Investing

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.

Securities Investing

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!

Long-Term Investments

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.


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14 thoughts on “Investing

  1. Pingback: Taxable Investments: The Best Opportunities Now « Consumer Maven

  2. Pingback: EmptorMaven » Blog Archive » Taxable Investments: The Best Opportunities Now

  3. Pingback: EmptorMaven » Blog Archive » Investment Advice: Swensen Update

  4. federalist Post author

    David Swensen notes that, like Vanguard, TIAA-CREF is a non-profit company. Hence it avoids conflicts between its responsibilities to its customers and to its owners. For all others:

    [T]here’s an irreconcilable conflict in the mutual fund industry between the profit motive and fiduciary responsibility. There are two major organizations, Vanguard and TIAA-CREF, which operate on a not-for-profit basis. That conflict between profit and fiduciary duty disappears. Vanguard and TIAA-CREF are dedicated to serving their investors. They are shining beacons in this otherwise ugly morass.

  5. federalist Post author

    A good WSJ column about investing in bonds, which warns:

    [A]t today’s high prices and low yields, bonds are riskier than they were a few months ago. The easiest way to tell is by looking at duration: the change in a bond’s market value when interest rates go up or down by one percentage point. If, for example, you own a bond with a duration of four, then its value will go up about 4% if interest rates fall by a percentage point; the bond will lose about 4% if rates rise by one point. For Treasury bonds, rising interest rates are the main form of risk; for corporate, municipal and other bonds, the financial soundness of the underlying assets raises another kind of risk.

    Duration generally rises in tandem with bond prices, meaning that bonds are now primed to lose even more money if interest rates go up. This is, in short, a dangerous time to chase yield.

  6. federalist Post author

    Seeking Alpha has a good list of asset classes and ETF offerings for them:

    US Equity Large cap
    Vanguard 500 VFINX, Spider SPY
    US Equity Mid cap
    Midcap Spider MDY
    US Equity Small cap
    Russell 2000 IWM, Russell 2000 Value IWN, Russell 2000 Growth IWO
    International Developed Countries Equities
    MSCI EAFE index EFA
    Emerging Markets Equity
    Vanguard VEIEX, MSCI Emerging Market Index EEM
    Commodities Agriculture
    DB Agriculture DBA
    Commodities Energy
    DB Energy DBE
    Commodities Precious metals

    DB Precious Metal DBP, SPDR Gold Shares GLD, Silver Trust SLV

    Commodities Industrial metals
    DB Industrial Metals DBB
    US Real Estate Investment Trust (REIT)
    REIT Index IYR, Cohen & Steers REIT Majors ICF
    International REIT
    SPDR Intl’ REIT IWX
    Fixed Income Treasuries
    Long Term Treasury TLT, Intermediate Term Treasury IEF, Short Term Treasury SHY
    Fixed Income Inflation Protected Bonds
    Vanguard VIPSX, iShares Tips Bond TIP, SPDR International Government Inflation Protected Bonds WIP
    Fixed Income Investment Grade Corporate Bonds
    Long Term investment grade LQD, Intermediate Credit Bonds CIU, Short Term Credit Bonds CSJ
    Fixed Income High Yield Bonds
    Vanguard High Yield Bonds VWEHX, iShares High Yield HYG, SPDR High Yield JNK
    Fixed Income GNMA
    Vanguard GNMA VFIIX, iShares MBS Bond MBB
    Fixed Income Foreign Bonds
    SPDR International Treasury Bonds BWX, Emerging Markets Sovereign Debt PCY
    Currency Pairs and Dollar Index
    Yen FXY, Euro FXE, Pound FXB, Swiss Franc FXF, US Dollar Bearish UDN
  7. federalist Post author

    Practical thinking on market efficiency from Cliff Asness and John Liew:

    So if markets are not perfectly efficient but not grossly inefficient either — though occasionally pretty darn wacky — what should investors do? We believe the vast majority would be better off acting like the market was perfectly efficient than acting like it was easily beatable. Active management is hard.

    That’s not to say we think it’s impossible. Take, for instance, our favorite example … of people who seem to be able to consistently beat the market: Renaissance Technologies. It’s really hard to reconcile their results long-term with market efficiency (and any reasonable equilibrium model). But here’s how it’s still pretty efficient to us: We’re not allowed to invest with them (don’t gloat; you’re not either). They invest only their own money. In fact, in our years of managing money, it seems like whenever we have found instances of individuals or firms that seem to have something so special (you never really know for sure, of course), the more certain we are that they are on to something, the more likely it is that either they are not taking money or they take out so much in either compensation or fees that investors are left with what seems like a pretty normal expected rate of return. (Any abnormally wonderful rate of return for risk can be rendered normal or worse with a sufficiently high fee.)

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