This turns out to be a pretty good instinct. After all, people consistently brag about their winning bets without disclosing their losers. They also tend to obsess over whatever’s happened in the markets most recently, assuming things will be that way forever.
But the one thing that we all ought to be able to agree on is this: The point of any long-term portfolio for the vast majority of investors is to earn whatever return you need to meet your goals while taking the least amount of risk.
I recalled this first principle of investing when I heard about something called the Larry Portfolio earlier this year.
Named for Larry Swedroe, the director of research and a principal at BAM, a wealth management firm in Clayton, Mo., the portfolio tracks indexes that achieved nearly the same 10 percent annual return between 1970 and 2010 as a portfolio invested entirely in the Standard Poor’s 500-stock index. And here’s the Larry Portfolio’s trick: It did so with less than a third of its money in stocks, with the rest in one-year Treasury bills.
So how does it work? It starts with a bit of investing history. Between 1927 and 2010, small-cap value stocks outearned the S. P. 500 by roughly four percentage points annually. This is according to an index of such stocks that two academics, Eugene Fama and Kenneth French, developed in conjunction with their research on the small-and-value phenomenon.
The reasons for this outperformance aren’t entirely clear, though plenty of theories exist.
Smaller companies may be more vulnerable if they lose a single big customer, or if a single big lender cuts them off. Value stocks, which generally have low price-to-earnings ratios, often have more debt. Then there are the many investors who choose growth stocks over value, buying them up because they tend to be more familiar names.
What these factors share is that they all have something to do with risk. For whatever reason, market participants see small and value companies as being more risky. So on average, it makes sense that investors should expect to get a little more back over the very long haul if they have the guts to take the risk and invest in them.
Mr. Swedroe, who is 60, was not the first person to build investment portfolios around these ideas. But he was particularly well suited to get the word out.
As a young adult, Mr. Swedroe, who was Bronx-born and still talks like it, worked diligently toward a night-school Ph.D. and considered becoming a professor. Instead, he found his way into the risk management field, working for CBS, the old Citicorp and Prudential Home Mortgage.
A friend had started a money management firm called Buckingham Asset Management in Missouri and was struggling to explain his investing philosophy to new clients. Seeing an opportunity to satisfy his teaching urge, Mr. Swedroe agreed to join the firm and help spread the word.
In the 15 or so years since then, Buckingham has come to be known as BAM and oversees investment strategy for other firms’ clients, too. Mr. Swedroe, the co-author of “Investment Mistakes Even Smart Investors Make and How to Avoid Them” and many other books, became enough of a cult figure that BAM’s Web site now sheepishly explains that, alas, he’s too busy to be the personal adviser for every BAM client who wants him to serve in that role.
As for the Larry Portfolio, which he prefers to refer to by more technical names, the only stocks it contains are mutual funds that hold small or value stocks (preferably both) from around the world. Everything else tends to go into very safe bonds.
For illustration purposes, he points people to the S. P. 500 index, which returned about 10 percent annually between 1970 and 2010. If you wanted to gin up a portfolio to match closely (at 9.8 percent) that performance with much less risk, all you would have needed to do was put 32 percent of your money in a fund mimicking the United States stock index of small and value companies that Mr. Fama and Mr. French developed. Then you’d put the other 68 percent of your money in one-year Treasury bills.
The execution is where this gets a little complicated. Mr. Swedroe, who invests this way with his own money, and BAM use small-cap value funds from, among others, Dimensional Fund Advisors, where both Mr. Fama and Mr. French are consultants and board members. Retail investors generally can’t put money into the funds unless they work with advisers who have been vetted by D.F.A. and have attended its California boot camp, which I wrote about in January. (Some 529 college savings and workplace retirement plans include D.F.A. funds too.)
Then there are the caveats. While having just 32 percent of your portfolio in stocks means you can lose only so much, that low equity allocation also keeps you from winning big when stocks are on a multiyear tear.
In fact, whenever something like the Larry Portfolio looks different from whatever the Dow or the Nasdaq are doing, there is sizable risk of regret. In 1998, for instance, the S. P. 500 earned 28.6 percent, while that Fama/French index lost 10 percent.
Anyone watching that unfold in slow motion would be at risk of giving in and selling, thus locking in their losses. “You have to tell yourself that you are not going to have portfolio envy or listen to what Jim Cramer is saying on CNBC,” Mr. Swedroe says. “Are you willing to pay that price?” (If you are, you might also see years like 2001, where the Fama/French index gained 40.6 percent while the S.P. 500 lost 11.9 percent.)
Education is the armor that protects you from emotions, according to Mr. Swedroe. Given who he works for, he’s a big believer in the idea of hiring an educator — an investment adviser — who protects you from the hair-trigger impulses that position your fingers over the sell button.
Lest you think this is all a ruse to get people to pay BAM’s fee — up to 1.25 percent of their invested assets annually, with additional family members benefiting from discounts — it’s worth noting that Mr. Swedroe spends about an hour on most days answering questions from people who write to him, BAM clients or not.
His challenge is that there aren’t a lot of options for people who want to have all of their stock money in the kind of inexpensive, very small and deep-value mutual funds that can most efficiently mimic the Larry Portfolio.
And much depends on how you construct that portfolio. Vanguard, using a set of indexes that serve as a foundation for its mutual funds, including an index that goes back only to 1979, couldn’t recreate the Larry Portfolio’s 4o-year performance. Mr. Swedroe countered with a different approach that would at least allow a Vanguard investor to reduce risk significantly without sacrificing returns. (Meanwhile, the future, as always, is unknowable, though all of the science would suggest that the small-and-value outperformance ought to persist.)
People should be so lucky as to have any choice among indexes in the first place. Too many investors are subject to whatever mediocre mutual fund choices their employer puts in front of them in their workplace retirement plans. If you’re not stuck in your employer’s plan, you can take a deep dive on some of the smallest and most value-oriented mutual funds that exist and take your pick. In the online version of this column, I’ve linked to a spreadsheet that Morningstar cooked up for me this week that lists more than 50 of them. Beware, as actively managed mutual funds can and do perform poorly over multiyear stretches with no warning or apology.
The Rydex SP SmallCap 600 Pure Value exchange-traded fund is also worth a look. Its expenses are low, and it contains stocks whose market capitalization, price-to-earnings ratios and price-to-book ratios are all low — attributes to seek from the mutual funds, too.
Hand-holding may still be attractive to you, though, and there are some professionals who can put you in D.F.A. funds for well under the standard annual fee — 1 percent of assets — that many professionals charge. I particularly like AssetBuilder, where annual fees start at 0.45 percent and go down from there. You need $50,000 to get started there.
Other firms worth a look include Index Fund Advisors, Evanson Asset Management and Cardiff Park Advisors. I’ve linked to their fee information from the online version of the column.
Just keep in mind that you may not always get comprehensive tax, insurance and estate advice from more value-priced money management operations. When and if your portfolio number gets bigger and your life becomes more complicated, paying for all of that wisdom is sometimes the best investment of all.
Article source: http://feeds.nytimes.com/click.phdo?i=c7dcdd71963fec3fc2c14a8516e7388d
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