Week 220 - Diversification Among Core Assets

Situation: Individual stocks are not a core asset unless you’ve created your own diversified mutual fund (i.e., 40+ stocks covering all 10 S&P Industries). The reason why individual stocks are considered a liability and not a core asset is because competition (aided by unforeseen technological advancements) can doom the prospects of any one company. There are 5 Core Assets, and your investment portfolio will need representation from some of each:
   1) diversified US stock mutual funds, especially index funds like VFINX and VEXMX (see the Table).
   2) Bonds, mainly US Treasuries but also intermediate-term investment-grade bond index funds like VBIIX (see the Table).
   3) Commodity-related investments. The relevant index fund is a “broad basket” collateralized futures ETF composed of iShares S&P GSCI Commodity Indexed Trust (GSG in the Table).
   4) Real estate. Most of us already have too much invested in real estate (i.e., the equity in our homes). The relevant REIT index fund is VGSIX in the Table.
   5) Cash-equivalents such as Savings Bonds, a Savings Account at an FDIC-insured bank, a short-term Treasury fund like VFISX (see the Table) or 3-6 month Treasury Bills purchased for zero cost at treasurydirect.

Mission: Set up a reasonable asset allocation, i.e., one that has worked well for me, using index funds as examples. This allocation needs to meet the standards of an acceptable personal retirement investment fund, and it does. However, opinions vary across a large spectrum. At one extreme, we have Warren Buffett who recommends that his relatives rely on a low-cost S&P 500 Index fund for 90% of their asset allocation, with the other 10% being invested in a short-term US Treasury fund. However, most investment advisors stress the importance of balancing among the 5 Core Assets listed above. In other words, hedge your bet on stocks even though the S&P 500 is well known to have outperformed all other asset classes over all rolling 20-yr periods on record. Warren Buffett takes a dim view of hedging strategies and continues to make bets that the S&P 500 Index will outperform international indexes as well as an esteemed group of hedge funds. The main reason for you to hedge your bets is that you’re not as rich as Warren Buffett’s relatives and could be financially devastated by a crash in the S&P 500 Index (if that’s where 90% of your retirement assets reside). So, hedging is a form of insurance and you’ll be glad you have it. (I never feel bad about dollar-averaging 30% of my new investment dollars into 10-yr Treasuries and Inflation-Protected Savings Bonds.) 

What lies at the other end of the spectrum of advice being offered by investment advisors? Well, if you include accountants and business school professors as “advisors” you’ll find a sizeable minority who recommend that most of your retirement savings be in US Treasury Notes and Bonds having as average of ~5 yrs remaining until maturity. You can do that yourself simply by dollar-averaging into 10-yr Treasury Notes through the zero-cost Treasury website. When I was living in New York City (while going to medical school), I had a personal accountant who made that exact recommendation when I asked for his views on asset allocation. I had great respect for him as a wise and prudent man but thought his recommendation bordered on the absurd. Then, a few years ago, I went to business school and started hearing the same view again, first from an accountant in my study group and then from a professor of Banking and Finance. Finally, I read Henry Paulson’s book about his experiences as US Treasury Secretary, titled “On the Brink.” Prior to that posting, he’d been the CEO of Goldman Sachs. In the book he mentions that his personal savings are limited to bonds. In other words, the message you’re hearing at this end of the spectrum is that bonds are backed by the assets of the institution issuing them, whereas, stocks are backed by nothing other than a faith in future earnings.

Execution: We recommend that you balance stock and fixed-income investments 50:50. Real Estate Investment Trusts (REITs) are a hybrid between stocks and bonds but (when assembled into and REIT) they’re essentially a type of bond called a “growing perpetuity” and I allocate 15% there. Cash equivalents are also bonds and I allocate 5% to those. Then I allocate 15% to intermediate-term bond index funds and 15% to Treasury bonds and notes, which brings me up to 50% allocated to fixed-income. For stocks, I allocate 30% to S&P 500 stocks (which represent 75% of the US market) and 10% to smaller capitalization stock mutual funds. Commodity-related stocks represent 10% of my portfolio, though the recent underperformance of many “long cycle” investments has caused many advisors (including me) to cut back to 5%. In summary, you now have a formula for allocating 50% to stocks and 50% to bonds or bond hybrids (see Table).  

Bottom Line: Core assets are vital to your financial well being. There are 5 categories, and this week’s Table gives index fund examples using an allocation that has worked well for me. By mixing 5 core assets you create your own hedge fund, the idea being to match returns of the S&P 500 Index over time while taking on less risk of a serious loss. Note: risk-adjusted returns for index funds in the commodity-linked and smaller capitalization stock categories typically underperform actively managed mutual funds. 

Risk Rating: 5

Full Disclosure: I dollar-average into 10-yr Treasury Notes, and have VFINX-like and VEXMX-like investments in my 401(k).

Note: Metrics highlighted in red denote underperformance relative to VBINX. Metrics are current for the Sunday of publication.

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