True Diversification

[getoutearly]

I keep seeing posts implying they are fully diversified. Then they give their allocations, and they are actually about 90% in the US market (US small caps, US large cap, US Mid cap, US short term bonds, US long term bonds. With maybe 10% in international

Am I missing something, or, if you are allocated like that, you are still 90% in the US market. If the US market tanks, most of your portfolio tanks to some extent. If you are planning to ER FI, that's not a comforting feeling.

Anyone have a recommendation for a Trully diversified portfolio? I've read some books lately that seem to make a lot of sense (How to Retire Early, and Enjoy Life, on less than $1MM is one), that make the argument to get truly diversified with very much noncorrelated investments.

Here's my portfolio thinking:
20% US stock index fund
20% International stock index fund
20% Emerging Markets (probably a managed fund, unless someone knows of a good index for emerging markets?)
20% Real Estate (REITS or individual houses / duplexes / apartments)
20% International Bonds?

Thoughts?? I'm thinking this is the portfolio (or something like it) that will work when you are building up your retirement, as well as after retirement.

Where are the holes in my theory?? (I'm sure there are plenty; I just can't seem to see them right now)

Gracias

 

[JPatrick]

Here's my portfolio thinking:
20% US stock index fund
20% International stock index fund
20% Emerging Markets (probably a managed fund, unless someone knows of a good index for emerging markets?)
20% Real Estate (REITS or individual houses / duplexes / apartments)
20% International Bonds?

Don't know anything about you, but here are a couple of thoughts:
*Excessive Emerging Markets.  Only 5 to 10% Try VEIEX for an index.  Try FEMKX if you want managed and better performance.
*I think it is the wrong time, wrong place for 20% REITS.  Maybe 5-10%.
*Within your international bonds I'd insert about 5% emerging nations bonds. FNMIX works for this.
* Use the funds you cut from EM and reits to get a good mix of US stocks.
*FSIIX is a good choice for that 20% International.

I could be wrong

 

[Gearhead Jim]

The big question is, "If the US markets tank will the foreign markets do any better?"

I don't know the answer, but there are intelligent people on both sides of the issue.

It probably would depend on WHY the US markets tanked. If you can accurately predict the reason and timing for the US problems, then you might be able to answer the rest. Otherwise...

 

[Marshac]

Gold has been in my portfolio since early 2005. Yup. I know.... no divs, etc. Regardless of that though, I have noticed that it has acted like a shock absorber in my relatively small portfolio...the performance has been nice too. Anyone know the beta for gold (or even GLD for that matter)?

 

[Delawaredave]

I've been reading David Swenson's (Yale endowment manager) book. Excellent reading.

His theme is "equity orientation with substantial diversification". Be an owner, not a lender (hates bonds). Aggressively diversify across asset classes that done correlate. Buy into asset classes when valuations are reasonable / out-of-favor.

Below is mix of Yale. Real assets is both Real Estate and natural resources (lots of timber). Suprising to me how low US stock portion is.

Domestic Equity 14.9%
Absolute Return 25.1
Foreign Equity 14.6
Private Equity 14.9
Real Assets 20.9
Fixed Income 7.4
Cash 2.1

 

[ladelfina]

Ddave, what's the nature of "Absolute Return"? (sure sounds good!)
That's the biggest chunk..

The equity is 1/3 domestic, 1/3 foreign, 1/3 private; since most people don't access private equity, the 50/50 domestic/foreign sounds about right to me at this point. All my gains lately have been from foreign stocks; if I held only domestic I would probably be behind.

I don't know why, but I would be nervous with getoutearly's 20% US and 60% foreign scenario. Can't put my finger on it; could just be emotional.

 

[wildcat]

I doubt any of us have access to some of Yale's investments - private equity and real assets to name two. They actually own the assets of timber land and do not invest via Plum Creek or some other timber REIT. If I had access to those investments I would consider owning less in the way of pure equities too.

Back to the OP -

I recall reading some asset allocation academic paper and it suggested an international allocation beyond 25-30% will provide your portfolio with unwanted currency risk - i.e. diminishing diversification effects and it could hamstring you in the end. So you basically have 60% open to currency fluctuations once you include another 20% in intl' bonds assuming it is all unhedged. I would not be comfortable with that much and I believe I have quite a bit - about 25% and I rebalanced out of emerging markets at the beginning of the year. Just remember how much the emerging markets move if the US has a hiccup.

I would cut the emerging markets allocation and slice and dice among different market cap/style US index funds. Why just intl' bonds? If I were to have 20% real estate in a portfolio it would be through direct investment/ownership and I don't think I would rush into REITs - yields are a major part of your return and its yield is very low from historical levels.

 

[dlhanson]

Yale Lazy Portfolio

Actually Swenson recommends the following diversified portfolio, with actual example funds from Vanguard:

Total Market Index (VTSMX)   30%
Total International Stock Index (VGTSX)   20%
REIT Index (VGSIX)  20%
US Treasury Bond index (VFISX) 15%
TIPS bond index (VIPSX)  15%

This includes 30% bonds.  He discusses these in his Core Assets chapter of his book.  Paul Farrell wrote an article about this portfolio which is available at marketwatch.com

 

[Spanky]

The big question is, "If the US markets tank will the foreign markets do any better?"

Probably not.

 

[vinhmen]

Ddave, what's the nature of "Absolute Return"? (sure sounds good!)
That's the biggest chunk..

Hedge funds

 

[cute fuzzy bunny]

I'm thinking lately that asset allocation is a lot of fun, but I'm not sure how productive it is.

Over longer term periods - say 15 to 20 years - you have a tough time beating a broad index.

Over shorter time periods, say 1 to 10 years - you might get some traction IF you pick the right buckets AND put enough into them to matter. The only problem is, finding the right buckets and avoiding the wrong ones.

Current asset allocation 'schemes' look at data historically and note historic yings and yangs and historic correlation and coupling of various asset classes. Aside from a few obvious connections that directly affect some assets, those buckets may or may not do anything remotely like what they did historically. I think you can analyze the bejesus out of it and think you see something, or go with a surface logic "these all moved differently and/or did well when these other ones didnt" and think you've got something.

A lot of that data relies on economic situations in the 50's, 60's, and 70's. Politically, economically and financially a very different time than the ones upcoming. A lot of them include a period during the late 90's that may have been a once in a lifetime event.

I was really into the slicing and dicing until I decided that I was probably fooling myself. Sure, I had good energy, precious metals and reit holdings that had just kicked the doors down; it was pretty easy to feel pretty smart.

Now...five or ten years ago, would you have picked those as being great places to put a large chunk of money? If you didnt bet big, you didnt really make much of it.

I've actually been into portfolio simplication lately. I did say several years ago and have felt so until recently that overall market indexes were slugs and overpriced. I dont feel so much that way anymore. My taxable portfolio these days is a big chunk of target retirement 2045 alongside a big chunk of windsor II; IRA is split between TSM and small cap value. Roth is in the Asset Allocation fund. So taxable is mostly large cap with a strong value tilt while IRA has more mid cap and a small cap value tilt.

5 funds down from about 20 a year or so ago. Dropped my expense ratio down to .18.

A lot of those large caps are multinationals. The funds own 8.5% foreign directly, so I have some of that.

I think that sometimes by "diversifying" you might refocus money from a broader chance to make lots of little wins to a narrower chance of making a big win in a lot of narrower categories.

Now if I only knew what was going to be hot, continue to be hot, or stop being hot over the next 10 years...

 

[free4now]

Good post. I think some people use "diversification" as an excuse to justify market timing that they wouldn't have done otherwise. They notice that REITs or gold or whatever is hot and then tell themselves they are getting into it for diversification when really they are doing market timing.

I especially see this with international... everyone is boosting their international percentage now that it's the hot thing. That's fine if you understand that you are doing market timing. But don't kid yourself that you are doing it for diversification. If you got into international 10 or more years ago and held it throughout all the declines, then you can claim to be a diversifyer. But if you looked at international over the past decades and didn't jump in until recently, you are timing.

 

[73ss454]

CFB,

You say that you have TSM in your IRA, would it be better served in a taxable account?

 

[cute fuzzy bunny]

Why?

I'm looking for long term growth, 20+ years, low cost.

What would I have in there instead?

In my taxable, I have target retirement 2045, a good sized portion of which is TSM, and a high dividend yield component.

Gives us additional income and good medium to long term growth.

Tax efficiency is sort of irrelevant. I either dont pay any or dont pay much.

Quite intentionally and by plan.

 

[Spanky]

They notice that REITs or gold or whatever is hot and then tell themselves they are getting into it for diversification when really they are doing market timing.

Sometime it is called momentum inesting ot strategic allocation.

 

[cute fuzzy bunny]

Oh...you mean speculation on a time table?

I did some of that in the late 90's with nasdaq etfs. To some good results early on. Not so good later.

But I guess if I had invested in 5-6 "buckets" I could just say that one was 'underperforming' and that the others would be 'kicking in' to keep the 'peanut butter' 'spread around' or some such.

If I said it with an english accent, it'd be positively compelling.

 

[73ss454]

Why?

I'm looking for long term growth, 20+ years, low cost.

What would I have in there instead?

In my taxable, I have target retirement 2045, a good sized portion of which is TSM, and a high dividend yield component.

Gives us additional income and good medium to long term growth.

Tax efficiency is sort of irrelevant.  I either dont pay any or dont pay much.

Quite intentionally and by plan.

If the target retirement has a large holding of TSM would it be cheaper to just hold Index funds such as TSM?

From what I've been reading it seems that TSM is better served in a taxable account. Just trying to learn which is best.

 

[cute fuzzy bunny]

Well, conventional wisdom of an accumulator is to hold stocks in your taxable and bond/reit holdings in your IRA/401k where the nonqualified dividends wont bang you in the head while you're in a high tax bracket.

Its still a good idea to hold tax inefficient holdings in your IRA after you're retired, unless you need access to the income.

The target retirement starts with a lot of stock now, and by the time we're in our 60's will be in the 60/40 range. I dont have to sell shares or rebalance.

For an ER that doesnt need high current income...like, say if you have a working wife...my plan is to keep the bond holdings low, keep the qualified dividend income high (and limited), and make as few changes as possible between now and when we start getting pissed that we arent going to get social security

My wife has a small invested pension plan and a small but growing 403b. When I feel the urge to 'tinker', I change her asset allocation all around. About once a year. Settles the urge. Nobody gets hurt.

 

[73ss454]

Got it, thanks.

 

[cute fuzzy bunny]

ust trying to learn which is best.

By the way, me too. I figure in ten years I'll know...

 

[ladelfina]

Most of the foreign stuff I have was bought in the 70s and 80s (credit my dad, may he rest in peace) but it's only Latin America, which is going gangbusters now. I recently added some EEM to balance things out, and that's going well, too. I don't think it's "market timing" to pull your head out of the sand and see that America is not the economic engine that it once was with respect to "everyone else". The rest of the world has a lot of growing to do.

 

[ats5g]

I think one of the major reasons that a whole lot of people only recommend 20-30% int'l and 80-70% US stocks is that they simply take the yearly returns of the MSCI EAFE and S&P 500 from 1970-today, and then use Excel [or whatever] to find the portfolio with the lowest volatility. This is all fine and good, but why should we believe that this will continue? Int'l stocks and bonds represent roughly 50% of the world market. I wish Vanguard would start an int'l bond fund and an int'l small cap index fund.

Now, there are some behavioral issues. Mainly that investors tend to want to overweight their home country for a variety of reasons. I think it's mostly because the emotional pain that investors feel when their country's stocks do better than a diversified portfolio is much higher than when another country's/region's stocks do better. Plus, when our country's stocks do much better than everyone else's, a whole lot of our country's media is going to do a lot of stories about how "smart/savvy/lucky" those investors are by having all their portfolio in our country's stocks

Personally, we're roughly 1/3-1/2 of our stock in int'l stocks. And I'm fine [I think] with the fact that no matter what allocation I choose, it will turn out not to be optimal. I've just got to have the stones to stick to it.

As for emerging markets, check out Active Management's Failure to Deliver in Emerging Markets: A View from the New Economy.

- Alec

 

[Spanky]

My exposure to overseas stocks was about 10% until 2003. Since then it has been increased to 25%.

 

[ladelfina]

Fear of foreign investing is not just emotional or "my country is whupping your country's butt!"  

Anyone who wants to buy individual foreign stocks will find it verrrry hard to get information. I have some Italian stocks and their annual reports come out about 1 year behind. Mexican stocks: I don't even get an annual report! No one in the US covers them, so people are rightly concerned since they don't even have access to the kind of generic info that one might come across in a local (Mexican, Italian, etc., ) newspaper.. The companies with ADRs are the tip of the foreign investing iceberg, and yet there is little to no analysis of even them.

On another level, I might not really want to see the results of serious analysis!    The US is the most transparent investing environment by far, and yet we are periodically subjected to Enrons and Tycos and S&L debacles. Imagine the other countries!!  It is somewhat the "Wild West" of investing.

 

[JPatrick]

As for emerging markets, check out Active Management's Failure to Deliver in Emerging Markets: A View from the New Economy.

- Alec

Your EM reference has some good info, but the meat of the stats is a bit dated. (latest 1999) Still the statement about how great the S&P has been compared to EM (for 5 year period ending 99) makes the case for diversification.  A look at the Fido and VG funds compared to the 500 for the LAST 5 years tells the slightly different story.

[/img]