The Four Pillars of Investing: Lessons for Building a Winning Portfolio_6 pot

Thiswill, in turn, determine your overall balance between risky and risk-less assets—that is, between stocks and short-term bonds and bills.Many investors start at the opposite end of th

Step One: Risky Assets, Riskless Assets

Distilled to its essence, there are only two kinds of financial assets:those with high returns and high risks, and those with low returns andlow risks The behavior of your portfolio is determined mainly by yourmix of the two As we learned in Chapter 1, all stocks are risky assets,

as are long-term bonds The only truly riskless assets are short-term,high-quality debt instruments: Treasury bills and notes, high-gradeshort-term corporate bonds, certificates of deposit (CDs), and short-term municipal paper To be considered riskless, their maturity should

be less than five years, so that their value is not unduly affected byinflation and interest rates Some have recently argued that TreasuryInflation Protected Securities (TIPS) should also be considered riskless,

in spite of their long maturities, because they are not negatively

affect-ed by inflation

What we’ll be doing for the rest of this chapter is setting up a oratory” in which we create portfolios composed of various kinds ofassets in order to see what happens to them as the market fluctuates.How we compute the behavior of these portfolios is beyond the scope

“lab-of this book; for those few “lab-of you who are interested, I suggest that

you read the first five chapters of my earlier book, The Intelligent Asset Allocator Suffice it to say that it is possible to simulate with great accu- racy the historical behavior of portfolios consisting of many assets Keep in mind that this is not the same as predicting the future behav-

ior of any asset mix As we discussed in the first chapter, historicalreturns are a good predictor of future risk, but not necessarily of futurereturn

Let’s start with the simplest portfolios: mixtures of stocks and T-bills.I’ve plotted the returns of Treasury bills, U.S stocks, as well as 25/75,50/50, and 75/25 mixes of the two, in Figures 4-1 through 4-5 In order

to give an accurate idea of the risks of each portfolio, I’ve shown them

on the same scale

As you can see, when we increase the ratio of stocks, the amountlost in the worst years increases This is the face of risk In Table 4-1,I’ve tabulated the return, as well as the damage, in the 1973–74 bearmarkets for a wide range of bill/stock combinations Finally, in Figure4-6, I’ve plotted the long-term returns of each of these portfolios ver-sus their performance in 1973–1974

Figure 4-6 provides the conceptual heart of this chapter, and it’sworth dwelling on for a few minutes What you are looking at is a map

of portfolio return versus risk The numbers along the left-hand edge

of the vertical axis represent the annualized portfolio returns Thehigher up on the page a portfolio lies, the higher its return The num-

Figure 4-1 All Treasury bill annual return, 1901–2000 (Source: Jeremy Siegel.)

Figure 4-2 Mix of 25% stock/75% Treasury bill annual returns, 1901–2000 (Source:

Jeremy Siegel.)

Figure 4-3 Mix of 50% stock/50% Treasury bill annual returns, 1901–2000 (Source:

Jeremy Siegel.)

Figure 4-4 Mix of 75% Stock/25% Treasury bill annual returns, 1901–2000 (Source:

Jeremy Siegel.)

bers on the horizontal axis, at the bottom of the graph, represent risk.The further off to the left a portfolio lies, the more money it lost in1973–74, and the riskier it is likely to be in the future.

It’s important to clear up a bit of confusing terminology first Untilthis point in the book, we’ve used two designations for fixed-incomesecurities: bonds and bills, referring to long- and short-duration obli-gations, respectively Bonds and bills are also different in one otherrespect: bonds most often yield regular interest, whereas bills do not—they are simply bought at a discount and redeemed at face value Themost common kinds of bills in everyday use are Treasury bills andcommercial paper, the latter issued by corporations

Long-duration bonds are generally a sucker’s bet—they are quitevolatile, extremely vulnerable to the ravages of inflation, and have lowlong-term returns For this reason, they tend to be bad actors in a port-folio Most experts recommend keeping your bond maturities short—certainly less than ten years, and preferably less than five From now

on, when we talk about “stocks and bonds,” what we mean by the ter is any debt security with a maturity of less than five to ten years—T-bills and notes, money market funds, CDs, and short-term corporate,

lat-government agency, and municipal bonds For the purposes of this book, when we use the term “bonds” we are intentionally excluding

Figure 4-5 All-stock annual returns, 1901–2000 (Source: Jeremy Siegel.)

long-term treasuries and corporate bonds, as these do not have an acceptable return/risk profile I’ll admit that this is a bit confusing A

more accurate designation would be “stocks and relatively short-termfixed-income instruments,” but this wording is unwieldy

The data in Table 4-1 and the plot in Figure 4-6 vividly portray thetradeoff between risk and return The key point is this: the choicebetween stocks and bonds is not an either/or problem Instead, thevital first step in portfolio strategy is to assess your risk tolerance Thiswill, in turn, determine your overall balance between risky and risk-less assets—that is, between stocks and short-term bonds and bills.Many investors start at the opposite end of the problem—by decidingupon the amount of return they require to meet their retirement, educa-tional, life style, or housing goals This is a mistake If your portfolio riskexceeds your tolerance for loss, there is a high likelihood that you willabandon your plan when the going gets rough That is not to say thatyour return requirements are immaterial For example, if you have saved

a large amount for retirement and do not plan to leave a large estate for

Table 4-1 1901–2000, 100-Year Annualized Return versus 1973–1974 Bear Market

your heirs or to charity, you may require a very low return to meet yourongoing financial needs In that case, there would be little sense inchoosing a high risk/return mix, no matter how great your risk tolerance.There’s another factor to consider here as well, and that’s the prob-ability that stock returns may be lower in the future than they havebeen in the past The slope of the portfolio curve in Figure 4-6 issteep—in other words, in the twentieth century, there was a generousreward for bearing additional portfolio risk It is possible, for example,that the future risk/reward plot may look something like Figure 4-7,with a much lower difference in returns between risky and risk-freeinvestments In this illustration, I’ve assumed a 7% return for stocksand a 5.5% return for bonds In such a world, it makes little sense totake the high risk of an all-stock portfolio.

Finally, it cannot be stressed enough that between planning andexecution lies a yawning chasm It is one thing to coolly design a port-folio strategy on a sheet of paper or computer monitor, and quiteanother to actually deploy it Thinking about the possibility of losing30% of your capital is like training for an aircraft crash-landing in asimulator; the real thing is a good deal more unpleasant If you are juststarting out on your investment journey, err on the side of conser-vatism It is much better to underestimate your risk tolerance at an

Figure 4-6 Portfolio risk versus return of bill/stock mixes, 1901–2000.

early age and adjust your risk exposure upwards later than to bite offmore than you can chew up front.

Millions of investors in the 1920s and 1960s thought that they couldtolerate a high exposure to stocks In both cases, the crashes that fol-lowed drove most of them from the equity markets for almost a gen-eration Since the risk of your portfolio is directly related to the per-centage of stocks held, it is better that you begin your investmentcareer with a relatively small percentage of stocks This flies directly inthe face of one of the prime tenets of financial planning conventionalwisdom: that young investors should invest aggressively, since theyhave decades to make up their losses The problem with an earlyaggressive strategy is that you cannot make up your losses if you per-manently flee the stock market because of them

This all adds up to one of the central points of asset allocation:Unless you are absolutely certain of your risk tolerance, you shouldprobably err on the low side in your exposure to stocks

Step Two: Defining the Global Stock Mix

Why diversify abroad? Because foreign stocks often zig when tic markets zag, or at least may not zig as much Let’s look at the mostrecent data

domes-Figure 4-7 Likely future portfolio risks/returns.

In the early part of this century, the international capital marketswere a good deal more integrated than they are now It was com-monplace for an Englishman to buy American bonds or French stocks,and there were few barriers to cross-border capital flow The twoWorld Wars changed that; the international flow of capital recoveredonly slowly afterwards The modern history of international diversifi-cation properly begins in 1969, with the inception of Morgan Stanley’sEAFE (Europe, Australasia, and Far East) Index As of year-end 2000,there is a 32-year track record of accurate foreign returns For the peri-

od, this index shows an 11.89% annualized return for foreign ing, versus 12.17% for the S&P 500

invest-Why invest in foreign stocks if their returns are the same, or perhapseven less than U.S stocks? There are two reasons: risk and return InFigure 4-8, I’ve plotted the annual returns of the two indexes Notehow there can be a considerable difference in return between the two

in any given year Particularly note that during 1973 and 1974, theEAFE lost less than the S&P: a total 33.16% loss for the EAFE versus a

Figure 4-8 Returns for S&P 500 and foreign stocks, 1962–2000.

37.24% loss for the S&P 500 What this means is that foreign investingprovided a bit of cushion to the global investor.

An even more vivid case for diversifying into foreign stocks is made

by looking at returns decade by decade, as shown in Figure 4-9 Noticehow during the 1970s, the return of the S&P 500 was less than infla-tion—that is, it had a negative real return—whereas the EAFE beatinflation handily You’ll also see that the EAFE beat the S&P 500 by asimilar margin in the 1980s

Thus, for a full two decades you would have been very happy withglobal diversification This would have been particularly true if thesetwo decades had been your retirement years, since a U.S.-only portfo-lio would have very likely run out of money due to its relatively lowreturns In the 1990s, the law of averages finally caught up with for-eign stocks, souring many on global diversification

Despite the slightly lower rewards of foreign stocks, the most erful argument, paradoxically enough, can actually be made on thebasis of return Most investors do not simply select an initial allocationand let it run for decades without adjustment Because of the varyingreturns of different assets over the years, portfolios must be “rebal-

pow-Figure 4-9 S&P 500, EAFE, and inflation, by decade (Source: Morningstar Inc.)

anced.” To see what rebalancing means, let’s look at the two-year

peri-od from 1985 to 1986

The overall return of the S&P 500 for those years was quite high—57%—but the return of the EAFE was off the charts—166%! Had youstarted with a 50/50 portfolio at the beginning of the period, at theend, it would have been 63% foreign and 37% domestic Rebalancingthe portfolio means selling enough of the better performing asset (inthis case, the EAFE) and with the proceeds buying the worse per-forming asset (the S&P 500) to bring the allocation back to the 50/50policy

Had you rebalanced a 50/50 S&P 500/EAFE portfolio every twoyears between 1969 and 2000, it would have returned 12.62% Thiswas almost one-half percent better than the best-performing asset, theS&P 500 Why? Because when you rebalance back to your policy allo-cation (your original 50/50 plan), you are generally selling high (thebest performer) and buying low (the worst performer) So, over thelong haul, international diversification not only reduces risk, but it mayalso increase return But be warned: as the past decade has clearlytaught us, foreign diversification is not a free lunch, especially if yourtime horizon is less than 15 or 20 years

Until recently, the average U.S investor did not have to worry aboutdiversifying abroad—it simply wasn’t an option Although domesticinvestors have been able to purchase foreign stocks for more than acentury, in practice this was expensive, cumbersome, and awkward; itcould only be done one stock at a time Although the first U.S.-basedinternational fund opened its doors almost five decades ago, it wasn’tuntil the early 1980s that these vehicles became widely available In

1990, the Vanguard Group made available the first easily accessible,low-cost indexed foreign funds

What is the proper allocation to foreign stocks? Here we run into anenormous problem—one that makes even the most devout believer inefficient markets a bit queasy The rub is that the total market cap ofnon-U.S stocks is about $20 trillion versus only $13 trillion for the U.S.market If you believe that the global market is efficient, then youshould own every stock in the world in cap-weighted fashion, mean-ing that foreign companies would comprise 60% of your stock expo-sure This is more than even the most enthusiastic proponents of inter-national diversification can swallow

So what’s a reasonable foreign allocation? Certainly less than 50% ofyour stock pool For starters, foreign stocks are more volatile, in gen-eral, than domestic stocks on a year-by-year basis Second, they aremore expensive to own and trade For example, the Vanguard Group’sforeign index funds, on average, incur about 0.20% more in annual

expenses than their domestic index funds Finally, a small portion ofthe dividends of foreign stocks are taxed by their national govern-ments Although these taxes are deductible on your tax returns, thisdeduction does not apply to retirement accounts Here, it is lostmoney.

Experts differ on the “optimal” foreign stock exposure, but mostagree it should be greater than 15% of your stock holdings and lessthan 40% Exactly how much foreign exposure you can tolerate hinges

on how much “tracking error” (the difference between the ance of your portfolio and the S&P 500) you can bear Take a lookagain at Figure 4-9 An investor with a high foreign exposure wouldhave suffered accordingly in the nineties Although their returns wouldhave been satisfying, they would have been much less than thoseobtained by their neighbors who had not diversified So although thelong-term return of a globally diversified stock portfolio should beslightly higher than a purely domestic one, there will be periods last-ing as long as 10 or 15 years when the global portfolio will do worse

perform-If this temporary shortfall relative to the S&P 500—tracking error—bothers you greatly, then perhaps you should keep your foreign expo-sure relatively low If it does not bother you at all, then you may beable to stomach as much as 40% in foreign stocks But whatever allo-

cation you settle on, the key is to stick with it through thick and thin,

including rebalancing back to your target percentage on a regularbasis

Step Three: Size and Value

Steps one and two —the stock/bond and domestic/foreign decisions—constitute asset allocation’s heavy lifting Once you’ve answered them,you’re 80% of the way home If you’re lazy or just plain not interest-

ed, you can actually get by with only three asset classes, and thus,three mutual funds: the total U.S stock market, foreign stocks, andshort-term bonds That’s it— done

However, there are a few relatively simple extra portfolio wrinklesthat are worth incorporating into your asset allocation repertoire.We’ve already talked about the extra return offered by value stocksand small stocks The diversification benefits of small stocks and valuestocks are less certain For example, during the 1973–74 bear market,value stocks did much better than growth stocks; the former lost only23% versus 37% for the latter But during the 1929–32 bear market,value stocks lost 78% of their worth, versus “only” 64% for growthstocks The academicians who have most closely examined the valueeffect—Fama and French—insist that the higher return of value stocks

reflects the fact that these companies are riskier than growth stocksbecause they are weaker and thus more vulnerable in hard times.Fama and French’s theory is consistent with stock performance duringthe 1929–32 bear market.

But there are also times when growth stocks demonstrate their ownpeculiar risks As we’ll see in the next chapter, from time to time, thepublic becomes overly enthusiastic about the prospects for companies

at the leading edge of the era’s technology These growth stocks canappreciate beyond reason—as happened in the late 1990s in the tech-nology and Internet areas When the bubble deflates, however, largesums can be lost On the other hand, we usually don’t have to worryabout a bubble in bank, auto, or steel stocks

There can be no question that small stocks are riskier than largestocks Small companies tend to be insubstantial and fragile Moreimportantly, they are thinly traded—relatively few shares changehands during an average day, and in a general downturn, a few moti-vated sellers can dramatically lower prices From 1929 to 1932, smallstocks lost 85% of their value, and from 1973 to 1974, a 58% loss wasincurred Why invest in small stocks at all? Because over the very longhaul, they do offer higher returns; this is particularly true for smallvalue stocks, as we saw in Figure 1-18

How much of your portfolio should be held in small and valuestocks? Again, it depends on the amount of tracking error you can tol-erate Small stocks and value stocks can underperform the broad mar-ket indexes for very long periods of time—in excess of a decade, asoccurred in the 1990s To demonstrate this, I’ve plotted the returns ofthe market, small stocks, large-value stocks, and small-value stocks forthe past three decades in Figure 4-10 From 1970 to 1999, small-valuestocks had the highest return (16.74% annualized), followed by large-value stocks (15.55%), the S&P 500 (13.73%), and small stocks(11.80%)

But Figure 4-10 also shows that during the last ten years of the

peri-od, this pattern was virtually reversed, with the S&P 500 being thebest-performing asset, and small value stocks, the worst So, again, itcomes down to tracking error: how long are you willing to watch yourportfolio underperform the market before it (hopefully) turns aroundand pays off? If you cannot tolerate playing second fiddle to your moreconventionally invested neighbors at cocktail parties, then small stocksand value stocks are not for you

What is the maximum you should allot to small stocks and valuestocks? This is a tremendously complex subject that we’ll tackle insome detail in Chapter 12 In general, you should own more large-capstocks than small-cap stocks In the large-cap arena, you should have