Vanguard's Bogle comments

[FUEGO]

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Originally Posted by NW-Bound And about holding just VFINX (pure S&P500) for one's equity AA, I believe that has been Bogle's doctrine. Is that true or have I been barking up the wrong tree? In any event, it appears very few of his self-professed disciples really practice that.

I'm not sure EXACTLY what Bogle's doctrine consists of today. But in a nutshell the underlying rationale and premise of Bogle's style of investing is this:

"You can't beat the market. Own it and let the intermediaries extract as little wealth as possible from you."

In other words, owning just 100% SP500 (for your equities component) will go a long way and is a better long term investment vehicle (based on risk adjusted returns) than, say, picking stocks you think will outperform or investing in actively managed mutual funds. My guess is that Bogle today may say but the Total Market Index fund or the Global Market index fund.

The slicers and dicers that tilt towards value, and small and mix in a little REITs and commodities are not following the orthodox Bogle doctrine. They are making their bets on multiple relatively uncorrelated asset classes with the goal being lowering overall portfolio volatility and as a result getting a higher risk adjusted return. The typical tools of implementing this strategy are index funds due to low expense ratios, low hidden trading costs (turnover related), tax efficiency, low tracking error, knowing what you are buying, etc.

[FinanceDude]

Bogle didn't foresee ETF's, ETN's, and inverse ETF's when he authored his principles.

But I am digressing, we have had hundreds of discussions about this on here........

[DblDoc]

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Originally Posted by FUEGO I'm not sure EXACTLY what Bogle's doctrine consists of today. But in a nutshell the underlying rationale and premise of Bogle's style of investing is this: "You can't beat the market. Own it and let the intermediaries extract as little wealth as possible from you." In other words, owning just 100% SP500 (for your equities component) will go a long way and is a better long term investment vehicle (based on risk adjusted returns) than, say, picking stocks you think will outperform or investing in actively managed mutual funds. My guess is that Bogle today may say but the Total Market Index fund or the Global Market index fund. The slicers and dicers that tilt towards value, and small and mix in a little REITs and commodities are not following the orthodox Bogle doctrine. They are making their bets on multiple relatively uncorrelated asset classes with the goal being lowering overall portfolio volatility and as a result getting a higher risk adjusted return. The typical tools of implementing this strategy are index funds due to low expense ratios, low hidden trading costs (turnover related), tax efficiency, low tracking error, knowing what you are buying, etc.

An excellent summary. I think the SP500 "mantra" grew from the fact that it was the original index fund. Now that we have TSM, All World ex USA and more recently the Total World Index they are the funds of choice. Another reason for its persistence may be because it is the only cheap index fund available- this is true for my 403b plan currently.

DD

[freebird5825]

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Originally Posted by FUEGO ...But in a nutshell the underlying rationale and premise of Bogle's style of investing is this: "You can't beat the market. Own it and let the intermediaries extract as little wealth as possible from you."

a.k.a "Cost matters."

[FUEGO]

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Originally Posted by DblDoc An excellent summary. I think the SP500 "mantra" grew from the fact that it was the original index fund. Now that we have TSM, All World ex USA and more recently the Total World Index they are the funds of choice. Another reason for its persistence may be because it is the only cheap index fund available- this is true for my 403b plan currently.

Yes, I think you are right. Decades ago when Bogle first formulated his "doctrine" you just couldn't buy "exotic" funds like small cap value emerging markets ETF's at all, let alone with a fairly modest expense ratio. Now the slice n dice investor is in luck with plenty of sub slices to take advantage of. I personally think the law of diminishing returns applies to quantity of slices too.

I am essentially forced into SP500 index in my Health Savings account because it is either that for 0.4% expense ratio and almost zero turnover or something else with expense ratios 1+% higher and much more turnover.

I think Bogle's take on International was that it was too expensive to own and too risky because of potential for currency exchange rate fluctuation. But with today's international funds available for just a few basis points more ER than domestic funds, the expense question loses importance. Currency risk may actually reduce overall portfolio volatility since it causes international investment returns to be less correlated with US returns.

[FUEGO]

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Originally Posted by freebird5825 a.k.a "Cost matters."

In two words, yes, cost matters.

[FUEGO]

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Originally Posted by FinanceDude But I am digressing, we have had hundreds of discussions about this on here........

That's true. It is sort of like believing in a religion (or denying belief in a religion. You either get it or you don't, and you take it on faith to a certain extent. There is empirical evidence to support the validity of passive indexing, and good evidence at that. But we all must remain at least a tiny bit agnostic and we won't know whether we are "right" until the end. We all make choices in life. When the day of judgment comes, we will either have selected the most optimal path or we will not have.

[FinanceDude]

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Originally Posted by FUEGO That's true. It is sort of like believing in a religion (or denying belief in a religion. You either get it or you don't, and you take it on faith to a certain extent. There is empirical evidence to support the validity of passive indexing, and good evidence at that. But we all must remain at least a tiny bit agnostic and we won't know whether we are "right" until the end. We all make choices in life. When the day of judgment comes, we will either have selected the most optimal path or we will not have.

Good point. I have often wondered why indexers like Bogle think index funds are "passive" when the stocks selected for the indexes like the S&P 500 are done by a committee. In effect, that is "active management"............

One could argue the Wilshire 5000 is the only REAL index fund of domestic stocks in the US, but that's a whole nuther can of worms.........

[FUEGO]

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Originally Posted by FinanceDude Good point. I have often wondered why indexers like Bogle think index funds are "passive" when the stocks selected for the indexes like the S&P 500 are done by a committee. In effect, that is "active management"............ One could argue the Wilshire 5000 is the only REAL index fund of domestic stocks in the US, but that's a whole nuther can of worms.........

Well, I suppose tracking the SP500 is only a little more "active" than tracking the wilshire 5000. Vanguard's SP500 fund had 5.6% turnover last year, meaning the average holding period for the fund's stocks is 17.9 years.

An index fund has to track SOME index after all. And even though the committee selects companies for inclusion in the index, they don't change a lot year to year (at least the SP500). You have to have some method to take out defunct companies and replace them with new companies (new because they grew large, or new because they just listed and went IPO).

In fact, many of vanguard's funds sample indexes and only pick certain stocks to seek to achieve the same returns as the index they are tracking (minus expenses). But this doesn't mean they aren't indexing, they are simply implementing their investment approach in an efficient manner.

[Dudester]

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Originally Posted by NW-Bound If there is "global market efficiency" between asset classes, then one shouldn't bother to rebalance his AA at all, the same as one should not change his stock components inside his MF. Call me a trouble maker, but I just want to ponder.

There seems to be a lot of confusion about the benefits of rebalancing. This confusion has led me to do some investigation on my own. I've never found a good explanation on the Internet, but as near as I can figure out, the benefits of rebalancing can be explained as follows:

Suppose two guys each have a portfolio. Let's call them portfolios A and B. Also suppose that portfolios A and B have the same value at year 1. Further suppose that over a period of N years each portfolio has the same average annual increase in value. Finally, suppose the portfolio A is rebalanced and portfolio B isn't.

Which portfolio has the higher value at the end of N years?

Apparently, the math says that portfolio A has a higher *expected* final value than portfolio B. (I'm using the word "expected" in its mathematical sense. In this sense, "expected" means roughly "most likely." In other words, portfolio A will *probably* be worth more than portfolio B).

Supposedly, the reason for this is due to the fact that rebalancing reduces the variance (another math term) in the annual return of portfolio A. Also note that reducing variance is sometimes considered to be a way of reducing risk. This is what people mean when they say that rebalancing reduces risk.

Now the kicker is that even though portfolio A will probably be worth more than portfolio B at the end of N years, THIS ISN'T GUARANTEED (it's probabilistic rather than certain). I'm reminded of a quote attributed to Damon Runyon:

“The race is not always to the swift nor the battle to the strong, but that’s the way to bet”

To paraphrase:

The riches do not always accrue to the rebalancer, but that's the way to manage a portfolio.

A parting comment: I've also seen comments on the Internet where someone said that they ran a couple of spreadsheet scenarios and didn't observe any benefits to rebalancing. Because of the probabilistic nature of rebalancing, a handful of spreadsheet scenarios proves absolutely nothing.

If anybody has a better explanation for all of this, I would love to hear it.

[samclem]

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Originally Posted by Dudester Suppose two guys each have a portfolio. Let's call them portfolios A and B. Also suppose that portfolios A and B have the same value at year 1. Further suppose that over a period of N years each portfolio has the same average annual increase in value. Finally, suppose the portfolio A is rebalanced and portfolio B isn't. Which portfolio has the higher value at the end of N years? Apparently, the math says that portfolio A has a higher *expected* final value than portfolio B. . . . If anybody has a better explanation for all of this, I would love to hear it.

According to my understanding, Portfolio B (the one that didn't rebalance) would actually have the higher expected value. Here's why: On average, risky assets (e.g. small company stocks) have higher expected returns than less risky assets (e.g. government bonds). If they didn't, people wouldn't invest in them. If Portfolio A and Portfolio B start out with the same mix, Portfolio B will tend to accumulate more and more of these high-risk, high-return assets, since they will tend to gain value at a higher rate than the stodgier stuff. Just as we'd expect a portfolio of 80% stocks to have higher gains than a portfolio of 80% CDs, Portfolio B should be expected to outperform Portfolio B.

On average.

But, that's the catch. We only have one retirement portfolio, and most of us care a lot about it. We aren't trying to maximize our portfolio "on average," we are trying to increase our gains commensurate with the risk we are willing to take. That's why we rebalance. Because Portfolio A has a large number of loosely correlated/uncorrelated asset classes, it's overall volatility is much lower than the increasingly risky Portfolio B. Having al these uncorrelated asssets means that they can each be riskier (achieving an overall better return) than if we tried to achieve the same volatility with a single asset class (stodgy CDs, etc.)

Even though Portfolio B has higher expected returns, most of us properly reject it. Think of it this way: If a guy offered to allow you to bet $100 on the roll of the dice, and would pay you $10,000 if you guess the outcome, would you take the bet? Of course you would--it's a great bet, and on average you'll come out far ahead. But if the same guy insisted that you could only take the bet if you put up your entire retirement savings, would you still take the bet? It's still the same great payoff, and on average it is still a great bet. But, the risk (volatility) is so high that trying to maximize the "average" outcome is not in your best interest.

So, we rebalance not to increase overall expected return in an absolute sense, but to increase overall average return while remaining within our specific risk (expressed as volatility) tolerance.

Yes, there is a sense that rebalancing encourages one to buy assets when they are down and to sell off higher priced assets (locking in gains), thus helping to increase the growth of the overall portfolio. The studies I've read, however, indicate that the effect is smaller than one might have guessed, and that overall letting the more volatile assets keep running (or starting with them to begin with) produced higher expected returns. It's a ride most of us will not find worth taking.

[Dudester]

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Originally Posted by samclem According to my understanding, Portfolio B (the one that didn't rebalance) would actually have the higher expected value. ... The studies I've read, however, indicate that the effect is smaller than one might have guessed, and that overall letting the more volatile assets keep running (or starting with them to begin with) produced higher expected returns. It's a ride most of us will not find worth taking.

You may be right (in fact part of my motivation was to shake the tree to see if someone who knows more than I do about this would fall out). However, under the assumptions that I made, it's not clear to me that portfolio B would end up with a higher expected value.

One of the sources of information about rebalancing that I used is William J. Bernstein's site, in particular, URL: The Retirement Calculator From Hell - Part II

On this page he states:

"Let’s say that we’re examining a 100% stock portfolio for which we’ve assumed a 7% real return, with a returns standard deviation of 12%. Because of "variance drag" (more on this four paragraphs below), in order to obtain an annualized return of 7.0%, we need an average annual return of 7.7%. (If you are confused about the difference between average and annualized returns, take a look at the discussion of this about a third of the way into Chapter 1 of The Intelligent Asset Allocator.)"

Bernstein doesn't seem to go into the details very much, but he seems to imply that by reducing standard deviation (more or less equivalent to variance) one increases total annualized returns (I was using final value as a proxy for annualized returns). In the case of his example above, it's obvious that if the annual return is 7.0% each year, then the annualized return is 7.0%. If you toss in some variance, then it requires an average annual return of 7.7% to produce an annualized return of 7.0% (according to Bernstein).

It appears to me that a portfolio of "risky" stocks is only going to beat out a rebalanced portfolio if the risky portfolio has a high enough average annual return to offset what Bernstein calls the "variance drag." In my earlier post, I assumed that portfolios A and B had the same average annual return. This assumption was critical in my claim that portfolio A has a higher expected final value than portfolio B. Portfolio B doesn't have enough "oomph" to offset the variance drag even though it's riskier.

I would still love to hear from somebody who understands this better than I do.

[samclem]

You're looking in the right spot. Keep poking around Bernstein's site and you'll find lots of great info. He does some good write-ups on Mean Variance Optimizers (MVO) in discussing the Efficient Frontier. Great stuff.

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Originally Posted by Dudester In my earlier post, I assumed that portfolios A and B had the same average annual return. This assumption was critical in my claim that portfolio A has a higher expected final value than portfolio B. Portfolio B doesn't have enough "oomph" to offset the variance drag even though it's riskier.

I think that's the root of the problem. Over time, the assets in Portfolio B will skew to ever-higher average returns as the riskier assets grow..

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Originally Posted by Dudester I would still love to hear from somebody who understands this better than I do.

There are lots of really smart people here, I'm always learning something.

[NW-Bound]

It so happened that as I thumbed through my BusinessWeek issue dated April 20, 2009 before throwing it away, I saw an interview with Bogle. And in this article was a discussion of the very thing that I have been raising in this thread regarding financial stocks. Following is an excerpt, and if you like to read the full article I have also located the link at BW for your convenience.

Jack Bogle's Last Crusade? - BusinessWeek

Of course, some managers did avoid bank stocks or sold before they blew up. There's a powerful counterargument to Bogle's index-funds-beat-all dogma: Because they're passive by nature, index funds have no choice but to hold (and ride all the way down) the likes of Fannie Mae (FNM), Freddie Mac (FRE), AIG, Bear, Lehman, and Citigroup (C). In contrast, Tom Forester, manager of the $68 million Forester Value Fund, eked out a small gain last year, largely by avoiding bank stocks. (The S&P plunged 39%.) Bogle concedes that in times of crisis, the passive approach can be dangerous. "The indexers are the ultimate holders," he says. "They can't sell."

Instead, they should flex more of the muscle they do have, says Bogle. Each spring shareholders vote on corporate directors, an exercise known as "proxy season" because fund managers vote on behalf of their fundholders. Bogle says too many index managers serve as rubber stamps for boards. He proposes they raise their fees a smidge to pay for more due diligence and monitoring. Such an effort, he says, might have influenced the boards of Citigroup and AIG.

Note that the Forester Value Fund mentioned above is a very small fund, hence enjoyed its advantage in agility. Bigger mutual funds like my Dodge & Cox may have a tough time unloading the financial shares. Who would be buying but small investors trying to "catch the knife"?


Regarding Monte Carlo simulation, there is a recent thread on this, started by samclem.

http://www.early-retirement.org/foru...isk-44061.html

I also have some new 2 cents to throw out on MPT for your amusement, along with some links. However, I need time to compose a coherent post, so please bear with me.

It is not that these tools aren't useful, but I think people may not realize their limitations. Remember the LTCM spectacular blow-up in the late 90s, using sophisticated trading strategies? Perhaps they were trying to maximize return without sufficient attention to risks, hence the problem is not the same as our more benign MPT problem which tries to trade off return vs risk. Nevertheless, the blowup may be caused by sensitivities to modeling parameters that in real life deviated too much from their assumptions. Garbage in, garbage out.

[FUEGO]

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Originally Posted by NW-Bound It so happened that as I thumbed through my BusinessWeek issue dated April 20, 2009 before throwing it away, I saw an interview with Bogle. And in this article was a discussion of the very thing that I have been raising in this thread regarding financial stocks. Following is an excerpt, and if you like to read the full article I have also located the link at BW for your convenience. Jack Bogle's Last Crusade? - BusinessWeek Of course, some managers did avoid bank stocks or sold before they blew up. There's a powerful counterargument to Bogle's index-funds-beat-all dogma: Because they're passive by nature, index funds have no choice but to hold (and ride all the way down) the likes of Fannie Mae (FNM), Freddie Mac (FRE), AIG, Bear, Lehman, and Citigroup (C). In contrast, Tom Forester, manager of the $68 million Forester Value Fund, eked out a small gain last year, largely by avoiding bank stocks. (The S&P plunged 39%.) Bogle concedes that in times of crisis, the passive approach can be dangerous. "The indexers are the ultimate holders," he says. "They can't sell." Instead, they should flex more of the muscle they do have, says Bogle. Each spring shareholders vote on corporate directors, an exercise known as "proxy season" because fund managers vote on behalf of their fundholders. Bogle says too many index managers serve as rubber stamps for boards. He proposes they raise their fees a smidge to pay for more due diligence and monitoring. Such an effort, he says, might have influenced the boards of Citigroup and AIG. Note that the Forester Value Fund mentioned above is a very small fund, hence enjoyed its advantage in agility. Bigger mutual funds like my Dodge & Cox may have a tough time unloading the financial shares. Who would be buying but small investors trying to "catch the knife"?

This is consistent with what Bogle has said all along. In his book Common Sense on Mutual Funds, he clearly lays out that typically every quarter or every year, an average of about 25% (give or take) of the actively managed funds beat the index funds. A select few can even do this for a few years in a row. There may be one or two that have a long string of successes (Magellan and Legg Mason Value Trust come to mind).

But the bet on index funds is a bet on the odds. Would you rather be in the 25% that beat the index funds? Of course! To succeed at this you must have a unique skill at selecting mutual fund managers AND the mutual fund managers stay with your fund AND the fund doesn't get too big and suffer from the inefficiences of bloat. Or you could use your own stock research skills to select superior stocks that beat the collective efforts of teams and teams of highly paid highly educated analysts that live, eat and breath equities analysis in their particular field of expertise every day.

Odds are you are going to fall in the 75% of funds that perform below the index. And in the meantime, you may be paying more in taxes if your fund has a lot of capital gains. And these statistics don't account for survivor bias - ie those mutual funds that close and cease to operate due to low subscriptions, massive outflows or near insolvencies.

If, before the fact, you could know to load up on Forester Value Fund, of course you would do so. After the fact it is easy to determine who the winners were and who the losers were.

[samclem]

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Originally Posted by FUEGO Odds are you are going to fall in the 75% of funds that perform below the index.

Ah, but reading this and believing it are two different things. We all want to believe we can do better. We won't be a dumb consumer, we'll find the "right" manager or stock picking system. Just like we are smart consumers and shop for the best value in cars, washing machines, and mortgages, we'll harness the tools of the internet to make the best selection of a mutual fund manager. Just like every other choice in our lives, we're sure we can optimize this one.

Except it's not possible. The data is too murky, the variables too many, the actual factors that will ultimately prove to be of importance too unknowable, and the market too efficient. But the belief that it is possible keeps the retail brokers and the investment pornography purveyors in business. And I think it always will.

But I'm glad there are researchers and stock pickers. Without them (and lots of them) indexing would quickly fail.

[NW-Bound]

It is not possible to predict which mutual fund managers will beat the S&P500, like you said. I do not dispute this at all, and in fact totally agree with it. As I have said, I am slowly getting out of some of the active mutual funds that I have left. However, I may send the MF portion to Buffet, and continue to manage the rest myself.

But I will re-iterate that the collapse of the financial AFTER the housing bubble burst is a crisis, not a normal time. It is not the same thing. It is not about predicting the winner. It is about bailing out of a sinking ship. Bogle admitted as much in the interview which I referenced.

The dogma of the "market efficiency" purists is that it will not allow you to acknowledge a calamity even if the entire world, not just yourself, can see it coming.

Malkiel, a buddy of Bogle and also a market efficiency believer, told of this self-mocking joke in his book, "A Random Walk down Wall St", that I will retell as follows. This joke is about the other side of the coin, about trying to profit, and not avoiding losses.

Two economists were discussing the economy while walking down the street. One interrupted the other to point to a $20 bill laying on the sidewalk that someone has dropped. The other shrugged and said to ignore it. Why, the first one asked. The other, being a market efficiency theorist, said "It is a mirage. If it were real, someone else would have picked it up long ago".

By the way, my edition of Random Walk is an older one. After the 2000 meltdown, Malkiel released a newer edition with new material to cover the tech bubble but I have not read it. Even in my old edition, Malkiel conceded that the market is efficient only in the long term. In the short term it is not, else how would bubbles developed.

So, it is up to the investor to see for himself if the $20 bill is real or not. My problem is that my poor vision does not allow me to see clearly all the time. But if I see a bill, I would pick it up. Or if I see a pot hole, I would sidestep it instead of accepting the fatalistic attitude that I must suffer a fall because of it.

[FUEGO]

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Originally Posted by NW-Bound The dogma of the "market efficiency" purists is that it will not allow you to acknowledge a calamity even if the entire world, not just yourself, can see it coming.

The problem is that as the collective knowledge of the market is created, everyone is reacting. By the time it is known as conclusive fact that X is going to happen, everyone has already bought or sold in reaction to X happening. In other words, by the time you know, it is too late.

That's not to say that $20 bills aren't waiting around in the market for someone to pick up. I have picked up a few on a particular arbitrage trade that I have executed repeatedly and done pretty well on that trade over the last few years. But it is a highly competitive marketplace with millions of market participants constantly trying to exploit their perceived or real competitive advantage.

By the way, I sort of tend to agree with you that at times you can intuitively spot market extremities (bubbles or inverse bubbles). I personally called it with the Chinese stock market bubble (didn't execute any trades though), the energy bubble (didn't execute other than avoiding buying any energy funds other than what is in the index funds, but had an option play lined up that would have paid 1000% returns if I had brass balls to execute), the bottom of the bank inverse bubble (going triple leveraged long on Mar 4). Treasury bubble. Junk bond inverse bubble. But I have also guessed wrong on some "bubbles" too. I would never put enough faith in my bubble-guessing skills to put any significant portion of my portfolio at risk pursuing those strategies. Just a little play money on the sidelines to keep me away from Las Vegas.

I have to admit I have a good bit of insight into behavioral finance. I sit on the management committee of our company's pension plan. The two other members are fairly novice investors. They constantly get sucked into the latest investing fad. I have to dissuade them out of their crazy notions constantly. So I know something is a bubble when the committee really gets interested in buying something! Energy, chinese stocks, utilities, junk bonds, treasuries, financials, etc.

[NW-Bound]

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Originally Posted by FUEGO The problem is that as the collective knowledge of the market is created, everyone is reacting. By the time it is known as conclusive fact that X is going to happen, everyone has already bought or sold in reaction to X happening. In other words, by the time you know, it is too late. ... Just a little play money on the sidelines to keep me away from Las Vegas.

Ah, but that's exactly the argument of the "market efficiency" theorists. But instead of believing in the "wisdom of the crowd", I tend to watch out for the "madness of the crowd" instead. Yes, as samclem wrote, the facts are often murky, and the variables too many. True, true. We all acknowledge we lack a crystal ball. Hence, the advice to do nothing rather than react violently to some rumors du jour often works out. Stay the course! Yes! But no exception? Don't count me in.

It is sometimes the lack of knowledge, not the crystal ball that keeps us from making an better-informed decision. We did not get to see the balance sheets of the financial stocks to decide to stay or to flee. I decided to flee and I am glad. Maybe I was just lucky. Who knows?

Buffet, in the late 07 when one bank after another admitted to capital shortfall, was asked by a reporter about the unfolding events. He said "when the tide is out, that's when you can see who has been swimming naked". He later decided to bail some of them out with his cash hoard, selling them beach towels at dear prices. He knew what he was doing, in addition to having info the public might not have. Again, I stayed clear of the financials, but actually bought some indirectly via Berkshire shares. I have not made any money yet, but I am willing to wait on these shares. Stay the course!


PS. Ah, if you keep prodding, you'll find out that none of these Bogle disciples could really stay away from the card table. Do they get excommunicated?

[DblDoc]

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But I will re-iterate that the collapse of the financial AFTER the housing bubble burst is a crisis, not a normal time. It is not the same thing. It is not about predicting the winner. It is about bailing out of a sinking ship. Bogle admitted as much in the interview which I referenced

I disagree. I think his point (which was not elaborated on further in the article) is that you take your lumps knowing that the index will eventually recover - you do not "bail" on the index or try to pick out the winning or losing sectors, simply hold them all passively within a cheap index fund.

DD