Total market index vs asset classes

[Roger_R]

I am just about on my last book to start reallocation of my traditional brokerage mutual funds into lower cost indexes. A couple of my books are on loan, so I may not be able to reference them well, but my take is that there is one school of thought (Random Walk Down Wall Street) that favors total market index funds. And that another (was it Four Pillars) favor asset allocation into the four or so classes of large growth, small growth, large value and small value index funds. Could you, the savy investor help me, the new guy with the differences and advantages of these two strategies? They seem quite similar to me?

[wabmester]

If you believe that the market is efficient and "smart", then go with the total market approach. If you want to try to beat the market, perhaps with a bit more risk, then take the segmented approach.

It's basically a toin coss, but historically the segmented approach has done a little better -- it also requires a little more work to rebalance. There's no guarantee it'll continue to do better going forward, of course.

Or take a hybrid approach (which is what I do), and make TSM your core holding and augment it with side bets on asset classes, sectors, individual stocks, whatever.

Yet another approach is to buy the total market, but to evenly weight rather than cap weight. This is essentially equivalent to being overweight in small cap.

The theory behind buying a cap-weighted total market index is that "smart" investors have already done the homework for you and allocated capital across all of the sectors and segments in the most efficient manner possible.

The theory behind segmenting the market is that some segments historically have consistently outperformed others (like small value) and some consistently underperformed (like small growth and midcaps), so you allocate more to the hot performers and less to the underperformers and try to balance out the risk by picking additional classes with low covariance, etc.

[Michael]

One thing about the 4 classes is that the majority of investors cannot follow it. *If the majority tried to put half of their portfolio into small caps, the valuations would become unreasonable. *Total stock market is a strategy that the majority of investors can follow, and 4 classes is a niche strategy that can only be followed by a small minority of investors, in the hopes of outperforming the majority.

When people say that the majority of investors are better off in total stock market, this is true because there is no place else the majority can profitably go. * When people say a small minority of investors can follow a strategy that has outperformed the majority in the past (no guarantees for the future), this is also true. *If too many people decide to put half of their portfolio into small caps, the strategy will badly underperform the total stock market. It is a judgement call as to when this point has been reached. A minority can sometimes outperform the majority, but the majority cannot possibly outperform itself.

[unclemick]

Nip over to Bernstein's Efficient Frontier website and read Spring 2004 lead article. It will give you a sense of the thrills and chills of slice - not his main point(performance) - but my prejudice. Read and see how it stikes you.

I'm a Boglehead - costs matter. But being less than pure:

70% - Lifestrategy(mod & cons) - ala Bogle's 'policy portfolio.

10% - REIT Index - ala Bernstein's low correlation

20% - hobby stocks ala Geraldine Weiss dividend payers and Ben Graham value types. Mostly DRIPs.

In sum, more toward the TSM camp but with other stuff.

[WilliamG]

Hi Roger -
One additional item for me in favor of the multiple asset classes approach: As a retiree we are faced with recurrent decisions as to where our spending money will come from. For me, I do that once a year when I rebalance. Having your assets broken out in different asset classes allows you to make a conscious decision about where to take money; i.e., you don't necessarily have to sell an asset class which is down. With a "total" fund you are selling on a pro-rata basis.
Regards, Bill

[Roger_R]

Thanks you for your suggestions and comments. I like the idea of using a total market as a core and then adding on some different domestic fund classes. The Efficient Frontier site had some interesting comments. With regard to the articles, it seems like small growth and value has been a good performer lately, but my guess is that rising interest rates with make debt more costly for these smaller companies. Of course, I'm learning to outguess things these days .