Investing is a simple trade-off between maximizing return and minimizing risk. In general you have to accept more risk to get a higher expected return. In theory, there is an “efficient frontier” — an upward-sloping curve that represents the greatest return you could expect to make for a given level of risk. Your concern as an investor is to decide how much risk you want to take, and then to allocate your assets to get as close as possible to the theoretical limit of return you can realize at that risk level.
Fortunately the Information Age has made this enterprise very straightforward. Thanks to the advent of liquid and cheap index instruments, any individual today can — with minimal expense — put together a diverse portfolio of public securities that sits as close to the efficient frontier as portfolios compiled by the most sophisticated professionals. In prior generations this was not the case. Lamentably, you can still pay a financial advisor or management company anywhere from .5% to 1.5% per year of your investable money to compile an efficient and diversified portfolio. However, these days they will simply allocate it across various mutual funds … which in turn will take a similar cut to simply allocate it across individual stocks or other securities. But to do so would be foolish: If you cut out these middlemen and allocate your investments to reasonably diversified low-cost index funds you will, in the end, experience the same level of risk as you would with active management. And you will, on average, experience the same returns as they generate before fees, which means you’ll actually make 1-3% more money per year.
Individual asset management is generally a scam: (1) Manager expenses do not vary as a function of assets under management, so they should not charge a fee that is a function of assets under management. (2) Managers cannot reliably increase risk-adjusted returns through active allocation, so they should not charge a fee that is a function of assets under management. (You will, of course, continue to see managers who advertise their record of “beating the market.” The problem is that you can’t predict ahead of time which managers will outperform their benchmark. Just because someone did it for ten years doesn’t mean they’ll do it for an eleventh. There is ample evidence that, on average, active managers underperform their benchmarks — by an amount roughly equal to the average they charge in fees. Cut out the middleman and keep the fees for yourself!)
In an efficient market you only have to look at two properties of any asset: Beta and Correlation. Your goal is to compile a portfolio where the net Beta meets your risk appetite, and where the Correlations between your holdings are as small as possible. Again: the greater the risk (beta) you can accept, the greater the potential returns. And the more diversified (low-correlation) the risk, and the longer you can hold, the greater the likelihood you will realize those outsized returns.
Granted, markets aren’t perfectly efficient. An inefficient market offers investors the ability to make money through various types of arbitrage. But today broad segments of the markets are so efficient that no retail investor is going to be able to make money through arbitrage. (That is strictly the domain of skilled professionals in hedge funds and proprietary desks, who can bring to bear enormous resources to exploit fleeting and statistical inefficiencies — and who generally do so in tax-inefficient ways, and for enormous fees. A small individual investor is not equipped to responsibly allocate capital to such endeavors, given the elevated due diligence required.) In these picked-over, highly-efficient market segments individual investors should stick to the well-defined indicies.
Do not invest a penny in securities so long as you have any non-mortgage or unsubsidized debt. You cannot expect to realize returns much higher than 8% per year — before taxes — by investing in stocks and bonds. So all credit card debt, car loans, and unsubsidized student loans should be paid off first, since in general you are paying interest on those with after-tax income, which puts the actual “return” on the debt lower than -8% per year. (I.e., you can’t earn more by investing than you can save by paying down retail debt).
Cash and Short-Term Investments
Now that you are debt-free and accumulating savings, make sure you are earning a fair return. There is no excuse for keeping any significant amount of cash in an account earning less than the money market rate — i.e., the rate you can earn with virtually zero risk and 100% liquidity. Vanguard and Fidelity have money-market funds (VMMXX and FDRXX) that are good benchmarks. There are often banks that will offer FDIC-insured savings accounts with rates that (at least for a time — keep an eye on them) beat the best Money Market Accounts (MMAs). Check BankRate. Right now (2007), with top money rates around 5%, you could be throwing away $500 a year on every $10,000 you leave languishing in a checking account!
Any money that you can afford to tie up for at least several years should be put in a diversified portfolio of index funds. This should include all money in retirement accounts (unless you are preparing to tap into them). It could even include your “emergency” fund of 6-12 months of living expenses: Most public securities can be stored in a margin account, which means you can take an immediate “margin loan” against up to half of their market value without selling them. The interest rate on margin loans is not cheap (usually prime plus 1-2%), but it’s a reasonable thing to do in an emergency — similar to using a home equity loan to borrow against the money you have invested in your house.
You can save yourself the trouble of asset allocation by putting all your securities investments in one of Vanguard’s LifeCycle funds, which will maintain a reasonable allocation based on the date you want to liquidate your investment, and which have total expenses right around .20%.
If you want to do your own allocation you should probably include an index from each of the following asset types. For each class I have listed index funds offered through Vanguard and/or Fidelity, which you can trade and hold for free directly through the fund company; and I have listed Exchange Traded Funds (ETFs), which you have to pay a commission to trade, but which can be traded from any brokerage account. Given the similarities between the indices and securities I think expenses should be the biggest consideration, so I have listed each fund’s expense ratio after its ticker.
Bonds: VBMFX (.20%), AGG (.20%)
U.S. Stocks: VTI (.07%), FSTMX (.10%), VTSMX (.19%), IWV (.20%), TMW (.20%), VEXMX (.25%)
U.S. Real Estate: VGSIX (.21%), RWR (.25%), ICF (.35%)
For international funds you should opt for those that do NOT hedge their currency exposure, since that is part of the diversification value of the investment.
International: FSIIX (.10%), VGTSX (.32%), EFA (.35%)
Emerging Markets: ADRE (.30%), VWO (.30%), VEIEX (.42%), EEM (.77%)
International Real Estate: RWX (.60%)
Note that you do not have to fine-tune your portfolio. All of the equity indices have correlations above .9, and even against the bond indices their correlation is above .7! If you fiddle with the allocations of an efficient portfolio of similar instruments like this by even ten percentage points, you won’t see a big difference in performance.
Why I prefer mutual funds from Vanguard: First, Vanguard is one of the largest investment management companies, which means it enjoys all of the economies of scale and access that come with size. Second, Vanguard is owned by the investors in its funds, which means it has absolutely no conflicts of interest. For example, Vanguard funds have been known to turn away institutional investors with characteristics that could negatively impact the performance of its existing retail investors.
2012 Update: A more attractive long-term investment strategy to which I now subscribe is known as “risk parity.” It is based on the realization that it makes more sense to allocate to investable asset classes in risk-adjusted terms rather than in nominal dollar terms. It is explained well here by Antti Ilmanen and Cliff Asness, and since it’s hard for a retail investor to implement a diversified risk parity strategy Cliff’s investment company, AQR, has offered a series of Risk Parity mutual funds.
Posts on Investing:
- Tax-Exempt Investments: The Best Opportunities now (26-Sep-2008)
- Where to Invest Now (26-Sep-2008)
- Taxable Investments: The Best Opportunities Now (6-Aug-2008)