Sunday, January 17

Week 237 - Respect The KISS Rule

Situation: How do we save for retirement? After all, a typical adult is disinclined to reduce discretionary spending by the needed ~50% to plan for her future (and that’s assuming that a series of favorable events will transpire). To effectively save for retirement, most people have to make a game out of it. We substitute the discretionary entertainment value that comes from immediate consumption by instead watching our nest egg grow. The entertainment value we receive can be amplified by trying to be more clever than our neighbors and co-workers. With the help of a financial advisor, we play around with our retirement portfolios. But it doesn’t have to be that way. You can forget about entertainment and one-upping your friends. Just pick mutual funds that balance stocks and bonds. Or pick only one, such as the Vanguard Balanced Index Fund (VBINX), which serves as Jack Bogle’s only personal investment during most years. He’s the originator of index fund investing and founder of Vanguard Group. Jack Bogle respects the KISS rule: “Keep it simple, stupid.” But he has many critics in the community of investment advisors (as the above link makes clear). Their main criticism is that VBINX minimizes international investing and overlooks “core” assets like real estate investment trusts (REITs), small-cap stocks, and commodities.

Mission: Test a balanced portfolio of “core assets” consisting of US stocks, international stocks, US bonds, international bonds, REITs, and Commodities. In other words, combine the most diversified mutual funds for US stocks (VTSMX), US bonds (VBMFX), real estate investment trusts (VGSIX), commodity futures (QRAAX), international bonds (RPIBX), and international stocks (VGTSX). 

Execution: Since the S&P 500 Index peaked on 9/1/00 (see Table), total return/yr for these 6 core assets has come in at 3.6%/yr, matching the lowest-cost S&P 500 Index fund (VFINX). Broad diversification among core assets is meant to reduce the risk of an S&P 500 index fund without reducing returns. The 6 core assets we selected did achieve our objective. Risk measures were lower for this asset group (see Columns D and I in the Table). However, these core assets under-performed VFINX by a wide margin during the bull market of the past 5 years (see Column F in the Table). More importantly, their average expense ratio is 3 times higher at 0.52% (vs. 0.17% for VFINX). And, QRAAX has to be purchased through a broker. 

As a “rule of thumb” you want some assurance that your investment will meet the “business case” and double in value over the next 10 years, i.e., total return will increase by at least 7%/yr. If the dividend yield plus the dividend growth rate is at least 7%, that is likely to be the case (see Columns G and H in the Table where those instances are highlighted in green). Core assets, except for the real estate fund (VGSIX), do not meet that criterion.

Administration: Mutual funds also have “tail risks,” a term used to describe unlikely yet destabilizing events. Managed funds are sold on the basis of performance, which means managers tend to choose small- and mid-cap stocks that often perform remarkably well (meaning they have a high return on equity or ROE), due in part to being overcapitalized by loans and bonds that are “less than investment grade.” Of course, that indebtedness is ignored when calculating ROE. Index funds are also sold on the basis of performance and overly dependent on their smallest (i.e., riskiest) companies for that performance. Finally, mutual funds maintain minimal cash balances which can force them to sell their bonds or stocks at a loss during a bear market (i.e., conduct a “fire sale”). In other words, they have to immediately honor every investor’s request to have her money returned. None of these problems exist if you’re a shareowner. You get to decide how much risk you want to assume and whether or not to “ride out” a bear market, or even continue dollar-averaging into your favorite positions, so as to “vacuum up” shares that mutual funds are unloading at a loss.

By now you’re getting the point: part of your retirement portfolio has to be devoted to owning shares in a diversified group of strong companies that you’ve selected, so as to avoid the “buy high, sell low” roller coaster that mutual funds can’t avoid. They’re constrained by market forces and the inflows/outflows of investor’s cash. They’ll engage in “momentum investing” as they ride bull markets up, and “fire sales” as they ride bear markets down. By owning individual stocks, you choose whether to play along or not. Individual stocks also have their place in a retirement portfolio for another reason we often highlight. Many companies issue dividends that have increased 2-5 times faster than inflation for more than 10 years, whereas, distributions from stock mutual funds rarely keep up with inflation (see Column H in any of our Tables). That means you don’t have to cash out shares during retirement but instead can simply live off your income. For example, you can do quite well by investing in 5 stocks (that represent half the S&P industries) combined with owning 10-yr Treasury Notes in a 60% stock/40% Treasury Note ratio (see Line 14 in the Table). 

Bottom Line: Broad diversification among “core assets” will allow you to match the performance of the lowest-cost S&P 500 Index fund (VFINX) while incurring less risk, as long as you ignore transaction costs, advisory fees, and front-end brokerage charges. But professional money managers prefer to get you into “core assets” for the very reason that they live off advisory fees (as well as often gaining a piece of the income from transaction costs and brokerage relationships). Warren Buffett is right. You will beat 90% of professional investors by investing online through Vanguard Group--placing 90% of your savings in the lowest-cost S&P 500 Index fund (VFINX) and 10% in the lowest cost US government short-term bond index fund (VSBSX), as shown in Line 23 of the Table. The key benchmark we recommend to our readers is the Vanguard Balanced Index Fund (VBINX) at line 21 in the Table, which does even better than the Buffett Plan while incurring less risk. 

Risk Rating: 5

Full Disclosure: I own shares of MCD, JNJ, and KO, as well as dollar-average into T, NEE and Treasury Notes.

Note: Metrics highlighted in red denote underperformance relative to our key benchmark (VBINX). Metrics are current for the Sunday of publication.

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