much like a stock would.

A common piece of advice that relates to this is when people are told not to hold too much of their employer’s company’s stock (often in 401k plans). Since your salary is already tied to that company, it would be wise to add some diversification so that all your eggs aren’t in one basket.

Along the same diversification argument, if you are a “bond” then you may be able to take more equity risk in your retirement portfolio. On the other hand, if you are a “stock” then you may want to reduce your exposure to stock market swings. “Your invested assets should zig when your salary zags… tilt your financial portfolio away from your human capital.”

Thoughts
Unfortunately, rarely are things so simple. Human capital is at best a guess of the future, and you could be really far off. And just because your income isn’t tied to the stock market, doesn’t necessarily mean you can stomach the swings of a highly risky portfolio. If you’re the type to panic and sell at the bottom, perhaps increasing stocks would only hurt your long-term investment returns.

I like to imagine a good financial couple as one that pairs up a stock and bond. Perhaps one person holds a steady government job with a pension and healthcare benefits into retirement, while the other is an entrepreneur that takes some risks and tries to strike it big.

Also, what if I don’t want take advantage of all my human capital? Sure I could work for another 35 years and consider a big chunk of human capital in my net worth, but I’d really rather not. 🙂

What do you think of this concept?